# Fight Finance

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Jan asks you for a loan. He wants $100 now and offers to pay you back$120 in 1 year. You can borrow and lend from the bank at an interest rate of 10% pa, given as an effective annual rate.

Ignore credit risk. Remember:

$$V_0 = \frac{V_t}{(1+r_\text{eff})^t}$$

Will you or Jan's deal?

Katya offers to pay you $10 at the end of every year for the next 5 years (t=1,2,3,4,5) if you pay her$50 now (t=0). You can borrow and lend from the bank at an interest rate of 10% pa, given as an effective annual rate.

Ignore credit risk.

Will you or Katya's deal?

The following equation is called the Dividend Discount Model (DDM), Gordon Growth Model or the perpetuity with growth formula: $$P_0 = \frac{ C_1 }{ r - g }$$

What is $g$? The value $g$ is the long term expected:

For a price of $13, Carla will sell you a share which will pay a dividend of$1 in one year and every year after that forever. The required return of the stock is 10% pa.

Would you like to Carla's share or politely ?

For a price of $6, Carlos will sell you a share which will pay a dividend of$1 in one year and every year after that forever. The required return of the stock is 10% pa.

Would you like to his share or politely ?

For a price of $102, Andrea will sell you a share which just paid a dividend of$10 yesterday, and is expected to pay dividends every year forever, growing at a rate of 5% pa.

So the next dividend will be $10(1+0.05)^1=10.50$ in one year from now, and the year after it will be $10(1+0.05)^2=11.025$ and so on.

The required return of the stock is 15% pa.

Would you like to the share or politely ?

For a price of $1040, Camille will sell you a share which just paid a dividend of$100, and is expected to pay dividends every year forever, growing at a rate of 5% pa.

So the next dividend will be $100(1+0.05)^1=105.00$, and the year after it will be $100(1+0.05)^2=110.25$ and so on.

The required return of the stock is 15% pa.

Would you like to the share or politely ?

For a price of $10.20 each, Renee will sell you 100 shares. Each share is expected to pay dividends in perpetuity, growing at a rate of 5% pa. The next dividend is one year away (t=1) and is expected to be$1 per share.

The required return of the stock is 15% pa.

Would you like to the shares or politely ?

For a price of $129, Joanne will sell you a share which is expected to pay a$30 dividend in one year, and a $10 dividend every year after that forever. So the stock's dividends will be$30 at t=1, $10 at t=2,$10 at t=3, and $10 forever onwards. The required return of the stock is 10% pa. Would you like to the share or politely ? For a price of$95, Sherylanne will sell you a share which is expected to pay its first dividend of $10 in 7 years (t=7), and will continue to pay the same$10 dividend every year after that forever.

The required return of the stock is 10% pa.

Would you like to the share or politely ?

For a price of $100, Vera will sell you a 2 year bond paying semi-annual coupons of 10% pa. The face value of the bond is$100. Other bonds with similar risk, maturity and coupon characteristics trade at a yield of 8% pa.

Would you like to her bond or politely ?

For a price of $100, Andrea will sell you a 2 year bond paying annual coupons of 10% pa. The face value of the bond is$100. Other bonds with the same risk, maturity and coupon characteristics trade at a yield of 6% pa.

Would you like to the bond or politely ?

For a price of $95, Nicole will sell you a 10 year bond paying semi-annual coupons of 8% pa. The face value of the bond is$100. Other bonds with the same risk, maturity and coupon characteristics trade at a yield of 8% pa.

Would you like to the bond or politely ?

A credit card offers an interest rate of 18% pa, compounding monthly.

Find the effective monthly rate, effective annual rate and the effective daily rate. Assume that there are 365 days in a year.

All answers are given in the same order:

$$r_\text{eff monthly} , r_\text{eff yearly} , r_\text{eff daily}$$

A three year bond has a face value of $100, a yield of 10% and a fixed coupon rate of 5%, paid semi-annually. What is its price? The following equation is the Dividend Discount Model, also known as the 'Gordon Growth Model' or the 'Perpetuity with growth' equation. $$p_{0} = \frac{c_1}{r_{\text{eff}} - g_{\text{eff}}}$$ What is the discount rate '$r_\text{eff}$' in this equation? You want to buy an apartment priced at$300,000. You have saved a deposit of $30,000. The bank has agreed to lend you the$270,000 as a fully amortising loan with a term of 25 years. The interest rate is 12% pa and is not expected to change.

What will be your monthly payments? Remember that mortgage loan payments are paid in arrears (at the end of the month).

Your friend wants to borrow $1,000 and offers to pay you back$100 in 6 months, with more $100 payments at the end of every month for another 11 months. So there will be twelve$100 payments in total. She says that 12 payments of $100 equals$1,200 so she's being generous.

If interest rates are 12% pa, given as an APR compounding monthly, what is the Net Present Value (NPV) of your friend's deal?

A fixed coupon bond was bought for $90 and paid its annual coupon of$3 one year later (at t=1 year). Just after the coupon was paid, the bond price was $92 (at t=1 year). What was the total return, capital return and income return? Calculate your answers as effective annual rates. The choices are given in the same order: $r_\text{total},r_\text{capital},r_\text{income}$. What is the NPV of the following series of cash flows when the discount rate is 10% given as an effective annual rate? The first payment of$90 is in 3 years, followed by payments every 6 months in perpetuity after that which shrink by 3% every 6 months. That is, the growth rate every 6 months is actually negative 3%, given as an effective 6 month rate. So the payment at $t=3.5$ years will be $90(1-0.03)^1=87.3$, and so on.

Bonds X and Y are issued by the same US company. Both bonds yield 10% pa, and they have the same face value ($100), maturity, seniority, and payment frequency. The only difference is that bond X and Y's coupon rates are 8 and 12% pa respectively. Which of the following statements is true? A European company just issued two bonds, a • 2 year zero coupon bond at a yield of 8% pa, and a • 3 year zero coupon bond at a yield of 10% pa. What is the company's forward rate over the third year (from t=2 to t=3)? Give your answer as an effective annual rate, which is how the above bond yields are quoted. A European bond paying annual coupons of 6% offers a yield of 10% pa. Convert the yield into an effective monthly rate, an effective annual rate and an effective daily rate. Assume that there are 365 days in a year. All answers are given in the same order: $$r_\text{eff, monthly} , r_\text{eff, yearly} , r_\text{eff, daily}$$ A 180-day Bank Accepted Bill has a face value of$1,000,000. The interest rate is 8% pa and there are 365 days in the year. What is its price now?

The following equation is the Dividend Discount Model, also known as the 'Gordon Growth Model' or the 'Perpetuity with growth' equation.

$$P_{0} = \frac{C_1}{r_{\text{eff}} - g_{\text{eff}}}$$

What would you call the expression $C_1/P_0$?

You want to buy an apartment priced at $300,000. You have saved a deposit of$30,000. The bank has agreed to lend you the $270,000 as an interest only loan with a term of 25 years. The interest rate is 12% pa and is not expected to change. What will be your monthly payments? Remember that mortgage payments are paid in arrears (at the end of the month). A share was bought for$20 (at t=0) and paid its annual dividend of $3 one year later (at t=1). Just after the dividend was paid, the share price was$16 (at t=1). What was the total return, capital return and income return? Calculate your answers as effective annual rates.

The choices are given in the same order: $r_\text{total},r_\text{capital},r_\text{income}$.

What is the NPV of the following series of cash flows when the discount rate is 5% given as an effective annual rate?

The first payment of $10 is in 4 years, followed by payments every 6 months forever after that which shrink by 2% every 6 months. That is, the growth rate every 6 months is actually negative 2%, given as an effective 6 month rate. So the payment at $t=4.5$ years will be $10(1-0.02)^1=9.80$, and so on. You really want to go on a back packing trip to Europe when you finish university. Currently you have$1,500 in the bank. Bank interest rates are 8% pa, given as an APR compounding per month. If the holiday will cost $2,000, how long will it take for your bank account to reach that amount? Bonds A and B are issued by the same company. They have the same face value, maturity, seniority and coupon payment frequency. The only difference is that bond A has a 5% coupon rate, while bond B has a 10% coupon rate. The yield curve is flat, which means that yields are expected to stay the same. Which bond would have the higher current price? A European company just issued two bonds, a • 1 year zero coupon bond at a yield of 8% pa, and a • 2 year zero coupon bond at a yield of 10% pa. What is the company's forward rate over the second year (from t=1 to t=2)? Give your answer as an effective annual rate, which is how the above bond yields are quoted. A stock pays annual dividends which are expected to continue forever. It just paid a dividend of$10. The growth rate in the dividend is 2% pa. You estimate that the stock's required return is 10% pa. Both the discount rate and growth rate are given as effective annual rates. Using the dividend discount model, what will be the share price?

If a project's net present value (NPV) is zero, then its internal rate of return (IRR) will be:

A two year Government bond has a face value of $100, a yield of 0.5% and a fixed coupon rate of 0.5%, paid semi-annually. What is its price? A stock is expected to pay the following dividends:  Cash Flows of a Stock Time (yrs) 0 1 2 3 4 ... Dividend ($) 0.00 1.00 1.05 1.10 1.15 ...

After year 4, the annual dividend will grow in perpetuity at 5% pa, so;

• the dividend at t=5 will be $1.15(1+0.05), • the dividend at t=6 will be$1.15(1+0.05)^2, and so on.

The required return on the stock is 10% pa. Both the growth rate and required return are given as effective annual rates. What is the current price of the stock?

A stock is expected to pay the following dividends:

 Cash Flows of a Stock Time (yrs) 0 1 2 3 4 ... Dividend ($) 0.00 1.00 1.05 1.10 1.15 ... After year 4, the annual dividend will grow in perpetuity at 5% pa, so; • the dividend at t=5 will be$1.15(1+0.05),
• the dividend at t=6 will be $1.15(1+0.05)^2, and so on. The required return on the stock is 10% pa. Both the growth rate and required return are given as effective annual rates. What will be the price of the stock in three and a half years (t = 3.5)? The following is the Dividend Discount Model (DDM) used to price stocks: $$P_0 = \frac{d_1}{r-g}$$ Assume that the assumptions of the DDM hold and that the time period is measured in years. Which of the following is equal to the expected dividend in 3 years, $d_3$? You just signed up for a 30 year interest-only mortgage with monthly payments of$3,000 per month. The interest rate is 6% pa which is not expected to change.

How much did you borrow? After 15 years, just after the 180th payment at that time, how much will be owing on the mortgage? The interest rate is still 6% and is not expected to change. Remember that the mortgage is interest-only and that mortgage payments are paid in arrears (at the end of the month).

A project to build a toll road will take 3 years to complete, costing three payments of $50 million, paid at the start of each year (at times 0, 1, and 2). After completion, the toll road will yield a constant$10 million at the end of each year forever with no costs. So the first payment will be at t=4.

The required return of the project is 10% pa given as an effective nominal rate. All cash flows are nominal.

What is the payback period?

The required return of a project is 10%, given as an effective annual rate. Assume that the cash flows shown in the table are paid all at once at the given point in time.

What is the Net Present Value (NPV) of the project?

