Prelims Reviewer for Financial Management 1

University of Santo Tomas Tomas Alfredo M. Velayo - College Col lege of Accountanc Accountancy y A.Y. 2016-2017 REVIEWER FOR FINANCIAL MANAGEMENT

I. NOTES Sole Proprietorship

Introduction to Financial Management

Finance consists of 3 inter-rel ated areas: 

money and capital markets



investments



financial fi nancial management management

Kinds of organizations: organizations: 

Sole Proprietorship



Partnership

- There’s always must be at least one general partner. When there are no general partners, it is called calle d an LLC. LLC. 

income: corporate income tax on the income and tax on dividends when income is distributed

- Publicly listed company: corporations whose shares are offered to the public and traded in the stock market. Corporations that already went through initial public offerings (IPO).

Corporation

easy and inex pensive to to form

Tedious to form

difficul dif ficultt to find fi nd financing/raise financing/raise capital

easy to find financing

unlimited unli mited personal liability

limited personal liability

limited life

unlimited life lif e

no corporate income tax

subject to corporate corporate income i ncome tax

regulated by DTI

regulated by SEC

no separate  judicial  judici al personality

has a separate judicial judici al personality

Corporation

- may be subject to double taxation on

Partnership (General)

subject to few government regulations

subject to stricter government regulations

- Privately owned company: corporations whose shares are NOT traded in the stock market. Also called as closely held corporations corporations.

or

privately

held

difficult diffi cult to transfer ownership

easy to transfer ownership

Other kinds of organizations:

General Professional Partnership (GPP) - partnership formed for the SOLE purpose of exercising their common profession of which





NO part of the income is derived from trade or business 

Limited Partnerships

corporation's stock price Agency problems 



- partnerships where there is at least one

problems that arise because of conflicts of interests Stockholders VS Managers - what managers want does not always align with what the stockholders want - some mechanisms used to motivate

limited partner 

maximizing earnings/profits is only a way toward the goal of maximizing the

managers to follow stockholders' best

Limited Liability Company

interest:  managerial compensation

- partnerships where all partners are limited partners



Professi onal Corporations

- like a GPP, except they are in the form of a corporation



- not all owed in the Philippines



- creditors lend funds at rates based on:

Chief Financial Officer (CFO) - also known as Vice President of Finance, responsible for financial planning and formulation of financial corporate strategies. The CFO



Treasurer - handles the financial aspect of the corporation including credit policies, maintaining good banking relationships, and





riskiness of firm's existing assets



expectations concerning riskiness of additional future assets



existing capital structure



expectations concerning capital structure decisions

future

The Financial Environment Different Types of Markets

raising and managing funds.

Financial Market - market for financial assets, equity securities and debt securities.

Controller - handles the accounting and

- Stock Market

budgeting aspect of the corporation including custody of financial records and



 

interpretation of financial data.

Stockholder wealth maximization - maximize the corporation's stock price

market for equity securities. considered a capital market because stocks are long-term securities because stocks generally do not have a maturity

Goals of a corporation 

threat of takeover

Stockholders VS Creditors - creditors have claim on firm's assets upon

Board of Directors - represents stockholders to manage the corporation

supervises the Treasurer and Controller.



bankruptcy

Financial Managers of a Corporation 



direct intervention by shareholders threat of firing



- not all owed in the Philippines

period

- Bond Market 

market for debt securities

also



called

fixed

income

market



Private Market VS Public Market

because of the fixed income brought by periodic interest payments.

- Money Market 

Market

for

short-term

securities.



(short term = 1 year or less) examples: T-bills, commercial papers, consumer credit loans, money market mutual funds, negotiable certificates

- Capital Market

Characteristic of product

unique/tailormade

standardized

Examples

life insurance

stock market

Financial Institutions

Direct transfer - when securities bought are bought directly from issuer.

