- The interest rate required by investors on a debt security can be expressed by the following equation: Interest rate = RRF + IP + DRP + LP + PRP + CRP. Define each term of the equation, and explain how it affects the interest rate.
RPF stands for real risk-free rate. Real risk-free rate is the minimum percentage of return required by investors identified for the moment of calculating the interest rate. RPF identifies maximum value of the risk that could be accepted. In practice, risk-free rate is bound to a three-month US Treasury bills. There is directly proportional to the interest rate and the risk-free rate. Actually, there is directly proportional relation between all of the equation components (Runy, 2006).
IP component is inflation premium which is identified as return on investment over the normal rate of return. Inflation premium is included in this formula because investors aim to compensate losses in value conditioned by inflation. Inflation premium increases the interest rate (Runy, 2006).
DRP is default risk premium meaning the amount a borrower has to pay to compensate assumed default risk. Therefore, companies having poor financials issue bonds with high yields aiming to compensate additional risk (Runy, 2006).
LP - liquidity premium – a premium required by an investor when a security cannot be easily converted into cash at the fair market value. An asset is liquid when the liquidity premium is high causing decrease in the price and increase in the interest rate (Runy, 2006).
PRP stand for price risk premium that is the premium required to take into account factors influencing the price of a security. For example, political factor can influence the price of a security thus adding to the risk premium value (Runy, 2006).
CRP is call risk premium which is paid when an investor has to reinvest in less favorable environment as a result of redeeming the issue prior to maturity (Runy, 2006).
2. Briefly define the following terms:
a. Term loan
Term loan is an amount borrowed from a bank that has a specific schedule of repayment and an interest rate which can be fixed or floating (Runy, 2006).
Bond is a debt issued when an entity needs to borrow money from investors for a defined period of time at a fixed rate of interest. Bonds can be issued by companies, governments, municipalities, and states to finance various initiatives, activities, and projects (Runy, 2006).
c. Mortgage bond
Mortgage bond is a bond secured by a mortgage on assets. These bonds are backed by real estate holdings or property. In case of default mortgage bonds holders can claim and then sell the property to compensate their investments (Runy, 2006).
d. Senior debt and junior debt
Senior debt is debt that should be repaid first in case of bankruptcy of a company. Junior debt is debt that has lower priority than senior debt. It is an unsecured form of debt that means that there is no collateral behind it (Runy, 2006).
Debenture is a type of debt tool that is not secured by assets or collateral. Debenture is backed by the reputation of an issuer or the general creditworthiness. This type of debt is typically issued by governments and corporations (Runy, 2006).
f. Subordinated debenture
Subordinated debenture is an unsecured bond that offer claims of assets subordinated to existing and future debts. In case of bankruptcy of the issuer, the claims of the holders of subordinated debentures are satisfied last. Usually, the issuers pay higher interest rates compensating higher risk (Runy, 2006).
g. Municipal bond
Municipal bond is a security issued by a municipality, county, or a state to finance capital expenditures. Municipal bonds are not subject of federal, state or local taxes (Runy, 2006).
A contract between a bond issuer and a bondholder is called indenture. It specifies the important features of a bond including maturity date, method of interest calculation, payment periods for interest payments, and convertible features if they are applicable. The indenture contains terms and conditions of the bond issue. It also includes the information related financial covenants governing issuer and criteria of identification whether an issuer is within the covenants (Runy, 2006).
- Restrictive covenant
Restrictive covenant is a type of agreement that requires the buyer t either taker or reject a specific action. Restrictive covenants are binding legal obligations into the deed of a property by a seller. Restrictive covenants may include reasonable provisions related limitations of bond issues (Runy, 2006).
Trustee is a person or a firm which holds assets for a third party benefit. For example, a trustee is appointed in the case of bankruptcy. Trustees are assigned to make decisions in the beneficiary’s interests (Runy, 2006).
k. Call provision
Call provision is provision on bond that allows an issuer to repurchase the bonds. Under the terms of call provision the time when the bonds can be called is identified and the price of bonds is identified.
a. What are the three major rating agencies?
The three major rating agencies are as follows: Moody’s, Standard& Poor’s, and Fitch Group.
b. What are some criteria that the rating agencies use when assigning ratings?
Rating criteria are mostly based on competitive situation, management quality, and the financial condition of the issuer.
c. What impact do bond ratings have on the cost of debt to the issuing firm?
The cost of debt decreases if the debt issuer has high bond rating because high ratings are assigned to the companies having good reputation in debt repayment and strong financial position. The lower the bond rating the higher is the cost of debt for the debt issuer (Runy, 2006).
