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:
General Professional Partnership (GPP)
- partnership formed for the SOLE purpose of
exercising their common profession of which
NO part of the income is derived from trade
or business
Limited Partnerships
- partnerships where there is at least one
limited partner
Limited Liability Company
- partnerships where all partners are limited
partners
- not allowed in the Philippines
Professional Corporations
- like a GPP, except they are in the form of a
corporation
- not allowed in the Philippines
Financial Managers of a Corporation
Board of Directors - represents stockholders
to manage the corporation
Chief Financial Officer (CFO) - also known as
Vice President of Finance, responsible for
financial planning and formulation of
financial corporate strategies. The CFO
supervises the Treasurer and Controller.
Treasurer - handles the financial aspect of
the corporation including credit policies,
maintaining good banking relationships, and
raising and managing funds.
Controller - handles the accounting and
budgeting aspect of the corporation
including custody of financial records and
interpretation of financial data.
Goals of a corporation
Stockholder wealth maximization - maximize
the corporation's stock price
maximizing earnings/profits is only a way
toward the goal of maximizing the
corporation's stock price
Agency problems
problems that arise because of conflicts of
interests
Stockholders VS Managers
- what managers want does not always align
with what the stockholders want
- some mechanisms used to motivate
managers to follow stockholders' best
interest:
managerial compensation
direct intervention by shareholders
threat of firing
threat of takeover
Stockholders VS Creditors
- creditors have claim on firm's assets upon
bankruptcy
- creditors lend funds at rates based on:
riskiness of firm's existing assets
expectations concerning riskiness of
additional future assets
existing capital structure
expectations concerning future
capital structure decisions
The Financial Environment
Different Types of Markets
Financial Market - market for financial assets,
equity securities and debt securities.
- Stock Market
market for equity securities.
considered a capital market because
stocks are long-term securities because
stocks generally do not have a maturity
period
- Bond Market
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
Theories
A. Introduction to Financial Management
True or False
1. Corporate earnings may be subject to double
taxation.
2. You can set up a Limited Liability Company in
the Philippines legally.
3. Limited Liability Companies is a hybrid
between a partnership and a corporation.
4. The primary goal of a corporation's
management is to maximize the
corporation's profit.
5. General Partnerships are treated like
corporations regarding 30% corporate
income tax.
6. The corporation will not suffer an agency
problem if the managers of the firm own
100% of the common stock.
7. Executive stock options are options to sell
stock at a stated price within a specified
time.
8. Conflicts between stockholders and creditors
of a corporation can exist.
9. The Controller does not handle the
accounting aspect of the corporation.
10. The Controller does not handle the investing
decisions of the corporation.
11. Maximizing earnings per share is the same as
maximizing stock price per share.
12. Creditors are not prioritized over
stockholders in the event of bankruptcy.
13. Hostile takeovers most likely occur when a
firm's stock is undervalued relative to its
potential because of poor management.
14. Interest rates can affect stock price.
15. All stockholders are stakeholders and all
stakeholders are stockholders.
B. The Financial Environment
Write A if the first statement is correct, B if the
second statement is correct, C if both
statements are correct, and D if none of the
statements are correct.
1. Initial Public Offering can be done twice by
the same corporation. A Seasoned Offering
can be done without making an Initial Public
Offering first.
2. Stocks of a corporation can be sold in a
primary market. Stocks of a corporation can
be sold in a secondary market.
3. Carson engages in a spot market transaction
if she buys 50 pieces of iPhone S7 at March
12, 2017 but arrives in her shop at March 14,
2017. Dio engages in a futures market
transaction if he contracted with the seller at
March 12, 2017 to buy 50 kilos of rice in the
date's current price but agreed with the
seller to deliver the goods on June 14, 2017.
4. Physical asset markets are those where the
products are real assets like house and lots.
Hence, mortgages are also sold on physical
asset markets because they are claims on
real assets.
5. Treasury notes are capital market
transactions. Similarly, treasury bills are
capital market transactions.
6. Life insurance is a private market
transaction. Sale of bonds by a private
corporation is also a private market
transaction.
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
financial intermediary. You can't invest in the
securities of an investment bank because
they don't issue their own securities.
10. Investment banks are merely intermediaries
for selling securities. Financial intermediaries
are not intermediaries to their investors
regarding the securities they buy.
11. Mutual funds pools money from investors to
buy a portfolio of securities. Mutual funds
are investment banks.
12. Preferred stocks are classified as money
market transactions. Common stocks are
capital market transactions.
