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Finance
FIN 3309 Exam 2
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Terms in this set (157)
Bond
Long-term debt security issued by a corporation or government entity.
Structured as an interest-only loan.
Ex: government activities (schools)
Issue date
Beginning date
Maturity date
Date on which the principal amount will be repaid
Face/maturity/par value
the amount of principal to be repaid at the end of the term of the bond. Corporate bonds are usually in denominations of $100.
Coupon rate
The annual interest rate determining periodic interest payments. Only used to calculate the coupon payment
Coupons or interest payments
Coupon rate x face value
The interest payments
How to value a bond
Find the present value of the asset's future cash flows
Bond cash flows are derived from...
1. Coupon payments - the interest payments (usually semiannual)
2. The payment of principal at the maturity date
Current yield
yield without taking into account the payment of the maturity value
Annual Coupon Payment/Market Price of Bond
If you own a bond and interest rates for debt of SIMILAR risk RISE, how is the intrinsic value of bonds affected?
It decreases
If higher yield investments are available, then a lower yield investment looks less attractive. People would pay ____ for it
less. This bond sells at a discount
Debt is NOT ...
ownership
Debt IS a ....
liability and can lead to bankruptcy
Bond indenture
Contract that governs the bonds between bond issuer and trustee (large institution that represents individual bondholders)
What's included in a bond indenture
Terms of the bond and bond issue, total amount of bonds issued, description of any property used as collateral (secured bonds), repayment arrangements (sinking fund), call provision, protective covenants
Sinking fund
every year they'll reserve a certain amount to repay bonds in the future. Gives security to bondholders
Call provision
Ability to prepay debt/end bond early
Bondholders don't want that because they don't get as much money
Offer a higher interest rate to entice buyers into contract
Bond issuers prepay when interest rates drop
Yield to maturity (YTM)
Yield taking into account coupon payments and maturity value
YTM ___ Current Yield
>
The _____ the time to maturity, the ______ the risk
longer, greater
(more opportunity for fluctuation in market against price)
The _____ the coupon rate, the ______ the risk
lower, greater
When interest rate < market rate, the price of the bond ______
increases
Protective covenants
Negative: "Do Not." new lending, mergers, amount of dividends, etc. (Bond issuer will NOT)
Positive: "Must Do." Maintain collateral, furnish financial to lender, etc. (Bond issuer WILL)
Bond Ratings
Measure risk of bond/how likely they're able to repay. Bond issuers pay private companies to evaluate company and bond and assign a grade to the bond
Non-Investment Grade bonds
junk bonds or high yield bonds. Promise high interest rates.
If Rate of Interest = Coupon Rate, then Price = ________
Face Value
Types of Bonds
Government, Corporate
Government bonds
Little or no default risk (US Federal), Certain tax advantages ("munis" coupons are exempt from federal taxation), zero coupon bonds (US Treasury)
Zero coupon bond
a bond issued with no coupon payment. The bond is issued at a discount to face or par value. That difference in price determines the investors yield on the bond. (US Treasury bonds)
Corporate Bonds
Debentures, Secured & Unsecured Bonds, Registered & Bearer, Floating rate "floaters", Convertible, Junior and Senior, Subordinated
Debentures
A debt instrument that is unsecured; an unsecured bond
Secured & Unsecured bonds
Secured have collateral pledged to secure payment. Unsecured are general obligations
Registered and Bearer Bonds
Registered: all that are now issued. A registry is kept of all owners of bonds
Bearer Bonds: no longer used, but payment is made to whoever has possession of the bond
Floating rate bonds "Floaters"
coupon rate is tied to an index so the interest rate may fluctuate as the index fluctuates; floaters have less interest rate risk
Convertible bonds
Bonds that can be converted to equity ownership
Junior and Senior Bonds; Subordinated Bonds
Bonds that can't be paid until some other debt is paid. Creates jr and sr bonds
Opportunity cost
The rate of return that an investor will demand on an investment, or the return that could be earned on the next best alternative
If the investor's rate of return is less than the inflation rate, their real return is...
less than 0%
We assume that investors are _______ and will only accept negative interest rate for ______ periods of time
rational, short
Nominal interest rate
The observed or stated interest rate (APR). Rate before it has been adjusted for loss in purchasing power that results from inflation. Most interest rates are quoted in nominal terms
Three components of nominal rate
1) the real rate
2) expected inflation
3) recognition that dollars earned are also worth less (usually so small that it is ignored)
Real rate equation
Nominal rate - inflation rate
Real interest rate
The real rate of return on an investment, accounting for percentage changes in purchasing power. The real rate adjusts the nominal rate to reflect changes in purchasing power.
