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# E120: Finance - Study Guide E120

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This 25 page Study Guide was uploaded by Mary Jensen on Thursday November 13, 2014. The Study Guide belongs to E120 at University of California Berkeley taught by Alder in Fall. Since its upload, it has received 323 views. For similar materials see Finance in Engineering and Tech at University of California Berkeley.

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Date Created: 11/13/14

Engineering 120 Principles of Engineering Economics Midterm 2 Course Review 1Lecture 1 11 Business Forms Text ch 1 12 Financial Accounting Text ch 2 121 Two types of financial statements 1211 A balance sheet which describes stock variables 1212 An income statement which describes 39floW39 variables 1213 The statement of equity is derived from the balance sheet 1214 The cash ow statement is derived from the income statement 1215 Double entry accounting makes accounts balance 122 Financial statements have many constituencies 1221 Internal analysts external investors lenders and regulators 1222 A subindustry security analysts devote great attention to financial statements including despite the Efficient Market Hypothesis 1223 Proprietary cash flow reconstruction 1224 More complex performance measures 13 Cash Flow Discounting Primer I 14 Cash Flow Discounting Primer II 15 Bonds as Numeraires 16 Present Value Arithmetic 17 Present Value Formulas 18 Present Value of an Annuity 19 Time Travel 110 Closing Notes 111The Term Structure of Interest Rates Page 1 Of 13 2 Lecture 23 21 Financial Statements vs Cash Flows 22 Financial Statements Availability 23 Income Statement amp Balance Sheet 231 The income statement generally tracks 2311 Gross profit 2312 Operating income 2313 EBIT EBITDA poor person39s cash flow 2314 Net earnings net income 232 The balance sheet generally tracks 2321 Short and longterm assets and liabilities 2322 Shortterm liabilities are a particular credit concern since they will come due within a year and could trigger a default 2323 Long term liabilities are a concern if they are too large 2324 Thus We have financial ratios Quick Cash Leverage and so on 2325 Consider the Data Case at the end of Chapter 2 24 Combinations and Synthesis 25 No Arbitrage Means No Value I 26 No Arbitrage Means No Value 11 27 Business Projects Don39t Arbitrage 28 NPVr gt 0 Means Return gt r 29 The Value of Capital Markets 210 Investment and Financing Separate 211What is an interest rate 212 Cash Flow Discounting Primer I 213 Cash Flow Discounting Primer II 214 Cash Flow Discounting Primer III Page 2 Of 13 215 216 217 218 219 220 221 DRAFT E 120 Spring 2014 NLG Course Review May 7 Bonds as Numeraires Present Value Formulas Present Value Arithmetic Present Value of an Annuity Time Travel Closing Notes The Term Structure of Interest Rates 3 Lectures 45 31 Quick Review 32 33 34 35 36 37 38 39 310 311 312 313 314 315 316 317 318 319 320 Do Arbitrages Really Exist The Present Value of Cash Flows I The PV of Cash Flows II Present Value of an Annuity Present Value of Growth Time Travel Analogy with Stock PE Other Relationships Introduction to the Price of Risk Ch 3 Appendix Different Rates The Term Structure of Interest Rates Textbook Example 51 Textbook Example 51 cont39d Alternative Example 51 Alternative Example 51 cont39d Other Things to Know from Chap 5 Zero PricesRates Discount Future Payments Another Timeline Only The Par Rates Are Observable Page 3 Of 13 321 Introduction to Bonds Traded Debt 322 RECALL Present Value Arithmetic 323 Can We Discount at Par Rates 4 Lecture 6 41 Financial vs Business Transactions 42 Review of Bonds and Stock 43 Compound Arithmetic 44 RECALL Present Value Arithmetic 45 Zero PricesRates Discount Future Payments 46 The Term Structure of Interest Rates 47 Another Timeline 48 Only The Par Rates Are Observable 49 Introduction to Bonds Traded DebtI 410 Can We Discount at Par Rates YTM 411 Introduction to Bonds Traded DebtII 412 A Bond with Discount 413 Another Example Level Payments 414 An Unexpected Equality 415 Accreted Value PVremaining payments 416 Alternatives to NPV for Bonds 417 The Value of Bonds 418 RECALL Present Value Arithmetic 419 Important Example Level Payments 420 Important Example Level Payments 421 Bond Replication 422 Other Things to Know from Chap 6 423 Projects IRR and Other Metrics Besides NPV I 424 Examples of IRR Problems Page 4 Of 13 425 Projects IRR and Other Metrics Besides NPV II Payback and Profitability Index 5 