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Exam 2 Review Bonds Stocks Capital Budgeting 1

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

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

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

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

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

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

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Stock Example 1 l 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? l Answer: _______

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Stock Example 2 l 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? l Answer: _____

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Stock Example 3 l 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? l Answer: ________

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

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

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

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

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

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

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

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

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

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Year Cash flow 0– $275 1100 2100 3100 4100 Net Present Value Profile Discount rate 2% 6% 10% 14% 18% 120 100 80 60 40 20 Net present value 0 – 20 – 40 22% IRR NPV>0 NPV < 0

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NPV Profile - Multiple IRR Problem $0.06 $0.04 $0.02 $0.00 ($0.02) NPV ($0.04) ($0.06) ($0.08) 0.20.280.360.440.520.60.68 IRR = 25% IRR = 33.3% IRR = 42.8% IRR = 66.6% Discount rate

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

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