Test 3 Flashcards
1
Q
What does this test consist of?
A
30 questions
chapter 7
- 8 computational, 2 conceptual
chapter 8
- 3 computational (coefficient variation, regular cap m, more complicated cap m), 7 conceptual
chapter 9
- 5 computational, 5 conceptual
2
Q
*** What is a bond?
A
- a (better/another) long-term debt instrument in which a borrower gets to make payments of principal and interest, on specific dates, to the holders of the bond
– result of money being borrowed with the promise to repay - can be issued by any corporation or any federal/state government
– when a bond is issued, it is issued at par value or at $1000
– when a bond matures, it is worth par value or $1000
3
Q
What is a bond contract?
A
contract that specifies the details of the repayment
4
Q
What are the two parties involved in bonds?
A
- issuer - party borrowing money (bond is a liability)
- investor/bondholder - party loaning money (bond is an asset)
5
Q
*** What is the par value or face value?
A
- the amount a bond sells for when it is first issued
- When the bond matures, this is the amount of debt to be repaid at maturity (a future date)
- Assume $1000 if not stated
6
Q
*** What are bond payments or coupons?
A
- Periodic interest payments to be made while the bond is outstanding
– bonds always sell at par value or $1000
– name came from physical coupons
– typically happens every 6 months
– constant throughout the life of the bond, unless specified in the contract
7
Q
What is the coupon rate?
A
the percentage of the par value paid in coupon payments each year on a bond (expressed as APR)
8
Q
What is the discount rate?
A
it is not the same thing as the coupon rate
– reflective of the current market rate of interest
9
Q
*** What is the value of a 10-year, 10% annual coupon bond, if the discount rate (rd) is 10%?
A
n = 10
I/yr = 10
* pv = -1000
pmt = 100
fv = 1000
10
Q
*** bond problem
- a 6-year bond has a 8% coupon rate and makes payments annually. Find the present value if the market rate (expressed as APR) is:
4%
7.5%
9%
A
1209.69
1023.47
955.14
11
Q
*** What do you do to the formula for a semi-annual bond?
A
(2) x N
I/yr / (2)
pmt / (2)
12
Q
*** semiannual bond problem
- A 6-year bond has a 6.5% coupon rate and makes payments semi-annually.
- Find the present value if the market value rate (expressed as APR) is
3.80%
6%
7.5%
A
(3.80)
n = 12 (6 x 2)
I/yr = 1.90 (3.80 / 2) /// 3 /// 3.75
* pv = 1143.65 /// 1024 /// 952.39
pmt = 32.5 ((6.5% x 1000) / 2)
fv = 1000
13
Q
*** semiannual bond problem
- A 3-year bond has a 6.5% coupon rate and makes payments semi-annually.
- Find the present value if the market value rate (expressed as APR) is 3.95%
A
n = 6 (3 x 2)
I/yr = 1.975 (3.95 / 2)
* pv = 1071
pmt = 32.5 ((6.5% x 1000) / 2)
fv = 1000
14
Q
*** semi-annual bond problem
- A 3-year bond has a 6.5% coupon rate and makes payments semi-annually.
- Find the present value if the market value rate (expressed as APR) is 6.5%
A
n = 6 (3 x 2)
I/yr = 3.25 (6.5% / 2)
* pv = 1000
pmt = 32.5 ((6.5% x 1000) / 2)
fv = 1000
15
Q
*** semi-annual bond problem
A 3-year bond has a 6.5% coupon rate and makes payments semi-annually.
- Find the present value if the market value rate (expressed as APR) is 10%
A
n = 6 (3 x 2)
I/yr = 5 (10% / 2)
* pv = 911
pmt = 32.5 ((6.5% x 1000) / 2)
fv = 1000
16
Q
When market interest rate = coupon rate…
A
the bond sells at exactly at par value
- or at $1000
17
Q
When market interest rate < coupon rate…
A
the bond sells at a discount
- or less than $1000
18
Q
When market interest rate > coupon rate…
A
the bond sells at a premium
- or greater than $1000
19
Q
What is the relationship between market interest rate and the price of bonds?
