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# FIN4424 Exam 1 Study Guide FIN 4424

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This 13 page Study Guide was uploaded by Emily Michel on Monday February 8, 2016. The Study Guide belongs to FIN 4424 at Florida State University taught by Dr. Don Autore in Spring 2016. Since its upload, it has received 237 views. For similar materials see Problems in Financial Management in Finance at Florida State University.

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Date Created: 02/08/16

Study Guide FIN4424 Exam 1 Time Value of Money Financial Management Goal: Max Shareholder Wealth/Firm Value Time Value of Money- Would you rather receive a dollar today or in 10 years? -Answer: Today because you could invest it and in 10 years it would be worth a lot more with interest. Investopedia.com You can compare values by getting the present value of all cash flows, or comparing at a specific time through compounding and discounting. FCF=future cash flow R=interest rate PV=present value If only one cash flow, use this to calculate time value: To maximize your value you want: -Small r because it reflects perceived risk, less risk of defaulting, less volatility/movement with shares -Many Cash Flows, obtain more by good business and customer satisfaction Stakeholders- owners, customers, employees, etc. Principle Agent problem- when manager’s actions are not to maximize shareholder wealth, they are more focused with their personal gain (ex. Corporate jet) -Sarbanes Oxley tries to cut down on this problem Example 1: If you borrow $2000 and have to payback in 1 year and you have to pay a 5% return the Present Value would be. 2000/(1+.05)=1905 If 10 years instead of 1… 2000/((1+.05)^10)= 1228.5 So, the person lending you the money is making more on the $2,000 dollars they lent you if it accrues interest over a longer period of time. If you keep the same problem and the interest rate increases to 12%... 2000/((1+.12)^10)=644 This shows that as interest rates go up, the fixed income goes down. When further out into the future (10 years instead of 1 year), changes in rates affect fixed income prices more drastically. Example 2: Compounding- what will it be worth If you invest $500 in mutual fund today, then $600 in a year from now and you make 9% on your investment annually, in 2 years how much will you have? Rearrange the formula to be: FV=PV(1+r)^t 500(1.09)^2 + 600(1.09)^1 = 769.31+846.94 = 1616.26 Example 3: Discounting Back- what is it worth today You receive $100 today, $40 in one year, $75 in two years, and you can make 15% on your investments. It helps to make a timeline!! Example 4: Combination Problem-What will the value be in year 3? You will have to discount and compound, OMG Cash Flows: Y1=$100, Y2=$200, Y3=$200, Y4=$300, Y5=$300 @7% interest What will it be worth in year 3?? Perpetuity is an infinite stream of equal payments. PV of perp=Cash flow you get each time/return rate PV=CF/r This is derived from the other formula. You would be indifferent between 1000 now and 100 a year for forever at a 10% return, because {100/.1=1000=PV} Risk and Return -For a given amount of return, you want the least amount of risk possible. In the graph anything northwest from the point indicates the optimal area, even less risk with the same return is better, and so is the same risk with more return. Market Efficiency- basically how well current market data reflects what is really going on, how quickly prices react/reflect to new info. The market is pretty efficient, meaning you cannot defy market efficiency! -An example of trying to defy market efficiency is the January effect. This is when people sell in December for tax purposes and buy back in January thinking there will be a pop in the market. However, doesn’t always work and people get screwed over. -Finding Alpha- finding mis-valued stocks and defying efficiency, its what hedge funds do. When they start to defy the market too often it is usually due to insider trading. Net Present Value=PV of inflows-PV of outflows Positive means earning a return higher than required 0= making consistently what is required Stocks have an NPV of 0. Sometimes they have positive NPV when they are defying market efficiency, but positive NPV ventures always get hit with competition and bumped back to market efficiency. This is called Curse of Competitive Markets. Bonds A firm has capital through its retained earnings, borrowing (bonds/debt), and issuing equity (stocks) On bonds the coupon rate is periodic payment based on the par value of the bond, and is usually fixed Yield to Maturity is the total required return on the investment, the market rate. In other words the COST OF DEBT. The actual market determines this. C=coupon payment r=YTM