ADV. Corporate Finance- Spring 2021

RP(m) is the market risk premium. It is the extra return above the risk-free rate that investors require to invest in the overall stock market:

RP(m)= R(m)-R(rf)

Indifference Curves:

Reflect an investor's attitude toward risk as reflected in his or her risk/return tradeoff function. They differ among investors because of differences in risk aversions.

What is the feasible set of portfolios?

Represents all portfolios that can be constructed from a given set of stocks.

Using SML how do you find R(s)

Required rate of return= Risk Free + (Market Risk Premium* Beta)

The Security Market Line (SML) puts the pieces together, showing how to determine the returns required for bearing a Stock's risk:

Required returns = R (rf) + (RPm)* b (i)

Investors require a _________________, which is the extra return above the risk-free rate that investors require to induce them to invest in stock i.

Return for Risk (risk premium)

Investors require a ______________ (for tying their funds up in the investment) Risk-Free Rate

Return for time

Are there problems with the CAPM tests?

Richard Roll questioned whether it was even conceptually possible to test the CAPM. -Proved that it is impossible to prove if investors behave in accordance with the CAPM theory

Required rate of return on debt security=

Risk Free rate + inflation premium + maturity risk premium + default risk premium + liquidity premium

Default Risk:

Risk that issuer will not make interest or principal payments

A bond spread is often calculated as the difference between a corporate bond's yield and a treasury security's yield of the same maturity. Therefore:

Spread= DRP + LP Bonds of large, strong companies often have very small LPs. Bond's of small companies often have LPs as high as 2%

In a regression analysis R^2 measures the percent of a stocks variance that s explained by the market:

The Typical R^2 is: .3 for an individual stock over .9 for a well diversified portfolio

What is the capital market line?

The capital market line (CML) is all linear combinations of the risk free asset and portfolio M. -The CML gives the risk/return relationship for efficient portfolios

What does the correlation coefficient measure?

The magnitude of an effect or the strength of a relationship between two stocks

Dividend Rights :(Rights of Common Stockholders)

The right to share equally on a per share basis in any dividends paid

Voting Rights: (Rights of Common Stockholders)

The right to vote on stockholder matters

What is reinvestment rate risk?

The risk that CFs will have to be reinvested in the future at lower rates, reducing income. Suppose you just won $500,000 playing the lottery. You'll invest the money and live off the interest. You buy a 1-year bond with a YTM of 10%. Year 1 income = $50,000. At year-end get back $500,000 to reinvest. If rates fall to 3%, income will drop from $50,000 to $15,000. Had you bought 30-year bonds, income would have remained constant.

If the market price is below the intrinsic value

The security is a bargain

What is the security Market line?

This is line showing the relationship of risk/return for individual stocks -The measure of risk used in the SML is the beta coefficient of company i SML Equation: R(i)= R(rf) + (RPm)* B(i)

Intrinsic value: (long-run concept)

To the extent that investors perceptions are incorrect, a stock's price in the short run may deviate from its intrinsic value

Buy orders will exceed sell orders, bidding up the market price and profitable trading will continue until the market price is equal to the intrinsic value

True

It is costly and or risky for traders to take advantage of mispriced assets.

True

Securities are normally in equilibrium and are fairly priced.

True

The expected return a security must equal its required return

True

The market price of a security must equal the security's intrinsic value (intrinsic value reflects the size, timing, and risk of the future cash flows)

True

How to determine the Correlation on Excel?

Use the excel function: =CORREL

Potter Industries has a bond issue outstanding with an annual coupon of 6% and a 10-year maturity. The par value of the bond is $1,000. If the going annual interest rate is 8%, what is the value of the bond? Do not round intermediate calculations. Round your answer to the nearest cent.

