Finance Exam #1
How do the variables in the lump sum PV formula line up with the 3 determinants of stock prices?
A. FV reflect future cash flows b. N reflects timing c. R reflects risk
What are the three areas of corporate financial management decision making?
Capital Budgeting Capital structure Working capital management
How do you solve for the PV perpetuity?
PVP=PMT/r
What is the "Cycle of Money" between investors and a corporation
The movement of money from investors to corporations and then back to investors
How do you construct a loan amortization schedule?
a. BB is loan amount b. PMT is calculated using formulas c. Interest= BB x r d. Principal = PMT - interest e. EB = BB - Principal
How do the various components of the fixed-payments loan amortization schedule change as the term of the loan progresses?
a. Balance decreases b. PMT remains constant c. Interest decreases d. Principal increases e. ending balance decreases until 0
What is the overriding goal of corporate financial management and what are the three ways of describing this goal?
a. Benefit the owners (shareholders) b. ways 1. Maximize wealth of shareholders 2. Maximize PPS of common stock Maximize the market value of equity
How do you solve for the price of a bond?
a. Bond price (PB) = Coupon PMT (1-1/(1+r)^n/r) + Par/(1+r)^n b. Since bonds involve a combination of an annuity (coupons) and a lump sum (par value) its price is best calculated by using the following steps i. Lay out the timing and amount of future cash flow promised ii. Determine the appropriate discount rate for the cash flow iii. Find the present value of the lump sum principal and the present value of the coupons iv. Add the present value of the lump-sum principal and the present value of the coupons
Why do we need to learn Time Value of Money (TVM) tools?
a. Cash flows are not occurring at the same time - need to be on the same time basis i. Different points of time cannot be compared without adjusting using TVM
What is involved with discounting and compounding?
a. Compounding is adding the interest part i. Finding FV from PV b. Discounting is subtracting the interest part i. Finding PV from FV
What is meant by "Bid" and "Ask" prices?
a. Dealer POV 1. Sell - bid 2. Buyer- bid 3. Seller- ask b. Bid Ask Spread - the absolute difference between the bid price and the ask price (the ask is higher that's why we take the absolute value of it)
What is the Rule of 72 and how is it used to solve for the appropriate values of r and n?
a. Determines how long it will take to doubles your money b. Works quite well for interest rates between 2% and 30% i. Divide 72 by the interest rate 72/r=n c. Can also determine the rate at which you will need to invest your money to have it double over a specified period of time i. Divide 72 by the time horizon 72/n=r d. Rule of 72: n(years) 72/r (annual %)
Excel: (Find a resource online) : How do you enter formulas, copy formulas and lock in cells in formulas?
a. Enter formulas using = b. Copy formulas ctrl+c+ sign and drag c. Lock formulas $ sign of f4
For lump sums, how do you solve for PV, FV, r and n?
a. FV= PV(1+r)^2 i. On Excel uses cell references = FV( Rate, # of periods, payment, present value, type) b. PV= (FV x (1/(1+r)^n) i. On Excel use cell references = PV ( Rate, # of periods, payment, present value, type) c. R = (FV/PV)^(1/n) -1 d. N - (ln(FV/PV)/ln(1+r)
What is the relationship between PV and FV?
a. FV=PV(1+r)^n
EXCEL: Which Excel functions do you use to find FVA, PVA, and PMT?
a. FVA i. =FV(rate, Nper, PMT) b. PVA i. =PV(rate, Nper, PMT) C. PMT i. =PMT(rate, Nper, Pv)
How do you solve for loan amounts and fixed payments for fully-amortized loans?
a. Fixed value loans use PVA formula - assume annual payments unless otherwise noted
What are the 3 main determinants of stock prices and how does each affect the stock price? (Ceteris Paribus)
a. Future cash flows (bigger is better) b. timing of future cash flows (sooner is better) c. Risk of cash flows (less is better)
How do changes in the Right-Hand Side variables affect PV and FV?
a. Future value has a positive correlation with PV, r, n b. Present value has a positive correlation with FV but a negative correlation with r and n
What are the 3 perspectives on the interest rate?
a. General - rental price of money B. Lender - reward for postponing consumption; save and postpone the use of the funds c. Borrower - a penalty for spending before earning
What does our author find to be the relative magnitude of the 4 components of historical nominal interest rates?
a. Inflation 4.05% b. Real rate 1.18% c. DP .49% (for AAA corporate bonds over government bonds) d. MP 1.41% (for twenty year maturity differences)
How do you determine which of the 3 PMTs you need to solve for?
