Exam 2 Flashcards
Interest rate levels
Price of capital. Borrows are willing to pay and lenders are going to recieve
What are the four factors that affect interest rates?
Production opportunities, time preferences for consumption, risk, and expected inflation
Time preferences for consumption
Supply side. More in future high supply =lower interest rate
Risk
Higher risk=higher interest
Expected inflation
High inflation = high IR
R*
Real risk free rate of interest
Rrf
The nominal rate of interest on treasury securities
Rrf=
R*+IP
Interest rate equation
R*+IP+DRP+LP+MRP
R
Required return on a debt security
DRP
Default risk premium. Chance for borrower not to make payment
LP
Liquidity premium. Convertibility to cash at fair market value
MRP
Maturity risk premium. Price of long term bonds changes over time as interest rate changes. Risk of capital loss
Short term treasury
IP
Long term treasury
IP and MRP
Short term corporate
IP DRP LP
Long term corporate
IP MRP DRP LP
Term structure
Relationship between interest rates and maturities
Yeild curve step one
Find the average expected inflatiob rate over years
Yeild curve step two
Find the appropriate maturity risk premium. .1%(t-1)
Yeild curve step 3
Add the premiums to r*
Upward sloping yeild curve
Due to an increase in expected inflation and MRP
Corporate yeild curves
Are higher than that of treasury securities though not parallel to t-curve
The spread between corporate and treasury yeild curves
Widens as fhe corporate bond rating decreases
Since corporate yields include a DRP and LP the yield spread can be calculated as
Corporate bond yield-Treasury bond yield
DRP+LP
Investment grade bonds
BBB and higher. Investment companies can only invest in these
Junk bond
BB and lower
Pure expectations theory
Contends that the shape of the yield curve depends on investors expectations about future interest rates. IR increase LT rates will be higher than ST rates
Assumptions of pure expectations
MRP for T-securities is zero, LT rates are an average of current and future ST rates, use to guess future rates
Macro factors that influence IR
Federal reserve policy, federal budget deflicits or surpluses, international factors, level of business activity
Federal reserve policy
Short term: money increases IR decreases
Long term: inflation increases IR increases
Bonds are primarily traded in the
Over the counter market
Most bonds are owned by and teades among
Large financial institutions
Par value
Face amount paid at maturity
Coupon rate
Stated interest rate
Yield to maturity
Rate of return earned on a bond held until maturity
Call provision
Allows issuer to refund the bond if rates decline, bond premium, deferred call and declining call
Sinking fund
Provision to pay off a loan over its life rather than all at maturity. Reduces risk to investor. Investors have reinvestment risk
Convertable bond
May be exchanged for common stock of the firm at the holders option
Warrant
Long term option to buy a stated number of shares of common stock at a specific price
Putable bond
Allows holder to sell the bond back to the company prior to maturity
Income bond
Pays interest only when interest is earned by the firm
Indexed bond
Interest paid is based upon the rate of inflation CPI+%
Opportunity cost of debt capital
Discount rate. Rate that could be earned on alternative investments of equal risk
If Rd remains constant
The value of prmium bond will decrease, value of discount bond will increase, par value stays the same
Current yield
Annual coupon payment/ current price
Capital gains yield
Change in price/ begining price
Expected total return
YTM= expected CY+ expected CGY
The longer the bond
The higher the price risn
Reinvestment risk
The concern that the rd will fall and the future CFs will have to be reinvested at lower rates
Short term/high coupon bonds
Low price risk, high reinvestment risk
Long term/ low coupon
High price risk, low reinvestment risk
Semiannual bonds
Period: 2N
Periodic rate: rd/2
PMT= annual rate/2
Callable bonds YTM or YTC
If YTC
When is a call more likely to occur?
