Finance Midterm 7-9

What are features of a common stock?

It has no special preference in bankruptcy It has no special preference in receiving dividends It generally has voting rights

When cash flows are conventional, NPV is _______________ if the discount rate is above the IRR.

Negative

If the growth rate (g) is zero, the capital gains yield is _____.

Zero

The IRR is the discount rate that makes the NPV of a project equal to _______________.

Zero.

Why is it more difficult to value common stock than it is to value bonds?

The rate of return required by the market is not easily observed. Common Stock cash flows are not known in advance. The life of a common stock is essentially forever.

T/F: Some projects, such as mines, have cash outflows followed by cash inflows, which are then followed by cash outflows, giving the project multiple rates of return.

True

Examples of mutually exclusive investments?

Two different choices for assembly lines that will make the same product. A restaurant or a gas station on the same piece of land.

Internal Rate of Return (IRR) must be compared to the __________ in order to determine the acceptability of a project.

Required Return

Which of the following projects is acceptable if the average accounting return is required to be at least 20%?

Restaurant: Average Income = $450,00, Average Book Value = $2,180,000 Book Store: Average Income = $140,000, Average Book Value = $600,000

What are the advantages of the payback period for management?

The payback period method is ideal for short projects. The payback period method is easy to use. It allows lower level managers to make small decisions effectively.

Default Risk

The risk that the issuer will not be able to make the required payments

T/F: It can be advantageous to have a staggered board because it provides "institutional memory".

True

What is the price in one year for a stock that pays a dividend in one year of $2 with a growth of 8% and a required return of 10%?

$108

What is the value of a stock if next year's dividend is $6, the discount rate is 11% and the constant rate of growth is 3 percent?

$75

What are expected cash flows to investors in stocks?

Capital Gains Dividends

Debt Securities

Classified by the collateral and the mortgages used to protect the bond holder.

Clean v. Dirty Price

Clean disclude interest while Dirty includes interest

Bid-ask Spread

Difference between ask and bid and shows the dealer's profit.

Effective Annual Yield

EAY = (1+r)^t

One reason corporations use staggered boards is that:

It makes takeover attempts less likely to be successful.

What occurs in the primary market?

Newly-issued stocks are initially sold.

The amount of time needed for the cash flows from an investment to pay for its initial cost is the?

Payback period

Call Premium

The amount by which the call price exceeds the par value of the bond.

Face Value (Par Value)

The amount that will be paid at the end of the loan; also called Par Value. The principle repaid at maturity.

What entities declare the dividend?

The board of directors.

The three attributes of NPV are that it:

Uses all the cash flows of a project. Discounts the cash flows properly. Uses cash flows.

What are usually rights of common shareholders?

Voting rights. The right to purchase a proportional share of new stock issues. The right to a proportional share of dividends paid.

When valuing a stock, the advantage to considering the stock price in the distant future (rather than a more near-term price) as a cash flow is that:

When discounted to present value, a stock price in the distant future is nearly zero.

YTM Equation

YTM= C x [1-1/(1+r)^t]/r+f/(1+r)^t

What is the IRR for a project with an initial investment of $250 and subsequent cash inflows of $100 per year for 3 years?

9.7%

What makes a financial market transparent?

A financial market is transparent if the prices and trading value are easily observable.

Discount Bonds

Bonds that sell for less than face value

Most voting in large corporations is done by proxy because:

Most small shareholders do not attend the annual meeting

If a project has multiple internal rates of return, which of the following methods should be used?

NPV MIRR

Is a company required to pay preferred dividends?

No; the company may defer dividends on preferred stock; however they can not pay dividends to common shareholders until preferred dividends are paid.

Bond Maturity

Number of years until the face value is paid

Real Rate of Return

The Rate of Return adjusted with inflation

Bond is trading at premium if ____?

Trades for more than face value

T/F: The crossover rate is the rate at which the NPVs of two projects are equal.

