Term 1 - Topic 3 - Sources & Valuation of Long term funds

Question 1

[…] - How Firms Raise Funds:

1. [...] Financing
Private [...] :	[...] from [...]
Public [...]:	Issuing [...] 

2.	[...] Financing: Issuing [...]

Answer 1

Capital Structure - How Firms Raise Funds:

1. Debt Financing
   Private Debt: Loans from Financial Institutions
   Public Debt: Issuing Bonds
2. Equity Financing: Issuing Shares

Question 2

A […] is nothing more than a loan for which you are the lender.
The organization that sells a bond is known as the issuer.
You can think of a bond as an IOU given by a […] (the […] ) to a […] (the […] ).
The interest rate is often referred to as the […].
The date on which the issuer has to repay the amount borrowed (known as […] ) is called the […] date.
Bonds are known as […]-income securities because you know the exact amount of cash you’ll get back if you hold the security until maturity.

Answer 2

a bond is nothing more than a loan for which you are the lender.
The organization that sells a bond is known as the issuer.
You can think of a bond as an IOU given by a borrower (the issuer) to a lender (the investor).
The interest rate is often referred to as the coupon.
The date on which the issuer has to repay the amount borrowed (known as face value) is called the maturity date.
Bonds are known as fixed-income securities because you know the exact amount of cash you’ll get back if you hold the security until maturity.

Question 3

Debt Versus Equity:
[…] are debt, whereas […] are equity. This is the important distinction between the two securities.

By purchasing equity (stock) an investor becomes an […] in a corporation. Ownership comes with […] rights and the right to share in any future […].
By purchasing debt (bonds) an investor becomes a […] to the corporation (or government).
The primary advantage of being a creditor is that you have a […] claim on assets than shareholders do: that is, in the case of bankruptcy, a bondholder will get paid […] a shareholder.
However, the bondholder does not share in the […] if a company does well - he or she is entitled only to the principal plus interest.
To sum up, there is generally […] risk in owning bonds than in owning stocks, but this comes at the cost of a […] return.

Answer 3

Debt Versus Equity:
Bonds are debt, whereas stocks are equity. This is the important distinction between the two securities.
By purchasing equity (stock) an investor becomes an owner in a corporation. Ownership comes with voting rights and the right to share in any future profits.
By purchasing debt (bonds) an investor becomes a creditor to the corporation (or government).
The primary advantage of being a creditor is that you have a higher claim on assets than shareholders do: that is, in the case of bankruptcy, a bondholder will get paid before a shareholder.
However, the bondholder does not share in the profits if a company does well - he or she is entitled only to the principal plus interest.
To sum up, there is generally less risk in owning bonds than in owning stocks, but this comes at the cost of a lower return.

Question 4

Bond characteristics:

The […] value (also known as the […] value or […]) is the amount of money a holder will get back once a bond matures.
A […] issued bond usually sells at the par value.
What confuses many people is that the par value […] the price of the bond. A bond’s price […] throughout its life in response to a number of variables ([…] rates in particular).
When a bond trades at a price above the face value, it is said to be selling at a [.]. When a bond sells below face value, it is said to be selling at a [.].
When bond prices are quoted in the financial press they are generally expressed as a [.] of the bond’s par value.

Answer 4

Bond Characteristics:

Face Value/Par Value

The face value (also known as the par value or principal) is the amount of money a holder will get back once a bond matures.
A newly issued bond usually sells at the par value. Corporate bonds normally have a par value of $1,000, but this amount can be much greater for government bonds.
What confuses many people is that the par value is not the price of the bond. A bond’s price fluctuates throughout its life in response to a number of variables (interest rates in particular).
When a bond trades at a price above the face value, it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount.
When bond prices are quoted in the financial press they are generally expressed as a percentage of the bond’s par value.

Question 5

Bond characteristics:

[.] (Interest Rate)
A rate that stays as a fixed percentage of the par value like this is a […]-rate bond. (Fixed-Income Security)
Another possibility is an adjustable interest payment, known as a […]-rate bond. In this case the interest rate is tied to […] rates through an index, such as the rate on Treasury bills.
All things being equal, a lower coupon means that the price of the bond will […] more.