Value of the bond=(1000*6%)*((1-(1+8%)^(-10))/8%)+1000/(1+8%)^10 =865.80

Potter Industries has a bond issue outstanding with a 6% coupon rate with semiannual payments of $30, and a 10-year maturity. The par value of the bond is $1,000. If the going annual interest rate is 8%, what is the value of the bond? Do not round intermediate calculations. Round your answer to the nearest cent

Value of the bond=(1000*6%/2)*((1-(1+(8%/2))^(-10*2))/(8%/2))+1000/(1+(8%/2))^(10*2) =$864.10

CAPM

W(i) is the percent of the portfolio invested in stock (i) STDEV(m) is the standard deviation of the market index P(i,m) is the correlation between stock i and the market -is an equilibrium model that specifies the relationships between risk and required rate of return for assets held in well-diversified portfolios. -it is based on the premise that only one factor affects risk.

What do well functioning financial markets facilitate?

Well functioning markets facilitate the flow of capital from investors to the users of capital.

Constant Growth Model Example:

What is the stocks Market Value? Dividend Zero= $2 Required Rate= 13 % Growth= 6% $2 *(1+ .06) = Dividend 1= $2.12 $2.12/(.13-.06)= $30.29

What impact does the risk free asset have on the efficient frontier?

When a risk free asset is added to the feasible set, investors can create portfolios that combine this asset with a portfolio of risky assets. -The straight line connecting R(rf) with M, the tangency point between the line and the old efficient set, becomes the new efficient frontier

How do you measure the amount of market risk that an individual stock brings to a well diversified portfolio?

William Sharpe developed the CAPM

Expected to earn

YTC on premium bonds and YTM on par and discount bonds

What is Yield to maturity?

YTM is the rate of return earned on a bond held to maturity. Also called promised yield -it assumes the bond will not default

Maturity:

Years until the bond must be repaid

Valuing common stock:

Dividend growth model -constant growth -non constant growth Using the multiples of comparable firms Free Cash Flow Model -constant growth - non constant growth

An investment costs $1000 and is sold after 1 year for $1060.

Dollar return: $1060-$1000= $60 Percentage return: $60/ $1000= .06 = 6%

Expected Total Return= YTM=

Expected Current Yield + Expected Capital Gains Yield

The Cost of Equity:

FCF1/(1+WACC)^1 + FCF2/(1+WACC)^2 ........

Par Value

Face amount paid at maturity

Preemptive Rights: (Rights of Common Stockholders)

Gives stockholders the right to share proportionately in any new stock sold

What is market equilibrium?

In equilibrium, stock prices are stable. There is no general tendency for people to buy versus sell. The expected price, must equal the actual price. In equilibrium, expected returns must equal required returns

Asset Rights: (Rights of Common Stockholders)

In the event of liquidation, stockholders have the right to share assets remaining after senior claims are satisfied

Portfolios below the CML are:

Inferior -The CML defines the new efficient set -All investors will choose a portfolio on the CML

What are investment returns?

Investment returns measure the financial results of an investment. -Returns may be historical or prospective -expressed in dollar terms, percentage terms

What is investment risk?

Investment risk is exposure to the chance of earning less than expected. -The greater the change of a return far below the expected return, the greater the risk

Investors Optimal Portfolio

Is defined by the tangency point between the efficient set and the investor's indifference curve

Managers are naturally inclined to:

act in their own best interest

Behavioral Finance:

borrows insights from psychology to better understand how irrational behavior can be sustained over time

The value of any asset is present value of:

cash flow stream to owners

coupon rate < YTM

discount bond

• Investors cannot "beat the market" except through:

good luck or better information

Demanders or users of capital:

individuals and institutions who need to raise funds to finance their investment opportunities. These groups are willing to pay a rate of return on the capital they borrow.

Suppliers of Capital:

individuals and institutions with "excess funds." These groups are saving money and looking for a rate of return on their investment.

Capital Gains Yield=

(ending price - beginning price) / beginning price YTM- Current Yield

Tests of the SML indicate:

-A more-or-less linear relationship between realized returns and market risk. -Slope is less than predicted -Irrelevance of diversifiable risk specified in the CAPM model can be questioned -Betas of individual securities are not good estimators of future risk -Betas of portfolios of 10 or more randomly selected stocks are reasonably stable -Past portfolio betas are good estimates of future portfolio volatility

Using Historical Data to Estimate Risk:

-Analysts often use discrete outcomes to analyze risk for projects. -But for investments, more analysts normally use historical data rather than discrete forecasts to estimate an investment's risk unless it is a very special situation -Most analysts use 48 to 60 months of monthly data or 52 weeks of data or shorter period using daily data

What are two potential tests that can be conducted to verify the CAPM?

