Finance Mid-term 2 Study Guide

Exam 2 Review Questions Chapter 4 1. What is time value of money? Please use your own language to explain why we need to apply the time value of money principle in financial decision making. a. A dollar in hand today is worth more than a dollar promised sometime in the future. Time value of money allows us to determine what options are best based on interest, inflation, risk and return 2. What is a compounding process and what is a discounting process? a. Compounding process i. The process of accumulating interest over time to earn more interest b. Discounting Process i. Finding PV of some future factor 3. What is the difference between simple interest and compound interest? How to find the total interests earned in an investment? a. Simple Interest = Is calculated on the principal b. Compound Interest (Interest on Interest) = Interest earned on both the initial principal and the interest earned from prior periods. i. c. Total Interest = Simple Interest + Interest on interest Chapter 5 1. What is the definition of APR? How to find out the period rate using APR information? a. APR = Period Rate x the number of periods per year b. Period Rate = APR / Number of periods per year 2. Can you calculate the FV of perpetuity cash flows? Why? a. You cannot calculate FV of perpetuity cash flow because there is no end date of receiving the cash flow. Essentially it’s a never ending stream of cash flow. 3. Be able to summarize the main ideas of the six articles on pension and retirement planning. a. A History of Pension Funds i. b. Stress Rises on Social Security -- Report Says Program Will Exhaust Reserves Three Years Earlier Than Expected c. d. e. f. Retiring Boomers Find 401 (k) Plans Fall Short Average 401(k) Balance by Age: The Full Data Set Longer Lives Hit Pension Plans Hard Fragile Retirement Funds Tested by Market Volatility, Bond Yields 4. What is defined benefit plan? How does a defined benefit plan usually work? Defined-benefit plans - provide eligible employees guaranteed income for life when they retire. Employers guarantee a specific retirement benefit amount for each participant that is based on factors such as the employee’s salary and years of service. How does it work - Employees have little control over the funds until they are received in retirement. The company takes responsibility for the investment and for its distribution to the retired employee. That means the employer bears the risk that the returns on the investment will not cover the defined-benefit amount due to a retired employee. Because of this risk, defined-benefit plans require complex actuarial projections and insurance for guarantees, making the costs of administration very high. As a result, defined-benefit plans in the private sector are rare and have been largely replaced by defined contribution plans over the last few decades. The shift to defined-contribution plans has placed the burden of saving and investing for retirement on employees. 5. What is defined contribution plan? What is 401(k)? How does a defined contribution plan or 401(k) usually work? Defined-contribution plan (most common) - is a 401(k) where participants can elect to defer a portion of their gross salary via a pretax payroll deduction to the plan, and the company may match the contribution if it chooses, up to a limit it sets. How does it work - As the employer has no obligation toward the account’s performance after the funds are deposited, these plans require little work, are low risk to the employer, and cost less to administer. The employee is responsible for making the contributions and choosing investments offered by the plan. Contributions are typically invested in select mutual funds and money market funds, but the investment menu can also include annuities and individual stocks. The investments in a defined-contribution plan grow tax deferred until funds are withdrawn in retirement. There is a limit to how much employees can contribute each year. In 2020, for example, the most an employee can contribute to a 401(k) is $19,500, or $26,000 if they are 50 or older. 6. What are some of the important factors that have influenced a typical baby boomer’s financial condition in his or her retirement years? Please list at least two. 7. What kind of problem(s) is the U.S. Social Security/defined benefit plan/defined contribution plan system facing respectively? What is(are) the challenge(s) in solving the problem(s)? Difference between Social security and pension - There are several other distinctions between pensions and Social Security. Social Security offers a disability insurance program that covers workers with enough credits (earned through work and payment into the system) if they become disabled. Pensions normally don’t provide disability benefits unless the employee is disabled in an on-the-job accident. Problems with social security: - Privatizing Social Security would do nothing to solve its impending insolvency, and would actually make it worse. - Private Social Security accounts will undermine the guaranteed retirement income provided by Social Security by putting peoples’ retirement money at the whim of the stock market. - Many people lack the basic financial literacy to make wise investment decisions on their own - Privatizing Social Security would dramatically increase the national debt - ● ● ● ● ● Privatizing Social Security would expand, not reduce, government bureaucracy. Guaranteed benefits would be reduced significantly under a privatized system Social Security Funding Is at Risk: Absent any major policy changes, the Social Security fund is expected to run out in between 2033 and 2037. To keep the program alive, benefits might have to be reduced or taxes raised. Uncertainty around the future of Social Security means we need to think of new ways to help fund our retirement lifestyles. Social Security Only Covers a Portion of Your Expenses: Social Security only provides 42% of the pre-retirement expenses of an average American. As a result, Americans today must have additional retirement savings or income sources available to help fund their lifestyles. This trend will likely become more pronounced in the future. Problems for definied benefit plan: Provides less income for non-career employees. Most DB plans were not designed with portability in mind. Hence, benefits are often not as portable as defined contribution benefits, although recent changes in federal laws have improved defined benefit plan portability somewhat. Cost of the plan will fluctuate from year to year as a result of plan experience being different from actuarial projections. Difficult for employees to understand how much the employer is contributing on their behalf. Usually more complicated to administer. Problems for defined contribution plan: - Employee bears the financial risk of outliving accumulated assets. Half of all retirees will outlive the average life expectancy, in many cases by decades. DC plan retirees rarely convert any of their assets to guaranteed lifetime income. - Provides less income for career employees. - Benefits