Finaaaaanceeeeee P2

how to find simple interest on lump sum

(n at any period)(rate)(principal)

how to find portfolio beta

(weights of stocks)(stock Beta) + (weight of stock)(Stock beta).....

disadvantages of payback period

-Ignores the time value of money -Requires an arbitrary cutoff point -Ignores cash flows beyond the cutoff date -Biased against long-term projects, such as research and development, and new projects

steps for a WACC problem

-calculate equity and debt rates -calculate market values for equity and debt -calculate the v-value -calculate weights of equity and debt (account for after tax effective rate)

how to find interest on interest from lump sum

-calculate future value compounded with interest -subtract principal value -subtract simple interest

IRR rule pitfalls

-delayed investments -multiple IRRs -no IRR -MUTUALLY EXCLUSIVE PROJECTS

you can only solve for return on equity using div growth model IF

-div paying firm -the expected growth rate must be estimated (may have to solve for some variables)

what is true about annuity formulas?

-ordinary annuity future formula gives the value of the annuity at the end of the first cash flow period -ordinary annuity future value formula gives the value of the annuity concurrent with the last cash flow -the annuity due present value formula gives the value of the annuity concurrent with the first cash flow

The majority of the diversifiable risk in a portfolio can be eliminated by owning as few as ________ stocks.

10

large company stocks had an average return of what?

12.1%

what is the probability that a bond will produce returns more than one STDEV below the average

16%, refer to normal distribution

unexpected return

= systematic portion + unsystematic portion

bonds

A certificate issued by a government or private company which promises to pay back with interest the money borrowed from the buyer of the certificate: The city issued bonds to raise money for putting in new sewers.

conventional cash flows

A project that does not have multiple sign changes in its cash flow stream, goes from negative to positive once

APR

Annual percentage rate; the annual rate of interest that is charged for using credit, takes simple interest into account

Disadvantages of the SML approach

Beta and market risk premium need to be estimated, relying on the past to predict the future

treasury bonds

Bonds issued by the federal government, sometimes referred to as government bonds, low default risk, high interest rate risk

What will investors do?

Buy more of the stock, increase the price of the stock

CPN equals what

CPN=Total coupon payments/N times the amount of payments a period

A bond that can be paid off early at the issuer's discretion is referred to as being which type of bond?

Callable

Which one of the following premiums is compensation for the possibility that a bond issuer may not pay a bond's interest or principal payments as expected?

Default risk

Large company stocks earned a higher average risk premium than small company stocks

FALSE

the average inflation rate exceeded the average return on US treasury bills

FALSE

the discount rate does not need to be expressed as an aftertax basis

FALSE

during recessions, US treasury bills offer investors a positive risk premium

FALSE, it would be zero

dividends are business expenses and are tax deductible

FALSE, they are not expenses and not tax deductible

the arithmetic average return characterizes past performance

FALSE, what we expect to happen in the future

Volatility

Indicates how much and how quickly the value of an investment, market, or market sector changes. RISK

accrued interest

Interest that has built up but has not yet been paid.

Which of the following statements is true of a portfolio's standard deviation?

It can be less than the weighted average of the standard deviations of the individual securities held in that portfolio.

individual risk premium

Market expected return minus risk free rate

disadvantages of profitability index

May lead to incorrect decisions in comparisons of mutually exclusive investments

how to calculate

NPV(B-A)= 0 = discounted difference in cash flows between projects

A cash flow that exists regardless of whether or NOT a project is undertaken is NOT relevant

TRUE

A firm that uses its WACC to evaluate all projects will have a tendency to both accept unprofitable investments and become increasingly risky

TRUE

Acquisition of debt is a source of cash

TRUE

Interest paid by a corporation is a tax deduction for the paying corporation

TRUE

NPV rule will always lead CEOs to making decisions that max value for investors

TRUE

NWC increases it is a cash outflow

TRUE

The EAR will always be greater than the APR.

TRUE

The expected return of an equally weighted portfolio of randomly selected stocks will equal the average of the expected returns of the stocks in the portfolio

TRUE

a zero growth dividend is basically a perpetuity

TRUE

eliminating the diversifiable risk is the responsibility of the investor when making a portfolio

TRUE

market value is what is taken into account for the weighted averages of returns

TRUE

stocks that are correctly priced have the same risk to reward ratio

TRUE

the difference between MV and BV is excess depreciation and taxes must be paid

TRUE

the geometric average characterizes past performance

TRUE

the yield to maturity is the return that investors get from a bond

TRUE

to have a equally weighted portfolio, it is important to buy more shares of stocks that fall and sell stocks that have risen

TRUE

for stocks that don't pay dividends we can value them from the PE ratio or the price to sales ratio

