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University of Santo Tomas

Alfredo M. Velayo - College of Accountancy


A.Y. 2016-2017

REVIEWER FOR FINANCIAL MANAGEMENT

I. NOTES
Sole Partnership Corporation
Introduction to Financial Management Proprietorship (General)
Finance consists of 3 inter-related areas: easy and inexpensive to form Tedious to
money and capital markets form
investments difficult to find financing/raise easy to find
financial management capital financing

Kinds of organizations: unlimited personal liability limited


personal
Sole Proprietorship liability
Partnership
- Theres always must be at least one limited life unlimited life
general partner. When there are no no corporate subject to corporate income
general partners, it is called an LLC. income tax tax
Corporation
- may be subject to double taxation on regulated by regulated by SEC
DTI
income: corporate income tax on the
income and tax on dividends when income no separate has a separate judicial
is distributed judicial personality
- Publicly listed company: corporations personality
whose shares are offered to the public and
subject to few subject to
traded in the stock market. Corporations
government stricter
that already went through initial public regulations government
offerings (IPO). regulations
- Privately owned company: corporations
whose shares are NOT traded in the stock difficult to easy to
market. Also called as closely held transfer transfer
corporations or privately held ownership ownership
corporations.
Other kinds of organizations: maximizing earnings/profits is only a way
toward the goal of maximizing the
General Professional Partnership (GPP)
corporation's stock price
- partnership formed for the SOLE purpose of
exercising their common profession of which Agency problems
NO part of the income is derived from trade
or business problems that arise because of conflicts of
interests
Limited Partnerships Stockholders VS Managers
- partnerships where there is at least one - what managers want does not always align
limited partner with what the stockholders want
- some mechanisms used to motivate
Limited Liability Company managers to follow stockholders' best
- partnerships where all partners are limited interest:
partners managerial compensation
- not allowed in the Philippines direct intervention by shareholders
threat of firing
threat of takeover
Professional Corporations
- like a GPP, except they are in the form of a
corporation Stockholders VS Creditors
- creditors have claim on firm's assets upon
- not allowed in the Philippines
bankruptcy
Financial Managers of a Corporation - creditors lend funds at rates based on:
riskiness of firm's existing assets
Board of Directors - represents stockholders
expectations concerning riskiness of
to manage the corporation
additional future assets
Chief Financial Officer (CFO) - also known as
existing capital structure
Vice President of Finance, responsible for
expectations concerning future
financial planning and formulation of
capital structure decisions
financial corporate strategies. The CFO
supervises the Treasurer and Controller. The Financial Environment
Treasurer - handles the financial aspect of
Different Types of Markets
the corporation including credit policies,
maintaining good banking relationships, and Financial Market - market for financial assets,
raising and managing funds. equity securities and debt securities.
Controller - handles the accounting and - Stock Market
budgeting aspect of the corporation market for equity securities.
including custody of financial records and considered a capital market because
interpretation of financial data. stocks are long-term securities because
stocks generally do not have a maturity
Goals of a corporation period
Stockholder wealth maximization - maximize - Bond Market
the corporation's stock price market for debt securities
also called fixed income market Private Market VS Public Market
because of the fixed income brought
by periodic interest payments. Private Market Public Market

Characteristic unique/tailor-
- Money Market standardized
of product made
Market for short-term securities.
Examples life insurance stock market
(short term = 1 year or less)
examples: T-bills, commercial papers,
consumer credit loans, money market Financial Institutions
mutual funds, negotiable certificates
Direct transfer - when securities bought are
of deposit
bought directly from issuer.

