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TCU Finance Exit Exam
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Terms in this set (67)
Calculate the present value or future value of a lump (single) sum.
o PV = FV / (1+i)^n
o FV = PV(1+i)^n
Calculate PV or FV of an annuity and of an annuity due
Remember to set TVM:
PMT: end/beginning
If solving for FV, set PV to 0
If solving for PV, set FV to 0
PMT=annual payment
FV=0 or solve for
i=market rate
PV=0 or solve for
Find PMT, interest rate, or number of payments in annuity or annuity due problem with annual or non-annual payments
Remember to adjust for non-annual payments
Find the PV, PMT, or interest rate for a perpetuity
Perpetuity: PV=PMT/interest rate
Calculate the effective annual rate for an interest rate compounded more than one time per year
o ((1+ i/n)^n) - 1
o i = stated annual interest rate
o n = number of periods
Prepare a loan amortization table
Monthly payment: Calculator: solve for PMT using PV=principal and FV=0
Pay attention to annuity or annuity due
For each payment, multiply interest rate times remaining principle to determine interest portion of payment. The remaining amount goes towards principle.
Understand the effect of time and interest rate on present and future values of a cash flow
• The further out in time, the less the PV becomes
• The higher the discount rate, the lower the PV becomes
Calculate the price of a bond
o PV of interest payments
-Find annual coupon rate, or semiannual
-Find semiannual discount rate, or the bonds with similar maturities
-Multiple time to maturity by 2
o PV of principal amount
Calculate the yield to maturity of a bond
o The yield to maturity is the discount rate that equates the bond's current price with its stream of promised future cash flows.
o On calculator, solve for I/Y, and then multiply by two if semiannual to get annual yield
Understand the impact of time to maturity on changes in bond prices as yield changes (check)
o A longer term bond needs to have a higher interest rate to be valuable due to more risk; also, as a bond approaches maturity, its price will converge with its face value
o When interest rates rise, the price of outstanding bonds fall. When interest rates fall, the price of outstanding bonds rise
*A change in yield produces a bigger change in a 10bond vs a 5 year note
Explain bond duration
o The weighted average period of time before the price of a bond is repaid by its cash flows. Zero-coupon bond duration=its time to maturity.
o Importance is that it predicts how sharply the market price of a bond will change as a result of changes in interest rates(or other factors of volatility)
Calculate the price of preferred stock
The price of preferred stock = preferred dividend / required return on the stock
Calculate the expected return of preferred stock (check this)
expected return = preferred dividend/price of the preferred stock
Calculate the value of common stock using the dividend discount model, earnings model, and firm's free cash flows. (check)
Dividend discount model: Value of stock = Dividend per share / (Discount rate - Dividend growth rate)
Earnings model:
Free cash flows:
Calculate the expected return of common stock
- (Return x Percentage of possibility)
- The amount one would anticipate receiving on an investment that has various known or expected rates of return. For example, if one invested in a stock that had a 50% chance of producing a 10% profit and a 50% chance of producing a 5% loss, the expected return would be 2.5% (0.5 x 0.1 + 0.5 x -0.05).
Calculate the current yield (dividend yield) of stock
Current yield = dividend / market price of stock
Explain relative riskiness of bonds, preferred stock, common stock relative to claims on assets and claims on income
Bondholders are most senior in claims on assets, next is preferred stockholders, and finally the common stock holders
Understand the effect of changes in discount rate on price of asset
As the discount rate increases, the price of the asset goes down and vice versa
Calculate the value of a merger using free cash flows, cash flows to equity, and adjusted present value approach (check this)
FCF:
NPV of FCFs+HV of FCF, using WACC as discount rate
WACC=wd
rd
(1-T)+ws+rs (can include preferred stock too)
APV:
Vops = Vunlevered +Vtaxshield
Vunlevered = npv of FCFs + HVunlevered
Vtaxshield = npv of TS + HVts
using unlevered cost of equity as discount rate
rsu = ws
rsl+wd
rd
FCFE:
FCFE=NI-Net investment in operating capital+change in debt
NPV of FCFEs + HVfcfe using levered cost of equity as discount rate
rsl=rsu+(rsu-rd)(wd/ws) (CAPM equation)
Steps: calculate free cash flow: FCF=NOPAT-net investment in op. capital
NOPAT=EBIT(1-T)
calculate rsl based on capm
plug this into wacc and rsu formula to derive those
Forward Contracts
agreements in which one party agrees to buy a commodity at a specific price on a specific future date and the other party agrees to sell the product
• Goods are actually delivered under forward contracts
Futures Contracts
Similar to a forward contract, but with three key differences:
• Futures contracts are marked-to-market on a daily basis, meaning that gains and losses are noted and money must be put up to cover losses
• With futures, physical delivery of the underlying asset is virtually never taken
• Futures contracts are generally standardized instruments that are traded on exchanges, whereas forward contracts are generally tailor-made, are negotiated between two parties, and are not traded after they have been signed
Swaps
Two parties agree to swap something, generally obligations to make specified payment streams
Explain the Efficient Market Hypothesis
o The theory that states it is impossible to beat the market because stock market efficiency causes share prices to always incorporate and reflect all relevant information.
