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Fin. 201 Midterm 2
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Dr. Pinegar chpts 5-8 BYU
Terms in this set (68)
TVM
Time Value of Money
Annuity
An equally-spaced sequence of equal cash flows
Ordinary Annuity
An annuity that pays at the end of each period
Annuity Due
An annuity with payments that occur at the beginning of each period.
Perpetuity
An annuity that goes on forever
Deferred Annuity
An annuity designed to be paid to the insured in the future, usually in retiremen
Bonds
A bond is basically a debt agreement that obligates the corporation (or gov't) to make certain payments to the investor in exchange for money the investor lends to the corporation (or gov't) today."
Par value or face value (FV)
Sum of money the borrower promises to pay at bond's expiration, typically $1,000
Coupon Payment (PMT)
Coupon Rate: % of face value paid as coupons annually
Ex: $1,000 bond with a 9% coupon rate pays $90 in interest each year
Maturity (N)
Bonds have finite lives, ranging from months to decades
Discount rate or yield to maturity or YTM (I)
This is the current market rate for the bond
Price (PV)
Bond prices change depending on market conditions
Annual vs. semiannual payment
It matters; US bonds pay half their coupon every 6 months
Changes your N, I, and PMT
Bonds typically have two types cash flows
Coupon payments (an annuity)
Repayment of par value (a lump sum)
Holding Period Return
the return you earn equals the cash you receive during the year, minus the cash you paid at the beginning of the year, divided by the cash you paid at the beginning of the year
Casino Royale sold an issue of 30-year, $1,000 par value bonds to the public that carry a 10.85% coupon rate, payable semiannually. It is now 10 years later, and the current market rate of interest is 9.00%. If interest rates remain at 9.00% until Royal Casino' bonds mature, what will happen to the value of the bonds over time?
The bonds will sell at a premium and decline in value until maturity.
Bond prices and discount rates have an inverse relationship
If market interest rates increase, bond prices go down
If market interest rates decrease, bond prices go up
General rule:
If YTM is greater than the coupon rate, the bond trades at a DISCOUNT - it sells below par value.
If YTM is less than the coupon rate, the bond trades at a PREMIUM - it sells above par value.
Bond duration tells us...
how much bond prices change with fluctuations in interest rates
Duration
how many percentage points the price of a bond goes up if interest rates go down 1%.
Common stock (aka common equity)
represents ownership in a firm. Common stock holders have a residual claim on the earnings and assets of the firm.
Stock Valuation
The intrinsic value of an asset = the present value of the stream of expected cash flows discounted at an appropriate required rate of return
Preferred Stock
A hybrid security:
it's like common stock - no fixed maturity.
-technically, it's part of equity capital.
it's like debt - preferred dividends are fixed.
- missing a preferred dividend does not constitute default, but preferred dividends are usually cumulative
Preferred Stock is:
Is usually non-voting, and non-participating.
Priority: lower than debt, higher than common stock.
Usually sold for $25, $50, or $100 per share par value.
Common Stock
is a variable-income security.
- dividends may be increased or decreased at management's discretion.
represents equity (or ownership).
includes voting rights.
Priority: Lowest (lower than everybody-- i.e, debt, preferred).
Constant Growth Model
Assumes common stock dividends will grow at a constant rate into the future.
aka Gordon Growth Model or GGM
Estimate cash flows for two different growth stages:
(2 stage growth)
Stage 1: dividends growing above average (i.e., the "super-normal" period).
Stage 2: dividends grow at the industry average after stage 1.
Value = Stage 1 + Stage 2
DDM: Constant Growth (Gordon)
Strengths:
Use for mature, stable, dividend paying firms
Supplements other methods
Weaknesses:
Very sensitive to estimates of g
Difficult to use with non-dividend-paying stocks
Not useful for acquisition valuation because doesn't take control perspective
DDM: Multi-Stage Models
Constant growth is not realistic for most firms
Two-stage assumes a "drop-off" in growth
How to measure risk
variance, standard deviation, beta
How to reduce risk
diversification
How to price risk
security market line, CAPM
For a Treasury security, what is the required rate of return?
Since Treasury's are essentially free of default risk, the rate of return on a Treasury security is considered the "risk-free" rate of return.
For a corporate stock or bond, what is the required rate of return?
Required Rate of return = risk free rate of return + risk premium
Required Return
the return that an investor requires on an asset given its risk.
Expected Return
the return investors anticipate earning.
In equilibrium, expected returns equal required returns.
What is Risk?
The possibility that an actual return will differ from our expected return.
Uncertainty in the distribution of possible outcomes.
How do we Measure Risk?
The standard approach is to examine the stock's STANDARD DEVIATION of returns.
