finance question

FINA 307

Study Guide

Key points for Conceptual and calculation questions:

1. What are the first and secondary stock markets in the U.S.? What is the difference between first and secondary market?

2. What are the stock market indices? What do they measure? How do we measure stock market return?

3. What are the EAR and APR? What’s the difference between EAR and APR? Which one is the quoted interest rate? Which one is the real interest rate? How to convert APR to EAR under

different frequencies of compounding?

4. The relation between interest rate and pricing of financial securities.

5. What’s the purpose of building investment portfolios? Differentiate firm’s specific risk and market risk. Which one is diversifiable? Which risk is systematic risk? Which one could be

reduced by forming portfolio? How does the diversification work, including high or low

correlated stocks?

6. What are the two parts in total return? What is the reward for taking risk? How does the market reward risk-taking investment? Does the efficient financial market compensate for taking firm’s

specific risk? Can you distinguish stock market return and market risk premium?

7. What does standard deviation measure? What is the interpretation of standard deviation? We should have several ways to phrase the answer to this question.

8. What does the beta in CAPM measure? (Firm’s total risk, firm’s specific risk, or firm’s market risk?) What does CAPM calculate for? If we break down the CAPM, what is each part

(Rf, Rm, Rm-Rf, beta)?

9. Structure of the income statement. How to get to EBIT and Net Income from the top Revenue?

10. Distinguish single cash flow/multiple cash flow/annuity/annuity due/perpetuity. How to calculate the P.V. and PMT for mortgage/loan.

11. Bond pricing. Bond’s quote. Bond’s cash flow. What is bond’s coupon rate/yield to maturity if bond is selling at par value? Rate of return of trading a bond.

12. Stock pricing. Dividend growth. If I know one dividend, with growth rate, can I calculate or other dividend payments? CGM model for stock pricing. How to calculate the sustainable

growth rate in CGM model?

Practice for Calculation questions:

13. You borrow $1,000,000 with annual payments at a 3.25% interest rate for 15 years. What are your annual payments?

Answer: $85,288.55

14. What is the EAR for a 14% APR if interest is daily compounding? Answer: 15.02%

15. A bond is selling at $1170. It pays semi-annual coupon at 6% coupon rate. Time to maturity is 8 years. What is the yield to maturity (YTM) of this bond?

Answer: 3.54%

16. You plan to finance a house that sells for $399,500 with a loan that carries a 4.35% APR for 30 years. What is your monthly payment if payments? What if the annuity payment is an

annuity due?

Answer: $1,988.76, $1981.57

17. You invest $20,000 in Delta, $50,000 in KEY, and $30,000 in Dell. If the expected returns

for Delta, KEY and Dell are 9%, 10% and 15%, respectively, then what is the portfolio's

expected return?

Answer: 11.30%

18. You receive a loan $6,000 today. You are required to pay back $30,000 in seven years. What is the annual interest rate of your loan?

Answer: 25.85%

19. Jay is considering the purchase of a rental home. He plans to hold the house forever (leave it to his heirs). He forecasts that he will receive rent of $5,000 every month forever. How much

should Jay pay for the rental property if his cost of capital in APR is 18% annually?

Answer: $333,333.33

20. Trans American forecasted dividend for next year is $5.66 per share. The company's ROE is 11% and its plowback ratio is 40%. If Trans American's required return is 15% then what is

the company's current stock price?

Answer: $53.40

21. Amazon has a Beta of 2. The risk-free rate is 4% and the market return is 9%. What is Amazon’s risk premium and expected rate of return?

Answer: 10%, 14%

Long Questions:

Requirements for long questions:

a. Draw the time line of the question. Put down all T.V.M factors: Size of cash flows, time, and interest rate.

b. Show the formula you should use to solve the problems, and the corresponding numbers in the formula.

c. Show all the financial calculators inputs and outputs.