 Project Cash Flows Time (yrs) Cash flow ($) 0 -100 1 0 2 121 The phone company Telstra have 2 mobile service plans on offer which both have the same amount of phone call, text message and internet data credit. Both plans have a contract length of 24 months and the monthly cost is payable in advance. The only difference between the two plans is that one is a: • 'Bring Your Own' (BYO) mobile service plan, costing$50 per month. There is no phone included in this plan. The other plan is a:
• 'Bundled' mobile service plan that comes with the latest smart phone, costing $71 per month. This plan includes the latest smart phone. Neither plan has any additional payments at the start or end. The only difference between the plans is the phone, so what is the implied cost of the phone as a present value? Assume that the discount rate is 2% per month given as an effective monthly rate, the same high interest rate on credit cards. The theory of fixed interest bond pricing is an application of the theory of Net Present Value (NPV). Also, a 'fairly priced' asset is not over- or under-priced. Buying or selling a fairly priced asset has an NPV of zero. Considering this, which of the following statements is NOT correct? In Australia, nominal yields on semi-annual coupon paying Government Bonds with 2 years until maturity are currently 2.83% pa. The inflation rate is currently 2.2% pa, given as an APR compounding per quarter. The inflation rate is not expected to change over the next 2 years. What is the real yield on these bonds, given as an APR compounding every 6 months? Most listed Australian companies pay dividends twice per year, the 'interim' and 'final' dividends, which are roughly 6 months apart. You are an equities analyst trying to value the company BHP. You decide to use the Dividend Discount Model (DDM) as a starting point, so you study BHP's dividend history and you find that BHP tends to pay the same interim and final dividend each year, and that both grow by the same rate. You expect BHP will pay a$0.55 interim dividend in six months and a $0.55 final dividend in one year. You expect each to grow by 4% next year and forever, so the interim and final dividends next year will be$0.572 each, and so on in perpetuity.

Assume BHP's cost of equity is 8% pa. All rates are quoted as nominal effective rates. The dividends are nominal cash flows and the inflation rate is 2.5% pa.

What is the current price of a BHP share?

A stock pays semi-annual dividends. It just paid a dividend of $10. The growth rate in the dividend is 1% every 6 months, given as an effective 6 month rate. You estimate that the stock's required return is 21% pa, as an effective annual rate. Using the dividend discount model, what will be the share price? A three year project's NPV is negative. The cash flows of the project include a negative cash flow at the very start and positive cash flows over its short life. The required return of the project is 10% pa. Select the most correct statement. A two year Government bond has a face value of$100, a yield of 2.5% pa and a fixed coupon rate of 0.5% pa, paid semi-annually. What is its price?

A stock is expected to pay the following dividends:

 Cash Flows of a Stock Time (yrs) 0 1 2 3 4 ... Dividend ($) 0.00 1.15 1.10 1.05 1.00 ... After year 4, the annual dividend will grow in perpetuity at -5% pa. Note that this is a negative growth rate, so the dividend will actually shrink. So, • the dividend at t=5 will be $1(1-0.05) = 0.95$, • the dividend at t=6 will be $1(1-0.05)^2 = 0.9025$, and so on. The required return on the stock is 10% pa. Both the growth rate and required return are given as effective annual rates. What is the current price of the stock? A stock is expected to pay the following dividends:  Cash Flows of a Stock Time (yrs) 0 1 2 3 4 ... Dividend ($) 0.00 1.15 1.10 1.05 1.00 ...

After year 4, the annual dividend will grow in perpetuity at -5% pa. Note that this is a negative growth rate, so the dividend will actually shrink. So,

• the dividend at t=5 will be $1(1-0.05) = 0.95$,
• the dividend at t=6 will be $1(1-0.05)^2 = 0.9025$, and so on.

The required return on the stock is 10% pa. Both the growth rate and required return are given as effective annual rates.

What will be the price of the stock in four and a half years (t = 4.5)?

Which of the following statements about risk free government bonds is NOT correct?

Hint: Total return can be broken into income and capital returns as follows:

\begin{aligned} r_\text{total} &= \frac{c_1}{p_0} + \frac{p_1-p_0}{p_0} \\ &= r_\text{income} + r_\text{capital} \end{aligned}

The capital return is the growth rate of the price.
The income return is the periodic cash flow. For a bond this is the coupon payment.

You just borrowed $400,000 in the form of a 25 year interest-only mortgage with monthly payments of$3,000 per month. The interest rate is 9% pa which is not expected to change.

You actually plan to pay more than the required interest payment. You plan to pay $3,300 in mortgage payments every month, which your mortgage lender allows. These extra payments will reduce the principal and the minimum interest payment required each month. At the maturity of the mortgage, what will be the principal? That is, after the last (300th) interest payment of$3,300 in 25 years, how much will be owing on the mortgage?

A project to build a toll bridge will take two years to complete, costing three payments of $100 million at the start of each year for the next three years, that is at t=0, 1 and 2. After completion, the toll bridge will yield a constant$50 million at the end of each year for the next 10 years. So the first payment will be at t=3 and the last at t=12. After the last payment at t=12, the bridge will be given to the government.

The required return of the project is 21% pa given as an effective annual nominal rate.

All cash flows are real and the expected inflation rate is 10% pa given as an effective annual rate. Ignore taxes.

The Net Present Value is:

The required return of a project is 10%, given as an effective annual rate. Assume that the cash flows shown in the table are paid all at once at the given point in time.

What is the Net Present Value (NPV) of the project?

 Project Cash Flows Time (yrs) Cash flow ($) 0 -100 1 11 2 121 The required return of a project is 10%, given as an effective annual rate. What is the payback period of the project in years? Assume that the cash flows shown in the table are received smoothly over the year. So the$121 at time 2 is actually earned smoothly from t=1 to t=2.

 Project Cash Flows Time (yrs) Cash flow ($) 0 -100 1 11 2 121 In Australia, domestic university students are allowed to buy concession tickets for the bus, train and ferry which sell at a discount of 50% to full-price tickets. The Australian Government do not allow international university students to buy concession tickets, they have to pay the full price. Some international students see this as unfair and they are willing to pay for fake university identification cards which have the concession sticker. What is the most that an international student would be willing to pay for a fake identification card? Assume that international students: • consider buying their fake card on the morning of the first day of university from their neighbour, just before they leave to take the train into university. • buy their weekly train tickets on the morning of the first day of each week. • ride the train to university and back home again every day seven days per week until summer holidays 40 weeks from now. The concession card only lasts for those 40 weeks. Assume that there are 52 weeks in the year for the purpose of interest rate conversion. • a single full-priced one-way train ride costs$5.
• have a discount rate of 11% pa, given as an effective annual rate.

Approach this question from a purely financial view point, ignoring the illegality, embarrassment and the morality of committing fraud.

The theory of fixed interest bond pricing is an application of the theory of Net Present Value (NPV). Also, a 'fairly priced' asset is not over- or under-priced. Buying or selling a fairly priced asset has an NPV of zero.

Considering this, which of the following statements is NOT correct?

In Germany, nominal yields on semi-annual coupon paying Government Bonds with 2 years until maturity are currently 0.04% pa.

The inflation rate is currently 1.4% pa, given as an APR compounding per quarter. The inflation rate is not expected to change over the next 2 years.

What is the real yield on these bonds, given as an APR compounding every 6 months?

Question 65  annuity with growth, needs refinement

Which of the below formulas gives the present value of an annuity with growth?

Hint: The equation of a perpetuity without growth is: $$V_\text{0, perp without growth} = \frac{C_\text{1}}{r}$$

The formula for the present value of an annuity without growth is derived from the formula for a perpetuity without growth.

The idea is than an annuity with T payments from t=1 to T inclusive is equivalent to a perpetuity starting at t=1 with fixed positive cash flows, plus a perpetuity starting T periods later (t=T+1) with fixed negative cash flows. The positive and negative cash flows after time period T cancel each other out, leaving the positive cash flows between t=1 to T, which is the annuity.

\begin{aligned} V_\text{0, annuity} &= V_\text{0, perp without growth from t=1} - V_\text{0, perp without growth from t=T+1} \\ &= \dfrac{C_\text{1}}{r} - \dfrac{ \left( \dfrac{C_\text{T+1}}{r} \right) }{(1+r)^T} \\ &= \dfrac{C_\text{1}}{r} - \dfrac{ \left( \dfrac{C_\text{1}}{r} \right) }{(1+r)^T} \\ &= \dfrac{C_\text{1}}{r}\left(1 - \dfrac{1}{(1+r)^T}\right) \\ \end{aligned}

The equation of a perpetuity with growth is:

$$V_\text{0, perp with growth} = \dfrac{C_\text{1}}{r-g}$$

Here are the Net Income (NI) and Cash Flow From Assets (CFFA) equations:

$$NI=(Rev-COGS-FC-Depr-IntExp).(1-t_c)$$

$$CFFA=NI+Depr-CapEx - \varDelta NWC+IntExp$$

What is the formula for calculating annual interest expense (IntExp) which is used in the equations above?

Select one of the following answers. Note that D is the value of debt which is constant through time, and $r_D$ is the cost of debt.

Due to floods overseas, there is a cut in the supply of the mineral iron ore and its price increases dramatically. An Australian iron ore mining company therefore expects a large but temporary increase in its profit and cash flows. The mining company does not have any positive NPV projects to begin, so what should it do? Select the most correct answer.

Government bonds currently have a return of 5%. A stock has a beta of 2 and the market return is 7%. What is the expected return of the stock?

The equations for Net Income (NI, also known as Earnings or Net Profit After Tax) and Cash Flow From Assets (CFFA, also known as Free Cash Flow to the Firm) per year are:

$$NI=(Rev-COGS-FC-Depr-IntExp).(1-t_c)$$

$$CFFA=NI+Depr-CapEx - \varDelta NWC+IntExp$$

For a firm with debt, what is the amount of the interest tax shield per year?

A company issues a large amount of bonds to raise money for new projects of similar risk to the company's existing projects. The net present value (NPV) of the new projects is positive but small. Assume a classical tax system. Which statement is NOT correct?

Treasury bonds currently have a return of 5% pa. A stock has a beta of 0.5 and the market return is 10% pa. What is the expected return of the stock?

You want to buy an apartment worth $500,000. You have saved a deposit of$50,000. The bank has agreed to lend you the $450,000 as a fully amortising mortgage loan with a term of 25 years. The interest rate is 6% pa and is not expected to change. What will be your monthly payments? Your friend just bought a house for$400,000. He financed it using a $320,000 mortgage loan and a deposit of$80,000.

In the context of residential housing and mortgages, the 'equity' tied up in the value of a person's house is the value of the house less the value of the mortgage. So the initial equity your friend has in his house is $80,000. Let this amount be E, let the value of the mortgage be D and the value of the house be V. So $V=D+E$. If house prices suddenly fall by 10%, what would be your friend's percentage change in equity (E)? Assume that the value of the mortgage is unchanged and that no income (rent) was received from the house during the short time over which house prices fell. Remember: $$r_{0\rightarrow1}=\frac{p_1-p_0+c_1}{p_0}$$ where $r_{0-1}$ is the return (percentage change) of an asset with price $p_0$ initially, $p_1$ one period later, and paying a cash flow of $c_1$ at time $t=1$. The equations for Net Income (NI, also known as Earnings or Net Profit After Tax) and Cash Flow From Assets (CFFA, also known as Free Cash Flow to the Firm) per year are: $$NI=(Rev-COGS-FC-Depr-IntExp).(1-t_c)$$ $$CFFA=NI+Depr-CapEx - \varDelta NWC+IntExp$$ For a firm with debt, what is the formula for the present value of interest tax shields if the tax shields occur in perpetuity? You may assume: • the value of debt (D) is constant through time, • The cost of debt and the yield on debt are equal and given by $r_D$. • the appropriate rate to discount interest tax shields is $r_D$. • $\text{IntExp}=D.r_D$ An Australian company just issued two bonds paying semi-annual coupons: • 1 year zero coupon bond at a yield of 8% pa, and a • 2 year zero coupon bond at a yield of 10% pa. What is the forward rate on the company's debt from years 1 to 2? Give your answer as an APR compounding every 6 months, which is how the above bond yields are quoted. An established mining firm announces that it expects large losses over the following year due to flooding which has temporarily stalled production at its mines. Which statement(s) are correct? (i) If the firm adheres to a full dividend payout policy it will not pay any dividends over the following year. (ii) If the firm wants to signal that the loss is temporary it will maintain the same level of dividends. It can do this so long as it has enough retained profits. (iii) By law, the firm will be unable to pay a dividend over the following year because it cannot pay a dividend when it makes a loss. Select the most correct response: A person is thinking about borrowing$100 from the bank at 7% pa and investing it in shares with an expected return of 10% pa. One year later the person will sell the shares and pay back the loan in full. Both the loan and the shares are fairly priced.

What is the Net Present Value (NPV) of this one year investment? Note that you are asked to find the present value ($V_0$), not the value in one year ($V_1$).