A
- inverse relationship
- as one goes up, the other will go down
20
Q
What are bond yields?
A
- I/yr
- bonds are traded in the markets, so price can be viewed as the market’s assessment of the present value of its cash flows
21
Q
What is Yield to Maturity? (YTM)
A
- I/yr
- discount rate that equates bond price to the present value of all promised cash flows
- if you buy a bond today, this is the interest rate that you are going to get if you hold that bond to maturity
22
Q
*** What is the YTM on the following bond? 10-year, 9% annual coupon, $1000 par value, selling for $887.
A
n = 10
* I/yr = 10.91
pv = -887
pmt = 90 (1000 x 9%)
fv = 1000
23
Q
*** What is the YTM on the following bond? 10-year, 7.5% annual coupon, $1000 par value, selling for $925.
A
n = 10
* I/yr = 8.65
pv = -925
pmt = 75 (1000 x 7.5%)
fv = 1000
24
Q
*** What is the YTM on the following bond? 14-year, 10% annual coupon, $1000 par value, selling for $1494.93.
A
n = 14
* I/yr = 5
pv = -1494.93
pmt = 100 (1000 x 10%)
fv = 1000
25
*** What is the YTM on the following bond? 15-year, $1000 par value, selling for $1145.68, coupon payment is $75.
n = 15
* I/yr = 6
pv = -1145.68
pmt = 75
fv = 1000
26
*** If price is equal to par value...
yield to maturity is equal to the coupon rate
27
*** If a bond is selling at a discount...
yield to maturity is greater than the coupon rate
28
*** If a bond sells at a premium...
yield to maturity is less than the coupon rate
29
How do we price a bond as maturity approaches?
- think of graph
- as a bond gets closer to maturity, the closer it gets to par value or $1000
- premium bond prices will slowly decrease until reaching par value or $1000 with time
- discount bond prices will slowly increase until reaching par value or $1000 with time
30
*** For a bond that is at a discount, current yield will be...
less than yield to maturity (YTM)
31
*** For a bond that is at a premium, current yield will be...
greater than yield to maturity (YTM)
32
What is current yield?
- formula
(annual coupon x years) / selling price
33
*** Find the current yield for a 10-year, 9% annual coupon bond that sells for $887, and has a face value of $1000.
90 / 887 = .1015 = 10.15%
34
What is interest rate risk (price risk)?
- risk associated with price fluctuations caused by interest rate changes
- price of bonds is inversely related to changes in interest rates
-- if a bond is held to maturity, the interest rate risk is irrelevant
-- the longer the term of the bond (term until maturity) , the higher the risk
-- lower-coupon bonds have greater interest rate risk
35
What is reinvestment rate risk?
- the risk that the market rate will be lower compared to what it once was when you actually go to reinvest the principle or coupon payments
- to earn the yield to maturity, the coupons must be reinvested at the same yield to maturity. if this is not achieved, final yield will be different
36
What is default risk?
the probability of not getting paid back
37
What is the role of junk bonds (high yield bonds)?
bonds considered to have a high default risk, so they pay a high rate of interest
38
What is a default premium?
- using higher interest rates to compensate the bondholder for the risk of default
- high risk is associated with high return
39
*** What are the bond ratings?
AAA - the strongest
AA - very strong
A - strong
BBB - adequate
BB - considerable uncertainty
B - questionable
-- A or B is investment grade
-- C or below is junk, because they may already be in default and they offer little prospect for interest or principle on the debt ever to be repaid
40
What is a corporate bond?
- a bond that is issued by a corporation
- typically pays interest semi-annually
- if a firm misses a payment, corporate bondholders can force the firm into bankruptcy, because they have first claim on assets
41
*** What factors affect default risk and bond ratings?
financial performance
- debt ratio
- TIE ratio
- current ratio
qualitative factors: bond contract terms
- secured (backed by assets) vs. unsecured debt
- senior (paid first) vs. subordinated (paid after senior debt) debt
- guarantee and sinking fund provisions
- debt maturity (when and how is debt going to be paid off)
42
What are zero coupon bonds?