Indirect transfer through Investment Bank VS

Market for long-term securities. examples: common and preferred



Public Market



of deposit



Private Market

Financial Intermediary

stocks, mortgages, t-bonds and tnotes, corporate bonds, leases Physical Market - market for real assets or tangible assets.



use of underwriters securities bought are

Spot Market VS Future Market

Spot Market Today

Today

Delivery

Today

Future

securities sold to clients



- Types of Future Market:



Forward

contract

Financial Intermediary

yes

no

sold to clients

kept or sold back in the market

other companies' securities

their own securities

Future Market

Price is determined



Investment Bank

-

the

price

Examples of Financial Intermediaries: commercial banks, mutual funds, life insurance companies

determined today is the price to be

Stock Markets

used in the future Option contract - the price determined

Initial Public Offering VS Season Offering

today which is the price to be used in the future is OPTIONAL

shares are issued by the corporation

IPO

SO

first time

after fi rst time (second, third…)

Primary Market VS Secondary Market

Primary

Secondary

issuer

anyone other than the issuer

shares are sold by

Interest Rates

Interest 

cost of money - price for the money borrowed



factors that affect the cost of money (interest rates): (t.r.i.p.) - time preferences for consumption

- risk - inflation - production opportunities

Example: Manfin issued a bond with a value of PHP100,000 with an interest PHP3,000 payable semi-annually. What is APR? APR = 3,000 / (100,000)(180/360) APR = 6% What is APY? m APY = [1+(i/m)] - 1 2 APY = [1+(6%/2)] - 1 APY = 6.09% Components of Nominal Interest Rate NIR = r + DRP + LP + MRP 

security w/o inflation

Nominal and Effective Interest Rate 

Nominal Interest Rate 



s tated rate/coupon rate rep resents the rate s tated on the bond

Effective Interest Rate 



eff ective rate/discount rate repre sents the p resent val ue of the payments to be made

account for inflation 



cos t of financing that cons iders only the simple interest

- if cross term format, r = r* + IP + (r* x IP)

possibility of non-payment of principal by borrower



- present in corporate bonds - not present in government bonds



APR = I / (PxT) I = in terest amount P = principal T = time p eriod (year, usually 360)

Default Risk Premium (DRP)

- premium imposed to account for the

APY cos t of financing that considers compounding al so known as Effe ctive Annual Rate m APY = [1+(i/m) ]  - 1 i = n omi nal annual interest rate m = n umber of periods in a year

Risk free interest rate (r) - interest rate that represents risk-free security w/ inflation - if simple format, r = r* + IP



APR

Inflation Premium (IP)

- premium imposed on interest rate to

Annual Percentage Rate (APR) and Annual Percentage Yield (APY)

Real risk free i nterest rate (r*) - interest rate that represents risk-free



Liquidity Premium (LP) - premium imposed to account for the convertibility of the security into cash - present in corporate bonds

- not present in government bonds



Market Risk Premium (MRP) - premium imposed to account for the interest rate risk

- Interest rate risk - the possible loss due to the fluctuations of interest rates and prices over time - the longer the maturity period, the higher the MRP - present in both LONG-term government and corporate bonds Nominal Interest Rate of Securities: 







Short-term, Government issued - NIR = r

profit earned on investment

rate of return (%) - (amount received or current value of investment - amount invested) / amount invested





ERR = 7% + 6% + 4% / 3 ERR = 5.67% (c) IDILY Co. is considering to invest on a merchandising firm with a series of probabilities regarding the investment's return: Return

Probability

8%

30%

4%

50%

-3%

20%

Long term, Corporate issued - NIR = r + DRP + LP + MRP





(b) Carson invested in a stocks of Lasinga Co.. She expects to earn 7% in the first year, 6% in the second year, and 4% in the third year. What is her expected rate of return?

Short-term, Corporate issued - NIR = r + DRP + LP

Returns



ARR = 4%

Long-term, Government issued - NIR = r + MRP

Risk and Returns



ARR = (104,000 - 100,000) / 100,000

Expected Rate of Return (ERR) = rate of return expected  to be realized Required Rate of Return (RRR) = minimum rate of return acceptable  by the investor Actual Rate of Return (ARR) = rate actually earned Market Equilibrium = when RRR is equal to ERR on an investment

Example: (a) Dio invested PHP100,000 in a money market placement. After a year, he sold it for PHP104,000. What is the rate of return?

