Chapter 1

The financial manager is responsible for making

decisions that are in the best interests of the firm's
owners.

In most situations this means that the financial manager

should make decisions that maximize the value of the
owners' stock.

The management of current assets, such as money owed

by customers who purchase on credit, inventory, and
current liabilities, such as money owed to suppliers, is
called working capital management.

Firm -> Generate income (Cash flow) -> Remaining

(Residual cash flow)

The reinvestment of cash flows (earnings) is the most

fundamental way that businesses grow in
size

 1. Capital budgeting
decisions: Identifying the
productive assets the firm
should buy.
 2. Financing
decisions: Determining how the
firm should finance or pay for
assets.
 3. Working capital
management
decisions: Determining how
day-to-day financial matters
should be managed so that the

firm can pay its bills, and how surplus cash should be invested.

Matter most to investor: Cash Flow

Agency Costs are costs that arise from incurring and preventing
conflicts of interest between a firm’s owners and its managers
Agency costs can be reduced by
 Increased oversight
Aligning incentives

Reduce agency conflicts: Management Compensation Effectively

Sarbanes Oxley: Great board independence, internal controls, compliance + ethic programs, expand audit
committee’s oversight power

Reasons for agency problems: management ownership, agency relationships, stock maximize

Align the behaviour between stockholders: well-designed compensation, managerial labour market, independent
BOD

Main objective of a firm’s management is maximizing its stock value

Hybrid organization: combines limited liability with no double taxation for its owners

Chapter 2:

Investment banks specialize in helping companies sell new

debt or equity, although they can also provide other services,
such as the broker and dealer services discussed later in this
chapter and traditional banking services.

Money centre banks are large commercial banks that provide

both traditional and investment banking services throughout the
world.

Origination is the process of preparing a security issue for sale

(SEC regulations)

Underwriting is the process by which the investment banker

helps the company sell its new security issue, which the
investment banker buys the new securities from the issuing
company and resells them to investors.

Distribution is the process of marketing and reselling the

securities to investors

Financial markets and institutions

o Financial markets include markets for trading financial assets such as stocks and bonds rather than real assets
o Financial institutions include banks, credit unions, insurance companies, and finance companies
• The financial system at work
o The financial system is competitive
o Money is borrowed in small amounts and loaned in large amounts
o The system directs money to the best investment opportunities in the economy
o Lenders earn profit from the spread between lending and borrowing rates

The primary function of a financial system is to efficiently transfer

funds from lender-savers to borrower-spenders
• Basic mechanisms by which funds are transferred in the
financial system
o Directly through financial markets
o Indirectly through financial institutions
A primary market is any market where companies sell new security issues (debt or equity) directly to investors.

A secondary market is any market where owners of outstanding securities can sell them to other investors.

Marketability is the ease with which a security can be sold and converted into cash. A security's marketability
depends in part on the costs of trading and searching for information, so-called transaction costs. The lower the
transaction costs, the greater a security's marketability. Because secondary markets make it easier to trade securities,
their presence increases a security's marketability.

Liquidity is the ability to convert an asset into cash quickly without loss of value. Liquidity implies that when the
security is sold, its value will be preserved; marketability does not carry this implication.

Brokers are market specialists who bring buyers and sellers together when a sale takes place. Dealers are market
specialists who bring buyers and sellers together when a sale takes place.

Money markets are global markets where short-term debt instruments (high liquidity), which have maturities of
less than one year, are traded. Capital markets are markets where equity and debt instruments with maturities of
greater than one year are traded.

Futures contracts are contracts for the future delivery of assets such assets as securities, foreign currencies, interest
cash flows, or commodities. Options contracts call for one party (the option writer) to perform a specific act if
called upon to do so by the option buyer or owner.

True (intrinsic) value: A security's true value is the present value (the value in today's dollars) of the cash flows an
investor who owns that security can expect to receive in the future. Efficient market: security prices fully reflect the
knowledge and expectations of all investors at a particular point in time.