Lecture 7 51 Projects IRR and NPV 52 NPV Risks Draw a graph 53 Incremental IRR and Profitability Index 54 Capital Budgeting I 55 Calculating FCF Directly 56 Capital Budgeting II 57 Forecasting Earnings Get Incremental Earnings with Accounting 571 Start With Revenue And Cost Estimates 572 Develop Gross Profit EBIT amp finally Unlevered Net Income 573 Capital Expenditures And Depreciation 574 Generally Exclude Interest Expense Separate Financing Decision 575 Include Taxes on EBIT 576 Result is UNI EBIT 1 170 Revenues Costs Depreciation 1 170 577 Opportunity Costs 578 Cannibalization 579 What to Include and Exclude 5710 Exclude Sunk Costs From Incremental Earnings 58 Calculate The Free Cash Flow From Earnings Add Depreciation and Subtract Capital Expenditures and I1IWCt 59 Calculating the NPV 510 Examples 511 Capital Budgeting III Page 5 Of 13 512 Project Analysis BreakEven Sensitivity and Scenario 6 Lecture 8 61 Dividend Yields Capital Gains and Total Returns 62 The Dividend Discount Model Equation 63 Dividends Versus Investment and Growth 64 Total Payout and Free Cash Flow Valuation Models 65 Valuation Based on Comparable Firms Valuation Multiples 66 Information Competition and Stock Prices 67 Competition and Efficient Markets 68 Lessons for Investors and Corporate Managers 69 The Efficient Markets Hypothesis Versus No Arbitrage 7 Lecture 9 71 Historical Returns of Stocks and Bonds 72 Difference Between Probability and Statistics 73 Risk and Return Insights from 86 Years of Investor History 74 Common Measures of Risk and Return 75 Expected Return Variance and Standard Deviation 76 Historical Returns of Stock and Bonds 761 Average Annual Return 762 The Variance and Volatility of Returns 77 Estimation Error Using Past Returns to Predict the Future 78 The Historical Tradeoff Between Risk and Return for Large Portfolios 79 The Returns of Individual Stocks 710 Common Versus Independent Risk 711Diversification in Stock Portfolios Firm Specific Versus Systematic Risk 712 No Arbitrage and the Risk Premium The risk premium for diversifiable risk is zero so investors are not compensated for Page 6 Of 13 holding firm specific risk 713 Measuring Systematic Risk The expected percent change in the excess return of a security for a 1 change in the excess return of the market portfolio 714 Beta and the Cost of Capital 8Lecture 10 81 Summary on Probability 82 Intuition for Covariance and Correlation 83 Linearity of Returns in Weights 84 Linearity of Expected Returns 85 The Expected Return of a Portfolio 86 The Volatility of a TwoStock Portfolio 87 Determining Covariance and Correlation 88 What are Probabilistic Measures of Association Conditional Probability Covariance and Correlation and Regression 89 Table 112 Computing the Covariance and Correlation Between Pairs of Stocks 810 Table 113 Historical Annual Volatilities and Correlations for Selected Stocks 811 Computing a Portfolio s Variance and Volatility 812 The Volatility of a Large Portfolio The variance of a portfolio is equal to the Weighted average covariance of each stock with the portfolio 813 Diversification with an Equally Weighted Portfolio The Covariance Persists and the Variance Disappears as n gt oo 814 Diversification with General Portfolios Returns are Weighted Average but Volatility is Generally Less than Weight Average providing the Diversification Benefit 815 Risk Versus Return Choosing an Efficient Portfolio 8151 With an inefficient portfolio it is possible to find another Page 7 Of 13 portfolio that is better in terms of both expected return and volatility 8152 With an efficient portfolio this is impossible 8153 Efficient Frontier for risky assets is a Hyperbola segment 816 The Effect of Correlation 817 Short Sales 818 Efficient Portfolios with Many Stocks 819 Efficient Frontier is again a better up and left Hyperbola segment 820 RiskFree Saving and Borrowing 821 Investing in RiskFree Securities 822 Borrowing and Buying Stocks on Margin Moves Beyond All Equity 823 Identifying the Tangent Portfolio ltgt Highest Sharpe Ratio Excess Expected ReturnReturn Volatility 824 The Efficient Portfolio and Required Returns with a risk free asset 8241 The Efficient Frontier become the line through the riskfree asset and the Tangent Portfolio the Efficient Portfolio of risky assets 8242 Computation is based on the required return for a portfolio P to increase the Sharpe Ratio Excess Returni gt SDRi CorrRiRPExcess ReturnPSDRP or 8243 with 311 SDRi gtIlt Corr Ri RPSDRP CovRiRPVarRP 8244 We have Excess Returni gt 311 Excess Returnp required