IDILY has a RRR of 4%. Should they invest on the merchandising firm? ERR = [( 8%)(30%)] + [(4%)(50%)] - [(3%)(20%)] ERR = 3.8% RRR = 4% > ERR = 3.8% IDILY Co. should not invest on the merchandising firm because the ERR doesn't meet or surpass the RRR. Risk 

chance of loss

Risk in a Single asset 

Stand Alone risk - risk when holding only one asset



Standard Deviation ( σ)

- a tool to determine level of risk 2 - σ = √∑ -     P

- the higher standard deviation, the higher probability of experiencing amounts of return

- as a rule, riskiness of a portfolio will

different

decline as the number of stocks in the portfolio increases

- impossible to form completely riskless

Example:

stock portfolios

Find the standard deviation of the return on the merchandising firm (from IDILY Co. example). Expected Return

 -     )

 -     )

2

2

 -     ) P**







8%

4%

-3%

8% - 3.8% = 4.2%

0.001764

4% - 3.8% = 0.2%

0.000004

-3% - 3.8% = -6.8%

0.004624

0.000529

Capital Asset Pricing Model (CAPM) - A model based on the proposition that any the risk-free rate of return plus a risk premium that reflects only the risk remaining after diversification

0.000925

2

P ) = 0.001456 2

when the expected returns on two alternatives are not the same

r = required return on the security rf   = risk-free rate of return or return on

- rm  = market rate of return or return on risky securities

Coefficient of Variation (CV)

the higher the CV, the higher the risk. - CV = σ /      - more meaningful basis for comparison

r = rf  + β(MRP); or r = rf  + Risk Premium

riskless securities

= 0.038157568 or 3.82%

- measure of risk per return - represent the relative level of risk. Hence,

CAPM formula: - r = rf  + β(rm - rf ); or

-

**P = Probabili ty

Standard Deviation ( √∑ -    P)



Market Risk - risk that cannot be eliminated by diversification.

0.000002



Variance ( ∑   -    

- MRP = market risk premium 

Beta Coefficient ( β) - measures the riskiness of a security

β = 1.0

β < 1.0

β > 1.0

average beta

defensive/ conservative beta

aggressive beta

change in market return is equal  to the change in the return on the investment

change in market return results to a lower  change in the return on the investment

change in market return results to a higher  change in the return on the investment

Risk in a Portfolio 

be

stock’s required rate of return is equal to

0.001456       

Diversifiable Risk - risk that can eli minated by proper diversification

Diversification

- investing in more securities to reduce risk - does nothing to reduce risk if the portfolio consists of perfectly positively correlated stocks

- reduces risk but does not eliminate it

Security Market Line (SML) 

graphically depict the interaction between Beta and Required Rates of Returns (RRR)

line representing market rate

RRR

ma rket risk premium

β



ris k free rate

change in SML due to change in inflation

-

MRP = same market rate = changes risk free rate = changes

ma rket risk premium

RRR ris k free rate

β



change in SML due to investors' behavior

-

MRP = change market rate = same risk free rate = same

ma rket risk premium

RRR

ris k free rate

β

II. Questions B. The Financial Environment Theories A. Introduction to Financial Management

True or False 1. Corporate earnings may be subject to double taxation. 2. You can set up a Limited Liability Company in the Phili ppines legally. 3. Limited Liability Companies is a hybrid between a partnership and a corporation. 4. The primary goal of a corporation's management is to maximize the corporation's profit. 5. General Partnerships are treated like corporations regarding 30% corporate income tax. 6. The corporation will not suffer an agency problem if the managers of the firm own 100% of the common stock. 7. Executive stock options are options to sell stock at a stated price within a specified time. 8. Conflicts between stockholders and creditors of a corporation can exist. 9. The Controller does not handle the accounting aspect of the corporation. 10. The Controller does not handle the investing decisions of the corporation. 11. Maximizing earnings per share is the same as maximizing stock price per share. 12. Creditors are not prioritized over stockholders in the event of bankruptcy. 13. Hostile takeovers most likely occur when a firm's stock is undervalued relative to its potential because of poor management. 14. Interest rates can affect stock price. 15. All stockholders are stakeholders and all stakeholders are stockholders.

