Chapter 8 Flashcards
What is the Fisher Effect formula?
(1 + R) = (1 + r)(1 + h), where R = nominal rate, r = real rate, h = inflation.
What is the main cost of equity?
Loss of ownership control and profit-sharing with shareholders.
How do you value a coupon bond?
Add the present value of coupon payment annuity and the present value of the face value.
What is the inflation premium in bond yields?
Extra return to compensate for expected inflation.
What’s the taxability premium in bond yields?
Extra yield on taxable bonds versus tax-exempt ones (e.g., municipal bonds).
What is a debenture?
An unsecured bond backed only by the issuer’s creditworthiness.
What is the approximate Fisher Effect formula?
R ≈ r + h.
What happens to bond prices when interest rates increase?
Bond prices decrease (inverse relationship).
What is a zero-coupon bond?
A bond with no periodic interest payments; return is from price difference and par value.
What is equity?
ownership, voting rights, non-taxable dividends, no legal obligation to pay.
What does a higher bond rating typically indicate?
Lower default risk and lower yield required by investors.
What are the six factors affecting bond yields?
Real interest rate, inflation premium, interest rate risk premium, default risk premium, taxability premium, liquidity premium.
What is the formula for the value of a coupon bond?
PV of coupon annuity + PV of face value.
What is financial distress in terms of debt?
A condition where a firm struggles to meet debt obligations, potentially leading to bankruptcy.
What are the types of U.S. Treasury securities?
T-bills (<1 year), T-notes (1–10 years), T-bonds (>10 years).
What is the par value of most bonds?
$1,000 (unless stated otherwise).
What is a liquidity premium?
Additional yield on less easily tradable (illiquid) bonds.
What is the first principle of valuing financial securities?
Value = Present value of expected future cash flows.
How do you calculate YTM in Excel?
Use the function =YIELD(settlement, maturity, rate, pr, redemption, frequency).
What does the Excel function =PRICE do?
Calculates the price of a bond based on settlement, maturity, coupon, yield, etc.
What is debt?
no ownership, tax-deductible interest, legal recourse
Why do low-coupon bonds have higher price risk?
They pay less interest over time, so more of their value depends on the discounted par.
What does a coupon bond pay?
Periodic interest payments (coupons) and the face value at maturity.
What happens when YTM < coupon rate?
The bond trades at a premium.
When are secured bonds likely to have lower coupon rates?
When compared to unsecured (debenture) or subordinated debt due to lower risk.
What is price risk?
The risk of bond price changes due to fluctuations in interest rates.
What is yield to maturity (YTM)?
The discount rate that equates the bond price with the present value of future cash flows.
What does the nominal interest rate include?
Both real interest rate and expected inflation.
What’s the difference between debt and equity?
Debt = no ownership, tax-deductible interest, legal recourse. Equity = ownership, voting rights, non-taxable dividends, no legal obligation to pay.
What happens when YTM > coupon rate?
The bond trades at a discount.
What types of bonds have more interest rate risk?
Long-term and low-coupon bonds.
What is the purpose of bond ratings?
To assess the creditworthiness and default risk of a bond issuer.
What does bond pricing rely on, regardless of coupon?
Risk and time to maturity; similar risk bonds should yield similarly.
What is a bond?
A legally binding agreement between a borrower and lender, typically with a par value, coupon rate, and maturity date.
What is senior debt?
Debt that has priority in claims over other types of debt in case of liquidation.
Are dividends tax-deductible for a company?
No, unlike interest payments on debt.
What does the coupon rate represent?
The annual interest paid as a percentage of the par value.
What kind of bonds have the lowest interest rate risk?
Short-term, high-coupon bonds.
What happens when YTM = coupon rate?
The bond trades at par.
What does “subordinated” mean in terms of bonds?
Lower priority in repayment compared to senior debt.
How do interest rates affect long-term vs. short-term bonds?
Long-term bonds are more sensitive to interest rate changes.
What is the main benefit of issuing equity instead of debt?
No obligation to make fixed payments, reducing bankruptcy risk.