-Beta stability tests -Tests based on the slope of the SML

What are some features of common stock?

-Corporations can issue more than one class of Common Stock (voting and nonvoting) -Stocks can be repurchased by the issuers known as treasury stock (firm can alter its capital structure to change leverage and it can be a tactic to reduce the risk of takeover) -Stock splits- to create a large number of lower valued shares and attract a wider range of investors -Reverse Stock split- to reduce the amount of shares and increase market price

Claims on Corporate Value

-Debtholders have first claim. -Preferred stockholders have the next claim. -Any remaining value belongs to stockholders.

What are the disadvantages of Common stock?

-Dilute earnings per share until the new investments pay off -expensive because of flotation, IB costs

Examples of Behavioral Finance:

-Evaluating risks differently in up and down markets. -Overconfidence leads to self-attribution bias and hindsight bias.

What are the advantages of common stock?

-Flexible (no fixed obligation) -Reduce Financial Leverage -Lower cost of capital

The 95% confidence interval shows the range in which we are 95% sure that the true value of beta lies. The typical range is:

-From about .5 to 1.5 for an individual stock -from about .92 to 1.08 for a well diversified portfolio

Call Provision:

-Issuer can refund if rates decline. That helps the issuer but hurts the investor -borrowers are willing to pay more, the lender require more, on callable bonds -Most bonds have a deferred call and declining premium

Sinking Fund:

-Provision to pay off a loan over its life rather than at maturity -Similar to amortization on a term loan -Reduces risk to investors, shortens average maturity -But not good for investors if rates decline after ussuance

The CAPM defines the risk premium for Stock i as:

RP(i)= B(i) *RP (m)

In SML how are betas calculated?

-Run a regression line of past returns on stock (i) versus returns on the market -The regression line is called the characteristic line. -The slope coefficient of the characteristic line is defined as the beta coefficient

Stand-Alone Risk: (standard deviation)

-Stand-alone risk is the risk of each asset held by itself -standard deviation measures the dispersion of possible outcomes

What is the difference between CAPM and the arbitrage pricing theory?

-The CAPM is a single factor model -The APT proposes that the relationship between risk and return is more complex and may be due to multiple factors such as GDP growth, expected inflation, tax rate changes and dividend yield.

What does the CML tell us?

-The expected rate of return on any efficient portfolio is equal to the risk free rate plus a risk premium -The optimal portfolio for any investor is the point of tangency between the CML and the investor's indifference curves

An efficient portfolio is one that offers:

-The most return for a given amount of risk or -the least risk for a given amount of return -The collection of efficient portfolios is called the efficient set or efficient frontier.

What is the nominal risk free rate?

-The rate on a U.S. Treasury Security Short term Security: T-Bill Long term Security: T-Bond

When new information becomes available under EMH prices move very quickly to equilibrium because:

-There are many really smart analysts looking for mispriced securities -new information is available to most professional traders almost instantly -when mispricing occurs, analysts have billions of dollars to use in advantage of the mispricing which then quickly eliminates the mispricing

What is the status of the APT?

-being used for some real world applications - its acceptance has been slow because the model does not specify what factors influence stock returns

Why do stock prices change?

-inflation expectations -Risk aversion -Company risk -growth could change

What are the assumptions of CAPM?

-investors all think in terms of a single holding period -all investors have identical expectations -Investors can borrow or lend unlimited amounts at the risk-free rate. -All assets are perfectly divisible -There are no taxes and no transaction costs -All investors are price takers, that is, investors buying and selling won't influence stock prices -Quantities of all assets are given and fixed

Market Bubbles

-prices climb rapidly to heights that would have been considered extremely unlikely before the run up -trading value is unusually high -many new investors eagerly enter the market -prices suddenly fall precipitously -Bubbles are hard to predict and puncture -trading strategies expose traders to possible big negative cash flows if the bubble is slow to burst

When can you apply FCF model?