Write A if the first statement is correct, B if the second statement is correct, C if both statements are correct, and D if none of the statements are correct. 1. Initial Public Offering can be done twice by the same corporation. A Seasoned Offering can be done without making an Initial Public Offering first. 2. Stocks of a corporation can be sold in a primary market. Stocks of a corporation can be sold in a secondary market. 3. Carson engages in a spot market transaction if she buys 50 pieces of iPhone S7 at March 12, 2017 but arrives in her shop at March 14, 2017. Dio engages in a futures market transaction if he contracted with the seller at March 12, 2017 to buy 50 kilos of rice in the date's current price but agreed with the sell er to deliver the goods on June 14, 2017. 4. Physical asset markets are those where the products are real assets like house and lots. Hence, mortgages are also sold on physical asset markets because they are claims on real assets. 5. Treasury notes are capital market transactions. Similarly, treasury bills are capital market transactions. 6. Life insurance is a private market transaction. Sale of bonds by a private corporation is also a private market transaction. 7. Hedging is an example of a derivative. Hedging is an example of a forward contract. 8. Underwriters facilitate issuance of securities in direct transfers of securities. Underwriters are unnecessary in direct transfers of securities.

9. You can invest in the securities issued by a financial intermediary. You can't invest in the securities of an investment bank because they don't issue thei r own securities. 10. Investment banks are merely intermediaries for selling securities. Financial intermediaries are not intermediaries to their investors regarding the securities they buy. 11. Mutual funds pools money from investors to buy a portfolio of securities. Mutual funds are investment banks. 12. Preferred stocks are classified as money market transactions. Common stocks are capital market transactions. 13. Bondholders have a fixed income. Stockholders also earn fixed income from their shares if the corporation has been earning at a net profit for several years continuously. 14. Commercial papers are money market transactions. Corporate bonds are also money market transactions. 15. Common stocks are less risky than preferred stocks. Bonds are riski er than common stock. C. Risk and Returns & Interest Rates

True or False 1. Default risk premiums act as a compensation in case a borrower will def ault. 2. When a market change will cause a higher degree of change in stock, there is a defensive beta. 3. Market return determines market risk premium. 4. In all the three types of beta, the di rection of movement of shares shall be in the same direction as the market change. 5. The term structure of interest rates pertain to the relationship between bond yields and the maturity of the bonds.

6. The reason why maturity risk premium is incorporated in calculating rates is to reflect the interest rate risk. 7. Measuring the risks of a standalone instrument is the same as measuring the risks of a portfolio. 8. If we measure the risk of an asset in a portfolio, we are only concerned to the extent it contributes to the market risks. 9. When we measure risk, we take into account all of the possible risks that may exist. 10. A change in investor behavior will shift the security market line. 11. The higher the standard deviation, the wider and flatter the graph. 12. Lender’s time preference fo r consumption,  just

like

the

borrower’s

production

opportunities, has a direct relationship with interest rate. 13. The lesser the production opportunities of a borrower, the lower the rate. 14. Systematic risks are those that may be eli minated through diversification. 15. Due to diversification, one may not simply get the weighted average of the standard deviation of each instrument to measure the risks of portfolios. D. Identification

1. A behavior wherein investors generally do not want risks but with considerable amount of risks, may ask for higher returns. 2. It is the interest rate that does not consider compounding effects. 3. It is the additional interest provided for securities that are fairly more difficult to convert into cash. 4. It is the relative level of risk per unit of return. 5. It is the state where the required rate equals the expected rate. 6. It is the beta when stocks respond directly to fluctuations in the market. 7. The term used to pertain to the rate where the real risk free interest rate is infused with infl ation premium.