True

What are advantage(s) of AAR?

Is easy to compute Needed information is always available.

IRR continues to be very popular in practice, partly because:

It gives a rate of return rather than a dollar value.

What is the nominal rate of return on an investment

Nominal rates have not been adjusted for inflation and are the exact percentage change for the dollar amount of the investment.

When voting for the board of directors, the number of votes a shareholder is entitled to is generally determined as follows:

One vote per share held.

Fundamentally, the business of the NYSE is to attract and process ____________.

Order flow

According to the basic IRR rule, we should:

Reject a project if the IRR is less than the required return

NPV accounts for the size of the project and thus mitigates the effects of __________.

Scale

NPV accounts for the size of the project and thus mitigates the effects of ______________.

Scale

Indenture

The written agreement between the borrower (corporation) and creditor.

Truth about Municipal Bonds?

They are not subject to federal tax Have some default risk Issued by State and Federal government Attractive to High-Incomes

3 components that determine the term structure of interest rates?

1. Inflation Premium 2. Real Interest Rate 3. Interest Rate risk Pemium

Three components of Treasury yield curve:

1. Interest rate risk premium 2. Real rate of return 3. Expected inflation

The internal rate of return is a function of ______________.

A project's cash flows.

Bond Ratings?

AAA - D (AAA being highest and D being Lowest)

What information do we need to determine the value of stock using the zero-growth model?

Annual dividend amount Discount Rate

The IRR rule can lead to bad decisions when ___________ or _____________.

Cash flows are not conventional Projects are mutually exclusive

What are weaknesses of the payback method?

Cash flows received after the payback period are ignored. Time value of money principles are ignored The cutoff date is arbitrary.

The largest number of NYSE members are registered as ___________________

Commission brokers.

Treasury Bonds

Offered by US Government Has tax benefits (only taxed at federal level) Often considered with no default risk

T/F: Two challenges with the IRR approach when comparing two mutually exclusive projects are scale and cash flow timing.

True

Bid vs Ask Price

Bid Price is the price sold at and Ask Price is the price asked for

Zero Coupon Bonds ____?

Bond that pays no coupons Make no interest payments Are always issued at a discount

A person who brings buyers and sellers together is called a(n) __________________

Broker

Matthews Company has two classes of common stock, and each share represents the same proportion in the company. Class A has 2 votes for each share. Class B has one vote per share. Which class is more valuable?

Class A

Three important features of Treasury Notes and Bonds

Highly Liquid Taxable Default Free

A(n) _________ project does not rely on the acceptance or rejection of another project.

Independent.

The most important alternative to NPV is the _________ method.

Internal Rate of Return

The point at which the NPV profile crosses the horizontal axis is the:

Internal Rate of Return

According to Graham and Harvey's 1999 survey of 392 CFOs, which of the following two capital budgeting methods are most used by firms in the U.S. and Canada?

Internal Rate of Return Net Present Value

Stock price reporting has increasingly moved from traditional print media to the __________________ in recent years.

Internet

The trading of existing shares occurs in the ____________ market.

Secondary

One requirement of the dividend growth model is:

g < R

The two most important stock markets in the U.S. are the New York Stock Exchange and ______________________

the NASDAQ

According to the average accounting return rule, a project is acceptable if its average accounting return exceeds:

A target average accounting return.

The basic NPV investment rule is:

Accept a project if the NPV is greater than zero If the NPV is equal to zero, acceptance or rejection of the project is a matter of indifference. Reject a project if its NPV is less than zero.

A project should be _________________ if its NPV is greater than zero.

Accepted

The three special case patterns of dividend growth include:

Constant Growth Non-Constant Growth Zero Growth

A zero-growth model for stock valuation is distinguished by a ___________________.

Constant dividend amount

What is needed to calculate the value of a bond?

Coupon Rate, number of periods remaining until maturity, face value, the coupon, and the market interest rate for similar bonds.