return 825 Expected Returns and the Efficient Portfolio The Return of Every Security Its Required Return 826 The Capital Asset Pricing Model The Efficient Portfolio is Page 8 Of 13 the Market Portfolio Return h eggtejeiewea iirweeter iirweeter iih EFquotgt ElfquotIj herrewe at the I39iS 3Q f39rEE39 rete K EP 2 Tehgeht Pertl e5ie eke E jCiIEA t Ptertfeiliie which EE rquotIES the Ef 3Ei EAFIt FFCIFItiEF ihriuatziiiheg the r39iie39 n f39reveA eeeet l t EEIHSiE WEttWE iimweetetr irweete in EP and in the V rie1t t39ree eeeet H 39 39 G G P e Frehitizer Perrtfeliize en the Et ei ehit F39rehtier et risky eeeetsquot P Ezieeerhee i IIEIIIFr i EIIjt whieh riaett 1139re e eeeete ere ihueliu ee AI theee pertfeffee ere e fetw bie ejr than F beeeuee thejr are up endfer the the heft Risk 827 Optimal Investing The Capital Market Line Page 9 Of 13 828 The Security Market Line 829 9 Lecture 11 91 The Equity Cost of Capital 911 The Capital Asset Pricing Model CAPM is a practical Way to estimate it 912 The estimate is provided by the Security Market Line equation 92 The Market Portfolio A ValueWeighted Portfolio Any Value Weighted Portfolio 921 Has Equal Ownership equals fractions of the shares of all companies 922 Is Passive 93 Market Indexes Represent the Market and Provide Basis for Market Index Funds and ETFs 94 The Market Risk Premium 95 Beta Estimation Regression Using Historic Returns 96 Debt Cost of Capital 961 Yield to Maturity Probdefault X Expected Loss Rate 962 Bucket Probdefault by credit rating and use 60 average loss rate 97 Or Compute Debt Cost of Capital from CAPM Bucketing Betas by Credit Rating 98 A Project s Cost of Capital Engineering Concern 981 All equity comparables 982 Unlever Betas of Levered firms to get Comparables 983 Use Net Debt 99 Average Unlevered Industry Betas 910 Consider Operating Leverage proportion of fixed costs gt higher beta see Textbook Example 128 Page 10 Of 13 911 Financing and the Weighted Average Cost of Capital Taxes 912 10 Lecture 12 101 Competition Capital Markets and Alpha 102 Information and Rational Expectations 103 Comments 1031 New information changes oc from zero 1032 Buying the market portfolio is the ignorant investor39s defense 104 The Behavior of Individual Investors including Systematic Trading Biases 105 The Efficiency of the Market Portfolio Seems to Rule Out Stock Picking 106 Style Based Anomalies and the Market Efficiency Debate 107 Response Multifactor Models of Risk 108 Methods Used In Practice Mostly CAPM or Worse 11 Lecture 13 111 Understanding Option Contracts 112 Interpreting Stock Option Quotations 113 Options on Other Financial Securities and Purpose of Option Positions Hedge or Speculate 114 Option Payoffs at Expiration C maxS K0 115 Short Position in an Option Contract a Written Option 116 Profits as Opposed to Payoffs for Holding an Option to Expiration 117 Returns for Holding an Option to Expiration 118 Combinations of Options 119 Put Call Parity 1110 Factors Affecting Option Prices Page 11 Of 13 1111 Arbitrage Bounds on Option Prices 1112 Option Prices and the Exercise Date 1113 Option Prices and Volatility 1114 Exercising Options Early 1115 NonDividendPaying Stocks American Call Worth No More than European Call 1116 DividendPaying Stocks Early Exercise May Be Optimal 1117 Options and Corporate Finance Equity as a Call Option 1118 Debt as an Option Portfolio Pricing New Debt 1119 Credit Default Swaps 12 Lecture 14 121 The Binomial Option Pricing Model Only Two States 1211 Two Equations in Two Unknowns Stock Debt 1212 Linear Dependence of Any Other Asset such as an Option 122 Allows a Replicating Portfolio 123 The Binomial Pricing Formula 124 A Multiperiod Model not covered in class 125 Making the Model Realistic not covered in class 126 The BlackScholes Option Pricing Model an Equation and a Derivation 1261 This formula for a Call has Two terms SNd1 PVKNd2 lnPVK oT 1262 d1 Wm 2 1263 dz d1 oT 1264 Nd is the cumulative normal distribution at d probability that a standard normal is less than d 1265 See Textbook at Section 212 127 Implied Volatility not covered in class Page 12 Of 13 128 129 1210 1211 class 1212 1214 1215 Page 13 Of 13 The Replicating Portfolio not covered in class RiskNeutral Probabilities A Risk Neutral TwoState Model Implications of the RiskNeutral World not covered in RiskNeutral Probabilities and Option Pricing 1213 Risk and Return of an Option not covered in class Beta of Risky Debt not covered in class Agency Costs of Debt not covered in class

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