FINAL EXAMINATION

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Webster University *

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5200

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Finance

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Jan 9, 2024

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Webster University BUSN 5200 Final Examination NAME: Suresh Kumar Donthula DATE: 12-15-2023 Short Essay 1. Explain the meaning of WACC (weighted average cost of capital)? The weighted average cost of capital (WACC) represents the average cost a company incurs to fund its assets. By combining the rates of all the sources of capital (including debt and equity), and considering their respective proportions, WACC provides a comprehensive picture of the company's overall financing expenses. Business owners often refer to their WACC to find the optimal balance between equity and debt in their company's financial structure. Typically, the cost of equity in a business exceeds the interest rate paid on its debt. Entrepreneurs usually expect a higher return on their investment compared to the interest charged by lenders for financing. Moreover, the interest paid on debt is tax deductible, which further influences the overall cost. As a result, when a company increases its debt as a portion of its total capital, the WACC tends to decrease. Similarly, obtaining lower financing rates also contributes to reducing the WACC.

2. Explain EMH (efficient market hypothesis). The Efficient Market Hypothesis (EMH), also known as the Efficient Market Theory, posits that stock prices fully incorporate all available information, making it impossible to consistently generate excess returns (alpha). According to the EMH, stocks are continuously traded at their fair value on exchanges, leaving no room for investors to identify undervalued stocks or sell overvalued ones. Attempting to achieve superior performance through expert stock selection or market timing is also deemed futile, as the overall market cannot be consistently outperformed. The only way investors can potentially attain higher returns is by accepting higher levels of risk through riskier investments. Despite being a fundamental concept in modern financial theory, the EMH is not without controversy. Its proponents argue that searching for undervalued stocks or predicting market movements through fundamental or technical analysis is futile. In theory, both technical and fundamental analyses cannot consistently produce risk- adjusted excess returns (alpha), and any possibility of achieving outsized risk-adjusted returns lies solely within the realm of new information becoming available. 3. List 3 money market securities and 3 capital market securities. Three common examples of money market securities are: 1. Treasury bills (T-bills) 2. bankers' acceptances 3. certificates of deposit (CDs) Three common examples of capital market securities: 1. Stocks (Equities) 2. Bonds (Fixed-Income Securities) 3. Mutual Funds 4. List and explain 3 different types of financial institutions.

There are various types of financial institutions worldwide, each serving specific purposes, among them three are listed below: Central Banks: These institutions oversee and regulate other financial institutions within a nation, acting as banks for banks. Examples include the Federal Reserve Bank in the United States. Commercial Banks: Retail and commercial banks cater to the financial needs of individuals and businesses, offering services like deposits, loans, credit cards, and mortgages. Credit Unions: Member-owned institutions offering traditional banking services, known for their cost-effective approach and tax-exempt status as not-for-profit organizations. 5. Why is PE (price earnings) ratio the most common valuation yardstick? Definition: The Price-Earnings (PE) ratio is a valuation metric used to assess the relative attractiveness of a company's stock by comparing its current market price to its earnings per share (EPS). It shows how much investors are willing to pay for each dollar of earnings generated by the company. Formula: PE Ratio = Stock Price / Earnings per Share The Price-Earnings (PE) ratio is the most common valuation yardstick for several reasons. Firstly, it is simple to calculate and understand, dividing the stock price by earnings per share. Secondly, its widespread usage in the financial industry makes it a widely accepted measure. Thirdly, the PE ratio allows for easy comparison between companies, helping investors assess relative valuations. Moreover, it serves as a benchmark to evaluate a company's value compared to the market or its industry. Additionally, the PE ratio offers insights into market expectations for a company's future growth. However, investors often use it in conjunction with other metrics and fundamental analysis to make well-informed investment decisions. 6. What are the differences between common stock and preferred stock? Common Stock and Preferred Stock: Aspect Common Stock Preferred Stock

