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UM - FIN 302 - Study Guide - Midterm

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MIDTERM 1 STUDY GUIDE

TEST IS ON CHAPTERS 1,3,4,5,6,7

CHAPTER 5 IS INTEREST RATE CONVERSIONS AND LOANS IT’S COVERED IN CHAPTER 3 AND 4 IN TERMS OF OUR CLASS CHAPTER 1

Financial assets: legally enforceable claim to other assets or payments Securities: assets that are traded publicly

Money Market: low-risk, low-return

Bonds: marketable debt exceeding one year when originally issued

Equities: ownership in a corporation. Common stock, preferred stock, Depository receipts

Derivatives: standardized contracts that trade publicly

Options contracts: Two types:

Call: Buyer has right to buy writer has obligation to sell.

EXAMPLE: You buy call options for Yahoo’s stock at $40/ share, guessing that the price will soon increase. When it does, you own the rights to buy a let’s say $70/ share stock for $40.

Put: Buyer has right to sell writer has obligation to buy. BUY THESE WHEN YOU THINK THE PRICE OF A STOCK WILL DROP

EXAMPLE: You buy shares of a stock knowing the current price is inflated and that it is bound to drop. This gives you the right to sell at a certain price. So you as the buyer of said contract stand to earn a profit if the price per share drops to $500, and you have a put for $550. People will want to buy the rights to the put from you. We also discuss several other topics like Which plant is considered to be an antidote for cobra bite?

Financial Markets:

Primary: initial issuance of a security (an IPO), issuer receives proceeds Secondary: existing owner sells to another party We also discuss several other topics like How do you go from vertex form to standard form?

Corporation: viewed as a separate legal entity. Limited liability to owners. Double taxation.

Investments Styles

Active management: try to find undervalued securities

Passive management: accept the market average

Price Contingent orders:

Stop-loss: sell if the price drops below some limit. You own the stock and want to sell it. Don't forget about the age old question of Who is considered the founder of classical conditioning?

Stop-buy: buy if the price rises above some limit. You don’t own the stock but you want it.

Limit-sell: sell if the price rises above some limit. You own the stock and want to sell it.

Limit-buy: buy if the price drops below some limit. You don’t own the stock but you want it. We also discuss several other topics like What are the changes in brain development in the first two years of life?

Trading costs:

Spread: cost of trading with a dealer

Bid: price at which the dealer will buy from you

Ask: price at which the dealer will sell to you

Bid-ask spread: profit to the dealer

Buying on margin: investor borrows money from a broker to help finance the stock purchase.

The investor’s own money is called the margin. The initial margin must be 50% of the investment.

IF the margin declines to 25% of the stock price, the broker can issue a margin call for the investor to add funds to the account

How low can the stock price drop before you get a margin call? Price (Minimum)= Initial Price (1- Initial Margin %)/ (1-Maintenance %)

Short Sales:

1) You borrow shares from a broker and immediately sell them, hoping for a price decline Don't forget about the age old question of What is the meaning of capital budgeting in financial management decisions?

We also discuss several other topics like What is the charge difference across a resting nerve cell membrane and how is it maintained?

2) You later repurchase the shares at a lower price and return those to the broker, and you make the money from the difference in prices

CHAPTER 3

Two complications when measuring “Value”:

1) Time

2) Uncertainty

Interest:

Simple interest: only paid on the original amount

Compound interest: earned interest becomes principal, so we earn interest on the prior interest

APR: periodic rate * # of periods in a year

FV= PV*(I + r)n

Effective Annual Rate (EAR): the true annualized rate of return EAR= (1 + r)m – 1

R= Rate per compounding period

M= Compounding periods in one year

***When calculating EAR in your calculator, AND SOLVING FOR FV, the answer is the decimal

REMEMBER TO ENTER IT WITH A “1.” IN THE FUTURE VALUE COLUMN

Compounding with Changing Rates:

FV= 1000*(1.08) *(1.04)2*(1.06) *(1.03)

WHEN A RATE IS COMPOUNDED ANNUALLY, EAR= APR= R Daily effective rate: 12/365=m

Monthly effective rate: 365/12=m

CHAPTER 4

Annuity: stream of consecutive, equal payments

1) Ordinary annuity: stream of equal, consecutive payments that begin at the end of the current period. Payments are in arrears (end of each period) 2) Annuity Due: payments are due at the beginning of each period. Ex: apartment rental payments

3) Deferred annuity: payments are postponed or deferred for some length of time

PV (of an annuity) = 100/ (1+r)n

PV0= (PMT1/r) * [1-(1/(1+r)n)]

PV is always one period before the first period

THE AMOUNT OWED ON ANY LOAN IS THE PV OF ALL FUTURE PAYMENTS DUE

FV= PMT1 * [(((1+r)n – 1)/r)]

Growing annuities: finite stream of consecutive payments that grow at a constant rate, “g”

EX: 100 110 121 133.10

Perpetuity: infinite stream of consecutive cash flows

1) Level perpetuities: an infinite stream of equal payments

“If the first payment is one year from today” = just the formula “If the first payment is today” = the formula + the initial payment 2) Deferred annuity: annuity where initial payment is some time in the future

3) Growing perpetuities: infinite stream of payments growing at a constant rate

Loans:

1) Discount loans: FV= principal + accumulated interest

2) Interest-only loans: Loan $= Ending Balance

3) Amortized loans: Payment= Principle + Interest, also called “Installment loans”

4) Balloon Payment loans: the “balloon” represents a principal balance due at the end of the loan

The “Balloon Payment” is the FV key on your calculator

CHAPTER 6

Bond: a bond is a loan on a BIG scale used to finance large corporations and governments

Coupon bond: like a fixed-rate interest only loan. You pay for the bond, receive interest every period, then you receive the face value of the bond at completion.

