Final exam study guideline

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Texas A&M University, Corpus Christi *

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5311

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Finance

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Feb 20, 2024

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Account payable AP Accounts receivable AR Cash flow CF Cash flow from assets CFFA Change in net working capital ∆NWC Common stock CS Cost of Goods sold CGS Current asset CA Long term debt LTD Current liabilities CL Earnings before interested and tax EBIT Earning before tax EBT Earning pershare EPS Net capital spending NCS Net fixed asset NFA Net income NI Net working capital NWC Note payable NP Operating cash flow OCF Owner’s equity or total equity OE/TE Price-earning ratio PE Retained earnings RE Tax rate T Total assets TA Total debt or debt or total liabilities TD/TL CHAPTER VIII: D n = D 0 (1+g) n ; P 0 = D t /(r-g) ; P n = D n+1 /(r-g) ; Dividend growth model (DGM): r = g + D 1 /P 0 = capital gains yield + dividend yield Stock pricing when the company pays a specified number of equal dividends: P 0 = D x (1+r) n −1 r(1+r) n Stock pricing when the company pays a specified number of dividends growing at a constant growth rate g: P 0 = (D 1 /(r-g)) x (1 − (1+g) n (1+r) n ) 1. A decrease in which of the following will increase the current value of a stock according to the DGM? Discount rate 2. The DGM: requires the growth rate to be less than the required return. 3. Which one of the following statements is correct? Stocks can have a negative growth rate. 4. Which one of the following types of stock is defined by the fact that it receives no treatment in respect to either dividends or bankruptcy proceeding? Common . 5. You cannot attend the shareholder’s meeting for Alpha United so you authorize another shareholder to vote on your behalf. What is the granting of this authority called? Voting by proxy 6. Answer this question based on DGM. If you expect the market rate of return to increase across the board on all equity securities, then you should also expect: a decrease in all stock values CHAPTER IX: Net present value (NPV): is the difference between a project’s market value and its cost: NPV = CF 0 (1+r) 0 + CF 1 (1+r) 1 + CF 2 (1+r) 2 + ….. + CF n (1+r) n Internal Rate of Return (IRR): is the discount rate that makes the project’s NPV equal to zero: IRR = CF 0 (1+IRR) 0 + CF 1 (1+IRR) 1 + CF 2 (1+IRR) 2 + ….. + CF n (1+IRR) n Profitability index = (PV of future cash flow) / Initial investment ; PV total = PV 1 + PV 2 + ….. + PV n = CF 1 (1+r) 1 + CF 2 (1+r) 2 + ….. ; NPV = PV total − Initial invest. 1. NVP: is the best method of analyzing mutually exclusive projects 2. The length of time a firm must wait to recoup the money it has invested in a project is called the: payback period . 3. A project has a net present value of zero. Given this information: the project’s cash inflows equal its cash outflow in current dollar terms . 4. The length of time a firm must wait to recoup, in present value terms, the money it has invested in a project is referred to as the: discounted payback 5. Which one of the following methods predicts the amount by which the value of a firm will change if a project is accepted? NPV 6. Which one of the following will decrease the NPV of a project? Increasing the project’s initial cost at time 0 7. Bui bakery has a required payback period of two years for all of its projects. Currently, the firm is analyzing two independent projects. Project X has an expected payback period of 1.4 years and NPV of $6,100. Project Z has an expected payback period of 2.6 years with a NPV of $ 18,600. Which projects should be accepted based on the payback decision rule? Project X only CHAPTER X: EBIT = Sales – variable cost – fixed cost – depreciation = Sales – CGS – depreciation ; EBT = EBIT – taxes ; NI = EBT – taxes or EBIT x (1 – T) Straight line depreciation: annual depreciation = capital spending/n ; accumulated depreciation = t x annual depreciation ; book value at time t, BV t = capital spending – acc After tax salvage value (ATSV) = MV – ((MV – BV) x T MACRs depreciation: annual depreciation = MACRs rate x capital spending ; accum. Depreciation = sum of MACRs rate x capital spending ; BV t = capital spending x (1 – (sum of MACRs rate) After tax salvage value (ATSV) = MV – ((MV – BV) x T Operating cash flow: OCF = EBIT – taxes + depreciation = EBIT x (1 – T) + depreciation (annual) Tax shield approach: OCF = (sales – CGS) x (1 – T) + depreciation x T = (reduction in cost – ann.depraciation) x (1 – T) + ann.depreciation Bottom-up approach: OCF = NI + depreciation ; Top-down approach: OCF = Sales – CGS – Taxes Change in NWC: NWC = CA – CL ; ∆NWC = NWC end – NWC beg = (CA END – CL END ) – (CA BEG – CL BEG ) = ∆CA - ∆CL 1. The stand-alone principle advocates that project analysis should be based solely on which one of the following costs? Incremental 2. Which one of the following types of cost was incurred in the past and cannot be recouped? Sunk 3. Cerda Diagnostics spent $5,000 last week repairing equipment. This week the company is trying to decide whether the equipment could be better utilized by assigning it to a proposed project. When analyzing the proposed project, the $5,000 should be treated as which type of cost? Sunk 4. Which one of the following best illustrates erosion as it relates to a snack stand located on the beach? Selling fewer cookies because ice cream was added to the menu. 5. The option that is forgone so that an asset can be utilized by a specific project is referred to as which one of the following? Opportunity cost 6. Bybee Printing makes custom posters and is currently considering making large-scale outdoor banners as well. Which one of the following is the best example of an incremental operating cash flow related to the banner project? Hiring additional employees to handle the increased workload should the firm accept the banner project. 