Study Guide for Midterm Exam

Finance and the Firm (Chapter 1.1~1.4)

Identify the components of the financial environment (financial managers, investors, and financial markets)
Major decisions faced by financial managers (capital budgeting, capital structure, working capital management)
The goal of financial management in corporation (maximizing the current price of the existing stock)
How investors monitor managers to ensure that managerial decisions are in the best interests of the owners

Sample questions

1.1. The person generally directly responsible for overseeing the cash and credit functions, financial planning, and capital expenditures is the:

treasurer. b. director.
controller. d. chairman of the board.

1.2. The management of a firm’s short-term assets and liabilities is called:

working capital management. b. debt management.
equity management. d. capital budgeting.

1.3. Which one of the following is a capital budgeting decision?

determining how much debt should be borrowed from a particular lender
deciding whether or not to open a new store
deciding when to repay a long-term debt
determining how much inventory to keep on hand

1.4. The primary goal of the financial manager is

minimizing risk
maximizing profit
Maximizing value per share of existing stocks
minimizing return

1.5. Capital structure decisions include consideration of the:

amount of long-term debt to assume.
cost of acquiring funds.

III. current assets and liabilities.

net working capital.

I and II only b. II and III only
III and IV only d. I, II, and IV only

Financial Institutions & Financial Markets (Chapter 1.5~1.6)

Financial institutions (serving as intermediaries by channeling the savings of individuals, business, and governments into loans and investments.)
Types of Financial Intermediaries

Financial Institutions Categories	Primary Sources of Funds
Depository Institutions
Commercial banks	Individual savings
Savings and loan associations	Individual savings
Savings banks	Individual savings
Credit unions	Individual savings
Contractual Savings Organizations
Insurance companies	Premium paid on policies
Pension funds	Employee/employer contributions
Securities Firms
Investment companies & mutual funds	Individual savings (investments)
Investment banking firms	Other financial institutions
Brokerage firms	Other financial institutions

Financial markets
- Primary market vs. secondary market
- Money market vs. capital market
  - Money market securities: Treasury bills, commercial paper, negotiable certificates of deposits (NCDs)
  - Capital market securities: Treasury bonds, municipal bonds, corporate bonds, common stocks, preferred stocks
- Public offering vs. private placement
- Major stock exchanges
  - Organized security exchange (e.g., NYSE)
  - Over-the-counter exchange (OTC, e.g., NASDAQ)
- Derivative markets (e.g., stock options, foreign exchange futures)

Sample questions

2.1. By definition, the money market involves the buying and selling of

funds that mature in more than one year
flows of funds
stocks and bonds
short-term funds

2.2. A __________________ allows firms access to a specified amount of bank funds over a specified period of time.

line of credit term loan
debt security savings account

2.3. In November 1999 President Clinton signed legislation repealing the Glass-Steagall Act. The Glass-Steagall Act was Depression Era legislation designed to

require the integration of investment banking and insurance activities.
encourage the chartering of state banks.
severely limit the amount of funds held by a single mutual fund.
separate commercial banking from investment banking activities.

2.4. Which of the following are TRUE regarding preferred stock?

Common stock has priority over preferred stock when receiving dividends
Preferred stock is promised a fixed dividend payment
Preferred stock dividends are tax deductible for corporations
All of these are true regarding preferred stock

2.5. The largest and best known security exchange is the

American Stock Exchange (ASE).
Chicago Board of Trade (CBOT).
Pacific Stock Exchange (PSE).
New York Stock Exchange (NYSE).

More on Bonds and Stocks (Chapter 6.1 and 7.1)

Legal aspect of bond financing
The general features, ratings, popular types, and international issues of corporate bonds (risk and return tradeoff)
The rights and features of common stock
The rights and features of preferred stock
The role of the investment banker in securities offerings
Compare debt and equity capital (ownership interest, voting rights, claims on income and assets, tax deductibility, etc.)

