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Exam 2 Review

Exam 2 Review. Bonds Stocks Capital Budgeting 1. Bonds. Know all bond features / terminology Know how to read WSJ quotations for corporate and treasury bonds Know how to calculate bond value Understand yield, YTM, coupon rate, current yield and their relation

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Exam 2 Review

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  1. Exam 2 Review Bonds Stocks Capital Budgeting 1

  2. Bonds • Know all bond features / terminology • Know how to read WSJ quotations for corporate and treasury bonds • Know how to calculate bond value • Understand yield, YTM, coupon rate, current yield and their relation • Understand interest rate risk, default risk

  3. Stocks • WSJ quotations • Stock valuation models: General DDM, Constant Growth DDM, Multi-Stage • Assumptions behind various DDM models • No dividend case • Required return based on constant growth

  4. Capital Budgeting • NPV, IRR, PI, Payback, Disc. Payback, AAR Rules • Cross over rate • Know how to make decisions using various rules • Know the weaknesses of the rules • Understand NPV profile diagrams • Understand terms: conventional, unconventional, mutually exclusive etc.

  5. Treasury Bonds Maturity Ask Rate Mo/Yr Bid Asked Chg. Yld. • Semi-annual coupon - _____ • Maturity date = ______ • Price you can buy 1 bond = _____ • Price you can sell 1 bond = _____ • YTM based on purchase price = ______ 5 7/8 Feb 08n 96:17 96:19 -6 6.46

  6. Bond Example 1 • Calculate the value of 10-year, 7% annual coupon bond with a yield of 5.5% • Answer: ______

  7. Bond Example 2 • Calculate the value of a 20-year, 8% semi-annual coupon bond yielding 11% • Answer: ________

  8. Stock Example 1 • Bozo corp. will pay a constant $7 dividend for the next seven years after which it will stop paying dividends forever. r = 12? What is the current stock price? • Answer: _______

  9. Stock Example 2 • T. Amos Corp. is a young start-up company. No dividends will be paid for the next five years. In the 6th year a dividend of $6 per share will be paid which will increase at 5% forever thereafter. r = 23%. What is the stock price? • Answer: _____

  10. Stock Example 3 • J Osborne Corp just paid a dividend of $1.50 which will grow at 30% for the next three years. Thereafter the growth will fall back to 7%. r = 23%. What is the current stock price? • Answer: ________

  11. Capital Budgeting • The projects are mutual exclusive. r = 15%

  12. NPV • NPV (A) = _____ • NPV (B) = _____ • Which project to accept? • If they were not mutually exclusive, which one(s) will you accept?

  13. IRR • IRR (A) = _____ • IRR (B) = _____ • Which project to accept? • If they were not mutually exclusive, which one(s) will you accept?

  14. Profitability Index • PI (A) = _____ • PI (B) = _____ • Which project to accept? • If they were not mutually exclusive, which one(s) will you accept?

  15. Crossover rate • Find the crossover rate of the two projects • Crossover rate = ______ • Roughly draw the NPV profiles, labelling all points of interest carefully

  16. Unconventional Cash flows Year Cash flow 0 -$4,000 1 +25,000 2 -25,000 IRR = ? • r = 25%, 35%, 400%. What is the NPV?

  17. Payback • Payback (A) = _____ • Payback (B) = _____ • Which project to accept? • If they were not mutually exclusive, which one(s) will you accept?

  18. Discounted Payback • Disc. Payback (A) = _____ • Disc. Payback (B) = _____ • Which project to accept? • If they were not mutually exclusive, which one(s) will you accept?

  19. NPV Profiles • Understand • What is being plotted • Axes, IRR, Accept/Reject regions, etc. • How to interpret them • Unconventional cash flows • Mutually exclusive projects

  20. Net Present Value Profile Net present value 120 Year Cash flow 0 – $275 1 100 2 100 3 100 4 100 100 80 60 40 NPV>0 20 0 NPV < 0 – 20 Discount rate – 40 2% 6% 10% 14% 18% 22% IRR

  21. NPV Profile - Multiple IRR Problem NPV $0.06 $0.04 IRR = 25% $0.02 $0.00 ($0.02) IRR = 66.6% IRR = 33.3% IRR = 42.8% ($0.04) ($0.06) ($0.08) 0.2 0.28 0.36 0.44 0.52 0.6 0.68 Discount rate

  22. IRR, NPV, and Mutually Exclusive Projects Net present value $ 160 Project A 140 120 100 80 Project B 60 40 NPV A >NPV B 20 0 – 20 – 40 – 60 NPV B >NPV A – 80 Discount rate % – 100 0 2% 16% 20% 24% 10% 6% IRR A < IRR B Crossover rate

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