1.Explain why the present value of a cash flow stream, and the asset associated

Question

1.Explain why the present value of a cash flow stream, and the asset associated therewith; fluctuate in value with the level of interest rates in the capital markets.

     2.   List and explain the points of financial impact on a company if it raises the credit

           standards required of its customers who utilized trade credit offered by the

           company.

3.Define Weighted Average Cost of Capital and explain why a company must earn at least its Weighted Average Cost of Capital on new investments. What are the financial implications if it does not?

    4. As a corporation what are the benefits and ramifications of using convertible debt

         to finance a publicly traded company? As an investor what are the benefits and

         ramifications of purchasing convertible debt in a publicly traded company? Are

         there any conflicts between the goals of the investor and the goals of the

         corporation?

5.Which two of the six methods used to evaluate projects, and to decide whether or not they should be accepted, do you prefer as a financial manager? Explain why you decided on these two and not the other four. List the perceived deficiencies of the four not selected.

6.What are the benefits and costs of placing a financially troubled company into a Chapter 11 Bankruptcy proceeding? Is this a legitimate and ethical vehicle for management to use for the benefit of the company’s stakeholders?

Explanation / Answer

1. Note that when interest rate rises in capital markets, the earnings ability of the underlying assets currently decreases (inversely proportional). If the company takes debt, the cash flow (outflow) decreses leading to lesser PAT available for shareholders. Any parameter affecting future cashlfow of firms has its effect on current asset prices and hence the reason.

2. If the company rasises the credit standards, credit sales (buyers doing business on credit basis will be allowed to borrow less) will decline. This will invariably affect the topline (sales) of the firm.

3.WACC - weighted average cost of capital is defined as the average return that a company expectes to compensate both of its equity investors and financial institutions that have provided debt.
WACC = (Equity X Expected return on equity) + (Debt X Cost of debt *(1-taxrate))
WACC is the rate that also serves as a discounting factor for calcualtion of NPV of future investments.
If the firm fails to generate a return more or equal to WACC, the value of the firm is declining and its imapct can be seen in stock prices. Also under such scenrio,financial instituions consider them as risky and may not extend credit / offer new loan.

4.Convertible debts allow companies to raise debt at a lower cost (generally 100-200 basis points) when compared to bonds. Hence they can lock in debt a lower rate for a longer period.
When the company fails to pay the debt, the same is converted as equity and investor can sell the stock in open market to recover their amount lent. This leads to falling stock price.

For Investors - If there is a convertilbe debt and coverted, the outstanding shares increase and EPS of the company decreases. This is at time signalled as unappropriate and it may pull down the share price leading to value loss for equity investors (lower roe).
Conflict in interest happens as company wants to minimize debt and improve ROE while investors are focussed on ROE.Imbalance leads to differences among shareholders and mgmt.

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