Fin 320_ Exam Review 2 (Presenter Version) (1)

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Finance Review Part I: Vocabulary Economic assets : Economic assets are entities functioning as stores of value and over which ownership rights are enforced by institutional units, individually or collectively, and from which economic benefits may be derived by their owners by holding them, or using them, over a period of time (the economic benefits consist of primary incomes derived from the use of the asset and the value, including possible holding gains/losses, that could be realized by disposing of the asset or terminating it) OECD Glossary of Statistical Terms Economic value: Economic value is the maximum dollar price someone will pay for an economic asset. Economic decision-making: Economic decision-making involves calculating economic values and comparing the economic value of an asset to the cost of obtaining the asset. Creating wealth: Economic decisions create wealth when the price paid for an economic asset is less than its economic value. This is at the heart of financial decisions and is the basis for every action in markets. Positional goods: Goods and services that people value because of their limited supply, and because they convey a high relative standing within society. They derive most of their value if they succeed in distinguishing their owners as members of a favored group. In general, the definition of positional goods extends to luxury services, memberships and vacations, even though these are not goods. Opportunity cost: The best alternative that is not chosen because another course of action is pursued. Economic decisions generally involve comparing rates of return. Opportunity cost is often called the discount rate, the hurdle rate, the benchmark rate, or the required rate of return. The time value of money: The concept that money available at the present time is worth more than the identical sum in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. Investopedia.com. Interest rate: a rate of return on an investment or paid on a debt. The First Principle of Finance: A dollar received today is worth more than a dollar received in the future. Cash flow: The flow of purchasing power that can be used to value and facilitate the transfer of economic assets.

Risk: The uncertain nature of future cash flows and rates of return will cause current economic values to vary. This variability is the major issue with all financial decisions. Present value: The value of a future cash flow stated as of today.. Future value: The future value of an amount given today. Compounding: The process of using a rate of return to determine a future value. Discounting: The process of using a rate of return to determine a present value. Decision rule: A quantitative rule that evaluates whether a course of action should be undertaken. Internal Rate of Return (IRR): The rate of return earned on an investment adjusted for time value. Net Present Value (NPV): A decision-making process using time value and opportunity cost to compare the benefits of a decision with its costs. If the benefits exceed the costs then the decision creates wealth. Fairly valued asset: The asset offers an acceptable rate of return equal to the rate of return offered on assets of equivalent risk. The IRR is equal to the opportunity cost, and the NPV = $0. This is an acceptable investment. Overvalued asset: The asset's rate of return is less than the rate of return offered on assets of equivalent risk. The IRR is less than the opportunity cost, and the NPV is negative. This is not an acceptable investment. Undervalued asset: The asset's rate of return is greater than the rate of return offered on assets of equivalent risk. The IRR exceeds the opportunity cost, and the NPV is positive. This is a desirable investment. Expected return: The future return, generally uncertain, that one expects to get from an investment. This is the return that is used in making most business decisions. Realized return: The return that is actually received at the end of the investment period. Risk-free rate of return: A rate of return on an asset whose future cash flows are certain.. Given the known payment made today for the promise of future cash flows that will be received with certainty, the rate of return is also certain. Risk premium: The extra return above the risk-free rate that is required given the uncertainty of the future cash flows.

Market price: The current price at which an asset can be exchanged between a willing buyer and a willing seller. Value in use: The value that a user expects to get from the use of an asset. Simple Interest is Interest earned on the original principal. Each period the interest rate is applied, but the principal remains the same. Compound Interest occurs when the Interest earned is applied to the principal each period. With compound interest, the principle grows over time and, if the principle grows so does the amount of interest paid each period. Annuity: A series of regular payments at regular intervals for a defined period of time. . Level annuity: An annuity with the same cash flow for each period of time. Level annuities are further classified as to when the payments are made in each period. Ordinary annuity: Payments occur at the end of each period. Annuity due: Payments occur at the beginning of each period. Growing annuity: An annuity where payments grow at a steady rate. Perpetuity: A series of regular payments for regular periods that go on indefinitely. Level perpetuity: Perpetual payments of the same amount at regular intervals Growing perpetuity: Perpetual payments where the amounts grow at a constant rate. Compounding period: The length of time that passes before interest is recognized and added to the principle. Stated annual interest rate: The interest rate stated on an annual basis. This is the rate normally used in contacts, including loans such as credit cards, auto loans and mortgages. Annual percentage rate (APR): The interest rate charged per period multiplied by the number of periods per year. Periodic interest rate: The interest per period, such as the semiannual rate for bond interest payments and the quarterly rate paid via dividends. Effective annual interest rate: The annual interest rate that reflects the impact of intra-year compounding.

