Financial Analysis and Management I MGMT 565

First Exam

Marisa Crawford Gray 9/12/2010

Question 1 In addressing the question of whether my ownership of $100,000 worth of 30year US Treasury bonds is a risk less asset, my response would be no. When looking at investments over a period of time, even with the federal government, there will be some risk involved. There might be a chance that the debtor will fail to make timely payments, (p156, Emery, Finnerty & Stowe). By definition risk less asset means an asset with zero standard deviation (p156, Emery, Finnerty & Stowe). However, even these assets are subject to inflation risk. If I were to take my $100,000 investment and roll over every 90 days this could be considered as a risk less investment because the initial cost of the investment has already occurred. There is however some risk involved due to the degree of uncertainty of future outcomes of the market. One would also have to take in account the possibility of a negative outcome. Bonds are also subject to default risk, call risk, inflation, currency risk and marketability risk. The inflation risk involves the decrease in purchasing power it causes. If the inflation turns out to be less than expected, the future cash flow will have more purchasing power than expected. The opposite is to be considered if the inflation turns out to be more than expected (p 121, Emery, Finnerty & Stowe, 2007). The Currency Risk is another factor involved with bonds. This risk depends on the value of the currency changes at the time of payment for the investment bond (p 121, Emery, Finnerty & Stowe, 2007). The final risk to consider is the marketability risk. This involves the volume of trading in the market. This reduces the bonds return if the bonds are less liquid and have larger trading cost, (p 121, Emery, Finnerty & Stowe, 2007). All of these factors have to be computed in the YTC when analyzing the selling off of the bonds. When looking at the five hierarchy of investments based on the information reviewed, ranking from least to most in risk factors as: 1) Treasury bills; 2)Treasury Bonds; 3) Bank CD; 4) Corporate bonds; 5) Stocks.

References: 1. Emery, Finnerty & Stowe, Corporate Financial Management, 2007 Third Edition, Pearson Prentice Hall, Upper Saddle River, New Jersey 2. http://www.investorwords.com/4301/riskless_asset.htm 3. http://www.investopedia.com/terms/r/rollover-risk.aspl

Question 2 Investments at any level have risk involved. When a person is looking at investing in a foreign investment there are additional risk factors to consider. These involve both economic and political risk related to the specific investment. It is important to consider the political stability and property rights of the county you are investing thru. There is no room for assumptions based on the operations of the United States. Not every county has protections for shareholders. These factors might include obtaining foreign financial information, foreign tax considerations, costs of converting currencies, higher transaction costs, expropriation risk, and legal and other forms of political risk. In addition there are considerations that include the Cultural Risk for the country being invested in. There is a chance of loss due to the foreign markets difference in consumer preference. There might also be Government Policy Risk if there has been a change in policy or based in a government takeover. There might be some benefits from diversification of international investing. A foreign investments required return is not found by tacking on an additional risk premium to the required return, (p 181, Emery, Finnerty & Stowe, 2007). Reference: 1. Emery, Finnerty & Stowe, Corporate Financial Management, 2007 Third Edition, Pearson Prentice Hall, Upper Saddle River, New Jersey 2. http://www.fool.com/investing/international/2008/07/10/international-superstar-stocks-acautionary-tale.aspx 3. http://www.csuchico.edu/~fshockley/syllabi/RISK_ch14/sld015.htm

Question 3 When a firm calculates its cost of debt ant finds it to be 9.75%. Then it calculates its cost of equity capital and finds it to be 16.25%. The firms CEO tells the firms CFO the firm should issue debt because it is cheaper than equity. If the firm were to use the cost of equity capital they would look at the rate of return required by a companys common stockholders. The formula (dividends per share/current market value) + dividend growth rate If the firm were to look at their debt/equity ratio, the formula is the long-term debt divided by the shareholders equity. The cost of equity is the amount after tax while the cost of the debt ratio is determined before tax. A firms responsibility is to leverage its ratio as much as possible. The amount of debt a firm uses has both positive and negative effects. The more debt, the more likely it is that the firm will have trouble meeting its obligations. The debt serves as a major source of financing because it provides significant tax advantages because the interest is tax deductable, (p64, Emery, Finnerty & Stowe, 2007). The CFO in this case should follow the advice of the CEO and report the findings showing the debt ratio vs. cost of equity capital. The dividends do not have to be declared is one of the advantages. A disadvantage being when reporting the cost equity capital it positions the firm to be dilution of ownership control because of the number of individuals sharing the profits.

References: 1. 2. 3. Emery, Finnerty & Stowe, Corporate Financial Management, 2007 Third Edition, Pearson Prentice Hall, Upper Saddle River, New Jersey http://www.investorwords.com/1156/cost_of_equity_capital.html#ixzz0zNZAhCOA http://www.investorwords.com/1316/debt_equity_ratio.html