Chapter 2 - Pricing of financial assets

Question 1

Why is bond financing easier than stock financing?

Answer 1

• Fixed income securities
• Dividends depends on the performance/Net income of the firm
• Stock owners are residual owners (risk)

Question 2

What are the four ways to finance?

Answer 2

• Retained earnings
• Bank loan
• Issue bond
• Issue stock

Question 3

Items in the Financial Statement

Answer 3

Sales
Costs
EBIT
Interest (in case of bond, treated as cost so lower tax)
EBT
Tax
Net Income (divided between dividend and retained earnings)

Question 4

Pecking order theory

Answer 4

Retained Earnings > Debt > Equity

Question 5

Why are stock hard to value?

Answer 5

• CF and FV are not guaranteed
• No maturity
• Hard to find required return

Question 6

What is the stock price?

Answer 6

The PV of all dividends discounted

Question 7

What are the three types of Dividend Discount Model?

Answer 7

• Perpetuity and no dividend growth
• Constant growth
• Non-constant growth

Question 8

DDM without growth

Answer 8

P0 = D/r

Question 9

Discount Growth Model

Answer 9

Pt = D(t+1) / (r - g)

Question 10

For a bank deposit, what is the relation between Deposit Value and Face Value?

Answer 10

Deposit Value = Face Value

Question 11

What are the component of Bond Valuation?

Answer 11

• Bond Price
• YTM (interest rate for bank deposit)
• Coupon rate
• Coupon
• Maturity

Question 12

How is YTM chosen?

Answer 12

Based on investors perception about risk and business forecasts

Question 13

What is a par bond?

Answer 13

Price = Face Value
Coupon rate = YTM

Question 14

What is a premium bond?

Answer 14

Price > Face Value
Coupon rate > YTM

Question 15

What is a discount bond?

Answer 15

Price < Face Value
Coupon rate < YTM

Question 16

What is the formula to have the PV of t constant dividend?

Answer 16

P0 = C * ((1 - (1/1+r^t)) / r

Question 17

What is the investment strategy if:
- Interest rate is expected to decrease?

Answer 17

Decrease in r => Increase in Price
= Need to buy immediately, especially long-term for greater gain

Question 18

What is the investment strategy if:
- Interest rate is expected to increase?

Answer 18

Increase in r => Decrease in Price
=> Need to sell, especially long-term
If need to buy, buy short term to minimize risk

Question 19

Relation between Face Value and Bond Price

Answer 19

Positive
The higher the Face Value, the higher the Price

Question 20

Relation between Coupon Rate and Bond Price

Answer 20

Positive
The higher the Coupon Rate, the higher the Price

Question 21

Relation between Maturity and Bond Price

Answer 21

Negative
The higher the maturity, the lower the Price

Question 22

Relation between interest rate and Bond Price

Answer 22

Negative
The higher the interest rate, the lower the Price