7. Which one of the following is an example of sunk cost? $2,000 paid last year to rent equipment. CHAPTER XII: dollar return per share = income from financial asset (dividends or coupon payments) + capital gains = D t (or C t ) + P t – P t – 1 Total dollar return = number of shares x dollar return per share = n x (D t (or C t ) + P t – P t – 1 ) ; total percentage return = dividend yield + capital gains yield = D t P t−1 + P t − P t−1 P t−1 Average or mean of historical returns for asset, R i = (1/N) x (R i,1 + R i,2 + R i,3 + ….. R i,N ) Variance of historical returns: Ϭ i 2 = 1 𝑁−1 x ((R i,1 – R i ) 2 + (R i,2 – R i ) 2 + …… + (R i,N – R i ) 2 ; Standard deviation: Ϭ i = ξ⬚ Ϭ i 2 Arithmetic and geometric averages: arithmetic average (AAR i ) = (1/N) x (R i,1 + R i,2 + R i,3 + ….. R i,N ) Geometric average (GAR i ) = ((1+R i,1 ) x (1 + R i,2 ) x ….. x (1 + R i,N )) 1/N – 1 Fisher equation: (1 + R) = (1 + r) x (1 + h) ; R: nominal interest ; r: real interest rate ; h: inflation rate 1. Which one of the following correctly describes the dividend yield? Next year’s annual dividend divided by today’s stock price. 2. The excess return is computed as the: return on a risky security minus the risk free rate. 3. Standard deviation is a measure of which one of the following? Volatility. 4. The average compound return earned per year over a multiyear period is called the ___ geometric ___ average return. 5. Generally speaking, which of the following best correspond to a wide frequency distribution? High standard deviation, large risk premium. 6. Assume that last year T-bills returned 2.2 percent while your investment in large-company stocks earned an average of 8.1 percent. Which one of the following terms refers to the difference between these two rates of return? Risk premium 7. Which one of the following is a correct ranking of securities based on the volatility of their annual returns over the period of 1926–2019? Rank from highest to lowest. Long-term government bonds, long term corporate bonds, intermediate-term government bonds CHAPTER XIII: MRP: market risk premium (MRP) ; E(R i ): expected return of asset ; r RF : risk-free rate ; E(R M ): expected return on market ; E(R i ) = r RF + MRP x ꞵ I = r RF + (E(R M ) – r RF ) x ꞵ I Portfolio: sum of weight must equal to 1: w 1 + w 2 + ….. w n = 1 ; E(R p ) = w 1 x E(R 1 ) + w 2 x E(R 2 ) + ….. + w n x E(R n ) ; ꞵ P = w 1 x ꞵ 1 + w 2 x ꞵ 2 + ….. + w n x ꞵ n Slope of the security market line (SML) = (E(R) – r RF ) / Stock ꞵ 1. To calculate the expected risk premium on a stock, one must subtract the ____ risk-free rate ____ from the stock’s expected return. 2. Rafia owns stocks of 15 different companies. Together, the stocks have a value of $78,640. Twelve percent of that total value is from one company, Gambrell & Valdez. The twelve percent figure is called a(n): portfolio weight 3. Of the options listed below, which is the best example of systematic risk? Investors panic causing security prices around the globe to fall precipitously . 4. Of the options listed below, which is the best example of unsystematic risk? A national decrease in consumer spending on entertainment. 5. Which of the following statements regarding unsystematic risk is accurate? It can be effectively by portfolio diversification. 6. Buchi owns several financial instruments: stocks issued by seven different companies, plus bonds issued by four different companies. Her investments are best described as a(n): portfolio CHAPTER XIII: Weighted average cost of capital (WACC): WACC = w D x (1 – T) x R D + w E x R E + w P x R P = (D/V) x (1 – T) x R D + (E/V) x R E + (P/V) x R P R D : cost of debt ; after-tax cost of debt = R D x (1 – T) ; R p : cost of preferred stock ; R P = D/P 0 = (dividend rate x par)/P 0 R E : cost of common stock ; R E (DGM) = (D 1 /P 0 ) + g = (D 0 x (1+g)/P 0 ) + g or R E (SML) = R F + (R M – R F ) x ꞵ E = R F + MRP x ꞵ E D: debt = number of bonds outstanding x price per bond ; P: preferred stock = number of preferred share x price per share E: common stock = number of common shares x price per share W D = D/V = (debt to equity ratio) / (1 + debt to equity ratio) ; w E = E/V = 1/(1 + debt to equity ratio) ; debt to equity ratio = (WACC – R E ) / (R D x (1 – T) – WACC) 1. The cost of preferred stock is equivalent to the: rate of return on a perpetuity. 2. When using the subjective approach to project analysis, a firm: assigns discount rates to project based on the discretion of the senior managers of a firm. 3. Assume a firm utilizes the security market line approach to determine the cost of equity. If the firm currently pays an annual dividend of $2.40 per share and has a beta of 1.42, all else constant, which of the following actions will decrease the firm’s cost of equity? A decrease in the firm’s beta.

