Finance Test 2 Cheat Sheet PDF

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Finance Test 2 1. Assuming two investments have equal lives, a high discount rate tends to favor: A. the investment with large cash flow early 2. You have the choice of two equally risk annuities, each paying $5,000 per year for 8 years. One is annuity due and the other is an ordinary annuity. If you are going to be receiving the annuity payments, which annuity would you choose to maximize your wealth?: A. the annuity due 3. You can buy a $50 savings bond today for $25 and redeem the bond in 10 years for its face value of $50. You could also put your money in a money market account that pays n% interest per year. Which option is better, assuming they are of equal risk?: C. The savings bond is better because it earns higher interest rate. 4. Last national bank is offering you a loan at 10%; payments on the loan are to be made monthly. Credit Onion is offering you a loan where payments are to be made semiannually. The rate on the loan is alos 10%. Local bank down the street is also offering a loan at 10% where payments are made quarterly. Which loan has the lowest annual cost?: C. Credit Onion’s Loan 5. The minimum rate of return necessary to attract an investor to purchase or hold a security is referred to as the: C. Investors required rate of return 6. If you were to use the standard deviation as a measure of investment risk, which of the following has historically been the highest risk investment?: C. Common stock of small firms 7. You are considering investing in Ford Motor Company. Which of the following are examples of diversifiable risk? I. Risk resulting from possibility of a stock market crash, II. Risk resulting from uncertainty regarding a possible strike against Ford, III. Risk resulting from an expensive recall of a Ford product, IV. Risk resulting from interest rates decreasing: D. II, III 8. If the Beta for Stock A equals zero then: B. Stock A’s required return is equal to the risk free rate of return. 9. If a corporation were to choose between issuing a debenture, a mortgage bond, or a subordinated debenture, which would have the highest yield to maturity, everything else equal?: C. The subordinated debenture. 10. Which of the following is FALSE concerning bonds?: C. Debentures are secured by specific assets other than real estate. 11. If market interest rates rise: C. Long-term bonds will rise in value more than short-term bonds 12. Preferred stock is similar to a bond in the following way: B. Both investments provide a stated income stream. 13. Which of the following is NOT true regarding common stock?: D. Dividend payments, like interest payments, are fixed. 14. Who bears the greatest risk of loss of value if a firm should fail?: C. Common stockholders 15. A small company struggling to reach profitability just announced a major new government contract that will validate its technology and generate revenue for the next several years. The announcement of the contract will: C. Cause the stock price to increase because rcs (the required return) is likely to decrease and the growth rate of return is likely to increase. 16. D’Anthony borrowed $50,000 today that he must repay in 15 annual end of the year installation of $5,000. What annual interest rate is D’Anthony paying on his loan?: C. 5.556% 17. Your daughter is born today and you want her to be a millionaire by the time she is 35 years old. You open an investment account that promises to pay 12% per year. How much money must you deposit each year, starting on her 1st birthday and ending on her 35th birthday, so your daughter will have $1,000,000?: A. $2,316.62 18. You sell valuable artifacts from your household estate for $200,000 and want to use the money to supplement your retirement. You receive the money on your 60th birthday, the day you retire. You want to withdraw equal amounts at the end of each of the next 25 years. What constant amount can you withdraw each year and have nothing remaining at the end of 25 years of you are earning 7% interest per year?: A. 17,162.10 19. How much money must you pay into an account at the end of each of 20 years in order to have $100,000 at the end of the 20th year? Assume that the account pays 6% per year: D. $2,718.46

