Finance 350 Business Finance Review

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Finance 350 Business FinanceReview

• Instructor Yen-cheng Chang

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What Have We Learned?

• Roles/Goals of a financial manager
• Financial Markets Primary vs. Secondary Markets
• Time Value of Money

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What Have We Learned?

• Single Period Problems FV, PV, Number of
  Periods, Rate of Return
• Multiple Period Problems Annuity, Perpetuity,
  Growing Annuity, Growing Perpetuity
• APR, EAR, effective rate ALWAYS DISCOUNT WITH AN
  EFFECTIVE RATE
• Rates of different horizons Term Structure of
  Interest Rates

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What Have We Learned?

• Bond Valuation Term, Coupon Rate, YTM, Principal
• Zero-coupon bonds, coupon bonds, corporate bonds
• Interest rate risk, default risk
• NPV and Alternative Decision Rules
• Payback period
• IRR nonconventional CFs, Mutually exclusive
  projects, CF timing

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What Have We Learned?

• Capital Budgeting Measure the incremental CFs of
  a project (or a firm)
• FCFEBIT(1-Tax Rate) Depreciation- Cap. Exp.
• Change in NWC
• Opportunity cost, project externalities, sunk
  cost
• Stock Valuation
• Dividend Discount Model
• Total Payout
• Discounted FCF Model
• Valuation Multiples

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What Have We Learned?

• Efficient Market Hypothesis
• Weak, Semi-Strong, Strong
• Where do I get the proper discount rate?
• Risk and Return
• Expected return vs. Standard Deviation (Total
  Risk)
• Total Risk Systematic Risk Unsystematic Risk
• Portfolio Theory Diversification
• Portfolio expected return and standard deviation
• Diversification depends on correlation among
  component stocks

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What Have We Learned?

• Diversification has limits Systematic Risk
  cannot be diversified
• Expected Return vs. Systematic Risk
• Efficient Frontier
• Capital Market Line
• Capital Asset Pricing Model
• Beta measures a securitys relative systematic
  risk

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What Have We Learned?

• Cost of Equity
• Cost of Debt
• Weighted Average Cost of Capital
• Can only be used for project with similar risk as
  the entire firm

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Quiz 4 1

• Suppose you are considering using stock A and B
  to form a portfolio. The expected returns of A
  and B are 20 and 30, respectively. The
  variance of returns of A and B are 1 and 4,
  respectively. Calculate the expected return and
  standard deviation of a portfolio that is
  composed of 70 in A and 30 in B. The
  correlation coefficient between the two stocks is
  0.5. Are there diversification benefits?

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Quiz 4 1

• Yes there are diversification effects since

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Quiz 4 3

• Compare two stocks. Stock A return has beta of 2
  and standard deviation of 5, and Stock B return
  has beta of 0.5 and standard deviation of 30.
  Further analyses show that Stock A has
  historically yielded higher average return than
  stock B, which seems counterintuitive given the
  higher standard deviation of B. Explain why this
  is happening. Use less than 3 sentences.

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Quiz 4 3

• Market only compensates for incurring systematic
  risk since this is the kind of risk that cannot
  be diversified away. A stocks systematic risk
  is measured by its beta. Stock A has a higher
  average return reflects its higher systematic
  risk.

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Quiz 4 4

• Targets stock return has been estimated to have
  a beta of 2. The risk-free rate is 2 and the
  market risk premium is 4.75. In addition,
  Targets outstanding debt currently has a YTM of
  6. Debt accounts for 18 and equity for 82 of
  Targets total market value.
• (a) What is Targets cost of equity?
• (b) Assume the corporate tax rate is 35. What
  is Targets after-tax cost of debt?
• (c) Given your answer in (a) and (b), what is
  Targets WACC?