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Frequency distribution: A representation of the historic returns over a period of time which shows how often each return occurs. Probability distribution: A formula or table of information that gives the potential outcomes and the likelihood of those outcomes. There are two types of probability distributions. Discrete probability distribution: A probability distribution that contains a discrete, or countable, number of observations. Continuous probability distribution: A probability distribution that contains an infinite number of observations, which are analyzed using quantitative measures based on mathematical relationships and calculus. Expected return: The average of the possible realized returns weighted by their probability of occurring Variance: A measure of how the possible realized returns might vary from the expected return. Standard deviation: The square root of the variance. Portfolio: A collection of economic assets. Diversification: The process of reducing the risk of a portfolio by holding assets whose returns are not perfectly correlated. Joint probability distribution: A probability distribution containing the likelihood of two events occurring together Expected return of a portfolio: The wealth-weighted average of the returns expected from the assets held in the portfolio. Portfolio variance: The combination of the wealth-weighted average of the variances of the two assets and their covariance. Covariance: A statistical measure of the degree to which two rates of return move together. Correlation coefficient: Measures not only the direction of covariability (positive or negative) but also the strength of the relationship. Unique risk: The risk that is unique to an individual company. Unique risk, varying from company to company, is the risk that can be diversified.

Market risk: The risk that affects all companies in the economy. Market risk, because it affects all market participants, cannot be diversified away and thus the risk that is relevant for determining the opportunity cost. A mutual fund is an investment vehicle made up of a pool of moneys collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and other assets. Mutual funds are operated by professional money managers, who allocate the fund's investments and attempt to produce capital gains and/or income for the fund's investors. A mutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus. Investopedia.com Hedge funds are alternative investments using pooled funds that employ numerous different strategies to earn active return, or alpha, for their investors. Hedge funds may be aggressively managed or make use of derivatives and leverage in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). It is important to note that hedge funds are generally only accessible to accredited investors as they require less SEC regulations than other funds. One aspect that has set the hedge fund industry apart is the fact that hedge funds face less regulation than mutual funds and other investment vehicles. Investopedia.com Beta: a measure of the market/systematic risk of an asset: how the asset return varies with the market return, and is thus a measure of the risk that cannot be diversified away. Capital Asset Pricing Model (CAPM): a model that uses market/systematic risk to calculate the opportunity cost/expected rate of return.

Finance Review Part II: Practice Problems Your house needs a new coat of paint. You could hire a painter for $7,000 or spend $1,000 for materials and devote 12 hours of your time to the project. (It's a small house!). If you normally make $700/hour at your consulting job, what is the opportunity cost of having the house painted by the professional painter? 9,400 You receive $50 today and deposit it in your savings account that has an interest rate of 8%. What will your savings account balance be in one year? 54 As an incentive for you to stay in school your Uncle Henry offers to pay you $5,000 in one year. If the interest rate is 4%, how much is the $5,000 payment worth to you today? 4,807.69 Your little sister Tiffany has received a special Piggy bank with a $20 bill in it. This is a special locked Piggy and will unlock itself in one year. Tiffany has offered to sell you Piggy today. Unfortunately, this nice Piggy bank will completely destroy itself in one year and have no value, so plan on getting only the $20! If your savings rate is 5%, how much is the $20 in Piggy worth to you today if you can't get at it for a year? 19.5 Your friend wants to pay back the money she borrowed from you. She offers you $300 today or $315 in one year. If you could save at 6%, what is the future value of the one you would choose? 318 Project IRR. A firm evaluates all of its projects by applying the IRR rule. The required rate of return is 14 percent. What is the IRR of a project that requires an investment today of $158,500 and has an expected cash flow in one year of $175,000? 10.41