-privately held companies -divisions of companies -companies that pay zero dividends

What is the real risk free rate?

-rate that a hypothetical riskless security pays each moment if zero inflation were expected -Real Risk Free Rate over time depending on economic conditions -can be approximated by rate on short-term treasury inflation protected securities

On a 9%, 10-year bond, Price= $887, and YTM= 10.91% What is the current yield?

.09 * 1000= 90 $90/$887= 10.15%

1) Calculate the weights for a portfolio with $1,400,000 million in Blandy and $600,000 in Gourmange. 2) Then calculate the portfolio beta: 3) Then calculate the Required Return on the portfolio:

1) Weight Blandy: $1,400,000/($1,400,000 + $600,000)= 70% Weight of Gourmange: $600,000/($1,400,000 + $600,000)= 30% 2) Beta Portfolio= .7(Beta Blandy) + .3 (Beta Gourmange) =.7*(.60) + .3* (1.30) =.81 3) Required Return on Portfolio= R(rf) + B (p) * (RPm) 4% + .81*(5%)= 8.05%

A company is more likely to call its bonds if they are able to replace their current high-coupon debt with less expensive financing. A bond is more likely to be called if its price is ________1________ par—because this means that the going market interest rate is less than its coupon rate.

1) Above

Portfolios risk can be broken down into two types. ________1________ risk is that part of a security's risk associated with random events. It can be eliminated by proper diversification and is also known as company-specific risk. On the other hand, ________2_______ risk is the risk that remains in a portfolio after diversification has eliminated all company-specific risk. Standard deviation is not a good measure of risk when a stock is held in a portfolio. A stock's relevant risk is the risk that remains once a stock is in a diversified portfolio. Its contribution to the portfolio's market risk is measured by a stock's _________3________, which shows the extent to which a given stock's returns move up and down with the stock market. An average stock's beta is _________4________ because an average-risk stock is one that tends to move up and down in step with the general market. A stock with a beta _______5______ is considered to have high risk, while a stock with beta ________6________ is considered to have low risk.

1) Diversifiable 2) Market 3) Beta Coefficient 4) Equal to 5) Greater than 6) Less than

Semi strong Form Efficiency market hypothesis

All publicly available information is reflected in stock prices, so it doesn't pay to pore over annual reports looking for undervalued stocks. Largely true.

Two important terms when discussing _______1_______ are correlation and correlation coefficient. Correlation is the tendency of two variables to move together, while correlation coefficient is a measure of the degree of relationship between two variables. If a portfolio consists of two stocks that are perfectly __________2__________ correlated then the portfolio is riskless because the stocks' returns move counter cyclically to each other. If the returns of the stocks are perfectly ________3_________ correlated then the stocks' returns would move up and down together and the portfolio would be exactly as risky as the individual stocks. In this situation, diversification would be completely __________4_________ for reducing risk. In reality, most stocks are ________5_________ correlated but not perfectly. So, combining stocks into portfolios reduces risk but does not completely eliminate it. This illustrates that ___________6__________ can reduce risk, but not completely eliminate risk.

1) Diversification 2) Negatively 3) Positively 4) Useless 5) Positively 6) Diversification

Risk is an important concept affecting security prices and rates of return. Risk is the chance that some unfavorable event will occur, and there is a trade-off between risk and return. The higher an investment's risk, the _________1___________ the return required to induce investors to purchase the asset. This relationship between risk and return indicates that investors are risk ______2________ ; investors dislike risk and require _________3_________ rates of return as an inducement to buy riskier securities. A _________4____________ represents the additional compensation investors require for bearing risk; it is the difference between the expected rate of return on a given risky asset and that on a less risky asset. An asset's risk can be considered in two ways: On a stand-alone basis and in a portfolio context.

1) Higher 2) Averse 3) Higher 4) Risk Premium

The capital asset pricing model (CAPM) explains how risk should be considered when stocks and other assets are held ______________1_________. The CAPM states that any stock's required rate of return is ___________2_________ the risk-free rate of return plus a risk premium that reflects only the risk remaining _________3_________ diversification. Most individuals hold stocks in portfolios. The risk of a stock held in a portfolio is typically __________4_________ the stock's risk when it is held alone. Therefore, the risk and return of an individual stock should be analyzed in terms of how the security affects the risk and return of the portfolio in which it is held.