Suppose Bob owns 20 shares and Vikki owns 30 shares in Good Company, and there are five members of the board of directors. Under which voting arrangement can Bob assure himself a board member that represents his interests?

Cumulative voting

A person who brings buyers and sellers together is called a(n) _______________________

Broker

Scott Corporation does not pay dividends. The PE ratio for its industry is 13.3, and Scott's EPS were $1.47. At what price should Scott's stock trade?

$19.55

What is the price of a stock at the end of one year (P1) if the dividend for Year 2 (Div2) is $5, the price for Year 2 (P2) is $20, and the discount rate is 10%?

$22.73

You expect the following dividends from ABC stock: Year 1 - $3.00 Year 2 - $2 Year 3 - $1 You expect that from year 4 onward, the dividend will grow at a constant 3% growth rate. If your required rate of return is 7%, what is your estimate for current stock price?

$26.39

What is the NPV of a project with an initial investment of $95, a cash flow in one year of $107, and a discount rate of 6 percent?

$5.94

Dusty corporation has an issue of preferred stock that pays a dividend of 7% of its state value, which is $100. What would be a commonly used name for that preferred stock?

$7 preferred.

What is the price of a stock if its dividend a year from now is expected to be $3.20, the discount rate is 9 percent, and the constant rate of growth is 5 percent?

$80

Break Even Rate For Muni

(Muni yield / Corporate yield) - 1 = BER

If a zero-dividend stock is purchased for $80 and sold one year later for $84, the 1-year return is ____________ percent.

5

Two Prices listed on WSJ?

Ask and Bid Price

Types of Bonds

CAT Bond: Protects Insurance companies from natural disasters. Structured Note: Based on financial securities, commodities, or currencies. Put Bond: Owner can force issuer to repay. Convertible Bond: Can be exchanged for shares of stock.

Coupon Rate

CR= Annual Coupon/Face Value (It is fixed until the bond matures)

What is the current yield of a 1000 par value bond that sells for 900 with a 10% coupon rate?

CY = (.1*1000)/900 = 11.11%

CY Equation

CY= Annual coupon/Quoted Price

NASDAQ has which of these features?

Computer Network of securities dealers Multiple market maker system

All else constant, the dividend yield will increase if the stock price _______________

Decreases

Steps involved in the discounted payback period in order starting with the first step.

Discount the cash flows using the discount rate. Add the discounted cash flows. Accept if the discounted payback period is less than some pre-specified number of years.

NPV________ cash flows properly

Discounts

The constant-growth model infers that __________________

Dividends change at a constant rate.

Which one of the followings is true about dividend growth patterns? Dividends never grow. Dividends always grow at a differential rate. Dividends always grow at a constant rate. Dividends may grow at a constant rate.

Dividends may grow at a constant rate.

The price of a share of common stock is equal to the present value of all ___________ future dividends.

Expected.

T/F: Investing more money in a project is a guarantee of greater profits.

False

T/F: The MIRR function eliminates multiple IRRS and should replace NPV

False

T/F: The discounted payback rule has an objective benchmark to use in decision-making.

False

A PE ratio that is based on estimated future earnings is known as a _____________ PE ratio.

Forward

An asset's value is determined by the present value of its _____________ cash flows.

Future

The profitability index is calculated by dividing the PV of the ______________ cash flows by the initial investment.

Future

WinWin Corporation has five board members, and each shareholder gets one vote per share. The company uses a straight board voting procedure. How does this arrangement affect minority shareholders?

No minority shareholder would have enough votes to win any seat on the board.

What is the present value of the annual interest payment of a 20 year, 1000$ par value bond, with a 5% coupon paid annually, if the yield on a similar bond with 10%yield on similar bonds?

PV = (.05x1000) x (1-1/1.1^20)/.1 = $425.68

The capital budgeting method allows lower management to make smaller, everyday financial decision effectively.

Payback method.

Preferred stock has preference over common stock in the:

Payment of dividends Distribution of corporate assets.