- Capital Market Indirect transfer through Investment Bank VS


Market for long-term securities. Financial Intermediary
examples: common and preferred
stocks, mortgages, t-bonds and t- Investment Financial
notes, corporate bonds, leases Bank Intermediary

use of
Physical Market - market for real assets yes no
underwriters
or tangible assets.
kept or sold
securities
Spot Market VS Future Market sold to clients back in the
bought are
market
Spot Market Future Market
other
Price is securities sold their own
Today Today companies'
determined to clients securities
securities
Delivery Today Future
Examples of Financial Intermediaries:
commercial banks, mutual funds, life
- Types of Future Market: insurance companies
Forward contract - the price
determined today is the price to be Stock Markets
used in the future Initial Public Offering VS Season Offering
Option contract - the price determined
today which is the price to be used in IPO SO
the future is OPTIONAL
shares are after first time
issued by the first time (second,
corporation third)
Primary Market VS Secondary Market

Primary Secondary Example:

anyone other Manfin issued a bond with a value of


shares are
issuer than the PHP100,000 with an interest PHP3,000 payable
sold by
issuer semi-annually.

What is APR?
Interest Rates APR = 3,000 / (100,000)(180/360)
APR = 6%
Interest What is APY?
APY = [1+(i/m)] m - 1
cost of money - price for the money
APY = [1+(6%/2)] 2 - 1
borrowed
APY = 6.09%
factors that affect the cost of money
(interest rates): (t.r.i.p.) Components of Nominal Interest Rate
- time preferences for consumption
- risk NIR = r + DRP + LP + MRP
- inflation Real risk free interest rate (r*)
- production opportunities - interest rate that represents risk-free
security w/o inflation
Nominal and Effective Interest Rate
Inflation Premium (IP)
Nomi na l Interes t Ra te Effecti ve Interes t Ra te - premium imposed on interest rate to
s ta ted rate/coupon effective rate/discount account for inflation
ra te ra te Risk free interest rate (r)
represents the ra te represents the present
s ta ted on the bond va l ue of the payments
- interest rate that represents risk-free
to be ma de security w/ inflation
- if simple format, r = r* + IP
Annual Percentage Rate (APR) and Annual - if cross term format, r = r* + IP + (r* x IP)
Percentage Yield (APY) Default Risk Premium (DRP)
- premium imposed to account for the
APR APY
possibility of non-payment of principal by
cos t of fi nancing that cos t of fi nancing that borrower
cons iders only the cons iders
s i mple i nterest compounding - present in corporate bonds
a l so known as - not present in government bonds
Effecti ve Annual Rate Liquidity Premium (LP)
APR = I / (PxT) APY = [1+(i /m)] m - 1
I = i nterest a mount i = nomi nal annual interest - premium imposed to account for the
P = pri ncipal ra te convertibility of the security into cash
T = ti me period (year, m = number of periods in a - present in corporate bonds
us ually 360) yea r
- not present in government bonds
Market Risk Premium (MRP) ARR = (104,000 - 100,000) / 100,000
- premium imposed to account for the
ARR = 4%
interest rate risk
- Interest rate risk - the possible loss due to (b) Carson invested in a stocks of Lasinga Co..
the fluctuations of interest rates and prices She expects to earn 7% in the first year, 6% in
over time the second year, and 4% in the third year. What
- the longer the maturity period, the higher is her expected rate of return?
the MRP ERR = 7% + 6% + 4% / 3
- present in both LONG-term government
ERR = 5.67%
and corporate bonds
(c) IDILY Co. is considering to invest on a
Nominal Interest Rate of Securities:
merchandising firm with a series of probabilities
Short-term, Government issued regarding the investment's return:
- NIR = r Return Probability
Long-term, Government issued
- NIR = r + MRP 8% 30%
Short-term, Corporate issued 4% 50%
- NIR = r + DRP + LP
-3% 20%
Long term, Corporate issued
- NIR = r + DRP + LP + MRP

