Questions

Questions

Review questions for Chapter 2, Finance Fundamentals

Q-2A.1 Give the general formula for absolute measure of value.
Q-2A1.1 What two processes are required to calculate the absolute measure of value?
Q-2A1.2 The choice of what variable is a major difficulty of absolute measure value calculation?
Q-2A1.3 Give examples of application of absolute measures of value.
Q-2A2.1 Give the formula for relative measure of value.
Q-2A2.2 Give examples of application of relative measures of value.
Q-2A2.3 Is the relative measure of value commonly used for stocks? Explain.
Q-2A2.4 What other relative measures of value are used for stocks?
Q-2A2.5 Which of the following two is the mathematically correct measure of average rate of return, arithmetic mean or geometric mean? Why?

Q-2B.1 What general term designates the benefits included in all measures of value?
Q-2B.2 What are the major characteristics of the cash flows that are included in value measurement?
Q-2B.3 Give examples of cash flows that increase wealth in investment decisions.
Q-2B.4 Are fixed costs relevant in an investment decision? Explain.
Q-2B.5 Should costs be deducted from cash flows? If so, which costs?
Q-2B.6 Are transaction, research and information costs deducted in stock purchase decisions? Why?
Q-2B.7 Should taxes be deducted from cash flows?
Q-2B.8 Are taxes deducted in stock purchase decisions? Why?
Q-2B.9 Should past costs be included in cash flow calculation?
Q-2B.10 Should the salvage cost of an existing equipment be considered or ignored when purchasing a replacement equipment?
Q-2B.11 Should depreciation be deducted from revenues in cash flow calculation?
Q-2B.12 What are cash flow equivalents? Name some.
Q-2B.13 Is the cash flow equivalent included in cash flow calculation for the full amount? If no, what amount?

Q-2B1.1 Is inflation ignored in cash flow calculation? When yes and when no?
Q-2B1.2 If cash flows are adjusted for inflation, how are they then called?
Q-2B1.3 If cash flows are adjusted for inflation what discount rate must be used?
Q-2B1.4 If cash flows are not adjusted for inflation, what discount should be used?
Q-2B1.5 If cash flows are adjusted for inflation, is there a distortion from depreciation? Which and why?
Q-2B1.6 Would you use a real discount rate in calculating the value of a bond?

Q-2B2.1 Why are past cost irrelevant?
Q-2B3.1 Is value affected by alternatives? Explain.
Q-2B3.2 What are the conditions for the initial purchase price to be relevant in investment decisions?
Q-2B3.3 How is a potential selling price entering in the assessment of value?

Q-2C.1 What do you call the process of converting amount in the future to their equivalent today?
Q-2C.2 What is the process of converting amount today into their equivalent at some date in the future?
Q-2C.3 What the branch of mathematics deals with discounting?

Q-2C1.1 Give the formula for future value of a single amount.
Q-2C1.2 What is the future value of $1,000 placed for two years at 10%?
Q-2C1.3 What is the future value of $800 placed for five years at 8%.
Q-2C1.4 What is the future value of $65,000 placed for twenty seven years at 6 and 3/8 %?
Q-2C1.5 Give formula for present value of single amount?
Q-2C1.6 What is the present value of $1,000 received two years from now and subject to a 10% discount rate?
Q-2C1.7 What is the present value of $3,000 received three years from now and subject to a 8% discount rate?
Q-2C1.8 What is the present value of $11,000 received three years from now and subject to a 5.75% discount rate?
Q-2C1.9 What is the present value of $357,000 received two years from now and subject to a 7 and 5/8% discount rate?
Q-2C1.10 What amount must be placed today to receive $6,500 four years from now, if the compounding rate is 4%?
Q-2C1.11 What is the price of a $10,000 bond maturing in six months and earning 10%?
Q-2C1.12 What is the price of a $10,000 bond maturing in 225 days and earning 8%?
Q-2C1.13 To what number of days is a year rounded to in US financial markets?
Q-2C1.14 To what number of days is a month rounded to in US financial markets?
Q-2C1.15 Give formula for intraannual compounding (compounding more than once within a year).
Q-2C1.16 What is the present value of $1,000 received in two years, discounted at 10% with quarterly compounding?
Q-2C1.17 What is the present value of $20,000 received five years from now, discounted at an annual rate of 7% with semiannual compounding?
Q-2C1.18 Give formula for continuous compounding using natural logarithms.