The value of an asset reflects...
an investor's expectations about the future
If interest rates increase, bond prices...
decrease (and vice versa)
What causes interest rates to fluctuate?
Inflation risk premium, interest rate premium, default risk premium, taxability premium, liquidity risk premium
Inflation risk premium
The premium required to compensate for the risk of inflation
Nominal rate - inflation rate = rate without inflation
Interest rate risk premium
The risk that the value of an asset will change due to fluctuations in interest rates over time. It's greater the greater the number of years to maturity.
Default risk premium
the premium required to compensate for the RISK of default
Taxability premium
the premium required to cover the cost of taxes on the interest. Calculated by multiplying the interest rate by (1- tax rate)
Munis can have lower interest rates because...
they are not taxed
Liquidity risk premium
If an asset cannot be quickly converted to cash, investors will require a premium to offset for the time and money taken to sell the asset
Bond yields, or the nominal rate of return are a function of the following 6 components
Real risk-free rate of return + inflation premium + interest rate risk premium + default risk premium + taxability premium + liquidity premium
Risk-free rate
The required rate of return on a risk-free asset (US Treasury bills). All other borrowers have to pay a premium above this rate to compensate investors for various types of risk
Yield to maturity
The yield that a DEBT SECURITY offers if the owner holds it to maturity.
Discount rate that makes the present value of a debt security's expected cash flows just = to the asset's current market price
Term structure of interest rates
the relationship between a security's yield and the number of years remaining to maturity
Shows the nominal interest rate on default-free, discount-only bonds (bonds without interest payments).
Tells the time value of money for different lengths of time
If we look at any moment in time interest rates for short-term and long-term debt will typically be...
different
Short-term rates will typically be lower
As the number of years remaining to maturity increasing, so does the _____
yield
In this case, the yield curve is UPWARD sloping but increasing at a decreasing level
If long-term rates are higher than short-term rates, the curve is....
upward sloping if rates are expected to rise
If long-term rates are less than short-term rates, the term structure is...
downward sloping or inverted
This indicated investor expectations that RATES WILL FALL in the future (unusual)
If long-term rates are equal to short-term rates, the curve will be...
flat
If market interest rates for similar debt INCREASE
1. The market price of older, outstanding bonds will FALL in order to bring their yield into line with higher-interest new issues
2. If the bond is now selling at a discount, the YTM will be greater than the coupon rate
If market interest rates for similar debt DECREASE
1. The market price of older, outstanding bonds will GO UP in order to bring their yield into line with lower-interest new issues of bonds
2. If the bond is now selling at a premium, the YTM will be less than the coupon rate
The YTM or "yield" is the discount rate that forces the present value of a bond's cash flows to __________ its current market price
Equal
The appropriate discount rate to use when valuing a bond is...
the bondholder's required return (the investor's required rate of return, the market rate)
If a bond is NOT a new issue, the number of years remaining to maturity must be...
less than the original life of a bond
Bond prices are primarily a function of...
interest rates
Asset value
Intrinsic or economic value of an asset is the present value of all future cash flows generated by the asset
The value of a financial asset is a function of...
1. The amount and timing of the asset's cash flows
2. The riskiness of these cash flows
3. The investor's required rate of return
Investor's reward for buying and holding an asset
1. cash flow
2. capital gains from appreciation
Bond cash flows
Relatively certain. Stated coupon rate and stated par value
Stock cash flows
Less certain. Future dividends are estimates, no definite term or defined value upon sale of stock
Valuing stocks
The intrinsic value of a stock is the present value of the stock's expected future cash flows (dividends)
Zero "NO Growth" dividends
Cash flows do not grow over time
Value of preferred stock
Annual divided / required rate of return
If the market rate < dividend rate...
