Finance

NYSE

Physical exchange

Live within our means

President Heber J Grant

Which of the following is NOT given as a possible way to harvest?

Reverse leveraged buyout

Expected return equation

Rf + Bi (Rm - Rf)

CAPM equation

Ri = Rf + Bi (Rm - Rf) Ri = return on the ith security Rf = risk free rate Rm = return on the market Bi = security's beta (Rm - Rf) = market risk premium

According to the reading, what is risk?

Risk is uncertainty.

market risk premium equation

Rm - Rf

Beta

Sensitivity of a stock's return to the return on the market portfolio

Which of the following is an example of diversifiable risk?

The employees of Textile, Inc. just voted to go on strike. Textile, Inc. is an individual firm. The risk of an individual firm can be diversified by forming a portfolio of stocks along with textile.

What type of risk-taking is rewarded?

The market compensates investors for accepting risk - but only for market risk. Firm-specific risk can and should be diversified away. That's the mystery element - how much market risk does a security have? We need to be able to measure market risk.

You decide to value an IPO using a price-to-sales ratio because the firm has negative earnings and a PE ratio would result in a negative price. Your discount rate is 20 percent, price-to-sales ratio is 1.1, and market-to-book ratio is 1.3. What is the value of your firm if it has the following simplified income statement? Sales $60,000 Cogs (40,000) Expenses (20,000) Depreciation (10,000) Taxes 4,000 Earnings (6,000)

The problem states that you want to use the price-to-sales ratio because a PE approach would not make sense. A negative price means the company is worth less than nothing using a PE, so instead you take sales of $60,000 and multiply it by the price-to-sales ratio of 1.1 to get $66,000.

You have been hired to value a firm that is not publicly traded. The firm has earnings of $300,000 per year on sales of $3 million a year. After some research, you determine that a fair PE ratio is 15x, the market-to-book ratio is 1.4, and the discount rate is 15 percent. What is the value of this firm using a comparable firm approach?

Using this method, we take earnings of $300,000 and we multiply it by the PE ratio of 15. $300,000 * 15 = $4,500,000

When using a DCF method with free cash flows to the firm to value a firm, what measure should we use for the discount rate?

WACC

Teri's Tires pays $7 per share on its preferred stock that sells for $68 a share. What is Teri's cost of preferred stock if flotation costs equal 5 percent?

We use a perpetuity for preferred stock. Don't forget to take out float costs. Rp = $7 / ($68 * (1 - 0.05)) = 11 percent

Turbo Charged Seafood has the following % returns on its stock, relative to the listed changes in the % return on the market portfolio. The beta of Turbo Charged Seafood can be derived from this information Month Market return% Turbo return % 1 +1 +.08 2 +1 +1.8 3 +1 -0.2 4 -1 -1.8 5 -1 +0.2 6 -1 -0.8

When the market was up 1%, Turbo average % change was +0.8% When the market was down 1%, Turbo average % change was -0.8% The average change of 1.6% (-0.8 to 0.8) divided by the 2% (-1.0 to 1.0) change in the market produces a beta of 0.8. B = 1.6 / 2 = 0.8

According to the text, which is not a primary method of computing the cost of common stock?

YTM

Do some firms have more market risk than others?

Yes. For example, an economic slow-down affects all firms, but which would be more affected? A- Harley Davidson; or B- American Electric Power. Answer is A, because people tend to postpone the purchase of luxury items during hard times.

firm-specific risk

a company's labor force goes on strike, a company's top management dies in a plane crash, a huge oil tank bursts and floods a company's production area

Which one of the following will decrease net working capital of a firm?

a decrease in accounts receivable

The DCF approach has five steps. Which of the following is not a step? all of the above are steps use time value of money to discount the future cash flows to present value estimate a terminal value compute free cash flow for each forecasted period forecast and construct pro forma statements

all of the above are steps

firm-specific risk =

also called diversifiable risk. this risk can be reduced through diversification

Market risk =

also called nondiversifiable risk. this risk can't be diversified away

What is the most valuable investment given up if an alternative investment is chosen?