20. Cindy wants 2.5 million for her retirement at age 65. Cindy is 25 years old today and plans to deposit equal amounts each year for the next 40 years. If her investments earn 6% per year, how much must each deposit be?: B. $16,153.84 21. Stock W has the following returns for various states of the economy, stock W’s standard deviation of returns is: C. 17% 22. Assume that you have $330,000 invested in a stock that is returning 11.5%, $17,000 invested in a stock that is returning 22.75%, and $470,000 invested in a stock that is returning 10.25%. What is the expected return of your portfolio?: A. 15.6% 23. If you had a portfolio made up of the following stocks: what is the beta of the portfolio? C. 1.15 24. Assume that you have $100,000 invested in a stock whose beta is . 85, $200,000 invested in a stock whos beta is 1.05, and $300,000 invested in a stock whose beta is 1.25. What is the beta of your portfolio? C. 1.12 25. Assume that Bunch Inc. has an issue of 18-year $1,000 par value bonds that pay 7% interest annually. Further assume that today’s required rate of return on these bonds is 5%. How much would these bonds sell for today? A. 1,233.79 26. Bart’s Moving Company bonds have an 11% coupon rate. Interest is paid semiannually and bonds have a par value of $1,000 and will mature 8 years from now. Compute the value of Bart’s Moving Company bonds if investors’ required rate of return is 9.5%. D. 1,082.75. 27. A $1,000 par value 14-year with a 10% coupon rate recently sold for $965. The yield to maturity is: A. 10.49% 28. Studio 55, Inc. has an issue of preferred stock that pays a dividend of $4.00 The preferred stockholders require a rate of return on this stock of 9%. At what price should the preferred stock sell for? B. 44.40 29. Perrine Industrial Inc. just paid a dividend of $5 per share. Future dividends are expected to grow at a constant rate of 7% per year. What is the value of the stock if the required return is 16%? C. 59.44 30.

The common stock of Cranberry Inc. is selling for $26.75 on the open market. Next year’s dividend is expected to be $3.68, and the growth rate of this company is estimated to be 5.5%. Richard Dean, an average investor, is considering purchasing this stock at the market price, what is his expected rate of return? C. 19.26%

Chapter 7  ROR on any security = based on: o Risk free rate o Rate of inflation o Risk of default  Risk measured as stdev or variance or spread from mean, secondly, risk = also measured w/ fluctuations in cash flow or dividends, in general, Larger risk, larger rate of return.  Bonds = lowest risk, pref. stocks = higher risk & common stocks = highest risk because of preference for debt (bonds) over equity(stock) in event of bankruptcy & liquidation.  Bonds have lowest ror, common stocks have highest ror.  Larger risk, larger would be rate of return & vice versa.  Bonds = type of debt or long-term promissory note, issued by borrower, promising to its holder a predetermined & mixed amount of interest per year.  Types: o Debentures  Any unsecured long-term debt, no collateral of any kind.  More risky than secured bonds & provide higher yield than secured bonds.  Claims of subordinated debentures are honored only after claims of secured debt & unsubordinated debentures have been satisfied; are riskiest of all bonds & carry higher yield to maturity. o Mortgage bonds  Bond secured by a lien on real property.  Value of real property = greater than that of bonds issued.  Subordinated debentures (riskiest), debentures, mortgage bonds (least risky) o 0 & very low coupon bonds  Don’t pay interest every period.  Sells @ substantial discount prior to maturity from $1,000 FV w/ a 0 coupon.  Return comes from appreciation of bond.  Always riskier than bonds w/ high coupon rate.  Disadvantages:  issuer faces large cash outflow more than cash inflow when bond was issued.  When market int. rate rises, 0 bond loses more in value than bond paying higher coupon rate w/ same maturity.  Advantages:  Cash outflows don’t occur w/ 0 bonds & are relatively low level w/ low coupon bonds. o Junk bonds (high-yield bonds)  High risk debt w/ ratings of BBB- probability of default = high.  High yield- earn higher ror, typically pay 3-5% more than AAA grade long-term bonds. o Convertible bonds  more desirable than other bonds because there’s an option to convert bonds into common shares at investor’s will.  Convertible bonds have par value of $1,000, market value could be larger or smaller than $1,000. Bonds can be converted into prespecified shares at market value. Have options attached to bonds that give bondholders right to purchase stock at preset price w/out giving up bond.  Increase in share price must be = (mkt. price of bond/ (conv. Ratio/stock price))-1  Conversion ratio = number of shares of common stock it can be converted into.  Claims on Assets & Income o In case of insolvency, claims of debt, including bonds are honored before those of preferred or common stock.  Par value = face value or principal of bond, returned to bondholder at maturity, corp. bonds are issued at denominations of $1,000.  Discount = market value of bond will be below par or face when investor’s required rate = greater than coupon interest rate. Bond will sell at discount or below face value. Here YTM would be larger than current yield & larger than coupon rate.  Premium= market value of bond will be above par or face value when investor’s required rate = lower than coupon interest rate. Bond will sell at premium or above face value. When bond sells at premium, coupon rate = larger than current yield & larger than YTM.  Coupon interest rate = % of par value of bond that will be paid out annually in form of interest, e.g.; 7% bond means investor gets $70 (.07 x 1000) per year,

