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Financial Analysis

and Management I

MGMT 565First Exam

Marisa Crawford Gray

9/12/2010

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Question 1

In addressing the question of whether my ownership of $100,000 worth of 30-

year 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

http://www.investorwords.com/4301/riskless_asset.htmhttp:/www.investopedia.com/terms/r/rollover-risk.asplhttp://www.investorwords.com/4301/riskless_asset.htmhttp:/www.investopedia.com/terms/r/rollover-risk.asplhttp://www.investorwords.com/4301/riskless_asset.htmhttp:/www.investopedia.com/terms/r/rollover-risk.asplhttp://www.investorwords.com/4301/riskless_asset.htmhttp:/www.investopedia.com/terms/r/rollover-risk.asplhttp://www.investorwords.com/4301/riskless_asset.htmhttp:/www.investopedia.com/terms/r/rollover-risk.asplhttp://www.investorwords.com/4301/riskless_asset.htmhttp:/www.investopedia.com/terms/r/rollover-risk.asplhttp://www.investorwords.com/4301/riskless_asset.htmhttp:/www.investopedia.com/terms/r/rollover-risk.aspl

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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-a-

cautionary-tale.aspx

3. http://www.csuchico.edu/~fshockley/syllabi/RISK_ch14/sld015.htm

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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 ofdebt 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. Emery, Finnerty & Stowe, Corporate Financial Management, 2007 Third Edition,

Pearson Prentice Hall, Upper Saddle River, New Jersey

2. http://www.investorwords.com/1156/cost_of_equity_capital.html#ixzz0zNZAhCOA

3. http://www.investorwords.com/1316/debt_equity_ratio.html

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