Finance Exam 3

Debt

includes all cash borrowing (debt) incurred by a firm, including bonds, and is repaid according to a fixed schedule of payments (coupon pmt and face value) (temporary)

Common Stock Valuation:

Present value of future cash flows (These investors buy shares that they believe to be undervalued and sell shares that they think are overvalued)

What is the value of an asset which pays $200 a year for the next 5 years and can be sold for $1,500 at the end of five years from now? Assume that the opportunity cost is 10 percent.

$1,689.54

conversion feature

(for convertible bonds) allows bondholders to change each bond into a stated number of shares of common stock (only when the market price of the stock is greater than the conversion price)

Cost of each source of Capital for the Firm:

- Cost of Long Term Debt - Cost of Preferred Stock - Cost of Common Stock - Cost of Using Retained Earnings

Sources of Capital (Cash):

- Long Term Debt (Bonds) - Equity (Stock) (Preferred Stock and Common Stock) - Retained Earnings

Common stock: dividends:

- The payment from the earnings to the firm's shareholders - Declared and paid at the discretion of the company's board of directors. - May be paid in cash, stock, or merchandise. - Not promised

The pre-tax cost of debt can be determined in any one of three ways:

- Using market quotations: observe the yield to maturity (YTM) on the firm's existing bonds or bonds of similar risk issued by other companies - Calculating the cost: find the before-tax cost of debt by calculating the YTM generated by the bond cash flows - Approximating the cost

The common stock of a firm can be:

- privately owned by private investors (ex. Colliers) - closely owned or held by an individual investor or a small group of investors (ex. Harps) or - publicly owned by a broad group of investors (ex. Tyson or Walmart)

three key inputs to the valuation process:

1. Future cash flows (cash inflows minus cash outflows over the life of the asset) 2. Timing of the future cash flows (how long the asset is held) 3. A measure of risk, which determines the required return (total return from the asset)

Perry purchased 100 shares of Ferro, Inc. common stock for $25 per share one year ago. During the year, Ferro, Inc. paid cash dividends of $2 per share. The stock is currently selling for $30 per share. If Perry sells all of his shares of Ferro, Inc. today, what rate of return would he realize?

28%

Yield to Call (YTC)

A call provision allows the bond's issuer to buy back the bond prior to maturity at a pre specified price

The future value of $100 received today and deposited at 6 percent for four years is ________. A) $126 B) $79 C) $124 D) $116

A) $126

Asset P has a beta of 0.9. The risk-free rate of return is 8 percent, while the return on the market portfolio of assets is 14 percent. The asset's required rate of return is ________. A) 13.4 percent B) 22.0 percent C) 15.4 percent D) 6.0 percent

A) 13.4%

If a United States Savings bond can be purchased for $29.50 and has a maturity value of $100 at the end of 25 years, what is the annual rate of return on the bond? A) 5 percent B) 6 percent C) 7 percent D) 8 percent

A) 5%

Since retained earnings are viewed as a fully subscribed issue of additional common stock, the cost of retained earnings is ________. A) less than the cost of new common stock equity B) equal to the cost of new common stock equity C) greater than the cost of new common stock equity D) not related to the cost of new common stock equity

A) less than the cost of new common stock equity

Current Yield (CY)

Actual interest the investor receives each year from a bond, Quoted in the financial press, Simply calculated as its annual coupon payment divided by it current price (PV), (not the price you paid for the bond)

Emmy Inc. has an expected dividend next year of $5.60 per share, a growth rate of dividends of 10 percent, and a required return of 20 percent. The value of a share of Emmy Inc.'s common stock is ________. A) $28.00 B) $56.00 C) $22.40 D) $18.67

B) $56.00

The approximate before-tax cost of debt for a 15-year, 10 percent, $1,000 par value bond selling at $950 is ________. A) 10 percent B) 10.7 percent C) 12 percent D) 15.4 percent

B) 10.7%

Which of the following is a difference between common stock and bonds? A) Bondholders have a voice in management; common stockholders do not. B) Bondholders have a senior claim on assets and income relative to stockholders. C) Stocks have a stated maturity but bonds do not. D) Dividend paid to stockholders is tax-deductible but interest paid to bondholders are not.