You want to buy an apartment worth $300,000. You have saved a deposit of$60,000.

The bank has agreed to lend you $240,000 as an interest only mortgage loan with a term of 30 years. The interest rate is 6% pa and is not expected to change. What will be your monthly payments? An Australian company just issued two bonds: • A 1 year zero coupon bond at a yield of 10% pa, and • A 2 year zero coupon bond at a yield of 8% pa. What is the forward rate on the company's debt from years 1 to 2? Give your answer as an APR compounding every 6 months, which is how the above bond yields are quoted. Question 109 credit rating, credit risk Bonds with lower (worse) credit ratings tend to have: The security market line (SML) shows the relationship between beta and expected return. Investment projects that plot above the SML would have: What is the Internal Rate of Return (IRR) of the project detailed in the table below? Assume that the cash flows shown in the table are paid all at once at the given point in time. All answers are given as effective annual rates.  Project Cash Flows Time (yrs) Cash flow ($) 0 -100 1 0 2 121

A zero coupon bond that matures in 6 months has a face value of $1,000. The firm that issued this bond is trying to forecast its income statement for the year. It needs to calculate the interest expense of the bond this year. The bond is highly illiquid and hasn't traded on the market. But the finance department have assessed the bond's fair value to be$950 and this is its book value right now at the start of the year.

Assume that:

• the firm uses the 'effective interest method' to calculate interest expense.
• the market value of the bond is the same as the book value.
• the firm is only interested in this bond's interest expense. Do not include the interest expense for a new bond issued to refinance the current one, as would normally happen.

What will be the interest expense of the bond this year for the purpose of forecasting the income statement?

An 'interest payment' is the same thing as a 'coupon payment'. or ?

An 'interest rate' is the same thing as a 'coupon rate'. or ?

An 'interest rate' is the same thing as a 'yield'. or ?

Calculate the effective annual rates of the following three APR's:

• A credit card offering an interest rate of 18% pa, compounding monthly.
• A bond offering a yield of 6% pa, compounding semi-annually.
• An annual dividend-paying stock offering a return of 10% pa compounding annually.

All answers are given in the same order:

$r_\text{credit card, eff yrly}$, $r_\text{bond, eff yrly}$, $r_\text{stock, eff yrly}$

A 90-day Bank Accepted Bill (BAB) has a face value of $1,000,000. The simple interest rate is 10% pa and there are 365 days in the year. What is its price now? A bond maturing in 10 years has a coupon rate of 4% pa, paid semi-annually. The bond's yield is currently 6% pa. The face value of the bond is$100. What is its price?

You want to buy an apartment worth $400,000. You have saved a deposit of$80,000. The bank has agreed to lend you the $320,000 as a fully amortising mortgage loan with a term of 30 years. The interest rate is 6% pa and is not expected to change. What will be your monthly payments? Your credit card shows a$600 debt liability. The interest rate is 24% pa, payable monthly. You can't pay any of the debt off, except in 6 months when it's your birthday and you'll receive $50 which you'll use to pay off the credit card. If that is your only repayment, how much will the credit card debt liability be one year from now? A stock was bought for$8 and paid a dividend of $0.50 one year later (at t=1 year). Just after the dividend was paid, the stock price was$7 (at t=1 year).

What were the total, capital and dividend returns given as effective annual rates? The choices are given in the same order:

$r_\text{total}$, $r_\text{capital}$, $r_\text{dividend}$.

The following cash flows are expected:

• 10 yearly payments of $60, with the first payment in 3 years from now (first payment at t=3 and last at t=12). • 1 payment of$400 in 5 years and 6 months (t=5.5) from now.

What is the NPV of the cash flows if the discount rate is 10% given as an effective annual rate?

Bonds A and B are issued by the same Australian company. Both bonds yield 7% pa, and they have the same face value ($100), maturity, seniority, and payment frequency. The only difference is that bond A pays coupons of 10% pa and bond B pays coupons of 5% pa. Which of the following statements is true about the bonds' prices? You're trying to save enough money to buy your first car which costs$2,500. You can save $100 at the end of each month starting from now. You currently have no money at all. You just opened a bank account with an interest rate of 6% pa payable monthly. How many months will it take to save enough money to buy the car? Assume that the price of the car will stay the same over time. When using the dividend discount model to price a stock: $$p_{0} = \frac{d_1}{r - g}$$ The growth rate of dividends (g): An Australian company just issued two bonds: • A 6-month zero coupon bond at a yield of 6% pa, and • A 12 month zero coupon bond at a yield of 7% pa. What is the company's forward rate from 6 to 12 months? Give your answer as an APR compounding every 6 months, which is how the above bond yields are quoted. A text book publisher is thinking of asking some teachers to write a new textbook at a cost of$100,000, payable now. The book would be written, printed and ready to sell to students in 2 years. It will be ready just before semester begins.

A cash flow of $100 would be made from each book sold, after all costs such as printing and delivery. There are 600 students per semester. Assume that every student buys a new text book. Remember that there are 2 semesters per year and students buy text books at the beginning of the semester. Assume that text book publishers will sell the books at the same price forever and that the number of students is constant. If the discount rate is 8% pa, given as an effective annual rate, what is the NPV of the project? A student just won the lottery. She won$1 million in cash after tax. She is trying to calculate how much she can spend per month for the rest of her life. She assumes that she will live for another 60 years. She wants to withdraw equal amounts at the beginning of every month, starting right now.

All of the cash is currently sitting in a bank account which pays interest at a rate of 6% pa, given as an APR compounding per month. On her last withdrawal, she intends to have nothing left in her bank account. How much can she withdraw at the beginning of each month?

A three year corporate bond yields 12% pa with a coupon rate of 10% pa, paid semi-annually.

Find the effective six month yield, effective annual yield and the effective daily yield. Assume that each month has 30 days and that there are 360 days in a year.

All answers are given in the same order:

$r_\text{eff semi-annual}$, $r_\text{eff yearly}$, $r_\text{eff daily}$.

A 30-day Bank Accepted Bill has a face value of $1,000,000. The interest rate is 8% pa and there are 365 days in the year. What is its price now? The following equation is the Dividend Discount Model, also known as the 'Gordon Growth Model' or the 'Perpetuity with growth' equation. $$p_0 = \frac{d_1}{r - g}$$ Which expression is NOT equal to the expected dividend yield? You want to buy an apartment priced at$500,000. You have saved a deposit of $50,000. The bank has agreed to lend you the$450,000 as a fully amortising loan with a term of 30 years. The interest rate is 6% pa and is not expected to change. What will be your monthly payments?

A share just paid its semi-annual dividend of $10. The dividend is expected to grow at 2% every 6 months forever. This 2% growth rate is an effective 6 month rate. Therefore the next dividend will be$10.20 in six months. The required return of the stock is 10% pa, given as an effective annual rate.

What is the price of the share now?

A share was bought for $30 (at t=0) and paid its annual dividend of$6 one year later (at t=1).

Just after the dividend was paid, the share price fell to $27 (at t=1). What were the total, capital and income returns given as effective annual rates? The choices are given in the same order: $r_\text{total}$ , $r_\text{capital}$ , $r_\text{dividend}$. The following cash flows are expected: • 10 yearly payments of$80, with the first payment in 3 years from now (first payment at t=3).
• 1 payment of $600 in 5 years and 6 months (t=5.5) from now. What is the NPV of the cash flows if the discount rate is 10% given as an effective annual rate? Bonds X and Y are issued by different companies, but they both pay a semi-annual coupon of 10% pa and they have the same face value ($100) and maturity (3 years).

The only difference is that bond X and Y's yields are 8 and 12% pa respectively. Which of the following statements is true?

You are a banker about to grant a 2 year loan to a customer. The loan's principal and interest will be repaid in a single payment at maturity, sometimes called a zero-coupon loan, discount loan or bullet loan.

You require a real return of 6% pa over the two years, given as an effective annual rate. Inflation is expected to be 2% this year and 4% next year, both given as effective annual rates.

You judge that the customer can afford to pay back $1,000,000 in 2 years, given as a nominal cash flow. How much should you lend to her right now? A 2 year government bond yields 5% pa with a coupon rate of 6% pa, paid semi-annually. Find the effective six month rate, effective annual rate and the effective daily rate. Assume that each month has 30 days and that there are 360 days in a year. All answers are given in the same order: $r_\text{eff semi-annual}$, $r_\text{eff yrly}$, $r_\text{eff daily}$. A 90-day Bank Accepted Bill has a face value of$1,000,000. The interest rate is 6% pa and there are 365 days in the year. What is its price?

The following equation is the Dividend Discount Model, also known as the 'Gordon Growth Model' or the 'Perpetuity with growth' equation.

$$p_0=\frac{d_1}{r_\text{eff}-g_\text{eff}}$$

Which expression is NOT equal to the expected capital return?

A three year bond has a fixed coupon rate of 12% pa, paid semi-annually. The bond's yield is currently 6% pa. The face value is $100. What is its price? You want to buy an apartment priced at$500,000. You have saved a deposit of $50,000. The bank has agreed to lend you the$450,000 as an interest only loan with a term of 30 years. The interest rate is 6% pa and is not expected to change. What will be your monthly payments?

A share just paid its semi-annual dividend of $10. The dividend is expected to grow at 2% every 6 months forever. This 2% growth rate is an effective 6 month rate. Therefore the next dividend will be$10.20 in six months. The required return of the stock 10% pa, given as an effective annual rate.

What is the price of the share now?

A share was bought for $10 (at t=0) and paid its annual dividend of$0.50 one year later (at t=1). Just after the dividend was paid, the share price was $11 (at t=1). What was the total return, capital return and income return? Calculate your answers as effective annual rates. The choices are given in the same order: $r_\text{total}$, $r_\text{capital}$, $r_\text{dividend}$. Bonds X and Y are issued by different companies, but they both pay a semi-annual coupon of 10% pa and they have the same face value ($100), maturity (3 years) and yield (10%) as each other.

Which of the following statements is true?

For certain shares, the forward-looking Price-Earnings Ratio ($P_0/EPS_1$) is equal to the inverse of the share's total expected return ($1/r_\text{total}$). For what shares is this true?

Use the general accounting definition of 'payout ratio' which is dividends per share (DPS) divided by earnings per share (EPS) and assume that all cash flows, earnings and rates are real rather than nominal.

A company's forward-looking PE ratio will be the inverse of its total expected return on equity when it has a:

A stock pays annual dividends. It just paid a dividend of $3. The growth rate in the dividend is 4% pa. You estimate that the stock's required return is 10% pa. Both the discount rate and growth rate are given as effective annual rates. Using the dividend discount model, what will be the share price? A project's net present value (NPV) is negative. Select the most correct statement. A four year bond has a face value of$100, a yield of 6% and a fixed coupon rate of 12%, paid semi-annually. What is its price?

A stock is expected to pay the following dividends:

 Cash Flows of a Stock Time (yrs) 0 1 2 3 4 ... Dividend ($) 8 8 8 20 8 ... After year 4, the dividend will grow in perpetuity at 4% pa. The required return on the stock is 10% pa. Both the growth rate and required return are given as effective annual rates. What is the current price of the stock? A stock is expected to pay the following dividends:  Cash Flows of a Stock Time (yrs) 0 1 2 3 4 ... Dividend ($) 8 8 8 20 8 ...

After year 4, the dividend will grow in perpetuity at 4% pa. The required return on the stock is 10% pa. Both the growth rate and required return are given as effective annual rates.

What will be the price of the stock in 5 years (t = 5), just after the dividend at that time has been paid?

The following is the Dividend Discount Model used to price stocks:

$$p_0=\frac{d_1}{r-g}$$

Which of the following statements about the Dividend Discount Model is NOT correct?