TRUE, P at t = Benchmark PE ratio times EPS at t

can calculate cost of equity from SML approach and equation

TRUE, account for risk, applicable for firms with steady div growth

it is possible for the expected return on the portfolio to be great than that of every asset in the portfolio

TRUE, investor can short sell which allows some weights to be greater than one and others will be less than one

Bonds that pay their coupon payments at the end of a period compared to bonds that pay them at the beginning of the period are more sensitive to interest rate risk

TRUE, more of the value generated is further out than the other so it is more sensitive to discounting

The cost of capital primarily depends on the use of the funds not the source

TRUE, use of the fund determines the riskiness of the projects

in a loan with a fixed interest rate and equal monthly payment, the PV of each month's payment toward the principal is constant

TRUE, while the actual principal portion in each payment rises as the interest declines, the PV of the principal portion of the payment remains constant

Divisional Cost of Capital

The cost of capital for a particular division of a company. This may be quite different from the Company WACC, depending on the risk of the division's cash flows.

what is the crossover rate

The discount rate at which we are indifferent between two mutually exclusive investments.

dirty price

The price of a bond including accrued interest, also known as the full or invoice price. This is the price the buyer actually pays.

With respect to risk, which of the following statements is accurate?

The systematic risk of a portfolio can be lowered by adding T-bills to the portfolio

What does the required return mean?

This is the amount of return you expect from a stock based on the risk. if a required return is 10%, you will have a positive NPV if the actual return exceeds that

A Treasury yield curve plots Treasury interest rates relative to:

Time to maturity

With respect to unexpected returns, which one of the following statements is accurate?

Unexpected returns can be either positive or negative in the short term but tend to be zero over the long term.

WACC

Weighted average cost of capital. Cost of capital for the firm as whole

zero coupon bond

a bond that makes no coupon payments and is thus initially priced at a deep discount

NPV profile

a graph of a project's NPV over a range of discount rates, where the NPV meets the x-axis is where the IRR is

Assume a stock experiences an actual return that is above the security market line. An analyst can safely conclude that the stock has:

a higher return than expected for the level of risk assumed

examples of when to use the WACC

a pizza business opening up a new location, renovating a warehouse for a business, manufacturers considering to expand production

call provisions

a provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal maturity date

unsystematic risk

a risk that affects at most a small number of assets

unsystematic risk

a risk that affects at most a small number of assets. Also, unique or asset-specific risk, can be eliminated through portfolio diversification

small company stocks had a average return of what?

about 16.3%

price above/below the SML

above: the price will rise, the stock is underpriced/undervalued below: the price will fall, the stock is overpriced/overvalued

NPV rule

accept investment if the NPV is positive and reject if negative

Diversified Portfolio

an investor who has holdings in several different industries; Don't put all your eggs in one basket, risk decreases an insane amount by adding 10 stocks to the portfolio, but the more stocks you add the risk won't decrease by a great amount as you keep adding

protective covenants

are primarily designed to protect bondholders, positive and negative covenants, what the corporation can and cannot do to protect the bondholder

US Treasury bonds

are quoted as a percentage

Bond statements

bonds often provide tax benefits to their issuers

Short Selling

borrowing stock from your broker and selling it with an obligation to replace the stock later

what does total return equal

cap gains yield and div yield

free cash flow

cash flow free to distribute investors, basis of firm value OCF-change NWC-CAPEX

what are current assets

cash, accounts receivable, inventory, assets with a life under a year

what is the formula for MRP

change in expected return/change in Betas

market risk premium

change in expected returns over change in beta

Blumes formula

combining two averages of geometric and artithmetic

agency problems

conflicts of interest between managers and stockholders

Recently, you discovered a convertible, callable bond with a semiannual coupon of 5 percent. If you purchase this bond you will have the right to:

convert the bond into equity shares

sunk costs

costs that have already been incurred and cannot be recovered. Irrelevant cash flow

In response to a change in the market rate of interest, the price sensitivity of a bond increases as the:

coupon rate decreases and the time to maturity increases.

the pure play approach

determining what the required return is for investments by trying to locate similar investments in the marketplace

IRR

discount rate that makes the NPV equal to 0, breakeven rate

sinking fund provision

does not wait until the time of maturity to pay off a portion of the bond or the whole bond, can repay to the bondholder early, to keep it financially stable

disadvantages of div growth model approach

doesn't account for risk, not applicable to non div paying firms cost of equity is sensitive to estimated growth rate

total return

expected return + unexpected return

what happens when an investment has non conventional cash flows

financing type cash flows, the IRR is a rate you are paying NOT receiving

How to find EAC

find NPV of both projects, set NPV equal to annuity formula and solve for EAC for both options

what is an example of an agency problem

hiring outside accountant to audit the company financial statement is an agency cost

Payback rule

if a project's calculated payback period is less than the pay cutoff then the project should be accepted

what happens if you accept an investment above this rate?