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Quiz 4 4

• Cost of Equity
• After-tax cost of debt
• WACC

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Quiz 4 5

• Recall the model we used to derive the CAPM.
  Below is the graph of the Capital Market Line. M
  denotes the market portfolio. The other two
  points on the CML denote the portfolio choices of
  two investors, A and B. Describe how A and B
  would form their portfolio under this model.
  Specifically,
• (a) What are the securities in their portfolios?
• (b) How much are they investing in each security?
  For both A and B, give a rough estimate of the
  weights on each security.

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Quiz 4 5

• (a) Both investors hold
• the risk-free bond and
• the market portfolio (M).
• (b) Investor A
• 50 in risk-free bond
• 50 in M
• Investor B
• -50 in risk-free bond
• 150 in M.

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Practice Problems for the Final

• Which bond would most likely possess the highest
  degree of interest rate risk?
• A) 8 coupon rate, 10 years to maturity
• B) 8 coupon rate, 20 years to maturity
• C) 10 coupon rate, 10 years to maturity
• D) 10 coupon rate, 20 years to maturity
• E) 12 coupon rate, 20 years to maturity

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Practice Problems for the Final

• Which bond would most likely possess the highest
  degree of interest rate risk?
• A) 8 coupon rate, 10 years to maturity
• B) 8 coupon rate, 20 years to maturity
• C) 10 coupon rate, 10 years to maturity
• D) 10 coupon rate, 20 years to maturity
• E) 12 coupon rate, 20 years to maturity

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Practice Problems for the Final

• Which of the following is true regarding the beta
  coefficient?
• A) It is a measure of unsystematic risk.
• B) A beta greater than one represents lower
  systematic risk than the market.
• C) Generally speaking, the higher the beta the
  higher the expected return.
• D) A beta of one indicates an asset is totally
  risk-free.
• E) The risk premium of an asset will increase
  if the beta of that asset decreases.

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Practice Problems for the Final

• Which of the following is true regarding the beta
  coefficient?
• A) It is a measure of unsystematic risk.
• B) A beta greater than one represents lower
  systematic risk than the market.
• C) Generally speaking, the higher the beta the
  higher the expected return.
• D) A beta of one indicates an asset is totally
  risk-free.
• E) The risk premium of an asset will increase
  if the beta of that asset decreases.

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Practice Problems for the Final

• Which of the following would increase a
  portfolio's systematic risk?
• I. Common stock is sold and replaced with
  Treasury bills.
• II. Stocks with a beta equal to the market beta
  are added to a portfolio of Treasury bills.
• III. Low-beta stocks are sold and replaced with
  high-beta stocks.
• A) I only
• B) II only
• C) III only
• D) I and II only
• E) II and III only

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Practice Problems for the Final

• Which of the following would increase a
  portfolio's systematic risk?
• I. Common stock is sold and replaced with
  Treasury bills.
• II. Stocks with a beta equal to the market beta
  are added to a portfolio of Treasury bills.
• III. Low-beta stocks are sold and replaced with
  high-beta stocks.
• A) I only
• B) II only
• C) III only
• D) I and II only
• E) II and III only

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Practice Problems for the Final

• Which of the following is generally true about a
  firm's cost of debt?
• A) It is equal to the yield to maturity on the
  firm's outstanding bonds.
• B) It is greater than the cost of equity.
• C) It cannot be observed, directly or
  indirectly, in the marketplace.
• D) It is greater than the average coupon
  payments on outstanding debt.
• E) It is equal to the coupon rate on the firm's
  outstanding bonds.

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Practice Problems for the Final

• Which of the following is generally true about a
  firm's cost of debt?
• A) It is equal to the yield to maturity on the
  firm's outstanding bonds.
• B) It is greater than the cost of equity.
• C) It cannot be observed, directly or
  indirectly, in the marketplace.
• D) It is greater than the average coupon
  payments on outstanding debt.
• E) It is equal to the coupon rate on the firm's
  outstanding bonds.