- coupon rate of 0%
-- par repayment is only cash flow
-- sell at a discount
-- all else equal, have a greater interest rate risk
43
What is a floating rate bond?
the bonds rates are variable based on the market interest rates
- very popular for institutional investors because it tkes a lot of the interest risk out of the equation
44
What are consol bonds?
- the exact same thing as perpetuities
- they pay interest forever and never mature
45
What are bonds with options attached?
- bonds that have special provisions that allow for different things
- they can go up or down on the interest rate based on their options and preferences
46
What is a convertible bond?
- the bond can be converted to shares of stock
- adds appeal to investors
- if your company has convertable bonds, you pay a lower interest rate
47
*** What is a callable bond?
- allows a company to pay off a bond early before its maturity
- if the interest rates go down, issuer can call the bonds in and then reissue at a lower rate
48
What is a puttable bond?
- the person buying the bond can require the company to redeem that bond early
- these bonds will have a lower interest rate, all else equal
49
What is the first relationship?
- (four key relationships)
- the value of the bond is inversely related to changes in the yield to maturity (YTM)
-- when YTM is higher, the value of the bond is lower
-- when YTM is lower, the value of the bond is higher
50
What is the second relationship?
- (four key relationships)
- discount bond - if a bond is selling at a discount, it means that bond is selling at less than $1000 or par value
- premium bond - if a bond is selling at a premium, it means that bond is selling at more than $1000 or par value
51
What is the third relationship?
- four key relationships
- as the maturity of the bond approaches, the value of the bond will approach its par value
-- this is due to the fact that at maturity, the bond will be taken away and the investor will receive the par value of the bond
52
What is the fourth relationship?
- four key relationships
- long term bonds (especially zero-coupon bonds) have greater interest rate risk than short term bonds
53
*** How do you calculate the realized return or realized cash return from an investment?
you measure the gain or loss on an invest
- cash return = ending price + cash distribution (dividend) -
beginning price
- % rate of return = cash return / beginning price
54
*** You invested in one share of Apple for $95 and sold a year later for $200. The company did not pay any dividends during that period. What will be the cash return on this investment?
$105
ending price - beginning price
55
*** Calculate the rate of return (table example)
- solve for *
Company, Beginning Price, Ending Price, Cash (dividend), Return in $, Rate of Return
Duke Energy
16.38
15.82
1.16
*(return in $) = 15.82 + 1.16 - 16.38 = (0.6)
*(rate of return) = 0.6 / 16.38 = (3.66%)
Sears Holdings
57.74
67.86
0.00
*(return in $) = 67.86 - 57.76 = (10.12)
(rate of return) (given) = 10.12 / 57.74 = (17.53)
Walmart
55.81
49.68
1.06
(return in $) (given) = 49.68 + 1.06 - 55.81 = (-5.07)
*(rate of return) = -5.07 / 55.81 = (-9%)
56
What is investor's intuition?
- investors prefer money now compared to money in the future due to the time value of money
- investors don't like risk (risk adversion)
-- they require compensation for taking risks in the form of higher expected return
-- example)) when professor lost 50 grand
57
*** What is risk?
- the probability of dispersion of events
-- no dispersion = no risk
-- greater dispersion = greater risk
- casinos (roulette and blackjack, 49.5%)
58
*** What is systematic risk
market risk
- cannot be diversified away
- war, recession, pandemics
59
*** What is unsystematic risk?
risk that is particular to a company or industry
- product recall, labor strike, change of management
60
*** How do we measure risk?
- variance - how much something deviates from the mean (average)
- higher variance represents greater dispersion and, hence, greater risk
61
*** How do we calculate standard deviation?
the square root of variance
62
What is expected return?