Risk and Returns IDILY has a RRR of 4%. Should they invest on the
merchandising firm?
Returns
ERR = [(8%)(30%)] + [(4%)(50%)] - [(3%)(20%)]
profit earned on investment
rate of return (%) ERR = 3.8%
- (amount received or current value of RRR = 4% > ERR = 3.8%
investment - amount invested) / amount
invested IDILY Co. should not invest on the
merchandising firm because the ERR doesn't
Expected Rate of Return (ERR) = rate of
meet or surpass the RRR.
return expected to be realized
Required Rate of Return (RRR) = minimum Risk
rate of return acceptable by the investor
chance of loss
Actual Rate of Return (ARR) = rate actually
earned Risk in a Single asset
Market Equilibrium = when RRR is equal to
Stand Alone risk - risk when holding only one
ERR on an investment
asset
Example: Standard Deviation ()
- a tool to determine level of risk
(a) Dio invested PHP100,000 in a money market
- = - 2 P
placement. After a year, he sold it for
PHP104,000. What is the rate of return?
- the higher standard deviation, the higher - as a rule, riskiness of a portfolio will
probability of experiencing different decline as the number of stocks in the
amounts of return portfolio increases
- impossible to form completely riskless
Example: stock portfolios
Find the standard deviation of the return on the Diversifiable Risk - risk that can be
merchandising firm (from IDILY Co. example). eliminated by proper diversification
Market Risk - risk that cannot be eliminated
Expected - ) - )2 - ) 2P**
by diversification.
Return
Capital Asset Pricing Model (CAPM)
8% 8% - 3.8% = 0.001764 0.000529 - A model based on the proposition that any
4.2% stocks required rate of return is equal to
4% 4% - 3.8% 0.000004 0.000002 the risk-free rate of return plus a risk
= 0.2% premium that reflects only the risk
remaining after diversification
-3% -3% - 3.8% 0.004624 0.000925
= -6.8%
CAPM formula:
0.001456 - r = rf + (rm - rf); or
- r = rf + (MRP); or
**P = Probability
- r = rf + Risk Premium
Variance ( - 2
P) = 0.001456 - r = required return on the security
2
- rf = risk-free rate of return or return on
Standard Deviation ( - P) riskless securities
= 0.038157568 or 3.82% - rm = market rate of return or return on
risky securities
Coefficient of Variation (CV)
- MRP = market risk premium
- measure of risk per return
- represent the relative level of risk. Hence,
Beta Coefficient () - measures the riskiness
the higher the CV, the higher the risk.
of a security
- CV = /
- more meaningful basis for comparison = 1.0 < 1.0 > 1.0
when the expected returns on two
alternatives are not the same average beta defensive/ aggressive beta
conservative
Risk in a Portfolio beta

Diversification change in change in change in


- investing in more securities to reduce risk market return market return market return
- does nothing to reduce risk if the portfolio is equal to the results to a results to a
consists of perfectly positively correlated change in the lower change higher change
stocks return on the in the return in the return
investment on the on the
- reduces risk but does not eliminate it
investment investment
Security Market Line (SML)

graphically depict the interaction


between Beta and Required Rates of
Returns (RRR)

l i ne representing
ma rket ra te

RRR ma rket risk premium

ri s 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

ri s k free rate

change in SML due to investors'


