Correlation: A perfect positive correlation means as X increases, Y increases at the same rate Y Corr =.0 X A perfect negative correlation means as X increases, Y decreases at the same rate Y Corr = -.0 X A Zero correlation means that there is NO relationship between X & Y Y Corr = 0 At what point does a competitive firm MAXIMIZE profits? A competitive firm maximizes profits at the point where Marginal Revenue (MR) equals Marginal Costs (MC). Profit Max MC MR Define and give an example of the Weighted Average Cost of Capital (WACC) The WACC is the weighted average cost of debt (after tax) plus the cost of Preferred Stock (if any) plus the cost of Equity. Example: Debt has a cost of 6% and a tax rate of 0% - Weight of 0% Equity has a cost of 0% with a Weight of 80% WACC = ((6% * ( -.0)*0%) + (0% * 80%) = (.% * 0%) +( 8%) =.8% + 8% = 8.8% D/E Equity Ratio is simply Debt / Equity. Above example is.0/.80 =.5 Discuss Features of a Callable Bond. Bonds are debt instruments issued by corporations and/or public entities. Generally, they are issued in increments of $,000 Face Value which means that at their maturity, the holder of the bond will be paid $,000. Coupon paying bonds pay a certain % (the coupon rate) either annually or semi-annually. Callable bonds are bonds that an entity reserves the right to "CALL" back from the holder. For example, if interest rates decrease, the call provision allows the bond issuer to "call" or buy back the higher interest rate bonds and then reissue lower paying debt. Consumers are aware of this and generally will demand a "sweetener" to allow the issuing entity to hold the call provision. This will usuually come in the form of: A call premium or a slightly higher interest rate than would be offered on non-callable bonds. 5 Ratio Analysis 5 5 Ratio Analysis is used to measure different aspects of a firm's performance. A Summary: Page of 5
5 Current Ratio = Cur Assets / Current Liabilities = Liquidity 5 Acid Test Ratio = Cur Assets less Inventory/ Cur Liabilities = More specific test of liquidity 5 Average Collection Period = Accts Receivable/Daily Credit Sales = Days from sale to cash. 5 Operating Profit margin = EBIT/Sales = A firm's margin on its core operations. 5 Asset Turnover = Sales / Total Assets = How many $ a firm is generating from each $ in Assets. 5 Fixed Asset Turnover = Sales / Net Fixed Assets = How well a firm is utilizing its net fixed assets. 5 Debt Ratio = Debt / Total Assets = How much of a firm's assets are financed by Debt. 5 Time Interest Earned = EBIT / Interest = How well a firm can meet its debt obligations 5 Return on Equity (ROE) = Net Income / Equity = % return to Equity Holders. 5 6 Corporate Bond Examination 6 A Bond is an I.O.U. of a public entity or a corporation. The components of a bond can generally be 6 expressed as a function of the following: 6 The Par Value = Generally, $,000 increments. The bond promises to pay you the Par amount (Face 6 Value ) at maturity which will normally be $,000. 6 The coupon rate which is a % of the Par Value paid to the bond-holder usually semi-annually or annually. 6 Example: A 0% coupon bond pays either $ 00 annually or $ 50 semi-annually (twice per year). 6 Time to Maturity: A 0 year bond will pay you the coupon payment over the life of the bond either 6 annually or semi-annually and the Par value at the end of the 0th year. 6 The Market Interest Rate or Yield to Maturity (YTM) = Current, market rate of interest that bonds of similar 6 risk are trading for which may be different than the coupon rate! 6 There is an INVERSE relationship between YTM and the Coupon rate. If YTM is > than Coupon the bond 6 trades at less than $,000 (discount). If the YTM is < Coupon, the bond trades at more than $,000! 6 If Coupon = YTM, the bond trades at par or exactly, $,000! 6 The Fischer Effect - Interest Rates Nominal Rate (The quoted Rate of Interest) = Real Rate plus (approximately) the Inflation component Example: Real Rate is 5% and Inflation is %, Therefore the Nominal rate is approximately 8% More exactly, the Equation should be ( +.05) * ( +.0) - =.085 - = 8.5%. The equation can be algebraically solved for any variable given two of the others are known. Example: Nominal Rate is 8% and Inflation is given at % - Find real rate: Nominal Rate of 8% less % = approximately 5% - Exactly, the equation would be: (+.08)/(+.0)- = an EXACT real rate of.85% 8 International Finance Glossary: 8 8 American Depository Receipt (ADR) = An instrument, issued by a bank, in US $ traded on a US exchange. 8 This provides a way for Foreign stocks to be effectively traded in the US. 8 Capital Account = All capital transfers into and out of a country related to the purchase and sale of fixed assets. 8 Current Account = All inflows and outflows of income derived from exporting and exporting goods and services. 8 Direct Foreign Investment = Investing in Plant & equipment and other assets abroad. Highest financial commitment. 8 Eurobonds and EuroDollars = US bonds and US $ held abroad. Example: US $ deposit in a French bank. 8 Hedging = Creation of offsetting positions so that gains in one asset will be balanced by losses in another. 