the return that the investors should expect to earn from an investment in the future
- it is a weighted average of all the possible returns
63
*** What is the coefficient of variation? (CV)
- include formula
- standard deviation / expected return
a standardized measure of dispersion about the expected value, that shows the risk per unit of return
tandard deviation / expected return
64
*** What are the determinants of interest rates?
- formula
r = r* + IP + DRP + LP + MRP
- r = required return on a debt security
- r* = the real risk free rate of interest
- IP = inflation premium
- DRP = default risk premium
- LP = liquidity premium
- MRP maturity risk premium
65
*** The risk and return of portfolios
expected return - a weighted average of the returns of the portfolios component assets
66
*** How do you calculate the portfolio expected return?
weight x expected return, then add them together
67
What is diversification?
- adding negatively correlated stocks to a portfolio in order to achieve maximum diversification benefits
- uncorrelated portfolios offer the most diversification
68
*** What is the portfolio diversification correlation coefficient range?
-1.0 (perfect negative correlation) - two variables perfectly move in opposite directions to
+1.0 (perfect positive relationship) - two variables move perfectly in the same direction
- lower the correlation, the greater the diversification benefits
69
What is stand alone risk or unsystematic risk?
- firm specific risk that can be diversified away
70
What is systematic risk or market risk?
- cannot be diversified away
- a widespread macroeconomic event
- different assets may be affected differently (COVID)
71
*** What is beta?
measures the stock's sensitivity to the market or systematic risk
- measures a stocks market risk
if beta = 1.0, the security is just as risky as the average stock
if beta > 1.0, the security risk is above the average stock
if beta < 1.0, the security risk is less than the average stock
- most stocks have betas in range of 0.5 - 1.5
72
What is the capital asset pricing model? (CAPM)
- also include formula
tells us what the required rate of return should be for investors, given what the beta or systematic risk is for a particular investment
- risk free rate + (return on market - risk free rate) x beta
73
*** What is the correlation coefficient?
the degree by which we are adding correlation
- negative is good
74
*** What is the risk of portfolios?
portfolio can be more or less risky after adding stocks to it
- two risky stocks are less risky together
- two positively correlated stocks are too much alike, and can be combustible
75
What is common stock?
common stockholders are the owners of the firm
- entitles you to vote on the board of directors, that's it
76
Who is the board of directors?
they appoint the firm's top management team, who carries out the day to day management of the firm
77
What are the shareholder manager conflicts?
- called an agency problem
managers are naturally inclined to act in their own best interest, which ideas may not be shared by the stockholders
- ex) Disney
78
What are the factors that affect managerial behavior?
- managerial compensation packages (stock options)
- direct intervention by shareholders (shareholders can/will vote individuals out of the board of directors)
- the threat of firing
- the threat of takeover (Elon Musk taking over Twitter)
- monitoring by the board of directors (oversee management and make sure they are doing their job)
- monitoring by financial markets (such as auditors, bankers, security analysts, credit agencies)
79
What are the stockholder bondholder conflicts?
stockholders prefer risk because riskier projects are what makes the company grow
bondholders prefer to limit risk to make sure the company does not default on payments, they want safety and security
- very concerned with the use of additional debt
- prefer to protect themselves through bond covenants that limit the use of additional debt to ensure the other debts are paid off
80
What are shareholder interests and societal interests?
the primary financial goal of the management is to create value for the shareholders, accomplished by maximizing stock price
managers realize that being socially responsible is not inconsistent with maximizing shareholder value
- Dolly Parton saying that everyone is loved and welcome at Dollyworld
- Michael Jordan saying that republicans buy shoes too
81
What are voting rights?
- a common stockholder's main advantage is that they have voting rights
82
What is proxy voting?
you assign your vote to someone else
- most shareholders vote via proxy
83
What are the types of classified stock?
class A - has many more times voting rights than individuals with class B shares of stock
class B - has less times voting rights than individuals with class A shares of stock
84
What are founders shares?
special shares that have special voting rights
- ex) Facebook, Mark Zuckerberg's founders shares make it to where it would be very hard for him to lose control of the company
85
*** Investor value example. You currently own 1000 shares of stock worth $35 per share. The company has 18,000 shares outstanding.