the price > par value
Preferred Stock
Hybrid security is technically part of "equity capital"
Preferred Stock similarities to bonds
-fixed income security (set dividend rate)
-has a par value
-usually nonvoting (no control in managing company)
-may contain protective provisions/covenants
-may be convertible
-dividends are preset, fixed, limited, often quoted as a % of par
Preferred Stock similarities to Common Stock
-no fixed maturity date
-nonpayment of dividends does not result in bankruptcy proceedings (dividends cumulative, not debt)
-Dividends NOT tax deductible (vs interest payments on a bond that can be deducted as a business expense)
Characteristics of Preferred Stock
-multiple classes of stock may exist
-paid after creditors in case of liquidation (first: creditors, second: preferred stock holders, third: common stock holders)
-dividends are cumulative; keep adding until paid
Common Stock
Represents ownership in the firm. Variable income security with NO set dividend payment
Unique characteristics of common stock
-residual claim on assets after debts & preferred stock in case of liquidation
-exposure to bankruptcy - paid last!
-residual claim on income
-voting rights (elect board of directors, accept/reject mergers): in person or by proxy, stock classes (different voting rights on different shares/classes)
-preemptive rights (first dibs on buying more stocks)
-limited liability (Corp. takes on liability)
Dividends of Common Stock
-OPTIONAL. Often based on firm's growth rate, desires of its shareholders, ability to generate profits
-Shareholders share proportionally
-regular dividends: "income stocks"
Differential growth dividends are used to value the stock of firms experiencing rapid growth as a result of...
1. Introduction of new product, New technology, Innovative marketing strategy
2. This period will end- competition will catch up, consumer tastes change, etc. Now constant growth model is relevant
3. Think of dividend as being 2 distinct components: High Growth period & Low Growth period
Zero dividends stocks
Firm pays no dividends. One common method is to use multiples of ratios like the price-earnings ratio.
Dividend Yield
Dividend / Price
Investor's expected rate of return
(Dividend / price) + growth rate
Stockholder's expected return comes not only from a cash dividend, but also from...
growth in the firm (which leads to growth in the value of the firm's common stock)
Financial Return
Total financial gain or loss on an asset over a given period of time
Average financial return
Historical return over a period of time
Expected financial return
What we expect based upon what we paid
Required financial return
Return adjusted for the risk of the investment
Risk
possibility of loss
What is the relationship between risk and return?
Higher the risk, higher the required return
To increase wealth, the rate of return must be above the...
inflation rate
Variance & Standard Deviation
Measures of volatility - risk
Variance
On average, how the actual return varies from the expected return
-GREATER variance = GREATER risk
Standard deviation
A measure of dispersion (square root of variance)
-average of how far all possible outcomes deviate from the expected return
-"How confident are we that we will receive the expected return"
-Measures total risk
-GREATER st dev = GREATER risk
Portfolio weight
Amount of money invested / total investment
Unsystematic Risk or Diversifiable Risk
COMPANY SPECIFIC RISK
-unique to company
-can revolve around people of company (Weinstein)
-Boeing 737 Max
-hiring/firing of CEO
-new product
-scandal/lawsuit
-acquisition
Systematic or Nondiversifiable Risk
MARKET RISK
-inflation
-interest rate
-political climate
-legislation
-war
-recession/depression
Total risk
unsystematic risk + systematic risk
Risk DECREASES as...
number of stocks in the portfolio INCREASES
At a certain point, INCREASING the number of stocks....
no longer decreases risk
Dealing w/ risk the companies/industries don't share eliminates _____________ risk through diversification
unsystematic
Diversification deals with ____________ risk
unsystematic
Portfolio should have a ___________ correlation
negative
Why does combining assets in a portfolio DECREASE risk?
Spreads risk out - deals with UNSYSTEMATIC risk
The Systematic Risk Principle
The expected return on an asset depends only on that asset's systematic risk. Does not take into account any unsystematic risk.