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o Sometimes paid semi-annually; ½ annual coupon twice a year; for 7% bond, semi-annual coupon would be ½ of 70 = $35 twice a year. Maturity: length of time until bond issuer returns par value to bondholder & terminates or redeems bond. It is usually $1,000 per bond. Convertibility: May allow investor to exchange bond for a predetermined number of firm’s shares of common stock. Call Provision o Callable bonds: if prevailing interest rate declines, firm may want to pay off bonds or call early & reissue at more favorable interest rate. o Issuer must pay bondholders a premium if bond is recalled. Also, a call protection period where firm cannot call bond for specified period. o Callable bonds are riskier & earn higher ror. Indenture: Legal agreement between firm issuing bond & trustee who represents bondholders. Provides for specific terms of loan agreement. Book value: value of asset as shown on firm’s balance sheet. Liquidation value: dollar sum that could be realized if asset were sold individually. Market value: observed value for asset in marketplace, could be different from par value. Intrinsic or economic value: Finance theory suggests that current value of any bond is based upon PV of principal & PV of bond’s interest payment; also, called fair value, present value of asset’s expected future cash flows. Present value of expected future cash flows of asset represents intrinsic value. Market price of bond = equal to present value of face value plus PV of annuity (coupon) payments. value of a bond = o a) function of its yield

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o b) function of its coupon o c) discounted value of its future cash flows Value of bond is NOT determined by rating agency or by default rate. Rating tells us default rate & not value. Current yield = annual interest in dollars / market value. FV = 1000 Yield to maturity = market interest rate or required rate of return. o YTM & expected ror or market ror are used interchangeably when referring to bonds. YTM = ror if bond is held to maturity. o YTM depends upon a) rating of bond, b) maturity of bond, & c) coupon rate o If market price of a bond decreases, YTM increases & vice versa. When calculating intrinsic value of bond, you must use market rate of interest or YTM as discount factor. Important Relationship o a) if YTM = greater than coupon rate, bond would sell at a discount (below par) o b) if YTM = smaller than coupon rate, bond would sell at a premium (above par) o c) if YTM = equal to coupon rate, bond would sell at par Intrinsic Value = to buy or not to buy depends upon intrinsic value of bond. o 2 investors can have different intrinsic values. If you decide not to buy bond, it implies your intrinsic value is greater than person whose value is lower. o Effect of interest rate movements o 2 bonds, 1 paying 7.5% maturing in 15 yrs. & other paying 9% maturing in 20 years; if market interest rates increase; both bonds would lose in value but the longer bond would lose more in value than the shorter bond & vice versa. 1st relationship o Decrease in market interest rates (required rates of return) will cause value of bond (regardless of maturity and coupon interest rate) to increase; on other hand, a market interest rate increase will (regardless of maturity and coupon interest rate) cause a decrease in value. Change in value caused by changing interest rates is called interest rate risk. 2nd relationship o If the bondholder's required rate of return (current interest rate) equals the coupon interest rate, the bond will sell at par, or maturity value. o If current interest rate exceeds bond's coupon rate, bond will sell below par value or at "discount." o If current interest rate is less than bond's coupon rate, bond will sell above par value or at "premium." 3rd relationship o As interest rate changes, longer term bonds are more affected than short term bonds, therefore, bondholder owning long-term bond is exposed to greater interest rate risk than when owning a short-term bond.