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Ownership and Voting Rights - Represents ownership in the company. - Generally grants voting rights at shareholder meetings. - Each share typically carries one vote. - Represents ownership in the company. - Usually does not carry voting rights. - Preferred shareholders may only vote in exceptional circumstances. Dividends - Dividends are not fixed and vary based on company profitability and the board's discretion. - Common shareholders may receive dividends if the company is profitable and decides to distribute them. - Dividends to common shareholders may be higher or lower depending on company performance. - Fixed dividend rate specified at the time of issuance. - Preferred shareholders entitled to receive dividends before common shareholders. - Preferred shareholders receive dividends at a predetermined rate. Priority in Liquidation - Common shareholders are last in line to receive company assets in the event of liquidation or bankruptcy. - They receive assets only after all debts, liabilities, and preferred stockholders' claims are settled. - Preferred shareholders have higher priority over common shareholders. - Preferred shareholders are paid off before common shareholders.

Price Volatility and Risk - Common stock tends to be more volatile and carries higher risk. - Its value can fluctuate widely based on company performance and market conditions. - Preferred stock is generally less volatile and carries lower risk. - Value is influenced more by interest rate changes and the company's financial health. Conversion and Callability - Common stock generally cannot be converted into other securities. - Companies typically cannot call back common shares. - Some preferred stocks have conversion features allowing them to be exchanged for common shares. - Certain preferred stocks may be callable, allowing the company to redeem or buy back the shares at a specified price. 7. What are 3 factors that determine the interest rate on a security? The interest rate on a security is influenced by various factors. Here are three key factors that determine the interest rate on a security: Risk Premium: Investors demand compensation for taking on risk. The riskier an investment is perceived to be, the higher the interest rate investors will require. Factors affecting risk include the creditworthiness of the issuer, economic conditions, geopolitical stability, and the overall risk environment. Inflation Expectations: Inflation erodes the purchasing power of money over time. Investors typically demand higher interest rates to offset the expected loss of purchasing power due to inflation. Central banks often set interest rates with the goal of controlling inflation, and changes in inflation expectations can impact market interest rates. Time to Maturity: The term or duration of a security also affects its interest rate. Generally, longer-term securities tend to have higher interest rates. This is partly because there is more uncertainty over future economic conditions, and investors want to be compensated for tying up their money for a more extended period. The relationship between interest rates and the time to maturity is known as the yield curve. These factors are interconnected, and changes in one factor can influence the overall interest rate environment. Additionally, central bank policies, economic indicators, and global market

conditions also play significant roles in determining interest rates on securities. Investors and policymakers closely monitor these factors to anticipate changes in interest rates and make informed decisions. 8. Provide the definition of a Premium, Discount, and Par value bond? A premium bond is a bond that is traded in the secondary market above its original par value. This occurs when the bond's coupon rate is higher than the current prevailing interest rates for new bonds. Investors are willing to pay more for the bond due to its higher yield. Conversely, a discount bond is a bond traded in the secondary market below its par value. This happens when the bond's coupon rate is lower than the prevailing interest rates. Investors pay less for the bond upfront to compensate for the lower coupon rate and achieve a higher yield. A par value bond is a bond that is issued and traded at its original face value, which is the amount repaid to the bondholder at maturity. It may trade at a premium or discount in the secondary market based on market conditions.