The greater the standard deviation, the greater the uncertainty, and therefore , the greater the RISK.
Standard Deviation
Standard deviation is a measure of the dispersion of possible outcomes.
Diversification
Investing in more than one security to reduce risk.
If two stocks are perfectly positively correlated, diversification has no effect on risk.
If two stocks are perfectly negatively correlated, the portfolio can be perfectly diversified.
Systematic Risk
is also called Nondiversifiable risk. This risk can not be diversified away
Firm-Specific risk
is also called diversifiable risk. This risk can be reduced through diversification
examples of systematic/Market Risk
Unexpected changes in interest rates.
Unexpected changes in cash flows due to tax rate changes, foreign competition, and the business cycle.
Examples of Firm specific risk
A company's labor force goes on strike.
A company's top management dies in a plane crash.
A huge oil tank bursts and floods a company's production area.
You zig when you should've zagged
Do some firms have more market risk than others?
Yes. For example:
An economic slow-down affects all firms, but which would be more affected:
a) Harley-Davidson******
b) insulin supplier
Important Insight:
The market compensates investors for accepting risk - but only for market risk. Firm-specific risk can and should be diversified away. That's the mystery element - how much market risk does a security have?
Beta:
Specifically, it is a measure of how an individual stock's returns vary with market returns.
Think of it as a measure of the "sensitivity" of an individual stock's returns to changes in the market.
The market's beta is 1
A firm that has a beta = 1 has average market risk. The stock is no more or less volatile than the market.
A firm with a beta > 1 is more volatile than the market (ex: Tech firms).
A firm with a beta < 1 is less volatile than the market (ex: utilities).
What is the Required Rate of Return?
The return on an investment required by an investor given the investment's risk.
Capital Asset Pricing Model
This linear relationship between risk and required return is known as the Capital Asset Pricing Model (CAPM).
In regards to Time Value of Money, the Discount Rate can be referred to as:
The cost of capital
The interest rate
The required rate of return
Effective yield is a term used interchangeably to describe the:
APY
How many of the following statements about bonds are correct?
(2)
I is correct. If the YTM is greater than the coupon rate, the price is below par value.
II is correct. The smaller the coupon payment, the higher the duration.
III is incorrect. Bond prices relate inversely with YTM.
IV is incorrect. Higher duration implies greater sensitivity.
Bonds will sell at par when their coupon rate is ______________ the discount rate
equal to
Which of the following S&P ratings applies to the most risky investment grade bonds?
BBB
If the bond currently sells at a premium, what is the relationship between YTM, current yield and the coupon rate?
YTM < Current Yield < Coupon Rate
Which of the following bonds most likely has the lowest duration?
Maturity: 20 years, Coupon rate: 10%
correct
Maturity: 20 years, Coupon rate: 14%
Maturity: 25 years, Coupon rate: 10%
The shorter the maturity and the larger the coupon rate, the lower the duration.
Maturity: 25 years, Coupon rate: 14%
The duration of a bond issued by Colby's Steak House is 3.0. If the bond's YTM decreases by 0.50%, the price of the bond will:
If the duration is 3 and YTM goes down by 0.5%, the price of the bond will go up by 3.0X0.5 = 1.5%.
If two firms are equal in all regards except their use of debt, ROE will be ______________ sensitive to variation in EBIT for the firm with debt than for the firm without debt.
more
If two firms are equal in all regards except their use of debt, net income for the firm that uses debt will
Be lower than net income for the firm that uses no debt.
If two firms are equal in all regards except their use of debt, ROE for the firm that uses debt will
The relationship between debt and ROE cannot be determined.
If two firms are equal in all regards except their use of debt, the firm that uses debt will
Have the same NOPAT/TA ratio as the firm that does not use debt.
What is the order by which claimholders are paid when a firm is liquidated?
Debt Holders first, Preferred Stockholders next, Common Stockholders last
The difference between preferred and common stock is that preferred stock
normally pays fixed dividends.
AceBook Inc. just paid a dividend of $2.01. Its stock is currently priced at $22.41. If its growth rate is 4% and its required rate of return is 13%, the stock is:
undervalued
Vcs = (2.01X1.04)/(0.13 - 0.04) = 23.23. Since the current price is 22.41, the stock is undervalued.
The standard deviation for an individual stock measures
Total risk
Returns on stocks A and B have equal standard deviations and are perfectly negatively correlated. In a two-stock portfolio with equal dollar investments in both stocks the portfolio standard deviation will be
Equal to zero
The Security Market Line (SML) is a graphical representation of return associated with beta. Choose the correct statement regarding to the SML.
If your estimated return is below the SML, the stock is overvalued.
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