Exam 2 Review

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.
5 7/8 Feb 08n 9617 9619 -6 6.46

• Semi-annual coupon - _____
• Maturity date ______
• Price you can buy 1 bond _____
• Price you can sell 1 bond _____
• YTM based on purchase price ______

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
Year Cash flow 0 275 1 100 2 100
3 100 4 100
120
100
80
60
40
NPVgt0
20
0
NPV lt 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 gtNPV B
20
0
20
40
60
NPV B gtNPV A
80
Discount rate
100
2
0
6
10
16
20
24
IRR A lt IRR B
Crossover rate