CH19-Long Term Investments Flashcards
Key issues to consider when determining capital market investment objectives
- Risk tolerance
- Return objectives
- Liquidity needs
- Time horizons or future funding needs
- Tax issues
- Asset/liability matching
- Legal or regulatory factors
What is a bond’s market price?
PV of coupon payments + PV of par value
= CF year 1 ÷ (1 + k)1
+ CF year 2 ÷ (1 + k)2
+ CF year 3 ÷ (1 + k)3
+ … + Cn ÷ (1 + k)n
Where:
n=CF year
k = Opportunity cost or required rate of return
What is YTM?
Yield To Maturity = CFs discounted at market’s required rate of return, which is the interest rate the market is demanding over the remaining life of the bond
When a bond pays semiannual coupons, how do you adjust the coupon payments and the required rate of return?
Multiply the number of coupon payments by 2.
Divide coupon payment $ amount by 2.
Divide required rate of return by 2.
Define YTC and Bond Call Provision
Yield To Call. Bond Call Provision=issuer redeem bonds prior to maturity. YTC uses call date instead of maturity date.
What is YTW?
Yield To Worst = where all the possible YTC values are determined and the lowest of the potential values is the YTW
What is the Gordon Growth Model AKA Dividend Discount Model?
An absolute or intrinsic valuation model used to Price Common Stock
= Dt(1 + g) ÷ (k – g)
where Dt is current dividend, g is growth rate, and k is market rate
Formula for PV of a Stream of Payments
same as valuation of capital market securities
(same as market price of bond–>coupon+par)
= CF year 1 ÷ (1 + k)1
+ CF year 2 ÷ (1 + k)2
+ CF year 3 ÷ (1 + k)3
+ … + Cn ÷ (1 + k)n
Where:
n=CF year
k = Opportunity cost or required rate of return
ABC is issuing preferred stock at $40.00 par value with dividend rate at 5.5%. What would the price be of the new preferred stock if the market requires 6.5% return?
Step 1 = Calc Pref. Stock Dividend
Step 2 = Calc Pref. Stock Price
Annual Preferred Stock Dividend = Preferred Stock Dividend Rate * Par Value
Annual Preferred Stock Dividend = 5.5% * $40 = $2.20
Price of Preferred Stock = Annual Preferred Stock Dividend / Required Rate of Return
Price of Preferred Stock = $2.20 ÷ 6.5% = $33.85
When should the Gordon Growth Model be used?
2 conditions
When Both:
- k>g required return exceeds dividend growth rate
- dividend growth rate is expected to be constant in perpetuity
T/F: bonds with longer durations are more sensitive to changes in interest rates
True
4 steps to calculation duration. Duration=bonds’ weighted average time to maturity
- Calculate the present value of each annual cash flow generated by the bond.
- Multiply the values from Step 1 by the year in which the cash flow occurs.
- Divide each product from Step 2 by the bond price.
- Sum the values from Step 3.
formula to Approximate % Change in Bond Price =
-Duration X Change in Interest Rate
2 Factors that affect bond duration
- Time to Maturity
(shorter maturity bonds have less price risk) - Coupon Rate
(bonds with larger coupon rates have shorter durations and less price risk)
What is the duration of a zero-coupon bond?
zero-coupon bond’s duration equals maturity of the bond
