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Questions and Answers of Finance

How do free cash flows and the weighted average cost of capital interact to determine a firm’s value?MINI CASE Assume that you recently graduated with a degree in finance and have just
What are financial assets? Describe some financial instruments.MINI CASE Assume that you recently graduated with a degree in finance and have just reported to work as an investment advisor at
Who are the providers (savers) and users (borrowers) of capital? How is capital transferred between savers and borrowers?MINI CASE Assume that you recently graduated with a degree in finance and
List some financial intermediaries.MINI CASE Assume that you recently graduated with a degree in finance and have just reported to work as an investment advisor at the brokerage firm of Balik
What are some different types of markets?MINI CASE Assume that you recently graduated with a degree in finance and have just reported to work as an investment advisor at the brokerage firm of
How are secondary markets organized?MINI CASE Assume that you recently graduated with a degree in finance and have just reported to work as an investment advisor at the brokerage firm of Balik
List some physical location markets and some computer/telephone networks.MINI CASE Assume that you recently graduated with a degree in finance and have just reported to work as an investment
Explain the differences between open outcry auctions, dealer markets, and electronic communications networks (ECNS).MINI CASE Assume that you recently graduated with a degree in finance and have
What do we call the price that a borrower must pay for debt capital? What is the price of equity capital? What are the four most fundamental factors that affect the cost of money, or the general
What is the real risk-free rate of interest (r*) and the nominal risk-free rate (rRF)? How are these two rates measured?MINI CASE Assume that you recently graduated with a degree in finance and
Define the terms inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). Which of these premiums is included when determining the interest rate on
What is the term structure of interest rates? What is a yield curve?MINI CASE Assume that you recently graduated with a degree in finance and have just reported to work as an investment advisor
Suppose most investors expect the inflation rate to be 5 percent next year, 6 percent the following year, and 8 percent thereafter. The real risk-free rate is 3 percent. The maturity risk premium is
At any given time, how would the yield curve facing an AAA-rated company compare with the yield curve for U. S. Treasury securities? At any given time, how would the yield curve facing a BB-rated
What is the pure expectations theory? What does the pure expectations theory imply about the term structure of interest rates?MINI CASE Assume that you recently graduated with a degree in
Finally, Dellatorre is also interested in investing in countries other than the United States. Describe the various types of risks that arise when investing overseas.MINI CASE Assume that you
Draw time lines for (a) a $100 lump sum cash flow at the end of year 2, (b) an ordinary annuity of $100 per year for 3 years, and (c) an uneven cash flow stream of -$50, $100, $75, and $50 at the end
What is the future value of an initial $100 after 3 years if it is invested in an account paying 10 percent annual interest?MINI CASE Assume that you are nearing graduation and that you have
What is the present value of $100 to be received in 3 years if the appropriate interest rate is 10 percent?MINI CASE Assume that you are nearing graduation and that you have applied for a job
We sometimes need to find how long it will take a sum of money (or anything else) to grow to some specified amount. For example, if a company's sales are growing at a rate of 20 percent per year, how
If you want an investment to double in three years, what interest rate must it earn?MINI CASE Assume that you are nearing graduation and that you have applied for a job with a local bank. As
What is the difference between an ordinary annuity and an annuity due? What type of annuity is shown below? How would you change it to the other type of annuity?
What is the future value of a 3-year ordinary annuity of $100 if the appropriate interest rate is 10 percent?MINI CASE Assume that you are nearing graduation and that you have applied for a job
What is the present value of the annuity?MINI CASE Assume that you are nearing graduation and that you have applied for a job with a local bank. As part of the bank's evaluation process, you
What would the future and present values be if the annuity were an annuity due?MINI CASE Assume that you are nearing graduation and that you have applied for a job with a local bank. As part of
What is the present value of the following uneven cash flow stream? The appropriate interest rate is 10 percent, compounded annually.MINI CASE Assume that you are nearing graduation and that you
Define (a) the stated, or quoted, or nominal rate, (iNom), and (b) the periodic rate (iPer).MINI CASE Assume that you are nearing graduation and that you have applied for a job with a local
Will the future value be larger or smaller if we compound an initial amount more often than annually, for example, every 6 months, or semiannually, holding the stated interest rate constant?