An efficient market in one in which current prices of securities incorporate the knowledge and expectations of all
participants
• Security prices are correct; securities are not over-valued or under-valued
• Participants are confident they pay or receive the intrinsic (fair) value of a security
• Operational Efficiency: extent to which transaction costs are minimized
• Informational Efficiency: extent to which security prices reflect all relevant information

Strong-Form Efficiency
o Security prices reflect all information, both public and private
o Even inside information is reflected in prices
• Semistrong-Form Efficiency
o Security prices always reflect all public information
o Inside, or confidential information, is not reflected in prices
• Weak-Form Efficiency
o Security prices only reflect historical information

Interest rates tend to rise and fall with changes in the rate of
inflation
• Rates tend to rise when the growth rate of the economy increases and tend to fall when the growth rate of the
economy slows
• Interest Rate, Business Cycle & Inflation
o Interest rates tend to follow the business cycle
o Interest rates tend to increase during an economic expansion
o Interest rates tend to decrease during an economic contraction

The real rate of interest is (1) the inflation-adjusted return earned by lender-savers and (2) the inflation-adjusted
cost incurred by borrower-spenders when they borrow. The rate that we actually observe in the marketplace at a
given time is unadjusted for inflation and is called the nominal rate of interest.
 Fisher Equation

Simplified: Get rid

the final one.

Real rate of return = ((1 + Nominal Rate) / (1 + Inflation Rate)) - 1

The retail individual investor is a common direct participant in the direct financial market: True

Interest rate increase when the demand for money increase

According to the Fisher equation, if the real rate of interest is 2.5% and the nominal rate of interest is 5.3%, the rate
of inflation is forecast to be approximately: 2.8% (5.3 – 2.5)

If your investment increased 12% this year and inflation for that period was 4%, what was your real rate of return?
8% (Use the formula above)

It is difficult for individuals to participate in the direct financial markets for the following reason: the direct
financial markets are wholesale markets with a typical minimum transaction size of $1 million.

An important function of the financial system is: to direct money to the best investment opportunities in the
economy.

Direct financing occurs when: a borrower-spender borrows directly from a lender-savers

Which of the following markets has no central trading location? Over-the-counter market

The term money market is used because: the instruments traded in this market are close substitutes for cash.

The most common reason that corporate firms use the futures and options markets is: to hedge risk

Which of the following theories states that security prices reflect all public information, but not all private
information? Semi strong-form efficiency

Which of the following theories states that security prices reflect all information, whether public or private? Strong-
form efficiency

The process of converting financial securities with one set of characteristics into securities with another set of
characteristics is called: financial intermediation

Which of the following statements best describes the relationship between interest rates and the business cycle?
Interest rates tend rise during economic expansion and decline during recessions

The real rate of return can be justified, at a basic level, by: compensation for deferring consumption

The critical role of the financial system in an economy is to: gather money from savers and channel it to
borrowers.
Chapter 3:

The annual report is the most important report that

firms issue to their stockholders and the public

1. Assumption of Arm’s Length Transaction

Parties involved in an economic transaction arrive at a decision
independently and rationally
2. Cost Principle
Asset values are recorded at the cost for which they were acquired
(and must be adjusted if they fall in value)
Investors want current prices and prefer a market value balance
sheet (finance) versus a book value balance sheet (accounting)
3. Realization Principle
• Revenue is recognized when a transaction is completed, although
cash may be received earlier or later

4. Matching Principle
Revenue is matched with the expense incurred to generate the
expense
5. Going Concern Assumption
Assumption that a company will continue to operation for the
predictable future

Preferred stock is similar to a bond because: it pays a fixed periodic amount.

Which of the following is a tax-deductible expense for a corporation? Interest Paid

Interest paid on debt obligations is a tax-deductible business expense. True

When a firm estimates future taxes, it should consider the: marginal tax rate

Fiore Manufacturing has the following amounts on its 12/31/14 balance sheet.

Cash $150
What was Fiore Manufacturing’s net working capital on December 31,
2014? 150 + 397 – 324 = 223 (Current assets – current liabilities)

Other current assets 397 The following financial data of Cotise Corp. for the past fiscal year is
given.

Property, plant, & Calculate company’s cash flow to investors from operating activities?
Net income $34,000
equipment, net of 538 68,000
depreciation NI + Depreciation + Payable + Accrued – Account Receivable
Increase in accounts
14,000
payable
Current liabilities 324

Increase in accrued
Total Liabilities 14,000
504
income taxes

Increase in accounts
16,000
receivable

Depreciation 22,000
Maddux, Inc., has completed its fiscal year and reported the following information. The company had current
assets of $153,413, net fixed assets of $412,331, and other assets of $7,822. The firm also has current liabilities
worth $65,314, long-term debt of $178,334, and common stock of $162,000. What is the amount of retained
earnings?