1. What is an investment banker’s role in assisting with the issuing of securities?
An investment banker is the person who serves as an intermediary between the investors and an organization that issues securities. When issuing securities, the representatives of a company contact investment banker to receive advice related issuing price, market conjuncture, and other factors. The firm, which is an investment banker, helps a company sell the securities. The securities’ issuer does not sell the securities itself. The issuer of securities may contact the investment banker before issuance and the relationships between the issuer and the investment banker may proceed after issuance. Investment bankers possess necessary expertise and knowledge to be able to reach investors. They also are aware of the state of capital markets and government regulations related securities’ issuance and management. Usually, investment bankers offer broker and dealer services for their customers (Gapenski, 2012).
2. Define the following terms:
- Expected rate of return
An expected rate of return is the amount an investor anticipates to receive on invested money. The expected return is based on historical data. There is no guaranteed amount of the expected return. The expected return is used to determine average net outcome which can be either positive or negative (Gapenski, 2012).
- Expected dividend yield
An expected dividend yield is a financial ratio indicating relationship between dividends and share price. The expected dividend yield is the return on investment for a stock. This is a measure of cash flow resulted from unit of currency invested (Gapenski, 2012).
c. Expected capital gains yield
The expected capital gains yield is the component of the price appreciation of a security total return. The capital gains yield can be the change in price divided by purchase price (for stock holdings) (Gapenski, 2012).
d. Efficient Markets Hypothesis
The efficient markets hypothesis is an investment theory stating that beating market is impossible because the current share prices incorporate relevant information. In accord with the efficient markets hypothesis, stocks are traded at fair value. Thus, investors cannot purchase undervalued stocks or sell them for inflated prices. Therefore, it is impossible to outperform the market with the help of expert selection of stocks or due to market timing. The only one alternative to receive higher returns is to invest in riskier assets (Gapenski, 2012).
e. Risk/return trade-off
The principle of risk and return trade-off is based on the tendency of increasing returns simultaneously with risk increase. According to this principle, low-risk assets having low level of uncertainty are associated with low returns while high-risk assets are associated with high returns. Thus, the risk-return tradeoff means that investments can render relatively high profits being subject to a potential loss (Gapenski, 2012).
3. Why might an investor-owned firm choose to issue different classes of common stock? 300
Common stock is the lower-ranked and more prevalent form of equity financing. As a rule, company issues different classes of common stock aiming to certain company founders, board members, and investors. Usually, the companies issue class A and class B shares of common stock. Common stock of class A are assigned more voting rights than stocks of class B. A company may issue a large number of common shares and provide large stakeholders, such as founders and executives, with common stock of higher class that carries multiple votes for a single share (Gapenski, 2012).
Usually, multiple voting shares are assigned up to ten votes per share, although the companies make them higher. The shares of the class A are superior to the shares of the class B. However, the standard nomenclature for the classes of multiple shares does not exist. Class B shares can be assigned more voting rights than the class A counterparts. As such, the investors have to research the company’s details regarding its share classes when they consider making investment in a company issuing stocks of different classes. The purpose of issuing super voting shares is to give greater control over the voting rights to the company insiders. The voting shares can be the effective tools of protecting a company from takeovers since the insiders of a company can maintain voting control owning more than a half of shares outstanding. The shares of different classes are typically assigned the same rights to the company ownership and profits. Retail investors may be limited in purchasing the shares of lower class, but they may enjoy the equal claim to the profits of the company. Thus, the investors can get their profit not being able to enjoy the voting power. Thus, the existence of two or more classes is not a big problem for the investors because investors still get their profit while managers receive the rights to rule the company to protect their interests (Runy, 2006).
a. Define average collection period.
Average collection period is the time required for receiving payments owed meaning “receivables” in accounting terms. Usually, accounting period between a company and its customers is meant (Gapenski, 2012).
b. How is it used to monitor a firm’s accounts receivable?
Average collection period is defined by dividing accounts receivable by the average daily sales that allows monitoring a firm’s accounts receivable by comparing the average collection period to other collection periods. If the collection period does not exceed the average collection period, then there is some time to wait until the customer settles accounts.
If the collection period exceeds the average collection period, then it is time to take measures related collecting debt (Gapenski, 2012).
c. What is an aging schedule?
A table that helps classify accounts receivable and accounts payable in accord with their dates is called an aging schedule. This schedule is used for analysis of the payments aiming to control their due dates (Gapenski, 2012).
d. How is it used to monitor a firm’s accounts receivable?
The aging schedule helps classify the accounts that should be paid or claimed first and last according to their dates. Monitoring of accounts receivable using the aging schedule helps organize the work of an accountant according to the current priorities (Gapenski, 2012).
a. What is a just-in-time (JIT) inventory system?
