Fundamentals of Corporate Finance Study Guide 9/26/21 PDF

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official study guide for Chapters 1,2,3 and part of Chapter 4. Professor Susan Elkinawy....

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Fundamentals of Corporate Finance Study Guide for Test #1 9/26/21 Professor Susan Elkinawy Chapter 1 ● Roles of the financial manager, including the principal decisions in financial management: Roles of financial managers in any corporation: 1. Caretakers of the shareholders’ money 2. Pick projects to invest in (capital budgeting) 3. How to pay for projects (debt versus equity) and what overall mix of debt and equity should it be for the firm 4. Ensure that the firm has enough money to meet its obligations and invest in all profitable projects Principal decisions in financial management: 1. Investment or capital budgeting decisions (real assets) 2. Financing decisions (financial assets) 3. Working capital decisions Financial manager: CFO; Treasurer: oversees cash management, credit management, capital expenditures, and financial planning; Controller: oversees taxes, cost accounting, financial accounting and data ● Goal of the financial manager, the agency problem between managers and shareholders, and ways to reduce the agency problem: Goal of Financial Decision Making: 1. Maximize shareholders’ (stockholders’) wealth 2. Maximize market value of assets, market value of financial claims, present value of free cash flow, present value of economic profits 3. Economic profits = opportunity costs, consider what else is being affected Agency problems: 1. Conflict of interest between management and owners, also stockholders and bondholders 2. Conflicts between managers and stockholders, result from stockholders are imperfect monitors of the managers Solutions to Agency problems: 1. Compensation plans 2. Board of Directors 3. Takeovers 4. Specialist Monitoring 5. Auditors Chapter 4

● Simple vs. compound interest: simple interest is based on the principal amount and compound interest is based on the principal amount and the interest that accumulates on it every period ● PV and FV of a single cash flow and multiple cash flows: Face/Par Value = the principal amount to be paid at maturity, usually $1,000 per bond ● Calculating the interest rate and number of periods for single and multiple cash flows ● APR vs. effective interest rates: APR is stated annual interest rate that ignores compounding. To contrast the annual percentage rate (APR) with the effective annual rate the compounding interval must be known. ● Perpetuities: annual fixed payments to be made forever ● PV and FV of annuities ● Annuity due and delayed annuity: annuities are identical fixed payments to be made for a specified number of periods. Annuity dues are the beginning of period payments. ● Solving for annuity payments ● Amortization: part of the periodic payment is used to pay interest on the loan and part is used to reduce the amount of the loan ● Growing annuity: a growing stream of cash flows with a fixed maturity ● Other variations (computing effective interest rates to match payment frequency): if payments are monthly and interest is compounded daily, you must convert the interest rate to an effective monthly interest rate in order to account for the daily compounding interest Chapter 5 (up through YTM) ● Valuation of bonds: the value of the bond is its present value. ● Relationship between interest rates and bond prices: inverse relationship between interest rates and bond value. ● Interest rate risk: change in price due to changes in interest rates, long-term bonds have more price risk than short-term bonds, low coupon rate bonds have more price risk than high coupon rate bonds ● Term structure of interest rates (what causes interest rates to vary among maturities): the term structure is the set of interest rates for various maturities for a particular class of bonds. If the Fed is expecting the economy to pick up, they will raise interest rates to combat inflation. Costs more to borrow, so it will temper people’s spending and keep prices under control. Greater price risk with longer time until maturity. ● Yield to maturity (YTM): we use the interest rate that applies to the timing of the cash flows Practice Test Questions 1. You are planning to save for retirement over the next 30 years. To do this, you will invest $750 per month in a stock account and $325 per month in a bond account. The return of the stock account is expected to be an APR of 10.5% and the bond account will earn an APR of 6.1%. When you retire, you will combine your money into an account with an