Total assets = $153,413 + $412,331 + $7,822 = $573,566 / Total liabilities = $65,314 + $178,334 = $243,648/ Total
stockholders' equity = Total assets - Total liabilities Total stockholders' equity = $573,566 - $243,648 = $329,918/
Retained earnings = Total stockholders' equity - Common stock Retained earnings = $329,918 - $162,000 =
$167,918

Tre-Bien Bakeries generated net income of $233,412 this year. At year end, the company had accounts receivables
of $47,199, inventory of $63,781, and cash of $21,461. It also had accounts payables of $51,369, short-term notes
payables of $11,417, and accrued taxes of $6,145. The net working capital of the firm is: 63,510

Centennial Brewery produced revenues of $1,145,227 in 2008. It has expenses (excluding depreciation) of
$812,640, depreciation of $131,335, and interest expense of $81,112. It pays an average tax rate of 34 percent. What
is the firm's net income after taxes? Round your final answer to the nearest dollar. 120,140 – 40, 848 = 79,292

Arco Steel, Inc. generated total sales of $45,565,200 during fiscal 2010. Depreciation and amortization for the year
totaled $2,278,260, and cost of goods sold was $27,339,120. Interest expense for the year was $9,641,300 and
selling, general, and administrative expenses totaled $4,556,520 for the year. What is Arco’s EBIT for 2010?
EBIT = Net Sales - Costs of Goods Sold - Selling, General & Administrative Expenses – Depreciation =
11,391,300

Chart worth Associates’ financial statements

Tax Rate Taxable Income indicated that the company has EBITDA of
$3,145,903. It had depreciation of $633,000, and its
interest rate on debt of $1.25 million was 7.5%. The
company is likely to owe $822,512 in taxes. What are
15% $0 to $50,000 the marginal and average tax rates for this company?

25 50,001 − 75,000 Marginal tax rate = 34 % (3,145,903 is in 34%)

Average tax rate = total taxes payable / total

taxable income = 822,512 / 2,419,153 (3,145,903 –
34 75,001 − 100,000

39 100,001 − 335,000

34 335,001 − 10,000,000

35 10,000,001 − 15,000,000

38 15,000,001 − 18,333,333

35 More than $18,333,333

633,000 – 1.25 x 7.5%) = 34%

Chapter 4:

Stockholders focus on net cash flows, risk, rate of return, and the market value of the firm’s stock
• Managers focus on rate of return, efficient use of assets, controlling costs, increasing net cash flows, increasing
the market value of the firm’s stock, and job security
• Creditors focus on the predictability of revenues and expenses, the ability to meet short-term obligations, the
ability to make loan payments as schedule, and avoidance of changes in risk

Benchmark to competitors of similar size with similar products and services

Common-size balance sheet may use total assets as the reference value; each item is expressed as a percentage of
total assets
o Common-size income statement may use net sales as the reference value; each item is expressed as a percentage of
net sales

Financial ratios establish a common reference point across firms, even though the numerical value of the reference
point will differ from firm-to-firm
o Ratios make it easier to compare the performance of large firms to that of small firms
o Ratios make it easier to compare the current and historical performance of a single firm as the firm changes over
time (trend analysis)

Liquidity ratios indicate a firm’s ability to pay short-term obligations with short-term assets without endangering the

firm. In general, higher ratios are a favorable indicator

Efficiency ratios indicate a firm’s ability to use assets to produce sales. These are also called turnover ratios. In
general, higher numbers are a favorable indicator. For Days Sales in Inventory, however, a lower number is
favorable.

Leverage ratios indicate whether a firm is using the appropriate amount of debt financing. In general, higher ratios
indicate greater potential return and greater bankruptcy risk.

For the following ratios, a higher number generally indicates less bankruptcy risk and (possibly) lower potential
return

Profitability ratios indicate whether a firm is generating adequate profit from its assets. In general, higher ratios
indicate better performance.

A ratio or ratio analysis is relevant only when compared to an appropriate benchmark

o Trend Analysis – comparison to the firm’s historical performance
o Industry Analysis – comparison to the aggregate of firms in the same
industry
• Standard Industrial Classification (SIC) System
• North American Industry Classification System (NAICS)
o Peer Group Analysis – comparison to a select group of firms in the same
industry
Weaknesses of financial statement analysis
o Not an exact science
o Relies on accounting data and historical costs
o Few guidelines or principles for determining whether a ratio is “high” or
“low,” or is a reason for confidence or for concern

Investors are likely to be most interested in a firm’s: P/E Ratio

A common-size income statement is useful for: comparing financial performance of different firms.