increase value for investment

cash flows that show the difference between the cash flows with and without the project

incremental cash flows

A "fallen angel" is a bond that has moved from:

investment grade to speculative grade

relevant cash flows or incremental cash flows

is a change in the firm's overall future cash flow that is a result of the decision of a project

how to find cost of debt

it is the YTM of a bond

You expect interest rates to decline in the near future even though the bond market is not indicating any sign of this change. Which one of the following bonds should you purchase now to maximize your gains if the rate decline does occur?

long term, zero coupon

market value of debt

market price of a bond times the number of outstanding bonds

disadvantages of the IRR rule

may result in multiple answers or no answer with non-conventional cash flows, may lead to incorrect decisions in comparisons of mutually exclusive investments

Beta of a stock

measures the sensitivity of its returns to market, systematic risk

market value of equity

outstanding shares times share price

actual returns below the SML are

overpriced and their stock prices will decrease in order to increase their returns to get back on the SML

profitability index

present value of all cash flows/initial investment

how to find expected return

probability(price)+probability(price)....

a deferred call provision:

prohibits the bond issuer from redeeming callable bonds prior to a specified date.

Market expected return (CAPM)

risk free plus MRP

what are current liabilities

short-term loans, accounts payable, any liability with a life under a year

Which one of the following bonds is the least sensitive to interest rate risk?

shortest year and high coupon percentage

CapEx (Capital Expenditure)

spending on stuff for the company minus after-tax proceeds

Beta measures what

systematic risk related to the market

how to find how much one pays toward the principal amount in an annuity

take the principal amount (loan amount) and subtract the PV at any time T

A lower return below the SML means

that the price is too high and investor will be discouraged to buying the stock and will want to sell it, makes the price decrease

Effective Annual Rate (EAR)

the actual rate paid (or received) after accounting for compounding that occurs during the year, takes on compound interest

call premium

the amount by which the call price exceeds the par value of a bond

coupon rate of a bond

the annual percentage of its par value that will be paid to bondholders

coupon rate LESS than YTM

the bond will sell at a discount

Coupon rate GREATER than YTM

the bond will sell at a premium

correlation coefficient of stock portfolios

the degree in which two stocks move in relation to one another

after-tax proceeds from sale of old asset

the difference between the old asset's sale proceeds and any applicable taxes or tax refunds related to its sale

Capital asset pricing model

the equation of the SML showing the relationship between expected return and beta

what does it mean for a company to save 22,000 dollars when investing an asset?

the firms operating (net) income increases by this 22,000

risk premium

the higher rate of return you can expect from riskier assets than investing in risk free assets

opportunity cost

the most desirable alternative given up as the result of a decision, requires to give up a benefit. Relevant cash flow

Erosion

the negative impact on the cash flows of an existing product from the introduction of a new product. Relevant cash flow when sales wouldn't be lost

what is the WACC

the overall return the firm must earn on the existing assets to maintain value

liquidity premium

the portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity

default risk premium

the portion of a nominal interest rate or bond yield that represents compensation for the possibility of default

taxability premium

the portion of a nominal interest rate or bond yield that represents compensation for unfavorable tax status

Equivalent Annual Cost (EAC)

the present value of a project's costs calculated on an annual basis

net present value in a project

the present value of current and future benefits minus the present value of current and future costs

what does the aftertax interest rate equal

the pretax interest rate times 1-tax rate

When to use WACC as discount rate

the project must be in the same risk class as the whole firm that is investing

yield to maturity

the rate of return a bondholder will receive if the bond is held to maturity

cost of capital

the rate of return a company must earn in order to meet the demands of its lenders and expectations of its equity holders

Fisher effect

the relationship between nominal returns, real returns, and inflation

expected return

the return on a risky asset expected in the future

cost of debt

the return that lenders require on the firm's debt, related to bonds

interest rate risk

the risk that arises for bond owners from fluctuating interest rates

stocks with the same beta:

the same systematic risk the same expected returns

The ________ is a positively sloped linear function that plots securities' expected returns against their betas.

the security market line

A stock with an actual return above the SML means

the stock is underpriced and the price will rise as a result in order to decrease the return to the SML

what is a tax shield and what is the formula

the tax saving that results from depreciation deduction, depreciation x tax rate

Efficient market hypothesis

the theory that asset prices reflect all publicly available information about the value of an asset

NWC is what

tied up cash, it is cash not available to investor, when NWC declines, means that money is freed up, this is an inflow of cash

what is the primary goal of financial management

to maximize the current price of the share of stock

STDEV measures what

total risk

the APR only accounts for simple interest

true

how to find the cost of equity

use div growth model to solve of return on equity

salvage value of an asset

what we think the asset will be worth when we dispose of it