Parts of a bond:

1) Face Value: the terminal value component (FV). What will be paid to you at maturity.

2) Coupons: the annuity components (interest payments).

a) Coupon rate: the ANNUAL rate of interest paid on the FV.

b) Coupon payment: dollar amount paid semi-annually. THESE ARE FIXED.

Bond Valuation: can be calculated by adding the annuity payments plus a terminal lump sum.

The market value of a bond will change inversely with interest rates. Interest rates UP, Bond Prices DOWN

Why do Bond Prices fluctuate?

Because if the market is offering a better return on investment, there will be less demand for bonds and the process will be driven down. Bonds must provide a return EQUAL TO THE MARKET RATE in order to be attractive to investors.

YTM= MARKET RATE OF RETURN

YTM > COUPON RATE= BOND SELLING AT A DISCOUNT

YTM < COUPON RATE= BOND SELLING AT A PREMIUM

BONDS EVALUATION IN YOUR CALCULATOR, WHERE TO PUT THE INTEREST RATES:

1) The market interest rate is DIVIDED BY 2 (semi-annual coupon payments) and entered in the I/Y column.

2) The coupon rate (on the bond) is multiplied by the bond’s FV. That represents annual interest payment for the bond. DIVIDE THAT NUMBER BY 2 and enter it as PMT.

PMT for bonds= (FV*Coupon rate)/2

3) N, I/Y, and PMT ALL HAVE TO BE ENTERED IN SEMI-ANNUAL FORMAT

RISKINESS:

∙ Longer term bonds have greater risk than shorter ones

∙ Lower coupon rates have greater risk than higher ones

∙ Least risky is short term bonds with a big coupon

∙ If you suspect a decrease in interest rates you go long term bond with small coupon

NOTES:

1) ASSUME FACE VALUE OF A BOND IS ALWAYS $1,000

2) EAY (Effective Annual Yield) = effective annual return taking semi-annual compounding into consideration

3) EAY = EAR = (1 + semi-annual rate)2-1

4) YTM IS AN ANNUAL %, SO MULTIPLY I/Y BY 2

5) “At that price, what is its YTM?” = “What’s the total return to the investor if held to maturity?”

Zero Coupon Bonds: no interest payments, bonds sold at a discount INTEREST IS IMPLICIT IN THE FUTURE VALUE

Government bonds:

Treasury Securities:

1) T-Bills: pure discount bonds with maturity of one year or less 2) T-Notes: coupon debt with original maturity between one and ten years 3) T-Bonds: coupon debt with original maturity greater than ten years

Municipal Securities: Debt of state and local governments. EXEMPT FROM GOVERNMENT TAXATION

After-tax yields: Taxable Yield * (1- Marginal Tax Rate)

Equivalent Taxable Yield: Tax Exempt Yield/ (1- Marginal Tax Rate)

^ Gives you the yield needed on a taxable bond to equal that of a tax exempt bond

Fisher Formula: (1 + nominal) = (1 + real) (1 + inflation)

Differences Between Debt and Equity:

Debt: not an ownership interest

1) Interest expense is tax-deductible

2) Fixed contractual obligation

3) Risk

Equity: an ownership expense

1) Dividends are not tax deductible

CHAPTER 7

Stock:

1) Ownership share in a corporation

2) Entitlement as owner to the residual earnings of a company 3) Receive dividends, if declared

4) Last in line of all claim holders

Stock Price = PV(Perpetuity)

So in a no-growth scenario…

Price0 = PMT1/r = D1/r

“r” = the appropriate discount rate, and the firm is deemed a “going concern”

If we expect the dividends to grow however…

P0 = D1/ (r-g) OR P0 = [D0 (1 + g)] / (r – g)

And to compute the dividend at any point in time…

Dn = D0 (1 + g)n

Note:

“A company just paid” = Both n’s are the same in the above formula “A company will pay” = Exponent “n” = Subscript “n” – 1

REVIEW SLIDES 30 ANS 31 ON CHAPTER 7 LECTURE FOR THIS NEXT PART:

Slide 30: When calculating a stock’s worth today, use the stock price calculation formula AND include the perpetuity value calculated in the last year of the current growth percentage

P/E Ratio: Stock Price per share/ Earnings per share

Preferred Stock: hybrid between debt and equity. Pays a perpetuity of level dividends.

P0 = D1 / r