1. Describe how a bond’s rating is an assessment of risk. How does the inverse relationship work?
A bond rating is a letter grade given to a bond by a rating organization that shows the bond’s credit worthiness. The financial strength of a bond issuer, or its capacity to pay the bond’s principal and interest on time, is considered in the rating. When an investor knows the quality of a bond, he or she can determine if they will benefit or take a loss. Bond ratings are, therefore, a risk assessment. Bonds and interest rates have an inverse connection. Bond prices normally decline as the cost of borrowing money rises (interest rates rise), and vice versa.
2. Differentiate between the features of common stock and preferred stock.
Common Stock Preferred Stock
The ability to vote and elect members of the board of directors. Shareholders have no voting powers.
They are not entitled to dividend arrears if they missed a payout the prior year If a dividend was missed in the prior year, they are entitled to arrears.
Common shares cannot be exchanged for preferred shares. Priority in receiving dividend payments over ordinary stock holders.
A common share’s returns are often dependent on the growth or decline in the share price Preferred share’s returns are mostly dependent on its mandated dividends.
3. Distinguish between the advantages and disadvantages of NPV and IRR.
Advantages of NPV
• It provides a financial appraisal at a specific point in time.
• Assists in business decision-making.
• It is a measurement of the magnitude of a business enterprise.
• Cash flows are used instead of net earnings.
• It’s simple to figure out.
• Because of the simple computation, it is difficult to make an appropriate discount choice that is representative of the investment’s genuine risk premium.
Advantages of IRR
• It takes into account the value of money over time.
• A project’s profitability may be assessed throughout its economic life cycle.
• It is not necessary to calculate the cost of capital or the cut-off rate.
• It takes into account cash input and outflow.
• It involves a lot of computations.
• It provides profitability information but not capital expenditure information.
4. Explain the cost of capital. What does the firm’s capital structure represent? How does it relate to the firm’s ability to maximize shareholder wealth?
The cost of capital is the minimal rate of return a company must achieve before it may generate value. It is crucial in examining a company’s finances and evaluating the worth of its assets. Besides, it’s especially significant when it comes to capital budgeting. The capital structure of a corporation represents the amount of debt or equity it uses to sustain its operations and fund its investments. The most typical approach to describe it is as a debt-to-equity or debt-to-capital ratio. It is utilized to finance a business activities capital expenditures, acquisitions, and other investments, resulting in increased shareholder value.
5. Describe risk in the context of financial decision making. How does it relate to expected return?
Financial decision-making refers to the process of making decisions about a company’s financial challenges. It enables the organization to make the most use of its resources. It entails investment, financing, and dividend decisions. The risks connected with financial decision-making and performance include that these decisions have a direct impact on the firm’s value. For instance the danger of investing in the incorrect securities when there is a danger of the borrower defaulting.