Finance Exam Review: Key Concepts and Calculations
Finance Exam Review
Dividend Valuation and Growth
PT Boats Dividend Valuation
PT Boats pays a $2.40 dividend per share for the next 2 years and a final liquidating dividend of $10 per share at the end of year 3. If the required rate of return is 16%, the current value of the stock is $10.26.
Main Street Ant Dividend Valuation
Main Street Ant pays an annual dividend of $2.40, decreasing by 2% annually. With a required rate of return of 15%, the current value of the stock is $14.12.
Factory Stores Dividend Income
Factory Stores pays a dividend and increases it by 2% annually. The stock is priced at $12 per share, and the required rate of return is 16%. If you own 400 shares, the expected income for next year is $672.
The Grand Isle Sustainable Growth Rate
The Grand Isle has 12,000 shares at a market price of $31.60. The book value per share is $12.08, EPS is $1.86, and the payout ratio is 40%. The sustainable growth rate is calculated as (EPS / Book Value) x (1 – Payout Ratio) which equals 9.24%.
Southern Foods Stock Valuation
Southern Foods pays an annual dividend of $1.10, expected to increase by 9% for 4 years, followed by a 3% annual growth rate thereafter. With a required rate of return of 14%, the value of the stock today is $12.55.
Newcomer Mills Stock Valuation
Newcomer Mills retains all earnings for 3 years and then pays a dividend of $0.15 per share for the next 4 years, increasing by 5% annually thereafter. With a required rate of return of 12%, the value of the stock today is $1.53.
P/E Ratio and Market Efficiency
P/E Ratio Calculation
With an earnings retention ratio of 40%, a market capitalization rate of 15%, and an ROE of 18%, the P/E ratio is calculated as (1 – Retention Ratio) / (Market Cap Rate – (ROE x Retention Ratio)), which equals 7.69.
Present Value of Growth Opportunities (PVGO)
With a stock price of $45, EPS of $3, and a market capitalization rate of 14%, the PVGO is calculated as Stock Price – (EPS / Market Cap Rate), which equals $23.57.
Miller’s Farms P/E Ratio
Miller’s Farms has 110,000 shares, sales of $960,000, and net income of $51,000. The expected price-to-earnings ratio is 16.7. The actual P/E ratio is calculated as (Net Income / Shares) x Expected P/E Ratio, which equals $7.74.
Electronics Galore Stock Price Prediction
Electronics Galore has a P/E ratio of 23.4 and EPS of $1.68, expected to increase by 4.2%. The predicted stock price one year from now is calculated as EPS x (1 + Growth Rate) x P/E Ratio, which equals $40.96.
PEG Ratio Calculation
With a stock price of $54.75, earnings of $75 million, 20 million shares, an ROE of 15%, and a plowback ratio of 65%, the PEG ratio is calculated as follows:
EPS = Earnings / Shares = $3.75
P/E Ratio = Stock Price / EPS
Growth Rate (g) = Plowback Ratio x ROE = 9.75%
PEG Ratio = P/E Ratio / g = 1.5
ART Stock Valuation
ART has a new product with an ROE of 25%, a plowback ratio of 20%, earnings of $3 per share, and a required rate of return of 12%. The price to sell the stock is calculated as (Earnings x (1 – Plowback Ratio)) / (Required Rate of Return – (ROE x Plowback Ratio)), which equals $34.29.
Bond Valuation and Duration
Free Cash Flow to Firm (FCFF) Calculation
A firm reports EBIT of $100 million, depreciation of $20 million, taxes of 35%, capital expenditures (Capex), and an increase in working capital of $10 million. The FCFF is calculated as EBIT x (1 – Tax Rate) + Depreciation – Capex – Change in Working Capital, which equals $75 million.
Value of Equity Calculation
With FCFF of $300 million in perpetuity, a cost of equity of 14%, a WACC of 10%, and debt of $1 billion, the value of equity is calculated as follows:
Firm Value = FCFF / WACC = $3 billion
Equity Value = Firm Value – Debt = $2 billion
Market Anomaly
A market anomaly refers to price behavior that differs from what is predicted by the efficient market hypothesis.
Material Non-Public Information
Material non-public information is information about a company that will have a significant effect on the price of its securities and is not known to the public.
January Effect
The January effect is the tendency for small-cap stocks to have higher returns in January than in other months.
Semi-Strong-Form Efficient Market
In a semi-strong-form efficient market, neither technical nor fundamental analysis leads to abnormal profits.
Random Walk Hypothesis
If you believe that stock market prices follow a random walk, then historical price information provides no benefit in predicting future prices.
Efficient Market Hypothesis and Portfolio Management
If financial markets are highly efficient, then holding a diversified, low-cost, passively-managed portfolio is probably the best investment strategy.
Asset Allocation in Efficient Markets
Even if markets are efficient, asset allocation is still important because the risk-return relationship must still be considered.
Bond Duration
Duration measures a bond’s sensitivity to changes in market interest rates.
Reinvestment Rate Risk
Reinvestment rate risk is the risk associated with investing a coupon payment at a rate that is lower than the bond’s yield-to-maturity.
Immunization
Immunization involves creating a portfolio in a manner that minimizes the uncertainty of the maturity target date value.
Bond Valuation
An 8-year bond with a 7% coupon, $1,000 face value, and semi-annual interest payments has a current price of $1,005.46 if the yield to maturity is 6.91%.
Macaulay Duration
A $1,000 face value bond with a 7% coupon and semi-annual interest payments has a Macaulay duration of 1.90 years if the yield to maturity is 6.8%.
Modified Duration
With a Macaulay duration of 7.5 years and a yield to maturity of 6.6% plus a coupon rate of 7.5%, the modified duration is 7.26.
Bond Price Change with Interest Rate Change
A bond with a modified duration of 7.22 and a yield to maturity of 8.9% will experience a price change of -5.42% if interest rates increase by 0.75%.
Pension Fund Immunization
A pension fund with a liability duration of 15 years can immunize its risk by allocating 52% of its portfolio to a 5-year, 6% coupon bond and the remaining 48% to a 4% perpetuity.
Bank Duration Gap
A bank with $50 million in assets, $47 million in liabilities, and $3 million in equity, and a liability duration of 1.3%, has a duration gap of 1.22.
Bond Return with Horizontal Analysis
A 20-year bond with a $90 interest payment and a $1,000 face value has a yield to maturity of 10%. If interest rates are expected to decline, the return using horizontal analysis is 29.6%.
Bond Convexity
As a result of bond convexity, an increase in a bond’s price when the yield to maturity falls is greater than the decrease in price when the yield to maturity rises by the same amount.