an opportunity cost

Systematic risk is measured by which of the following?

beta

The market value proportions of the firm's assets, financed via debt, common stock, and preferred stock, are called the firm's ____________.

capital structure weights

We should never enter into financial bondage through..

consumer debt

In the discounted cash flow method, which rate of return is associated with free cash flow to equity in the valuation equation?

cost of equity

The return that shareholders require on their investment in the firm is called the _____________.

cost of equity

The text mentions some valuation caveats. Which of the following is not one of them? all of the above are mentioned as caveats crown jewel adjustment taking out salary control premium liquidity discount

crown jewel adjustment

if two stocks are perfectly positively correlated,

diversification has no effect on risk

In the study of Guatemala microfinance discussed in the text, how many measures of outcomes did they use?

eight

Which of the following is the cost incurred by the firm when new issues of stocks or bonds are sold?

flotation costs

From which viewpoint does the text not teach how to think about the cost of capital?

from the viewpoint of auditors

Which website below is not a webpage mentioned in the text to further your education of car values and other information you should know prior to purchasing a vehicle?

http://careerfair.com

The changes in a firm's future cash flows that are a direct consequence of accepting a project are called __________ cash flows.

incremental

What type of funds historically out-performs actively-managed mutual funds (in terms of average return rate)?

index funds The section "Strategies for Personal Investing," on page 15-7, says that BYU professors and many others have documented that if you invest in index funds you will earn more on average than if you invested in actively-managed funds.

What is tricky to evaluate when valuing a firm?

intangible assets

Diversification

investing in more than one security to reduce risk

The pre-tax cost of debt for a firm:

is equal to the yield to maturity on the outstanding bonds of the firm.

Which is not a part of the build-up method for finding the required rate of return?

large-cap risk premium

Measuring market risk

market portfolio; beta

Which of the following is not a valuation caveat mentioned in the text?

multiples approach

The risk premium for an individual security is computed by:

multiplying the security's beta by the market risk premium

According to the reading, what does NGO stand for?

non-government organization

Which entity below does not require registering with the state in order to start the business?

partnership

market portfolio

portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market

What does the PE ratio stand for in the comparable trades method?

price-to-earnings

The overall cost of capital for a retail store:

reflects the return that investors require on the total assets of the firm.

The book shows a house appraisal that contains two methods for valuing the house. What are they?

replacement cost and comparables

What are the three primary ways to value a firm, according to the chapter?

replacement cost, DCF, comparable trades

market risk premium

risk premium of market portfolio. It is the difference between market return and return on risk-free treasury bills

For a treasury security, what is the required rate of return?

risk-free rate of return

For a corporate stock or bond, what is the required rate of return?

risk-free rate of return + risk premium

The salvage value of an asset creates an after-tax cash inflow to the firm in an amount equal to which of the following?

sales price minus the tax due, based on the sales price minus the book value, plus the recapture of working capital

How many best-practices does the text discuss?

six

Because the poor typically don't own traditional asset-based capital, what type of collateral is typically used by MFIs?

social capital

A cost that has already been paid, or the liability to pay has already been incurred, is a(n):

sunk cost

if two stocks are perfectly negatively correlated,

the portfolio is perfectly diversified

required return

the return that an investor requires on an asset given its risk

The intercept point of the security market line is the rate of return which corresponds to which of the following?

the risk-free rate of return.

What does the cost of capital depend upon?

the sources of financing for capital and the associated costs

CAPM

theory of the relationship between risk and return which states that the expected risk premium on any security equals its beta times the market risk premium

Standard deviation measures what type of risk?

total

Benefits of financial markets & intermediaries

transport cash across time, provide liquidity, allow for payments, reduce risks, provide information, estimate cost of capital

treasury securities

treasury securities are as close to riskless as possible

Market risk

unexpected changes in interest rates, unexpected changes in cash flows due to tax rate changes, foreign competition, and the business cycle

What is the replacement cost method for valuing a firm?

what it would cost to build up the company from nothing

it is ____ and _____ that make the family independent

work and thrift

Jamestown Ltd. currently produces boat sails and is considering expanding its operations to include awnings for homes and travel trailers. The company owns land beside its current manufacturing facility that could be used for the expansion. The company bought this land ten years ago at a cost of $250,000. Today, the land is valued at $425,000. The grading and excavation work necessary to build on the land will cost $15,000. The company currently owns some unused equipment, valued at $60,000, which could be used for producing awnings if $5,000 is spent for equipment modifications. Other equipment, costing $780,000, will also be required. What is the amount of the initial cash flow for this expansion project?

