IMPORTANT QUESTIONS

Q. 1. Describe the differences between the capital markets and the money
markets.
In the money market, savers who want a temporary place to deposit funds
where they can earn interest interact with borrowers who have a short-term need
for funds. Marketable securities, including Treasury bills, commercial pa per, and
other instruments, are the primary securities traded in the money market. The
Eurocurrency market is the international equivalent of the domestic money
market.
In contrast, the capital market is the forum in which savers and borrowers
interact on a long-term basis. Firms issue either debt (bonds) or equity (stock)
securities in the capital market. Once issued, these securities trade on secondary
markets that are either broker markets or dealer markets. An important function
of the capital market is to determine the underlying value of the securities issued
by businesses. In an efficient market, the price of a security is an unbiased
estimate of its true value
Q. 2. Understand who uses financial ratios and how.
Ratio analysis enables stockholders, lenders, and the firm’s managers to
evaluate the firm’s financial performance. It can be performed on a cross-
sectional or a time-series basis. Benchmarking is a popular type of cross-sectional
analysis. Users of ratios should understand the cautions that apply to their use
Q. 3. Use ratios to analyze a firm’s liquidity and activity.
Liquidity, or the ability of the firm to pay its bills as they come due, can be
measured by the current ratio and the quick (acid-test) ratio. Activity ratios
measure the speed with which accounts are converted into sales or cash, or
inflows or outflows. The activity of inventory can be measured by its turnover:
that of accounts receivable by the average collection period and that of accounts
payable by the average payment period. Total asset turnover measures the
efficiency with which the firm uses its assets to generate sales.
Q. 4. Discuss the relationship between debt and financial leverage and the ratios
used to analyze a firm’s debt.
The more debt a firm uses, the greater its financial leverage, which
magnifies both risk and return. Financial debt ratios measure both the degree of
indebtedness and the ability to service debts. A common measure of
indebtedness is the debt ratio. The ability to pay fixed charges can be measured
by times interest earned and fixed-payment coverage ratios.
Q.5. Explain the time value of money and its importance in the business world.
Money grows over the period of time when it earn interest. Money expected
or promised in the future is worth less the same amount of money in hand today.
Due to that we lose the opportunity to earn interest when we have to wait to receive
money. Similarly, money we owe is less burdensome if it is to be paid in the future
rather than now. These concepts are at the heart of investment and valuation
decisions.
Q. 6. Discuss the role of time value in finance, the use of computational tools,
and the basic patterns of cash flow.
Financial managers and investors use time value-of-money techniques
when assessing the value of expected cash flow streams. Alternatives can be
assessed by either compounding to find future value or discounting to find
present value. Financial managers rely primarily on present value techniques.
Financial calculators, electronic spreadsheets, and financial tables can streamline
the application of time value techniques. The cash flow of a firm can be described
by its pattern: single amount, annuity, or mixed stream.
Q. 7. Understand the concepts of future value and present value, their
calculation for single amounts, and the relationship between them.
Future value (FV) relies on compound interest to measure future amounts.
The initial principal or deposit in one period, along with the interest earned on it,
becomes the beginning principal of the following period. The present value (PV)
of a future amount is the amount of money today that is equivalent to the given
future amount, considering the return that can be earned. Present value is the
inverse of future value.
Q. 8. Discuss the features of both common and preferred stock.
The common stock of a firm can be privately owned, closely owned, or
publicly owned. It can be sold with or without a par value. Preemptive rights allow
common stockholders to avoid dilution of ownership when new shares are issued.
Not all shares authorized in the corporate charter are outstanding. If a firm has
treasury stock, it will have issued more shares than are outstanding. Some firms
have two or more classes of common stock that differ mainly in having unequal
voting rights. Proxies transfer voting rights from one party to another. The
decision to pay dividends to common stockholders is made by the firm’s board of
directors. Firms can issue stock in foreign markets. The stock of many foreign
corporations is traded in U.S. markets in the form of American depositary receipts
(ADRs), which are backed by American depositary shares (ADSs).