13. Bondholders have a fixed income.
Stockholders also earn fixed income from
their shares if the corporation has been
earning at a net profit for several years
continuously.
14. Commercial papers are money market
transactions. Corporate bonds are also
money market transactions.
15. Common stocks are less risky than preferred
stocks. Bonds are riskier than common stock.
C. Risk and Returns & Interest Rates
True or False
1. Default risk premiums act as a compensation
in case a borrower will default.
2. When a market change will cause a higher
degree of change in stock, there is a
defensive beta.
3. Market return determines market risk
premium.
4. In all the three types of beta, the direction of
movement of shares shall be in the same
direction as the market change.
5. The term structure of interest rates pertain
to the relationship between bond yields and
the maturity of the bonds.
6. The reason why maturity risk premium is
incorporated in calculating rates is to reflect
the interest rate risk.
7. Measuring the risks of a standalone
instrument is the same as measuring the
risks of a portfolio.
8. If we measure the risk of an asset in a
portfolio, we are only concerned to the
extent it contributes to the market risks.
9. When we measure risk, we take into account
all of the possible risks that may exist.
10. A change in investor behavior will shift the
security market line.
11. The higher the standard deviation, the wider
and flatter the graph.
12. Lenders time preference for consumption,
just like the borrowers production
opportunities, has a direct relationship with
interest rate.
13. The lesser the production opportunities of a
borrower, the lower the rate.
14. Systematic risks are those that may be
eliminated through diversification.
15. Due to diversification, one may not simply
get the weighted average of the standard
deviation of each instrument to measure the
risks of portfolios.
D. Identification
1. A behavior wherein investors generally do
not want risks but with considerable amount
of risks, may ask for higher returns.
2. It is the interest rate that does not consider
compounding effects.
3. It is the additional interest provided for
securities that are fairly more difficult to
convert into cash.
4. It is the relative level of risk per unit of
return.
5. It is the state where the required rate equals
the expected rate.
6. It is the beta when stocks respond directly to
fluctuations in the market.
7. The term used to pertain to the rate where
the real risk free interest rate is infused with
inflation premium.
 8. The method in calculating the interest rate
used when the real risk free interest rate and
inflation premium are relatively high and
material.
9. What is the premium not incorporated in the
rates of sovereign state-issued and
government-issued securities?
10. What are the possible reasons for a shift in
the security market line?
11. What are the possible reasons for a change
in the slope of a security market line?
12. It is the particular risk of a security in relation
to its existence in the market.
13. It is the minimum rate of return acceptable
for an investor on a portfolio investment.
14. This measures portfolio riskiness and
volatility
15. It is the risk which states that it is better to
invest in a long-maturity security than to
invest yearly.
E. Multiple Choice
1. The beta that causes a higher degree of
change in stock when the market changes
A. Defensive beta
B. Aggressive beta
C. Conservative beta
D. None of the above
2. A change in investor behavior causes
A. the security market line to shift
downwards
B. the security market line to shift
upwards
C. the security market lines slope to
become steeper
D. the security market lines slope to
become flatter
3. A defensive beta has a beta that is
A. Equal to one
B. Less than zero
C. Less than one
D. More than one
4. Which is correct?
A. Calculating the weighted average of the
standard deviations will determine
portfolio risks and volatility
B. Diversification makes more sense in a
perfectly positive relationship
C. Market portfolios contain diversifiable
risks
D. Correlation coefficient is measured
through roh
5. A normal term structure of a bond is
A. Upward sloping
B. Downward sloping
C. Humped
D. Consistent
6. What does a negative beta suggest?
A. If market performance gets better,
returns will be higher
B. The portfolio is that of luxury goods
C. A and B
D. The portfolio is that of inferior goods
7. Which is incorrect?
A. Risk is about the dispersal of the
possible returns rather than the loss
itself
B. Variable returns may be based on
simple averages or on probabilities
C. Market risk premium determines
market rate
D. Due to their high prices, luxury goods
are less volatile and have betas less
than one
8. Investors who are willing to take risks when
higher returns are offered
A. Risk Averse
B. Risk Takers
C. Either a or b
D. Neither a or b
 9. This premium depends on the several credit
characteristics ultimately embodied in some
credit scores or ratings
A. Inflation premium
B. Default risk premium
C. Liquidity premium
D. Maturity risk premium
10. Which is true about the security market line?
A. If the real risk free rate change, market
rate changes at the same rate
B. If an investor becomes more risk
averse, the change in market risk
premium is not the same as the rate of
change in slope
C. Both A and B
D. Neither A or B
3. Consider Joe Investor once again (the
previous problem). If he had invested
P100,000 in Security C (instead of P20,000),
with all other investments the same, what is
Joe's portfolio beta?