$1,285,000 CF0 = $425,000 + $15,000 + $60,000 + $5,000 + $780,000 = $1,285,000

Ernie's Electrical is evaluating a project which will increase sales by $50,000 and costs by $30,000. The project will cost $150,000 and be depreciated straight-line to a zero book value over the 10 year life of the project. The applicable tax rate is 34 percent. What is the operating cash flow for this project?

$18,300 Tax = 0.34 * [$50,000 - 30,000 - ($150,000 / 10)] = $1,700 Operating Cash Flow = $50,000 - $30,000 - $1,700 = $18,300

Marshall's & Co. purchased a corner lot in Eglon City five years ago at a cost of $640,000. The lot was recently appraised at $810,000. At the time of the purchase, the company spent $50,000 to grade the lot and another $4,000 to build a small building on the lot to house a parking lot attendant who has overseen the use of the lot for daily commuter parking. The company now wants to build a new retail store on the site. The building cost is estimated at $1.2 million. What amount should be used as the initial cash flow for this building project?

$2,010,000 CF0 = $810,000 + $1,200,000 = $2,010,000. The historical cost is irrelevant. The grading and small building expenses are not incremental; they are in the past so they do not count.

You are interested in valuing your firm. You have sales of $2 million, NI (earnings) of $200,000, and a tax rate of 40 percent. You have researched your industry and the average PE ratio is 15. What is your firm worth, according to the comparable multiples approach?

$3 million PE * earnings = price, so, 15 * $200,000 = $3 million

RP&A, Inc. purchased some fixed assets four years ago at a cost of $19,800. They no longer need these assets, so they are going to sell them today at a price of $3,500. The assets are classified as five-year property for MACRS. What is the current book value of these assets? MACRS five-year property Year Rate 1 20.00% 2 32.00% 3 19.20% 4 11.52% 5 11.52% 6 5.76%

$3,421.44 Book value at the end of year three = $19,800 - [$19,800 * (0.20 + 0.32 + 0.192 + 0.1152)] = $3,421.44

If the economy booms, RTF, Inc. stock is expected to return 10 percent. If the economy goes into a recessionary period, then RTF is expected to return only 4 percent. The probability of a boom is 60 percent while the probability of a recession is 40 percent. What is the variance of the returns on RTF, Inc. stock?

0.000864 E(r) = (0.60 * 0.10) + (0.40 * 0.04) = 0.06 + 0.016 = 0.076 Variance = 0.60 * (0.10 - 0.076)2 + .40 * (0.04 - .076)2 = 0.0003456 + 0.0005184 = 0.000864 Remember that variance is the square of the standard deviation. See the section "Risk" on page 8-2 for the equation for standard deviation.

The risk-free rate of return is 4 percent and the market risk premium is 8 percent. What is the expected rate of return on a stock with a beta of 1.28?

14.24 percent This is the CAPM. E(r) = 0.04 + (1.28 * 0.08) = 0.1424 = 14.24 percent

Bill is analyzing a security. One-year Treasury rates are currently 4.30 percent. What is the following investment's expected return? Probability Associated return .15 -2% .37 3% .30 4% .18 5%

2.9 percent

Zelo, Inc. stock has a beta of 1.23. The risk-free rate of return is 4.5 percent and the market rate of return is 10 percent. What is the amount of the risk premium on Zelo stock?

6.77 percent Risk premium = 1.23 * (0.10 - 0.045) = 0.06765 = 6.77 percent

You recently purchased a stock that is expected to earn 12 percent in a booming economy, 8 percent in a normal economy and lose 5 percent in a recessionary economy. There is a 15 percent probability of a boom, a 75 percent chance of a normal economy, and a 10 percent chance of a recession. What is your expected rate of return on this stock?

