Finance Exam 1

What is the goal of financial management? How, specifically, should managers achieve this goal?

The goal is to maximize shareholder’s wealth. Managers do this by maximizing the stock price.

What are the three most important elements of asset valuation?

1. The amount of CFs

2. The timing of CFs

3. The riskiness of CFs / the required return

True or false: interest rates and bond prices are inversely related

True

True or false: long-term bonds have greater interest rate risk than shorter-term bonds

True

*Financial markets help facilitate the transfer of funds from “saving surplus” units to “saving deficit” units (transfer money from those who have the money to those who need it)

Three ways to transfer capital in the economy

1. Direct transfer

2. Indirect transfer using the investment banker

3. Indirect transfer using the financial intermediary

Money market vs. Capital market

Money market is for short-term debt instruments (maturity equal to one year or less) whereas Capital market is for long-term financial securities (maturity longer than a year)

The underwriter’s spread

price the corporation gets - price the public is offered

Higher returns are associated with….

higher risk

idk if we need to know interest rates? i feel like no

real risk-free interest rate= risk-free rate - inflation premium

nominal risk-free interest rate ~ real rate of interest + inflation risk premium

real rate of interest: nominal rate of interest - any loss in purchasing power of the dollar in time of investment

Simple interest: compute simple interest on $100 investment at 6% per year for three years

total interest earned: $18

total: $118

Definition of future value

The amount a sum will grow to in a certain number of years when compounded at a specific rate

PRESENT VALUE IS ALWAYS NEGATIVE IN THE CALCULATOR

FV example: “What will be the FV of $100 in 2 years at interest rate of 6%”

N= 2

I/YR= 6

PV= -100

PMT= 0

Get FV= 112.36

Three ways FV can be increased

1. Increasing number of years of compounding (N)

2. Increasing the interest or discount rate ( r)

3. Increasing the original investment (PV)

Present value definition

The current value of a future payment or receipt

Present value example: what will be the present value of $500 to be received 10 years from today if the discount rate is 6%

N= 10

I/YR= 6

PMT= 0

FV= 500

Get PV= -279, only says negative because it’s an outflow

PV is lower if

the time period is longer or the interest rate is higher

FV annuity example: what will be the FV of a 5 year $500 annuity compounded at 6%

N= 5

I/YR= 6

PV= 0

PMT= 500

Get FV= 2,818.50

*So, for FV where annuity is mentioned, PV is often 0 and the annuity price goes to PMT

PV annuity example: what will be the PV of a 5 year $500 annuity compounded at 6%

N= 5

I/YR= 6

PMT= 500

FV= 0

Get PV= 2106

Amortized loans

• Loans paid off in equal installments

• The periodic payment is fixed 

• BUT different amounts of each payment are applied toward the principal and interest

Amortization example: if you want to finance a new machinery with a purchase price of $6000 at an interest rate of 15% over 4 years, what will your annual payments be?

N= (years) x (M)= 4

PV= - loan amount= -6000

I/YR= annual rate / M= 15/1= 15

FV= 0 (because it’s an amortizing loan)

Get PMT of 2101.59

KNOW HOW TO COMPLETE AMORTIZATION TABLE

Step 1: finding PMT using the financial calculator (previous card)

Step 2: finding periodic interest payment

= beginning balance x periodic interest rate

Step 3: finding principal repayment

= PMT - Int (found in last step)

Step 4: finding ending balance

= beginning balance - prin1

Completing an amortization table with example

Step 1: if you want to finance a new machinery with a purchase price of $6000 at an interest rate of 15% over 4 years, what will your annual payments be? 

Get PMT of 2101.59

Step 2: period interest payment= beginning balance x periodic interest rate 

= 6000 (0.15)

= 900

Step 3: principal repayment= PMT - period interest payment

= 2102 - 900

= 1202

Step 4: ending balance= beginning balance - principal repayment

= 6000 - 1202

= 4729

Lastly, set beginning balance in period 2 equal to ending balance in period 1 and repeat steps 2-4

To make interest rates comparable…

calculate the annual percentage yield (APY) or effective annual rate (EAR)

EAR example: what is the effective annual rate for a loan with 6% annual rate and quarterly compounding?

EAR= (1+ rate/M)^M -1

EAR= (1+ 0.06/4)^4 -1

EAR= 0.0614 or 6.14%

Present value of uneven streams

(don’t know if we need to know this) what is the present value of $2,000 perpetuity discounted back to the present at 10% interest rate?

2000/0.10= 20,000

Bond definition

A type of debt or long-term promissory note, issued by a borrower, promising to its holder a predetermined and fixed amount of interest per year and repayment of principal at maturity

Par value definition

the face value of the bond, returned to the bondholder at maturity

**Coupon interest rate

the percentage of the par value of the bond that will be paid periodically in the form of interest

Coupon interest rate example: a bond with $1000 par value and 5% annual coupon rate will pay how much annually and how much semiannually?

Annually= (0.05 × 1000)= $50

Semiannually= (0.025 × 1000)= $25

Maturity definition

maturity of bond refers to the length of time until the bond issuer returns the par value to the bondholder and terminates or redeems the bond

Factors having a favorable effect on a bond rating

• A greater reliance on equity as opposed to debt 

• Profitable operations

• Low variability in past earnings

• Large firm size

• Little use of subordinated debt

Defining value

• Book value: value of an asset as shown on a firm’s balance sheet

• Liquidation value: the dollar sum that could be realized if an asset were sold individually and not as part of a going concern

• Market value: the observed value for the asset in the marketplace

• Intrinsic or economic value: also called fair value; represents the present value of the asset’s expected future cash flows

The price of bond =

the PV of it’s future cash flows

Bond valuation example: consider a bond issued by Toyota with a maturity date of 2020 and a stated coupon of 4.5%. In 2015m with 5 years left to maturity, investors owning the bonds are requiring a 2.1 rate of return

N= 5

I/YR= 2.1 (the rate of return)

PV= 1,000 (par value is typically assumed to be 1,000)

PMT= 45 (coupon %)(par value) so 4.5 × 1000- 45

YTM definition

the rate of return the investor will earn is the bond is held to maturity

OR

the bondholder’s expected rate of return

Computing YTM example: what is the yield to maturity of a corporate bond with 13 years to maturity, a coupon rate of 8% per year, a $1000 par value, and a current market price of $1250. Assume semiannual coupon payments.

N= (13)(2)= 26

PMT= (0.08)(1000)/2= 40\

PV= -1250

FV= 1250

Get I/YR of 2.636%

Have to convert back to an annualized yield so (2.636)(2)= 5.31%

Current yield=

annual interest payment / current market price of the bond

Current yield example: the current yield on a $1,000 par value bond with 4% coupon rate and market price of $920

Current yield= (0.04)(1000)/920= 4.35%

Three important relationships of bonds

1. Bond prices and interest rates are inversely related

2. Market value of bond will be less than the par value if the investor’s required rate of return is above the coupon interest rate

3. Long-term bonds have greater interest rate risk than do short-term bonds