Unsystematic risk is IRRELEVANT when...
estimating investor's required rate of return when asset is a part of a diversified portfolio
Beta
Measure of responsiveness when comparing an individual asset to the market portfolio
-Measure of a firm's market or SYSTEMATIC risk
-Measure of the VOLATILITY of a security and its returns relative to the market as a whole
Beta tells what will happen on average to ___________________________________ when the market changes
the returns of a single stock or portfolio
Beta of market
1
A beta of "1" means
the stock moves in unison with the market portfolio
A beta of "0" means
the stock has no systematic risk and is not affected by events in the market
A beta of LESS than 1
means that on average the stock moves less than the market (note negative betas are VERY uncommon)
A beta of MORE than 1
Means that on average the stock moves more than the market portfolio
Portfolio beta
Sum of (Beta * Portfolio weight) of each stock
What information does the portfolio beta provide?
How fast/slow the firm moves. Measures volatility/risk.
Market rate of return
risk-free rate of return + market risk premium
Investor's required rate of return
risk-free rate of return + asset risk premium
The risk-free rate
Amount of the return that compensates for expected inflation
The risk premium
The additional return, or reward, that investors expect to receive for assuming risk. As risk increases, investors will require a larger risk premium
Since beta tells us the RISK of an asset (relative to the market), use beta to estimate...
the risk premium
The required rate of return =
Risk-free rate + beta(market return - risk-free rate)
Market risk premium
market return - risk-free rate
Asset risk premium
beta(market return - risk-free rate)
What does the security-market line demonstrate?
Risk-Return
Securities BELOW the sml are...
OVERPRICED. Return is less than it should be
Securities ABOVE the sml are...
UNDERPRICED. Return more than expected
The Efficient Market Hypothesis: Prices tend to move toward...
The intrinsic value (the SML)
What will happen if a security is underpriced or undervalued?
People will buy so the price will increase. As the price increases, the return will lower. The security will start to move toward the SML.
What will happen if a security is overpriced or overvalued?
Price will decrease until return places it on SML.
In the long-run, the investor can only expect to earn...
the return indicated by the SML
The slope of the SML is equal to
the risk premium on the asset
(Expected Return - Risk-free Return)/Beta
What is cost of capital?
Required return
a) the cost to a firm to obtain capital funding
b) it EQUALS the required return to the provider of those funds (purchasers of stocks and bonds)
What the cost of capital represents
a) how the market views the risk of the firm's assets
b) a firm must earn at least the required rate of return to compensate investors for the financing they've provided
c) the required return is the same as the appropriate discount rate the firm should use in valuing its activities or projects
Uses of the cost of capital
a) Capital budgeting decisions - neither the NPV rule nor the IRR rule can be implemented without knowledge of the appropriate discount rate
b) Financing decisions - the optimal/target capital structure MINIMIZES the cost of capital
How to determine the cost of Common Stock
TWO methods:
1) Constant Dividend Growth Method - solve for rate
2) Capital Asset Pricing Method (CAPM)
How to determine the cost of Preferred Stock
No Growth Method
R = Dividend/Price
Interest is deducted from...
taxable income
Interest ________ taxable income, meaning it _____ money
DECREASES, saves
every payment of interest doesn't cost the full amount (bond)
Debt is ______ costly than equity because of tax savings
LESS
Cost of debt (bonds)
the yield to maturity of the outstanding debt adjusted to an after-tax yield by multiplying it by (1-tax rate)
Cost of debt equation
YTM(1-tax rate)
Weighted Average Cost of Capital
Use the individual costs of capital to compute a weighted average cost of capital for the firm
-common stock, preferred stock, debt (usually bonds)
-the weights are determined by how much of each type of financing is used
Market value of equity (E)
number of outstanding shares times price per share
Market value of debt (D)
number of outstanding bonds times bond price
Market value of the firm (V)
D + E
E/V
Percent financed with equity (equity weight)
D/V
Percent financed with debt (debt weight)
Target weights
the firm's ideal debt to equity ratio
Capital Structure Weights
EV, DV, PV
Divisional Cost of Capital
Divisions have different risks and different costs of capital
(Tesla: cars, batteries)
Pure Play Approach
A company with multiple business lines uses a WACC for a project in one business line that compares to a WACC of a company that only engages in that one type of business
1. Find WACC of comparison company
2. Subtract first company's WACC
Subjective Approach
Adjusting WACC using a subjective classification of project risk
-can calculate WACC of firm and then add/subtract risk adjustment
The greater the cost of capital, the _________ the cash flows of the project must be
greater
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