Chapter 8 Preferred Stock Features o Owners of preferred stock receive dividends instead of interest. o Most preferred stocks are perpetuities (non-maturing). o Multiple classes, each having different characteristics, can be issued. o In the case of bankruptcy, preferred stock has priority over common stock about claims on assets, but preferred stock holders have a lower priority than the bondholders o Most preferred stock carries a cumulative feature that requires all past unpaid preferred stock dividends to be paid before any common stock dividends are declared. o May contain other protective provisions. o Contains provisions to convert to a predetermined number of shares of common stock. o Retirement features for preferred stock are frequently included. o Callable preferred refers to a feature which allows preferred stock to be called or retired, like a bond. o A sinking fund provision requires the firm to periodically set aside an amount of money for the retirement of its preferred stock. o Dividend is not a legal obligation o Differs from common stock in that preferred stock dividends are fixed whereas common stock dividends are not. Preferred stock is often referred to as a hybrid security because it has many characteristics of both common stock & bonds. o Like commons stocks: no fixed maturity date, failure to pay dividends des not bring on bankruptcy, dividends are not deductible as business expenses and hence not tax deductible. o Like bonds: dividends are for limited time, both bonds & preferred stocks provide a stated income stream, dividends are typically same for each year and can be valued as perpetuity. Common stockholders bear the greatest risk, preferred stock, bonds. Value of preferred stock is present value of all future dividends. o Vps = annual dividend in $/ required rate of return = $D/Kps o if the ror increases, the value of preferred stock and common stock decreases; if the ror decreases, the value of both preferred and common stock increases… inverse relationship. Required rate of return o Cost of preferred stock = required rate of return or yield on preferred stock = preferred stock dividend/ market price of the preferred stock o Kps = D/Vps Common Stock Yield o Common stock when sold has two kinds of yields: dividend yield and capital gains yield o Suppose you purchased common stock at $15 per share, got $2 dividend and sold for $16.50, what are your dividend and capital gains yields? o Capital gains (C.G.) is the appreciation or depreciation in the price, capital gains = 16.50-15 =$1.50, capital gains yield before tax = 1.50/15 * 100 =10% o The dividend yield before tax= 2/15 * 100 =13.33%

Total yield before tax= Div. yield + C.G. yield = 13.33 +10 = 23.33% Dividends are taxed as ordinary income tax rate, while C.G. are taxed at a lower rate In the above case, the $2 dividend would be taxed as ordinary income tax rate and 1.50 would be taxed at a lower rate; suppose your marginal income tax rate is 30% and C.G. tax rate is 20%, what is your after-tax yield or ror? o You’re after tax total ror = [2(1-.30) + 1.50(1-.20)]/ 15] x 100 = o Yields are always in percent. Valuing Common Stock o = Present value of future or expected dividends and growth rate. o 3 kinds of stock: a) No growth, b) constant growth, & c) differential growth stock o Growth: g = ROE x RE o Where g = growth rate of future earnings & growth in common stockholder’s investment in firm, ROE = the return on equity (net income/common book value) and RE = the company’s percentage of profits retained - --profit retention rate or retained earnings. o Most growth & growing firms keep a larger portion of profits as RE, but established firms keep smaller proportion in RE. o Common stock holders receive 2 types of income: dividends & capital gains/loss (appreciation/depreciation in price), o Constant dividend growth model assumes 1) the dividends increase at a constant rate forever, 2) this model as discussed below can be used to compute a stock price at any point of time. o Dividend Valuation Method: constant dividend growth model o Common stock value = expected dividend in year 1 / (required rate of return – growth rate) o Vcs= D1 / (kcs – g) o Expected dividend for next year: D1 = D0 (1+g) o D0 is the current or past dividend o Vcs= D1 / (kcs – g) reduces to Vcs= D0 / kcs as g=0 o Valuation model assumes that required ror must be larger than growth rate, g; otherwise value of common stock would turn out to be negative and that is not possible. o The reqd. rate of return, kcs on common stock is also called the cost of raising funds through common stock o Higher risk, higher required rate of return, ceteris paribus – a fundamental principle of Finance. Current vs. Expected Dividend o In calculating value of common stock, it is expected dividend that counts and not current dividend or past dividend and value of any asset including common stock is expected present value of future cash flows or dividends, o Relationship between past and expected: Expected dividend = present or past dividend (1+ growth rate) or D1 = D0(1+g), Expected ROR o …on a security is required ror of investors who are willing to pay market price for security. Expected ror differs from investor to investor. o Preferred Stock Expected Return: Annual dividend/market price. o Common Stock Expected Return o (Dividend in year 1 / market price) + dividend growth rate o ROR= (D1/P0) + g o If company is expected to generate profits and revenues for next several years, thus stock price is likely to increase because required ror is likely to decrease and growth in future dividends is likely to increase, o Common stock dividends are not fixed, whereas dividends on preferred are fixed. These dividends are not tax deductible to individual investors and issuing firms, but are 70% tax exempt to holding corporations. Growth Factor o Growth of a firm depends upon 2 factors: return on equity and profit retention rate or RE o g = ROE x Retained earnings ratio o ROE = Net income/book value of common equity o RE ratio = RE/EACSH o Net income is 4mm, common stock or common equity is 16mm and the dividend payout ratio is 40% then what is the growth rate? o ROE = net income/common equity =...