In a common size income statement, each item is divided by net sales. True

The DuPont system identifies some areas where a firm’s management should focus its efforts in order to maximize
the firm’s ROE, which of the following is one of them? How efficient management is in using the firm’s assets

You observe that a firm’s ROE is above the industry average, but both its profit margin and equity multiplier are
below the industry average. Which of the following statements is CORRECT? Its total assets turnover must be
above the industry average.

A commercial bank wants to determine if an applicant for a loan is likely to be able to pay its bills as they come due.
Which type of ratio is most appropriate? Liquidity Ratio
Which one of the following is an efficiency ratio? Day Sales Outstanding
Which of the following aspects about a company’s health does the current ratio measure? Short term solvency

Which of the following is an appropriate benchmark in ratio analysis? The average collection period for a peer
group of firms
The quick ratio may be a better indicator of liquidity than the current ratio because _inventory_ may be relatively
difficult to convert to cash in a short period of time.

DuPont analysis involves breaking return-on-assets ratios into their: profit margin and turnover components
The most useful way to prepare a common size income statement is to express each account item as a percentage of
Net Sales

Liquidity Ratio: Acid- test ratio

Net Income= (EBIT - Interest Expense) x (1-Average Tax Rate)

What will be a firm's equity multiplier given a debt ratio of 0.65? Total assets / Total equity = 1 / (1- 0.65) = 2.86

Kelby & Sons has a current ratio of 1.2, current assets of $508,315, and inventory of $98,666. What is the firm's
quick ratio? Current Ratio = Current assets / Current liabilities. Quick Ratio = (current assets - inventories) /
current liabilities

Contrary Computer Corp. has reported that its net income for 2010 is $2,700,000. The firm has 600,000 shares
outstanding and a price-earnings ratio of 15.8 times. What is the firm's share price? 2,700,000 / 600,000 * 15.8

Last year coral gables Corp had $410,000 of assets, $403,000 of sales, $28,250 of net income, and a total debt
ratio of 39%. The new CFO believes the firm has excessive fixed assets and inventory that could be sold, enabling it
to reduce its total assets and total invested capital to $252,500. The firm finances using only debt and common
equity. Sales, costs, and net income would not be affected, and the firm would maintain the same capital structure
(but with less total debt). By how much would the reduction in assets improve the roe? Do not round your
intermediate calculations

Since 39% of the assets are financed by Debt, we can conclude that the remaining 61% of total assets are financed
by equity. Thus, of $410000, 61% constitutes Equity, which is $250100.
In order the find Return on Equity we may used the below formula:

Return on Equity=

Return on Equity= *100 = 11.30%

In cash assets are reduced to $252500, and the firm expects to keep the same capital structure of 39:61, Amount of
Debt will be $98475 and Equity will be $154025

Thus, New Return on Equity will Be= $28250/$154025*100 =18.34%

Thus, return on equity increases by 7.05% (Approximately)

DuPont method, ROE= Net profit margin × Total asset turnover × Equity multiplier.
In the DuPont method of financial analysis, a decrease in total asset turnover causes ROE to decrease

Bobcat Industries has a net profit margin of 3%, a total asset turnover of 2 times; and a debt ratio of 40%. What is
the firm’s ROE?
Debt ratio = Total debt / Total assets = 1 - (Total equity / Total assets) = 0.40, Total equity / Total assets = 1 - 0.40 =
0.60. Equity multiplier = Total assets / Total equity = 1/0.60 = 1.67, ROE = 3% × 2 × 1.67 = 10%.
Samaya Company had depreciation and amortization expenses of $522,311, interest expenses of $114,077, and an
EBITDA of $1,521,087 for the year ended June 30, 2010. What is the times-interest-earned for this company?
Times Interest Earned= (EBITDA-D&A) / Interest Expense

Jet, Inc., has net sales of $326,352, accounts receivables of $98,765, and inventory of $72,989. What is the firm's
accounts receivables turnover? Net Sales / Account Receivables

Reel Time Video has reported a total asset turnover of 2.3 times and an ROA of 17% and ROE of 25%. What is the
firm's net profit margin?

The TBI Company has a number of days of inventory of 50. Therefore, the TBI Company’s inventory turnover is
closest to:

If a company’s net profit margin is –5 percent, its total asset turnover is 1.5 times, and its financial leverage ratio is
1.2 times, its return on equity is closest to:

Chapter 5

The time value of money (TVM) is the difference between a dollar in hand today and a dollar promised in the future

Future Value (FV) measures the value of an investment after it earns interest for one or more periods
• Present Value (PV) measures the current value of future cash flows discounted at the appropriate interest rate
• Compounding is the process of increasing cash flows to
a future value
• Discounting is the process of reducing future cash flows to a present value

You deposit $100 in an account that pays 5% annually with semi-annual compounding for two years. What is the
ending account balance?

