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Finance Questions

⦁ Exam Availability: 8 am – 11:59 pm, Tuesday, 6/30/2020
⦁ Exam Duration: 110 Minutes

⦁ Covered Chapters : 2-10-12-13-14-21

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FRL 3000 Common Exam Formula sheet

Chap 2

Chapter 10

OCF = (sales revenue – costs -depreciation) *(1-Tc) + depreciation
or
OCF = (sales revenue – costs)*(1-TC) + depreciation* TC

Book value = Initial cost – accumulated depreciation

After Tax Salvage Value (ATSV) = market value – TC (market value – book value)

NWC = (cash + AR + inventory) – (AP +NP)

Chapter 12

Percentage of return:

Arithmetic return:
Geometric return:
Variance for historical returns:

Chapter 13

Exp. Ret of a Security:

Std. Dev. of a Security:

Exp. Ret of a Portfolio:

Portfolio Beta:

CAPM

Reward- to- risk ratio for security A=

Chapter 14
Cost of preferred stock:
Cost of common stock:
V = E + D + P

Flotation cost:

Amount to be raised =

Chapter 21

Purchasing Power Parity :

Forward rate in one year [Exact form]:

Forward rate in other terms (half year, three years, etc) [Approximate form]:

Ft = S0 [1 + (RFC – R RUS )]t

Uncovered Interest Parity:

International Fisher Effect:

FRL 3000 Study Guide

Chapter 2 Financial Statements, Taxes and Cash Flow
⦁ Understand concepts of financial statements: balance sheet, income statement, cash flow statements
⦁ Balance sheet: Assets = Liabilities + Stockholders’ Equity
⦁ Net working capital = Current Asset- Current Liability
⦁ Be able to calculate missing balance sheet item
⦁ Know the difference between Current Asset and Fixed Asset
⦁ Understand Asset liquidity
⦁ Income statement: know how to calculate EBIT, Taxable Income, Net Income.
⦁ Understand marching principle: depreciation
⦁ Understand Net Income= Dividend + Addition to Retained Earnings
⦁ Difference between average tax rate and marginal tax rate
⦁ Be able to calculate the following cash flows:
⦁ Operating cash flow = EBIT + Depr. – Taxes
⦁ Net capital spending = Ending Period N.F.A. – Beginning Period N. F.A. + Depr.
⦁ Change in NWC = Ending Period N.W.C. – Beginning Period N.W.C.
⦁ Cash flow from assets = operating cash flow – net capital spending – change in NWC
⦁ Cash flow to creditors = interest pmts – net new borrowing
⦁ Cash flow to stockholders = div paid – net new equity raised
= div paid – ( in equity – in RE)

Chapter 10: Making Capital Investment Decisions

⦁ The incremental Cash Flows()
⦁ Sunk Costs()
⦁ – a cost that has already been incurred and cannot be removed.
⦁ Opportunity Costs()
⦁ – the most valuable alternative that is given up if a particular investment is undertaken.
⦁ Side effects()
⦁ Negative side effects – costs to other projects
⦁ Positive side effects – benefits to other projects
⦁ Net Working Capital ()
⦁ Yes, count.
⦁ Additional funds required at the beginning of a project to purchase inventory and finance accounts receivable – usually recovered at the end of the project.
⦁ Financing Costs()
⦁ – interest/principal/dividend

⦁ Pro Forma Financial Statements and Project Cash Flow:
⦁ Project Operating Cash Flow (!)
⦁ OCF= EBIT – taxes + depreciation
⦁ OCF = (Sales – Costs)(1 – T) + Depreciation*T

⦁ Net Working Capital spending (!)
⦁ Remember all NWC changes will be reversed/recovered in the end.
⦁ Project could have NWC changes in any single year, does not have to be only at the beginning or the end.