and Par= lump sum paid up at maturity. Many bonds are issued where YTM=Coupon Rate. But, if…. YTM>Coupon Rate, then it is a discount bond. -You require more than your coupon payment, so to get your required return you get a discount on the bond! YTM< Coupon Rate, then it is a premium bond. -You require less than the coupon payment, so the bond is more desirable, meaning you will have to pay more for it…so it will sell at a premium. The line outlining the less shaded region represents a premium bond. The longer time you hold a premium bond, the longer you will be getting the coupon payments that exceed your required return, so the more valuable it will be. Hence, the more it will cost on the market to buy. But, as a premium bond gets closer to maturity, it becomes less valuable and its market price drops. A discount bond is represented by the line bordering the more shaded region, and it rises closer to maturity because the less time means less to be compensated with for taking a rate less than YTM. **The closer to maturity, the less volatility and interest rate risk. Interest rate risk is how much price changes given a change in interest rate. This means that a 1- year bond is less sensitive than a 10-year bond. Default Risk- measured by bond ratings AAA to BBB is investment grade, BB or less are junk bonds (they are so risky because you may not get your money back! But, sometimes they payoff because they pay high returns since they are so sketchy) -Companies really depend on ratings. Better earnings to interest expense when better ratings. Less they have to pay to get people to invest. -Can change ratings with capital structure, i.e reduce amount of debt to look better, then make debt offer at a better yield because are supposedly less risky. Interest Coverage Ratio- a debt ratio and profitability ratio used to determine how easily a company could pay interest on outstanding debt. Bond Types- -Callable Bond: issuer can pay it off and recall it -Why? If interest rates drop because you are a safer company (get a better rating) then you can make more $$$ by calling the bond, and making investors buy back at a higher price or less coupon. -Putable Bond: Lender has option to sell the bond back to the issuer before maturity at specified date. -Convertible: investors have option to convert pre-specified ratio into equity shares. Take a lower yield; usually the company gets the better deal. Remember: Shorter-term bonds are less volatile to interest rate changes (interest rate risk) Reinvestment Rate- short term=more risk, but less interest rate risk Zero coupon paying bond is riskier, BC no incremental cash flows. Slope= sensitivity Steeper line=more sensitive, because more cash flows are occurring out in the future *Duration gives an actual # to sensitivity. It is measured in time but it is not the same as the common definition. It is the weighted average of when all cash flows occur. Longer Duration=more sensitive. Example: $1000 face value bond, 10% coupon, 3 year, 12%YTM Find Market price of bond and then Duration. ▯▯▯ + ▯▯▯ + ▯▯▯▯ = Present Value=951.96 ▯.▯▯▯ ▯.▯▯▯ ▯.▯▯▯ ▯▯▯ ▯▯▯ ▯ ▯▯▯▯ ▯ Duration= ▯.▯▯ + 2 ▯.▯▯ + 3 ▯.▯▯ =2.73 ▯▯▯.▯▯ ▯▯▯.▯▯ ▯▯▯.▯▯ **More coupons=less sensitive=less duration **Duration will be LONGER if no coupons! It will be entire maturity time because only one payment! Formula for portfolio Duration: Weight (Dura1ion) +Weight1(Duration)2 2……for all weight=V Yield Curve: upward sloping yield curve means that short-term interest rates are expected to rise in the future. The yield curve shows which way interest rates will go. -If rates are going up everyone wants short-term investments instead of locking in a rate for a while. When rates start to go down is when people get into long term, so they lock in highest possible rate. Standard Deviation and Expected return are used to plot risk and return. Which was previously mentioned and explained with a graph on page 4. Standard Deviation represents risk, how much deviation from the average. -In finance standard deviation is always taken from a sample so the equation is slightly different. (R bar in the formula means of the past, historical data) So take the sum of ((each rate for each sample minus the average rate) squared)/(number in the sample-1) and then take the square root of that number. Expected Return Probabilities times each rate to get a weighted like average. *If all equal probabilities then just add up and divide by number of returns. Market Risk Premium- Expected Return-Risk Free Rate=Market Risk Premium Example: If the T-Bill (which is equivalent as the risk free rate, because if the government started defaulting on bonds that’d be bad and there would be some problems!) is 2% and expected return is 10% -> 10-2= 8; the MRP is 8%! Smaller