Midterm II + Final Flashcards
What is an annuity due?
annuity where payments occur at the BEGINNING of each period
What happens to future value (FV) with other things being equal if present value (PV) goes up?
future value (FV) goes up
What happens to future value (FV) with all other things being equal if interest rate (r) goes up?
future value (FV) goes up
What happens to future value (FV) with all other things being equal if time period (t) goes up?
future value (FV) goes up
From the formula FV = PV (1+r)^t, what does (1+r)^t stand for?
(1+r)^t is the compounding factor or the Future Value Interest Factor (FVIF)
What is simple interest?
Interest earned only on the original principal invested.
SI = PV * r * t
What is compound interest?
Interest earned on both the initial principal and the interest reinvested from prior periods.
CI = TI - SI
How do you calculate Total Interest (TI)?
TI = Future Value (FV) - Present Value (PV)
What is interest on interest?
Interest earned on the reinvestment of previous interest payments.
What is the primary goal of management?
to maximize the value of a firm’s stock.
What is perpetuity?
An annuity in which the cash flows continue forever.
PV = Cash amount (C)/ Interest rate (r)
In real life, bonds pay every ____ months.
6
What is a discount bond?
When the bond sells for less than face value.
Pb < FV
What is a premium bond?
When the bond sells for more than face value.
Pb > FV
What happens to the price of the bond (Pb) if interest rate (r) goes up? and vice versa?
If interest rate (r) goes up, price of the bond (Pb) goes down.
If interest rate (r) goes down, price of the bond (Pb) goes up.
What causes interest rate risk to go up?
- If Maturity (t) goes up
2. If Coupon rate (CR) goes down
What is a debenture?
an unsecure debt, usually with a maturity of 10 years or more
What is a note?
an unsecure debt, usually with a maturity under 10 years
What are government bonds?
The federal government borrows money by selling treasury notes and treasury bonds. (DON’T PAY STATE TAX & NO DEFAULT RISK)
What are municipal bonds?
State and local governments also borrow money by selling municipal notes and bonds. (DON’T PAY FEDERAL INCOME TAX, BUT VARYING DEGREES of DEFAULT RISK)
What is a zero-coupon bond?
A bond that makes no coupon payments and is thus initially priced at a deep discount.
Pzero = FV/(1+r)^t
What is a par bond?
The bond is equal to the face value is a par bond.
Pb = FV
How do you calculate current yield (CY)?
CY = Annual coupon (C)/Price (P)
How do you calculate Coupon rate (CR)?
CR = Annual Coupon (C)/Face Value of bond (FV)
What is a level coupon bond?
coupon is constant and paid every year.
What are the four bond pricing theorems?
- Bond prices (Bp) and market interest rates (r) move in opposite directions.
- When CR ( > , < , =) market’s required return (r), market value (PV) ( > , < , =) par value (FV).
- The price of a long-term bond will change more than that of short-term bond for a given change in market interest rates (r).
- The price of a lower-coupon bond will change more than that of a higher-coupon bond for a given change in market interest rates (r).
What is an amortized loan?
Which the lender may require the borrower to repay parts of the loan amount over time.
Which is riskier, a high coupon? or a low coupon?
low coupon
How do you calculate the annual percentage rate (APR)?
APR = m[(1+EAR)^(1/m) - 1] APR = ln(1+EAR) if Infinitive
All else constant, a bond will sell at _______ when the yield to maturity is _______ the coupon rate.
at discount; higher than
What is the nominal rate on an investment?
The percentage change in the number of dollars you have.
What is the real rate on an investment?
The percentage change in how much you can buy with your dollars–in other words, the percentage change in your buying power.
What is the formula to calculate the value of a stock?
P = D/(r - g) D = Dividend payment (per share) r = required return g = growth rate
How do you calculate dividend yield and capital gains yield?
r = (D/P) + g (D/P) = dividend yield D = dividend payment (per share) P = price of the stock g = growth rate (capital gains yield)
When does a dividend become a liability of the firm?
Until a dividend has been declared by the Board.
A firm cannot go bankrupt for ____________ dividends.
not declaring
Why are dividend payments not tax deductible?