Answer 5

Bond characteristics:

Coupon (Interest Rate):
A rate that stays as a fixed percentage of the par value like this is a fixed-rate bond. (Fixed-Income Security)
Another possibility is an adjustable interest payment, known as a floating-rate bond. In this case the interest rate is tied to market rates through an index, such as the rate on Treasury bills.
All things being equal, a lower coupon means that the price of the bond will fluctuate more.

Question 6

Bond characteristics:

Maturity
The maturity date is the date in the future on which the investor’s [.] will be repaid.

A bond that matures in one year is much more [.] and thus [.] risky than a bond that matures in 20 years. Therefore, in general, the longer the time to maturity, the [.] the interest rate. Also, all things being equal, a longer term bond will fluctuate [.] than a shorter term bond.

Answer 6

Bond characteristics:

Maturity
The maturity date is the date in the future on which the investor’s principal will be repaid. Maturities can range from as little as one day to as long as 30 years (though terms of 100 years have been issued).
A bond that matures in one year is much more predictable and thus less risky than a bond that matures in 20 years. Therefore, in general, the longer the time to maturity, the higher the interest rate. Also, all things being equal, a longer term bond will fluctuate more than a shorter term bond.

Question 7

Bond Issuer

The issuer of a bond is a crucial factor to consider, as the issuer’s stability is your main assurance of getting paid back.
For example, the U.S. government is far more secure than any corporation. Its [.] risk (the chance of the debt not being paid back) is extremely small - so small that U.S. government securities are known as [.-.] assets.
The reason behind this is that a government will always be able to bring in future revenue through taxation. A company, on the other hand, must continue to make profits, which is far from guaranteed. This added risk means corporate bonds must offer a [.] yield in order to entice investors - this is the risk/return trade-off in action.

Answer 7

Bond Issuer

The issuer of a bond is a crucial factor to consider, as the issuer’s stability is your main assurance of getting paid back.
For example, the U.S. government is far more secure than any corporation. Its default risk (the chance of the debt not being paid back) is extremely small - so small that U.S. government securities are known as risk-free assets.
The reason behind this is that a government will always be able to bring in future revenue through taxation. A company, on the other hand, must continue to make profits, which is far from guaranteed. This added risk means corporate bonds must offer a higher yield in order to entice investors - this is the risk/return trade-off in action.

Question 8

Bond Rating

The bond rating system helps investors determine a company’s [..] .
Think of a bond rating as the report card for a company’s credit rating.
Blue-chip firms, which are safer investments, have a high rating, while risky companies have a low rating.

Answer 8

Bond Rating

The bond rating system helps investors determine a company’s credit risk.
Think of a bond rating as the report card for a company’s credit rating.
Blue-chip firms, which are safer investments, have a high rating, while risky companies have a low rating.

Question 9

Bond - [.] Provision

Some bonds have a [.] option in them which enables the issuer to buy back the bond before maturity.
The attraction of callable bonds is that they typically offer [.] rates than non-callable bonds.
However, higher return means higher risk.
If interest rates drop low enough, the bond’s issuer can save money by repaying its callable bonds and issuing new bonds at [.] coupon rates.

Answer 9

Call Provision

Some bonds have a call option in them which enables the issuer to buy back the bond before maturity.
The attraction of callable bonds is that they typically offer higher rates than non-callable bonds.
However, higher return means higher risk.
If interest rates drop low enough, the bond’s issuer can save money by repaying its callable bonds and issuing new bonds at lower coupon rates.

Question 10

Bond [.]:
A contract between an issuer of bonds and the bondholder stating the time period before [.], if the bond is callableand the amount of money that is to be repaid.
The [.] is another name for the bond [.] terms, which are also referred to as a [.] of [.].