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

ma rket risk premium


RRR

ri s k free rate


II. Questions
B. The Financial Environment
Theories
Write A if the first statement is correct, B if the
A. Introduction to Financial Management
second statement is correct, C if both
True or False statements are correct, and D if none of the
statements are correct.
1. Corporate earnings may be subject to double
taxation. 1. Initial Public Offering can be done twice by
2. You can set up a Limited Liability Company in the same corporation. A Seasoned Offering
the Philippines legally. can be done without making an Initial Public
3. Limited Liability Companies is a hybrid Offering first.
between a partnership and a corporation.
4. The primary goal of a corporation's 2. Stocks of a corporation can be sold in a
management is to maximize the primary market. Stocks of a corporation can
corporation's profit. be sold in a secondary market.
5. General Partnerships are treated like
corporations regarding 30% corporate 3. Carson engages in a spot market transaction
income tax. if she buys 50 pieces of iPhone S7 at March
6. The corporation will not suffer an agency 12, 2017 but arrives in her shop at March 14,
problem if the managers of the firm own 2017. Dio engages in a futures market
100% of the common stock. transaction if he contracted with the seller at
7. Executive stock options are options to sell March 12, 2017 to buy 50 kilos of rice in the
stock at a stated price within a specified date's current price but agreed with the
time. seller to deliver the goods on June 14, 2017.
8. Conflicts between stockholders and creditors
of a corporation can exist. 4. Physical asset markets are those where the
9. The Controller does not handle the products are real assets like house and lots.
accounting aspect of the corporation. Hence, mortgages are also sold on physical
10. The Controller does not handle the investing asset markets because they are claims on
decisions of the corporation. real assets.
11. Maximizing earnings per share is the same as
maximizing stock price per share. 5. Treasury notes are capital market
12. Creditors are not prioritized over transactions. Similarly, treasury bills are
stockholders in the event of bankruptcy. capital market transactions.
13. Hostile takeovers most likely occur when a
firm's stock is undervalued relative to its 6. Life insurance is a private market
potential because of poor management. transaction. Sale of bonds by a private
14. Interest rates can affect stock price. corporation is also a private market
15. All stockholders are stakeholders and all transaction.
stakeholders are stockholders.
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 6. The reason why maturity risk premium is
financial intermediary. You can't invest in the incorporated in calculating rates is to reflect
securities of an investment bank because the interest rate risk.
they don't issue their own securities. 7. Measuring the risks of a standalone
instrument is the same as measuring the
10. Investment banks are merely intermediaries risks of a portfolio.
for selling securities. Financial intermediaries 8. If we measure the risk of an asset in a
are not intermediaries to their investors portfolio, we are only concerned to the
regarding the securities they buy. extent it contributes to the market risks.
9. When we measure risk, we take into account
all of the possible risks that may exist.
11. Mutual funds pools money from investors to 10. A change in investor behavior will shift the
buy a portfolio of securities. Mutual funds security market line.
are investment banks. 11. The higher the standard deviation, the wider
and flatter the graph.
12. Preferred stocks are classified as money 12. Lenders time preference for consumption,
market transactions. Common stocks are just like the borrowers production
capital market transactions. opportunities, has a direct relationship with
interest rate.
13. Bondholders have a fixed income. 13. The lesser the production opportunities of a
Stockholders also earn fixed income from borrower, the lower the rate.
their shares if the corporation has been 14. Systematic risks are those that may be
earning at a net profit for several years eliminated through diversification.
continuously. 15. Due to diversification, one may not simply
get the weighted average of the standard
14. Commercial papers are money market deviation of each instrument to measure the
transactions. Corporate bonds are also risks of portfolios.
money market transactions.