What is the future value of $100 after 5 years under 12 percent annual compounding? Semiannual compounding Quarterly compounding Monthly compounding Daily compounding?MINI CASE Assume that you
What is the effective annual rate (EAR)? What is the ear for a nominal rate of 12 percent, compounded semiannually? Compounded quarterly? Compounded monthly? Compounded daily?MINI CASE Assume
Will the effective annual rate ever be equal to the nominal (quoted) rate?MINI CASE Assume that you are nearing graduation and that you have applied for a job with a local bank. As part of the
1. Construct an amortization schedule for a $1,000, 10 percent annual rate loan with 3 equal installments.2. What is the annual interest expense for the borrower, and the annual interest income for
Suppose on January 1 you deposit $100 in an account that pays a nominal, or quoted, interest rate of 11.33463 percent, with interest added (compounded) daily. How much will you have in your account
What is the value at the end of year 3 of the following cash flow stream if the quoted interest rate is 10 percent, compounded semiannually?MINI CASE Assume that you are nearing graduation and
What is the PV of the same stream?MINI CASE Assume that you are nearing graduation and that you have applied for a job with a local bank. As part of the bank's evaluation process, you have been
Is the stream an annuity?MINI CASE Assume that you are nearing graduation and that you have applied for a job with a local bank. As part of the bank's evaluation process, you have been asked to
An important rule is that you should never show a nominal rate on a time line or use it in calculations unless what condition holds? (Hint: think of annual compounding, when iNom = EAR = iPer.) What
Suppose someone offered to sell you a note calling for the payment of $1,000 15 months from today. They offer to sell it to you for $850. You have $850 in a bank time deposit which pays a 6.76649
What are the key features of a bond?MINI CASE Sam Struthers and Shawna Tibbs are vice-presidents of Mutual of Seattle Insurance Company and co-directors of the company's pension fund management
What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky?MINI CASE Sam Struthers and Shawna Tibbs are vice-presidents of Mutual of Seattle
How is the value of any asset whose value is based on expected future cash flows determined?MINI CASE Sam Struthers and Shawna Tibbs are vice-presidents of Mutual of Seattle Insurance Company
How is the value of a bond determined? What is the value of a 10-year, $1,000 par value bond with a 10 percent annual coupon if its required rate of return is 10 percent?MINI CASE Sam Struthers
What would be the value of the bond described in part d if, just after it had been issued, the expected inflation rate rose by 3 percentage points, causing investors to require a 13 percent return?
What would happen to the bonds' value if inflation fell, and rd declined to 7 percent? Would we now have a premium or a discount bond?MINI CASE Sam Struthers and Shawna Tibbs are vice-presidents
What would happen to the value of the 10 year bond over time if the required rate of return remained at 13 percent, or if it remained at 7 percent? (Hint: with a financial calculator, enter PMT, I,
What is the yield to maturity on a 10-year, 9 percent annual coupon, $1,000 par value bond that sells for $887.00? That sells for $1,134.20? What does the fact that a bond sells at a discount or at
What are the total return, the current yield, and the capital gains yield for the discount bond? (Assume the bond is held to maturity and the company does not default on the bond.)MINI CASE Sam
What is interest rate (or price) risk? Which bond has more interest rate risk, an annual payment 1-year bond or a 10-year bond? Why?MINI CASE Sam Struthers and Shawna Tibbs are vice-presidents
What is reinvestment rate risk? Which has more reinvestment rate risk, a 1-year bond or a 10-year bond?MINI CASE Sam Struthers and Shawna Tibbs are vice-presidents of Mutual of Seattle Insurance
How does the equation for valuing a bond change if semiannual payments are made? Find the value of a 10-year, semiannual payment, 10 percent coupon bond if nominal rd = 13%.MINI CASE Sam
Suppose you could buy, for $1,000, either a 10 percent, 10-year, annual payment bond or a 10 percent, 10-year, semiannual payment bond. They are equally risky. Which would you prefer? If $1,000 is
What is the bond's nominal yield to call (YTC)?MINI CASE Sam Struthers and Shawna Tibbs are vice-presidents of Mutual of Seattle Insurance Company and co-directors of the company's pension fund