FV = 100 x ((1 + 0.05/2)^ 2 x 2) = 100 x (1.025)^4 = 110.38

The Rule of 72 is a shortcut to estimate the number of periods it takes for an amount to double If you can earn 8%
compounded annually, how long will it take for your money to double? 72/8 = 9 years

A firm’s sales increased from $20 million to $35 million in three years. What was the average annual growth rate in
sales? Growth rate = (Present / Past) ^ (1/n) - 1

Emily Smith deposits $1,200 in her bank today.

(a) If the bank pays 4 percent simple interest, how much money will she have at the end of five years?
(b) What if the bank pays compound interest?
(c) How much of the earnings will be interest on interest?

Future value with simple interest

Simple interest per year = $1,200 × 0.04 = $48
Simple interest for 5 years = $48 × 5 = $240
FV5 = $1,200 + $240 = $1,440
b. Future value with compound interest
FV5 = $1,200 × (1 + 0.04)^5
= $1,459.98
Simple interest = ($1,440 – $1,200) = $240
Interest on interest = $1,459.98 – $1,200 – $240 = $19.98

The time-value-of-money concept assumes that people accept less money to reduce the time they must wait.

Which of the following situations will result in an increase in the future value of an investment? An increase in the
rate of interest

Which of the following statements is true about the compound factor? The compound factor decreases as the
number of periods increase.

The future value of $200,000 invested at a 7% annual rate, compounded quarterly for 3 years is _____. FV = P (1 +
r)^n = 200,000( 7%/4)^(4x3) = 246,287.86

If Norman invested $100,000 for 3 years at 12%, how much interest on interest will he earn?

Interest = principal x rate x duration = 100,000 x 0.12 x 3 = 36,000

FV = 140,492 -> interest on interest= 140,492 – 36,000- 100,000 = 4,492.8

If Johnson put $800,000 in a savings account today, how much will it grow to in 3 years if the bank pays 4% annual
interest compounded continuously? A = P x e^ (rt)

Which one of the following processes do we use when calculating the price of an asset? Discounting

The present value factor is also known as the discount factor. True

Castelda company issues zero coupon bonds which mature in 30 years. These bonds can be bought for $999.38 and
then pay no annual interest payments, only $100,000 at maturity. What is the annual percentage cost of these bonds
to the issuing company?

Future value = Present value × (1 + interest rate)n; $100,000 = $999.38 × (1 + i)30; i = 16.59%

Floor planning refers to the relationship with banks that allows the dealer to help customers arrange financing.
The customer benefits from arranging financing through the dealer because the customer often gets to drive the
car home that day.
Time lines are an important tool for analyzing problems that involve cash flows over time.
Generally, the future value of an investment will be greater if: the investment is compounded at a higher rate of
return.

Total compound interest is the: sum of simple interest and the interest on interest

Why do earnings from compounding drive much of the return earned on a long-term investment? A longer
investment period will result in a greater proportion of total earnings from interest earned on interest.

The present value of future cash flows: increases as the discount rate decreases.

Which of the following is a similar concept to the compound growth rate of money? Yield on a bond

If her bonus of $300,000 is equivalent to the bonus paid to her dad 10 years ago, how much was her dad’s bonus?
Assume that the average annual inflation rate was 3.8%. Real bonus = 300,000/1.038 = $206,608.28

Chapter 6:

Annuity
o A series of equally-spaced and level cash flows extending over a
finite number of periods
• Perpetuity
o A series of equally-spaced and level cash flows that continue forever
• Ordinary Annuity
o Cash flows occur at the end of a period
o Examples include mortgage payments and interest payments to
bondholders
• Annuity Due
o Cash flows occur at the beginning of a period
o Examples include leases and car insurance

Loan amortization is how borrowed funds are

calculated over the life of a loan
• Each payment includes less interest and more principal;
the loan is paid off with the last payment
• Amortization schedule shows interest and principal in
each payment, and amount of principal still owed after
each payment

Present Value of Annuity Due

o Cash flows are discounted for one period less than in an ordinary annuity
• Future Value of Annuity Due
o Cash flows earn compound interest for one period more than in an ordinary annuity
• The present or future value of an annuity due is always
higher than that of an ordinary annuity that is otherwise
identical