You just signed up for a 30 year fully amortising mortgage loan with monthly payments of $2,000 per month. The interest rate is 9% pa which is not expected to change. How much did you borrow? After 5 years, how much will be owing on the mortgage? The interest rate is still 9% and is not expected to change. Find Candys Corporation's Cash Flow From Assets (CFFA), also known as Free Cash Flow to the Firm (FCFF), over the year ending 30th June 2013.  Candys Corp Income Statement for year ending 30th June 2013$m Sales 200 COGS 50 Operating expense 10 Depreciation 20 Interest expense 10 Income before tax 110 Tax at 30% 33 Net income 77
 Candys Corp Balance Sheet as at 30th June 2013 2012 $m$m Assets Current assets 220 180 PPE Cost 300 340 Accumul. depr. 60 40 Carrying amount 240 300 Total assets 460 480 Liabilities Current liabilities 175 190 Non-current liabilities 135 130 Owners' equity Retained earnings 50 60 Contributed equity 100 100 Total L and OE 460 480

Note: all figures are given in millions of dollars ($m). A project has the following cash flows. Normally cash flows are assumed to happen at the given time. But here, assume that the cash flows are received smoothly over the year. So the$250 at time 2 is actually earned smoothly from t=1 to t=2:

 Project Cash Flows Time (yrs) Cash flow ($) 0 -400 1 200 2 250 What is the payback period of the project in years? Why is Capital Expenditure (CapEx) subtracted in the Cash Flow From Assets (CFFA) formula? $$CFFA=NI+Depr-CapEx - \Delta NWC+IntExp$$ Which one of the following bonds is trading at a discount? A firm wishes to raise$20 million now. They will issue 8% pa semi-annual coupon bonds that will mature in 5 years and have a face value of $100 each. Bond yields are 6% pa, given as an APR compounding every 6 months, and the yield curve is flat. How many bonds should the firm issue? A stock pays annual dividends. It just paid a dividend of$5. The growth rate in the dividend is 1% pa. You estimate that the stock's required return is 8% pa. Both the discount rate and growth rate are given as effective annual rates.

Using the dividend discount model, what will be the share price?

A project's NPV is positive. Select the most correct statement:

A five year bond has a face value of $100, a yield of 12% and a fixed coupon rate of 6%, paid semi-annually. What is the bond's price? A stock is expected to pay the following dividends:  Cash Flows of a Stock Time (yrs) 0 1 2 3 4 ... Dividend ($) 2 2 2 10 3 ...

After year 4, the dividend will grow in perpetuity at 4% pa. The required return on the stock is 10% pa. Both the growth rate and required return are given as effective annual rates.

What is the current price of the stock?

A stock is expected to pay the following dividends:

 Cash Flows of a Stock Time (yrs) 0 1 2 3 4 ... Dividend ($) 2 2 2 10 3 ... After year 4, the dividend will grow in perpetuity at 4% pa. The required return on the stock is 10% pa. Both the growth rate and required return are given as effective annual rates. What will be the price of the stock in 5 years (t = 5), just after the dividend at that time has been paid? The following is the Dividend Discount Model used to price stocks: $$p_0=\frac{d_1}{r-g}$$ All rates are effective annual rates and the cash flows ($d_1$) are received every year. Note that the r and g terms in the above DDM could also be labelled as below: $$r = r_{\text{total, 0}\rightarrow\text{1yr, eff 1yr}}$$ $$g = r_{\text{capital, 0}\rightarrow\text{1yr, eff 1yr}}$$ Which of the following statements is NOT correct? You just signed up for a 30 year fully amortising mortgage with monthly payments of$1,000 per month. The interest rate is 6% pa which is not expected to change.

How much did you borrow? After 20 years, how much will be owing on the mortgage? The interest rate is still 6% and is not expected to change.

Find Trademark Corporation's Cash Flow From Assets (CFFA), also known as Free Cash Flow to the Firm (FCFF), over the year ending 30th June 2013.

 Trademark Corp Income Statement for year ending 30th June 2013 $m Sales 100 COGS 25 Operating expense 5 Depreciation 20 Interest expense 20 Income before tax 30 Tax at 30% 9 Net income 21  Trademark Corp Balance Sheet as at 30th June 2013 2012$m $m Assets Current assets 120 80 PPE Cost 150 140 Accumul. depr. 60 40 Carrying amount 90 100 Total assets 210 180 Liabilities Current liabilities 75 65 Non-current liabilities 75 55 Owners' equity Retained earnings 10 10 Contributed equity 50 50 Total L and OE 210 180 Note: all figures are given in millions of dollars ($m).

A project has the following cash flows:

 Project Cash Flows Time (yrs) Cash flow ($) 0 -400 1 0 2 500 The required return on the project is 10%, given as an effective annual rate. What is the Internal Rate of Return (IRR) of this project? The following choices are effective annual rates. Assume that the cash flows shown in the table are paid all at once at the given point in time. A project has the following cash flows:  Project Cash Flows Time (yrs) Cash flow ($) 0 -400 1 0 2 500

What is the payback period of the project in years?

Normally cash flows are assumed to happen at the given time. But here, assume that the cash flows are received smoothly over the year. So the $500 at time 2 is actually earned smoothly from t=1 to t=2. Which one of the following bonds is trading at par? A firm wishes to raise$8 million now. They will issue 7% pa semi-annual coupon bonds that will mature in 10 years and have a face value of $100 each. Bond yields are 10% pa, given as an APR compounding every 6 months, and the yield curve is flat. How many bonds should the firm issue? A share pays annual dividends. It just paid a dividend of$2. The growth rate in the dividend is 3% pa. You estimate that the stock's required return is 8% pa. Both the discount rate and growth rate are given as effective annual rates.

Using the dividend discount model, what is the share price?

A highly leveraged risky firm is trying to raise more debt. The types of debt being considered, in no particular order, are senior bonds, junior bonds, bank accepted bills, promissory notes and bank loans.

Which of these forms of debt is the safest from the perspective of the debt investors who are thinking of investing in the firm's new debt?

A stock is expected to pay the following dividends:

 Cash Flows of a Stock Time (yrs) 0 1 2 3 4 ... Dividend ($) 0 6 12 18 20 ... After year 4, the dividend will grow in perpetuity at 5% pa. The required return of the stock is 10% pa. Both the growth rate and required return are given as effective annual rates. What is the current price of the stock? A stock is expected to pay the following dividends:  Cash Flows of a Stock Time (yrs) 0 1 2 3 4 ... Dividend ($) 0 6 12 18 20 ...

After year 4, the dividend will grow in perpetuity at 5% pa. The required return of the stock is 10% pa. Both the growth rate and required return are given as effective annual rates.

What will be the price of the stock in 7 years (t = 7), just after the dividend at that time has been paid?

A stock is expected to pay the following dividends:

 Cash Flows of a Stock Time (yrs) 0 1 2 3 4 ... Dividend ($) 0 6 12 18 20 ... After year 4, the dividend will grow in perpetuity at 5% pa. The required return of the stock is 10% pa. Both the growth rate and required return are given as effective annual rates. If all of the dividends since time period zero were deposited into a bank account yielding 8% pa as an effective annual rate, how much money will be in the bank account in 2.5 years (in other words, at t=2.5)? The following is the Dividend Discount Model (DDM) used to price stocks: $$P_0=\dfrac{C_1}{r-g}$$ If the assumptions of the DDM hold, which one of the following statements is NOT correct? The long term expected: Currently, a mining company has a share price of$6 and pays constant annual dividends of $0.50. The next dividend will be paid in 1 year. Suddenly and unexpectedly the mining company announces that due to higher than expected profits, all of these windfall profits will be paid as a special dividend of$0.30 in 1 year.

If investors believe that the windfall profits and dividend is a one-off event, what will be the new share price? If investors believe that the additional dividend is actually permanent and will continue to be paid, what will be the new share price? Assume that the required return on equity is unchanged. Choose from the following, where the first share price includes the one-off increase in earnings and dividends for the first year only $(P_\text{0 one-off})$ , and the second assumes that the increase is permanent $(P_\text{0 permanent})$:

Note: When a firm makes excess profits they sometimes pay them out as special dividends. Special dividends are just like ordinary dividends but they are one-off and investors do not expect them to continue, unlike ordinary dividends which are expected to persist.

You just signed up for a 30 year fully amortising mortgage loan with monthly payments of $1,500 per month. The interest rate is 9% pa which is not expected to change. How much did you borrow? After 10 years, how much will be owing on the mortgage? The interest rate is still 9% and is not expected to change. You just signed up for a 30 year fully amortising mortgage loan with monthly payments of$1,500 per month. The interest rate is 9% pa which is not expected to change.

To your surprise, you can actually afford to pay $2,000 per month and your mortgage allows early repayments without fees. If you maintain these higher monthly payments, how long will it take to pay off your mortgage? Interest expense (IntExp) is an important part of a company's income statement (or 'profit and loss' or 'statement of financial performance'). How does an accountant calculate the annual interest expense of a fixed-coupon bond that has a liquid secondary market? Select the most correct answer: Annual interest expense is equal to: For a bond that pays fixed semi-annual coupons, how is the annual coupon rate defined, and how is the bond's annual income yield from time 0 to 1 defined mathematically? Let: $P_0$ be the bond price now, $F_T$ be the bond's face value, $T$ be the bond's maturity in years, $r_\text{total}$ be the bond's total yield, $r_\text{income}$ be the bond's income yield, $r_\text{capital}$ be the bond's capital yield, and $C_t$ be the bond's coupon at time t in years. So $C_{0.5}$ is the coupon in 6 months, $C_1$ is the coupon in 1 year, and so on. Find UniBar Corp's Cash Flow From Assets (CFFA), also known as Free Cash Flow to the Firm (FCFF), over the year ending 30th June 2013.  UniBar Corp Income Statement for year ending 30th June 2013$m Sales 80 COGS 40 Operating expense 15 Depreciation 10 Interest expense 5 Income before tax 10 Tax at 30% 3 Net income 7
 UniBar Corp Balance Sheet as at 30th June 2013 2012 $m$m Assets Current assets 120 90 PPE Cost 360 320 Accumul. depr. 40 30 Carrying amount 320 290 Total assets 440 380 Liabilities Current liabilities 110 60 Non-current liabilities 190 180 Owners' equity Retained earnings 95 95 Contributed equity 45 45 Total L and OE 440 380

Note: all figures are given in millions of dollars ($m). Find Piano Bar's Cash Flow From Assets (CFFA), also known as Free Cash Flow to the Firm (FCFF), over the year ending 30th June 2013.  Piano Bar Income Statement for year ending 30th June 2013$m Sales 310 COGS 185 Operating expense 20 Depreciation 15 Interest expense 10 Income before tax 80 Tax at 30% 24 Net income 56
 Piano Bar Balance Sheet as at 30th June 2013 2012 $m$m Assets Current assets 240 230 PPE Cost 420 400 Accumul. depr. 50 35 Carrying amount 370 365 Total assets 610 595 Liabilities Current liabilities 180 190 Non-current liabilities 290 265 Owners' equity Retained earnings 90 90 Contributed equity 50 50 Total L and OE 610 595

Note: all figures are given in millions of dollars ($m). Assume that the Gordon Growth Model (same as the dividend discount model or perpetuity with growth formula) is an appropriate method to value real estate. The rule of thumb in the real estate industry is that properties should yield a 5% pa rental return. Many investors also regard property to be as risky as the stock market, therefore property is thought to have a required total return of 9% pa which is the average total return on the stock market including dividends. Assume that all returns are effective annual rates and they are nominal (not reduced by inflation). Inflation is expected to be 2% pa. You're considering purchasing an investment property which has a rental yield of 5% pa and you expect it to have the same risk as the stock market. Select the most correct statement about this property. The coupon rate of a fixed annual-coupon bond is constant (always the same). What can you say about the income return ($r_\text{income}$) of a fixed annual coupon bond? Remember that: $$r_\text{total} = r_\text{income} + r_\text{capital}$$ $$r_\text{total, 0 to 1} = \frac{c_1}{p_0} + \frac{p_1-p_0}{p_0}$$ Assume that there is no change in the bond's total annual yield to maturity from when it is issued to when it matures. Select the most correct statement. From its date of issue until maturity, the income return of a fixed annual coupon: A stock just paid its annual dividend of$9. The share price is $60. The required return of the stock is 10% pa as an effective annual rate. What is the implied growth rate of the dividend per year? A stock is expected to pay a dividend of$15 in one year (t=1), then $25 for 9 years after that (payments at t=2 ,3,...10), and on the 11th year (t=11) the dividend will be 2% less than at t=10, and will continue to shrink at the same rate every year after that forever. The required return of the stock is 10%. All rates are effective annual rates. What is the price of the stock now? A project has the following cash flows. Normally cash flows are assumed to happen at the given time. But here, assume that the cash flows are received smoothly over the year. So the$105 at time 2 is actually earned smoothly from t=1 to t=2:

 Project Cash Flows Time (yrs) Cash flow ($) 0 -90 1 30 2 105 What is the payback period of the project in years? You just agreed to a 30 year fully amortising mortgage loan with monthly payments of$2,500. The interest rate is 9% pa which is not expected to change.