1. A news flash just appeared that caused all stocks to suddenly drop in value by 20%. What type of risk does this news flash best represent? Unsystematic 2. Ann’s is a furniture store that is considering adding appliances to its offerings. Which one of the following is the best example of an incremental cash flow related to the appliances? Selling furniture to appliances 3. Inside information has the least value when financial markets are: Strong form efficient 4. The average compound return earned per year over a multi-year period is called the ____ Geometric ____average return 5. The average of a firm’s cost of equity and after tax cost of debt that is weighted based on the firm’s capital structure is called the: Weighted average cost of capital 6. The difference between a firm’s future cash flows if it accepts a project and the firm’s future cash flows if it does not accept the project is preferred to as the project’s: Incremental cash flow 7. Estimates of the rate of return on a security based on the historical arithmetic average will probably tend to ____ overestimate _ ___ the expected return for the long term and estimates using the historical geometric average will probably tend to ___ underestimates ___ the expected return for the short term. 8. Unsystematic risk: can be effectively to the eliminated by portfolio diversification 9. Which one of the following methods of analysis provides the best information on the cost benefit aspects of a project? Profitability index 10. The common stock of ABS Inc has a beta of 1.24 and an expected return of 13.25%. The risk-free rate of return is 3.7% and the market rate of return is 11.78%. Which one of the following statements is true given this information? The expected stock return indicates the stock is currently overpriced 11. The internal rate of return is unreliable as an indicator of whether or not an investment should be accepted given which one of the following? The investment is mutually exclusive with another… 12. The principle of diversification tells us that: spreading an investment across many diverse assets will eliminate some of the total risk. 13. When a company estimates it’s cost of capital by adjusting it’s WACC upwards or downwards, depending on the project’s riskiness, this approach is called: 14. A firm’s after tax cost of debt will increase if there is an: decrease in the company tax rate. 15. Assume a manager determines the cost of capital for a specific project based on the cost of capital at another firm with a line of business that is similar to the project. Accordingly, the manager is using the ____ pure play ____ approach. 16. A project has an initial cost of $18,400 and is expected to produce cash inflows of $7,200, $8,900, and $7,500 over the next three years, respectively. What is the discounted payback period if the required rate of return is 12 percent. Payback period = (4,876.403/5338.3518) + 2 = 2.91 Year Cash flow Discount CF Accumulate 0 −18,400 −18,400 −18,400 1 7,200 (7,200/(1 + 0.12) 1 = 6,428.571 −18,400 + 6,428.571 = −11, 971.42857 2 8,900 (8,900/(1 + 0.12) 2 = 7095.0255 −11, 971.42857 + 7095.0255 = −4,876.403 3 7,500 (7,500/(1 + 0.12) 3 = 5338.3518 −4,876.403 + 5338.3518 = 461.94886 17. A stock has annual returns of 5.4 percent, 12.9 percent, -3.8 percent, and 9.4 percent for the past four years. The arithmetic average of these returns is ________ percent while the geometric average