Exam 1 ( CH 1, 5, 6)

HPR Formula

(current income+ Capital gains)/ Beginning value

5 principles of finance

1. Cash flow is what matters 2.Money has a time value 3. Risk required a reward 4. Market prices are generally right 5. Conflict of interest causes agency problems

Sole Proprietorship

A business owned by one person, owner maintains title to assets and profits, unlimited liability, termination occurs on owner's death or by the owner's choice.

BETA

A number measures the systematic risk. Beta indicates how a security price responds to the overall market. For example, if beta of a stock (say ABC) is 1.2 and the overall market increases by 10%, then ABC's stock p increase by 1.2 times rice is expected to this 10% i.e., 12%.

Cash flow is what matters

Cash Flow, and Net profits, drive the value of business. Accounting profits are not equal to cash flows. Incremental or marginal cash flows matters in financial decisions

HPR Example; Last year you bought 5 bonds which pays a coupon of 7% for $980 each and sold it today at $984. What is your HPR?

Current income= 70*5= 350 Capital gain= (984-980)*5 = 20 HPR= 370 / 4900= 7.55%

HPR example; Suppose you purchased 16 shares of Diamond Company stock for $24.22 per share on May 1, 2016. On September 1 of the same year, you sold 12 shares of the stock for $25.68 pre share. Calculate the holding-period dollar gain for the shares you sold, assuming no dividend was distributed, and calculate the holding-period rate of return.

Current income=0 Capital gains= (25.68-24.22)*12=17.52 HPT= 17.52/290.64=6.03%

Non annual periods example; To buy a new house you take our a 25- year mortgage for $300,000. What will you monthly payments be if the interest rate on your morgate is an APT of 8% compounded monthly?

Financial Calc inputs; N=25*12=300 I=8/12=0.666 PV= 300,000 FV=0 Compute PMT.. = -2,315.45= (absolute value & rounded)= $2,315

Compound interest example; We place $100 in savings account that pays 6% interest, compounded annually. How will our savings grow at the end of the first year?

Financial Calculator inputs; N= 1 I=6 PV= 100 PMT=0 Compute FV .. Answer = -106 (absolute value)... = $106, (if more yrs change N)

Annuity example; you want to borrow $10,000 at 5% interest rate for 5 years and want to compute the amount you need to repay every year?

Financial Calculator inputs; N=5 I=5 PV=-10,000 (LOAN IS NEG) FV=0 (pay off loan) Compute PMT .... = 2,309.75= 2,310 (rounded)

Simple interest

If you only earned interest on your initial investment.

Risk Required a Reward

Investors will not take on additional risk unless they expect to be compensated with additional reward or return. Investors expect to be compensated for "delaying consumption" and "taking on risk"

Goal of a firm

Maximize shareholder wealth (owners wealth) ; implies maximizing the price of a common stock

Capital Asset Pricing Model (CAPM)

Model that uses the notion of beta to link the risk and return Rj= Rf +Bj*(Rm-Rf) CAPM has 3 components: (i) risk free rate (Rf) (ii) market return (Rm) and (iii) beta (βj). Subscript j is used to denote the stock of a company j

Compound Interest

Occurs when interest paid on the investment during the first period is added to the principle; then, during the second period, interest is earned on this new sum.

Annuity

Payment or (pmt) a series or equal dollar payments for a specified number of periods (ex; home and auto loans, pensions)

Holding Period Return (HPR)

Total return over a specific period of time (<1 year)

Money has a time value

a dollar received today is work more than a dollar received in the future. Almost all financial decisions involve comparing money in different time periods (investing today and receiving returns later, or borrowing money today and paying it off later)

Market Prices are generally right

in a financial market, the market prices of all traded assets (such as stocks and bonds) fully reflect all available information at any instant in time. Stock prices are a useful indicator of the value of the firm. markets are quick to impound new information into stock prices, and the prices tend to be correct

Market Risk Premium

is the amount of return beyond the risk free rate that an investor demands for bearing the systematic risk. it is the difference between Rm and Rf (Rm-Rf)

Corporation

legally functions separate and apart from its owners, owners (shareholders) dictate direction and policies of the corporation, oftentimes through elected board of directors. Shareholder's liability is restricted to amount of investment in Co. Life of corp. does not depend on the owners it continues to be run by managers after transfer of ownership through sale or inheritance

Conflict of interest causes agency probles

separation of management and the ownership creates an agency problem. Managers may make decisions that are not consistent with the goal of maximizing shareholder wealth; managers may not work for the owners' best interest unless it is in the managers' best interest as well.

Forms of business organization

sole proprietorship, partnership, corporation

Effective annual rate (EAR)

the annual compound rate that produces the same return as the nominal, or quoted, rate when money is compounded on a nonannual basis. In effect, the EAR provides the true rate of return.

Partnership

two or more owners; general partnership= all partners are fully responsible for liabilities incurred by the partnership. Limited partnership= one or more partners can have limited liability, restricted to the amount of capital invested in the partnership. there must be at least one partner with unlimited liability. ( cannot participate in the management of business and their names cannot appear in the name of the firm.

Non- Diversifiable of Systematic Risk

§Portion of Risk attributable to general forces that affect all investments §It is the market risk and cannot be eliminated through diversification §Every security has its own unique level of systematic risk

Diversifiable or unsystematic risk

§Portion of risk attributable to firm specific events §Can be eliminated through diversification §Diversifiable risk can be significantly reduced by a portfolio of 8-15