⦁ Depreciation (MACRS, straight line) (!)
⦁ D = (Initial cost – salvage) / number of years
⦁ How to calculate book value of the machine?
⦁ Need to know which asset class is appropriate for tax purposes
⦁ Multiply percentage given in table by the initial cost
⦁ Depreciation tax shield (!)
⦁ Depreciation tax shield =Depreciation*T

⦁ Net Capital Spending (!)
⦁ Buy machines at the beginning, sell machines at the end (ATSV)
⦁ After-tax salvage = salvage – T(salvage – book value)
⦁ Book value = initial cost – accumulated depreciation

⦁ Project Total Cash Flow (Cash Flow from Assets) (!)
⦁ Project cash flow
= operating cash flow – change in NWC – capital spending

⦁ NPV and IRR (!)
⦁ See lecture examples
⦁ Practice using Cash Flow Keys using your calculator!

Chap 12: Some Lessons from Capital Market History

Concepts:
⦁ The Historical Record
⦁ Understand the historical returns on various types of investments
⦁ Understand the historical risks on various types of investments
⦁ Need to know the rankings.
⦁ Understand risk premium- excess return; the “extra” return earned for taking on risk.
Risk Premium=Return on Risky Assets-Risk Free Return

⦁ Arithmetic and geometric average

⦁ The arithmetic average is overly optimistic for long horizons
⦁ The geometric average is overly pessimistic for short horizons
⦁ Understand the three forms of market efficiency, misconceptions, applications.
⦁ Strong Form Efficiency- Prices reflect all information, including public and private; even insiders can not make abnormal returns.
⦁ Semi-strong Form Efficiency- Prices reflect all publicly available information including trading information, annual reports, press releases, etc. Insiders make profit, but not fundamental analysis, or technical analysis

⦁ Weak Form Efficiency- Prices reflect all past market information such as price and volume. Insiders and fundamental analysis make profit, but not technical analysis
⦁ Efficient markets do not mean that you can’t make money. They do mean you will earn a return that is appropriate for the risk undertaken. Market efficiency will not protect you from wrong choices .

Problems:

⦁ Know how to calculate the return on an investment, dollar, percent of return, dividend yield and capital gain.
⦁ Calculate risk (volatility, standard deviation)

Std.Dev.=Sqrt(VAR)

⦁ Calculate Arithmetic and geometric average

Chapter 13: Return, Risk, and the Security Market Line
⦁ Expected Return of a stock. (!)
Example:

State Probability C T
Boom 0.3 15 25
Normal 0.5 10 20
Recession 0.2 2 1
⦁ RC = .3(15) + .5(10) + .2(2) = 9.9%
RT = .3(25) + .5(20) + .2(1) = 17.7%

⦁ Variance and Standard Deviation of a stock (!)

⦁ Stock C
⦁ 2 = .3(15-9.9)2 + .5(10-9.9)2 + .2(2-9.9)2 = 20.29
⦁ = 4.50%

⦁ Calculating the expected Return of a Portfolio:
⦁ Portfolio weights (!)
⦁ Portfolio Expected Return (!)
Example:

Return Weight
DCLK: 19.69% .133
KO: 5.25% .200
INTC: 16.65% .267
KEI: 18.24% .400

E(RP) = .133(19.69) + .2(5.25) + .267(16.65) + .4(18.24)
= 15.41%

⦁ Systematic Vs. Unsystematic Risk ()

Systematic Risk Unsystematic Risk
Influence affect a large number of assets affect a limited number of assets
Also called non-diversifiable risk or market risk unique risk and asset-specific risk, firm-specific risk
Examples changes in GDP, inflation, interest rates, labor strikes, part shortages, etc.