Q-2C2.1 Give formula for future value of an annuity.
Q-2C2.2 Give formula for present value of an annuity.
Q-2C2.3 Give formula for the future value factor of an annuity.
Q-2C2.4 Give formula for present value factor of an annuity.
Q-2C2.5 What amount is present in a savings account in which $500 are deposited each year for 20 years with annual compounding at 8%?
Q-2C2.5 What is the future value of an annuity of $2,000 received over 8 years with annual compounding at 7%?
Q-2C2.6 What is the future value of an annuity of $734 received over 35 years with annual compounding at 5.37%?
Q-2C2.7 What is the present value of a $800 annuity received over 9 years with annual compounding at 6%?
Q-2C2.8 What is the present value of a $23,000 annuity received over 19 years with annual compounding at 3.67%
Q-2C2.9 What is the price of $10,000 bond maturing in 10 years, earning an annual coupon of 6.75% and discounted at 7%?
Q-2C2.10 What is the price of a $10,000 bond maturing in 8 years, earning a semi-annual coupon of 8%, and discounted at 6%?
Q-2C2.11 What is the price of a $10,000 bond maturing in four and a half year, earning a semi-annual coupon of $345, and discounted at 7.85%?
Q-2C2.12 Give formula of an annuity received for ever.
Q-2C2.13 What is the present value of a $40 annuity received forever discounted at an annual rate of 2.5%?
Q-2C2.14 What is the present value of a $65 annuity received forever discounted at an annual rate of 8.7%?
Q-2C2.15 Give the formula of an annuity received forever and growing at a constant rate.

Q-2D.1 What are the six components affecting interest rates?
Q-2D.2 Which component of the six components affecting interest rates can dwarf all others?

Q-2D1.1 Give the general formula relating real and nominal interest rates when inflation is moderate.
Q-2D1.2 Give the mathematically correct formula relating real and nominal rates.
Q-2D1.3 How does one deal with very high inflation in valuation of projects?
Q-2D1.4 Is restating all cash flows as real amount useful in the case of a financial instrument with stated installments and payments? Explain.

Q-2D2.1 In which periods (of recession or expansion) is the compensation for non-use of money driving interest rates higher?
Q-2D2.2 What is the name given to the component of interest rates attributable foregone earnings?

Q-2D3.1 What are the three reasons for holding cash?

Q-2D3.2 When is liquidity preference higher, in recession or expansion?
Q-2D3.3 What is the name given to the speed with which money turns over in the hands of consumers?
Q-2D3.4 When is velocity higher in recession or expansion?
Q-2D3.5 When is a larger volume cash held on hand, in recession or expansion?
Q-2D3.6 When is it unwise to hold long term bonds and make long term loans?
Q-2D3.7 How does liquidity preference affect interest rates?
Q-2D3.8 When financial markets are well developed, are individuals encouraged to hold large cash balances?

Q-2D4.1 Does a longer contract require a higher interest rate? Why?
Q-2D4.2 What are the three names given to the pattern of relationship between length of contract and interest rate?
Q-2D4.3 In which circumstances is the yield curve extremely steep? Give reasons.
Q-2D4.4 In which circumstances is the yield curve downsloping? Give reasons.
Q-2D4.5 How does segmentation of markets affect the yield curve?

Q-2E.1 Is the interest on riskier assets higher? Explain.
Q-2E.2 Do historical rates verify the relationship between rates and risk? Give examples of rates.
Q-2E.3 Are historic rates appropriate when selecting a discount rate? Why.
Q-2E.4 What financial assets are used to calculate a risk free rate?
Q-2E.5 What assures that the risk free financial assets are truly risk free?
Q-2E.6 Where can representative risk free rates be found?
Q-2E.7 What is the name of the theory that formulates how to measure risk?
Q-2E.8 What are the two sources of motivation in constructing a portfolio?
Q-2E.9 Does the portfolio theory suggest that investors hold only stocks? Explain.
Q-2E.10 What do you call the process of buying a similar assets that has a slightly lower risk or a slightly higher return?
Q-2E.11 What determines the risk of a stock in mathematical terms? Give different concepts.
Q-2E.12 When a stock becomes more risky, how does investors' behavior affects mathematical measures of risk?

Q-2E1.1 Give the formula for BETA.
Q-2E1.2 Give formula for risk adjusted required rate of return.
Q-2E.13 Give formula for market risk premium.
Q-2E.14 Is risk premium for stocks higher than bonds? Why.
Q-2E1.5 What is the value of market BETA?
Q-2E1.6 What is the value of BETA for an asset of above average risk?

Q-2E2.1 What is the problem with BETA estimates?
Q-2E2.2 When measuring BETA is especially unreliable?
Q-2E2.3 How are adjusted BETA's calculated?

Q-2E3.1 Give examples of industries with BETA lower than one.
Q-2E3.2 Give examples of industries with BETA higher than one.

Q-2E4.1 Describe what efficient market hypothesis states?
Q-2E4.2 Do all practitioners support the efficient market hypothesis? Explain.
Q-2E4.3 What are the names of more advanced description of portfolio theory?

Q-2F.1 Give definition and formula of stock period return.
Q-2F.2 Give formula for dividend yield.
Q-2F.3 Define and give formula for yield to maturity.
Q-2F.4 Give formula for current yield.
Q-2F.5 Give formula for coupon yield.
Q-2F.6 Define loan effective rate of interest.
Q-2F.7 Define APR.
Q-2E.8 Define internal rate for return.

Q-2G.1 What relationship exist between price and return?
Q-2G.2 What prediction can be made about the price of stock which has an actual rate of return lower than the required rate of return?
Q-2G.3 If a coupon rate is lower than yield to maturity, does the bond sell at a discount or premium?
Q-2G.4 As time approached maturity, to which value does the price of bond tend?

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Last modified: Jun/01/01 Next: Exercises, Cases & Assignments