7.30% E(r) = (0.15 * 0.12) + (0.75 * 0.08) + (0.10 * -0.05) = 0.018 + 0.06 - 0.005 = 0.073 = 7.3 percent

Hotchow is issuing a $1000 face value bond that pays 10% annual interest, and matures in 20 years. The bond will be sold at par ($1000) and flotation costs will be 15% of the market value. The company is in the 25% tax bracket. What is the firm's after-tax cost of debt on the bond?

9.0% FV = 1000 PV after flotation costs = -1000 * (1 - 0.15) = -850 PMT = 1000 * 0.10 = 100 n = 20 Use calculator to solve for I/Y. Before tax YTM = 12.01 percent Tax rate = 25 percent After tax YTM = 12.01 * (1 - 0.25) = 9.0 percent

Financial Intermediaries

Banks, mutual funds, insurance companies, pension funds

What is the name of the strategy of minimizing costs and finding creative ways to fund the venture?

Bootstrapping

What does the reading say is the best advice for buying a house?

Buy a first-time homebuyer's book.

Jack's Construction Co. has 80,000 bonds outstanding that are selling at par value. Bonds with similar characteristics are yielding 8.5 percent. The company also has 4 million shares of common stock outstanding, which has a beta of 1.1 and sells for $40 a share. The US Treasury bill is yielding 4 percent and the market risk premium is 8 percent. Jack's tax rate is 35 percent. What is Jack's weighted average cost of capital?

By the CAPM: Weights: Debt: 80,000 * $1,000 = $80,000,000 Common: 4,000,000 * $40 = $160,000,000 Total = $80,000,000 + $160,000,000 = $240,000,000 WACC = (160,000,000/240,000,000 * 0.128) + (80,000,000 / 240,000,000 * 0.085 * (1 - 0.35)) = 10.38 percent Ke = 0.04 + (1.1 * 0.08) = 0.128

NASDAQ

Electronic exchange

The Bet-r-Bilt Company has a six-year bond outstanding with a 5 percent coupon. Interest payments are paid semi-annually. The face amount of the bond is $1,000 and it is currently selling for 98 percent of its face value. The firm must pay 2 percent to float its debt. The tax rate is 40 percent. What is the company's after-tax cost of debt?

Enter N = 6 * 2 pv = -980 * (1 - 0.02) PMT = 50 / 2 FV = 1000 Solve for semiannual I/Y = Take 2.9 * 2 to get the annual YTM and you get 5.8 percent. Now you have to take out taxes. Annual YTM * (1 - tax rate) = 5.8 * (1 - 0.4) = 3.47 percent

What is one possible difference between corporate and entrepreneurial finance mentioned in the text?

Entrepreneurial finance often maximizes utility function, not wealth function.

When buying a home, what specific tip will save you thousands of dollars on your mortgage purchase?

Finance your house with a fifteen-year mortgage as opposed to a thirty-year mortgage. In the section "Strategies for Car and House Buying," on page 15-2, the text gives key advice: use a fifteen-year mortgage, not a thirty-year mortgage. The three reasons that they give as support are the following: 1) You will buy within your means. 2) You will pay more towards principal faster; that is, you will pay the debt off faster, and save tens of thousands of dollars. This will help you to invest in your future since you will have, on average, $100,000 dollars left over that you would have paid with the thirty-year mortgage. 3) You will almost always get a lower interest rate (i/y on the calculator. With your TVM skills you can see this will further save you money compared to a thirty-year loan).

Types of markets

Financial markets, commodities markets

Jake's Sound Systems has 210,000 shares of common stock outstanding at a market price of $36 a share. Last month, Jake's paid an annual dividend in the amount of $1.593 per share. The dividend growth rate is 4 percent. Jake's also has 6,000 bonds outstanding with a face value of $1,000 per bond. The bonds carry a 7 percent coupon, pay interest annually, and mature in 4.89 years. The bonds are selling at 99 percent of face value. The company's tax rate is 34 percent. What is Jake's weighted average cost of capital?