How much did you borrow? After 10 years, how much will be owing on the mortgage? The interest rate is still 9% and is not expected to change. The below choices are given in the same order.

Cash Flow From Assets (CFFA) can be defined as:

A firm has forecast its Cash Flow From Assets (CFFA) for this year and management is worried that it is too low. Which one of the following actions will lead to a higher CFFA for this year (t=0 to 1)? Only consider cash flows this year. Do not consider cash flows after one year, or the change in the NPV of the firm. Consider each action in isolation.

Find World Bar's Cash Flow From Assets (CFFA), also known as Free Cash Flow to the Firm (FCFF), over the year ending 30th June 2013.

 World Bar Income Statement for year ending 30th June 2013 $m Sales 300 COGS 150 Operating expense 50 Depreciation 40 Interest expense 10 Taxable income 50 Tax at 30% 15 Net income 35  World Bar Balance Sheet as at 30th June 2013 2012$m $m Assets Current assets 200 230 PPE Cost 400 400 Accumul. depr. 75 35 Carrying amount 325 365 Total assets 525 595 Liabilities Current liabilities 150 205 Non-current liabilities 235 250 Owners' equity Retained earnings 100 100 Contributed equity 40 40 Total L and OE 525 595 Note: all figures above and below are given in millions of dollars ($m).

A very low-risk stock just paid its semi-annual dividend of $0.14, as it has for the last 5 years. You conservatively estimate that from now on the dividend will fall at a rate of 1% every 6 months. If the stock currently sells for$3 per share, what must be its required total return as an effective annual rate?

If risk free government bonds are trading at a yield of 4% pa, given as an effective annual rate, would you consider buying or selling the stock?

The stock's required total return is:

An investor bought two fixed-coupon bonds issued by the same company, a zero-coupon bond and a 7% pa semi-annual coupon bond. Both bonds have a face value of $1,000, mature in 10 years, and had a yield at the time of purchase of 8% pa. A few years later, yields fell to 6% pa. Which of the following statements is correct? Note that a capital gain is an increase in price. A firm wishes to raise$10 million now. They will issue 6% pa semi-annual coupon bonds that will mature in 8 years and have a face value of $1,000 each. Bond yields are 10% pa, given as an APR compounding every 6 months, and the yield curve is flat. How many bonds should the firm issue? A fairly priced stock has a beta that is the same as the market portfolio's beta. Treasury bonds yield 5% pa and the market portfolio's expected return is 10% pa. What is the expected return of the stock? A stock has a beta of 0.5. Its next dividend is expected to be$3, paid one year from now. Dividends are expected to be paid annually and grow by 2% pa forever. Treasury bonds yield 5% pa and the market portfolio's expected return is 10% pa. All returns are effective annual rates.

What is the price of the stock now?

A four year bond has a face value of $100, a yield of 9% and a fixed coupon rate of 6%, paid semi-annually. What is its price? An 'interest only' loan can also be called a: The security market line (SML) shows the relationship between beta and expected return. Investment projects that plot on the SML would have: Diversification in a portfolio of two assets works best when the correlation between their returns is: A company increases the proportion of debt funding it uses to finance its assets by issuing bonds and using the cash to repurchase stock, leaving assets unchanged. Ignoring the costs of financial distress, which of the following statements is NOT correct: A bank grants a borrower an interest-only residential mortgage loan with a very large 50% deposit and a nominal interest rate of 6% that is not expected to change. Assume that inflation is expected to be a constant 2% pa over the life of the loan. Ignore credit risk. From the bank's point of view, what is the long term expected nominal capital return of the loan asset? The total return of any asset can be broken down in different ways. One possible way is to use the dividend discount model (or Gordon growth model): $$p_0 = \frac{c_1}{r_\text{total}-r_\text{capital}}$$ Which, since $c_1/p_0$ is the income return ($r_\text{income}$), can be expressed as: $$r_\text{total}=r_\text{income}+r_\text{capital}$$ So the total return of an asset is the income component plus the capital or price growth component. Another way to break up total return is to use the Capital Asset Pricing Model: $$r_\text{total}=r_\text{f}+β(r_\text{m}- r_\text{f})$$ $$r_\text{total}=r_\text{time value}+r_\text{risk premium}$$ So the risk free rate is the time value of money and the term $β(r_\text{m}- r_\text{f})$ is the compensation for taking on systematic risk. Using the above theory and your general knowledge, which of the below equations, if any, are correct? (I) $r_\text{income}=r_\text{time value}$ (II) $r_\text{income}=r_\text{risk premium}$ (III) $r_\text{capital}=r_\text{time value}$ (IV) $r_\text{capital}=r_\text{risk premium}$ (V) $r_\text{income}+r_\text{capital}=r_\text{time value}+r_\text{risk premium}$ Which of the equations are correct? Your neighbour asks you for a loan of$100 and offers to pay you back $120 in one year. You don't actually have any money right now, but you can borrow and lend from the bank at a rate of 10% pa. Rates are given as effective annual rates. Assume that your neighbour will definitely pay you back. Ignore interest tax shields and transaction costs. The Net Present Value (NPV) of lending to your neighbour is$9.09. Describe what you would do to actually receive a $9.09 cash flow right now with zero net cash flows in the future. You have$100,000 in the bank. The bank pays interest at 10% pa, given as an effective annual rate.

You wish to consume an equal amount now (t=0) and in one year (t=1) and have nothing left in the bank at the end (t=1).

How much can you consume at each time?

You have $100,000 in the bank. The bank pays interest at 10% pa, given as an effective annual rate. You wish to consume an equal amount now (t=0), in one year (t=1) and in two years (t=2), and still have$50,000 in the bank after that (t=2).

How much can you consume at each time?

You just started work at your new job which pays $48,000 per year. The human resources department have given you the option of being paid at the end of every week or every month. Assume that there are 4 weeks per month, 12 months per year and 48 weeks per year. Bank interest rates are 12% pa given as an APR compounding per month. What is the dollar gain over one year, as a net present value, of being paid every week rather than every month? Your main expense is fuel for your car which costs$100 per month. You just refueled, so you won't need any more fuel for another month (first payment at t=1 month).

You have $2,500 in a bank account which pays interest at a rate of 6% pa, payable monthly. Interest rates are not expected to change. Assuming that you have no income, in how many months time will you not have enough money to fully refuel your car? In these tough economic times, central banks around the world have cut interest rates so low that they are practically zero. In some countries, government bond yields are also very close to zero. A three year government bond with a face value of$100 and a coupon rate of 2% pa paid semi-annually was just issued at a yield of 0%. What is the price of the bond?

A 2 year corporate bond yields 3% pa with a coupon rate of 5% pa, paid semi-annually.

Find the effective monthly rate, effective six month rate, and effective annual rate.

$r_\text{eff monthly}$, $r_\text{eff 6 month}$, $r_\text{eff annual}$.

A 10 year bond has a face value of $100, a yield of 6% pa and a fixed coupon rate of 8% pa, paid semi-annually. What is its price? A 60-day Bank Accepted Bill has a face value of$1,000,000. The interest rate is 8% pa and there are 365 days in the year. What is its price now?

You want to buy a house priced at $400,000. You have saved a deposit of$40,000. The bank has agreed to lend you $360,000 as a fully amortising loan with a term of 30 years. The interest rate is 8% pa payable monthly and is not expected to change. What will be your monthly payments? A share just paid its semi-annual dividend of$5. The dividend is expected to grow at 1% every 6 months forever. This 1% growth rate is an effective 6 month rate.

Therefore the next dividend will be $5.05 in six months. The required return of the stock 8% pa, given as an effective annual rate. What is the price of the share now? A share was bought for$4 and paid an dividend of $0.50 one year later (at t=1 year). Just after the dividend was paid, the share price fell to$3.50 (at t=1 year). What were the total return, capital return and income returns given as effective annual rates? The answer choices are given in the same order:

$r_\text{total}$, $r_\text{capital}$, $r_\text{income}$

A 90-day $1 million Bank Accepted Bill (BAB) was bought for$990,000 and sold 30 days later for $996,000 (at t=30 days). What was the total return, capital return and income return over the 30 days it was held? Despite the fact that money market instruments such as bills are normally quoted with simple interest rates, please calculate your answers as compound interest rates, specifically, as effective 30-day rates, which is how the below answer choices are listed. $r_\text{total}$, $r_\text{capital}$, $r_\text{income}$ A company's shares just paid their annual dividend of$2 each.

The stock price is now $40 (just after the dividend payment). The annual dividend is expected to grow by 3% every year forever. The assumptions of the dividend discount model are valid for this company. What do you expect the effective annual dividend yield to be in 3 years (dividend yield from t=3 to t=4)? The following equation is the Dividend Discount Model, also known as the 'Gordon Growth Model' or the 'Perpetuity with growth' equation. $$P_0=\frac{d_1}{r-g}$$ A stock pays dividends annually. It just paid a dividend, but the next dividend ($d_1$) will be paid in one year. According to the DDM, what is the correct formula for the expected price of the stock in 2.5 years? On his 20th birthday, a man makes a resolution. He will deposit$30 into a bank account at the end of every month starting from now, which is the start of the month. So the first payment will be in one month. He will write in his will that when he dies the money in the account should be given to charity.

The bank account pays interest at 6% pa compounding monthly, which is not expected to change.

If the man lives for another 60 years, how much money will be in the bank account if he dies just after making his last (720th) payment?

Bonds X and Y are issued by the same company. Both bonds yield 10% pa, and they have the same face value ($100), maturity, seniority, and payment frequency. The only difference is that bond X pays coupons of 6% pa and bond Y pays coupons of 8% pa. Which of the following statements is true? A European company just issued two bonds, a • 3 year zero coupon bond at a yield of 6% pa, and a • 4 year zero coupon bond at a yield of 6.5% pa. What is the company's forward rate over the fourth year (from t=3 to t=4)? Give your answer as an effective annual rate, which is how the above bond yields are quoted. You're trying to save enough money for a deposit to buy a house. You want to buy a house worth$400,000 and the bank requires a 20% deposit ($80,000) before it will give you a loan for the other$320,000 that you need.

You currently have no savings, but you just started working and can save $2,000 per month, with the first payment in one month from now. Bank interest rates on savings accounts are 4.8% pa with interest paid monthly and interest rates are not expected to change. How long will it take to save the$80,000 deposit? Round your answer up to the nearest month.

A student won $1m in a lottery. Currently the money is in a bank account which pays interest at 6% pa, given as an APR compounding per month. She plans to spend$20,000 at the beginning of every month from now on (so the first withdrawal will be at t=0). After each withdrawal, she will check how much money is left in the account. When there is less than $500,000 left, she will donate that remaining amount to charity. In how many months will she make her last withdrawal and donate the remainder to charity? You own an apartment which you rent out as an investment property. What is the price of the apartment using discounted cash flow (DCF, same as NPV) valuation? Assume that: • You just signed a contract to rent the apartment out to a tenant for the next 12 months at$2,000 per month, payable in advance (at the start of the month, t=0). The tenant is just about to pay you the first $2,000 payment. • The contract states that monthly rental payments are fixed for 12 months. After the contract ends, you plan to sign another contract but with rental payment increases of 3%. You intend to do this every year. So rental payments will increase at the start of the 13th month (t=12) to be$2,060 (=2,000(1+0.03)), and then they will be constant for the next 12 months.
Rental payments will increase again at the start of the 25th month (t=24) to be $2,121.80 (=2,000(1+0.03)2), and then they will be constant for the next 12 months until the next year, and so on. • The required return of the apartment is 8.732% pa, given as an effective annual rate. • Ignore all taxes, maintenance, real estate agent, council and strata fees, periods of vacancy and other costs. Assume that the apartment will last forever and so will the rental payments. Suppose you had$100 in a savings account and the interest rate was 2% per year.