8. The method in calculating the interest rate used when the real risk free interest rate and inflation premium are relatively high and material. 9. What is the premium not incorporated in the rates of sovereign state-issued and government-issued securities? 10. What are the possible reasons for a shift in the security market li ne? 11. What are the possible reasons for a change in the slope of a security market line? 12. It is the particular risk of a security in relation to its existence in the market. 13. It is the minimum rate of return acceptable for an investor on a portfolio investment. 14. This measures portfolio riskiness and volatility 15. It is the risk which states that it is better to invest in a long-maturity security than to invest yearly. E.Multiple Choice

1. The beta that causes a higher degree of change in stock when the market changes A. Defensive beta B. Aggressive beta C. Conservative beta D. None of the above 2. A change in investor behavior causes A. the security market line to shift downwards B. the security market line to shift upwards C. the security market line’s slope to become steeper D. the security market line’s slope to become flatter 3. A defensive beta has a beta that is A. Equal to one B. Less than zero C. Less than one D. More than one

4. Which is correct? A. Calculating the weighted average of the standard deviations will determine portfolio risks and volatility B. Diversification makes more sense in a perfectly positive relationship C. Market portfolios contain diversifiable risks D. Correlation coeff icient is measured through roh 5. A normal term structure of a bond is A. Upward sloping B. Downward sloping C. Humped D. Consistent 6. What does a negative beta suggest? A. If market performance gets better, returns will be higher B. The portfolio is that of luxury goods C. A and B D. The portfolio is that of inferior goods 7. Which is incorrect? A. Risk is about the dispersal of the possible returns rather than the loss itself B. Variable returns may be based on simple averages or on probabilities C. Market risk premium determines market rate D. Due to their high prices, luxury goods are less volatile and have betas less than one 8. Investors who are willi ng to take risks when higher returns are offered A. Risk Averse B. Risk Takers C. Either a or b D. Neither a or b

9. This premium depends on the several credit characteristics ultimately embodied in some credit scores or ratings A. Inflation premium B. Default risk premium C. Liquidity premium D. Maturity risk premium 10. Which is true about the se curity market line? A. If the real risk free rate change, market rate changes at the same rate B. If an investor becomes more risk averse, the change in market risk premium is not the same as the rate of change in slope C. Both A and B D. Neither A or B F. Problems Risk and Returns

1. Consider the following investments. Which investment would a risk averse investor prefer? a. Investment A: Expected return = 11%, Standard deviation = 12% b. Investment B: Expected return = 10%, Standard deviation = 10% c. Investment C: Expected return = 11%, Standard deviation = 10% d. Investment D: Expected return = 11%, Standard deviation = 11% 2. Joe Investor has invested in three securities: A, B, and C. What is the beta of his portfolio, considering the amount invested in each security and the individual security betas? Security A: Invested P30,000, beta of 1.50 Security B: Invested P20,000, beta of 2.00 Security C: Invested P20,000, beta of 0.50 a. b. c. d.

1.3572 1.4789 1.2098 0.8943

3. Consider Joe Investor once again (the previous problem). If he had invested P100,000 in Security C (instead of P20,000), with all other investments the same, what is Joe's portfolio beta? a. 0.8900 b. 0.6578 c. 0.8997 d. 1.0909 4. An analyst has provided information on possible returns (and their likelihood of occurring) for the Icahn Trust Corporation stock. What is the standard deviation of the expected returns for this stock, given the following distribution? Scenario 1: probability = 20%, return = -40% Scenario 2: probability = 50%, return = 0% Scenario 3: probability = 30%, return = 30% a. b. c. d.

35.78% 21.56% 24.26% 56.12%

5. Calculate the expected peso return and the standard deviation of these possible returns for the Pizza Palace, given the following possible returns:

Scenario Probability

Possible dollar return

Success

20%

+P50

Normal

50%

+P10

Bomb

30%

-P10

a. b. c. d.