Answer 10

Bond Indenture:
A contract between an issuer of bonds and the bondholder stating the time period before repayment, if the bond is callableand the amount of money that is to be repaid.
The indenture is another name for the bond contract terms, which are also referred to as a deed of trust.

Question 11

Bond - [.] :
This refers to how likely you are to be repaid if a bond issuer goes bankrupt.
Bondholders with [.] over others will be paid back [.] other bondholders.

Answer 11

Seniority

This refers to how likely you are to be repaid if a bond issuer goes bankrupt.
Bondholders with seniority over others will be paid back before other bondholders.

Question 12

The [.] value of an asset is the observed value (price) of the asset in the marketplace.
This value is determined by [.] and [.].

Answer 12

The market value of an asset is the observed value (price) of the asset in the marketplace.
This value is determined by supply and demand.

Question 13

The [.], or [.] value of an asset – also called [.] value – is the [..]of the asset’s future cash flows.
Cash flows are discounted back to the present using the investor’s required rate of return – r (r is normally current [.-. .] rate + some [.]).This is true for valuing all assets (including bonds), and it serves as the basis of almost all that we do in finance.
This value is the amount an investor should be willing to pay for the asset given the amount, timing, and riskiness of its future cash flows.
Once the investor has estimated the [.] value of a security, this value could be compared with its [.] value.
If IV > MV – security is [.] and vice versa.
If the market is working efficiently, MV should = IV i.e. whenever a security’s IV differs from MV, the competition among investors seeking opportunities to make a profit will quickly drive MV back to IV.

Answer 13

The intrinsic, or economic value of an asset – also called fair value – is the PV of the asset’s future cash flows.
Cash flows are discounted back to the present using the investor’s required rate of return – r (r is normally current risk-free interest rate + some premium). This is true for valuing all assets (including bonds), and it serves as the basis of almost all that we do in finance.
This value is the amount an investor should be willing to pay for the asset given the amount, timing, and riskiness of its future cash flows.
Once the investor has estimated the intrinsic value of a security, this value could be compared with its market value.
If IV > MV – security is undervalued and vice versa.
If the market is working efficiently, MV should = IV i.e. whenever a security’s IV differs from MV, the competition among investors seeking opportunities to make a profit will quickly drive MV back to IV.

Question 14

Bond Price = [..] of [.] cashflows
Bond Future cash flows = [.] payments and [.] value.
Price of Bond = CF1/(1 + r)^1 + CF2/(1 + r)^2 + CF3/(1 + r)^3+…
We can also price a bond using the [.] formula to calculate [..] of coupon payments and add that to PV of par value, we’ll get Bond price.

Answer 14

Bond Price = PV of future cashflows
Bond Future cash flows = coupon payments and par value
Price of Bond = CF1/(1 + r)^1 + CF2/(1 + r)^2 + CF3/(1 + r)^3
We can also price a bond using the annuity formula to calculate Present Value of coupon payments and add that to PV of par value, we’ve get Bond price. .

Question 15

Buyers will generally want to pay less for a bond whose coupon rate is lower than prevailing interest rates.
Conversely, buyers will generally be willing to pay more for a bond whose coupon rate is higher than prevailing interest rates.

Answer 15

Buyers will generally want to pay less for a bond whose coupon rate is lower than prevailing interest rates.
Conversely, buyers will generally be willing to pay more for a bond whose coupon rate is higher than prevailing interest rates.

Question 16

Bond - [.] to [.]
Financial manager is interested only in the expected rate of return that is implied by the market prices of the firm’s bonds, or what we call the yield to maturity.
Yield is the anticipated return on an investment, expressed as an annual percentage.
For example, a 6% yield means that the investment averages 6% return each year.
There are several ways to calculate yield, but the most accurate is the yield to maturity.
Whichever way you calculate it, the relationship between price and yield remains constant: The higher the price you pay for a bond, the [.] the yield, and vice versa.
The yield to maturity (YTM) is the discount rate (interest rate) which, when applied to the bonds cashflows, yields the current market price of the bond.
The YTM must offer a competitive return to investors, similar to the return achievable elsewhere from investments of comparable risk.
Unlike the coupon rate, the YTM varies [.] as the price of the bond changes in the market place.
Calculate the approximate YTM by trial and error and:
YTM = A + [ Na(B-A) / (Na-Nb)
where:
A = the lower rate
B = the higher rate
Na = the NPV at lower rate
Nb = the NPV at lower rate
YTM is the discount rate which makes the bonds cashflows [.] to its current market price.

