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Principles of Finance > Chapter 7 > Flashcards

Chapter 7 Flashcards

1
Q

Bond

A

Long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of a bond

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2
Q

Key features of a bond

A
  • Par value
  • Coupon interest rate
  • Maturity years
  • Issue date
  • Yield to maturity
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3
Q

Par Value

A

Face amount of bond, paid at maturity

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4
Q

Coupon Interest Rate

A

-Stated interest rate (generally fixed) paid by the issuer

**Multiply by par value to get $ payment of interest

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5
Q

Maturity Years

A

Years until the bond must be repaid

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6
Q

Issue Date

A

When the bond was issued

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7
Q

Yield to Maturity

A

-Rate of return earned on a bond held until maturity, “promised yield”

**Par/Discount bonds

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8
Q

Convertible Bonds

A

May be exchanged for common stock of the firm, at the holders option

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9
Q

Warrant

A

Long-term option to buy a stated number of shares of common stock at a specified price

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10
Q

Puttable Bond

A

Allows holder to sell the bond back to the company prior to maturity

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11
Q

Income Bond

A

Pays interest only when interest is earned by the firm

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12
Q

Indexed Bond

A

Interest rate paid is based upon the rate of inflation

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13
Q

Call Provision

A
  • Allows issuer to refund bond issue if rates decline
  • Require higher yields on callable bonds
  • Include a deferred provision and a declining premium
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14
Q

Registered Bond

A

Name of bondholder is registered with the issuer; identity known

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15
Q

Bearer Bond

A

Issuer has no record of the name of the investor; investor anonymous

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16
Q

Sinking Fund

A
  • Provision to pay off a loan over its life rather than all at maturity
  • Similar to amortization on a long-term loan
  • Reduces risk to investor, shortens average maturity
  • But not good for investors if rates decline after issuance—– because they can call the bond and reissue it at a lower interest rate, so they pay less
17
Q

How are sinking funds executed?

A
  • Call X% of the issue at par for sinking funds
  • —Likely to be used if the bond sells at a premium
  • Buy bonds in the open market
  • —Likely to be used if the bond sells at a discount
18
Q

Premium

A

Greater than par value

19
Q

Discount

A

Less than par value

20
Q

Opportunity Cost of Debt Capital

A

Rate that could be earned on an alternative investment

21
Q

Expected Return

A

(Coupon payment + capital gain (loss))/Original investment

22
Q

Current Yield

A

Annual coupon payment/Current Price

23
Q

Capital Gains Yield

A

Change in Price/Beginning Price

24
Q

Expected Total Return=YTM

A
  • Expected CY+Expected CGY

- CGY=YTM-CY

25
Q

Price Risk

A
  • The concern that rising cost of debt will cause the value of the bond to fall
  • A 10 year bond would be more sensitive to interest payments compared to a 1 year bond; 10 year bond has higher price risk
26
Q

Reinvestment Risk

A

Interest rate will fall and reduce return

27
Q

Semiannual Bonds

A
  • Paid twice a year, every 6 months
  • Multiply number of periods by 2 (2N)
  • Divide nominal rate by 2, periodic rate=(i/2)
  • Divide coupon rate by 2, payment=(annual coupon/2)
28
Q

Yield to Call

A

-The rate of return earned on a bond when it is called before its maturity date

**Premium bonds

29
Q

Bond Ratings

A

Designed to reflect the probability of a bond issue going into default

30
Q

Moody’s

A
  • Investment Grade: Aaa, Aa, A, Baa

- Junk Bonds: Ba, B, Caa, C

31
Q

S&P

A
  • Investment Grade: AAA, AA, A, BBB

- Junk Bonds: BB, B, CCC, C

32
Q

Factors Affecting Default Risk and Bond Ratings (Financial Performance)

A
  • Debt Ratio
  • TIE Ratio
  • Current Ratio
33
Q

Factors Affecting Default Risk and Bond Ratings (Qualitative)

A
  • Secured vs. Unsecured debt
  • Senior vs. Unsubordinated debt
  • Guarantee and sinking fund provisions
  • Debt maturity
34
Q

Miscellaneous Qualitative Factors

A
  • Earnings stability
  • Regulatory environment
  • Potential antitrust or product liabilities
  • Pension liabilities
  • Potential labor problems
35
Q

Bankruptcy (Chapter 11)

A
  • To stop creditors from foreclosing, taking assets, and closing the business and it has 120 days to file a reorganization plan.
  • Court appoints a “trustee” to supervise reorganization
  • Management usually stays in control.Company must demonstrate in its reorganization plan that it is “worth more alive than dead.”
  • If not, judge will order liquidation under Chapter 7.
36
Q

Bankruptcy (Chapter 7)

A
  1. Secured creditors from sales of secured assets
  2. Trustee’s costs
  3. Wages, subject to limits
  4. Taxes
  5. Unfunded pension liabilities
  6. Unsecured creditors
  7. Preferred stock
  8. Common stock

Principles of Finance (11 decks)

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