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9. How many companies comprise the Dow Jones Industrial Average? The Dow Jones Industrial Average (DJIA) is a stock index that monitors 30 of the largest U.S. companies. Established in 1896, it is one of the oldest stock indexes and is widely regarded as a significant indicator of the overall health of the U.S. stock market. The index is managed by S&P Dow Jones Indices, with majority control held by S&P Global (SPGI -0.89%). Contrary to its name, the Dow Jones Industrial Average includes not only industrial stocks but also stocks from various sectors and industries, except utilities and transportation. These sectors have their separate indexes dedicated to measuring their performance. 10. Explain NPV (net present value) and purpose? Net Present Value (NPV) measures the discrepancy between the present value of cash inflows and cash outflows over a specific timeframe. It plays a vital role in capital budgeting and investment assessment by analyzing the profitability of a projected venture or project. To arrive at NPV, the calculations determine the present value of future payment streams, employing an appropriate discount rate. Generally, projects with a positive NPV are considered viable and worth pursuing, while those with a negative NPV are deemed unfavorable and should be avoided. The purpose of Net Present Value (NPV) is to evaluate the profitability and financial viability of an investment or project. It helps decision-makers determine whether an investment is expected to generate positive or negative returns over time, allowing them to make informed choices about capital allocation and resource prioritization. A positive NPV indicates a financially attractive opportunity, while a negative NPV suggests potential losses. Formula: If analyzing a longer-term project with multiple cash flows, then the formula for the NPV of the project is as follows: ? ? ? NPV = ? = 0 (1 + i) t where: R t net cash inflow-outflows during a single period i: discount rate or return that could be earned in alternative investments t : number of times periods ∑

Problems 1. Rates: Stock 10%, Preferred 6%, Debt 11%. Percentages: Common stock 20%, Preferred, 15%, Debt 65%. T=35%. Compute WACC? What does it mean? Given:  Cost of common stock (Re) = 10%  Cost of preferred stock (Rp) = 6%  Cost of debt (Rd) = 11%  Corporate tax rate (T) = 35%  Market value of equity (E) = $20 million  Market value of preferred stock (P) = $15 million  Market value of debt (D) = $65 million Step 1: Calculate the total market value of the firm's financing (V): V = E + P + D = $20 million + $15 million + $65 million = $100 million Step 2: Calculate the weighted cost of each component:  Weighted cost of equity (Re) = (E / V) * Re = ($20 million / $100 million) * 10% = 2%  Weighted cost of preferred stock (Rp) = (P / V) * Rp = ($15 million / $100 million) * 6% = 0.9%  Weighted cost of debt (Rd) = (D / V) * Rd * (1 - T) = ($65 million / $100 million) * 11% * (1 - 35%) = 0.65 * 0.11 * 0.65 = 0.046475 or 4.65% Step 3: Calculate the WACC by summing the weighted costs of each component: WACC = Weighted cost of equity + Weighted cost of preferred stock + Weighted cost of debt WACC = 2% + 0.9% + 4.65% WACC = 7.55% Therefore, Weighted Average Cost of Capital (WACC) for the company is approximately 7.55%. a WACC of approximately 7.55% indicates the financial threshold that an investment project must meet to create value for the company and its shareholders. It is a critical tool for evaluating the profitability of investments, making capital allocation decisions, and assessing the overall cost of capital for the company. 2. UFO has a beta of .65. If the market return is expected to be 11% and the risk-free rate is 4%, what is UFO’s required return? Compute CAPM. What is the purpose of CAPM and what does it mean? Required Return (CAPM)=Risk-Free Rate+Beta×(Market Return−Risk-Free Rate) Given the input values:

Beta ( β ) = 0.65 Market Return = 11% or 0.11 (in decimal) Risk-Free Rate = 4% or 0.04 (in decimal) Let's calculate the required return using CAPM: Required Return (CAPM)=0.04+0.65×(0.11−0.04) Required Return (CAPM)=0.04+0.65×0.07 Required Return (CAPM)=0.04+0.0455 Required Return (CAPM)≈0.0855 Hence, the required return of the investment in UFO, according to the Capital Asset Pricing Model (CAPM), is approximately 8.55%. The Capital Asset Pricing Model (CAPM) is a widely used financial model that aids investors and analysts in determining the expected return on an asset or a portfolio of assets based on their systematic risk. It provides a framework to assess whether an investment is reasonably priced considering the level of risk it carries. The purpose of CAPM is to assist investors in determining whether an asset is undervalued or overvalued relative to its risk. If the expected return calculated using CAPM is higher than the actual return an asset is currently providing in the market, it may be considered an attractive investment opportunity (underpriced). Conversely, if the expected return is lower than the current market return, the asset might be considered overpriced, prompting investors to explore better investment options. CAPM serves as a valuable tool in portfolio management, allowing investors to evaluate the risk-return trade-offs of different assets and construct a diversified