After 5 years, how much do you think you would have in the account if you left the money to grow?

than $102,$102 or than $102? Value the following business project to manufacture a new product.  Project Data Project life 2 yrs Initial investment in equipment$6m Depreciation of equipment per year $3m Expected sale price of equipment at end of project$0.6m Unit sales per year 4m Sale price per unit $8 Variable cost per unit$5 Fixed costs per year, paid at the end of each year $1m Interest expense per year 0 Tax rate 30% Weighted average cost of capital after tax per annum 10% Notes 1. The firm's current assets and current liabilities are$3m and $2m respectively right now. This net working capital will not be used in this project, it will be used in other unrelated projects. Due to the project, current assets (mostly inventory) will grow by$2m initially (at t = 0), and then by $0.2m at the end of the first year (t=1). Current liabilities (mostly trade creditors) will increase by$0.1m at the end of the first year (t=1).
At the end of the project, the net working capital accumulated due to the project can be sold for the same price that it was bought.
2. The project cost $0.5m to research which was incurred one year ago. Assumptions • All cash flows occur at the start or end of the year as appropriate, not in the middle or throughout the year. • All rates and cash flows are real. The inflation rate is 3% pa. • All rates are given as effective annual rates. • The business considering the project is run as a 'sole tradership' (run by an individual without a company) and is therefore eligible for a 50% capital gains tax discount when the equipment is sold, as permitted by the Australian Tax Office. What is the expected net present value (NPV) of the project? The 'option price' in an option contract is paid at the start when the option contract is agreed to. or ? The 'futures price' in a futures contract is paid at the start when the futures contract is agreed to. or ? The 'option strike price' in an option contract, also known as the exercise price, is paid at the start when the option contract is agreed to. or ? The 'initial margin', also known as the performance bond in a futures contract, is paid at the start when the futures contract is agreed to. or ? Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After one year, would you be able to buy , exactly the as or than today with the money in this account? Do you think that the following statement is or ? “Buying a single company stock usually provides a safer return than a stock mutual fund.” A 30-day Bank Accepted Bill has a face value of$1,000,000. The interest rate is 2.5% pa and there are 365 days in the year. What is its price now?

A 30 year Japanese government bond was just issued at par with a yield of 1.7% pa. The fixed coupon payments are semi-annual. The bond has a face value of $100. Six months later, just after the first coupon is paid, the yield of the bond increases to 2% pa. What is the bond's new price? There are many ways to write the ordinary annuity formula. Which of the following is NOT equal to the ordinary annuity formula? In the dividend discount model: $$P_0 = \dfrac{C_1}{r-g}$$ The return $r$ is supposed to be the: Which of the below statements about effective rates and annualised percentage rates (APR's) is NOT correct? Find Scubar Corporation's Cash Flow From Assets (CFFA), also known as Free Cash Flow to the Firm (FCFF), over the year ending 30th June 2013.  Scubar Corp Income Statement for year ending 30th June 2013$m Sales 200 COGS 60 Depreciation 20 Rent expense 11 Interest expense 19 Taxable Income 90 Taxes at 30% 27 Net income 63
 Scubar Corp Balance Sheet as at 30th June 2013 2012 $m$m Inventory 60 50 Trade debtors 19 6 Rent paid in advance 3 2 PPE 420 400 Total assets 502 458 Trade creditors 10 8 Bond liabilities 200 190 Contributed equity 130 130 Retained profits 162 130 Total L and OE 502 458

Note: All figures are given in millions of dollars ($m). The cash flow from assets was: When valuing assets using discounted cash flow (net present value) methods, it is important to consider inflation. To properly deal with inflation: (I) Discount nominal cash flows by nominal discount rates. (II) Discount nominal cash flows by real discount rates. (III) Discount real cash flows by nominal discount rates. (IV) Discount real cash flows by real discount rates. Which of the above statements is or are correct? Which one of the following will decrease net income (NI) but increase cash flow from assets (CFFA) in this year for a tax-paying firm, all else remaining constant? Remember: $$NI=(Rev-COGS-FC-Depr-IntExp).(1-t_c )$$ $$CFFA=NI+Depr-CapEx - ΔNWC+IntExp$$ A prospective home buyer can afford to pay$2,000 per month in mortgage loan repayments. The central bank recently lowered its policy rate by 0.25%, and residential home lenders cut their mortgage loan rates from 4.74% to 4.49%.

How much more can the prospective home buyer borrow now that interest rates are 4.49% rather than 4.74%? Give your answer as a proportional increase over the original amount he could borrow ($V_\text{before}$), so:

$$\text{Proportional increase} = \frac{V_\text{after}-V_\text{before}}{V_\text{before}}$$

Assume that:

• Interest rates are expected to be constant over the life of the loan.

• Loans are interest-only and have a life of 30 years.

• Mortgage loan payments are made every month in arrears and all interest rates are given as annualised percentage rates compounding per month.

What is the net present value (NPV) of undertaking a full-time Australian undergraduate business degree as an Australian citizen? Only include the cash flows over the duration of the degree, ignore any benefits or costs of the degree after it's completed.

Assume the following:

• The degree takes 3 years to complete and all students pass all subjects.
• There are 2 semesters per year and 4 subjects per semester.
• University fees per subject per semester are $1,277, paid at the start of each semester. Fees are expected to remain constant in real terms for the next 3 years. • There are 52 weeks per year. • The first semester is just about to start (t=0). The first semester lasts for 19 weeks (t=0 to 19). • The second semester starts immediately afterwards (t=19) and lasts for another 19 weeks (t=19 to 38). • The summer holidays begin after the second semester ends and last for 14 weeks (t=38 to 52). Then the first semester begins the next year, and so on. • Working full time at the grocery store instead of studying full-time pays$20/hr and you can work 35 hours per week. Wages are paid at the end of each week and are expected to remain constant in real terms.
• Full-time students can work full-time during the summer holiday at the grocery store for the same rate of $20/hr for 35 hours per week. • The discount rate is 9.8% pa. All rates and cash flows are real. Inflation is expected to be 3% pa. All rates are effective annual. The NPV of costs from undertaking the university degree is: Is it possible for all countries' exchange rates to appreciate by 5% in the same year, including the USD? or ? If the AUD appreciates against the USD, the American terms quote of the AUD will or ? If the USD appreciates against the AUD, the American terms quote of the AUD will or ? A 10 year Australian government bond was just issued at par with a yield of 3.9% pa. The fixed coupon payments are semi-annual. The bond has a face value of$1,000.

Six months later, just after the first coupon is paid, the yield of the bond decreases to 3.65% pa. What is the bond's new price?

In the dividend discount model:

$$P_0= \frac{d_1}{r-g}$$

The pronumeral $g$ is supposed to be the:

The following equation is the Dividend Discount Model, also known as the 'Gordon Growth Model' or the 'Perpetuity with growth' equation.

$$p_0= \frac{c_1}{r-g}$$

Which expression is equal to the expected dividend return?

Bonds X and Y are issued by the same US company. Both bonds yield 6% pa, and they have the same face value ($100), maturity, seniority, and payment frequency. The only difference is that bond X pays coupons of 8% pa and bond Y pays coupons of 12% pa. Which of the following statements is true? When using the dividend discount model, care must be taken to avoid using a nominal dividend growth rate that exceeds the country's nominal GDP growth rate. Otherwise the firm is forecast to take over the country since it grows faster than the average business forever. Suppose a firm's nominal dividend grows at 10% pa forever, and nominal GDP growth is 5% pa forever. The firm's total dividends are currently$1 billion (t=0). The country's GDP is currently $1,000 billion (t=0). In approximately how many years will the company's total dividends be as large as the country's GDP? A new company's Firm Free Cash Flow (FFCF, same as CFFA) is forecast in the graph below. To value the firm's assets, the terminal value needs to be calculated using the perpetuity with growth formula: $$V_{\text{terminal, }t-1} = \dfrac{FFCF_{\text{terminal, }t}}{r-g}$$ Which point corresponds to the best time to calculate the terminal value? An old company's Firm Free Cash Flow (FFCF, same as CFFA) is forecast in the graph below. To value the firm's assets, the terminal value needs to be calculated using the perpetuity with growth formula: $$V_{\text{terminal, }t-1} = \dfrac{FFCF_{\text{terminal, }t}}{r-g}$$ Which point corresponds to the best time to calculate the terminal value? A new company's Firm Free Cash Flow (FFCF, same as CFFA) is forecast in the graph below. To value the firm's assets, the terminal value needs to be calculated using the perpetuity with growth formula: $$V_{\text{terminal, }t-1} = \dfrac{FFCF_{\text{terminal, }t}}{r-g}$$ Which point corresponds to the best time to calculate the terminal value? Estimate Microsoft's (MSFT) share price using a price earnings (PE) multiples approach with the following assumptions and figures only: • Apple, Google and Microsoft are comparable companies, • Apple's (AAPL) share price is$526.24 and historical EPS is $40.32. • Google's (GOOG) share price is$1,215.65 and historical EPS is $36.23. • Micrsoft's (MSFT) historical earnings per share (EPS) is$2.71.

Source: Google Finance 28 Feb 2014.

Question 345  capital budgeting, break even, NPV

 Project Data Project life 10 yrs Initial investment in factory $10m Depreciation of factory per year$1m Expected scrap value of factory at end of project $0 Sale price per unit$10 Variable cost per unit $6 Fixed costs per year, paid at the end of each year$2m Interest expense per year 0 Tax rate 30% Cost of capital per annum 10%

Notes

1. The firm's current liabilities are forecast to stay at $0.5m. The firm's current assets (mostly inventory) is currently$1m, but is forecast to grow by $0.1m at the end of each year due to the project. At the end of the project, the current assets accumulated due to the project can be sold for the same price that they were bought. 2. A marketing survey was used to forecast sales. It cost$1.4m which was just paid. The cost has been capitalised by the accountants and is tax-deductible over the life of the project, regardless of whether the project goes ahead or not. This amortisation expense is not included in the depreciation expense listed in the table above.

Assumptions

• All cash flows occur at the start or end of the year as appropriate, not in the middle or throughout the year.
• All rates and cash flows are real. The inflation rate is 3% pa.
• All rates are given as effective annual rates.

Find the break even unit production (Q) per year to achieve a zero Net Income (NI) and Net Present Value (NPV), respectively. The answers below are listed in the same order.

Which one of the following will increase the Cash Flow From Assets in this year for a tax-paying firm, all else remaining constant?

Harvey Norman the large retailer often runs sales advertising 2 years interest free when you purchase its products. This offer can be seen as a free personal loan from Harvey Norman to its customers.

Assume that banks charge an interest rate on personal loans of 12% pa given as an APR compounding per month. This is the interest rate that Harvey Norman deserves on the 2 year loan it extends to its customers. Therefore Harvey Norman must implicitly include the cost of this loan in the advertised sale price of its goods.

If you were a customer buying from Harvey Norman, and you were paying immediately, not in 2 years, what is the minimum percentage discount to the advertised sale price that you would insist on? (Hint: if it makes it easier, assume that you’re buying a product with an advertised price of $100). Your friend overheard that you need some cash and asks if you would like to borrow some money. She can lend you$5,000 now (t=0), and in return she wants you to pay her back $1,000 in two years (t=2) and every year after that for the next 5 years, so there will be 6 payments of$1,000 from t=2 to t=7 inclusive.

