Finance 3113 - Exam 2

Identify and explain briefly the theories of the term structure of interest rates. Expected hypothesis, liquidity preference, market segmentation

- Expected hypothesis: explains the yield curve in terms of expected short term rates - Liquidity preference: investors want to be compensated for interest rate risk that is associated with long term issues - Market segmentation: most investors have set preferences regarding the length of maturities that they will invest in

Identify the problems associated with the IRR and how are those problems resolved?

- May result in multiple answers or not deal with nonconventional cash flows - May lead to incorrect decisions in comparisons of mutually exclusive investments. By using a modified internal rate of return

What is the difference between common stock and preferred stock?

- Preferred stock must be paid dividends before common stock, preferred stock does not carry voting rights like common stock - common stock - voting rights, proxy voting, classes of stock

What is the price of a bond and what are the variables in determining the price of a bond?

- The price of a bond is the bond value or the present value of all expected future earnings. - the variables are market rate (discount rate), coupon rate (stated rate), and face value(par value)

Which of the following affect an assets value to an investor? 1. amount of an assets expected cash flow 2. the riskiness of the cash flows 3. timing of an assets cash flows 4. investors required rate of return

1,2,4

How and why can a conflict in ranking occur and how is the conflict resolved?

1. scale of investment 2. cash flow pattern 3. project life choose highest NPV or lowest NICO

To use the constant growth model, which of the following must be true? 1. Growth rate > required rate of return 2. required rate of return > growth rate 3. firm must pay dividends 4. required rate of return = growth rate 5. firm must pay a constant dividend

2: required rate of return > growth rate 3: firm must pay dividends

In estimating the price of common stock, what kind of companies would be most likely to use the benchmark P/E model?

A company that doesn't pay dividends

In estimating the price of common stock, what kind of companies would be most likely to use the variable growth model?

A company with unusual and inconsistent growth rates

Explain and calculate the current yield.

A current yield is a bond's annual coupon divided by its price. Annual coupon: $80, Price: 955.14 Current yield = 80/955.14 = 8.38%

If you expect the market rate or return to increase across the board on all equity securities, then you should also expect:

An increase in all stock values

In estimating the price of common stock, what kind of companies would be most likely to use the constant growth model?

Companies with constant future dividends with growth rates smaller than the discount rate

Distinguish between a coupon bond and a zero coupon or discount bond

Coupon bond: N, I/Y, PV, PMT, FV Discount (Zero-coupon) bond: N, I/Y, PV, FV

Which of the following would be more likely to make an acceptable project appear unacceptable? a. discounting nominal cash flows with nominal rates b. discounting real cash flows with real rates c. discounting nominal cash flows with real rates d. discounting real cash flows with nominal rates

D: Discounting real cash flows with nominal rates

Which one of the following methods determines the amount of the change a proposed project will have on the value of a firm? a. payback b. internal rate of return c. probability index d. discounted payback e. net present value

E: net present value

Identify different terminology that can be used to describe the maturity value

Face value, par value, principle, redemption value, $1000

What kind of risks can be represented by the risk premium?

Higher interest rate risks - Longer maturity bonds have higher interest rate risks

What capital budgeting technique is the mot popular to use as a primary method?

IRR and NPV

Conventional vs. nonconventional cash flow patterns

In a nonconventional cash flow pattern, the initial outflow is not followed by inflows only, but the cash flows can flip from positive (inflows) to negative (outflows) again (or even change signs several times)

How is interest expense calculated on a zero coupon bond?

Interest expense is found by applying the discount rate to the book value of debt at the beginning of the period

What is accrued interest?

Interest that has been accumulated since the last interest payment date

What are investment grade bonds? What are junk bonds?

Investment Grade: AAA, AA, A, BBB Junk Bonds: BB, B, CCC, CC, C, D

What is the difference between a municipal bond and a corporate bond?

Municipal bonds are tax exempt while corporate bonds are not

Describe and calculate the compound growth rate. How can it be used

N, I/Y, PV, FV ((FV/PV)^(1/n)) - 1

In capital budgeting analysis, the best evaluation method, theoretically is:

NPV

What capital budgeting technique used to make decisions is the best theoretically?

NPV

Expansion projects

New products, services or markets. These projects involve strategic decisions and explicit forecasts of future demand and require full analysis

What are the possible components of the terminal cash flow, CFn?

OCF, NWC recovery, taxes, and depreciation

How do you estimate the price of common stock?

P0=D1/ r-g, Constant growth

How are treasury bonds prices quoted or reported?

Pay interest every 6 months and mature in 30 years with a face value of $1000 - actual/actual

Define the primary market, secondary market, dealer market, and broker market

Primary market: the market in which new securities are originally sold to investors Secondary market: the market in which previously issued securities are traded among investors Dealer market: trades with investors for bid and ask prices Broker Market: arranges transactions between investors

What is the required return on stock and what are other terms that can be used to describe the required return?

R= D1/P0 + g

The real rate of interest represents what?

Rate at which the purchasing power of an investment increases

What is the sustainable growth rate and how can it be used?

