P2B.2 LONG TERM FINC MGMT Flashcards
Relationship: As Interest Rate INCREASES, yield ______ and prices _________
Interest Rate and Yields move in SAME direction: as Interest Rate goes UP, Yields go UP
Interest Rate and Prices move in OPPOSITE direction: Interest Rate goes UP, Prices go DOWN
What happens in UPSLOPING Yield Curve?
Interest Rate goes UP, Yields go UP but prices go DOWN
In other words: everybody wants a piece of that increased $ owed from a company -→ prices go down to everyone buying
What is Pure Expectation Theory?
Interest rates driven by market’s expectations of short-term interest rate
UPSLOPING YIELD CURVE: market thinks short-term interest rate will go UP
Common Shareholders have which of the following priviledges: Pre-emptive rights or/and Voting Power?
Common shareholders have both pre-emptive rights (allowed to buy share for new issues of stock) and can vote in Annual Shareholders Meeting for BoD or in matters of M&A
Do Common Stocks appreciate in value?
YES!
Max, an investor, gets dividends but not at regular intervals. What kind of shareholder is he?
Common shareholder, as they get dividends but not all the time
Susan, an investor, has no pre-emptive right nor voting power but she gets dividends before her peers and has first dibs on a company during its liquidation. What kind of shareholder is she?
Preferred Shareholder
TRUE/FALSE - PREFERRED SHARES go up in value
False!
What is a positive covenant?
Action taken by the issuing firm and is beneficial to investors
Ex: issuing firm pays interest on time and has collateral assets to shares
What’s a negative covenant?
Action set upon issuing firm to protect bondholders
ex: issuer has to meet financial ratio expectations
How do you find bond price?
PV of Principal + PV of interest payments
Equation of PV of Principal
PV Factor (use single payment table and use MARKET INTEREST RATE) * Principal or Face Value of Bond
Equation of PV of Interest
PV Factor (use annuity table and MARKET interest rate) * Interest per period (use COUPON RATE or stated interest rate)
What’s the journal entry of a firm issuing a bond?
Ask yourself: what decreases or increases?
Assets INCREASES, so we DEBIT Cash
Liabilities INCREASE, so we CREDIT Bonds Payable
If bonds are sold @ premium, firm has to shell out more $, so we CREDIT Premium Paid on Bonds
Example Problem of Weighted Marginal Cost of Capital
A company is considering a project with an initial cost of $15,000,000 and an expected internal rate of return of 11.5%. The amount of retained earnings in the last financial quarter is $3,000,000 at a cost of 15.7%. A bank has offered a $12,000,000 loan at a 9.5% interest rate. The corporate tax rate is 25%.
Should the company management accept the project?
Step 1: Define WMCC
[weighted average of capital source of fund 1 cost of source 1] + [weight of capital source of fund 2 * cost of source 2}
if source is a debt, like a loan, * (1-tax rate)
Step 2:
do each piece separately
Step 3: add all the pieces together
Step 4: is this < or > IRR? Accept ONLY IF < IRR
Since the cost of capital is lower than the IRR, the company should accept the project.
Weighted Marginal Cost of Capital
Cost of raising additional capital
Constant Growth Dividend Discount Model
Tells us today’s stock price
P0 = D1/(r - g)
where P0 is stock price today, r is firm’s required rate of return, and g is growth rate of firm and D1 is dividends paid per share
Price to Sales ratio
Total Market capitalization
÷
Total Sales
or
Market Price per share
÷
Sales per share
Weighted Average Cost of Capital (WACC)
Cost of capital needed to finance a firm’s business
WACC = (CWD × CD(1−t)) + (CWP × CP) + (CWC × CC)
Basically, we take the sum of the weighted average of the costs that sum up the capital structure: debt, preferred stock and common stock
What are warrants?
- financial instruments that give the holder the right (but not obligation) to buy a specific # of units of security at a specific price BEFORE expiration date of warrants
- Characteristics
- issued @ lower interest rates
- offered by issuing firms only
- longer terms than options
- can be exercised BEFORE expiration date (US)
- can be exercised only ON expiration date (European)
- Ex: NAKED (issued alone) or Detachable (issued with bonds and preferred stock)
What’s considered “IN THE MONEY”?