P12; P18.7685 P12; P21.6789 P12; P22.9123 P12; P20.8806

6. Espinosa Coffee & Trading, Inc.'s common stock measured beta is calculated to be 0.75. The market beta is, of course, 1.00 and the beta of the industry of which the company is a part is 1.10. If Merrill Lych were to calculate an "adjusted beta" for Espinosa's common stock, that adjusted beta would most likely be a. less than 0.75 b. more than 0.75, but less than 1.10 c. equal to 1.10 d. equal to 0.95 {i.e ., (1/3) x (0.75 + 1.00 + 1.10)} 7. Plaid Pants, Inc. common stock has a beta of 0.90, while Acme Dynamite Company common stock has a beta of 1.80. The expected return on the market is 10 percent, and the risk-free rate is 6 percent. According to the capital-asset pricing model (CAPM) and making use of the information above, the required return on Plaid Pants' common stock should be, and the required return on Acme's common stock should be a. 3.6 percent; 7.2 percent b. 9.6 percent; 13.2 percent c. 9.0 percent; 18.0 percent d. 14.0 percent; 23.0 percent 8. The firm of Sun and Moon purchased a share of Acme.com common stock exactly one year ago for P45. During the past year the common stock paid an annual dividend of P2.40. The firm sold the security today for P85. What is the rate of return the firm has earned? a. 5.3% b. 194.2% c. 88.9% d. 94.2% 9. Clive Rodney Megabucks offers your friend, Melanie, an interesting gamble involving giving her the choice of the contents in one of two sealed, identical-looking boxes. One box has P20,000 in cash and the second has nothing inside. There is an equal probability that the chosen box contains cash versus

nothing. Melanie states that she would not call off the gamble if you offered her a certain P10,999 instead of her choice of box. However, she would be indifferent if P11,000 was offered in place of the risky gamble; and she would definitely take P11,001 to call off the gamble. We would describe Melanie as __________ in this instance. a. being risk averse b. being risk indifferent c. having a risk preference 10. Clive Rodney Megabucks offers your friend, Yunyoung, an interesting gamble involving giving her the choice of the contents in one of two sealed, identical-looking boxes. One box has P20,000 in cash and the second has nothing inside. There is an equal probability that the chosen box contains cash versus nothing. Yunyoung states that she would not call off the gamble if you offered her a certain P4,999 instead of her choice of box. However, she would be indifferent if P5,000 was offered in place of the risky gamble; and she would definitely take P5,001 to call off the gamble. We would describe Yunyoung as __________ in this instance. a. being risk averse b. being risk indifferent c. having a risk preference Interest Rates

11. For an interest rate of 12% per year compounded quarterly, the effective interest rate per year is closest to: a. 4% b. 12% c. 12.55% d. 12.68% 12. For an interest rate of 2% per month, the effective semiannual rate is closest to: a. 11.55% b. 12% c. 12.62% d. 26.82%

13. An interest rate of 1% per month is the same as: a. Nominal 3% per quarter compounded monthly. b. Effective 12.683% per year compounded monthly. c. Nominal 12% per year compounded monthly. d. All of the above. 14. An interest rate of effective 12% per year compounded monthly is nearest to: a. 1% per month. b. 3.04% per quarter. c. 6.15% per semiannual period. d. Nominal 11.39% per year compounded monthly. 15. When interest is compounded continuously: a. The cash flow must also occur continuously. b. The cash fl ow must be converted into continuous cash flow. c. The interest rate must be converted into an annual rate. d. None of the above. 16. An interest rate stated as nominal 12% per year compounded quarterly is the same as: a. effective 1% per month. b. nominal 1% per month. c. 3% per quarter. d. 12.68% per year. 17. An interest rate of 12% per year compounded continuously is the same as: a. Nominal 1% per month compounded continuously. b. Effective 1.08% per month compounded continuously. c. Effective 12.683% per year compounded continuously. d. None of the above

18. Determine the nominal risk-free rate of return if the risk-free rate is 3% and the rate of inflation is 3%.

19. The real risk-free rate is 6% per year, and the expected inflation rate is 2% per year. What is the annual nominal rate of interest?

