Finance I

Question 1

Relative Valuation

Answer 1

Goods are valued in relation to similar goods. This is easier to do when there are available comparables

Question 2

Stock

Answer 2

A type of security that signifies ownership in a corporation and represents a claim on part of the corporation’s assets and earnings. Stocks are also known as shares or equity.

Question 3

Bond

Answer 3

A bond is a debt investment in which an investor loans money to an entity for a defined period of time at a variable or fixed interest rate. Bonds are paid off before stocks so they are less risky but have a more limited upside. Bondholders are creditors.

Question 4

Main Objective of Corporate Managers

Answer 4

Maximize the value of the firm (i.e., maximize share price)

Question 5

Finance is a hybrid of…

Answer 5

(In order)

1. Economics
2. Statistics
3. Accounting

Question 6

Four Assumptions of a Perfect Market

Answer 6

1. No taxes
2. No transaction costs
3. No difference in opinion
4. Many buyers and sellers

A) simplifies computations
B) models must work in simple situations or they won’t work in complex ones

Question 7

Time Value of Money

Answer 7

A dollar today is worth more than a dollar tomorrow, assuming no inflation. This is because of interest.

Question 8

Simple Interest

Answer 8

Only paid on principal

FV = PV( 1 + nt )

Question 9

Compound Interest

Answer 9

Pays interest on principal and previously earned interest.

FV = PV( 1 + r )^t

( 1 + r(t) ) = ( 1 + r )^t

Question 10

Basis Point

Answer 10

A basis point is 1/100 of a percent.

e.g., if interest rate of 10% increases by 500 basis points, then the new rate is 15%

Question 11

Capital Budgeting

Answer 11

Investors lend (stocks, bonds), firms borrow to finance projects. Capital budgeting is the process of choosing which project to invest in (highest net return). Capital is an asset with life greater than 1 year.

Question 12

Provisions

Answer 12

Govern how a bond pays money to the bondholder. Also called indentures.

Question 13

Holding Rate of Return

Answer 13

[C(t) - C(0)] / C(0)

(FV - PV) / PV

This is the rate of interest earned if you hold the investment for an entire period - or periods (using compound interest)

Question 14

Future Value (FV)

Present Value (PV)

Answer 14

FV = PV( 1 + r(t) )

PV = FV / ( 1 + r(t) )

** ( 1 + r(t) ) = ( 1 + r )^t

Question 15

How long to double (triple, etc…) your investment with a given interest rate?

Answer 15

Double:
ln2 / ln(1+r)

Triple:
ln3 / ln(1+r)

** r must be the correct period rate. May be given an annual rate and asked how many months to triple. Use the formula to convert.

Question 16

Annual Percentage Rate

APR

Answer 16

Simple rate, this is usually the quoted rate. Must convert to effective to solve most problems by dividing APR by # of periods to get r, then using:

( 1 + r(t) ) = ( 1 + r )^t

r(t) will be the APY

Question 17

Annual Percentage Yield

APY

Answer 17

An effective rate (compounding interest)

Question 18

Discounting

Answer 18

discount factor:
1 / (1 + r)^t

discount rate:
r

Question 19

Compounding

Answer 19

compound factor:
(1+r)^t

compound rate:
r

Question 20

Net Present Value

NPV

Answer 20

NPV of an investment is the present value of all future cash flows minus the present value of its cost

1. Translate all future cash flows into today’s dollars
2. Add them all up (PV of all future cash flows)
3. Subtract initial investment

Question 21

Law Of One Price

Answer 21

If two items are perfect substitutes in all dimensions then they should have the same price in the same venue