D. Identification
15. Common stocks are less risky than preferred
stocks. Bonds are riskier than common stock. 1. A behavior wherein investors generally do
not want risks but with considerable amount
C. Risk and Returns & Interest Rates of risks, may ask for higher returns.
True or False 2. It is the interest rate that does not consider
compounding effects.
1. Default risk premiums act as a compensation 3. It is the additional interest provided for
in case a borrower will default. securities that are fairly more difficult to
2. When a market change will cause a higher convert into cash.
degree of change in stock, there is a 4. It is the relative level of risk per unit of
defensive beta. return.
3. Market return determines market risk 5. It is the state where the required rate equals
premium. the expected rate.
4. In all the three types of beta, the direction of 6. It is the beta when stocks respond directly to
movement of shares shall be in the same fluctuations in the market.
direction as the market change. 7. The term used to pertain to the rate where
5. The term structure of interest rates pertain the real risk free interest rate is infused with
to the relationship between bond yields and inflation premium.
the maturity of the bonds.
8. The method in calculating the interest rate 4. Which is correct?
used when the real risk free interest rate and A. Calculating the weighted average of the
inflation premium are relatively high and standard deviations will determine
material. portfolio risks and volatility
9. What is the premium not incorporated in the B. Diversification makes more sense in a
rates of sovereign state-issued and perfectly positive relationship
government-issued securities? C. Market portfolios contain diversifiable
10. What are the possible reasons for a shift in risks
the security market line? D. Correlation coefficient is measured
11. What are the possible reasons for a change through roh
in the slope of a security market line?
12. It is the particular risk of a security in relation 5. A normal term structure of a bond is
to its existence in the market. A. Upward sloping
13. It is the minimum rate of return acceptable B. Downward sloping
for an investor on a portfolio investment. C. Humped
14. This measures portfolio riskiness and D. Consistent
volatility
15. It is the risk which states that it is better to 6. What does a negative beta suggest?
invest in a long-maturity security than to A. If market performance gets better,
invest yearly. returns will be higher
B. The portfolio is that of luxury goods
E. Multiple Choice C. A and B
D. The portfolio is that of inferior goods
1. The beta that causes a higher degree of
change in stock when the market changes 7. Which is incorrect?
A. Defensive beta A. Risk is about the dispersal of the
B. Aggressive beta possible returns rather than the loss
C. Conservative beta itself
D. None of the above B. Variable returns may be based on
simple averages or on probabilities
2. A change in investor behavior causes C. Market risk premium determines
A. the security market line to shift market rate
downwards D. Due to their high prices, luxury goods
B. the security market line to shift are less volatile and have betas less
upwards than one
C. the security market lines slope to
become steeper 8. Investors who are willing to take risks when
D. the security market lines slope to higher returns are offered
become flatter A. Risk Averse
B. Risk Takers
3. A defensive beta has a beta that is C. Either a or b
A. Equal to one D. Neither a or b
B. Less than zero
C. Less than one
D. More than one
9. This premium depends on the several credit
characteristics ultimately embodied in some 3. Consider Joe Investor once again (the
credit scores or ratings previous problem). If he had invested
A. Inflation premium P100,000 in Security C (instead of P20,000),
B. Default risk premium with all other investments the same, what is
C. Liquidity premium Joe's portfolio beta?
D. Maturity risk premium a. 0.8900
b. 0.6578
10. Which is true about the security market line? c. 0.8997
A. If the real risk free rate change, market d. 1.0909
rate changes at the same rate
B. If an investor becomes more risk 4. An analyst has provided information on
averse, the change in market risk possible returns (and their likelihood of
premium is not the same as the rate of occurring) for the Icahn Trust Corporation
change in slope stock. What is the standard deviation of the
C. Both A and B expected returns for this stock, given the
D. Neither A or B following distribution?