Because dividend payments are not considered a business expense.
The taxation of dividends received by individuals depends on the _________.
holding period
Dividends received by corporations have a minimum ___% exclusion from taxable income.
70
What are features of preferred stock?
Preferred stock generally does not carry voting rights.
What are features of preferred dividends?
- Stated dividend that must be paid before dividends can be paid to common stockholders.
- Dividends are not a liability of the firm and preferred dividends can be deferred indefinitely.
- Most preferred dividends are cumulative - any missed preferred dividends have to be paid before common dividends can be paid.
How do you calculate the profitability index (PI)?
PI = Present Value of all Cash Flows (from discounted payback method)/ Initial Cost
How do you calculate the payback period (PB)?
PB = (# of Years to recover cost - 1) + [(Cost - Total amount recovered before last year)/Cash flow in last year]
If the NPV > 0, IRR > r (cost of capital), PI (Profitability Index) > 1, should the firm accept the project?
Yes
If the NPV < 0, IRR < r (cost of capital), PI (Profitability Index) < 1, should the firm accept the project?
No
If the NPV = 0, IRR = r (cost of capital), PI (Profitability Index) = 1, should the firm accept the project?
It would be OK.
Under what condition would there be NO conflict between IRR and NPV?
When r (required return) > cross-over rate
What is payback?
The length of time to return the original investment or the time it takes to break even in an accounting sense.
What are the advantages of the payback method?
- Ease of calculation
- Liquidity indicator
- Risk indicator
What are the disadvantages of the payback period?
- Ignores returns beyond payback period.
2. Ignores time value of money
What are the factors affecting required return (r)?
- Default risk premium - remember bond ratings
- Taxability premium - remember municipal vs. taxable
- Liquidity premium - bonds that have more frequent trading will generally have lower required returns
- Anything that affects the risk of cash flows to the bondholders, will affect the required returns.
What is the term structure of interest rates?
Term structure is the relationship between time to maturity and yields, all else equal
- It is important to recognize that we pull out the effect of default risk, different coupons, etc.
Net working capital is defined as:
Current assets - current liabilities
What is a liquid asset?
One which can be quickly converted into cash without significant loss in value.
Noncash items refer to:
Expenses charged against revenues that do not directly affect cash flow.
What is cash flow from assets?
The net total cash flow of a firm which is available for distribution to the firm’s creditors and stockholders.
Cash flow from assets is also known as the firm’s:
free cash flow
What is shareholder’s equity?
represents the residual value of a firm
The sources and uses of cash over a stated period of time are reflected on the:
statement of cash flows
A decrease in accounts payable ______ net working capital, all else constant.
increases
As discount rate is increased, IRR ________ while NPV __________.
remains constant, decreases
Decreasing the time to maturity ___________ the price of a discount bond, all else constant.
increases
If a bond has a market price > face value, then it is a ___________ price and has a yield-to-maturity that is __________ than the coupon rate.
premium, less
When analyzing a capital budgeting project, a financial manager should consider the following:
- project start-up costs
- timing of all projected cash flows
- dependability of future cash flows
- dollar amount of each projected cash flow
The decision to issues additional shares of stock is an example of?
capital structure decision
The sustainable growth rate of a firm is best described as the:
maximum growth rate achievable excluding any external equity financing while maintaining a constant debt-equity ratio.
An increase in _____________ will increase a firm’s quick ratio without affecting its cash ratio.
accounts receivable
All else equal, a ___________ in total assets will increase the internal rate of growth.
decrease
What is the Fisher Effect?
(1+R) = (1+r)(1+h) R = nominal rate r = real rate h = expected inflation rate (i.e., R = r + h for APPROXIMATION)
What is a bond indenture?
A 3 party contract between the bond issuer, the bondholders, and the trustee. The trustee is hired to protect the bondholder’s interests.
What is the real rate of interest?
change in purchasing power
What is the nominal rate of interest?
quoted rate of interest, change in purchasing power and inflation
R = real rate (r) + inflation rate (h)
What is an ordinary annuity?
annuity where payments occur at the END of each period (90% of the time)
