FIN 125 exam 2

bonds

Financial instruments that represent a loan made by an investor to a borrower. Bonds typically include a fixed interest rate and are used by companies and governments to raise capital.

coupon paying bond

A bond that pays periodic interest payments, known as coupons, to the bondholder until maturity, when the principal amount is returned.

zero coupon bond

A bond that does not pay periodic interest; instead, it is sold at a discount and matures at its face value.

Yield to maturity

The total return expected on a bond if held until it matures, reflecting the bond's current market price, interest payments, and time remaining until maturity.

relationship between YTM and coupon rate

indicates how changes in market interest rates affect bond pricing. A bond's YTM may exceed or fall below the coupon rate based on its trading price.

invoice (dirty) price

The total cost paid for a bond that includes the accrued interest as well as the bond's clean price.

difference between taxable and non taxable bonds

Taxable bonds generate interest income that is subject to federal, state, and local taxes, while non-taxable bonds, such as municipal bonds, often provide tax-exempt interest income to investors.

equivalent taxable yield

The interest rate that a tax-exempt bond must offer to match the after-tax yield of a taxable bond.

nominal rate equation

The formula used to calculate the nominal interest rate as the sum of the real interest rate and the expected inflation rate.

stock

A type of security that signifies ownership in a corporation and represents a claim on part of the corporation's assets and earnings.

why do stock prices move

Stock prices are influenced by supply and demand, company earnings, economic conditions, interest rates, industry news, and investor sentiment.

intrinsic vs market value

Intrinsic value is the true, underlying worth of an asset based on its fundamentals, while market value is its current price in the marketplace.

zero growth model

A method for valuing a stock that assumes a company's dividends will remain constant indefinitely. It values the stock as the annual dividend divided by the required rate of return.

gordon growth model

dividend discount model, calculates the intrinsic value based off of discounted dividends and current price]=

valuation by comparables

finding the firms price based off of their EPS and the industry benchmark

net present value

NPV measures the value a project adds to the firm by finding the present value of all cash inflows and outflows using a required rate of return (discount rate).

How do you find NPV?

NPV=∑CFt/(1+r)t−Initial Investment

where CFt​ = cash flow at time t and r = required rate of return.

How do you interpret the dollar amount of NPV?

It represents the total value added (or lost) by the project in today’s dollars.

What is the decision rule for NPV?

• NPV > 0: Accept (project adds value; firm grows)

• NPV < 0: Reject (project destroys value)

• NPV = 0: Indifferent (break-even)

What type of project should use NPV for decision-making?

Both growth and diversification projects, but especially when evaluating mutually exclusive projects.

What is the concept behind IRR?

IRR is the discount rate that makes NPV = 0. It shows the project’s expected rate of return.

How do you find IRR?

Solve for rr in:

0=∑CFt/(1+r)t−Initial Investment

How do you interpret the IRR percentage?

It’s the project’s expected rate of return. Compare it to the required rate of return to decide.

What is the decision rule for IRR?

• IRR > required return: Accept

• IRR < required return: Reject

• IRR = required return: Indifferent

When can’t you use IRR?

• Mutually exclusive projects (can give conflicting rankings)

• Unconventional cash flows (multiple IRRs possible)

What is the concept behind PI?

PI measures the value created per dollar invested.

How do you find PI?

PI=PV of Future Cash Inflows​/Initial Investment

How do you interpret PI?

• PI > 1: value created per $1 invested is more than cost

• PI = 1: break-even

• PI < 1: destroys value

When can’t you use PI?

When evaluating mutually exclusive projects, since it can give conflicting rankings.

How do you find the exact payback period?

Add cash inflows until they equal the initial investment. If it falls between years, divide the remaining amount by the next year’s cash flow.