8 Managed Float = Currencies are allowed to "float" against each other with Government intervention to manage 8 valuation of a country's currency. This is the model used primarily today. 8 Purchasing Power Parity (PPP) = A theory that states that goods should be worth the same all over the world 8 given a fair exchange rate. The "law" of one price! 8 9 Capital Budgeting Concepts: 9 ) Use free cash flows that are INCREMENTAL and RELEVANT to the decision! IGNORE interest payments 9 or sunk costs. The interest payment will be built into the required rate of return and sunk costs are irrelevant 9 as they have already been spent! 9 ) The relevant cash flows are the incremental INITIAL OUTLAY, ANNUAL-After Tax FREE CASH FLOWS, and the Page of 5
9 TERMINAL CASH FLOW. 9 ) Methods of making the Capital Budgeting Decision are: 9 A) Payback method which simply computes the time it takes to recover the Initial Outlay with no interest charge 9 B) Discounted Payback - Same as Payback but does discount future cash flows to Present Value. 9 C) Profitability Index - Ratio of Present Values of Cash Flows to Initial Outlay. If.0 or greater, ACCEPT 9 D) Internal Rate of Return (IRR) - The rate at which the Present Value of the future cash flows equals the IO 9 E) NPV - Net Present Value Method - Computes the Present Value of future cash flows less IO 9 If positive, ACCEPT - If Negative - REJECT. Note: Most analysts believe the NPV method is the 9 BEST method for Capital Budgeting Decisions. 9 0 Efficient Markets: 0 0 Modern Finance Theory is, in great part, predicated on the fact that markets are efficent. 0 0 Three forms- Efficent Market Hypothesis (EMH): 0 Weak Form - Market prices reflect all information that can be derived by examining market trading data 0 and historical information. Thus, technical analysis is not useful. 0 Semi-Strong Form - Market prices reflect all publicly known information about a firm including future 0 prospects. Thus, fundamental analysis is not useful. 0 Strong Form - Market prices reflect ALL information even insider knowledge. Thus, even insider knowledge 0 is not useful. 0 It is an unproven hypothesis but the theory underlying the EMH are that prices will be quickly bought 0 or sold to eliminate any mispricings. In short, a stock "truly" worth $ 00 that is trading for $ 05 will be 0 quickly sold off so that the price drops to the "correct" price of $ 00. Arbitrage opportunities, if available, 0 will not be available for more than moments. What are possible uses and results of Fiscal Policy? During Boom, Government may INCREASE taxes or DECREASE spending to slow down the economy. This would tend to lead to or increase a Government surplus. This is Contractionary Fiscal Policy. During Recession, Government may DECREASE taxes or INCREASE spending to increase economic activity. This would tend to lead to or increase a Government deficit. This is Expansionary Fiscal Policy. Define and Discuss Fiscal Policy: Fiscal Policy, as opposed to Monetary Policy, consist of tools used by the Federal Government to influence economic and financial performance of a nation's economy. Commonly these tools are as follows: Increase spending to fend off a recession. Decrease spending to slow expansion. Cut taxes to stop a recession and increase private spending Raise taxes to slow down an economy and reduce private spending. Discuss Monetary Policy. Monetary policy is administered by a Central Bank, which in the US is the Federal Reserve Board (FRB). The FRB is "independent" of the Federal Government in that it is responsible for implementing monetary policy to promote stable economic growth while maintatining a low and stable inflation rate. The main tools of the FRB or "the Fed" are: The Discount rate = the rate at which the Fed will loan to member banks. Raising (Lowering) this rate makes money more Expensive (Cheaper) which will Slow (Speed) up the economy. Not used often. The Fed Funds Rate = the rate at which member banks can borrow from each other for a short time. The Fed influences this rate generally by using Open market operations and targeting. Open Market Operations = The Fed sells Treasury securities which contracts money supply or buys Page of 5
Treasury securities which increases money supply. Used often! Reserve Requirements: The Fed sets the percentage of deposits which all banks must keep on reserve. It is apparent that "easy" monetary policy decreases interest rates which stimulates investment and consumption and "tight" monetary policy increases interest rates which slows consumption and investment. What happens if the Exchange Rate between Japan and the US goes from 00 Y/$ to 0 Y/$? Value in $ is the reciprocal of the Y/$ rate. $ 0.000 $ 0.009 00 0 Thus, it takes MORE Yen to buy a $ OR less $ to buy a Yen This means that US $ buys MORE Yen which means Japanese goods become cheaper to a US Buyer. Japanese goods will be CHEAPER which will INCREASE Japanese imports to US. Conversely, US goods become more expensive to the Japanese and US Exports to Japan will decrease. 