1. You are holding 2 portfolios. At the beginning of January you owned $7,000 of Dollar Rental, $9,000 of Quarter Rental, and $15,000 of Dime Rental in your portfolio. During

the month the three company's returns were -12.5%, 20.4%, and 5.8%, respectively.

a. What is your portfolio 1’s return in January? For the next 3 months (Feb, March, and April), the returns of portfolio 1 are 7%, -9%, and 14%, respectively. What is the risk of your

portfolio 1?

b. In this question, you need to find out the portfolio that is not on the efficient frontier. (You’ve done this in the class and quiz)

2. Calculate WACC. Go over the slides of WACC. Do the last sample question as practice.

3. Given project’s cash flows, calculate NPV, IRR, and PB

Formula Sheet

Chapter 3

Income Statement:

Earnings before Interest and Tax (EBIT) = Revenue – COGS – Administrative Expenses –

Depreciation Expenses

= Interest Expenses + Tax Expenses + Net Income

Chapter 5

Future Value of Ordinary Annuity:

F.V.An = 𝐶× (1+𝑟)𝑡−1

𝑟 = 𝐶×[

1

𝑟 −

1

𝑟(1+𝑟)𝑡 ]×(1 + 𝑟)𝑡

Present Value of Ordinary Annuity:

P.V.An = 𝐶×[ 1

𝑟 −

1

𝑟(1+𝑟)𝑡 ]

Future Value of Annuity Due:

F.V.An (DUE) = F.V.An × (1+ r)

Present Value of Annuity Due:

P.V.An (DUE) = P.V.An × (1+ r)

EAR and APR:

EAR = (1 + 𝐴𝑃𝑅

𝑚 )m – 1

Real Rate of Return and Inflation Rate

1 + 𝑟𝑒𝑎𝑙 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = 1 + 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛

1 + 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒

Chapter 6

Total Holding Period Rate of Return on Bond

Total Rate of Return = 𝐶𝑜𝑢𝑝𝑜𝑛 𝐼𝑛𝑐𝑜𝑚𝑒+(𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 −𝐵𝑢𝑦𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒)

𝐵𝑢𝑦𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒

Chapter 7

Constant Growth Dividend Discount Model CGM:

𝑃0 = 𝐷𝑜 (1 + 𝑔)

𝑟 − 𝑔 =

𝐷1 𝑟 − 𝑔

𝑃𝑡 = 𝐷𝑡 (1 + 𝑔)

𝑟 − 𝑔 =

𝐷𝑡+1 𝑟 − 𝑔

Required Rate of Return from CGM model:

𝑟 = 𝐷1 𝑃0

+ 𝑔

Payout Ratio:

𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

Plowback Ratio:

𝑃𝑙𝑜𝑤𝑏𝑎𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 = 𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛 𝑡𝑜 𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 = 1 − 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜

Sustainable growth rate:

Sustainable growth rate (g) = Return on Equity × plowback ratio

Chapter 11

Holding Period Rate of Return for stock:

Holding Period Rate of Return = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐼𝑛𝑐𝑜𝑚𝑒+(𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒−𝐵𝑢𝑦𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒)

𝐵𝑢𝑦𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒

Return:

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑒𝑡𝑢𝑟𝑛 = ∑ 𝑟𝑡

𝑛 𝑡=1

𝑛

The weighted-average return on a portfolio

𝑟𝑃 = 𝑟1×𝑤1 + 𝑟2×𝑤2 + ⋯ + 𝑟𝑛 ×𝑤𝑛

Chapter 12

The weighted-average beta on a portfolio

𝛽𝑃 = 𝛽1×𝑤1 + 𝛽2×𝑤2 + ⋯ + 𝛽𝑛×𝑤𝑛

Total Return, Risk-free Return and Risk Premium:

Total Return = Risk-free Return + Risk Premium

CAPM:

𝑅 = 𝑟𝑓 + 𝛽 ∗ (𝑟𝑚 − 𝑟𝑓 )

Chapter 13

WACC:

𝑊𝐴𝐶𝐶 = 𝑊𝑒 ×𝑟𝑒 + 𝑊𝑝×𝑟𝑝 + 𝑊𝑑×𝑟𝑑×(1 − 𝑡𝑎𝑥)