After Tax Yield Equation

Percent Yield x (1 - tax bracket) = ATY

When cash flows are conventional, NPV is

Positive for discount rates below the IRR. Negative for Discount rates above the IRR Equal to zero when the discount rate equals the IRR.

For a project with conventional cash flows, the NPV is __________ if the required return is less than the IRR, and it is ___________ if the required return is greater than the IRR.

Positive, Negative

In capital budgeting, the net ___________ determines the value of a project to the company.

Present Value

Initial public offerings of stock occur in the ___________ market.

Primary

Nominal Rate

R is about Inflation Rate + Real Rate

APR computed?

Rate per period x Number of periods per year

Project Alpha's NPV profile crosses the vertical axis at $230,000. Project Beta's NPV profile crosses the vertical axis at $150,000. If Projects Alpha and Beta have conventional cash flows, are mutually exclusive and the NPV profiles crosses at 15% (where the NPVs are positive), which of the projects has higher internal rate of return?

Project Beta

Term Structure of Interest Rates

Relationship of long and short term interest rates. Most common structure is upward sloping, which means long term is greater than short term.

What is the PI for a project with an initial cash outflow of $30 and subsequent cash inflows of $80 in Year 1 and $20 in Year 2 if the discount rate is 12%?

2.91

The NYSE differs from the NASDAQ primarily because the NYSE has

A physical location Specialists An auction market

How is preferred stock like a bond?

Some preferred stock has credit ratings, like bonds. Preferred stock sometimes has a sinking fund, giving ti a set maturity like bonds. Preferred shareholders receive a stated dividend, similar to interest on a bond. Preferred shareholders receive a stated value if the firm liquidates, like bondholders.

Mota Motors has eight directors on its board, two of whom go up for election each year. This is an example of a :

Staggered board

The goal of many successful organizations is a(n) _____________________ rate of growth in dividends.

Steady

Saxon Company is considering a project that will generate net income of $50,000 in Year 1, $75,000 in Year 2, and $90,000 in Year 3. The cost of the project is $700,000, and this cost will be depreciated to zero in the three years of the investment. What is their average accounting return?

20.48%

The PI rule for an independent project is to _________________ the project if the PI is greater than 1.

Accept

Payback period tells the time it takes to break even in an _____________ sense. Discounted payback period tells the time it takes to break even in an ______________ or financial sense.

Accounting Economic

How does timing and the size of cash flows affect the payback method? Assume the project does pay back within the project's lifetime.

An increase in the size of the first cash flow will decrease the payback period, all else held constant.

Default Risk Premium

The extra compensation investors may ask for in the possibility that the issuer may not make all the promised payments.

Capital ___________ is the decision-making process for accepting and rejecting projects.

Budgeting

The value of a firm is the function of its ___________ rate and its _____________ rate.

Growth; discount

Junk Bonds have ____?

High Probability of Default Less than investment grade rating

One common reason for having two classes of common stock with different voting rights is:

It is easier for insiders such as founding families to maintain control of the company.

The discounted payback period has what weaknesses?

Loss of simplicity as compared to the payback method Exclusion of some cash flows Arbitrary cutoff date

When cash flows are conventional, NPV is ___________.

Negative for discount rates above the IRR. Equal to zero when the discount rate equals the IRR. Positive for discount rates below the IRR.

The payback period rule __________ a project if it has a payback period that is less than or equal to a particular cutoff date.

Suggests accepting

The point at which the NPV profile crosses the vertical axis is the:

Sum of the cash flows of the project

A benchmark PE ratio can be determined using:

The PEs of similar companies A company's own historical PEs

The dividend yield is determined by dividing the expected dividend by:

The current price (P0)

When the stock is being valued does not pay dividends,

The dividend growth model can still be used.

Capital Corp is considering a project whose internal rate of return is 14%. If Capital's required return is 14%, the project's NPV is:

Zero