o Stocks always trade at their fair value, and nobody can time the market
Explain the three different types of market efficiency and its implications to abnormal returns.
o The weak form -all past prices and data are fully reflected in prices, technical analysis is of no use
o The semistrong form - all publicly available information is fully reflected in prices, fundamental analysis is of no use
o The strong form - all information is fully reflected in prices, insider information is of no use
Calculate the beta and alpha of a common stock based on historical stock price data (check this)
o For beta, use a regression in excel. It equals the Covariance (stock vs. market returns) / Variance (market returns). Use historical S&P index returns and the stock returns.
o Alpha = Return on portfolio - (risk free +Beta(Market return - risk free))
Explain the benefits of diversification
o Reduces unsystematic/idiosyncratic risk, performance of certain investments will neutralize losses on others.
o Yields higher return and lowers risk because of investments in different industries
Understand the difference between systematic and unsystematic risk.
o Systematic/market risk - risk inherent to the entire market or market segment, un-diversifiable
o Unsystematic/idiosyncratic risk - company or industry specific risk that is inherent in each investment, and can be diversified
Calculate the Sharpe ratio and explain its relation to risk-benefit tradeoff
o (Expected portfolio return - risk free rate) / Portfolio standard deviation
o Used to analyze how much additional return you are receiving for the additional volatility of holding the risky asset over a risk free asset, the higher the better
o The greater the ratio, the better the portfolio's risk adjusted performance has been
Explain the role of an investment banker regarding security issues, capital structure analysis, and merger and acquisitions
(check this)
o Investment bankers offer advice on when and how to place their securities on an open market
o provide advice and financing for M&A: the buying and selling of companies
Explain financial leverage and operating leverage and how they impact firm performance
o Financial leverage is the use of debt to acquire additional assets. High leverage is risky, as it increases the possibility of bankruptcy. Exchange higher upside potential for higher downside potential
o Operating leverage is a ratio of a company's fixed costs to variable costs. More fixed to variable is a high operating leverage. The higher the leverage ratio, the greater danger from forecasting risk.
Understand the 'random walk' of stock prices
o It explains that stocks take a random and unpredictable path, the possibility of the price going up is just the same as it is going down
o It is impossible to outperform the market without assuming additional risk
o Use the buy and hold strategy
Understand primary and secondary security market transactions
o Primary market - where securities are created. Firms sell their shares to the market for the first time in this market, also an IPO. Purchased directly from an issuing company
o Secondary market - The NYSE etc. Investors trade amongst themselves
Calculate the cost of debt with and without flotation costs (check this)
Without flotation costs: After tax cost of debt = rd(1-T)
With flotation costs: After tax cost of debt = (rd)(1-T)
PV in calculator = PV (1-F)
Calculate the cost of preferred stock with and without flotation costs (check this)
Without flotation costs:
With flotation costs: D1/(1-f)P0
Calculate the cost of common stock using the dividend growth model with and without flotation costs (check this-whats the difference between this and DDM)
flotation = (D1/price*(1-f)) + g
Calculate the cost of equity using the Capital Asset Pricing Model
CAPM: cost of equity = risk free rate + beta * (return on market - risk free rate)
Understand what a stock's beta measures and how it is calculated
Beta=COVAR/VAR
A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.
Understand how a firm's level of debt affects the cost of common equity
The cost of equity rises as more debt is added because of the increased risk due to financial distress, which is borne primarily by common shareholders.
Calculate the firm's capital structure weights
debt/value
equity(market value)/value
ps/value
Calculate the firm's weighted average cost of capital
WACC=rd
wd
(1-T)+rs
ws+rps
wps
Understand marginal cost of capital
Marginal cost of capital is the cost of the next dollar of financing. Once a company has expended all of its internally generated funds, transaction fees and an increasing cost of debt/equity increases the cost to finance project. You should raise additional capital until the point where the cost of capital is equal to the IRR of the last project you can afford to fund. After that point, any additional funding raised will cost more than the return any other projects can provide.
Be able to evaluate a project's cash flows using payback period, discounted payback period, net present value, internal rate of return, and modified internal rate of return
Payback Period: # of years until full recovery +unrecovered cost at beginning of the year/cash flow during full recovery year
Discounted Payback Period: same thing but discount the cash flows using WACC first.