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portfolio that maximizes returns for a given level of risk. However, it's essential to recognize that CAPM relies on certain assumptions, and its predictions may not always precisely align with real-world outcomes. Nonetheless, it remains a valuable concept within modern portfolio theory and investment decision-making. 3. What is the PayBack Period of Outflow: $12,592 Inflow: Year 1: $10,000 Year 2: $3,000 Year 3: $1,390 Year 4: $580038001squared Answer: Outflow: $12,592 Year Cash Inflow Cum. Inflow Remaining Balance 1 $10,000 $10,000 12592-10000 =2592 ( less than next year inflow) 2 $3,000 $13,000 3 $1,390 $14,390 4 $580 $14,970 Here after year 1, remaing balance is 2592 which is less than $ 3000 inflow of next year so, We have , Years before full recovery = Year 1 Unrecovered cost at start of the year 2= 12592-10000= $2592 Cash Flow during year 2= $3000 Using the formula below, Payback Period = 1 + 2592/3000 Payback Period =1.864 Years.

4. Outflow: $10,000, 10%, n=5 Inflow: Year 1: $2,500 Year 2: $3,500 Year 3: $5,000 Year 4: $4,000 Year 5: $2,000 Compute NPV? Accept of Reject Decision? Answer: Where PV is the present value, CF is the cash flow, r is the discount rate, and n is the number of periods. Then Using the Present value of a dollar table to calculate PV we get, Year Cash Inflow Present Value (PV) 1 $2,500 2500*0.90909=2272.725 2 $3,500 $3,500 *0.82645=2892.575 3 $5,000 $5,000* 0.75131=3756.55 4 $4,000 $4,000 *0.68301=2732.04 5 $2,000 $2,000 *0.62092=1241.84 The Net Present Value (NPV) of the cash flows from Year 1 to Year 5, using a discount rate of 10% is given by, NPV= (10000) +2272.725+2892.575+3756.55+2732.04+1241.84

NPV= $12895.73-$10000 NPV= $2895.73 The Net Present Value (NPV) of the cash flows, using a discount rate of 10%, is $2,895.73. Since the NPV is positive, the project should be accepted as it is expected to generate a positive return and add value to the company. .5. Outflow: $10,000, 10%, n=5 Inflow: Year 1: $2,500 Year 2: $3,500 Year 3: $5,000 Year 4: $4,000 Year 5: $2,000 Compute IRR? What does IRR mean in relation to NPV? To calculate the Internal Rate of Return (IRR), you need to find the discount rate that makes the Net Present Value (NPV) of the cash inflows and outflows equal to zero. The IRR is the discount rate at which the present value of inflows equals the present value of outflows. Given the information: - Outflow: $10,000 - Inflows: - Year 1: $2,500 - Year 2: $3,500 - Year 3: $5,000 - Year 4: $4,000 - Year 5: $2,000 The IRR is the discount rate (r) for which the following equation is satisfied: NPV = 2,500/(1+r)^1 + 3,500/(1+r)^2 + 5,000/(1+r)^3 + 4,000/(1+r)^4 + 2,000/(1+r)^5 - 10,000 = 0 Finding the exact IRR involves numerical methods, such as trial and error, or you can use financial calculators or spreadsheet functions. When calculated, the IRR for this investment is approximately 17.2%. Relation to NPV: - NPV and IRR are both methods used to evaluate the profitability of an investment. - If IRR is greater than the required rate of return (discount rate), the project is considered acceptable. If it's less than the required rate of return, the project may not be considered worthwhile. - In relation to NPV, IRR is the discount rate that results in a NPV of zero. So, when the IRR is positive, it implies that the project's rate of return is higher than the discount rate, leading to a positive NPV, and the project is typically considered economically viable. Conversely, if IRR is negative, the NPV would be negative, indicating an unattractive investment.

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