If you bought this bond, do you think you would be more likely to earn the YTM or the YTC? Why?MINI CASE Sam Struthers and Shawna Tibbs are vice-presidents of Mutual of Seattle Insurance Company
Boeing's bonds were issued with a yield to maturity of 7.5 percent. Does the yield to maturity represent the promised or expected return on the bond?MINI CASE Sam Struthers and Shawna Tibbs are
Boeing's bonds were rated AA- by S&P. Would you consider these bonds investment grade or junk bonds?MINI CASE Sam Struthers and Shawna Tibbs are vice-presidents of Mutual of Seattle
What factors determine a company's bond rating?MINI CASE Sam Struthers and Shawna Tibbs are vice-presidents of Mutual of Seattle Insurance Company and co-directors of the company's pension fund
If this firm were to default on the bonds, would the company be immediately liquidated? Would the bondholders be assured of receiving all of their promised payments?MINI CASE Sam Struthers and
Describe briefly the legal rights and privileges of common stockholders.MINI CASE Sam Struthers and Shawna Tibbs are senior vice presidents of the Mutual of Seattle. They are co-directors of the
Write out a formula that can be used to value any stock, regardless of its dividend pattern.MINI CASE Sam Struthers and Shawna Tibbs are senior vice presidents of the Mutual of Seattle. They are
What is a constant growth stock? How are constant growth stocks valued?MINI CASE Sam Struthers and Shawna Tibbs are senior vice presidents of the Mutual of Seattle. They are co-directors of the
What happens if a company has a constant g which exceeds its rs? Will many stocks have expected g > rs in the short run (i.e., for the next few years)? In the long run (i.e. forever)MINI
Assume that temp force has a beta coefficient of 1.2, that the risk-free rate (the yield on T-bonds) is 7 percent, and that the market risk premium is 5 percent. What is the required rate of return
What is the firm’s expected dividend stream over the next 3 years?MINI CASE Sam Struthers and Shawna Tibbs are senior vice presidents of the Mutual of Seattle. They are co-directors of the
What is the firm’s current stock price?MINI CASE Sam Struthers and Shawna Tibbs are senior vice presidents of the Mutual of Seattle. They are co-directors of the company’s pension fund
What is the stock’s expected value one year from now?MINI CASE Sam Struthers and Shawna Tibbs are senior vice presidents of the Mutual of Seattle. They are co-directors of the company’s
What are the expected dividend yield, the capital gains yield, and the total return during the first year?MINI CASE Sam Struthers and Shawna Tibbs are senior vice presidents of the Mutual of
Now assume that the stock is currently selling at $30.29. What is the expected rate of return on the stock?MINI CASE Sam Struthers and Shawna Tibbs are senior vice presidents of the Mutual of
What would the stock price be if its dividends were expected to have zero growth?MINI CASE Sam Struthers and Shawna Tibbs are senior vice presidents of the Mutual of Seattle. They are
Now assume that Temp Force is expected to experience supernormal growth of 30 percent for the next 3 years, then to return to its long-run constant growth rate of 6 percent. What is the stock’s
Is the stock price based more on long-term or short-term expectations? Answer this by finding the percentage of Temp Force current stock price based on dividends expected more than three years in the
Suppose Temp Force is expected to experience zero growth during the first 3 years and then to resume its steady-state growth of 6 percent in the fourth year. What is the stock’s value now? What is
Finally, assume that Temp Force’s earnings and dividends are expected to decline by a constant 6 percent per year, that is, g = -6%. Why would anyone be willing to buy such a stock, and at what
What is market multiple analysis?MINI CASE Sam Struthers and Shawna Tibbs are senior vice presidents of the Mutual of Seattle. They are co-directors of the company’s pension fund management
Why do stock prices change? Suppose the expected D1 is $2, the growth rate is 5 percent, and rs is 10 percent. Using the constant growth model, what is the impact on stock price if g is 4 percent or
What does market equilibrium mean?MINI CASE Sam Struthers and Shawna Tibbs are senior vice presidents of the Mutual of Seattle. They are co-directors of the company’s pension fund management
If equilibrium does not exist, how will it be established?MINI CASE Sam Struthers and Shawna Tibbs are senior vice presidents of the Mutual of Seattle. They are co-directors of the company’s
What is the efficient markets hypothesis, what are its three forms, and what are its implications?MINI CASE Sam Struthers and Shawna Tibbs are senior vice presidents of the Mutual of Seattle.