Sample questions

3.1. A is a complex and lengthy legal document stating the conditions under which a bond has been issued.

sinking fund b. bond indenture
bond debenture d. warrant

3.2. A _____________ is a bond issued in a foreign country but denominated in the issuer’s domestic currency, and a ____________ is a bond issued in a foreign country and denominated in the foreign currency.

foreign bond; Eurobond eurobond; foreign bond
eurobond; Eurobond foreign bond; foreign bond

3.3. Corporate bonds which feature stock purchase warrants have

lower coupon interest rates because bondholders have the option to purchase more bonds at a specified price for a specified time.
higher coupon interest rates because bondholders have the option to purchase more bonds at a specified price for a specified time.
lower coupon interest rates because bondholders have the option to purchase shares of stock at a specified price for a specified time.
higher coupon interest rates because bondholders have the option to purchase shares of stock at a specified price for a specified time.

3.4. Which of the following best describes a junk bond?

The stated interest rate is adjusted periodically and they tend to sell at or close to par value.
Short maturities, usually 1 to 5 years, they can be renewed for similar periods at the option of the holder.
Debt rated BB or lower, they are high-risk bonds with high yields.
Bonds that can be redeemed for par at the option of their holder at specific dates after issue.

3.5. Preferred stockholders

are senior to bondholders.
are senior to common stockholders.
receive interest payments.
generally have “super” voting rights.

Interest Rate Fundamentals (Chapter 5.3 and Lecture Slides)

The risk-free rate of interest (R_F) reflects the real rate of interest (k^*) plus a premium (IP) to compensate investors for inflation (rising prices). R_F = k^*+IP
The nominal rate of interest (k_N) contain an inflation premium (IP) to compensate investors for inflation and a risk premium (RP) to compensate investors for issuer risk characteristics such as the risk of default.
The risk-free interest rate changes over time in response to changes in the supply of funds available and in the demand for funds.
Understand the term structure of interest rates (yield curve).
Risk premiums on debt securities should reflect the following: default risk, maturity risk (interest rate risk), liquidity risk, contractual provisions, and tax provisions
The returns required on risky assets (stocks and bonds) change over time in response to changes in the risk-free rate and/or in the risk premium required by investors

Sample questions

4.1. Your uncle would like to restrict his interest rate risk and his default risk, but he would still like to invest in corporate bonds. He would most likely invest in

AAA bonds with 10 years to maturity
BBB bonds with 10 years to maturity
AAA bonds with 5 years to maturity
BBB bonds with 5 years to maturity

4.2. The is/are a graphic depiction of the term structure of interest rates.

risk-return profile
aggregate demand curve
yield curve
supply and demand functions

4.3. The rate on 1-year Treasury notes is 5.50%, the rate on 10-year treasury bonds is 5.85%, and the rate on 10-year AAA rated corporate bonds is 6.60%. The approximate risk premium on the corporate bonds is

35%.
75%.
10%.
45%.

Use the following information to answer questions 4.4. and 4.5.

Security Yield

Risk-free long-term capital 6.7%

Grade AA long-term corporate bonds 8.0%

Grade BB long-term corporate bonds 9.4%

The S & P 500 stock index 13.5%

If inflation were to unexpectedly increase by 1%, then the rate on newly issued AA and BB corporate bonds would

be approximately 8.0% and 9.4%.
also increase by approximately 1% each.
decrease since the risk-free rate no longer covers expected inflation.
none of the above.

Among firms, who experiences the lowest average cost of long-term financing?

corporations with AA-rated debt
corporations with only equity financing
corporations with BB-rated debt
none of the above

Time Value of Money (Chapter 3.3~3.4, Chapter 4.1)

How to determine the future value of an investment made today.
How to determine the present value of cash to be received at a future date.
How to find the return on an investment.
How to determine the number of time periods.
How to determine the future and present value of investments with multiple cash flows.
Annuity and perpetuity

· Future Value and Compounding A future value (FV) is the amount of money an investment today (present value, or PV) will grow to over some period of time (n) at some given interest rate (r). The fundamental future value equation for multiple time periods is: FV = PV(1 + r)ⁿ, where n represents the number of time periods.