Preferred stockholders have preference over common stockholders with
respect to the distribution of earnings and assets. They do not normally have
voting privileges. Preferred stock issues may have certain restrictive covenants,
cumulative dividends, a call feature, and a conversion feature.
Q. 9. Explain the relationships among financial decisions, return, risk, and the
firm’s value.
In a stable economy, any action of the financial manager that increases the
level of expected dividends without changing risk should increase share value; any
action that reduces the level of expected dividends without changing risk should
reduce share value. Similarly, any action that increases risk (required return) will
reduce share value; any action that reduces risk will increase share value. An
assessment of the combined effect of return and risk on stock value must be part
of the financial decision-making process
Q. 10. Understand the meaning and fundamentals of risk, return, and risk
preferences.
Risk is a measure of the uncertainty surrounding the return that an investment
will produce. The total rate of return is the sum of cash distributions, such as
interest or dividends, plus the change in the asset’s value over a given period,
divided by the investment’s beginning-of-period value. Investment returns vary
both over time and between different types of investments. Investors may be risk
averse, risk neutral, or risk seeking. Most financial decision makers are risk averse.
A risk-averse decision maker requires a higher expected return on a more risky
investment alternative
Q. 11. Explain the types of risks that a firm encounter.
There are three types of risks that a firm/business encounter:
Business risk
Business risk is the risk that a company’s operating income will differ from
what is company expected income. The more the volatile a company’s operating
income, the more the business risk. Business risk is a result of sales volatility,
which translates into operating income volatility. Business risk is increased by the
presence of fixed costs, which magnify the effect on operating income due to
changes in sales.
Financial risk
Financial risk occurs when the companies depends on debt financing and
companies borrow money and incur interest charges that show up as fixed
expenses on the income statements. Fixed interest expenses effects the net
income of the companies as the business risk effect the company’s operating
income. So, the interest expenses increases the volatility. The additional volatility
of a firm’s net income caused by the presence of fixed interest is called financial
risk.
Portfolio risk
Portfolio risk is the chance that investor would not get the return they
expect from the portfolio. This can be measured by standard deviation. It can be a
diversifiable risk and non-diversifiable. Non-diversifiable risk is measured by the
term beta. Market always has a beta of 1.0. If beta of portfolio is greater than 1
contain high portfolio risk or vice a versa.
Q. 12. Understand working capital management, net working capital, and the
related trade-off between profitability and risk.
Working capital (or short-term financial) management focuses on managing
each of the firm’s current assets (inventory, accounts receivable, cash, and
marketable securities) and current liabilities (accounts payable, accruals, and
notes payable) in a manner that positively contributes to the firm’s value. Net
working capital is the difference between current assets and current liabilities.
Risk, in the context of short-term financial decisions, is the probability that a firm
will be unable to pay its bills as they come due. Assuming a constant level of total
assets, the higher a firm’s ratio of current assets to total assets, the less profitable
the firm and the less risky it is. The converse is also true. With constant total
assets, the higher a firm’s ratio of current liabilities to total assets, the more
profitable and the more risky the firm is. The converse of this statement is also
true.
Q. 13. Explain why companies holds cash.

Transactions motive: to meet payments, such as purchases, wages, taxes, and

dividends, arising in the ordinary course of business.

Speculative motive: to take advantage of temporary opportunities, such as a

sudden decline in the price of a raw material.

Precautionary motive: to maintain a safety cushion or buffer to meet unexpected

cash needs. The more predictable the inflows and outflows of cash for a firm, the
less cash that needs to be held for precautionary needs. Ready borrowing power
to meet emergency cash drains also reduces the need for this type of cash
balance.
Q. 14. Describe Net Present Value (NPV) Rule.
Like the internal rate of return method, the net present value method is a
discounted cash flow approach to capital budgeting. The net present value (NPV)
of an investment proposal is the present value of the proposal’s net cash flows
less the proposal’s initial cash outflow
The present value of an investment project’s net cash flows minus the
project’s initial cash outflow