Temp Force recently issued preferred stock. It pays an annual dividend of $5, and the issue price was $50 per share. What is the expected return to an investor on this preferred stock?MINI
What is a financial option what is the single most important characteristic of an option?MINI CASE Assume that you have just been hired as a financial analyst by Triple Trice Inc., a mid-sized
Options have a unique set of terminology. Define the following terms:(1) Call option;(2) Put option;(3) Exercise price;(4) Striking, or strike, price;(5) Option price;(6) Expiration date;(7) Exercise
Consider Triple Trice's call option with a $25 strike price. The following table contains historical values for this option at different stock prices: Create a table which shows (a) Stock price, (b)
What happens to the premium of option price over exercise value as the stock price rises? Why?MINI CASE Assume that you have just been hired as a financial analyst by Triple Trice Inc., a
In 1973, Fischer Black and Myron Scholes developed the Black-Scholes Option Pricing Model (OPM).MINI CASE Assume that you have just been hired as a financial analyst by Triple Trice Inc., a
Write out the three equations that constitute the model.MINI CASE Assume that you have just been hired as a financial analyst by Triple Trice Inc., a mid-sized California company that
What is the value of the following call option according to the OPM?Stock Price = $27.00.Exercise Price = $25.00Time to Expiration = 6 Months.Risk-Free Rate = 6.0%.Stock Return Variance = 0.11.MINI
What impact does each of the following call option parameters have on the value of a call option?1. Current Stock Price2. Exercise Price3. Option’s Term to Maturity4. Risk-Free Rate5 .Variability
What is put-call parity?MINI CASE Assume that you have just been hired as a financial analyst by Triple Trice Inc., a mid-sized California company that specializes in creating exotic clothing.
What sources of capital should be included when you estimate Harry Davis’ weighted average cost of capital (WACC)?MINI CASE During the last few years, Harry Davis Industries has been too
Should the component costs be figured on a before-tax or an after-tax basis?MINI CASE During the last few years, Harry Davis Industries has been too constrained by the high cost of capital to
Should the costs be historical (embedded) costs or new (marginal) costs?MINI CASE During the last few years, Harry Davis Industries has been too constrained by the high cost of capital to make
What is the market interest rate on Harry Davis’ debt and its component cost of debt?MINI CASE During the last few years, Harry Davis Industries has been too constrained by the high cost of
Should flotation costs be included in the estimate?MINI CASE During the last few years, Harry Davis Industries has been too constrained by the high cost of capital to make many capital
Should you use the nominal cost of debt or the effective annual cost?MINI CASE During the last few years, Harry Davis Industries has been too constrained by the high cost of capital to make
What is the firm's cost of preferred stock?MINI CASE During the last few years, Harry Davis Industries has been too constrained by the high cost of capital to make many capital investments.
Harry Davis’ preferred stock is riskier to investors than its debt, yet the preferred's yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a
What are the two primary ways companies raise common equity?MINI CASE During the last few years, Harry Davis Industries has been too constrained by the high cost of capital to make many
Why is there a cost associated with reinvested earnings?MINI CASE During the last few years, Harry Davis Industries has been too constrained by the high cost of capital to make many capital
Harry Davis doesn’t plan to issue new shares of common stock. Using the CAPM approach, what is Harry Davis’ estimated cost of equity?MINI CASE During the last few years, Harry Davis
What is the estimated cost of equity using the discounted cash flow (DCF) approach?MINI CASE During the last few years, Harry Davis Industries has been too constrained by the high cost of
Suppose the firm has historically earned 15 percent on equity (ROE) and retained 35 percent of earnings, and investors expect this situation to continue in the future. How could you use this

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