1) In portfolios 2) Equal to 3) After 4) Lower than

_________1_______ risk is the risk of a decline in a bond's value due to an increase in interest rates. This risk is higher on bonds that have long maturities than on bonds that will mature in the near future. ________2__________ risk is the risk that a decline in interest rates will lead to a decline in income from a bond portfolio. This risk is obviously high on callable bonds. It is also high on short-term bonds because the shorter the bond's maturity, the fewer the years before the relatively high old-coupon bonds will be replaced with new low-coupon issues. Which type of risk is more relevant to an investor depends on the investor's __________3____________, which is the period of time an investor plans to hold a particular investment. Longer maturity bonds have high ________4__________ risk but low ________5_______ risk, while higher coupon bonds have a higher level of ______6______ risk and a lower level of ________7________ risk. To account for the effects related to both a bond's maturity and coupon, many analysts focus on a measure called ______8_______, which is the bond's sensitivity to interest rates.

1) Interest Rate 2) Reinvestment Rate 3) Investment Horizon 4) Interest Rate 5) reinvestment rate 6) reinvestment rate 7) Interest Rate 8) Duration

The expected rate of return on a portfolio equals the weighted average of the expected returns on the assets held in the portfolio. A portfolio's risk _______1________ calculated as the weighted average of the individual stock's standard deviations; the portfolio's risk is generally ________2________ because diversification _______3_______ the portfolio's risk.

1) Isn't 2) Smaller 3) Lowers

The term structure of interest rates describes the relationship between long- and short-term rates. When these data are plotted, the resulting graph is called a yield curve. A(n) __________1_________ yield curve is upward sloping because investors charge higher rates on longer-term bonds, even when inflation is expected to remain constant. A(n) ______2________ yield curve occurs when interest rates on intermediate-term maturities are higher than rates on either short- or long-term maturities. A(n) _________3__________ yield curve is downward sloping and indicates that investors expect inflation to decrease. The shape of the yield curve depends on expectations about future inflation and the effects of maturity on bonds' risk Because of their additional default and liquidity risk, corporate bonds yield __________4___________ Treasury bonds with the same maturity. In addition, the yield spread between corporate and Treasury bonds is _______5_______ the longer the maturity. This occurs because longer-term corporate bonds have _______6_______ default and liquidity risk than shorter-term bonds, and both of these premiums are ________7_________ in Treasury bonds.

1) Normal 2) Humped 3) Abnormal 4) More than 5) Larger 6) More 7) Absent

The __________1_________ value of a bond is its stated face value or maturity value, and its coupon interest rate is the stated annual interest rate on the bond. The maturity date is the date on which the par value must be repaid. A _________2__________ provision gives the issuing corporation the right to redeem the bonds under specified terms prior to their normal maturity date, although not all bonds have this provision. Some bonds have _________3________ provisions which require the corporation to systematically retire a portion of the bond issue each year. Because sinking fund provisions facilitate their orderly retirement, bonds with these provisions are regarded as being _______4________ so they will have _________5___________ coupon rates than otherwise similar bonds without these provisions. Bonds can be _________6_________ -rate bonds with a constant coupon rate over the life of the bond, or they can be ________7__________ -rate bonds with a coupon rate that varies over time depending on the level of interest rates. _________8__________ bonds pay no annual interest but are sold at a _______9__________ par, thus compensating investors in the form of capital appreciation. An original issue discount (OID) bond is any bond originally offered at a price ________10_________ par value. ___________11__________ bonds are exchangeable at the option of the holder for the issuing firm's common stock. Bonds can be issued with warrants giving the holder the option to purchase the firm's stock for a stated price, thereby providing a capital gain if the stock's price rises. _________12__________ bonds contain a provision that allows holders to sell them back to the company prior to maturity at a prearranged price. An ________13_________ bonds pay interest only if the firm has earnings, while an indexed (purchasing power) bond bases interest payments on an inflation index to protect the holder from inflation. Mortgage bonds are backed by ___________14__________. First mortgage bonds are senior in priority to claims of second mortgage bonds. Debentures are long-term bonds that are not secured by a mortgage. Subordinated debentures are bonds having claims on assets only after senior debt has been paid in full in the event of liquidation. _________15____________ bonds are rated triple B or higher, and many banks and other institutional investors are legally limited to only holding these bonds. In contrast, junk bonds are high-risk, high-yield bonds.