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For the investment in the previous problem, suppose the firm uses the NPV decision rule. At the same required rate of return of 14 percent, what is the NPV of the project? -4,991 You are planning to place your money in safe government securities, which currently offer a 4% riskless rate of return. Before making this investment, an entrepreneur approaches you and asks you to purchase her new business venture, FastDrop, a delivery service for legal documents that would produce a single cash inflow of $80,000 at the end of the year. You have determined that 6% is an appropriate risk premium for this investment. How much would you be willing to pay for Fast Drop? 72,727 In question 1 you determined the economic value of FastDrop Delivery Service, given its end-of-year cash inflow of $80,000 and its opportunity cost of 10%. In further negotiations the entrepreneur offers to sell you the business for $70,000. What is the IRR of this offer? 14.29 You are very popular with entrepreneurs! Just as you are ready to finalize your deal with FastDrop, another entrepreneur offers you another business deal: Hive Bliss, a company that sells home bee hives as a personal source of honey. Hive Bliss would require an investment of $95,000 and offers a cash inflow of $120,000 at the end of the year. An apiculture consultant advises that this is a fairly risky investment and suggests a risk premium of 14%. What is its NPV? 6,694 Given your financial situation, you can only make one investment. You want to consider both profitability and safety. You only have enough funds to invest in one of these attractive projects. What is the NPV of the best investment? 6,694 First City Bank pays 6 percent simple interest on its savings account balances, whereas Second City Bank pays 6 percent interest compounded annually. If you made a deposit of $8,100 in each bank, how much more money would you earn from your Second City Bank account at the end of 10 years? 1,545.87

You invest $3,150 for 7 years at 13%. What is the future value? 7,410.71 You make an investment that earns 7 percent annual interest and pays you $17,328 in sixteen years. How much did you invest today? 5,869.59 (with margin: 100) You invest $715 today and receive $1,381 in 11 years. What interest rate have you earned? 6.17 (with margin: 1) You invest $195 today and receive $873 at the conclusion of the investment, earning a 9% rate of return. How long did you have to wait for your payoff? 17.39 Assume the total cost of a college education will be $295,000 when your child enters college in 18 years. You presently have $53,000 to invest. What annual rate of interest must you earn on your investment to cover the cost of your child's college education? 10.01 (with margin: 1) At 4.7 percent interest, how long does it take to double your money? 15.09 (with margin: 2) In 2014, an 1874 $20 double eagle sold for $15,000. What was the rate of return on this investment over its 140-year life? 4.84 (with margin: 1) You're trying to save to buy a new $150,000 Ferrari. You have $35,000 today that can be invested at your bank. The bank pays 2.1 percent annual interest on its accounts. How long will it be before you have enough to buy the car? 70.02 (with margin: 10)

Imprudential, Inc., has an unfunded pension liability of $730 million that must be paid in 25 years. To assess the impact of this liability on the value of the firm's stock, financial analysts want to discount this liability back to the present. If the relevant discount rate is 5.5 percent, what is the present value of this liability? 191,430,603 (with margin: 1,000) You have just received notification that you have won the $1 million first prize in the Centennial Lottery. However, the prize will be awarded on your 100th birthday (assuming you're around to collect), 80 years from now. What is the present value of your windfall if the appropriate discount rate is 7.25 percent? 3,700.12 (with margin: 10) Your coin collection contains fifty 1952 silver dollars that your grandparents obtained at their face value when they were new, how much will your collection be worth when you retire in 2063, assuming they have appreciated at an annual rate of 4.3 percent since they were issued? 5,352.15 (with margin: 10) In 1895, the first U.S. Open Golf Championship was held. The winner's prize money was $150. In 2014, the winner's check was $1,620,000. What was the annual percentage increase in the winner's check over this period? 8.12 (with margin: 2) In 2014, an Action Comics No. 1, featuring the first appearance of Superman, was sold at auction for $3,207,852. The comic book was originally sold in 1938 for $.10. What was the annual increase in the value of this comic book? 25.54 (with margin: 10) Although appealing to more refined tastes, art as a collectible has not always performed so profitably. During 2003, Sotheby's sold the Edgar Degas bronze sculpture Petite Danseuse de Quatorze Ans at auction for a price of $10,311,500. Unfortunately for the previous owner, he had purchased it in 1999 at a price of $12,377,500. What was his annual rate of return on this sculpture? -4.46 (with margin: 1)