Total risk = systematic risk + unsystematic risk
⦁ Total risk is measured by standard deviation of returns
⦁ Systematic risk is measured by beta.
⦁ A beta of 1 implies the asset has the same systematic risk as the overall market
⦁ A beta < 1 implies the asset has less systematic risk than the overall market
⦁ A beta > 1 implies the asset has more systematic risk than the overall market
⦁ Beta=0 implies risk-free asset

⦁ Realized returns (actual returns) are generally not equal to expected returns
⦁ There is the expected component and the unexpected component
⦁ At any point in time, the unexpected return can be either positive or negative
⦁ Over time, the average of the unexpected component is zero
⦁ It is the surprise component in the announcements and news that affects a stock’s price and therefore its return
⦁ Efficient markets are a result of investors trading on the unexpected portion of announcements

⦁ The Principle of Diversification ()
⦁ Spreading an investment across assets (and thereby forming a portfolio) is diversification.
⦁ This reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another

⦁ Diversification and Systematic Risk ()
⦁ Can we diversify systematic risk?
No.
⦁ Will diversifiable risk be rewarded?
No.
⦁ Can we reduce variability without reduce equivalent amount of returns?
Yes.
⦁ Does risky assets always lead to risky portfolio?
No.
⦁ Is there a limit that how much risk we can diversify away?
Yes.

⦁ Beta:
⦁ Stock Beta ()
⦁ Portfolio Betas (;!)
⦁ Use weighted average of the beta
⦁ Can you solve the weight or beta of one stock, given the portfolio beta?

⦁ Beta and the Risk Premium (;!)
⦁ Risk premium = Expected return – Risk-free rate
⦁ The higher the beta, the greater the risk premium should be

⦁ The Capital Asset Pricing Model (CAPM):
E(RA) = Rf + A(E(RM) – Rf)

⦁ The security market line ()
⦁ The security market line (SML) shows the relation between expected return and systematic risk(beta).
⦁ The slope of the SML is the reward-to-risk ratio is Risk premium/Beta
For market portfolio, slope (E(RM) – Rf) / M= E(RM) – Rf = market risk premium
Reward-to- Risk Ratio:

⦁ The reward-to-risk ratio is the slope of the SML:
Reward-to-risk ratio = (E(RA) – Rf) / A
Reward-to-risk ratio for the above example =
(20 – 8) / (1.6 – 0) = 7.5

⦁ The expected return on a stock based on CAPM (;!)
⦁ The expected return on a portfolio based on CAPM (;!)
⦁ Given the expected return on a stock or a portfolio:
⦁ The risk-free rate (!)
⦁ The market rate (!)
⦁ The market risk premium (!)
⦁ The stock (portfolio) beta (!)

Chapter 14: Cost of Capital

⦁ The Cost of Equity
There are two major methods for determining the cost of equity

⦁ Dividend Growth Model(;!)
⦁ What is D0, what is D1?

Past dividend is D0, need to convert to D1 by * (1+g)

⦁ Advantage – easy to understand and use
⦁ Disadvantages
⦁ Only applicable to companies currently paying dividends
⦁ Not applicable if dividends aren’t growing at a reasonably constant rate
⦁ Extremely sensitive to the estimated growth rate – an increase in g of 1% increases the cost of equity by 1%
⦁ Does not explicitly consider risk

⦁ The SML Approach(;!)

⦁ What is market risk premium? What is market return?

⦁ Advantages
⦁ Explicitly adjusts for systematic risk
⦁ Applicable to all companies, as long as we can estimate beta
⦁ Disadvantages
⦁ Have to estimate the expected market risk premium, which does vary over time
⦁ Have to estimate beta, which also varies over time
⦁ We are using the past to predict the future, which is not always reliable

⦁ Calculate the Cost of Debt (!)
⦁ The Costs of debt is YTM of the bond
⦁ After-tax cost of debt = RD(1-TC)
⦁ Semi-annual bond or annual bond?
⦁ Bond price quote- how much is bond price if it is quoted at 98.

Example:
Suppose we have a bond issue currently outstanding that has 25 years left to maturity. The coupon rate is 9%, and coupons are paid semiannually. The bond is currently quoted for $90.88 per $1,000 bond. What is the cost of debt?

⦁ Calculate the Cost of Preferred Stock (!)
⦁ RP = D / P0
⦁ Note: preferred dividend is based on $ 100 par value.
⦁ Calculate the Weighted Average Cost of Capital (!)
⦁ WACC = wERE + wPRP + wDRD(1-TC)
⦁ Debt’s Market Value = (# of outstanding bonds ) x (the market price of one bond)
⦁ Equity’s Market Value = (# shares of outstanding common stock) x (the market price of one share of common stock)

⦁ Be able to calculate capital structure weights using D/E ratio?