- What is the current value of your market investment?
- What is the company's total market value?
- Suppose the company adds 2,000 more shares at $30 per share. What is the new value of the stock to you?
- (1000 x 35) = 35,000
- (18000 x 35) = 630,000
- (18000 x 35) = 630000
(2000 x 30) = 60000
630000 + 60000 = 690000
690000/20000 = 34.5
86
What is preemptive right?
If you are a stockholder, and there are any newly issued shares, it gives you the right to buy whatever percentage you already own in the company so that you do not lose any ownership
87
*** how to calculate dividend yield
- formula
dividend / price
88
*** how to calculate capital gains yield
- formula
(ending price - beginning price) / beginning price
89
*** how to calculate total returns
- formula
dividend yield + capital gains yield
90
How do you estimate intrinsic value?
discounted dividend model - based on present value of future dividends
corporate valuation model - company does not pay dividends, based on a value of free cash flow
91
*** What is the dividend discount model?
- include formula
- if a firms cash dividends grow by a constant rate, then the common stock can be valued as a perpetuity
dividends in period one / (required rate of return - dividend growth rate)
92
*** What is the required rate of return?
what we require as investors in order to participate in some investment
- what is the level of interest rates in the economy?
- what is the risk of the firms stock?
93
*** What are the Cap M variables and formula?
Rf + B (Rm - Rf)
Rf = risk free rate
Rm = market return
B = beta
94
*** Use the Cap M model to calculate the required rate of return.
- if the risk free rate is 3%, the return on the market is 8%, and beta is 1.2, what is the required rate of return on the stock?
3% + 1.2 x (8% - 3%) = 9%
95
What are the two key determinants for growth rate?
return on equity (ROE) - how much is the company making by reinvesting its earnings back into the company?
the retention ratio - the amount of a firms earnings that is reinvested in the company versus payout in dividends
96
What are the model assumptions?
- dividends grow at a constant rate to infinity (not true, they do not)
- the growth rate must be less than the required rate of return (true because the denominator would be zero or negative)
- model can be used for negative growth or no growth stocks
97
*** dividend discount model example.
- what is the value of a share of a common stock that paid $6 dividend at the end of last year and is expected to pay a cash dividend at the end of every year from now to infinity, with that dividend growing at a rate of 5% per year, if the investors required rate of return is 12% on that stock?
- calculate dividends in period one.
- what if the growth rate is zero? (d1/r)
6 x 1.05 = 6.3
6.3 / (0.12 - 0.05) = 90
6 / .12 = 50
98
*** non-constant growth example
Consider a firm that just paid a dividend of $2.75 per share. The company expects growth in the coming year to be 15%. After this first year, the firm expects dividends to grow and a constant rate of 3% per year.
- The risk free rate is 4%, the market risk premium is 4.8% and the beta for the firm is 1.8
- Assuming the market is in equilibrium calculate the intrinsic value of the firm’s stock
2.75 x 1.15 = 3.16
4% + 1.8(4.8%-4%) = *5.4%
3.16 / .054 - .03 = *$131
99
What is the corporate valuation model?
free cash flow method - how do we value this company that pays zero dividends?
100
what is the firm multiples method?
looking at other ways that stocks are valued by analysts
- price to earnings (P/E)
- price to cash flows (P/CF)
- price to earnings (P/sales)
- this is not always political
101
what is preferred stock?
- a hybrid between common stocks and bonds
- preferred stock dividends (or bonds) must be paid before dividends are paid to common stockholders
-- however, dividends are not legally required unless you declare the dividends
102
*** what is the preferred stock formula?
dividends / growth rate
103
*** preferred stock example
- If preferred stock has an annual dividend of $5.00 and it is currently selling in the market for $100, what is the preferred stock’s expected return?
5 / ___ = 100?
0.05