a. Look for the amount they are giving you (r and n) or the amount of PV or FV
What do the time subscripts in the PVA and PVP formulas tell us
a. Never have to solve for t b. When you solve - the answer you get will be 1 time period before the first PMT year you are calculating for (go up by one from left to right) c. When you use either of the formulas the value you get is one period before d. When the cash flows occur
What is meant by real and nominal interest rates?
a. Nominal values include the effect of inflation b. real rate is why you can actually buy
What is meant by a "lump sum"
a. One time cash flow
Which Excel functions can be used to find bond prices and YTMs?
a. PV(rate, nPer, PMT) b. =Rate(nPer, PMT, Pv)
How do you solve for the PV and the FV formulas of an annuity
a. PVA = PMT((1-1/(1+r)^n)/r) b. FVA = PMT ((1+r)^n-1)/r
What is meant by the periodic interest rate, APR, frequency of compounding and EAR?
a. Periodic interest rate - The rate for any period that is mentioned (Daily, Weekly, etc.) b. APR- annual percentage rate i. Compounding- How frequently interest is charged to an account c. EAR- effective annual rate (compounded once a year -anually) i. EAR= (1+APR/m)^m-1
What is the relationship between the periodic interest rate, APR, frequency of compounding and EAR?
a. Periodic interest rate r= APR/m b. EAR = (1+APR/m)^m -1
What is the meaning of PV and FV?
a. Present values are early values (leftward of timeline) i. Amount needed earlier in order to have a given later amount b. Future values are later values (rightward on timeline) i. The cash value of an asset in the future is equivalent in value to a specific amount today
What are the 4 possible components of the nominal interest rate and what purpose does each serve?
a. Purchasing premium protects b. DP = default premium - protects the lender from the borrower defaulting on the loan i. Bond ratings ii. Maturity premium (mp)
How do you solve for each variable in the approximate Fisher Effect?
a. R (approximate) - r*+h b. R = r*+inf+dp+mp
What do bond ratings represent and what is the relationship between those ratings, credit quality and required rates of return?
a. Ratings are produced by Moody's, Standard and Poor's and Fitch b. Range from AAA (top-rated) to C (lowest-rated) or D (default) c. Help investors gauge likelihood of default by issuer d. Assist issuing companies establish a yeild on newly-issued bond i. Junk bond - the label given to bonds that are rated below BBB. These bonds are considered to be speculative in nature and carry higher yields than those rated BBB or above (investment grade) ii. Fallen angels- the label given to bonds that have had their ratings lowered from investment to speculative grade
How do you solve for "PMT" in the 3 formulas in which it appears?
a. Rearrange the formulas to isolate PMT
What is the difference between simple and c?
a. Simple - every period we earn interest on the initial amount b. Compound - earning interest on earlier interest; adds to each ending period amount; balance grows quicker
What does the buying and selling of bond represent?
a. The buying of bonds - lending b. Selling of bonds - borrowing
How do current interest rates compare to those in the late 1970s-early 1980s and what accounts for the difference
a. The nominal interest rates were higher in the late 1970s-early 1980s than they are now b. Inflation accounts for the difference - annual inflation was higher back then
What does the Fisher Effect show?
a. The nominal rate is approximately equal to the real rate+ inflation
What is the process used to find the YTm of a coupon-paying and what key relationship from Chapter 3 is at the heart of the process?
a. Trial and error b. Inverse relationship between the present value and the discount rate
What are the three basic multiple cash flow patterns?
a. Uneven - cash flows are not the same b. Perpetuity - repeated equal cash flows - PMT i. The future value of a perpetuity does not exist - infinite c. Annuity - equal cash flows that do not go on forever
How do you find the amount needed to fully pay off a fixed-payments fully-amortized loan?
a. Use amortization table
How do you solve for the PV and FV of uneven stream
a. Use lump sum PV and FV formulas, apply them to problems, add them up
How do you solve for the YTM of a zero coupon bond?
a. YTM= (PAR/PB)^ (1/n) -1
What are the 2 bond pricing situations that you could face in this course?
a. Zero Coupon Bond b. Annual Coupon Bond
What are the three things that a timeline shows?
a. magnitude/amount of cash flow b. Inflow or outflow c. What time the cash flows occur
How do you solve for a bond's current yeild?
a.YTM (approx) = (Couple +(Par-PB)/n)/(.4Par+.6PB) b. Excel or Financial Calculator