20. Jungle Jim’s Outfitters, a local outdoor equipment retail store, wants a 1-year, $50k loan from your bank. You have already determined that this firm warrants an DRP of 5%, an LP of 1% and an MRP of 0.5%. Today’s WSJ reports 30-day T-bills are currently yielding 2.3%. What is an appropriate interest rate for this loan?

(nos. 21- 23) Jihad Jim’s Travel Adventures, a new travel agency, wants a 3-year, $500k loan from your bank. You have already determined that this firm warrants an DRP of 10%, an LP of 3% and an MRP of 1.5%. Today is 2 January. Inflation for the rest of this year is expected to

26. The real risk-free rate is 3%, and inflation is expected to be 3% for the next 2 years. A 2year Treasury security yields 6.2%. What is the maturity risk premium for the 2-year security?

remain at 2 %. Net year’s inflation is epected to be 2.5% and the following year’s inflation is epected to be 3%. Today’s WSJ reports 30-day

T-bills are currently yielding 2.3%. What is an appropriate interest rate for this loan? 21. Find r* 22. Find IP 23. Find r

24. Real risk-free rate You read in The Wall Street Journal that 30-day T-bills are currently yielding 5.5 percent. Your brotherin-law, a broker at Safe and Sound Securities, has given you the following estimates of current interest rate premiums: Inflation premium 3.25% Liquidity premium 0.6% Maturity risk premium 1.8% Default risk premium 2.15% On the basis of these data, what is the real risk-free rate of return?

25. A Treasury bond that matures in 10 years has a yield of 6%. A 10-year corporate bond has a yield of 8%. Assume that the liquidity premium on the corporate bond is 0.5%. What is the default risk premium on the corporate bond?

27. Calculate the effective annual interest rate equivalent to a nominal interest rate of 8,75% p.a. compounded monthly

28. If your credit card calculates the interest based on 12.5% APR, what is your monthly interest rate and annual effective interest rate, respectively? What is the monthly interest rate?

29. From no. 28 , what is the effective annual rate?

30. One-year Treasury securities yield 5%. The market anticipates that 1 year from now, 1year Treasury securities will yield 6%. If the pure expectations theory is correct, what is the yield today for 2-year Treasury securities?

III. Answer Key Theories: A.

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15.

T F T F T T F T F T F F T T F

B.

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15.

D C C A A A C B C C A B A A D

C.

1. 2. 3. 4. 5. 6. 7. 8. 9.

T F F T T T F T F

10. 11. 12. 13. 14. 15.

F T T T F T

D.

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15.

Risk Aversion Nominal interest rate Liquidity Premium Coefficient of Variation Market Equili brium Average Beta Risk free interest rate Cross term format Default Risk Premium Inflation (A change in risk free rate or market rate) A change in investor behavior or a change in risk aversion Systematic/Non-diversifiable/Market risk Required rate of return Beta Reinvestment rate risk

E.

1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

B C C D A D D A B C

5. Answer: D

F. Problems

1. Answer: C Since it provides the greater return for the lowest risk (in comparison with the other three investments)

Expected dollar return = (0.2)(P50) + (0.5)(P10) + (0.3)(-P10) = P12 Variance = 288.80 + 2.00 + 145.20 = 436.00

2. Answer: A Total investment in the portfolio is P70,000 Proportion invested in Security A = P30,000 / P70,000 = 0.4286 Portfoli o beta = (0.4286)(1.5) + (0.2857)(2.0) + (0.2857)(0.5) Portfoli o beta = 0.6429 + 0.5714 + 0.1429 Portfoli o beta = 1.3572

6. Answer: B Merrill Lych would adjust for the tendency of measured betas to revert toward the beta of the market portfolio or toward the beta of the industry to which the company is a part. So, its adjusted beta would end up higher than 0.75, but never more than 1.10. 7. Answer: B Plain required return = 0.06 + [(0.90)(0.10 – 0.06)] = 0.096

3. Answer: C Total investment in the portfolio = P150,000 Proportion invested in Security A = P30,000/P150,000 = 0.2000 Portfoli o beta = 0.8997 4. Answer: C p x return return)2 -0.08 0.00 0.09 0.01

Standard deviation = 0.5 436.00  = P20.8806

p x (return - Expected 0.03360 0.00005 0.02520 0.0589

Expected return = .01 or 1% Standard deviation = square root (0.0589) = 0.2426 or 24.26%

Acme required return = 0.06 + [(1.8)(0.10 – 0.06)] = 0.132 8. Answer: D Return is over the two-ye ar period and includes both dividends and capital gains. Return = [(P2.40) + (P85 - P45)] / P45 = 94.2% 9. Answer: C Melanie would have had to tell us that she was indifferent at a guarantee of P10,000. Thus the expected value = the certainty equivalent.