return for the period is ________ percent. AAR=(1/4) x (.054+.129+-.038+.094)=5.98 GAR=((1+.054) x (1+.129) x (1+-.038) x (1+.094)) 1/4 − 1=0.057869 or 5.79% 18. ABC Inc desires a weighted average cost of capital of 12 percent. The firm has an aftertax cost of debt of 5.4 percent and a cost of equity of 15.2 percent. What debt-equity ratio is needed for the firm to achieve its targeted weighted average cost of capital? WACC = w D x after-tax cost of debt + w E x r E 0.12 = w D x 0.054 + (1-w D ) x 0.152 => 0.12= 0.054w D + 0.152 − 0.152w D 0.152w D − 0.054w D = 0.152 − 0.12 => 0.098w D = 0.032 => w D = 0.032/0.098 = 0.326531 => w E = 1 – w D = 1 − 0.326531 = 0.673469 D/E = 0.325631/0.673469 = 0.483513 19. ABC Inc just announced it is increasing its annual dividend to $1.68 next year and establishing a policy whereby the dividend will increase by 3.25 percent annually thereafter. How much will one share of this stock be worth ten years from now if the required rate of return is 13.5 percent?? D 1 = 1.68 ; g = 3.25% ; r = 13.5% ; P 10 = ? P 10 = D 11 /(r-g) = (D 1 x (1+g) (11-1) ) / (r-g) = (1.68 x (1+0.0325) 10 ) / (0.135 – 0.0325) = 22.57 20. ABC Inc is considering a project that will require $41,000 in net working capital and $64,000 in fixed assets. The project is expected to produce annual sales of $62,000 with associated cash costs of $41,000. The project has a 3-year life. The company uses straight- line depreciation to a zero book value over the life of the project. The tax rate is 34 percent. What is the operating cash flow for this project? OCF = EBIT x (1 – T) + depreciation EBIT = Sales – CGS – depreciation = 62,000 – 41,000 – (64,000/3) = −333.33333  OCF = −333.33333 x (1 – 0.34) + (64,000/3) = 21,113.333 21. ABC Inc purchased some fixed assets two years ago at a cost of $43,800. It no longer needs these assets so it is going to sell them today for $32,500. The assets are classified as five-year property for MACRS. The MACRS rates are .2, .32, .192, .1152, .1152, .0576, for years 1 to 6, respectively. What is the after tax salvage value if the firm's tax rate is 35 percent? ATSV = MV – ((MV – BV 2 ) x T) = 32,500 – ((32,500 – ((43,800 x (1 – (0.20 + 0.32))) x 0.35) = 28,483.40 22. ABC's has a debt-equity ratio of .6 and a tax rate of 35 percent. The firm does not issue preferred stock. The cost of equity is 14.5 percent and the aftertax cost of debt is 4.8 percent. What is the weighted average cost of capital? D/E = 0.6, wd = 0.6/(1+0.6), we = 1/(1+0.6) ; Rd*(1-T)= 0.048 ; Re = 0.145 WACC = (0.6/1.6)*0.048 + (1/1.6)*0.145 = 0.10862 23. Assume a project has cash flows of -$51,300, $18,200, $37,300, and $14,300 for years 0 to 3, respectively. What is the profitability index given a required return of 12.5 percent? 1.09 24. John will receive $7,500 at the end of Year 2. At the end of the following two years, he will receive $9,000 and $12,500, respectively. What is the future value of these cash flows at the end of Year 5 if the interest rate is 8 percent? 33, 445 25. The common stock of ABC Inc is expected to earn 13 percent in a recession, 6 percent in a normal economy, and -4 percent in a booming economy. The probability of a boom is 5 percent while the probability of a recession is 45 percent. What is the expected rate of return on this stock? E(R ABC ) = 0.05 x ( − 0.04) + 0.045 x 0.13 + 0.05 x 0.06 = 0.0865 = 8.65%

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