NPV: sum of the discounted cash flows using WACC. Calculator: NPV(discount rate, initial outlay,{CF1,CF2,CF3})
IRR: the discount rate that forces the PV of expected future cash flows to equal the initial cash flow. Calculator: IRR(initial outlay, {CF1,CF2,CF3...})
MIRR: Compound each cash flow using WACC or other explict reinvestment rate, sum them to find the terminal value, find the rate that causes the PV of the TV to equal the cost.
Be able to select between projects of different life length and different size (initial outlay)
NPV is the preferred method to base the decision on
Be able to develop a project's cash flows
Sales revenue (units*price per unit)
- Variable costs (units*cost per unit)
-Nonvariable costs (exluding depreciation)
-Depreciation
=EBIT
-Taxes on operating profit
=NOPAT
+Depreciation
-Change in working capital
=project net cash flows for year
Understand why the WACC curve is u-shaped
Initially as more debt is added, the cost of equity only rises slowly and doesn't offset the reduction in WACC due to increased amounts of cheaper financing through debt. Once it hits a certain point though, the cost of equity rises at an accelerating rate due to the cost/risk of financial distress to the point where the benefits of adding cheaper debt (which also rises due to increased financial distress risk) do not overcome this increase and the total WACC begins to rise.
Understand the uses of financial statement analysis
Used to look at the financial position of a firm, and to compare firms in various industries
investors use financial statements to assess the viability of investing in a business
creditors use financial statements to assess loans
Understand the use of profitability ratios, liquidity ratios, asset utilization ratios, and debt utilization ratios
o Profitability - Used to assess a business's ability to generate earnings as compared to expenses, and how well the firm is doing. A higher ratio is better.
o Liquidity - Used to determine a company's ability to pay off its short term debt obligations. A higher ratio is better.
o Asset utilization ratios - Used to determine how efficiently a firm is using its assets to turn them into money.
o Debt utilization ratios - Used to examine how much debt a company has compared to its equity. Also used to find the level of risk for a company.
Calculate the following ratios: profit margin, return on equity, return on assets, debt ratio, times interest earned, receivables turnover, average collection period, total asset turnover, current ratio
Profit margin = Net income / revenues
Return on Equity = Net income / shareholder's equity
Return on Assets = Net income / total assets
Debt Ratio = Total debt / total assets
Times interest earned = EBIT / interest expense
Receivables turnover = Total credit sales / Average accounts receivable
Average Collection period = (365 x AR) / Sales
Total asset turnover = revenue / assets
Current Ratio = current assets / current liabilities
Use the DuPont system of analysis
o Used to analyze where movements in ROE are coming from
o ROE = Profit margin (profit/sales) x Total asset turnover (sales/assets)xEquity multiplier (assets/equity)
It is believed that measuring assets at gross book value removes the incentive to avoid investing in new assets. New asset avoidance can occur as financial accounting depreciation methods artificially produce lower ROEs in the initial years that an asset is placed into service. If ROE is unsatisfactory, the DuPont analysis helps locate the part of the business that is underperforming.
Understand the limitations of ratio analysis
o Large firms operate in different industries, it may be hard to find a set of industry average ratios and compare them
o Different accounting practices can distort ratio analysis
o Ratio analysis only looks at the past while many users are concerned more about the future
Understand agency theory, agency problem, and ways firms can minimize the agency problem
o Agency theory - Resolving problems that can exist in agency relationships between principals, or shareholders, and agents, or company executives.May have different goal or different levels of risk tolerance
o Agency problem - A conflict of interest where one party is expected to act in another's best interest. The agent is naturally motivated by self interest and they differ from the principal's interest. The agent is supposed to maximize shareholder wealth but only wants to maximize own.
o Ways to minimize are performance-based compensation, direct influence by shareholders, and the threat of firing.
Explain the goal of a firm and how corporate governance policies influence management's actions to achieve the goal
o To maximize value for the shareholders
o corporate governance - sticks and carrots
sticks: threat of being fired
carrots: compensation
Can be accomplished through:monitoring and discipline by the board of directors, charter provisions and bylaws that affect the likelihood of hostile takeovers, compensations plans, capital structure choices, and accounting control systems
Understand the effects of debt on firm value, cost of debt, and cost of equity
o Debt is included in the enterprise value of a firm. It makes a firm more leveraged and potentially can help gain more revenues
o Debt can make the firm more risky though so the cost of debt and the cost of equity rise as debt level increases
Explain and calculate interest tax shields(check discount rate)
o Interest tax shield = Debt level x Interest rate x Tax rate
o PV of tax shield = (Debt x Cost of debt x tax) / rsu
-This is for a perpetuity or if not specified how long debt lasts
This is the benefit due to leverage
Discuss the effect of debt on the cost of financial distress
o The bankruptcy costs are the effects of financial distress
- Direct costs are legal fees, accounting fees, trial fees
- Indirect costs are reduced effectiveness in the market, loss of value of intangible assets
o Leverage can encourage managers and shareholders to act in ways that reduce firm value
- It is the shareholders who bear the burden
Two components: probability and level of distress
Understand how market interest rates are determined (check this)
o The supply and demand of credit. An increase in demand for credit increases rates, a decrease will decrease rates.
