Finance

Question 1

What is the time value of money

Answer 1

The idea that money is more valuable today than in the future, since it can be invested to earn interest r

Question 2

Give the equation for rates of return

Answer 2

Question 3

What is the compound interest calculation

Answer 3

C_T = C₀(1 + r)^T

Question 4

Whats the holding period return

Answer 4

the overall return for the full period

r = (1 + r_t)^1/t - 1 where r_t is the interest rate per period

Question 5

What’s present value

Answer 5

the value of all future cash flows

Question 6

What is the discount factor

Answer 6

1 / (1 + r)

Question 7

Whats a zero coupon bond

Answer 7

A bond that costs CF₀ today and promises to make CF_T = (1+r)CF₀ in the future

Question 8

What’s Net Present Value

Answer 8

the present value of all its future cash flows minus the present value of it’s costs

Question 9

What is the Capital budgeting rule for Present value?

Answer 9

Take all with NPV > 0

Question 10

What’s a perpetuity?

Answer 10

A bond that pays C pounds, per period, forever.

Question 11

What’s the equation for a growing perpetuity

Answer 11

Question 12

State the three equations associated with the Gordon Growth model

Answer 12

Question 13

What’s an annuity

Answer 13

an instrument that pays CF for T years

Question 14

Whats the equation for a growing annuity

Answer 14

Question 15

What’s the internal rate of return

Answer 15

the value of the discount rate r which sets the NPV = 0

Question 16

does the IRR reflect cost of capital?

Answer 16

NO

Question 17

What’s the capital budgeting rule for IRR

Answer 17

Accept the project if it’s IRR is higher than a ‘hurdle rate’

Question 18

Give 2 advantages and 2 disadvantages for using IRR

Answer 18

• allows for a margin of error
• doesnt include cost of capital
• some projects have no IRR, others have multiple
• can’t handle different interest rates for different periods

Question 19

Give the steps for incremental cash flow analysis

Answer 19

i) order alternatives in increasing order of the initial investment
ii) if the smallest investment has IRR > hurdle rate we consider the incremental cash flow
iii) if the IRR_incremental > hurdle then accept the more expensive investment

Question 20

Whats Profitability index and give the capital budgeting rule

Answer 20

The PV of the future cash flows, divided by the cost.

Invest if PI > 1, reject if PI < 1

Question 21

Whats the payback rule

Answer 21

Choose the project with the shortest payback time, or projects that payback sooner than some cut off

Question 22

What’s the Yield to maturity

Answer 22

the discount rate that sets the NPV of the bond equal to 0

P₀ = FV / (1 + YTM)ⁿ

Question 23

Whats expected value and variance?

Answer 23

Question 24

what utility functions fit

i) risk averse
ii) risk neutral
iii) risk seeking

Answer 24

i) U(w) = w^1/2
ii) U(w) = w
iii) U(w) = w²

Question 25

What is expected interest rates and promised interest rates equal to

Answer 25

Expected interest rates = Time premium Promised interest rates = Time premium + default premium

Question 26

What are equity holders repaid?

Answer 26

whatever profits remain after bond holders are paid off

Question 27

Whats covariance?

Answer 27

Question 28

Whats correlation?

Answer 28

Question 29

What is the expected return on a market portfolio consisting of X and Y

Answer 29

Question 30

What's the variance of the market portfolio

Answer 30

Question 31

What are diversification benefits

Answer 31

come from mixing together assets with less than perfect co-movement, makes the portfolio less volatile

Question 32

What shocks are eliminated by diversification

Answer 32

firm specific shocks

Question 33

What is the market portfolio

Answer 33

Tangency portfolio, the portfolio that provides the highest return per unit of risk

Question 34

Whats the association between project P and the market portfolio M

Answer 34

Question 35

What is CAPM?

Answer 35

Capital Asset Pricing Model

Question 36

State the CAPM

Answer 36

Question 37

How do we calculate NPV when using CAPM

Answer 37

numerator uses expected cash flows, cost of capital is expected return, derived from CAPM

Question 38

For risk averse investors, what are promised returns and expected returns

Answer 38

promised returns = time premium + default premium + risk premium expected return = time premium + expected risk premium

Question 39

When a firm has equity, what is the beta_project

Answer 39

Question 40

in a stock market, what do we buy and sell at

Answer 40

buy at ask price, sell at bid price

Question 41

Whats the average tax rate

Answer 41

total tax paid / total taxable income

Question 42

what is r_{after tax}

Answer 42

(1 - marginal tax rate) r_{before tax}

Question 43

What is the nominal and real cash flow

Answer 43

nominal cash flow is simply the number of pounds you pay real cash flow is adjusted for inflation

Question 44

whats the relationship between real r and nominal R interest rates

Answer 44

1 + r = 1 + R / 1 + inflation

Question 45

What does the Modiglani Miller irrelevance theorem state?

Answer 45

in perfect markets the firm value is equal to PV, regardledd of how its projects are financed

Question 46

Does MM hold in imperfect markets?

Answer 46

No

Question 47

Give the equation for APV, adjusted present value

Answer 47

Question 48

What is the debt to capital ratio

Answer 48

Debt / APV

Question 49

What is price_cum-dividend price_ex

Answer 49

The price before the expiration date, P_cum = current dividend + PV(future dividend) P_ex = PV(future dividend)

Question 50

In imperfect markets, do investors prefer repurchases or dividends?

Answer 50

repurchases, since dividends typically are charged at a higher tax rate

Question 51

What is a call option?

Answer 51

a contract that gives its owner the right to buy the asset at some future date at some specificed price

Question 52

What is a put option?

Answer 52

a contract that gives its owner the right the sell the asset at some future date at some specified price

Question 53

whats the strike price?

Answer 53

the pre-specified price at which the owner can buy or sell the asset

Question 54

When should we buy

Answer 54

When S(stock price) \> K(strike price) Price_call = max(S-K, 0)

Question 55

When should we sell?

Answer 55

When S \< K P_put = max ( K-S , 0)

Question 56

What does the law of one price state?

Answer 56

S + P = PV(K) + C known as put-call parity