A coffee shop will operate for fifty more years. Cash

flow was $300,000 last year and increases by 2.5% each
year. The discount rate for similar firms is 15%.
Estimate the value of the firm.
CF1  $300,000 1 0.025  $307,500
PVA = (307000 / (0.15 – 0.025) ) x (( 1 – (1.025 / 1.15)^50))
 $2,460,000 0.9968  $2,452,128

The most common way to quote interest rates is in terms of annual percentage rate (APR). It does not incorporate
the effects of compounding
• The most appropriate way to quote interest rates is in terms of effective annual rate (EAR), which incorporates the
effects of compounding

The APR does not account for the number of compounding periods or adjust the annualized interest rate for the time
value of money

• APR is not a precise measure of the rates involved in borrowing and investing

Anna is charged 1% interest when she borrows $2,000 for

one week. What is the annual percentage interest (APR)
on the loan?
APR = (0.01) × 52 = .52, or 52%

The EAR accounts for the number of compounding periods and adjusts the annualized interest rate for the
time value of money
• EAR is a more accurate measure of the rates involved in
lending and investing

Anna is charged 1% interest when she borrows $2,000

for one week (1% is the weekly rate). What is the
effective annual interest rate (EAR) on the loan? 52
EAR  1 0.01^52 1  0.6777, or 67.77%

Stowell earns 20% interest compounded annually on his savings. He will deposit $1,500 today, $1,650 one year
from today, and $1,820 two years from today. What will be the account balance three years from today? $7,152
Work:
Year 0: $1,500 x (1+ 20%)³
Year 1: $1,650 x (1+ 20%)³⁻¹
Year 2: $1,820 x (1+ 20%)³⁻²
Sum: $7,152

You have won the lottery and will receive 20 annual payments of $10,000 starting today. If you can invest these
payments at 8.5%, what is the present value of your winnings?

You are purchasing a used car and will make 5 annual payments of $3,500 starting one year from today. If your
funds could be invested at 9%, what is the present value of the car? P = PMT * [1 – [ (1 / 1+r)^n] / r
A perpetuity bond pays a coupon of $136 per year and has a required rate of return of 3.5%. What is the market
value of the bond? PVP = CF / i, = $136 / 3.5% = $3,885.71
You have received a share of preferred stock that pays an annual dividend of $10. Similar preferred stock issues are
yielding 22.5%. What is the value of this share of preferred stock? PVP = CF / i = 10 / 22.5% = 44.4
Kronka, Inc., is expecting cash inflows of $13,000, $11,500, $12,750, and $9,635 over the
next four years. What is the present value of these cash flows if the appropriate
discount rate is 8 percent? PV  13 000 / 1.08 + 11 500 / (1.08)^2 + 12 750 / (1.08)^3 + 9635 / (1.08)^4
A consol, issued by the British government to finance the Napoleonic Wars is an example of: perpetuity

You are invited to participate in a new company. The company is projected to payout $10,000 in the first year, and
after that the payouts will grow by an annual rate of 6 percent forever. If you can invest the cash flows at 8 percent,
how much will you be willing to pay for this perpetuity?

PVP = CF / (i – g) = 10,000 / (8%-6%) = 500,000

What is the value of this 20-year lease? The first payment, due one year from today is $2,000 and each annual
payment will increase by 4%. The discount rate used to evaluate similar leases is 9%. PV An = (CF1 / (i - g)) × [1 -
((1+g) / (1+i))^n] = ($2,000 / (9% - 4%)) × [1 - ((1 + 4%) / (1+9%))^20] = $40,000 × 0.60903 = 24,361
Which of the following is NOT a typical way in which interest rates are quoted in the marketplace? Discounted
Interest Rate

The Truth-in-Lending Act requires borrowers to disclose the: Annual Percentage Rate (APR)

You are starting college this month, and your favorite aunt has agreed to give you $4,000 at the end of each of your
four years and you can save $8,000 at the end of each year for the first two years after you graduate. If all of these
amounts are invested at 14%, how much will you have to start graduate school, six years from now?

$4,000 x (1+ 14%)^5+$4000x (1+ 14%)^4 + $4000 x (1+ 14%)^3 + 4000 x (1.14%)^2 + 8000 x (1.14%)^1 +8000 x
(1.14%)^0
A modern-day example of a perpetuity is a: share of preferred stock

Cavin care has 50 years remaining on a service contract with Martin, Inc. Today, Martin paid $120,000 for services
received last year and the annual payment increases by 2.5% each year. The firm’s required rate of return is 15%.
What is the value of the contract to Cavincare? PV An = (CF1 / (i - g)) × [1 - ((1+g) / (1+i))^n] = [123000/ (15% -
2.5%)] x [1 – ((1+2.5%)/(1+15%))^50] = 980,879
An investment pays 18 percent interest compounded quarterly. What is the effective annual interest rate? EAR = ( 1
+ (0.18/4))^4 - 1 = 19.3%

The amount borrowed on a loan equal: discounted value of the loan payments

Milner is saving for her retirement. She will make a deposit into her IRA account at the end of each quarter for the
next 36 years. The expected return on the account is 8%. How much will she have to deposit each quarter to have
$650,000 in the account when she retires 36 years from today?

