Page 497 - Introduction to Business

CHAPTER 13 Financial Management of the Firm and Investment Management 471

Chapter Questions net present value (NPV)? (Hint: Use a calculator to
do your work.)
1. What are the main responsibilities of the CFO, 12. What are the main sources of financing to pay for
treasurer, and controller in a firm? acceptable capital budgeting projects? How do div-
2. Do financial managers and shareholders always idends affect the use of these financing sources?
work together to maximize share prices? How can 13. Differentiate between the following different types
financial managers be motivated to accomplish of debt: commercial paper, bonds, and Eurobonds.
this firm goal? 14. Why is debt a lower-cost form of external finance
3. Are accounting profits and economic profits the than equity for a firm?
same thing? Explain. 15. A firm has income before interest expenses of
4. How is people’s time preference for consumption $1000. It has interest payments of $400 and a tax
related to the real interest rate? rate of 25 percent. What is the net income before
5. If the real rate of interest is 2 percent and the taxes? Net income after taxes? How much was the
expected inflation rate is projected to be 5 percent tax savings on interest payments due to their tax
over the next year, what should the nominal inter- deductability? Who gets these tax savings?
est rate be? 16. What is investment grade debt? Is it lower or
6. A bank makes a loan for $1000 to a firm at an higher risk than junk bonds? If a firm defaults on
interest rate of 8 percent. How much did the firm its debt, why would it want to file for bankruptcy?
have to pay back if the loan was due or matured in 17. What is an initial public offering of stock by a firm?
one year? What if the firm paid back the loan in Why is this a significant event?
two years? (Hint: Convert present values to future 18. How are securities brokers and dealers alike? How
values using the interest rate. See “The Time Value do they differ from one another? What do invest-
of Money: How Money Grows” to figure out the ment bankers do?
answer for two years.) 19. Write the basic formulas for the rate of return on a
7. Assume you invest $1000 in a bond that pays 8 stock and the rate of return for a bond. What is the
percent per year. Draw a graph with future value difference between dividend versus interest pay-
on the Y axis and time in years on the X axis. Show ments?
how compound interest, or the force of interest, 20. There are many risks involved in investing in
would increase the future value of the bond after 1, bonds and stocks. What is market risk? Liquidity
5, 10, 15, and 20 years. (Hint: See “The Time Value risk? Tax risk? Firm-specific risk? Reinvestment
of Money: How Money Grows” and use the future risk?
value equation. You will need a calculator to com- 21. List five basic tips for making sound investment
pute your answer. The power function can be used decisions.
to enter the number of years.) 22. Draw a picture of the efficient frontier, market
8. Assume that your firm invests in a machine cost- portfolio, and capital market line. How does the
ing $100 at time 0 (now). One year from now, the existence of a riskless asset like government secu-
machine is sold and the net profit from its opera- rities affect investment decisions for market par-
tion is estimated to be $120. Why is the economic ticipants?
profit not equal to $20?
9. Do financing decisions affect capital budgeting Interpreting Business News
decisions? For example, if a firm borrowed some
money from a bank to finance building a new 1. Assume that you read that interest rate declines in
product, how would the interest rate on the loan recent months have increased borrowing by firms.
affect the discount rate used in capital budgeting It is expected that the new debt funds will be used
analyses? How should firms determine the correct by firms to expand production. Some experts
discount rate to use in capital budgeting analyses? believe that the low-cost debt will have a beneficial
10. What is the process of capital budgeting? Which effect on firms’ profits. Other experts worry that
projects should be accepted versus rejected? What increased debt burdens will increase bankruptcy
is the net present value (NPV)? risk among firms. Why might these experts be
11. In “Capital Budgeting Decisions for Multiple-Year right?
Investments,” we presented a capital budgeting 2. Yesterday, a firm announced a new compensation
analysis of a firm evaluating the purchase of a scheme for top executives in the firm. The new
machine for $100. Instead of using an opportunity scheme will reduce salaries and wages and
cost of 16 percent in the analysis, use an opportu- increase the use of stock options to motivate top
nity cost of funds of 6 percent. What is the present executives to boost the firm’s profitability. Why do
value of cash flows for the machine? What is the you think that top management would become

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