may not bear any relationship to pre-retirement working pay. - Per dollar of benefits paid, a defined contribution plan in more expensive than a defined benefit plan. - Employee bears the financial risk of poor investment return. In particular a series of poor investment returns during the first few years of retirement can devastate the retiree’s accumulated assets. - During periods of extended inflation, individual account accumulations tend not to produce benefits that have kept pace with increases in the cost of living. Even though salaries, related contributions and investment income would be increa sing, the increase would generally not be adequate to offset the disproportionately lower salaries, contributions and investment earnings of earlier years. - Loss of the financial security that accompanies regular monthly retirement income, particularly for employees who are not covered by Social Security. - While generally alleged as having the advantage of portability, evidence suggests that short- term employees who terminate prior to retirement eligibility will take a lump sum distribution and use the money for other than savings toward retirement. - Retirees are more likely to take a lump-sum benefit than a periodic payment for life. - Outside service credit is not easily recognized. - Does not motivate employees to continue in service to the extent that a defined benefit plan provides that motivation. - Lower overall benefits may be available, if individual account balances are invested too "conservatively." 8. Have a sense of numbers. 9. Please use your own language to describe some financial situations that reflect (a) PV of annuity; (b) FV of annuity; and (c) perpetuity scenarios. a. PV of Annuity = Taking out a loan and finding out how much you need to pay b. FV of Annuity = Wanting to know how much you will earn in a given year for your retirement plan. c. Perpetuity Scenarios = Receiving a constant dividend from a stock. Chapter 8 1. How do Payback Period, NPV, and IRR capital budgeting decision rules work? A capital budgeting decision is both a financial commitment and an investment. By taking on a project, the business is making a financial commitment, but it is also investing in its longer-term direction that will likely have an influence on future projects the company considers. When a firm is presented with a capital budgeting decision, one of its first tasks is to determine whether or not the project will prove to be profitable. The payback period (PB), internal rate of return (IRR) and net present value (NPV) methods are the most common approaches to project selection. Although an ideal capital budgeting solution is such that all three metrics will indicate the same decision, these approaches will often produce contradictory results. Depending on management's preferences and selection criteria, more emphasis will be put on one approach over another. Nonetheless, there are common advantages and disadvantages associated with these widely used valuation methods. Payback period - Payback periods are typically used when liquidity presents a major concern. If a company only has a limited amount of funds, they might be able to only undertake one major project at a time. Therefore, management will heavily focus on recovering their initial investment in order to undertake subsequent projects. IRR - An IRR which is higher than the weighted average cost of capital suggests that the capital project is a profitable endeavor and vice versa. NPV - The net present value approach is the most intuitive and accurate valuation approach to capital budgeting problems. Discounting the after-tax cash flows by the weighted average cost of capital allows managers to determine whether a project will be profitable or not. And unlike the IRR method, NPVs reveal exactly how profitable a project will be in comparison to alternatives. The NPV rule states that all projects with a positive net present value should be accepted while those that are negative should be rejected. If funds are limited and all positive NPV projects cannot be initiated, those with the high discounted value should be accepted. 2. What are the advantages and disadvantages of payback period rule? Why payback period rule is still often used by CFOs even if it ignores time value of money? Advantages of the Payback Method The most significant advantage of the payback method is its simplicity. It's an easy way to compare several projects and then to take the project that has the shortest payback time. However, the payback has several practical and theoretical drawbacks. Disadvantages of the Payback Method Ignores the time value of money: The most serious disadvantage of the payback method is that it does not consider the time value of money. Cash flows received during the early years of a project get a higher weight than cash flows received in later years. Two projects could have the same payback period, but one project generates more cash flow in the early years, whereas the other project has higher cash flows in the later years. In this instance, the payback method does not provide a clear determination as to which project to select. Neglects cash flows received after payback period: For some projects, the largest cash flows may not occur until after the payback period has ended. These projects could have higher returns on investment and may be preferable to projects that have shorter payback times. Ignores a project's profitability: Just because a project has a short payback period does not mean that it is profitable. If the cash flows end at the payback period or are drastically reduced, a project might never return a profit and therefore, it would be an unwise investment. Does not consider a project's return on investment: Some companies require capital investments to exceed a certain hurdle of rate of return; otherwise the project is declined. The payback method does not consider a project's rate of return. They payback method is a handy tool to use as an initial evaluation of different projects. It works very well for small projects and for those that have consistent cash flows each year. However, the payback method does not give a complete analysis as to the attractiveness of projects that receive cash flows after the end of the payback period. And it does not consider the profitability of a project nor its return on investment. Chapter 9 1. Please use your own language to describe the basic steps in calculating a company’s fair/intrinsic value (a measure of what the company is worth). ● ● ● ● ● ● Step 1: Find the net income statement of the firm Step 2: Calculate the Operating Cash Flow of the Company by getting the Earning Before Interest and Taxes (EBIT) + Depreciation - Taxes Step 3:Find the Projected Capital Requirements Step 4: Calculate the Cash Flow From Assets (CFFA) by subtracting net capital spending (NCS) - changes in NWC by Operating Cash Flow (OCF) ○ CFFA = OCF - net capital spending (NCS) - changes in NWC Step 5: Set up the projected cash flows table Step 6: Calculate the fair/ intrinsic value from year 1 to the end of the year