1) Par 2) Call 3) Sinking Fund 4) Safer 5) Lower 6) Fixed 7) Floating 8) Zero Coupon 9) Discount Below 10) Below its 11) Convertible 12) Putable 13) Income 14) Fixed Assets 15) Investment Grade

How to find the dividend of a constant growth stock?

Dividend One= Dividend Zero*(1+g)^1 Dividend Two= Dividend Zero * (1+g)^2

The value of any financial asset is the __________1____________ value of the cash flows the asset is expected to produce. For a bond with fixed annual coupons, its value is equal to the present value of all its annual interest payments and its maturity value as shown in the equation below: We could use the valuation equation shown above to solve for a bond's value; however, it is more efficient to use a financial calculator. Simply enter N as years to maturity, I/YR as the going annual interest rate, PMT as the annual coupon payment (calculated as the annual coupon interest rate times the face value of the bond), and FV as the stated maturity value. Once those inputs are entered in your financial calculator, you can solve for PV, the value of the bond. Remember that the signs for PMT and FV should be the same, so PV will have an opposite sign. Typically, you would enter PMT and FV as positive numbers, so PV would be shown as a negative value. The negative sign means that you are purchasing the bond, so the purchase price of the bond is paid out of your funds (thus the negative sign) and is received by the issuing firm (a positive flow to the firm).Note that we calculated the bond's value assuming coupon interest payments were paid annually; however, most bonds pay interest on a semiannual basis. Therefore, to calculate the value of a semiannual bond you must make the following changes: N should reflect the number of interest payment periods so multiply years to maturity by 2, I/YR should reflect the periodic going rate of interest so divide the going annual interest rate by 2, and PMT should reflect the periodic interest payment so divide the annual interest payment by 2. For fixed-rate bonds it's important to realize that the value of the bond has a(n) ___________2__________ relationship to the level of interest rates. If interest rates rise, then the value of the bond ____________3____________ ; however, if interest rates fall, then the value of the bond _________4________. A _________5__________ bond is one that sells below its par value. This situation occurs whenever the going rate of interest is above the coupon rate. Over time its value will ________6_________ approaching its maturity value at maturity. A ________7_______ bond is one that sells above its par value. This situation occurs whenever the going rate of interest is below the coupon rate. Over time its value will ________8_________ approaching its maturity value at maturity. A par value bond is one that sells at par; the bond's coupon rate is equal to the going rate of interest. Normally, the coupon rate is set at the going market rate the day a bond is issued so it sells at par initially.

1) Present 2) Inverse 3) Falls 4) Rises 5) Discount 6) Increase 7) Premium 8) Decreases

As more stocks are added, each new stock has a ______1____ risk-reducing impact on the portfolio

1) Smaller -Standard deviation of the portfolio falls slowly after about 40 stocks are added. -By forming well-diversified portfolios, investors can eliminate about half the risk of owning a single stock

Stocks Beta:

1.0 is average risk Beta > 1.0, stock is riskier than average Beta < 1.0, stock is less risky than average -Most stocks have betas in the range of .5 to 1.5

Assume Beta=1.2 r(RF)= 7% RP(m)=5% What is the firms required rate of return on the firms stock?

= 7% + (5%*1.2) =13%

Proprietorship

A business owned by one person Advantages: -ease of formation -subject to few regulations Disadvantages: -difficult to raise capital -unlimited liability

Corporation

A business owned by stockholders who share in its profits but are not personally responsible for its debts Advantages: -unlimited life -ease of transfer of ownership -limited liability -ease of raising capital Disadvantages: -double taxation -cost of setup and report filing

What is a market?