You plan to buy a new car. The price is $30,000 and you will make a down payment of $4,000. Your annual interest
rate is 10% and you intend to pay for the car over five years. What will be your monthly payment?
P x r x [(1+r)^n / ((1+r)^n -1) ]

What is the market value of a stock that paid a dividend of $3.80 last year if the dividend is increasing at 10%
annually and the required rate of return on the stock is 20%? $3.80*(1+10%) / (20% - 10%) = $41.80

What constant annual cash payment must you receive in order to earn a 6.5% rate of return on a perpetuity that has a
cost of $2,500? Perpetuity Value=Payment / Rate

Chapter 7

The rate of return that investors require for an investment depends on the risk associated with that
investment
o The greater the risk, the larger the return investors require as compensation for bearing that risk
• The rate of return is what you earn on an investment, stated in percentage terms
• Risk is a measure of how certain you are that you will receive a particular return

The greater the risk associated with an investment, the greater the return investors expect
• Investors want the highest return for a given level of risk or the lowest risk for a given level of return

The expected return is the weighted average of possible investment returns, i.e. the sum of each possible return
multiplied by the probability that it will occur

The normal distribution is symmetric, and the mean and standard deviation are the only information we need to
determine the shape
o The mean (average) is the center and is the reference point to which all other values in the distribution are
compared
o Values less than the mean are on the left and values greater than the mean are on the right
o The left and right sides are mirror images

For a normal distribution, a standard deviation is associated with the probability that an outcome occurs within a
certain distance from the mean
o 90% of outcomes are within 1.645 standard deviations from the mean
o 95% of outcomes are within 1.960 standard deviations from the mean
o 99% of outcomes are within 2.575 standard deviations from the mean

The arithmetic average return is the return earned in an average period

• The geometric average return is the average compounded return earned by an investor

A portfolio is the collection of assets an investor owns

Diversification involves reducing portfolio risk by investing in two or more assets whose values do not always move
in the same direction at the same time

The Sharpe ratio is a modified version of the coefficient of variation which measures return per unit of risk

Covariance indicates whether stocks’ returns tend to move in the same direction at the same time. If so, the
covariance is positive. If not, it is negative or zero

Firm-specific risk relevant for a particular firm can be diversified away and is called unsystematic or diversifiable
risk
• Risk that cannot be diversified away is non-diversifiable, or systematic risk. This is the risk inherent in the market
or economy

Investors do not like risk and will not bear risk they can avoid by diversification
o Well-diversified portfolios contain only systematic risk
o Portfolios that are not well-diversified face systematic risk plus unsystematic risk
o No one compensates investors for bearing unsystematic risk, and investors will not accept risk that they are not
paid to take
• Systematic risk cannot be eliminated by diversification
o Competition among diversified investors will drive the prices of assets to the point
where the expected returns will compensate investors for only the systematic risk

If the beta of an asset is

o Zero, the asset has no measurable systematic risk
o Greater than one, the systematic risk for the asset is greater than the average for assets in the market
o Less than one, the systematic risk for the asset is less than the average for assets in the market

The Capital Asset Pricing Model (C A P M) describes the relationship between risk and required return for an asset
o The graph of the C A P M equation is known as the Security Market Line (S M L)
• The S M L illustrates the C A P M’s prediction for the required expected total return for various values of beta.
The expected total return depends on an asset’s current price
o If the expected return is greater than the required return estimated with the C A P M, the expected return will plot
above the S M L and the asset is considered to be underpriced
o If the expected return is less than the required return estimated with the C A P M, the expected return will plot
below the S M L and the asset is considered to be overpriced

What is the expected return for a stock that has a beta of 1.5, if the risk-free rate is 6% and the market rate of return
is 11%?