10. Answer: A

17. Answer: A

Yunyoung would have had to tell us that she was indifferent at a guarantee of P10,000. Thus the expected value = the certainty equivalent.

18. Answer: 6.09% Rnominal = (1 + 0.03) x (1 + 0.03) - 1 = 6.09% 19. Answer: 8.1%

11. Answer: C i = (1+.12/4)^4 – 1 = 12.55 %

Nominal rate = (1.06) x (1.02) - 1 = 8.1% 20. Answer: 8.8%

12. Answer: C i = (1+.12/6)^6 – 1 = 12.62%

r = rRF  + DRP + LP + MRP = 2.3% + 5% + 1% + 0.5% = 8.8% 21. Answer: 0.3%

13. Answer: D 1% per month is a nominal 12% per year compounded monthly, which is the same as 12%/4 = 3% nominal per quarter compounded monthly. Also, computing the effective rate for nominal 12% compounded monthly, is: 12 (1 + 0.12/12)  – 1 = 0.12683 All values listed are correct. 14. Answer: 11.39% For a nominal rate compounded monthly equivalent to an effective 12% compounded monthly, find r. 12

0.12 = (1 + r/12)  – 1 1/12 (1.12)  = (1 + r/12) r/12 = 0.00949 r =11.39% 15. Answer: D 16. Answer: C Because both bonds are 10-year bonds the inflation premium and maturity risk

r* =rRF - Current Inflation Rate r* = 2.3% - 2% = 0.3% 22. Answer: 2.5% IPn= ( I1  + I2 + I3 ……..In) / n IP3 = (2% + 2.5% + 3%)/3 = 2.5% 23. Answer: 17.3% r = r* + IP + DRP + LP + MRP r = 0.3% + 2.5% + 10% +3% + 1.5% = 17.3% 24. Answer: 2.25% T-bill rate = r* + IP 5.5% = r* + 3.25% r* =2.25% 25. Answer: 1.5% rT10  = 6% = r* + IP 10  + MRP 10 ; DRP = LP = 0. rC10  = 8% = r* + IP 10  + DRP + 0.5% + MRP10 .

premium on both bonds are equal. The only difference between them is the liquidity and default risk premiums.

SOURCES:

rC10  = 8% = r* + IP + MRP + 0.5% + DRP.

Fundamentals of Financial th Management 12   Edition by Brigham and Houston

But we know from above that: r* + IP 10  + MRP 10  = 6%

Financial Management Vol. 1 (2   Ed) by Bagayao, Layug and Manalo.

Therefore, rC10  = 8% = 6% + 0.5% + DRP So, DRP = 1.5% 26. Answer: 0.2% rT2 = r* + IP 2  + MRP2  = 6.2% rT2 = 3% + 3% + MRP 2  = 6.2% MRP2   = 0.2%. 27. Answer: 9.1% i = (1+ .0875/12)^12  – 1 = 9.1 % 28. Answer: 1.0417% i = (12.5%/12) = 1.0417% 29. Answer: 13.24% i = (1+0.010417)

12

= 13.24%

30. Answer: 5.5% rT1 = 5%; 1 rT1 = 6%; rT2= ? 2 (1 + rT2)  = (1.05)(1.06) 2 (1 + rT2)  = 1.113 1 + rT2 = 1.055 rT2 = 5

nd

PREPARED BY:

Kyle Patrick Mallare Venz Zeus Baba Nicole Gimarino Jeanne Marie V icente