a. 0.8900
b. 0.6578
c. 0.8997
d. 1.0909
4. An analyst has provided information on
possible returns (and their likelihood of
occurring) for the Icahn Trust Corporation
stock. What is the standard deviation of the
expected returns for this stock, given the
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
stock measured beta is calculated to be
0.75. The market beta is, of course, 1.00
and the beta of the industry of which the
company is a part is 1.10. If Merrill Lych
were to calculate an "adjusted beta" for
Espinosa's common stock, that adjusted
beta would most likely be
a. less than 0.75
b. more than 0.75, but less than 1.10
c. equal to 1.10
d. equal to 0.95 {i.e., (1/3) x (0.75 +
1.00 + 1.10)}
7. Plaid Pants, Inc. common stock has a beta
of 0.90, while Acme Dynamite Company
common stock has a beta of 1.80. The
expected return on the market is 10
percent, and the risk-free rate is 6 percent.
According to the capital-asset pricing model
(CAPM) and making use of the information
above, the required return on Plaid Pants'
common stock should be, and the required
return on Acme's common stock should be
a. 3.6 percent; 7.2 percent
b. 9.6 percent; 13.2 percent
c. 9.0 percent; 18.0 percent
d. 14.0 percent; 23.0 percent
8. The firm of Sun and Moon purchased a
share of Acme.com common stock exactly
one year ago for P45. During the past year
the common stock paid an annual dividend
of P2.40. The firm sold the security today
for P85. What is the rate of return the firm
has earned?
a. 5.3%
b. 194.2%
c. 88.9%
d. 94.2%
9. Clive Rodney Megabucks offers your friend,
Melanie, an interesting gamble involving
giving her the choice of the contents in one
of two sealed, identical-looking boxes. One
box has P20,000 in cash and the second has
nothing inside. There is an equal probability
that the chosen box contains cash versus
nothing. Melanie states that she would not
call off the gamble if you offered her a
certain P10,999 instead of her choice of
box. However, she would be indifferent if
P11,000 was offered in place of the risky
gamble; and she would definitely take
P11,001 to call off the gamble. We would
describe Melanie as __________ in this
instance.
a. being risk averse
b. being risk indifferent
c. having a risk preference
10. Clive Rodney Megabucks offers your friend,
Yunyoung, an interesting gamble involving
giving her the choice of the contents in one
of two sealed, identical-looking boxes. One
box has P20,000 in cash and the second has
nothing inside. There is an equal probability
that the chosen box contains cash versus
nothing. Yunyoung states that she would
not call off the gamble if you offered her a
certain P4,999 instead of her choice of box.
However, she would be indifferent if P5,000
was offered in place of the risky gamble;
and she would definitely take P5,001 to call
off the gamble. We would describe
Yunyoung as __________ in this instance.
a. being risk averse
b. being risk indifferent
c. having a risk preference
Interest Rates
11. For an interest rate of 12% per year
compounded quarterly, the effective
interest rate per year is closest to:
a. 4%
b. 12%
c. 12.55%
d. 12.68%
12. For an interest rate of 2% per month, the
effective semiannual rate is closest to:
a. 11.55%
b. 12%
c. 12.62%
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
premium on the corporate bond is 0.5%.
What is the default risk premium on the
corporate bond?
30. One-year Treasury securities yield 5%. The
market anticipates that 1 year from now, 1-
year Treasury securities will yield 6%. If the
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
Since it provides the greater return for
the lowest risk (in comparison with the
other three investments)
2. Answer: A
Total investment in the portfolio is
P70,000
6. Answer: B
Proportion invested in Security A =
P30,000 / P70,000 = 0.4286
Portfolio beta = (0.4286)(1.5) +
(0.2857)(2.0) + (0.2857)(0.5)
Portfolio beta = 0.6429 + 0.5714 +
0.1429
Expected dollar return = (0.2)(P50) +
(0.5)(P10) + (0.3)(-P10) = P12
Variance = 288.80 + 2.00 + 145.20 =
436.00
Standard deviation =
436.000.5 = P20.8806
Merrill Lych would adjust for the
tendency of measured betas to revert
toward the beta of the market portfolio
or toward the beta of the industry to
which the company is a part. So, its
adjusted beta would end up higher than
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
Portfolio beta = 0.8997
4. Answer: C
Return is over the two-year period and
includes both dividends and capital
gains. Return = [(P2.40) + (P85 - P45)] /
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