A market is a venue where goods and services are exchanged. A financial market is a place where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds.

Yield to Maturity and Call with Semiannual Payments Thatcher Corporation's bonds will mature in 16 years. The bonds have a face value of $1,000 and a 7.5% coupon rate, paid semiannually. The price of the bonds is $1,100. The bonds are callable in 5 years at a call price of $1,050. Do not round intermediate calculations. Round your answers to two decimal places. A) What is their yield to maturity? B) What is their yield to call?

A) Semi-annual Interest: $1,000*.075*(6/12)= $37.50 Periods= 16*2=32 YTM=(Interest+ (Face Value- Price/N) Divided by: (Face Value+ Price)/2 =3.27%*2= 6.54% B) Yield To Call=(Interest+ (Face Value- Price/N) Divided by: (Issue Price+ Call Price)/2 =3%*2= 6%

The real risk-free rate of interest is 2%. Inflation is expected to be 2% this year and 5% during each of the next 2 years. Assume that the maturity risk premium is zero. A) What is the yield on 2-year Treasury securities? B) What is the yield on 3-year Treasury securities

A) 5.7 B) 6.2

Ace Products has a bond issue outstanding with 15 years remaining to maturity, a coupon rate of 8.8% with semiannual payments of $44, and a par value of $1,000. The price of each bond in the issue is $1,200.00. The bond issue is callable in 5 years at a call price of $1,088. A) What is the bond's current yield? B) What is the bond's nominal annual yield to maturity (YTM)? C) What is the bond's nominal annual yield to call (YTC)? D) Assuming interest rates remain at current levels, will the bond issue be called? The firm _____1___ call the bond.

A) Current Yield= Annual PMT/ PV (44*2)/1200= 7.33% B) N=30, PV=1200, Pmt=44, PV=0, Solve For R R=3.345%*2= 6.69% C) FV= 1088, N=10, PV=0, PMT=0 =2.847%* 2= 5.69% 1) should

Suppose Hillard Manufacturing sold an issue of bonds with a 10-year maturity, a $1,000 par value, a 10% coupon rate, and semiannual interest payments. A) Two years after the bonds were issued, the going rate of interest on bonds such as these fell to 6%. At what price would the bonds sell? B) Suppose that 2 years after the initial offering, the going interest rate had risen to 16%. At what price would the bonds sell? C) Suppose that 2 years after the issue date (as in Part a) interest rates fell to 6%. Suppose further that the interest rate remained at 6% for the next 8 years. What would happen to the price of the bonds over time? I. The price of the bond will decline, approaching $1,000 at the maturity date. II. The price of the bond will remain the same. III. The price of the bond will rise, approaching $1,000 at the maturity date.

A) R=6%/2= .03 NPer=(10-2)*2= 16 PMT= -1000*(10%/2)= -50 FV= -1000 Solve for PV= $1251.22 B) R=12%/2= .06 NPer=(10-2)*2= 16 PMT= -1000*(10%/2)= -50 FV= -1000 PV= $898.94 C) I.

CFO

Accounting, Treasury, Credit, Legal, Capital Budgeting, and Investor Relations

Strong Form Efficiency market hypothesis

All information, even inside information, is embedded in stock prices. Not true--insiders can gain by trading on the basis of insider information, but that's illegal.

What is IPO?

An initial public offering occurs when a company issues stock in the public market for the first time. "Going Public" enables a company's owners to raise capital from a wide variety of outside investors. Public companies are subject to additional regulations and reporting requirements. -Prior to an IPO, shares are typically owned by the firm's managers, key employees, and, in many situations, venture capital providers. -A seasoned equity offering occurs when a company with public stock issues additional shares. -After an IPO or SEO, the stock trades in the secondary market (exchanges or OTC).

Current Yield=

Annual Coupon/ Current Price

Find the expected dividend yield and capital gains yield during the first year

Dividend Yield= D1/P0 $2.12/ $30.29= 7% GC Yield= P1-P0/ P0 $32.10-$30.29/ $30.29= 6%

Why are stockholders more likely to prefer riskier projects?