B) Bondholders have a senior claim on assets and income relative to stockholders.

Risk aversion is the behavior exhibited by managers who require ________. A) an increase in return, for a given decrease in risk B) an increase in return, for a given increase in risk C) no changes in return, for a given increase in risk D) decrease in return, for a given increase in risk

B) an increase in return, for a given increase in risk

The key inputs to the valuation process include ________. A) cash flow and risk B) cash flow, cash flow timing, and risk C) cash flows and discount rate D) returns, discount rate, and risk

B) cash flow, cash flow timing, and risk

The ________ is the rate of return that a firm must earn on its investments in order to maintain the market value of its stock. A) yield to maturity B) cost of capital C) internal rate of return D) modified internal rate of return

B) cost of capital

If the coupon rate of a bond is equal to its required rate of return, then ________. A) the current value is not equal to par value B) the current value is equal to par value C) the maturity value is equal to par value D) the current value is equal to maturity value

B) the current value is equal to par value

Adam borrows $4,500 at 12 percent annually compounded interest to be repaid in four equal annual installments. The actual end-of-year payment is ________. A) $942 B) $1,125 C) $1,482 D) $2,641

C) $1,482

A firm has an issue of preferred stock outstanding that has a stated annual dividend of $4. The required return on the preferred stock has been estimated to be 16 percent. The value of the preferred stock is ________. A) $64 B) $16 C) $25 D) $50

C) $25

A firm has an issue of $1,000 par value bonds with a 9 percent stated interest rate outstanding. The issue pays interest annually and has 20 years remaining to its maturity date. If bonds of similar risk are currently earning 11 percent, the firm's bond will sell for ________ today. A) $1,000 B) $716.67 C) $840.73 D) $1,123.33

C) $840.73

A firm has determined its cost of each source of capital and optimal capital structure, which is composed of the following sources and target market value proportions: The weighted average cost of capital is ________. A) 6 percent B) 10.7 percent C) 11 percent D) 15 percent

C) 11%

A firm has issued preferred stock at its $125 per share par value. The stock will pay a $15 annual dividend. The cost of issuing and selling the stock was $4 per share. The cost of the preferred stock is ________. A) 7.2 percent B) 12 percent C) 12.4 percent D) 15 percent

C) 12.4%

The before-tax cost of debt for a firm, which has a marginal tax rate of 40 percent, is 12 percent. The after-tax cost of debt is ________. A) 4.8 percent B) 6.0 percent C) 7.2 percent D) 12 percent

C) 7.2%

Systematic risk is also referred to as ________. A) business specific risk B) internal risk C) nondiversifiable risk D) maturity risk

C) nondiversifiable risk

The two primary models for Stock Valuation:

Constant-dividend growth model (D0) (Gordon Model using g to grow the dividend) Zero-dividend growth model (D1) (Gordon Model using expected dividend (no change in D))

Bill plans to fund his individual retirement account (IRA) with the maximum contribution of $2,000 at the end of each year for the next 20 years. If Bill can earn 12 percent on his contributions, how much will he have at the end of the twentieth year? A) $19,292 B) $14,938 C) $40,000 D) $144,104

D) $144,104

Accrued Interest

If one buys a bond at any other timethan the year or half year, you'll owe the issuer, in addition to the bond's price, the accrued interest since the lastcoupon payment date

The primary approach to valuation of any asset (physical or financial) is:

Present Value (PV) of future cash flows (both inflows and outflows) associated with the asset put into operation/force

how would one value a bond (a financial asset)?

The present value of future cash flows from the bond

The Zero Growth Model

The zero dividend growth model assumes that the stock will pay the same dividend each year, year after year.

True or False: Combining negatively correlated assets can reduce the overall variability of returns.