F. Problems Scenario 1: probability = 20%, return = -40%


Scenario 2: probability = 50%, return = 0%
Risk and Returns Scenario 3: probability = 30%, return = 30%
1. Consider the following investments. Which a. 35.78%
investment would a risk averse investor b. 21.56%
prefer? c. 24.26%
a. Investment A: Expected return =
d. 56.12%
11%, Standard deviation = 12%
b. Investment B: Expected return =
5. Calculate the expected peso return and the
10%, Standard deviation = 10%
standard deviation of these possible returns
c. Investment C: Expected return =
for the Pizza Palace, given the following
11%, Standard deviation = 10% possible returns:
d. Investment D: Expected return =
11%, Standard deviation = 11%
Possible dollar
Scenario Probability return
2. Joe Investor has invested in three securities:
A, B, and C. What is the beta of his Success 20% +P50
portfolio, considering the amount invested Normal 50% +P10
in each security and the individual security Bomb 30% -P10
betas?

Security A: Invested P30,000, beta of 1.50 a. P12; P18.7685


b. P12; P21.6789
Security B: Invested P20,000, beta of 2.00 c. P12; P22.9123
d. P12; P20.8806
Security C: Invested P20,000, beta of 0.50
a. 1.3572
b. 1.4789
c. 1.2098
d. 0.8943
6. Espinosa Coffee & Trading, Inc.'s common nothing. Melanie states that she would not
stock measured beta is calculated to be call off the gamble if you offered her a
0.75. The market beta is, of course, 1.00 certain P10,999 instead of her choice of
and the beta of the industry of which the box. However, she would be indifferent if
company is a part is 1.10. If Merrill Lych P11,000 was offered in place of the risky
were to calculate an "adjusted beta" for gamble; and she would definitely take
Espinosa's common stock, that adjusted P11,001 to call off the gamble. We would
beta would most likely be describe Melanie as __________ in this
a. less than 0.75 instance.
b. more than 0.75, but less than 1.10 a. being risk averse
c. equal to 1.10 b. being risk indifferent
d. equal to 0.95 {i.e., (1/3) x (0.75 + c. having a risk preference
1.00 + 1.10)}
10. Clive Rodney Megabucks offers your friend,
7. Plaid Pants, Inc. common stock has a beta Yunyoung, an interesting gamble involving
of 0.90, while Acme Dynamite Company giving her the choice of the contents in one
common stock has a beta of 1.80. The of two sealed, identical-looking boxes. One
expected return on the market is 10 box has P20,000 in cash and the second has
percent, and the risk-free rate is 6 percent. nothing inside. There is an equal probability
According to the capital-asset pricing model that the chosen box contains cash versus
(CAPM) and making use of the information nothing. Yunyoung states that she would
above, the required return on Plaid Pants' not call off the gamble if you offered her a
common stock should be, and the required certain P4,999 instead of her choice of box.
return on Acme's common stock should be However, she would be indifferent if P5,000
a. 3.6 percent; 7.2 percent was offered in place of the risky gamble;
b. 9.6 percent; 13.2 percent and she would definitely take P5,001 to call
c. 9.0 percent; 18.0 percent off the gamble. We would describe
d. 14.0 percent; 23.0 percent Yunyoung as __________ in this instance.
a. being risk averse
8. The firm of Sun and Moon purchased a b. being risk indifferent
share of Acme.com common stock exactly c. having a risk preference
one year ago for P45. During the past year
the common stock paid an annual dividend Interest Rates
of P2.40. The firm sold the security today
for P85. What is the rate of return the firm 11. For an interest rate of 12% per year
has earned? compounded quarterly, the effective
a. 5.3% interest rate per year is closest to:
b. 194.2% a. 4%
c. 88.9% b. 12%
d. 94.2% c. 12.55%
d. 12.68%
9. Clive Rodney Megabucks offers your friend,
Melanie, an interesting gamble involving 12. For an interest rate of 2% per month, the
giving her the choice of the contents in one effective semiannual rate is closest to:
of two sealed, identical-looking boxes. One a. 11.55%
box has P20,000 in cash and the second has b. 12%
nothing inside. There is an equal probability c. 12.62%
that the chosen box contains cash versus d. 26.82%
13. An interest rate of 1% per month is the 18. Determine the nominal risk-free rate of
same as: return if the risk-free rate is 3% and the rate
a. Nominal 3% per quarter of inflation is 3%.
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: 19. The real risk-free rate is 6% per year, and
a. 1% per month. the expected inflation rate is 2% per year.
b. 3.04% per quarter. What is the annual nominal rate of interest?
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 flow must be converted
into continuous cash flow. 20. Jungle Jims Outfitters, a local outdoor
c. The interest rate must be converted equipment retail store, wants a 1-year,
into an annual rate. $50k loan from your bank. You have
d. None of the above. already determined that this firm warrants
an DRP of 5%, an LP of 1% and an MRP of
16. An interest rate stated as nominal 12% per 0.5%. Todays WSJ reports 30-day T-bills
year compounded quarterly is the same as: are currently yielding 2.3%. What is an
a. effective 1% per month. appropriate interest rate for this loan?
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
(nos. 21-23) Jihad Jims Travel Adventures, a 26. The real risk-free rate is 3%, and inflation is
new travel agency, wants a 3-year, $500k loan expected to be 3% for the next 2 years. A 2-
from your bank. You have already determined year Treasury security yields 6.2%. What is
that this firm warrants an DRP of 10%, an LP of the maturity risk premium for the 2-year
3% and an MRP of 1.5%. Today is 2 January. security?
Inflation for the rest of this year is expected to
remain at 2 %. Ne t years inflation is e pected
to be 2.5% and the following years inflation is
e pected to be 3%. Todays WSJ reports 30-day
T-bills are currently yielding 2.3%. What is an
appropriate interest rate for this loan?
27. Calculate the effective annual interest rate
21. Find r* equivalent to a nominal interest rate of
22. Find IP 8,75% p.a. compounded monthly
23. Find r