Because they receive more of the upside if the project succeeds.

Finance within the organization

Board of Directors CEO COO & CFO

Weak Form Efficiency market hypothesis

Can't profit by looking at past trends. A recent decline is no reason to think stocks will go up (or down) in the future. Evidence supports weak-form EMH, but "technical analysis" is still used.

To determine Beta of a stock based off of CAPM

Correlation between stock and market * (STDEV of stock/STDEV of Market) Investors required returns are based on future risk, but betas are calculated with historical data

Issue Date:

Date when bond was issued

Price Zero=

Dividend One/ R(s)- G This required R(s) > g

The maturity risk premium:

Long Term Bonds: High interest rate risk, low reinvestment rate risk Short Term Bonds: Low interest rate risk, high reinvestment rate risk -Yields on longer term bonds usually are greater than on shorter term bonds, so the MRP is more affected by interest rate risk than by reinvestment rate risk

Investments with bigger standard deviations have:

MORE RISK High risk doesn't mean you should reject the investment, but: -You should know the risk before investing -You should expect a higher return as compensation for bearing risk

COO

Marketing, production, human resources, other operating departments

If Stock (i) has a higher beta is contributes:

More risk and its standalone risk is the beta

To determine the expected rate of return on the bond for the next year.

Multiply the corresponding probability by the return and add together.

The Bond consists of a 10-year, 10% annuity of $100/year plus a $1000 lump sum at T=10

N=10 I/YR=10 PV= -1000 PMT= 100 FV= 1000

Wilson Corporation's bonds have 7 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 9%. The bonds sell at a price of $1,095. What is their yield to maturity?

N=7, PV= 1095, FV= 1000, PMT= 90 Solve for R= 7.22%

You hear in the news that a medical research company received FDA approval for one of its products. If the market is highly efficient, can you expect to take advantage of this information by purchasing the stock?

No. If the market is efficient, this information will already have been incorporated into the company's stock price. So, it's probably too late for you to capitalize on the information.

Constant Growth Model:

Price = dividend * (1+growth rate of dividend) / required rate of return - growth rate of dividends. You should buy the stock if your calculated price is higher than the market price. -If the market lowers the required rate of return for the stock, the value of the common stock will rise -If investors expect that growth in dividends will be higher as a result of favorable developments for the firm, the value of the common stock will rise Compare predicted stock value with actual value. focuses solely on dividends and ignores other factors like competition, new products and investor setiment. Used for large stable companies in a mature market.

If the expected return = (Expected dividend one/ Price zero ) + G > Expected return, then

Price Zero is too low If the price is lower than the fundamental value, then the stock is a bargain

To determine the standard Deviation:

Probability *(Return- Expected Return)^2 For each probability and return do this then add them all together. Then you should square root it.

A small investor has been reading about a "hot" IPO that is scheduled to go public later this week. She wants to buy as many shares as she can get her hands on, and is planning on buying a lot of shares the first day once the stock begins trading. Would you advise her to do this?

Probably not. The long-run track record of hot IPO's is not that great unless you are able to get in on the ground floor and receive an allocation of shares before the stock begins trading. It is usually hard for small investors to receive shares of hot IPO's before the stock begins trading.

If bonds sells at a premium, then coupon

is > YTM -so a call is likely

At maturity, the value of any bonds must equal:

its par value

Bondholders receive fixed payments and are more interested in:

limiting risk

Stand Alone Risk=

market risk + diversifiable risk

What is a constant growth stock?

one whose dividends are expected to grow forever at a constant rate, g

How is P1 calculated?

p1= D2/ r-g $2.2427/ .13-.06= $32.10

coupon rate > YTM

premium

In equilibrium a stocks ____1______ should equal its true or intrinsic value.

price

Coupon rate = YTM

price = par value

YTM rises

price falls

The primary financial goal of management is:

shareholder wealth maximization, which translates to maximizing stock price

Efficient Market Hypothesis

the hypothesis that prices of securities fully reflect available information about securities

coupon interest rate

the percentage of a bond's par value that will be paid annually, typically in two equal semiannual payments, as interest