Finance Exit Exam Summary

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Questions and Answers

What is the term for the rate of return you could earn on an alternative investment of similar risk?

Opportunity Cost

What is the process of finding the Present Value called, which is the reverse of compounding?

Discounting

What term is used to describe a series of equal payments made at fixed intervals?

Annuity

If payments are made at the end of each period, what type of annuity is it?

Ordinary Annuity Signup and view all the answers

Which of the following are examples of ordinary annuities?

Car loans Signup and view all the answers

If payments are made at the beginning of each period, what type of annuity is it?

Annuity Due Signup and view all the answers

Which of the following are examples of annuities due?

Rental payments Signup and view all the answers

What is the formula for finding the Future Value of an Ordinary Annuity (END)?

FV = PMT[((1+r)^n - 1)/r] Signup and view all the answers

What is the formula for finding the Future Value of an Annuity Due (BEGIN)?

FV = (PMT [((1 + r)^n - 1) / r])(1 + r) Signup and view all the answers

The Future Value (FV) of an annuity due is greater than the FV of a similar ordinary annuity.

True Signup and view all the answers

What is the formula for finding the Present Value of an Ordinary Annuity?

PV = PMT [(1 - (1 / (1 + r)^n)) / r] Signup and view all the answers

What is the formula for finding the Present Value of an Annuity Due?

PV = (PMT [(1 - (1 / (1 + r)^n)) / r]) x (1+r) Signup and view all the answers

The Present Value (PV) of an annuity due is less than the PV of a similar ordinary annuity.

True Signup and view all the answers

What type of bond was issued by the British government in 1749 to consolidate its debt?

Consols Signup and view all the answers

What is the term for a promise to pay interest perpetually?

Perpetuity Signup and view all the answers

What is the term for the interest rate that is actually earned or paid on an investment, loan, or other financial product due to compounding over a given time period?

Effective Annual Rate (EAR) Signup and view all the answers

What's another name for Effective Annual Rate (EAR)?

EFF% Signup and view all the answers

What is the formula for calculating Effective Annual Rate (EAR)?

(1 + Inom/M)^M - 1.0 Signup and view all the answers

When should Effective Annual Rate (EAR) be used?

When comparing the effective cost or rate of return on loans or investments with different payment periods Signup and view all the answers

What is a loan that is to be repaid in equal amounts on a monthly, quarterly, or annual basis?

Amortized Loan Signup and view all the answers

What is a breakdown of each payment of an amortized loan called?

Amortization Schedule Signup and view all the answers

How does time affect the present and future values of cash flows?

The later you receive the payment, the lower the present value of the cash flow. Signup and view all the answers

How does the interest rate affect the present and future values of cash flows?

The higher the interest rate, the higher the future value of the cash flows. Signup and view all the answers

What is a long-term contract in which a borrower agrees to make payments of interest and principal on specific dates to bondholders?

Bond Signup and view all the answers

What type of bond is issued by the US federal government and has no default risk?

Treasury Bond Signup and view all the answers

What kind of bond is issued by a corporation to raise financing for operations, mergers, or expansion?

Corporate Bond Signup and view all the answers

What is the relationship between default risk and the interest rate a company must pay on corporate bonds?

The larger the default risk, the higher the interest rate the issuer must pay. Signup and view all the answers

What type of bond is issued by state and local governments and typically offers interest that's tax-exempt at the federal level?

Municipal Bond Signup and view all the answers

How do interest rates on municipal bonds compare to those on corporate bonds with the same default risk?

Municipal bonds carry interest rates that are lower than those on corporate bonds with the same default risk. Signup and view all the answers

What type of bond is issued by foreign corporations or governments, and may be subject to currency risk if the investor is domiciled in a different country?

Foreign Bond Signup and view all the answers

What is the term for the value of a bond if you bought it and held it until maturity?

Yield to Maturity (YTM) Signup and view all the answers

What is another name for Yield to Maturity (YTM)?

Market Rate of Interest (rd) Signup and view all the answers

What are the effects of Time to Maturity (TTM) and Yield on bond prices?

<ul> <li>The further out in time the bond matures, the less its present value becomes.</li> <li>The higher the discount rate, the lower the present value becomes.</li> </ul> Signup and view all the answers

What kind of security is similar to bonds and common stock, has a par value, and pays fixed dividends before dividends can be paid on common stock?

Preferred Stock Signup and view all the answers

What is the formula for calculating the price of preferred stock?

Vps = Dps / rps Signup and view all the answers

What is the name of the model that evaluates stock based on the NPV of future dividends?

Dividend Discount Model (DDM) Signup and view all the answers

What is the formula for calculating the value of common stock using the Dividend Discount Model?

Stock Value = Current Div. Per Share/ Disc. Rate - Div. Growth Rate P0 = D1 / rs - g Signup and view all the answers

Study Notes

Finance Exit Exam Flashcards - Summary

Opportunity Cost: The rate of return you could earn on an alternative investment of similar risk.

Discounting & Annuities

Discounting: Finding the present value of a future cash flow, the opposite of compounding.
Annuity: A series of equal payments made at fixed intervals.
Ordinary Annuity: Annuity payments made at the end of each period. Examples include mortgages, car loans, and student loans.
Annuity Due: Annuity payments made at the beginning of each period. Examples include rental payments and life insurance.