Answer 16

Bond - Yield to Maturity
Financial manager is interested only in the expected rate of return that is implied by the market prices of the firm’s bonds, or what we call the yield to maturity.
Yield is the anticipated return on an investment, expressed as an annual percentage.
For example, a 6% yield means that the investment averages 6% return each year.
There are several ways to calculate yield, but the most accurate is the yield to maturity.
Whichever way you calculate it, the relationship between price and yield remains constant: The higher the price you pay for a bond, the lower the yield, and vice versa.
The yield to maturity (YTM) is the discount rate (interest rate) which, when applied to the bonds cashflows, yields the current market price of the bond.
The YTM must offer a competitive return to investors, similar to the return achievable elsewhere from investments of comparable risk.
Unlike the coupon rate, the YTM varies constantly as the price of the bond changes in the market place.
Calculate the approximate YTM by trial and error and:
YTM = A + [ Na(B-A) / (Na-Nb)
where:
A = the lower rate
B = the higher rate
Na = the NPV at lower rate
Nb = the NPV at lower rate
YTM is the discount rate which makes the bonds cashflows equal to its current market price.

Question 17

ROE = Net [.] / [..]

Shareholders Equity = [..] + [..]

If a firm retains all of it’s profits (earnings), and reinvests them back into the business, then the shareholders investment in the firm would grow by the amount of [..] times the […] .
We can express the relationship as:

g = […] x [..]

Answer 17

Return on Equity (ROE) = Net Income/Shareholders Equity

Shareholders Equity = Common Stock + Retained Earnings

If a firm retains all of it’s profits (earnings), and reinvests them back into the business, then the shareholders investment in the firm would grow by the amount of profits retained times the return on equity.
We can express the relationship as:

g = ROE X PR

g = growth rate of future earnings and the growth in the shareholders investment.
ROE = return on equity
PR = Profit-Retention Rate (also equal to 1 - % profits paid out in dividends)

Question 18

The value of a common share is simply the present value of future dividends:

V0 = […] + […] +…+ […]

We are discounting the dividend at the end of the first year, D1, back 1 year, the dividend at the end of the second year, D2, back 2 years etc.

The above equation can be reduced to a more manageable form if we assume dividends grow each year at a constant rate, g.

V0 = [.] / […]

=> r = […] + [.]
The required rate of return is equal to the [..] plus a [.] factor.
If we replace intrinsic value (V0) with the stock’s current market price (P0) we can express the stock’s expected return as:
E(r) = […] + [.]

If dividends are not constant, we need to use this formula instead:
V0 = [D1/(1+r)] + [D2/(1+r)^2] + … + [Dn/(1+r)^n] + […]

Answer 18

The value of a common share is simply the present value of future dividends:

V0 = [D1/(1+r)^1] + [D2/(1+r)^2] +…+ [Dn/(1+r)^n]

We are discounting the dividend at the end of the first year, D1, back 1 year, the dividend at the end of the second year, D2, back 2 years etc.

The above equation can be reduced to a more manageable form if we assume dividends grow each year at a constant rate, g.

V0 = D1 / (r-g)

=> r = D1/V0 + g
The required rate of return is equal to the dividend yield (D1/V0) plus a growth factor.
If we replace intrinsic value (V0) with the stock’s current market price (P0) we can express the stock’s expected return as:
E(r) = D1 / P0 + g

If dividends are not constant, we need to use this formula instead:
V0 = [D1/(1+r)] + [D2/(1+r)^2] + … + [Dn/(1+r)^n] + [Vn/(1+r)^n]