APR of 6.9%. All interest rates are compounded monthly. How much can you withdraw each month from your account assuming a withdrawal period of 25 years? Although the stock and bond account have different interest rates, we can draw one timeline, but we need to remember to apply different interest rates. We need to find the annuity payment in retirement. Our retirement savings ends at the same time the retirement withdrawals begin, so the PV of the retirement withdrawals will be the FV of the retirement savings. So, we find the FV of the stock account and the FV of the bond account and add the two FVs. Stock account: FVA = $750 [{{1+(.105/120]^360 -1}/(.105/12)] = $1,887,300.74 Bond account: FVA = $325[{[1+(.061/12)]^360 -1}/(.061/12)] = $332,782.27 So the total amount saved at retirement is: $1,887,300.74 + $332,782.27 = $2,220,083.01 Solving for the withdrawal amount in retirement using the PVA equation gives us: PVA = $2,220,083.01 = C[1-{1/[1+(.069/12]^300}/(.069/12)] C = $2,220,083.01/142.773 C = $15,549.74 withdrawal per month Using the financial calculator: Stock: N = (12)(30) = 360 I/Y = 10.5/12 = .875 PV = 0 PMT = 750 CPT, FV = $1,887,300.74 Bond: N = (12)(30) = 360 I/Y = 6.1/12 = 0.5083 PV = 0 PMT = 325 CPT, FV = $332,756.73 Total at T = 30: $2,220,057.47 N = (12)(25) = 300 I/Y = 6.9/12 = 0.575 PV = $2,220,057.47 FV = 0 CPT, PMT = $15,549.57 2. A 5-year annuity of 10 $6,500 semiannual payments will begin with the first payment occurring 9.5 years from now. If the discount rate is 9% compounded monthly, what is the current value of the annuity? The cash flows in this problem are semiannual, so we need the effective semiannual rate. The interest rate given is the APR, so the monthly interest rate is:

Monthly rate = .09/12 = .0075 To get the semiannual interest rate, we can use the EAR equation, but instead of using 12 months as the exponent, we will use 6 months. The effective semiannual rate is: Effective semiannual rate = (1.0075)^6 - 1 = 4.59% We can now use this rate to find the PV of the annuity. The PV of the annuity is: PVA @ T = 9: $6,500[(1 - 1/1.0459^10)/0.0459] = $51,217.83 This is the value of one period (six months) before the first payment, so it is the value at t = 9. To get the value at t = 0, we need to discount back 18 6-month periods: PV @ T = 0: $51,217.83/1.0459^18 = $22,853.63 Note, that you can also calculate this present value using the number of years (rather than the number of semi-annual periods). To do this, you need the EAR. The EAR is: EAR = (1+.0075)^12 - 1 = 9.38% PV @ T = 0: $51,217.83/(1.0938)^9 = $22,853.63 Using the financial calculator: Effective semi-annual rate: (1 + .09/12)12/2 - 1 = 4.59% = 0.04585 N = 10 I/Y = 4.585 PMT = 6500 FV = 0 CPT, PV = $51,218.39 @ t = 9 NEXT FV = $51,218.39 I/Y = 4.585 N = 18 (you are at year 9 trying to get to year 0, semi-annual compounding) PMT = 0 CPT, PV = $22,854.76 @ t = 0

3. Lydic Corporation has bonds on the market with 12.5 years to maturity, a YTM of 6.4%, a par value of $1,000, and a current price of $1,040. The bonds make semi-annual payments. What must the coupon rate be on these bonds? Here we need to find the coupon rate of the bond. We need to set up the bond pricing equation and solve for the coupon payment as follows: P = $1,040 = C(PVIFA3.2%,25) + $1,000(PVIF3.2%,25) Solving for the coupon payment, we get: C = $34.35 Since this is the semiannual payment, the annual coupon payment is: 2 x $34.35 = $68.70 And the coupon rate is the annual coupon payment divided by par value, so: Coupon rate = $68.70/$1,000 = .0687 or 6.87%

4. Suppose the following bond quote for IOU Corporation appears in the financial page of today’s newspaper. Assume the bond has a face value of $1,000 and the current date is September 28, 2021. The bond makes coupon payments semi-annually. What is the yield to maturity of the bond? The bond has 13 years to maturity, so the bond price equation is: P = $1,043.55 = $27(PVIFA R%,26) + $1,000(PVIFR%,26) Using a financial calculator we find: R = 2.471% This is the semiannual interest rate, so the YTM is: YTM = 2x2.471% YTM = 4.94%...