True

True or False: Dividend payments to a firm's stockholders are not tax-deductible.

True

True or False: Equity has no maturity date and never has to be repaid by the firm.

True

True or False: Most managers are risk-averse, since for a given increase in risk they require an increase in return.

True

True or False: New shares are underpriced if the stock is sold at a price below its current market price

True

True or False: The value of an asset is determined by discounting the expected cash flows back to its present value, using an appropriate discount rate.

True

True or False: The weights must be non-negative and sum to 1.00

True

True or False: Typically, the cost of long-term debt for a given firm is always less than the cost of preferred or common stock, partly because of the tax deductibility of interest.

True

True or False: the only relevant risk is nondiversifiable risk

True

True or false: The shares of privately owned firms, which are typically small corporations, are generally not traded.

True

True or false: The value of a share of common stock is equal to the present value of all future cash flows (dividends) that it is expected to provide

True

Flotation costs include two components:

Underwriting costs—compensation earned by investment bankers for selling the security (1/2% to 2% of total value). Administrative costs—issuer expenses such as legal, accounting, and printing.

Preferred Stock

While legally an equity, most investors consider preferred stock to be another form of debt

cash inflow

a cash receipt (a positive value)

portfolio

a collection, or group, of assets.

The Gordon model

a common name for the constant-growth model that is widely cited in dividend valuation

Range

a measure of an asset's risk, which is found by subtracting the return associated with the pessimistic (worst) outcome from the return associated with the optimistic (best) outcome

correlation coefficient

a measure of the degree of correlation between two series

Risk

a measure of the uncertainty surrounding the return that an investment will earn or, more formally, the variability of returns associated with a given asset

probability distribution

a model that relates probabilities to the associated outcomes

cash outflow

a payment, cost, or deposit (a negative value)

price/earnings multiple approach

a popular technique used to estimate the firm's share value; calculated by multiplying the firm's expected earnings per share (EPS) by the average price/earnings (P/E) ratio for the industry

efficient portfolio

a portfolio that maximum return for a given level of risk

continuous probability distribution

a probability distribution showing all the possible outcomes and associated probabilities for a given event

beta coefficient

a relative measure of nondiversifiable risk. An index of the degree ofmovement of an asset's return in response to achange in the market return

annuity

a series of equal cash flows received or paid at regular intervals

A proxy statement

a statement transferring the votes of a stockholder to another party

Correlation

a statistical measure of the relationship between any two series of numbers

The Constant-growth model

a widely cited dividend valuation approach that assumes that dividends will grow at a constant rate, but a rate that is less than the required return

perpetuity

an annuity with an infinite life, providing continual annual cash flow

Scenario analysis

an approach for assessing risk that uses several possible alternative outcomes (scenarios) to obtain a sense of the variability among returns

Before new dividends are paid to common stockholders:

any past due dividends owed to preferred stockholders must be paid.

constant-growth valuation (Gordon) model

assumes that the value of a share of stock equals the present value of all future dividends that it is expected to provide over an infinite time horizon

Equity

consists of cash funds provided by the firm's owners (investors or stockholders), buying ownership, that are"repaid" subject only to the firm's performance (permanent)

Outstanding shares

issued shares of common stock held by investors, this includes private and public investors

Treasury stock

issued shares of common stock held by the firm. Often these shares have been repurchased by the firm

For computational convenience:

it is best to convert the weights into decimal form and leave the individual costs in percentage terms.

weighted average cost of capital

reflects the expected average future cost of capital over the long run

What are the cash flows from a bond?

regular annual/semi-annual interest payments called coupon payments and the bond's principal at maturity (price appreciation if discount bond or depreciation if premium bond)

Common stockholders, who are sometimes referred to as:

residual owners or residual claimants

There are two forms of common stock financing:

retained earnings and new issues of common stock

Issued shares

shares of common stock that have been put into circulation (Issued shares = outstanding shares + treasury stock)

