MIDTERM EXAM ESSAY QUESTION

1. Do you think agency problems arise in sole proprietorships and/or

partnerships?

Agency conflicts typically arise when there is a separation of ownership and

management of a business. In a sole proprietorship and a small partnership, such
separation is not likely to exist to the degree it does in a corporation. However,
there is still potential for agency conflicts. For example, as employees are hired to
represent the firm, there is once again a separation of ownership and management.

2. What is difference between financial statement of cash flow and

accounting financial statement of cash flow?

Three are three component of accounting financial cash flow, which is the addition
of cash flows from operations, cash flows from investing activities, and cash flows
from financing activities. While in the perspective of finance, cash flow of the firm
which is the cash flows received from the firm’s assets CF(A), it must be equal the
cash flows to the firm’s creditors, CF(B), and equity investors, CF(S). CF(A) ≡
CF(B) + CF(S)

Besides, a primary difference between the accounting cash flow and the financial
cash flow of the firm is interest expense. In accounting, interest paid is excluded
from financing activities. The reason is that interest is deducted as an expense
when net income is computed.

3. Discuss the difference between book values and market values on the
balance sheet and explain which is more important to the financial manager
and why?
The accounts on the balance sheet are generally carried at historical cost, not
market values. Although the book value of the current assets and the liabilities may
closely approximate market values, the same cannot be said for the rest of the
balance sheet accounts. Market values are more relevant as they reflect today's
values whereas the balance sheet reflects historical costs as adjusted by various
accounting methods. To determine the current value of a firm, and its worth to the
shareholders, financial managers must monitor market values

4. Suppose a firm calculates its external funding needs and finds that it is
negative. What are the firm's options in this case? 


When a firm has negative external funding needs it will have surplus to use so that
their current liabilities get reduced, like long term debt, buy back their common
stocks and distribute increasing dividends. Thus the firms use these opportunities
and add to their asset values.

5. Should financing costs be included as an incremental cash flow in

capital budgeting analysis? 


we will not include interest paid or any other financing costs such as dividends or
principal repaid because we are interested in the cash flow generated by the assets
of the project.

6. Why is it not necessarily bad for the operating cash flow to be negative
for a particular period? 


For a successful company that is rapidly expanding, for example, capital outlays
will be large, possibly leading to negative cash flow from assets. In general, what
matters is whether the money is spent wisely, not whether cash flow from assets is
positive or negative.

7. What should be the goal of the financial manager of a corporation?

Does it mean that financial managers have to do anything and everything to
achieve that goal? Explain your answer. 


The goal of financial manager of corporation is to maximize the value of

stockholders. Do things within legal and ethical framework.

8.

a. What is the relationship between the price of a bond and its YTM? 


The yield to maturity of a bond is the discount rate that sets the present value of the
promised bond payments equal to the current market price of the bond. Thus, the
bond price is negatively related to its yield to maturity. When the interest rate and
the bond's yield to maturity rise, the bond price will fall (vise versa).

b. Explain why some bonds sell at a premium over par value while other
bonds sell at a discount. What do you know about the relationship between
the coupon rate and the YTM for premium bonds? What about for discount
bonds? For bonds selling at par value? 


What is the relationship between the price of a bond and its YTM? (b)
Explain why some bonds sell at a premium to par value, and other bonds sell
at a discount. What do you know about the relationship between the coupon
rate and the YTM for premium bonds? What about discount bonds? For
bonds selling at par value? (c) What is the relationship between the current
yield and YTM for premium bonds? For discount bonds? For bonds selling at
par value?

a. Bond price is the present value term when valuing the cash flows from a
bond; YTM is the interest rate used in valuing the cash flows from a bond. They
have an inverse relationship.

b. If the coupon rate is higher than the required return on a bond, the bond will sell
at a premium, since it provides periodic income in the form of coupon payments in
excess of that required by investors on other similar bonds. If the coupon rate is
lower than the required return on a bond, the bond will sell at a discount, since it
provides insufficient coupon payments compared to that required by investors on
other similar bonds. For premium bonds, the coupon rate exceeds the YTM; and
for discount bonds, the YTM exceeds the coupon rate. For bonds selling at par, the
YTM is equal to the coupon rate.

c. Current yield is defined as the annual coupon payment divided by the current
bond price. For premium bonds, the current yield exceeds the YTM; for discount
bonds the current yield is less than the YTM; and for bonds selling at par value, the
current yield is equal to the YTM. In all cases, the current yield plus the expected
one-period capital gains yield of the bond must be equal to the required return.

9. What are the components of the required rate of return on a share of

stock? Briefly explain.
The two components are dividend yield, which measures the annual percentage
income return on a stock, and the capital gains yield, which is the percentage of
price appreciation or depreciation.

10. What are major determinants of growth?

Profit margin – operating efficiency

Total asset turnover – asset use efficiency
Financial leverage – choice of optimal debt ratio
Dividend policy (b) – choice of how much to pay to shareholders versus
reinvesting in the firm