28. If your credit card calculates the interest


24. Real risk-free rate You read in The Wall based on 12.5% APR, what is your monthly
Street Journal that 30-day T-bills are interest rate and annual effective interest
currently yielding 5.5 percent. Your brother- rate, respectively? What is the monthly
in-law, a broker at Safe and Sound interest rate?
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? 29. From no. 28 , what is the effective annual
rate?

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 30. One-year Treasury securities yield 5%. The
premium on the corporate bond is 0.5%. market anticipates that 1 year from now, 1-
What is the default risk premium on the year Treasury securities will yield 6%. If the
corporate bond? pure expectations theory is correct, what is
the yield today for 2-year Treasury
securities?
III. Answer Key 10. F
11. T
Theories: 12. T
A. 13. T
1. T 14. F
2. F 15. T
3. T
D.
4. F
1. Risk Aversion
5. T
2. Nominal interest rate
6. T
3. Liquidity Premium
7. F
4. Coefficient of Variation
8. T
5. Market Equilibrium
9. F
10. T 6. Average Beta
11. F 7. Risk free interest rate
12. F 8. Cross term format
9. Default Risk Premium
13. T
10. Inflation (A change in risk free rate or
14. T
market rate)
15. F
11. A change in investor behavior or a
change in risk aversion
B.
12. Systematic/Non-diversifiable/Market
1. D
risk
2. C
3. C 13. Required rate of return
4. A 14. Beta
5. A 15. Reinvestment rate risk
6. A
E.
7. C
1. B
8. B
2. C
9. C
3. C
10. C
4. D
11. A
5. A
12. B
6. D
13. A
14. A 7. D
15. D 8. A
9. B
10. C
C.
1. T
2. F
3. F
4. T
5. T
6. T
7. F
8. T
9. F
F. Problems 5. Answer: D

1. Answer: C
Expected dollar return = (0.2)(P50) +
Since it provides the greater return for (0.5)(P10) + (0.3)(-P10) = P12
the lowest risk (in comparison with the
other three investments) Variance = 288.80 + 2.00 + 145.20 =
436.00
2. Answer: A
Standard deviation =
Total investment in the portfolio is 436.000.5 = P20.8806
P70,000
6. Answer: B
Proportion invested in Security A =
P30,000 / P70,000 = 0.4286 Merrill Lych would adjust for the
tendency of measured betas to revert
Portfolio beta = (0.4286)(1.5) + toward the beta of the market portfolio
(0.2857)(2.0) + (0.2857)(0.5) or toward the beta of the industry to
which the company is a part. So, its
Portfolio beta = 0.6429 + 0.5714 + adjusted beta would end up higher than
0.1429 0.75, but never more than 1.10.