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Practice Problems for the Final

• Rickys Cup of Life Co. has a bond outstanding
  that has a 7 coupon rate and a market price of
  887.76. If the bond matures in 5 years and
  coupon is paid semiannually, what is the YTM?
• A) 5.0
• B) 5.5
• C) 7.5
• D) 9.9
• E) 14.9

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Practice Problems for the Final

• Rickys Cup of Life Co. has a bond outstanding
  that has a 7 coupon rate and a market price of
  887.76. If the bond matures in 5 years and
  coupon is paid semiannually, what is the YTM?
• A) 5.0
• B) 5.5
• C) 7.5
• D) 9.9
• E) 14.9

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Practice Problems for the Final

• Jon, the CFO of Bon Jovi Co., is considering a
  project which costs 300 and produces cash flows
  of 100 over each of the following six years.
  What is the IRR of the project?
• A) There is not enough information a discount
  rate is required
• B) 10.0
• C) 24.3
• D) 34.9
• E) 38.1

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Practice Problems for the Final

• Jon, the CFO of Bon Jovi Co., is considering a
  project which costs 300 and produces cash flows
  of 100 over each of the following six years.
  What is the IRR of the project?
• A) There is not enough information a discount
  rate is required
• B) 10.0
• C) 24.3
• D) 34.9
• E) 38.1

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Practice Problems for the Final

• If investors require a 7 nominal return and the
  expected inflation rate is 3, what is the exact
  expected real return?
• A) 3.88
• B) 4.00
• C) 5.00
• D) 10.00
• E) 10.21

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Practice Problems for the Final

• If investors require a 7 nominal return and the
  expected inflation rate is 3, what is the exact
  expected real return?
• A) 3.88
• B) 4.00
• C) 5.00
• D) 10.00
• E) 10.21

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Practice Problems for the Final

• You are evaluating two mutually exclusive
  projects, A and B. Project A costs 350 and has
  cash flows of 250 in each of the next 2 years.
  Project B costs 300 and generates cash flows of
  300 and 100 for the next 2 years, respectively.
  What is the crossover rate for these projects?
• A) 26.38
• B) 27.47
• C) 30.28
• D) 61.80
• E) 83.48

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Practice Problems for the Final

• You are evaluating two mutually exclusive
  projects, A and B. Project A costs 350 and has
  cash flows of 250 in each of the next 2 years.
  Project B costs 300 and generates cash flows of
  300 and 100 for the next 2 years, respectively.
  What is the crossover rate for these projects?
• A) 26.38
• B) 27.47
• C) 30.28
• D) 61.80
• E) 83.48

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Practice Problems for the Final

• What is the portfolio beta with 125 of your
  funds invested in the market portfolio via
  borrowing 25 of the funds at the risk-free
  interest rate?
• A) 0.25
• B) 0.50
• C) 0.75
• D) 1.00
• E) 1.25

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Practice Problems for the Final

• What is the portfolio beta with 125 of your
  funds invested in the market portfolio via
  borrowing 25 of the funds at the risk-free
  interest rate?
• A) 0.25
• B) 0.50
• C) 0.75
• D) 1.00
• E) 1.25

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Practice Problems for the Final

• Suppose that WHAM Inc. has a cost of equity of
  14 and a cost of debt of 9. If the target
  debt/equity ratio is 75, and the tax rate is
  34, what is WHAMs WACC?
• A) 6.6
• B) 7.9
• C) 8.4
• D) 10.5
• E) 10.9

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Practice Problems for the Final

• Suppose that WHAM Inc. has a cost of equity of
  14 and a cost of debt of 9. If the target
  debt/equity ratio is 75, and the tax rate is
  34, what is WHAMs WACC?
• A) 6.6
• B) 7.9
• C) 8.4
• D) 10.5
• E) 10.9

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Practice Problems for the Final

• Which of the following statements is NOT true?
• A) The WACC of a firm is the proper discount rate
  for projects with beta equals one.
• B) The WACC consists of both the cost of debt and
  cost of equity (common stock preferred stock).
• C) The average return of the overall market has
  an effect on a companys WACC.
• D) A firms WACC can change every day.
• E) When the Fed increases short-term rates, a
  firms WACC also increases.