companies have higher expected returns, but more risk than larger companies. More market risk premium. Ex: Small expected return =12% v Large expected return =10% t-bill=2%, then small MRP=10, large=8 Portfolio Risk (???? ) ???? Expected return on portfolio= weight1 (return1)+w2 (r2)… Standard Deviation: ???? ???? ???? ???? ???? ???????????? …. ???? ???? *Only true if assets are perfectly correlated (correlation coefficient=1) needs a correlation coeffiecient if not. *Perfect correlation= when 1 asset goes down, so does the other; move together. Negative correlation means one goes up the other goes down exactly. *Diversification with portfolios reduces variance, hence reduces risk. Diversifiable risk is risk that can be taken away through (you wouldn’t guess!!!), diversification. *Negative correlations are almost impossible to find Covariance: *Only have to pay attention to covariance’s sign (+ or -) *Won’t have to solve for covariance on test supposedly… Correlation: *Covariance will be given…so easy calculation Beta: how sensitive stock returns are to market movements, measures systemic risk: risk that is external to the company and effects everyone. Some are affected differently than overall market. I=Stock measuring, M=market -Complicated to get estimate right, can use different intervals to come up with a beta more in a companies favor. (Can be inflated by only a couple outliers of info) On a scatter plot, the steeper the regression line’s slope, the higher the beta. If Beta=(1) similar to market, movement mirros SNP500 for example (0) The return is the same as risk free (-1) opposite of the market movements >1= more sensitive to economic news <1= less sensitive than market *Security Characteristic Line calculates Beta. Idiosyncratic- other factors other than the market/systematic that affect returns. Can cause outliers in data that affect a companies Beta calculation. CAPM Model- Expected Return of a company=Risk Free + Beta of a company (Market Rate-Risk Free) -Cost of Equity *Securities Market Line is synonymous with CAPM. SML- This shows that higher the beta, the higher the expected return. The calculation of Beta determines where you sit on the line. Market’s Beta= 1. Line can change due to risk free rate (y- intercept) changing. Which results in an upward shift (same slope different y-intercept) 2. Line can also change due to higher risk premium in the market, which results in greater slope because return goes up for the same level of risk. Goal is to find big winners not plotted on the line and get higher realized returns (r bar), this is what hedge funds try to do. Finding alpha is when you locate these abnormal returns. Rbar is found by adding this alpha amount onto the CAPM equation. *When intrinsic value does not match the market value is when people buy or sell. Stock Price Evaluation Required Return= Dividend Yield + Capital Gains Yield Div. Yield= dividend expressed as a percentage of a current share price. Cap. Gains Yield= change in price divided by the original (purchase) price. { P0=D 1r} if constant divs forever, no growth: This means price now is next years dividend divided by the return, which is the same equation basically as perpetuity. The price remains unchanged! Zero Growth Div. Discount Model t D tD (0+g) : This is to find the dividend of a certain year when it is growing at a constant rate. Constant Growth Model- This means that price at time zero of the stock equals the dividend paid out in year one dived by the required return minus growth rate. *This can only be done once there will be constant growth. For problems with constant growth after periods of inconstant growth, you must do them a little differently and take time value into equation. *G must be less than r when growth becomes constant. *Example: Price at Y@? Set up like P =D /(r-g 2 ; 3rice a2 year 2 is value at time 2 of all Future cash flows Example 2: Price at time 2 in this problem represents that present value at time 2 of all future dividends growing at 6%. This is why it only needs to be discounted by 2 years and not 3. Problems that people often have with these problems: This is showing if after solving the last example and was told to find price at time 1 instead, you cannot take the short cut of simply compounding it. This is because there are different growth rates factored in and you cannot just compound with out again factoring those in. Do it out the long way. Major Keys to the Test for people who didn’t come to class: -Show ALL work, he gives LOTs of partial credit.. -wont have to calculate co-variances or complex beta problems -Full front and back formula sheet that can be typed -bring a calculator -he uses problems similar to those in the homework

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