What is the net present value (NPV) of borrowing from your friend?

Assume that banks loan funds at interest rates of 10% pa, given as an effective annual rate.

Which of the following investable assets are NOT suitable for valuation using PE multiples techniques?

Estimate the Chinese bank ICBC's share price using a backward-looking price earnings (PE) multiples approach with the following assumptions and figures only. Note that the renminbi (RMB) is the Chinese currency, also known as the yuan (CNY).

• The 4 major Chinese banks ICBC, China Construction Bank (CCB), Bank of China (BOC) and Agricultural Bank of China (ABC) are comparable companies;
• ICBC 's historical earnings per share (EPS) is RMB 0.74;
• CCB's backward-looking PE ratio is 4.59;
• BOC 's backward-looking PE ratio is 4.78;
• ABC's backward-looking PE ratio is also 4.78;

Note: Figures sourced from Google Finance on 25 March 2014. Share prices are from the Shanghai stock exchange.

Which one of the following will have no effect on net income (NI) but decrease cash flow from assets (CFFA or FFCF) in this year for a tax-paying firm, all else remaining constant?

Remember:

$$NI=(Rev-COGS-FC-Depr-IntExp).(1-t_c )$$ $$CFFA=NI+Depr-CapEx - ΔNWC+IntExp$$

Find Ching-A-Lings Corporation's Cash Flow From Assets (CFFA), also known as Free Cash Flow to the Firm (FCFF), over the year ending 30th June 2013.

 Ching-A-Lings Corp Income Statement for year ending 30th June 2013 $m Sales 100 COGS 20 Depreciation 20 Rent expense 11 Interest expense 19 Taxable Income 30 Taxes at 30% 9 Net income 21  Ching-A-Lings Corp Balance Sheet as at 30th June 2013 2012$m $m Inventory 49 38 Trade debtors 14 2 Rent paid in advance 5 5 PPE 400 400 Total assets 468 445 Trade creditors 4 10 Bond liabilities 200 190 Contributed equity 145 145 Retained profits 119 100 Total L and OE 468 445 Note: All figures are given in millions of dollars ($m).

The cash flow from assets was:

Over the next year, the management of an unlevered company plans to:

• Make $5m in sales,$1.9m in net income and $2m in equity free cash flow (EFCF). • Pay dividends of$1m.
• Complete a $1.3m share buy-back. Assume that: • All amounts are received and paid at the end of the year so you can ignore the time value of money. • The firm has sufficient retained profits to legally pay the dividend and complete the buy back. • The firm plans to run a very tight ship, with no excess cash above operating requirements currently or over the next year. How much new equity financing will the company need? In other words, what is the value of new shares that will need to be issued? Three years ago Frederika bought a house for$400,000.

Now it's worth $600,000, based on recent similar sales in the area. Frederika's residential property has an expected total return of 7% pa. She rents her house out for$2,500 per month, paid in advance. Every 12 months she plans to increase the rental payments.

The present value of 12 months of rental payments is $29,089.48. The future value of 12 months of rental payments one year ahead is$31,125.74.

What is the expected annual capital yield of the property?

A residential investment property has an expected nominal total return of 8% pa and nominal capital return of 3% pa.

Inflation is expected to be 2% pa. All rates are given as effective annual rates.

What are the property's expected real total, capital and income returns? The answer choices below are given in the same order.

Which firms tend to have high forward-looking price-earnings (PE) ratios?

Stocks in the United States usually pay quarterly dividends. For example, the software giant Microsoft paid a $0.23 dividend every quarter over the 2013 financial year and plans to pay a$0.28 dividend every quarter over the 2014 financial year.

Using the dividend discount model and net present value techniques, calculate the stock price of Microsoft assuming that:

• The time now is the beginning of July 2014. The next dividend of $0.28 will be received in 3 months (end of September 2014), with another 3 quarterly payments of$0.28 after this (end of December 2014, March 2015 and June 2015).
• The quarterly dividend will increase by 2.5% every year, but each quarterly dividend over the year will be equal. So each quarterly dividend paid in the financial year beginning in September 2015 will be $0.287 $(=0.28×(1+0.025)^1)$, with the last at the end of June 2016. In the next financial year beginning in September 2016 each quarterly dividend will be$0.294175 $(=0.28×(1+0.025)^2)$, with the last at the end of June 2017, and so on forever.
• The total required return on equity is 6% pa.
• The required return and growth rate are given as effective annual rates.
• Dividend payment dates and ex-dividend dates are at the same time.
• Remember that there are 4 quarters in a year and 3 months in a quarter.

What is the current stock price?

A company selling charting and technical analysis software claims that independent academic studies have shown that its software makes significantly positive abnormal returns. Assuming the claim is true, which statement(s) are correct?

(I) Weak form market efficiency is broken.

(II) Semi-strong form market efficiency is broken.

(III) Strong form market efficiency is broken.

(IV) The asset pricing model used to measure the abnormal returns (such as the CAPM) had mis-specification error so the returns may not be abnormal but rather fair for the level of risk.

Select the most correct response:

Your friend claims that by reading 'The Economist' magazine's economic news articles, she can identify shares that will have positive abnormal expected returns over the next 2 years. Assuming that her claim is true, which statement(s) are correct?

(i) Weak form market efficiency is broken.

(ii) Semi-strong form market efficiency is broken.

(iii) Strong form market efficiency is broken.

(iv) The asset pricing model used to measure the abnormal returns (such as the CAPM) is either wrong (mis-specification error) or is measured using the wrong inputs (data errors) so the returns may not be abnormal but rather fair for the level of risk.

Select the most correct response:

Select the most correct statement from the following.

'Chartists', also known as 'technical traders', believe that:

Fundamentalists who analyse company financial reports and news announcements (but who don't have inside information) will make positive abnormal returns if:

Diversification is achieved by investing in a large amount of stocks. What type of risk is reduced by diversification?

Which statement(s) are correct?

(i) All stocks that plot on the Security Market Line (SML) are fairly priced.

(ii) All stocks that plot above the Security Market Line (SML) are overpriced.

(iii) All fairly priced stocks that plot on the Capital Market Line (CML) have zero idiosyncratic risk.

Select the most correct response:

A stock's correlation with the market portfolio increases while its total risk is unchanged. What will happen to the stock's expected return and systematic risk?

Which statement is the most correct?

A firm changes its capital structure by issuing a large amount of equity and using the funds to repay debt. Its assets are unchanged. Ignore interest tax shields.

According to the Capital Asset Pricing Model (CAPM), which statement is correct?

Examine the following graph which shows stocks' betas $(\beta)$ and expected returns $(\mu)$:

Assume that the CAPM holds and that future expectations of stocks' returns and betas are correctly measured. Which statement is NOT correct?

You're the boss of an investment bank's equities research team. Your five analysts are each trying to find the expected total return over the next year of shares in a mining company. The mining firm:

• Is regarded as a mature company since it's quite stable in size and was floated around 30 years ago. It is not a high-growth company;
• Share price is very sensitive to changes in the price of the market portfolio, economic growth, the exchange rate and commodities prices. Due to this, its standard deviation of total returns is much higher than that of the market index;
• Experienced tough times in the last 10 years due to unexpected falls in commodity prices.
• Shares are traded in an active liquid market.
Your team of analysts present their findings, and everyone has different views. While there's no definitive true answer, whose calculation of the expected total return is the most plausible?

Assume that:

• The analysts' source data is correct and true, but their inferences might be wrong;
• All returns and yields are given as effective annual nominal rates.

A man inherits $500,000 worth of shares. He believes that by learning the secrets of trading, keeping up with the financial news and doing complex trend analysis with charts that he can quit his job and become a self-employed day trader in the equities markets. What is the expected gain from doing this over the first year? Measure the net gain in wealth received at the end of this first year due to the decision to become a day trader. Assume the following: • He earns$60,000 pa in his current job, paid in a lump sum at the end of each year.
• He enjoys examining share price graphs and day trading just as much as he enjoys his current job.
• Stock markets are weak form and semi-strong form efficient.
• He has no inside information.
• He makes 1 trade every day and there are 250 trading days in the year. Trading costs are $20 per trade. His broker invoices him for the trading costs at the end of the year. • The shares that he currently owns and the shares that he intends to trade have the same level of systematic risk as the market portfolio. • The market portfolio's expected return is 10% pa. Measure the net gain over the first year as an expected wealth increase at the end of the year. A managed fund charges fees based on the amount of money that you keep with them. The fee is 2% of the start-of-year amount, but it is paid at the end of every year. This fee is charged regardless of whether the fund makes gains or losses on your money. The fund offers to invest your money in shares which have an expected return of 10% pa before fees. You are thinking of investing$100,000 in the fund and keeping it there for 40 years when you plan to retire.

What is the Net Present Value (NPV) of investing your money in the fund? Note that the question is not asking how much money you will have in 40 years, it is asking: what is the NPV of investing in the fund? Assume that:

• The fund has no private information.
• Markets are weak and semi-strong form efficient.
• The fund's transaction costs are negligible.
• The cost and trouble of investing your money in shares by yourself, without the managed fund, is negligible.

Fill in the missing words in the following sentence:

All things remaining equal, as a firm's amount of debt funding falls, benefits of interest tax shields __________ and the costs of financial distress __________.

Which of the following discount rates should be the highest for a levered company? Ignore the costs of financial distress.

Which of the following statements about the weighted average cost of capital (WACC) is NOT correct?

There are many different ways to value a firm's assets. Which of the following will NOT give the correct market value of a levered firm's assets $(V_L)$? Assume that:

• The firm is financed by listed common stock and vanilla annual fixed coupon bonds, which are both traded in a liquid market.
• The bonds' yield is equal to the coupon rate, so the bonds are issued at par. The yield curve is flat and yields are not expected to change. When bonds mature they will be rolled over by issuing the same number of new bonds with the same expected yield and coupon rate, and so on forever.
• Tax rates on the dividends and capital gains received by investors are equal, and capital gains tax is paid every year, even on unrealised gains regardless of when the asset is sold.
• There is no re-investment of the firm's cash back into the business. All of the firm's excess cash flow is paid out as dividends so real growth is zero.
• The firm operates in a mature industry with zero real growth.
• All cash flows and rates in the below equations are real (not nominal) and are expected to be stable forever. Therefore the perpetuity equation with no growth is suitable for valuation.

Where:

$$r_\text{WACC before tax} = r_D.\frac{D}{V_L} + r_{EL}.\frac{E_L}{V_L} = \text{Weighted average cost of capital before tax}$$ $$r_\text{WACC after tax} = r_D.(1-t_c).\frac{D}{V_L} + r_{EL}.\frac{E_L}{V_L} = \text{Weighted average cost of capital after tax}$$ $$NI_L=(Rev-COGS-FC-Depr-\mathbf{IntExp}).(1-t_c) = \text{Net Income Levered}$$ $$CFFA_L=NI_L+Depr-CapEx - \varDelta NWC+\mathbf{IntExp} = \text{Cash Flow From Assets Levered}$$ $$NI_U=(Rev-COGS-FC-Depr).(1-t_c) = \text{Net Income Unlevered}$$ $$CFFA_U=NI_U+Depr-CapEx - \varDelta NWC= \text{Cash Flow From Assets Unlevered}$$

A firm is considering a new project of similar risk to the current risk of the firm. This project will expand its existing business. The cash flows of the project have been calculated assuming that there is no interest expense. In other words, the cash flows assume that the project is all-equity financed.

In fact the firm has a target debt-to-equity ratio of 1, so the project will be financed with 50% debt and 50% equity. To find the levered value of the firm's assets, what discount rate should be applied to the project's unlevered cash flows? Assume a classical tax system.

A manufacturing company is considering a new project in the more risky services industry. The cash flows from assets (CFFA) are estimated for the new project, with interest expense excluded from the calculations. To get the levered value of the project, what should these unlevered cash flows be discounted by?

Assume that the manufacturing firm has a target debt-to-assets ratio that it sticks to.

Which statement about risk, required return and capital structure is the most correct?