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Practice Problems for the Final

• Which of the following statements is NOT true?
• A) The WACC of a firm is the proper discount rate
  for projects with beta equals one.
• B) The WACC consists of both the cost of debt and
  cost of equity (common stock preferred stock).
• C) The average return of the overall market has
  an effect on a companys WACC.
• D) A firms WACC can change every day.
• E) When the Fed increases short-term rates, a
  firms WACC also increases.

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Practice Problems for the Final

• Y-box Inc. has just paid a 10 dividend, and the
  management announces that it will reduce dividend
  payout by 8 percent per year, indefinitely. If
  the market is requiring 11 return on this stock,
  what will the stock price be today?
• A) 46.78
• B) 48.42
• C) 56.33
• D) 20.98
• E) 39.79

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Practice Problems for the Final

• Y-box Inc. has just paid a 10 dividend, and the
  management announces that it will reduce dividend
  payout by 8 percent per year, indefinitely. If
  the market is requiring 11 return on this stock,
  what will the stock price be today?
• A) 46.78
• B) 48.42
• C) 56.33
• D) 20.98
• E) 39.79

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Practice Problems for the Final

• Assume the financial manager is working for a
  for-profit corporation
• (a) What should be the goal of the financial
  manager of a corporation? Why?
• (b) List and briefly describe TWO of the three
  basic questions a financial manager must be
  concerned with.

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Practice Problems for the Final

• Slick Willy wishes to save money to provide for
  his retirement from Ellipse.com. Beginning one
  month from now, he will begin depositing a fixed
  amount into a retirement savings account that
  will earn 12 compounded monthly. He will make
  such deposits each month for 30 years. Then, one
  year after making his final deposit, he will
  withdraw 100,000 annually for 25 years. The fund
  will continue to earn 12 compounded monthly. How
  much should the monthly deposits be for his
  retirement plan?

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Practice Problems for the Final

• How much would he need by the time of retirement
  for 25 years of 100,000/year?
• PV(n25, C100000, r12.68)748,767.70
• How much does he have to save for the first 30
  years (360 months) to have that amount by the
  time of retirement?
• FV(n360, C, r1)748,767.70
• C214.24

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Practice Problems for the Final

• Consider the following information on asset A and
  B
• var(RA) 0.01, var(RB) 0.04,
• (b) Suppose var(RM) 0.25, corr(RA, RM) 0.25,
  and corr(RB, RM) 0.5. Find ßA and ßB. Also
  construct a zero beta portfolio, i.e., determine
  the weights on A and B such that the portfolio
  has zero beta.

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Practice Problems for the Final

• ßACov(RA, RM)/Var(RM)
• Corr(RA, RM)SD(RA)SD(RM)/ SD(RM)2
• 0.25 X 0.1 / 0.5
• 0.05
• ßBCov(RB, RM)/Var(RM)
• Corr(RB, RM)SD(RB)SD(RM)/ SD(RM)2
• 0.5 X 0.2 / 0.5
• 0.2

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Practice Problems for the Final

• Zero Beta Portfolio
• 0 wA X 0.05 wB X 0.2
• ? wA / wB -4 / 1
• ? wA4/3, wB-1/3

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Practice Problems for the Final

• As the CFO of your firm, you are evaluating a
  marketing project that is going to yield you 2
  million dollars at the end of the first year, and
  grow at 5 indefinitely. Your firm has two times
  the systematic risk of the overall market, and
  the market premium is 8. Your firms after tax
  cost of debt is 5.5. The debt-to-equity ratio
  of your firm is 0.6, and the risk-free rate is
  3. Since the project is riskier than the
  average project, the CEO has decided to adjust
  the WACC by 2. Should you take on the project
  if it costs 15 million today?

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Practice Problems for the Final

• Cost of Equity 3 2 x 8 19
• After tax cost of debt 5.5
• D/E 0.6 ? D3/8, E5/8
• WACC 5/819 3/85.5 13.94
• Discount rate 13.94 2 15.94
• NPV -15 2/(15.94 - 5) 3.28

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