Final Exam

Question 1

Alternative Investments

Answer 1

• Real Estate
• Commodities
• Private Equities
• Hedge Funds
• Currencies
• Derivative Secerities

Question 2

Derivative Securities

Answer 2

A security whose value derives from the value of some underlying asset.

Examples: futures, forwards, swaps, options

Underlying assets:
interest rate, foreign exchange rate, index value such as stock, commodity price, common stock

Question 3

Uses of Derivatives

Answer 3

• Hedge risk
• speculate
• Arbitrage profit lock-in
• change nature of liability
• Change nature of investment

Question 4

Forward Contract

Answer 4

an agreement to buy or sell an asset at a certain time in the future for a certain price

At delivery (end of contract) ownership is transferred

Question 5

Futures Contract

Answer 5

A futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain price (futures price)

• The party that is buying has a long position
• The party that is selling has a short position

Question 6

Forward vs Future

Answer 6

Forwards are: private, non standard, 1 specified delivery date, settled at maturity, delivery or final cash usually occurs

Futures are: exchange traded, standard, range of delivery dates, settled daily, usually closed out prior to maturity

Question 7

Swaps

Answer 7

A financial contract between two counterparties who exchange future cash flows according to a prearranged formula.

Example: Interest rate swaps

Purpose is to hedge interest rate cash flows on balance sheets

Question 8

LIBOR

Answer 8

London Interbank Offer Rate

Question 9

Call option

Answer 9

A call option on an asset is an option to buy the asset at a fixed price.

Buyer is betting on price increasing
Seller is betting on price decreasing

Question 10

Put Option

Answer 10

AN asset that is an option to sell the asset at a fixed price.

Buyer is betting on price decreasing
Seller is betting on price increasing

Question 11

Options vs Forward/Futures

Answer 11

A forward/future contract gives the holder the obligation to buy/sell at a certain price.

A option gives the holder the right to buy/sell at a certain price.

Question 12

A successful option

Answer 12

In the Money

Question 13

Naked Call

Answer 13

Means you write a call without owning the underlying asset.

Question 14

Cover call

Answer 14

Means you write a call while owning the underlying asset to hedge downside risk

Question 15

Option Premium

Answer 15

Premium = intrinsic value (@ any point in time) + time value (is premium when intrinsic value is 0)

Always better to sell vs buy because you capture the time value.

Intrinsic value = value if about to expire

Question 16

Factors affecting option premium

Answer 16

Risk: an option is insurance. The greater the risk, the more the option is worth.

Interest rates: Call options are worth more if the interest rate is higher. Put options are less.

Time to maturity: A greater time to maturity implies a higher investment factor and generally implies greater risk.

Current stock price
Future stock price=strike price

Question 17

Long Put

Answer 17

Is a good way to hedge stock project against downside

Question 18

Options in corporate securities

Answer 18

• convertible debt and preferred stock
• callable debt and preferred stock
• callable convertible debt and preferred
• warrants (call options)
• put warrants

Question 19

NPV Rule

Answer 19

Net Present Value of all cash flows

All projects with NPV>0 should be accepted.

Question 20

IRR

Answer 20

Internal Rate of Return: the discount rate that makes the NPC of investment =0.

• Break even discount rate
• Measures annualized rate of return
• In general, take project for which IRR > cost of capital

Question 21

IRR & YTM

Answer 21

The YTM on a bond is an example of an internal rate of return. They are equal

Question 22

IRR Rule

Answer 22

A project is standard if there are negative cash flows in one or more years at the beginning and positive cash flows in the later years.

For standard projects, NPV > 0 if and only if IRR >cost of capital

A standard project should only be taking if and only if its IRR is greater than the opportunity cost of capital.

For nonstandard projects, don’t use IRR not NPV.

Question 23

Mutually Exclusive Projects

Answer 23

You want the largest NPV, not necessarily the largest IRR.

-It is usually better to earn 30% on 10 million than investment than earn 100% on a $100 investment.

Question 24

Profitability Index (PI)

Answer 24

THe profitability index of a project expresses the present value as a proportion of the initial outlay.

Decision rule: accept a project if PI>1 and reject a project if PI<1.

For every $1 I put into a project, I make $x.

PI=Present value of all cash inflow/present value of all cash outflows

Question 25

Payback Period

Answer 25

If payback period < cutoff period internally.. invest Rank in order of lowest to highest payback periods

Question 26

Working Capital

Answer 26

- Cash that is tied up but not consumed. At end of project company gets paid. - Cash employed to run the day-to-day

Question 27

Net working capital

Answer 27

- inventories and accounts receivable are working capital (current assets). - For most projects, inventories + accounts receivable - accounts payable A growth in net working capital = negative cash flow

Question 28

Example of NWC

Answer 28

Net cash from equipment sale = Market value - (Market value -Book value (price of purchase - depreciation) times tax rate.

Question 29

Investing now or later?

Answer 29

These are mutually exclusive projects, so choose one with highest NPV

Question 30

Sunk Costs

Answer 30

Costs that have already been incurred and cannot be removed should be ignored

Question 31

Opportunity Costs

Answer 31

AN opportunity cost is the most attractive alternative that is given up if a particular investment is undertaken. Typically at a minimum of current market resale value.

Question 32

Stand Alone Principle

Answer 32

A project should be evaluated on a stand alone basis | In effect, the cash flows from the project should be sufficient to meet the requirements of its security holders

Question 33

Incremental Cash Flows

Answer 33

Always consider increment cash flows from a project, not total cash flows. Example: company already makes 1M, with project makes 3M, Incremental value is 3-1=2M

Question 34

Incremental Costs

Answer 34

- Forget sunk costs - Allocate only incremental overhead - Include opportunity costs

Question 35

Cost of capital

Answer 35

Is the hurdle rate - appropriate discount rate - risk adjusted discount

Question 36

Consequences of wrong discount rates

Answer 36

if discount rate is too high, NPV will be lower, so you are going to decline projects that could've been profitable If discount rate is low, NPC will be higher, so you might take projects that you shouldn't.

Question 37

Capital Components

Answer 37

Debt (bonds), Equity (stocks), preferred stock Sources of funding that come from investors

Question 38

WACC (Weighted Avg Cost of Capital)

Answer 38

WACC is the average cost of funds from all sources A firm's WACC represents: - individual costs of capital and - financing mix

Question 39

WACC Formula

Answer 39

Weight of debt*cost of debt*(1-tax rate) + weight of preferred stock* cost of PS + Weight of stock * cost of stock

Question 40

Estimating Cost of Debt

Answer 40

Pre-tax cost of debt =yield to maturity on new bond issue after tax cost = pretax cost * (1-tax rate) Actual expected cost may be somewhat lower: - possibility of default lowes expected returns to investors relative to calculated YTM - Call provisions lower expected corp interest costs

Question 41

CAPM

Answer 41

Expected return on equity=risk free rate + Beta*Market risk premium

Question 42

Source of Risk

Answer 42

THe cost of capital for a project depends on the riskiness of the assets being financed, not on the source of financing.

Question 43

WACC

Answer 43

Is the hurdle rate on graph.... Shows that you should use different hurdle rates for different levels of risk on projects. The lower the risk, the lower the hurdle. The higher the risk, the higher the hurdle.