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