Please go over both lecture examples and homework examples.

⦁ Using the firm’s WACC as the discount rate for all projects and divisions within the firm ()

⦁ If we are looking at a project that does NOT have the same risk as the firm, then we need to determine the appropriate discount rate for that project
⦁ Divisions also often require separate discount rates
⦁ Know the definition and difference between “The Pure Play Approach”; “Subjective Approach”

⦁ Calculate the weighted average flotation Costs (!)

⦁ Flotation costs in project evaluation ()
Affect the initial cost of the project. We need to raise more money as initial investment:
Amount to be raised =

⦁ Calculate a project’s NPV with flotation costs (!)

Go over lecture examples (what if they have equity, debt AND preferred stock?)
How would you adjust your formula then ?

(in the formula sheet)

( NOT in the formula sheet)

Chapter 21: International Corporate Finance

⦁ Terminology
⦁ Cross-Rate (;!)
– implied exchange rate between two currencies that are both quoted in a third currency
⦁ Foreign bond vs. Eurobond()
⦁ Eurobond International bonds issued in multiple countries but denominated solely in the issuer’s currency.

⦁ Foreign bond -International bonds issued in a single country and denominated in that country’s currency
Yankee bonds (U.S), Samurai bonds (Japan), Bulldog bonds (British).

⦁ The London Interbank Offer Rate (LIBOR) ()
Loan rate that most international banks charge one another for loans of Eurodollars overnight in the London market.
Interest rates are frequently quoted as some spread over LIBOR, and they often float with the LIBOR rate.

⦁ Foreign Exchange Markets and Exchange Rates ()
⦁ Type of Transactions
⦁ Spot trade – exchange currency immediately
⦁ Spot rate – the exchange rate for an immediate trade
⦁ Forward trade – agree today to exchange currency at some future date and some specified price (also called a forward contract)
⦁ Exchange Rate Risk ()

⦁ Purchasing Power Parity
⦁ Absolute PPP (;!)
Price of an item should be the same in real terms, regardless of the currency used to purchase it.
Absolute PPP rarely holds in practice due to transaction costs, taxes, tariffs , etc.
⦁ Relative PPP (;!)
Provides information about what causes changes in exchange rates. The basic result is that exchange rates depend on relative inflation between countries

Purchasing Power Parity :

Forward rate in one year [Exact form]:

Forward rate in other terms (half year, three years, etc) [Approximate form]:

Ft = S0 [1 + (RFC – R RUS )]t

Uncovered Interest Parity:

International Fisher Effect:

⦁ The International Fisher Effect tells us that the real rate of return (R – h) must be constant across countries

⦁ International Capital Budgeting(!)
⦁ Calculate the NPV by the Foreign Currency Approach
⦁ Estimate cash flows in foreign currency
⦁ Use the International Fisher Effect ( IFE) to convert domestic required return to foreign required return
⦁ Discount using foreign required return
⦁ Convert NPV to dollars using current spot rate

Eg: Your company is looking at a new project in Mexico. The project will cost 9 million pesos. The cash flows are expected to be 2.25 million pesos per year for 5 years. The current spot exchange rate is 10.91 pesos per dollar. The risk-free rate in the US is 4%, and the risk-free rate in Mexico 8%. The dollar required return is 15%.

RUS – hUS = RFC – hFC
15%-4%= RFC -8%
Required Return in Peso RFC =19%
⦁ PV of future cash flows = $6,879,679 pesos
⦁ PV annuity: N = 5; PMT = 2,250,000; I/Y = 19; CPT PV = 6,879,679
⦁ NPV = 6,879,679 – 9,000,000 = 2,120,321 pesos
⦁ NPV = – 2,120,321 / 10.91 = – $ 194,347

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