Finance Exam Study Guide: Key Concepts & Formulas
Final Exam Study Guide
Chapter 4: Time Value of Money
Present Value (PV)
The current value of future cash flows discounted at the appropriate discount rate, calculated at t = 0 on a timeline.
Formula: PV = FV / (1+r)^t
Discount Rate
The rate of return used to determine the present value of future cash flows. It represents the minimum rate of return required by an investor or business to undertake an investment project or value an investment opportunity.
Future Value (FV)
The amount an investment is worth after one or more periods, representing “later” money on a timeline.
Formula: FV = PV(1+r)^t
Key Parameters
- N: Number of compounding periods per year
- Interest Rate (r): Annual interest rate
- PV: Present value of the investment or loan
- FV: Future value of the investment or loan
- PMT: Payment per period
Discounted Cash Flow (DCF)
Used to calculate the future and present values of multiple cash flows.
Formulas:
FV = ∑n, t=1, CF^t × (1+r)^t
PV = ∑n, t=1, CF^t / (1+r)^t
Annuity
A level stream of equal dollar payments that lasts for a fixed time.
Perpetuity
A constant stream of cash flows without end.
Amortized Loan
A loan that requires fixed, periodic payments applied to both principal and interest until the loan is paid in full. Expect to pay more interest than principal at the beginning of the loan, with this reversing toward the end.
Chapter 5: Capital Budgeting
Capital Budgeting
The analysis of potential projects involving long-term decisions and large expenditures that are difficult or impossible to reverse. It determines a firm’s strategic direction.
Net Present Value (NPV)
The amount of value created from undertaking an investment.
Payback Period
The time it takes to recover the initial cost of a project.
Internal Rate of Return (IRR)
The discount rate that makes the NPV equal to zero.
Chapter 8: Bonds
Bond Price
The market value or purchase price of a bond. Bonds are debt securities issued by governments, municipalities, or corporations to raise capital.
Coupon Interest Rate
The stated interest rate multiplied by the par value to calculate the coupon payment.
Yield to Maturity (YTM)
The total return earned on a bond, assuming the bond owner holds it until maturity.
Key Formulas
- Coupon Rate = Annual Interest / Par Value
- Current Yield = Annual Interest / Market Price
Bond Ratings
Ratings assess the creditworthiness and risk of default associated with bonds.
- Investment Grade: High-quality bonds with low risk of default (e.g., Moody’s Aaa, S&P AAA).
- Speculative Grade: Lower-quality bonds with higher risk of default (e.g., Moody’s Ba, S&P BB).
Types of Bonds
- Municipal Bond: Issued by government entities for public projects.
- Coupon Bond: Pays periodic interest payments (coupons).
- Zero-Coupon Bond: Makes no periodic payments; the entire yield comes from the difference between the purchase price and par value.
Bond Pricing Terms
- Quoted Bond Price: The value of the bond at the time of trading.
- Bid Price: The price a buyer is willing to pay.
- Ask Price: The price a seller is willing to accept.
- Bid-Ask Spread: The difference between the bid and ask prices.
Chapter 9: Stocks
This chapter covers topics related to stock valuation, including:
- Calculating stock prices using models like the constant dividend model and the constant dividend growth model.
- Finding the required rate of return on a stock.
- Understanding dividend yield and capital gain yield.
- Distinguishing between primary and secondary markets.
- Differentiating between dealers and brokers.
- Comparing the New York Stock Exchange (NYSE) and NASDAQ.
Chapter 10: Risk & Return
This chapter explores the relationship between risk and return in investments, covering concepts such as:
- The risk-return trade-off.
- Calculating total return (dollar and percentage returns).
- Historical average returns in U.S. financial markets.
- Risk premium.
- Mean and standard deviation as measures of risk.
- Normal distribution.
- Arithmetic and geometric returns.
Chapter 11: Portfolio Diversification
This chapter delves into portfolio theory and diversification, including:
- Calculating expected returns for individual stocks and portfolios.
- Measuring risk using variance and standard deviation.
- Understanding the impact of diversification on portfolio risk.
- Differentiating between systematic and unsystematic risk.
- The Capital Asset Pricing Model (CAPM).
Chapter 13: Cost of Capital
This chapter focuses on the cost of capital for a company, covering topics such as:
- Cost of equity.
- Cost of debt (including tax benefits).
- Equity financing vs. debt financing.
- Cost of preferred stock.
- Weighted Average Cost of Capital (WACC).
- Factors influencing WACC.