Future Value of Annuities

Ordinary Annuity (FV): FV = PMT[((1+r)^n - 1)/r]. PV = 0 (for calculator)
Annuity Due (FV): FV = (PMT [((1 + r)n - 1) / r])(1 + r)

Present Value of Annuities

Ordinary Annuity (PV): PV = PMT [(1 - (1 / (1 + r)n)) / r]
Annuity Due (PV): PV = (PMT [(1 - (1 / (1 + r)n)) / r]) x (1+r)

Bonds & Perpetuities

Consols: British government bonds issued in 1749, used to consolidate debt, promise to pay interest perpetually.
Perpetuity: A promise to pay interest perpetually.
Effective Annual Rate (EAR/EFF%): The actual interest rate earned or paid on an investment considering compounding over a period. Calculation: (1 + Inom/M)^M - 1.0

Amortized Loans & Bond Characteristics

Amortized Loan: A loan repaid in equal amounts over time, each payment consisting of interest and principal repayment.
Amortization Schedule: A table that shows the breakdown of each loan payment into interest and principal.
Bond: A long-term contract where a borrower agrees to make interest and principal payments to bondholders on specific dates.
Treasury Bond: A US government bond with no default risk.
Corporate Bond: A bond issued by a corporation to raise funds, carries credit risk.
Municipal Bond: Issued by state and local governments, carries default risk; interest often tax-exempt.
Foreign Bond: Issued by foreign corporations or governments, carrying default and potential currency risk.
Yield to Maturity (YTM): The value if you bought the bond and held it to maturity.

Preferred & Common Stock

Preferred Stock: A hybrid security with a par value and fixed dividends, paid before common stock dividends. Failure to pay doesn't lead to bankruptcy.
Preferred Stock Price Calculation: Vps = Dps / rps (Dividend / Required Rate of Return)
Dividend Discount Model (DDM): Evaluates a stock's value based on the present value of future dividends. Applicable to dividend-paying stocks.
Constant Growth DDM: Assumes constant dividend growth rate.
No/Zero Growth DDM: Assumes no dividend growth.
Common Stock Value Calculation DDM: P0 = D1 / rs - g
Earnings Per Share (EPS): The amount of earnings a company retains and reinvests, along with the rate of return on its equity.

Free Cash Flow & Mergers

Free Cash Flow: Cash flow remaining after all operating expenses, debt service, taxes etc., including all sources of capital.
Value of a Firm: The present value of the firm's expected future free cash flows, discounted at the weighted average cost of capital (WACC).
Adjusted Present Value (APV): A technique to value mergers. Incorporates adjustments for tax shields from leverage.

Financial Instruments & Investment Analysis

Forward Contracts: Agreements to buy or sell a commodity at a specific price on a specific future date.
Futures Contracts: Standardized financial contracts traded on exchanges, marked-to-market daily.
Swaps: Agreements to swap something (generally obligations to make payment streams).
Efficient Market Hypothesis (EMH): States that stock prices reflect all relevant information.
Market Efficiency Types:
- Weak-form: Prices reflect all past price movements.
- Semi-strong-form: Prices reflect all publicly available information.
- Strong-form: Prices reflect all information, publicly and privately held.
Beta: A measure of a security's systematic risk relative to the market. (Calculation: Covariance(stock vs. market returns) / Variance(market returns)). Beta = 1 indicates same volatility as the market, <1 less volatile, >1 more volatile.
Alpha: A measure of a security's abnormal return above what an equilibrium model (like CAPM) would predict. (Calculation: Return on portfolio - [risk-free rate + beta * (market return - risk-free rate)])
Systematic Risk: The day-to-day potential for losses from security price fluctuations. Cannot be diversified away.
Unsystematic Risk: Company- or industry-specific risk; can be diversified away.
Sharpe Ratio: A measure of risk-adjusted return. (Calculation: [Asset Return - Risk-free rate] / Standard Deviation of asset return)

Capital Budgeting & Cost of Capital

Capital Budgeting: Analysis of potential projects; long-term decisions.
Independent Projects: Projects whose cash flows are unaffected by the acceptance of another.
Mutually Exclusive Projects: Projects where the acceptance of one can negatively impact the other.
Payback Period: The time needed to recoup an investment's cost.
Discounted Payback Period: Similar to payback, but considers the time value of money.
Internal Rate of Return (IRR): The discount rate that makes the present value of inflows equal to the cost.
Cost of Preferred Stock (with flotation cost): rps = Dps/[Pps(1-F)]
Cost of Common Stock (with DDM and flotation costs) : r(e) =D1/(P0(1-F)) + g
Cost of Equity (CAPM): CAPM: cost of equity = risk-free rate + beta * (return on market - risk-free rate)
Adjusted Beta: An adjusted historical beta to be closer to the average beta of 1.0
Fundamental Beta: Beta that includes company-specific factors.
Effect of Debt on Cost of Common Equity: The cost of equity rises as debt increases due to higher financial risk. Additional debt increases the probability of bankruptcy.
Weighted Average Cost of Capital (WACC): The average rate of return required by all the company's investors for a marginal dollar of capital. Affected by capital structure, interest rates, risk, and investor attitude toward risk.
Marginal Cost of Capital: The cost to raise the last dollar of capital.

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Description

This quiz covers key concepts in finance, including opportunity cost, discounting, annuities, future value, and present value calculations. It highlights the differences between ordinary and annuity due payments, as well as discusses bonds and perpetuities. Ideal for those preparing for finance exit exams.