· Present Value and Discounting. The fundamental present value equation for multiple time periods is: PV = FV[1/(1 + r)ⁿ].

· Determining the Discount Rate. The basic PV equation contains four variables: present value (PV), future value (FV), discount rate (k), and the number of time periods (n). Given any three of these, we can always solve for the fourth. The implied interest rate in an investment is r= (FV / PV)^1/n – 1, or

· Finding the Number of Periods. Finding the number of periods is simply solving the basic PV or FV equation for n. .

· Future and Present Values of Multiple Cash Flows

- Future Value with Multiple Cash Flows The future value of a set of cash flows is equal to the sum of the future values of the individual flows.
- Present Value with Multiple Cash Flows Similarly, the present value of a set of cash flows is equal to the sum of the present values of the individual flows.
- A Note on Cash Flow Timing In solving time value problems, it is important to specify when each cash flow occurs: at the beginning each period, or at the end. Unless told otherwise, we generally assume cash flows occur at the end of each period.

Valuing Level Cash Flows: Annuities and Perpetuities

o Present Value for Annuity Cash Flows. The fundamental present value equation for an ordinary annuity is: Annuity Present Value = C (1 – 1/(1 + k)ⁿ)/k

o Future Value for Annuities. The fundamental future value equation for an ordinary annuity is: Annuity Future Value = C [(1 + k)ⁿ– 1]/k.

o A Note on Annuities Due. When payments occur at the beginning of each time period, we have an annuity due.

o Perpetuities. A perpetuity is an annuity where t is equal to infinity. Thepresent value of a perpetuity is C/k.

APR vs. EAR
- APR refers to Annual Percentage Rate
- EAR stands for Effective Annual Rate
Loan Amortization
- Pure Discount Loan: repay a single lump sum in the future
- Interest Only Loan: pay interest each period and repay the entire principal in the future
- Amortized Loan: repay parts of the loan amount over time

Sample questions

The future value technique uses ___________ to find the future value, and the present value technique uses ______________ to find the present value.

a) compounding; discounting
b) compounding; compounding
c) discounting; discounting
d) discounting; compounding

How much money will Elian have in three years if he places $1500 into a CD earning an annual interest rate of 6.5% compounded annually?

$1597.50
$1695.00
$1792.50
$1811.92

William has a choice of investing $2,500 for 5 years in CD #1 that pays 6% compounded annually or a CD #2 that pays 6.5% simple interest annually (meaning it does not pay interest on the interest). What will be the value of each investment at the end of five years?

#1, $3,250.00; #2, $3,312.50
#1, $3,250.00; #2, $3,425.22
#1, $3,345.56; #2, $3,312.50
#1, $3,345.56; #2, $3,425.22

Theo and Shauna want to make a down payment of $25,000 on a condominium when they retire in three years. If they can earn 8% on their investments, how much money do they need to invest today to have enough for the down payment?

$19,735.23
$19,845.81
$25,000.00
$31,492.80

5.5.You are considering a project with the following cash flows:

Year 1 Year 2 Year 3

$1,200 $1,800 $2,900

What is the present value of these cash flows, given a 9 percent discount rate?

a) $4,713.62

b) $4,855.27

c) $5,103.18

d) $5,292.25

5.6. An annuity stream of cash flow payments is a set of:

a) level cash flows occurring each time period for a fixed length of time.

b) level cash flows occurring each time period forever.

c) increasing cash flows occurring each time period for a fixed length of time.

d) increasing cash flows occurring each time period forever.

Marie has a $1,000,000 investment portfolio, and she wishes to spend $87,500 per year as an ordinary annuity. If the investment account earns 6% annually, how long will her portfolio last?