First do the weights: Debt: 6,000 * $1,000 * 0.99 = $5,940,000 Common: 210,000 * $36 = $7,560,000 Total = $5,940,000 + $7,560,000 = $13,500,000 Next do the cost of equity: Ke = [($1.593 * 1.04) / $36] + 0.04 = 0.08602 Next do the cost of debt: Enter 4.89 -990 70 1000 N I/Y PV PMT FV Solve for 7.250 = 6.9 percent Finally, combine into WACC: WACC = (7,560,000/13,500,000 * 0.08602) + (5,940,000 / 13,500,000 * 0.0725 * (1 - 0.34)) = 6.92 percent

Assume that after 2010, earnings before interest and tax will remain constant at $210 million, depreciation will equal capital expenditures in each year, and working capital will not change. ThinkSmart's WACC is 14 percent and its tax rate is 40 percent. What is the estimated market value of ThinkSmart at the end of 2006. Following is a four-year forecast for ThinkSmart LLC. Free cash flow ($ mil) 2007: -85 2008: -32 2009: 62 2010: 66

First, we need to recognize that this is a DCF approach, so the market value will equal the present value of the 2007-2010 free cash flows plus the present value of the terminal value. The present value of the 2007-2010 FCF equals -$18,300,000. The terminal value equals FCF/r (according to perpetuity or a zero growth Gordon Model). FCF = [EBIT * (1 - tax rate)] + depreciation - CAPEX - Inc NWC. The problem tells us that depreciation = CAPEX, so they cancel each other out. The problem also says that NWC does not change, so it equals zero. Therefore, FCF = EBIT * (1 - tax rate). (This is the same as EBIT - taxes in dollars.) So the terminal value = EBIT(1 - t) / r = $126 / 0.14 = $900,000,000 The present value of $900 million is $532.9 million. Add the PV of FCF to the PV of TV, -$18.3 + $532.9 = $514,600,000

When is it appropriate to use WACC in an NPV decision?

For when we are extending the firm.

Daniel's Enterprises has a beta of 1.98 and a growth rate of 12 percent. The stock is currently selling for $12 a share. The overall stock market has an 11 percent rate of return and a market risk premium of 8 percent. What is the expected rate of return on Daniel's Enterprises stock?

Here, you have to figure out that you should use the CAPM. They give us some parts to the Gordon model, but the dividend is not provided. We can't use the Gordon model, and the growth rate and current price are extraneous. Also, note that they give use the market risk premium (Rm-Rf) of 11 percent. To find the Rf we have to subtract the 8 percent market return from the overall market risk premium. Re = (0.11 - 0.08) + (1.98 * 0.08) = 18.84 percent

According to the text, what specific phrase should you almost always use when negotiating?

Is that the very best you can do?

Which of the following is not a definition of required rate of return?

It is the Sharpe ratio. It is the compensation investors require for accepting risk. It is the return on an investment required by investors given the investment's risk. It is the risk free rate plus (+) the risk premium. = It is the Sharpe ratio

You are considering purchasing stock S. This stock has an expected return of 8 percent if the economy booms and 3 percent if the economy goes into a recessionary period. How will the overall expected rate of return on this stock behave?

It will increase as the probability of a boom economy increases. Remember the equation for expected rate of return: ER = sum (each probability * each state of return). See section "Return to Review" on page 8-2. If the probability of a boom increases, there will be more weight on the 8 percent and less on the 3 percent, so the expected rate of return will increase.

Which of the following is not one of the types of business entity structures mentioned in the reading?

L-corp

Other international exchanges

London, Tokyo, Hong Kong, Africa

What is the relationship between risk and correlation?

Lower correlation leads to lower risk

The depreciation method currently allowed under US tax law, which governs the accelerated write-off of property under various lifetime classifications, is called __________ depreciation.

MACRS

What is the name of the person who won the 2006 Nobel Peace Prize for his work in microfinance?

Muhammad Yunus