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Eulis Co. has identified an investment project with the following cash flows. If the discount rate is 10 percent, what is the present value of these cash flows? 2,547.97 (with margin: 10) An investment offers $5,430 per year for 15 years, with the first payment occurring one year from today. If the required return is 8 percent, what is the value of the investment? 46,478 (with margin: 100) You plan to spend six years in college and obtain both your bachelors and masters degrees. Your uncle is gifting you a six-year ordinary annuity to help you pay for your education. The annuity has a present value of $24,500, with interest rates set at 11%. How much will you have each year to support your education? 5,791 (with margin: 100) You’ve taken on as a consultant for a non-profit and have a contract that pays you $2,100 annually for seven years. If your opportunity cost is 5%, what is the present value of this contract? 12,151 (with margin: 100) You make annual end-of-year deposits $1,900 in your savings account that earns 8%. How much will your investment be worth in 10 years? 27,524 (with margin: 100) Investment X offers to pay you $3,400 per year for nine years, whereas Investment Y offers to pay you $5,200 per year for five years. If the discount rate is 6 percent, what is the present value of the best investment?

23,126 (with margin: 100) Curly's Life Insurance Co. is trying to sell you an investment policy that will pay you and your heirs $30,000 per year forever. If the required return on this investment is 5 percent, how much will you pay for the policy? 600,000 (with margin: 100) In the previous problem, suppose Curly's told you the policy costs $645,000. At what interest rate would this be a fair deal? 4.65 (with margin: 100) Based on the following information, calculate the asset's expected return. 11.4 (with margin: 1) Based on the following information, calculate the variance and standard deviation of the asset. Please enter your answer for the variance. 0.157 (with margin: 2)

Based on the following information, calculate the standard deviation for stock A. Please enter your answer for the standard deviation 3.87 (with margin: 1) A portfolio that has 165 shares of Stock A that sell for $69 per share and 125 shares of Stock B that sell for $44 per share. What proportion of the portfolio is invested in Stock A? 67.43 (with margin: 0) You own a portfolio that has $2,750 invested in Stock A and $3,900 invested in Stock B. If the expected returns on these stocks are 9 percent and 14 percent, respectively, what is the expected return on the portfolio? 11.93 (with margin: 5) You want to create a two-asset portfolio of equal proportions of the stock of Calvin Clothing (CC) and Perfect Pets (PP). What is the expected return and variance of your portfolio? Economy Probability Rate of return CC PP Boom 80% 18% 2% Bust 20% 12% 5% 11.67 (with margin: 5) You own a stock portfolio invested 15 percent in Stock Q, 25 percent in Stock R, 40 percent in Stock S, and 20 percent in Stock T. The betas for these four stocks are .75, .87, 1.26, and 1.76, respectively. What is the portfolio beta? 1.19 (with margin: 1)

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A stock has an expected return of 11.4 percent, the risk-free rate is 3.7 percent, and the market risk premium is 7.1 percent. What must the beta of this stock be? 1.085 (with margin: 1) A stock has an expected return of 10.9 percent, its beta is .85, and the risk-free rate is 2.8 percent. What must the expected return on the market be? 12.33 (with margin: 1) A stock has an expected return of 10.7 percent and a beta of .91, and the expected return on the market is 11.5 percent. What must the risk-free rate be? 2.61 (with margin: 1) Jackne Business Services (JBS) provides IT, procurement, shipping and financial services to small retail companies in Central Texas. Their controller wants to calculate the discount rate to use in their capital budgeting projects. She’s determined that the riskfree rate is 0.41%, the market rate of return is 7.25%, and JBS’ beta is 1.2. What is JBS’ discount rate? 8.62 (with margin: 1)

Finance Review Part III: Exam Formula Sheet