Interest payments to debtholders are treated as:

tax-deductible expenses by the issuing firm

Liquidation value per share

the actual amount per share of common stock that would be received if all of the firm's assets were sold for their market value, liabilities (including preferred stock) were paid, and any remaining money were divided among the common stockholders

Book value per share

the amount per share of common stock that would be received if all of the firm's assets were sold for their exact book (accounting) value and the proceeds remaining after paying all liabilities (including preferred stock) were divided among the common stockholders

effective (true) annual rate (EAR)

the annual rate of interest actually paid or earned

Risk neutral

the attitude toward risk in which investors choose the investment with the higher return regardless of its risk

Risk seeking

the attitude toward risk in which investors prefer investments with greater risk even if they have lower expected returns

Risk averse

the attitude toward risk in which investors would require an increased return as compensation for an increase in risk

Expected value of a return

the average return that an investment is expected to produce over time

capital asset pricing model (CAPM)

the basic theory that links risk and return for all assets.(it measures how much additional return an investor should expect from taking a little extra risk)

Probability

the chance that a given outcome will occur

Interest rate risk

the chance that interest rates will change and thereby change the required return and bond value

Total risk

the combination of a security's nondiversifiablerisk and diversifiable risk

nominal (stated) annual rate

the contractual annual rate of interest charged by a lender or promised by a borrower

cost of a new issue of common stock

the cost of common stock, net of underpricing and associated flotation costs.

Pretax cost

the financing cost associated with new funds, before taxes are applied

cost of capital

the firm's total cost of financing (what they pay to get capital) as a % of the total financing, and the minimum rate of return as a % that an investment must earn to add value to the firm (what they need to earn as a % of the total investment)

Net proceeds

the funds actually received by the firm from the sale of a security (the price paid by investors for the instrument less floatation costs)

Standard deviation

the most commonstatistical indicator of an asset's risk; it measuresthe dispersion around the expected value

Diversifiable risk

the portion of an asset's risk that is attributable to firm-specific, random causes (can be eliminated through diversification)

Valuation

the process that links risk and return to determine the worth or value of any asset (physical or financial)

cost of common stock equity

the rate at which investors discount the expected dividends of the firm to determine its share value (stock price).

Yield to Maturity (YTM)

the rate of return that investors earn if they buy a bond at a specified price and hold it until maturity

cost of preferred stock

the ratio of the preferred stock dividend to the firm's net proceeds from the sale of preferred stock

Nondiversifiable risk

the relevant portion of an asset's risk attributable to market factors that affect all firm (cannot be eliminated through diversification)

risk-free rate of return

the required return on a risk-free asset, typically a 3-month U.S. Treasury bill.

market return

the return on the market portfolio of all traded securities

The cost of common stock is:

the return required on the stock by investors in the marketplace.

cost of retained earnings

the same as the cost of an equivalent fully subscribed issue of additional common stock, which is equal to the cost of common stock equity

Authorized shares

the shares of common stock that a firm's corporate charter allows it to issue

bar chart

the simplest type of probability distribution; shows only a limited number of outcomes and associated probabilities for a given event

Flotation costs

the total costs of issuing and selling a security

Return

the total gain or loss experienced on an investment over a given period of time

present value

the value of a cash flow at the beginning of a period, "today" for example

future value

the value of a cash flow at the end of a specific period or time, for example the value "one year from today"

Perfectly negatively correlated

two negatively correlated series that have a correlation coefficient of -1

Perfectly positively correlated

two positively correlated series that have a correlation coefficient of +1

Uncorrelated

two series that lack any interaction and therefore have a correlation coefficient close to zero

Negatively correlated

two series that move in opposite directions

Positively correlated

two series that move in the same direction

Par bond

when the Price (amount you pay for the bond) equals the Face or Par Value

Premium bond

when the Price (amount you pay for the bond) is greater than the Face or Par Value

Discount bond

when the Price (amount you pay for the bond) is less than the Face or Par Value