Financial Management Assignment

Financial Management Assignment

 

 

Question: 1) Explain the difference between “present value” and “future value” of a sum of money.

 

Answers:

Present value is the value today of a stream of payments to be received in the future at a given cost of capital. On the other hand, future value is the value of a stream of payments at some point in the future. To clearly understand these concepts, let’s try to consider these formulas i.e.

PV = FV/(1+r)^t

FV = PV(1+r)^t

 

Let say you are given the future value of an item, and you might like to know how much that value will be worth TODAY. So if your friend tells you that he will pay you 0 in 2 years for the radio you sold to him, you should know that 0 in 2 years is worth less today if the interest rate rises.

PV of 0 in 2 years :

PV = FV/(1 + r)^t

PV= 100/(1+interest rate)^2

 

Assuming the interest rate is 4%, you sold your radio to your friend for:

100/(1.04^2) = .46

If the radio is worth 0 today, you would want him to pay you:

FV = 100(1.04)^2 = 8.16 in 2 years

 

With respect to this presentation, we may say that the Present Value (PV) of an amount refers to the sum of money that will be received in the future. On the other hand, Future Value (FV) refers to amount invested (such as in a deposit account) now at a given rate of interest.

 

Question: 2) When examining bonds, what at is the coupon rate?

 

Answers:

 

In bonds, coupon rate is actually the amount of interest paid per year expressed as a percentage of the face value of the bond. Thus, the coupon rate is the interest rate on the face value of the bond.

Let say, you are holding ,000 nominal of a bond described as a 4.5% loan stock, thus you will receive 0 in interest each year which probably to be paid in two installments of 5 each. Moreover, if a bond that has a face value of ,000 and it is paying per year, then the coupon rate is 4%. If the same bond with the same coupon rate of 4% is selling for 0, the coupon rate doesn’t change, but the bond is yielding 4.44%.

Not all bonds have coupons. Zero coupon bonds are those which do not pay interest, but are sold to investors at a price less than the par value paid out when the bond has matured.

 

Question: 3) When examining stocks, what is beta?

Answers:

In examining stocks, beta is used as a parameter in Capital Asset Pricing Model that describes how sensitive the expected return of a stock is to the market. It gives an indication of how sensitive a stock is to macroeconomic events. Beta does not measure firm specific events. Contrary to popular belief, Beta does not tell you the correlation of a stock’s expected return to the marked. This should be obvious, as correlation coefficients have to between -1 and 1. While the Betas in CAPM cannot be below 0.

            Basically, a way to evaluate an investment’s volatility is to look at its beta, which compares an individual investment’s volatility to that of the market. A stock or mutual fund with a beta of 1.0 would have exactly as much market risk as its benchmark–for example, the S&P 500 stock index. A stock or mutual fund with a beta of 1.5 would involve 50 percent more market risk than the benchmark; if the benchmark went up, the individual security would be expected to go 50 percent higher. If the benchmark’s return dropped, the security’s return should be 50 percent lower. Conversely, a stock or fund with a beta of less than 1.0 would involve less market-related volatility than the overall market. If the S&P rose by 50 percent, an investment with a beta of .5 should benefit by only 25 percent. If the benchmark fell by 50 percent, the individual security with a .5 beta should experience only a 25 percent drop.

 

Question: 4) Briefly explain the trade off theory of capital structure.

Answers:

The Trade-Off Theory of Capital Structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. An important purpose of the theory is to explain the fact that corporations usually are financed partly with debt and partly with equity. It states that there is an advantage to financing with debt, the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms, bondholder/stockholder infighting, etc).

 

Question: 5) What is the definition of a call option?

Answers:

A call option is a financial contract between two parties, the buyer and the seller of this type of option. Often it is simply labeled a “call”. The buyer of the option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying instrument) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or “writer”) is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.

 

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