Expected return, E(Ri) = Rrf + βi[E(Rm) – Rrf ] = 6% + [1.5 × (11% – 6%)] = 6% + [1.5 × 5%] = 13.5%

Gunther earned a 62.5 percent return on a stock that he purchased one year ago. The stock is now worth $12, and he
received a dividend of $1 during the year. How much did Gunther originally pay for the stock?
($12−$X+$1) / $X = 0.625 => $X= $8

Barbra purchased a piece of real estate last year for $85,000. The real estate is now worth $102,000. If Barbra needs
to have a total return of 25 percent during the year, then what is the dollar amount of income that she needs to have
to reach her objective?
($102,000−$85,000+$X)/ $85,000= 0.25 => $X= $4,250

Books Brothers stock was priced at $15 per share two years ago. The stock sold for $13 last year and now it sells for
$18. What was the total return for owning Books Brothers stock during the most recent year? ($18−$13)/ $13=
0.3846

Niles is making an investment with an expected return of 12 percent. If the standard deviation of the return is 4.5
percent, and if Niles is investing $100,000, then what dollar amount is Niles 90 percent sure that he will have at the
end of the year?

{1 + [0.12 – 1.645 (0.045)]} × $100,000 = $104,597.50

You have observed that the average size of a particular goldfish is 1.5 inches long. The standard deviation of the size
of the goldfish is 0.25 inches. What is the size of a goldfish such that 90 percent of the goldfish are smaller from
such size? 1.5 + 1.645 × (0.25) = 1.91 inches

Tommie has made an investment that will generate returns that are based on the state of the economy during the
year. Use the following information to calculate the standard deviation of the return distribution for Tommie's
investment. (Do not round intermediate computations. Round your final answer to four decimal places.)

State Return Probability

E(R) = (0.30 × 0.13) + (0.40 × 0.20) + (0.30 × 0.25) = 0.194

Weak 0.13 0.30

= 0.30 × (0.13 – 0.194)2 + 0.4 × (0.20 –
Var(R) = 0.002184
0.194)2 + 0.30 × (0.25 – 0.194)2

OK 0.20 0.40
Std(R) = √(0.002184)= 0.0467 (rounded)

Great 0.25 0.30

A portfolio with a level of systematic risk that is the same as that of the market has a beta that is equal to one.
Which of the following represents a plot of the relation between expected return and systemic risk? The security
market line

When choosing between two investments that have the same level of risk, investors prefer the investment with the
higher return.

Data for Hugh’s Corporation is provided below. Hugh’s recently acquired some risky assets that caused its beta to
increase by 30%. What is the stock's new expected rate of return according to the CAPM?

Initial beta 1.00

Old beta = 1.00
Old E(R) = Rrf + b(RPM) = 10.20%
RPM = (E(Rm) – Rrf) = 6.00%
Initial expected return (rs) 10.20% Percentage increase in beta = 30.00%
Find new beta after increase = 1.30
Find old Rrf: Old E(R) = Rrf+ b(RPM): 10.2% =
Market risk premium, E(Rm – Rrf) 6.00% Rrf + 1.0(6.0%) => Rrf = 4.20%
Find new E(R) = new Rrf + new beta(RPM) = 4.2 +
1.3*6 = 12%

Percentage increase in beta 30.00%

Ben would like to invest in gold and is aware that the returns on such an investment can be quite volatile. Use the
following table of states, probabilities, and returns to determine the expected return and the standard deviation of the
return on Ben’s gold investment.

Probability Return

Boom 0.1 40.00%

Good 0.2 30.00%

OK 0.3 15.00%

Level 0.2 2.00%

Slump 0.2 -12.00%

LO 4

Step 1 – Calculate the Expected Return

E(Ri) (Expected Return) = (0.1 × 0.4) + (0.2 × 0.3) + (0.3 × 0.15) + (0.2 × 0.02) + (0.2 × –0.12 = 0.125

Step 2 – Calculate the Variance

σ2 return (Variance) = 0.1 × (0.4 – 0.125)2 + (0.2) × (0.3 – 0.125)2 + (0.3) × (0.15 – 0.125)2 + (0.2) × (0.02 – 0.125)2
+ (0.2) × (–0.12 – 0.125)2 = 0.02809

Step 3 – Calculate the Standard Deviation

σ return (Standard Deviation) = (0.02809)1/2 = 0.16759 rounded to 0.168

A 95 percent confidence level corresponds to 1.96 standard deviations from the mean. Therefore, 95% of the time
you would expect the return for the next year to be in the range:

The high end of the range is

0.125 + (1.96 × 0.168) = 0.45 or 45.0%

The lower end of the range is

0.125 – (1.96 × 0.168) = -0.21 or -20.5%,

This represents the return that you can expect the investment to beat 95 percent of the time