For a CALL option: exercise < market price
(call option: holder of option bets stock price ⇡ to buy it at a discount price (strike price))
For a PUT option: exercise > market price
(put option: holder of option bets stock price ⇣ so you’ll exercise it when it does and profit by selling it when stock price goes down)
What is the break point in a capital structure?
This is the point where marginal cost of capital increases
Unappropriated Retained Earnings
÷
Target Weight of Common Stock in capital structure
What classifies a lease a capital or financial lease?
- lease of asset is majority of life of asset
- buy option - asset’s price is set to where lessee is most likely to buy it
- PV of lease payments + residual value > asset’s fair value
- asset is so specialized that lessor will not want it at end of lease
- FULL transfer of risks & ownerships
Example Problem:
On March 31st, 2019. Acme Manufacturing issued a $1,000,000 par value, AA-rated, 6% coupon bond outstanding, which matures in five years. The bond was issued at a discount, with a selling price of $980,000, and the market rate for the bond is 6.8%. What is the carrying amount of the bond and the amount of amortization on March 31st, 2020?.
A $986,640, $6,640
B $1,000,000, $6,640
C $980,000, $6,640
D $986,640, $80,000
Beginning carrying amount (issue price)$980,000Interest paid ($1,000,000 X 6%)$60,000Interest expense ($980,000 X 6.8%)$66,640
Amortization of the premium (interest expense – interest paid)
$6,640March 31st, 2020 carrying amount$986,640
What is an interest rate swap?
- exchanges of cash flows during a specific time period
- companies pay difference between loan interest rates on each payment date
- “boutique” version - OTC and customizable
Securities Act of 1933
- ensures investors get financial information associated with securities for sale
- prohibits fraud, deceit and misinformation on securities for sale
Securities and Exchange Act of 1934
oversees transactions done btwn parties that are not the original issuers
TRUE/FALSE: Creditor’s risk reflected in interest rate of debt security
FALSE! It is DEBTOR’s risk that is reflected in interest rate of debt security
What do Credit Rating agencies do?
Assess corporate debtor’s risk or ability to repay debt
What is hedging?
A way to reduce risk by offsetting an asset with a financial instrument similar in maturity to the asset
i.e. offset a short-term ass with a short-term financial instrument
If a contract price > market price of a hedged instrument, do you recognize it as income immediately?
Yes, record in FS as ‘Interest Income’
What happens if the fair value of a hedged item changes?
- gains and losses associated with these changes are recognized immediately as interest income/interest loss
- changes need to be recognized in net income at same time of change
- carrying value needs to be adjusted at time of change in fair value
Inflation goes ______ as interest rate _____
⇡, ⇣
Definition: Discounted Cash Flows
a way to calculate market price of a stock
Does by: taking the sum of the present value of future cash flows, using investor’s expected rate of return
Equation: DCF
Effective interest rate
original contractual rate
Debentures
Backed by credit of issuer
Safer than income bonds due to interest payments being made at all times, regardless if issuer has positive or negative earnings
Serial Bonds
- coupon rate is fixed
- investor can choose maturity dates of bonds in this series
What is the market value of a bond that is trading at 87 on an exchange?
This means it’s trading at 87% of its par value
Fair Value Hedge
Hedging approach to reduce risk from changes in an asset’s or liability’s fair value
Cash Flow Hedge
Hedging approach to ensure cash flow is certain and consistent by locking in the price at a certain date
Unmatched swap
type of interest swap with NO accompanying asset or obligation; contract states other ways to reduce/eliminate risk
Matched Swap
a type of swap that is hedged by another swap
Offsetting swap
type of swap that involves receiving a certain rate and paying a different rate
(ex: receiving fixed rate and paying floating rate)
As degree of total leverage _____, financial leverage ____ in same amount
DECREASES, DECREASES
Operating Leverage _____ in same amount as _____ in ratio of fixed interest payments and preferred divs to “variable” (aka CS dividends)
INcreases, Increases