5 What factors are relevant in causing the value of the US $ to rise or fall? 5 5 US Inflation rates. Inflation UP = $ DOWN or Inflation DOWN = $ UP 5 US Real Interest rates. Real Rate UP = $ UP or Real Rate DOWN = $ DOWN 5 Foreign demand for US products. Foreign Demand UP = $ UP or Foreign Demand DOWN = $ DOWN. 5 US Incomes relative to other nations. US Incomes UP = $ DOWN or US Incomes DOWN = $ UP. 5 Consumer Tastes and preferences. 5 5 Example: If demand for US goods increases, foreign nations need more US $ 5 which causes the demand for US $ to increase which raises its price related to 5 a foreign currency. 5 If $.00 was worth 00 Yen, an increase in US goods would cause the $.00 to cost 5 more than the base 00 Yen or perhaps 0 Yen. The US $ has increased in value 5 compared to the Japanese yen. 6 Discuss methods of International Currency hedging. 6 6 Often, a Multi-National Company (MNC) that exports or imports products and/or 6 services abroad faces the risk of a foreign currency fluctuating in value versus the 6 home (U.S.) $. A method of dealing with this would be hedging the transaction. 6 For example, if a US firm sells a product worth $,000 to a Japanese buyer and agrees 6 to receive payment in Japanese Yen, there is a risk that the Yen could depreciate against 6 the US $ at time of payment. The US seller could insulate itself agains this by hedging or, 6 in this case, sell Japanese Yen futures at a locked in price. Assume that Japanese Yen futures 6 were selling for 00 Yen per $. The US firm could sell Japanese Yen futures at the futures rate 6 of 00 Yen per $. Thus, if the Yen depreciated to 0 Yen per dollar, the US seller would have locked 6 in the option to obtain $.00 for 00 Yen which hedges its risk against currency movements. 6 Results of hedging would tend to make the cash flows of the less volatile and therefore less risky. 6 Examination of Interest Rate Parity Interest Rate Parity exists when the real component of interest rates in different countries equate so that the currencies are equivalent in value at the end of a specific time. In theory, this would make the purchasing power of the two currencies equal after the specific time. For example, say the Japanese Yen was trading at 00 Yen per US $. If the real interest rate in both countries was 5%, there would be no difference in purchasing power at the end of a specific time. However, if the Japanese real rate was less than the US real rate, the Japanese Yen would depreciate in value at the end of the time so that the exchange rate would be say, 0 Yen to US $. In short, it now takes more Japanese Yen to purchase US $. If an MNC issued debt denominated in Japanese Yen, it would theoretically benefit from a strong US $ and falling Japanese interest rates as it would take less US $ to redeem the Japanese denominated debt which will have fallen in value against the US $. Page of 5
8 Foreign Currency Concept & Example: 8 8 Most nations now use what is called a Managed Float system. This means that the base currency is allowed 8 to float as the world market dictates but with a central government intervention if the Government wishes to 8 control its home currency's value. 8 8 Example: Assume Japanese Yen is currently at 00 Yen to US $. 8 8 If the Yen DEPRECIATES in value to 0 Yen per US $, the Japanese government may take action to 8 revalue the Yen by making the Yen MORE valuable per US $ than the world market perceives it. 8 The Japanese government may try to decrease the world supply of Yen by buying back Yen or making 8 Japanese goods more expensive by imposing tarriffs or import quotas, etc. In short, actions that make 8 the Japanese Yen MORE valuable will tend to restore the original equilibrium of 00 Yen per $. 8 Of course, if the Japanese Yen appreciated (e.g. 90 Yen per $) the actions could be reversed. 8 9 Computation of Net Present Value (NPV) 9 9 Net Present Value is a function of amount of cash flows, time of cash flows, and the discount rate 9 (interest charge) applied against the cash flows. 9 9 Example: 9 Time: 5 9 Cash Flows: $ 00.00 $ 00.00 $ 00.00 $ 00.00 $ 00.00 9 Rate: 0% 0% 0% 0% 0% 9 PV $ 90.9 $ 8.6 $ 5. $ 68.0 $ 6.09 9 NPV $ 9.08 9 The NPV of $ 00 each year for the next 5 years at 0% is $ 9.08 9 It should be apparent that the earlier the cash flows are received, the more they are worth 9 in present value terms. The later the cash flows are received, the less they are worth in present value. 9 0 Computation of Present Value and Future Values 0 0 Like the NPV, one can think of concepts of Present Value, Future Value, time (discounting periods), and 0 an (interest charge) applied against the cash flows. 0 0 Example: 0 PV = $ 00.00 Time Interest 0% Future Value = $ 0.00 0 or 00 * ( + i)^t.in short, the Future Value of $ 00 compounded at 0% for year is $ 0.00 0 0 Looked at from a different perspective: 0 FV = $ 0.00 Time Interest 0% Present Value = $ 00.00 0 or 0 / ( + i)^t..in short, the Present Value of $ 0 discounted at 0% for year is $ 00.00 0 Page 5 of 5