Market
Default risk
Influenced by the issuers finanacal strength and the terms of the bond contract
Mortgage bonds
Backed by fixed assets
Debenture bonds
Bond with no collateral
Subordinated debenture
3rd tear
Liquidation
Assets are auctioned off to obtain cash that is then distrubuted to creditors
Priority claims of liquidation
Secured creditors, trustee costs, wages, taxes, unfunded pensions, unsecured creditors, preferred stock, common stock
Reprganization
Emerges from bankruptcy with lower debts reduced interest and a chance for success. Unsecured creditors more willing to participate
Investment risk
The chance that unfavorable events will occur from an investment. Probability that earn low or negative return
Stand alone risk
Investing in one companys stock
Portfolio risk
Investing in multiple companys stock
Probability distributions
Narrower is lower risk. Wider is higher risk
Stocks are said to provide
Relativly higher return with higher risk. Trade off
High tech relative to economy
Moves with the economy and has positive correlation
Collections relation to economy
Is countercyclical and has negative correlation
Expected rate of return calculation
Weighted average of all probablities
Standard deviation for each investment
Weighted average of expected returns minus actual returns
Larger SD
The lower the prob that actual returns will be closer to expected returns. Associated with a wider prob distribution of returns
Corfficient of variation
A standardized measure of dispersion about the expected value that shows the risk per unit of return. SD/expected return
Risk aversion
Assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities
Risk premium
The difference between the return on a risky asset and riskless asset which serves as compensation for investors to hold riskier securites
A portfolios expected return is
A weighted average of the returns of the portfolios component assets
Correlation
A tendency of 2 variables to move together
SD for average stock
35%
Most stocks are
Positivley correlated with the market
Correlation that is very low or negative
Reduces risk
Stand alone risk =
Market risk + diversifiable risk
Market risk
Portion of a securitys stand alone risk that cannot be eliminated through diversification. Measured by beta
Diversifiable risk
Portion of a securitys stand alone risk that can be eliminated through proper disverification
Capital asset pricing model
Model linking risk and required returns
CAPM suggests
That there is a security market line that states a stocks required return equals the risk free return plus a risk premium
Primary conclustion for CAPM
The relevant riskiness of a stock is its contributiob to the riskibess of a well diversified portfolio. Not to the riskiness of added specific asset
Beta
Measures a stocks market risk and shows voliatiliy relatice to the market. Indicates how risky a stock is if held in difersified
Beta equation
Ri/rm
Beta=1
The security is just as risky as the average stock
Beta>1
Riskier than average
Beta<1
Less risky than average
SML equation
Ri= Rrf+ (Rm-Rrf) b
Market risk premium
Additional return over risk free needed to compensate investors for assuming an average amount of risk (Rm-Rrf)
Fed stimilates
R* decreases causing a decrease in Rrf and SMl decreases
Facts about common stock
Represent ownership, implies control, elect directors, directs elect management, management max stock price
Stocks with price below intrinsic value
Undervalued
Discounted dividend model
Value of a stock is the present value of the future dividends expected to be generated
Stock price equation DDM
D1/rs-g
Growth factor is
Comes feom the RE and reinvestment. The increased % of RE means increased g
Dividend yield
D1/Po (dividends/stock price)
Capital gains yield stock
P1-po/po
%change in stock price
Total return stock
Dividend yield-capital gains yield
If g=0
Would be perpetuity. Pmt/r
Negitive growth stock
Do(1+g)/(rs-g)
Corporate valuation model
Free cash flow method. Suggest the value of the entire firm equals the present value of the firms free cash flows
Free cash flows equation
(Ebit(1-T)+dep)-(capital expenditures+change in working captial)
Applying CVM
1) find pv of FCF
2) subtract debt anf preferred stock
3) divide by # of shares
Issues CVM
Used when firm doesnt pay dividends, assumes fcf growth constant, horizon value is point growth becomes constant
Firm multiples method
Analysts often us the following multiples to value stocks:p/e, p/cf, p/sales. Multiply but expected earnings
Economic value added approach
Find EVA, add future values to BV of equity, divide by # of shares
EVA
Equaity capital(ROE-cost of equity)
Preferred stock
Hybrid security, fixed dividends that must be paid before common stock, dont have to pay
Preferred stock expected return
Dividends/selling price