o The higher the level of inflation, the more interest rates will rise.
o When economy is growing, Fed raises short term interest rates by selling treasuries to keep from building too fast and risking inflation. When economy is contracting the Fed lowers interest rates by buying treasuries to encourage borrowing
*The funds rate rises as the supply of reserves goes down because banks will then need to borrow more to meet the minimum reserve requirement.
Explain the term structure of interest rates
o Also known as the yield curve. It plots the yields of similar quality bonds against their maturities.
• Normal curve - short term yields are lower than long term yields
• Inverted - if short term yields are higher than long term yields (can be a sign of a recession)
• Flat - there is no variation between short and long term yields (can also be a predictor of economic transition
Understand foreign-exchange markets and exchange rates (check this)
o The market in which participants are able to buy, sell, exchange and speculate on currencies.
o If have $1.50/euro, and it goes to $1.60/euro then it is weakening. If it goes to $1.30/euro than it is strengthening
Understand the functions of financial institutions
o Focuses on dealing with investments, loans, deposits, insurance, etc.
o Organizations like banks, trust companies, insurance companies
Explain the money supply process (check this)
o Four players in the money supply: central bank, banks, depositors, borrowers from banks
o An increase in the money supply lowers interest rates, which generates more investments gives money to consumers.
o Open market transactions - buying of treasuries injects money into the supply to stimulate growth while selling does the opposite.
Explain the organization of central banks, monetary policy tools, and the conduct of monetary policy (check this)
o Central banks are responsible for overseeing the monetary system, monetary policy, currency stability, low inflation and full employment.
o Monetary policy - that determine the size and rate of growth of the money supply, which in turn affects interest rates.
• Federal funds rate - the rate at which banks borrow reserves from each other
• Open market operations - the selling and buying of US government securities like US treasury bills.
• Buy securities to increase the monetary base and lower interest rates, and sell to decrease the monetary base and raise interest rates
Explain the IS-LM-FE model (check this)
o IS - Goods market equilibrium - investment and saving equilibrium; downward sloping. shifts to the right when spending (for reasons other than interest rates)
o LM - Money market equilibrium - liquidity preference (demand for money) and money supply, upward sloping. shift down and right when money supply is increased
o FE - Labor market equilibrium - equates labor demand and labor supply; full employment, shifts to right as population increases
Know what causes shift
Understand aggregate demand and aggregate supply
the total amount of goods and services demanded in the economy at a given overall price level and in a given time period. There is a negative relationship between aggregate demand and price level.
• Aggregate demand = consumer expenditures on goods and services + investment spending +governmental expenditures + (exports - imports)
• If shift to the left it is an economic contraction, if to the right it is expansion
The total supply of goods and services provided within an economy at a given overall price level in a given time period. There is a positive relationship between aggregate supply and the price level.
• A shift in aggregate supply can be caused by changes in size and quality of labor, innovations, increases in wages, and inflation.
• A shift to the left is adverse, raising price levels
Explain the causes and consequences of inflation
Causes:
o Aggregate demand being more than aggregate supply.
o Over expansion of the money supply
Effects:
o People lose faith in the currency system as a store of value
o The ability of the country to compete in the world market is damaged
o Higher interest rates, no growth
unemployment/increased labor costs, social unrest, hoarding of goods,
Discuss the implications of the moral hazard problem
o The risk that a party to a transaction has not entered into the contract in good faith, has provided misleading information about its assets, liabilities, or credit capacity, or has incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles. Can limit this by aligning interest. Ex. Salesperson and commission.
Explain the adverse selection problem
o It refers to a situation in which the buyer or seller of a product knows something about the product quality or condition that the other party does not know, allowing them to have a better estimate of what the true cost of the product should be. An insurance company could limit this by increase premiums or limiting coverage.
Calculate MIRR
1. Calculate the total present value of each of the cash flows, starting from period 1 (set the initial outlay to 0). Use the calculator's NPV function.
2. Calculate the future value as of the end of the project life of the present value from step 1. The interest rate that you will use to find the future value is the reinvestment rate. Go to TMV Solver and Solve for the FV and enter the PV just calculated above.
3. Finally, find the discount rate that equates the initial cost of the investment with the future value of the cash flows. Do this by replacing the PV with the original investment and solve for I. this discount rate is the MIRR, and it can be interpreted as the compound average annual rate of return that you will earn on an investment if you reinvest the cash flows at the reinvestment rate.
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