A firm's weighted average cost of capital before tax ($r_\text{WACC before tax}$) would increase due to:

A firm has a debt-to-assets ratio of 50%. The firm then issues a large amount of equity to raise money for new projects of similar systematic risk to the company's existing projects. Assume a classical tax system. Which statement is correct?

A firm's WACC before tax would decrease due to:

A company has:

• 50 million shares outstanding.
• The market price of one share is currently $6. • The risk-free rate is 5% and the market return is 10%. • Market analysts believe that the company's ordinary shares have a beta of 2. • The company has 1 million preferred stock which have a face (or par) value of$100 and pay a constant dividend of 10% of par. They currently trade for $80 each. • The company's debentures are publicly traded and their market price is equal to 90% of their face value. • The debentures have a total face value of$60,000,000 and the current yield to maturity of corporate debentures is 10% per annum. The corporate tax rate is 30%.

What is the company's after-tax weighted average cost of capital (WACC)? Assume a classical tax system.

A firm can issue 5 year annual coupon bonds at a yield of 8% pa and a coupon rate of 12% pa.

The beta of its levered equity is 1. Five year government bonds yield 5% pa with a coupon rate of 6% pa. The market's expected dividend return is 4% pa and its expected capital return is 6% pa.

The firm's debt-to-equity ratio is 2:1. The corporate tax rate is 30%.

What is the firm's after-tax WACC? Assume a classical tax system.

One of Miller and Modigliani's (M&M's) important insights is that a firm's managers should not try to achieve a particular level of leverage in a world with zero taxes and perfect information since investors can make their own leverage. Therefore corporate capital structure policy is irrelevant since investors can achieve their own desired leverage at the personal level by borrowing or lending on their own.

This principal of 'home-made' or 'do-it-yourself' leverage can also be applied to other topics. Read the following statements to decide which are true:

(I) Payout policy: a firm's managers should not try to achieve a particular pattern of equity payout.

(II) Agency costs: a firm's managers should not try to minimise agency costs.

(III) Diversification: a firm's managers should not try to diversify across industries.

(IV) Shareholder wealth: a firm's managers should not try to maximise shareholders' wealth.

Which of the above statement(s) are true?

Assume that there exists a perfect world with no transaction costs, no asymmetric information, no taxes, no agency costs, equal borrowing rates for corporations and individual investors, the ability to short the risk free asset, semi-strong form efficient markets, the CAPM holds, investors are rational and risk-averse and there are no other market frictions.

For a firm operating in this perfect world, which statement(s) are correct?

(i) When a firm changes its capital structure and/or payout policy, share holders' wealth is unaffected.

(ii) When the idiosyncratic risk of a firm's assets increases, share holders do not expect higher returns.

(iii) When the systematic risk of a firm's assets increases, share holders do not expect higher returns.

Select the most correct response:

Question 99  capital structure, interest tax shield, Miller and Modigliani, trade off theory of capital structure

A firm changes its capital structure by issuing a large amount of debt and using the funds to repurchase shares. Its assets are unchanged.

Assume that:

• The firm and individual investors can borrow at the same rate and have the same tax rates.
• The firm's debt and shares are fairly priced and the shares are repurchased at the market price, not at a premium.
• There are no market frictions relating to debt such as asymmetric information or transaction costs.
• Shareholders wealth is measured in terms of utiliity. Shareholders are wealth-maximising and risk-averse. They have a preferred level of overall leverage. Before the firm's capital restructure all shareholders were optimally levered.

According to Miller and Modigliani's theory, which statement is correct?

A newly floated farming company is financed with senior bonds, junior bonds, cumulative non-voting preferred stock and common stock. The new company has no retained profits and due to floods it was unable to record any revenues this year, leading to a loss. The firm is not bankrupt yet since it still has substantial contributed equity (same as paid-up capital).

On which securities must it pay interest or dividend payments in this terrible financial year?

A fast-growing firm is suitable for valuation using a multi-stage growth model.

It's nominal unlevered cash flow from assets ($CFFA_U$) at the end of this year (t=1) is expected to be $1 million. After that it is expected to grow at a rate of: • 12% pa for the next two years (from t=1 to 3), • 5% over the fourth year (from t=3 to 4), and • -1% forever after that (from t=4 onwards). Note that this is a negative one percent growth rate. Assume that: • The nominal WACC after tax is 9.5% pa and is not expected to change. • The nominal WACC before tax is 10% pa and is not expected to change. • The firm has a target debt-to-equity ratio that it plans to maintain. • The inflation rate is 3% pa. • All rates are given as nominal effective annual rates. What is the levered value of this fast growing firm's assets? Your friend just bought a house for$1,000,000. He financed it using a $900,000 mortgage loan and a deposit of$100,000.

In the context of residential housing and mortgages, the 'equity' or 'net wealth' tied up in a house is the value of the house less the value of the mortgage loan. Assuming that your friend's only asset is his house, his net wealth is $100,000. If house prices suddenly fall by 15%, what would be your friend's percentage change in net wealth? Assume that: • No income (rent) was received from the house during the short time over which house prices fell. • Your friend will not declare bankruptcy, he will always pay off his debts. A firm has a debt-to-assets ratio of 50%. The firm then issues a large amount of debt to raise money for new projects of similar market risk to the company's existing projects. Assume a classical tax system. Which statement is correct? The US firm Google operates in the online advertising business. In 2011 Google bought Motorola Mobility which manufactures mobile phones. Assume the following: • Google had a 10% after-tax weighted average cost of capital (WACC) before it bought Motorola. • Motorola had a 20% after-tax WACC before it merged with Google. • Google and Motorola have the same level of gearing. • Both companies operate in a classical tax system. You are a manager at Motorola. You must value a project for making mobile phones. Which method(s) will give the correct valuation of the mobile phone manufacturing project? Select the most correct answer. The mobile phone manufacturing project's: A retail furniture company buys furniture wholesale and distributes it through its retail stores. The owner believes that she has some good ideas for making stylish new furniture. She is considering a project to buy a factory and employ workers to manufacture the new furniture she's designed. Furniture manufacturing has more systematic risk than furniture retailing. Her furniture retailing firm's after-tax WACC is 20%. Furniture manufacturing firms have an after-tax WACC of 30%. Both firms are optimally geared. Assume a classical tax system. Which method(s) will give the correct valuation of the new furniture-making project? Select the most correct answer. Your friend is trying to find the net present value of an investment which: • Costs$1 million initially (t=0); and
• Pays a single positive cash flow of $1.1 million in one year (t=1). The investment has a total required return of 10% pa due to its moderate level of undiversifiable risk. Your friend is aware of the importance of opportunity costs and the time value of money, but he is unsure of how to find the NPV of the project. He knows that the opportunity cost of investing the$1m in the project is the expected gain from investing the money in shares instead. Like the project, shares also have an expected return of 10% since they have moderate undiversifiable risk. This opportunity cost is 0.1m $(=1m \times 10\%)$ which occurs in one year (t=1). He knows that the time value of money should be accounted for, and this can be done by finding the present value of the cash flows in one year. Your friend has listed a few different ways to find the NPV which are written down below. Method 1: $-1m + \dfrac{1.1m}{(1+0.1)^1}$ Method 2: $-1m + 1.1m - 1m \times 0.1$ Method 3: $-1m + \dfrac{1.1m}{(1+0.1)^1} - 1m \times 0.1$ Which of the above calculations give the correct NPV? Select the most correct answer. One formula for calculating a levered firm's free cash flow (FFCF, or CFFA) is to use earnings before interest and tax (EBIT). \begin{aligned} FFCF &= (EBIT)(1-t_c) + Depr - CapEx -\Delta NWC + IntExp.t_c \\ &= (Rev - COGS - Depr - FC)(1-t_c) + Depr - CapEx -\Delta NWC + IntExp.t_c \\ \end{aligned} \\ Does this annual FFCF or the annual interest tax shield? A method commonly seen in textbooks for calculating a levered firm's free cash flow (FFCF, or CFFA) is the following: \begin{aligned} FFCF &= (Rev - COGS - Depr - FC - IntExp)(1-t_c) + \\ &\space\space\space+ Depr - CapEx -\Delta NWC + IntExp(1-t_c) \\ \end{aligned} Does this annual FFCF or the annual interest tax shield? There are many ways to calculate a firm's free cash flow (FFCF), also called cash flow from assets (CFFA). Some include the annual interest tax shield in the cash flow and some do not. Which of the below FFCF formulas include the interest tax shield in the cash flow? $$(1) \quad FFCF=NI + Depr - CapEx -ΔNWC + IntExp$$ $$(2) \quad FFCF=NI + Depr - CapEx -ΔNWC + IntExp.(1-t_c)$$ $$(3) \quad FFCF=EBIT.(1-t_c )+ Depr- CapEx -ΔNWC+IntExp.t_c$$ $$(4) \quad FFCF=EBIT.(1-t_c) + Depr- CapEx -ΔNWC$$ $$(5) \quad FFCF=EBITDA.(1-t_c )+Depr.t_c- CapEx -ΔNWC+IntExp.t_c$$ $$(6) \quad FFCF=EBITDA.(1-t_c )+Depr.t_c- CapEx -ΔNWC$$ $$(7) \quad FFCF=EBIT-Tax + Depr - CapEx -ΔNWC$$ $$(8) \quad FFCF=EBIT-Tax + Depr - CapEx -ΔNWC-IntExp.t_c$$ $$(9) \quad FFCF=EBITDA-Tax - CapEx -ΔNWC$$ $$(10) \quad FFCF=EBITDA-Tax - CapEx -ΔNWC-IntExp.t_c$$ The formulas for net income (NI also called earnings), EBIT and EBITDA are given below. Assume that depreciation and amortisation are both represented by 'Depr' and that 'FC' represents fixed costs such as rent. $$NI=(Rev - COGS - Depr - FC - IntExp).(1-t_c )$$ $$EBIT=Rev - COGS - FC-Depr$$ $$EBITDA=Rev - COGS - FC$$ $$Tax =(Rev - COGS - Depr - FC - IntExp).t_c= \dfrac{NI.t_c}{1-t_c}$$ A residential real estate investor believes that house prices will grow at a rate of 5% pa and that rents will grow by 2% pa forever. All rates are given as nominal effective annual returns. Assume that: • His forecast is true. • Real estate is and always will be fairly priced and the capital asset pricing model (CAPM) is true. • Ignore all costs such as taxes, agent fees, maintenance and so on. • All rental income cash flow is paid out to the owner, so there is no re-investment and therefore no additions or improvements made to the property. • The non-monetary benefits of owning real estate and renting remain constant. Which one of the following statements is NOT correct? Over time: The CAPM can be used to find a business's expected opportunity cost of capital: $$r_i=r_f+β_i (r_m-r_f)$$ What should be used as the risk free rate $r_f$? A pharmaceutical firm has just discovered a valuable new drug. So far the news has been kept a secret. The net present value of making and commercialising the drug is200 million, but $600 million of bonds will need to be issued to fund the project and buy the necessary plant and equipment. The firm will release the news of the discovery and bond raising to shareholders simultaneously in the same announcement. The bonds will be issued shortly after. Once the announcement is made and the bonds are issued, what is the expected increase in the value of the firm's assets (ΔV), market capitalisation of debt (ΔD) and market cap of equity (ΔE)? The triangle symbol is the Greek letter capital delta which means change or increase in mathematics. Ignore the benefit of interest tax shields from having more debt. Remember: $ΔV = ΔD+ΔE$ You just bought a house worth$1,000,000. You financed it with an $800,000 mortgage loan and a deposit of$200,000.

You estimate that:

• The house has a beta of 1;
• The mortgage loan has a beta of 0.2.

What is the beta of the equity (the \$200,000 deposit) that you have in your house?

Also, if the risk free rate is 5% pa and the market portfolio's return is 10% pa, what is the expected return on equity in your house? Ignore taxes, assume that all cash flows (interest payments and rent) were paid and received at the end of the year, and all rates are effective annual rates.

Which of the following companies is most suitable for valuation using PE multiples techniques?