Just-in-time inventory system is a specific inventory strategy employed by a company aimed to increase efficiency of inventory turnover and decrease waste. For example, goods and materials in the manufacturing process should be received in case of need. This approach helps reduce inventory costs thus the demand should be accurately forecasted. This strategy is opposed to “just in case” strategy when manufacturers carried large inventories in case is demand will increase.
b. What are the advantages and disadvantages of JIT systems?
The main benefits of JIT system are as follows: funds tied up in inventory can be used in other areas, areas used for inventory storage can be used more productively, the time spent for throughput can be reduced resulting in an increased potential for output, quicker response to customers is possible due to quicker goods turnaround, defect rates can be reduced resulting in lower waste and greater customers’ satisfaction. The disadvantages of JIT are connected with overhauling of business systems used before that could be expensive and difficult to implement. Also, JIT forces a company to be exposed to a number of risks related the supply chain management because a minor disruption in supply could cause production outage due to the lack of stocks (Purchasing and Procurement Center, n.d.).
c. Can JIT inventory systems be used by health care providers? Explain your answer.
Despite of the fact that JIT system is often employed in manufacturing, it can also be implemented in healthcare services because healthcare services have a lot of processes similar to manufacturing. JIT system is focused on a process rather than a product, thus, it can be applied to any processes disregard of manufacturing or service. At the present time, healthcare industry becomes more dependent on technology and progressive systems aiming to make the processes in healthcare more efficient. Using JIT elements in healthcare can help reduce service time, establish long-term relationships with suppliers, involve medical personnel in the cycle of quality, and improve handling of materials. JIT can be used for managing storage facilities and supply of the central stores containing surgical instruments and medicines.
Leasing companies often promote the following benefits of leasing. Critique the merits of each hypothesized benefit.
- Leasing preserves a business’s liquidity because it avoids the large cash outlay associated with buying the asset.
In order to acquire long-term assets, large cash flows are required. However, the company has to make periodical rental payments and interest that represents cash outlay. Paying interest the company buys assets at a higher price. Besides, inflation rate should be also taken into account. Thus, present high liquidity ratio of the company can be achieved at the expense of future liquidity.
- Leasing (with operating leases) allows businesses to use more debt financing than would otherwise be possible because leasing keeps the liability off the books.
Under the terms of operating leasing, the leased equipment is not fully amortized. Thus, the actual value of the equipment is less than its book value. The lease contracts under operating leasing terms are signed for as shorter period of time than the useful life of an asset. As such, more debt financing is available, but the actual liability is not evident that could distort the real picture of assets and liabilities.
- The full amount of each lease payment is a tax-deductible expense for the lessee.
If a lease does not meet the guidelines for the taxes, it is called non-tax oriented lease. In this case the lessee can deduct a portion of interest of each payment. Therefore, the lessee obtains only some tax depreciation benefits, but the full amount of each lease payment is not tax-deductible.
List the six best practices described in the Purchasing and Procedure Center’s online article. For each best practice, explain how it will achieve cost reductions and/or service level improvements.
The following six principles were listed in the article of Purchasing and Procurement Center
(n.d.): manage dollars, not just materials; collaborate with physicians and nursing staff;
consider total cost, not just price, create integrated policies and procedures; develop a process,
not departmental focus; develop team focused, not individual focused processes.
Implementing efficient management (for example, JIT) of critical stocks will allow saving
costs on its storage. Collaboration with actual working staff (physicians and nurses) can help
use strategic cost management based on actual data resulting in reduction of the costs spent on
hospital materials (Purchasing and Procurement Center, n.d.).
Considering total cost, not just price will help better control inventory expenditures instead of
calculating dollars spent. Thus, the costs of expedited delivery of stock can be more expensive
than the materials required. Using centralized ordering systems within the integrated policies
and procedures ensures consistent stock quality and reduces unnecessary spending. Using
consistent possesses helps evaluate and improve the efficiency of the usage of materials thus
saving costs on materials. The processes in healthcare should be team focused aiming to
support team goals rather than being focused on individual achievements. This approach
could help improve the quality of services delivered and serve the interests of all team
Gapenski, L.C. (2012). Fundamentals of healthcare finance. 2nd ed. Chicago, IL: Health Administration Press.
Purchasing and Procurement Center. (n.d.). Six best practices in hospital materials management. Retrieved from http://www.purchasing-procurement-center.com/hospital-materials-management.html
Runy, L.A. (2006). H & HN Magazine. Debt financing. Retrieved from http://www.hhnmag.com/hhnmag/jsp/articledisplay.jsp?dcrpath=HHNMAG/PubsNewsArticle/data/2006June/0606HHN_FEA_Gatefold&domain=HHNMAG.