Finance 2

Question 1

what is the simple formula for the current price of a share, P0

Answer 1

• P0 = (D1 + P1) / (1+r)
• D1 = dividend next year
• P1 = price next year

Question 2

what is the dividend discount model (or the share price valuation model)

Answer 2

• P = Σ(t=1 to ∞) D_t / (1+r)^t

Question 3

how does the dividend discount model change for constant dividend growth

Answer 3

• D1 remains constant but is multiplied by (1+g)^t-1
• so P =Σ D1*(1+g)^t-1 / (1+r)^t

Question 3

how does the dividend discount model change for zero dividend growth

Answer 3

• zero dividend growth means D1 = D2 = D3 = ….
• so the model decays to just being the simple perpetuity model

Question 4

what is the dividend growth model (gordon-shapiro model)

Answer 4

• P_n = D_n+1 / r - g
• given r > g

Question 5

how does the dividend discount model change for non-constant dividend growth

Answer 5

• step 1: find the PV of dividends from year 1 to year n
• step 2: add the PV of the share price in year n
• step 3: discount step 2 and add step 1

Question 6

what is a bond

Answer 6

• a bond is a ceritificate showing that the borrower owes a specific amount

Question 7

what is the formula for the price of a bond, P_bond

Answer 7

• P_bond = C/(1 + YTM) + C/(1+YTM)^2 + … + C+F/(1+YTM)^n
• C = coupon = face value * coupon rate
• F = face value
• YTM = yield to maturity

Question 8

how does the formula for the price of a bond change if the coupon is paid semi-annually instead of annually

Answer 8

• the C’s and YTM’s are divided by 2

Question 9

when is a bond said to sell at a premium, discount or at par

Answer 9

• sell at a premium = when the bonds price is higher than its face value
• to sell at a discount = when the bonds price is lower than its face value
• to sell at par = the bonds price and face value are the same

Question 10

what are the two forces that determine the yield-to-maturity

Answer 10

• central bank policy
• future expectations

Question 11

how do central banks influence the YTM

Answer 11

• central banks use monetary yields to manage the economy by increasing or decreasing interest rates (the base rate)
• they can lower rates to stimulate economic activity or raise rates to cool down the economy

Question 12

what is the yield curve

Answer 12

• a plot of the comparison between bonds with the same characteristics but different terms of maturities
• its basically a ratio of long-term bonds to short-term bills

Question 13

what are the 4 types of risks that investors expose themselves to with bonds

Answer 13

• default risk
• liquidity risk
• regulatory risk
• interest rate risk

Question 14

what is default risk

Answer 14

• the risk that a bond issuer will default on making the promised interest and principal payments to the buyer of the bond

Question 15

what is liquidity risk

Answer 15

• the risk that a bond can be sold at a predictable price with low transaction costs on short notice

Question 16

what is regulatory risk

Answer 16

• the risk that regulators will change the rules so as to adversely impact the earnings of the institution

Question 17

what is interest rate risk

Answer 17

• the risk that volatility in the interest rate can change the value of the bond
• since bond holders receive a fixed coupon and will only realize all returns when the bond expires

Question 18

which of the 4 types of risks are the most important and why

Answer 18

• interest rate risk
• because bond prices are affected whenever the government or central banks change interest rates

Question 19

how are the prices of bonds influenced by a rise or drop in interest rates

Answer 19

• when interest rates go up, bond prices fall
• when interest rates go down, bond prices rise

Question 20

what is the difference between growth shares and income shares

Answer 20

• for growth shares, investors expect to benefit from capital gains and are interested in future growth of earnings
• for income shares, investors seek cash dividends

Question 21

what is the formula for payout ratio

Answer 21

• payout ratio = dividends / EPS
• EPS = earnings per share

Question 22

what is the formula for earnings per share, EPS

Answer 22

• EPS = (net income - dividends to preferred shares) / average shares outstanding

Question 23

what is the formula for return on equity, ROE

Answer 23

• ROE = net income / shareholders equity

Question 24

what is the formula for plowback or retention ratio, b

Answer 24

b = 1 - payout

Question 25

what is the formula for price earnings ratio, PER

Answer 25

• PER = market value per share / EPS

Question 26

as a fund investing in growth stocks, what are the key factors you need to consider

Answer 26

• the factors that influence the growth rate of dividends, g
• and the net present value of growth opportunity, NPVGO

Question 27

what is the formula for the growth rate of dividends, or capital gain yield, g

Answer 27

• g = b * ROE
• b = plowback ratio
• ROE = return on equity

Question 28

what is the formula for the net present value of growth opportunity, NPVGO

Answer 28

• NPVGO = share price - EPS/r