7. Answer: B
Portfolio beta = 1.3572
Plain required return = 0.06 +
3. Answer: C
[(0.90)(0.10 0.06)] = 0.096

Total investment in the portfolio = Acme required return = 0.06 +


P150,000 [(1.8)(0.10 0.06)] = 0.132

Proportion invested in Security A = 8. Answer: D


P30,000/P150,000 = 0.2000
Return is over the two-year period and
Portfolio beta = 0.8997 includes both dividends and capital
gains. Return = [(P2.40) + (P85 - P45)] /
4. Answer: C P45 = 94.2%

p x return p x (return - Expected 9. Answer: C


return)2
-0.08 0.03360 Melanie would have had to tell us that
0.00 0.00005 she was indifferent at a guarantee of
0.09 0.02520 P10,000. Thus the expected value = the
0.01 0.0589 certainty equivalent.

Expected return = .01 or 1%


Standard deviation = square root
(0.0589) = 0.2426 or 24.26%
10. Answer: A 17. Answer: A

Yunyoung would have had to tell us 18. Answer: 6.09%


that she was indifferent at a guarantee
of P10,000. Thus the expected value = Rnominal = (1 + 0.03) x (1 + 0.03) - 1
the certainty equivalent. = 6.09%

11. Answer: C 19. Answer: 8.1%

i = (1+.12/4)^4 1 Nominal rate = (1.06) x (1.02) - 1 = 8.1%


= 12.55 %
20. Answer: 8.8%
12. Answer: C
r = rRF + DRP + LP + MRP
i = (1+.12/6)^6 1 = 2.3% + 5% + 1% + 0.5% = 8.8%
= 12.62%
21. Answer: 0.3%
13. Answer: D
r* =rRF - Current Inflation Rate
1% per month is a nominal 12% per r* = 2.3% - 2% = 0.3%
year compounded monthly, which is the
22. Answer: 2.5%
same as 12%/4 = 3% nominal per
quarter compounded monthly. Also,
computing the effective rate for IPn= ( I1 + I2 + I3 ..In) / n
nominal 12% compounded monthly, is: IP3 = (2% + 2.5% + 3%)/3 = 2.5%
(1 + 0.12/12) 12 1 = 0.12683
All values listed are correct. 23. Answer: 17.3%

r = r* + IP + DRP + LP + MRP
14. Answer: 11.39%
r = 0.3% + 2.5% + 10% +3% + 1.5%
For a nominal rate compounded = 17.3%
monthly equivalent to an effective 12% 24. Answer: 2.25%
compounded monthly, find r.
T-bill rate = r* + IP
0.12 = (1 + r/12) 12 1
5.5% = r* + 3.25%
(1.12) 1/12 = (1 + r/12) r* =2.25%
r/12 = 0.00949
r =11.39% 25. Answer: 1.5%

15. Answer: D rT10 = 6% = r* + IP10 + MRP10 ; DRP = LP =


0.
16. Answer: C rC10 = 8% = r* + IP10 + DRP + 0.5% +
MRP10.
Because both bonds are 10-year bonds
the inflation premium and maturity risk
premium on both bonds are equal. The SOURCES:
only difference between them is the
Fundamentals of Financial
liquidity and default risk premiums.
Management 12th Edition by Brigham
rC10 = 8% = r* + IP + MRP + 0.5% + DRP. and Houston

But we know from above that: Financial Management Vol. 1 (2nd Ed)
r* + IP10 + MRP10 = 6% by Bagayao, Layug and Manalo.

Therefore,
rC10 = 8% = 6% + 0.5% + DRP
PREPARED BY:
So, DRP = 1.5%

26. Answer: 0.2% Kyle Patrick Mallare


Venz Zeus Baba
rT2 = r* + IP2 + MRP2 = 6.2% Nicole Gimarino
Jeanne Marie Vicente
rT2 = 3% + 3% + MRP2 = 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%; 1rT1 = 6%; rT2= ?


(1 + rT2 ) 2 = (1.05)(1.06)
(1 + rT2 ) 2 = 1.113
1 + rT2 = 1.055
rT2 = 5