Retained earnings / stockholders equity, ROE x b/ 1-ROE x b It can be used to determine the maximum growth rate that can be achieved with no external equity financing while maintaining a constant debt-equity ratio

What is the Fisher equation and what are the variables in the equation?

Rn=(1+Rreal)(1+E(1))-1 Rn - nominal rate Rreal - real rate E(I) - expected inflation

With__one variable at a time is changed; whereas with __multiple variables are changed to determine the impact to NPV.

Sensitivity analysis; scenario analysis

What are the two problems with project ranking?

Size disparity problem and time disparity problem

What are the effects on cash flow when using straight-line depreciation vs. MACRS depreciation?

Straight line has a constant depreciation, where as MACRS depreciation would change year to year

What is the operating cash flow and how is it calculated?

The annual cash flow generated by a project. OCF = NI + depreciation

Stand-alone principle

The assumption that evaluation of a project may be based on the project's incremental cash flows. Allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows.

What is inflation?

The change in the value of a dollar

Net Present Value

The difference between an investments market value and its costs

Internal Rate of Return

The discount rate that makes the NPV of an investment zero

What is the crossover rate and how can it be used?

The discount rate that makes the NPVs of two projects equal; you can decide which project should be accepted at the required rate of return

Replacement projects

The firm replaces existing assets generally to reduce costs

What is the relationship between the price of a bond and the yield to maturity?

The higher the yield to maturity, the lower the price of the bond - If the YTM is < the coupon interest rate, the bond value will be > 1000 - If the YTM is > the coupon interest rate, the bond value will be < 1000

What are the possible components of the initial investment, CF0?

The initial investment and any required net working capital

What is the effect on cash flow of a change in net working capital?

The initial investment price could change or the terminal cash flow could change This could change the overall value of the project

What is the relationship between interest rate risk and the term to maturity?

The longer the time to maturity, the greater the interest rate risk

What is the relationship between interest rate risk and the coupon rate?

The lower the coupon rate, the greater the interest rate risk

Bond ratings measures what kind of risk?

The possibility of default, how likely the firm is to default and the protection creditors have in the event of a default

What is the equivalent annual cost and how can it be used?

The present value of a projects costs calculated on an annual basis. It can be used to determine which project is cheaper

Probability Index

The present value of an investments future cash flows divided by its initial cost

What does the P/E ratio measure and how do investors use it to make decisions

The ratio of a stocks price per share to its earnings per share over the previous year; if a company doesn't pay dividends investors use it as a benchmark or reference

What is interest rate risk?

The risk that arises for bond owners from fluctuating interest rates

What is the depreciation tax shield?

The tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate

How does the NASDAQ operate?

a computer network that has a multiple market marker system

What is a bond?

a contract between 2 parties; one is the investor and the other is a company or government agency

Sunk cost

a cost that has already been incurred and cannot be removed and therefore should not be considered in an investment decision

If the coupon rate is equal to the market rate, the bond will sell at

a price equal to its face value

The yield curve depicts the current relationship between:

bond yields and maturity

Scenario analysis

changing more than one input variable

Monte Carlo Simulation

considering all possible situations

Identify different terminology that can be used to describe the coupon rate

contract rate, stated rate

Financing costs

cost incurred by a company that often includes interest expense and preferred dividends

If the coupon rate is less than the market rate, the bond will sell at a

discount

Identify different terminology that can be used to describe the yield to maturity

discount rate, opportunity cost, required return, market rate

Sensitivity analysis

effect of changing one input variable

A high risk, high yield bond used to finance mergers, leverage buyouts, and troubled companies is generally called a/an:

junk bond

Decision Tree Analysis

most applicable for projects that require subsequent decisions

When acceptance of one project eliminates another project from consideration, the projects are said to be:

mutually exclusive

Modified Internal Rate of Return (combination approach)

negative cash flows are discounted back to the present, and positive cash flows are compounded to the end of the project

Multiple internal rates of return can be obtained if there exists:

nonconventional cash flow patterns

If the coupon rate is greater than the market rate, the bond will sell at a

premium

Independent projects

projects that, if accepted or rejected, will not affect the cash flows of another project

What is the effect on the price of a bond and the variables if a bond pays interest annually or semiannually?

semiannual payments will have a slightly smaller value than annual

Soft rationing

situation that occurs when units in a business are allocated a certain amount of finning for capital budgeting

Hard rationing

situation when a business cannot raise financing for a project under any circumstances

Payback Period

the amount of time required for an investment to generate cash flows sufficient to recover its initial costs

How does the New York Stock Exchange (NYSE) operate?

the business of the NYSE is to attract and process order flow - market in which brokers represent buyers and sellers and prices are determined by supply & demand

What is the dividend yield?

the expected cash dividend divided by the current price

Capital rationing occurs when:

the firm does not have enough financing to fund all positive NPV projects

A projects opportunity cost of capital is:

the forgone return from investing in another project of similar risk

Discounted Payback Period

the length of time required for an investments discounted cash flows to equal its initial cost

Opportunity cost

the most valuable alternative that is given up if a particular investment is undertaken

Capital rationing

the situation that exists if a firm has positive NPV projects but cannot find the necessary financing

Mutually exclusive projects

when acceptance of one project eliminates another project from consideration