Finance homework questions

Which are rights of common stockholders? Check all that apply: 1. The right to vote on major decisions at the annual general meeting 2. The right to a share of dividends paid 3. The right to receive regular dividends 4. The right to vote for members of the board of directors

1, 2, 4 Common shareholders are not entitled to regular dividends. Dividend payments are at the discretion of the board of directors.

Bonds are _____. Check all that apply: 1. issued by governments or corporations 2. less costly than bank loans for the borrower 3. loans from investors to issuers 4. riskier than stocks

1, 2, and 3 Stocks are riskier than bonds, since stock prices are more volatile than bond prices and bondholders have precedence over stockholders in the case of bankruptcy.

The risk premium is _____. Check all that apply: 1. the reward for bearing risk 2. normally positive for risky assets 3. the difference between the expected rate of return on an asset and the risk-free rate 4. normally zero for risky assets

1, 2, and 3 The risk premium compensate investors for bearing risk. An additional return of zero would be no compensation.

What are valid approaches for valuing a share of stock? Check all that apply: 1. Valuation by comparables 2. Valuation by discounting dividends 3. Valuation by discounting market values 4. Valuation by discounting free cash flows

1, 2, and 4 We can value a share of stock by comparing certain financial ratios, such as the P/E ratio, and by discounting dividends or free cash flows.

Which factors shape the Treasury yield curve? Check all that apply: 1. Real rate of interest 2. Default risk 3. Interest rate risk 4. Expected inflation

1, 3, and 4 Treasuries are assumed to have no risk of default, since the government could always print more money to meet its obligations. Therefore, default risk is not reflected in the Treasury yield curve.

What is a bond's yield to maturity (YTM)? 1. The return you'll earn if the issuer does not default, you hold the bond to maturity, and yields stay the same 2. The expected return you'll earn if the bond issuer defaults 3. The return you have made if you sell the bond today 4. The same as the bond's coupon rate

1. The return you'll earn if the issuer does not default, you hold the bond to maturity, and yields stay the same The YTM equals the return for an investor who buys the bond today, holds it until maturity, is able to reinvest all coupons at the current yield, and the issuer makes all promised payments on time. In an efficient market, expected returns must be the same for similar securities. Therefore, the YTM can also be interpreted as the market interest rate for similar bonds.

A discount bond is a bond _____. 1. whose price is less than its par value 2. whose price is expected to decline until maturity 3. that doesn't make any interest payments 4. whose price is below fair market value

1. whose price is less than its par value A discount bond trades at a discount to par value. Its price must therefore increase as the maturity date approaches. The price of any bond, including discount bonds, typically reflects its fair market value.

Which are elements of the bond indenture? Check all that apply: 1. Price of the bond 2. Basic terms of the bonds, such as coupon rate and maturity date 3. Description of protective covenants 4. Repayment arrangements 5. Description of collateral

2, 3, 4, and 5 The indenture will specify the par or face value of the bond, but not its price, since prices fluctuate over time and in line with market interest rates.

Why do bonds with lower seniority have higher yields to maturity than comparable bonds with higher seniority? 1. To compensate investors for lower face value. 2. To compensate investors for greater default risk. 3. To compensate investors for lower coupons. 4. To compensate investors for less time to maturity.

2. To compensate investors for greater default risk. Lower seniority means lower priority in the case of bankruptcy, thus increasing the risk of default.

The constant-growth dividend model is based on the assumption that _____. 1. stock prices grow by a constant amount every period 2. dividends grow at a constant rate every period 3. dividends grow by a constant dollar amount every period 4. discount rates grow at a constant rate every period

2. dividends grow at a constant rate every period It assumes that dividends grow at some constant rate g every period, such that Dt= Dt-1 (1+g).

Which factors could explain the higher yield to maturity on the Hunter bond? Check all that apply: 1. Coupon rate 2. Issue size 3. Bond rating 4. Original time to maturity 5. Time to maturity

3 and 4 Bond rating: An A-rated bond is riskier than an AAA-rated bond. Therefore, the A-rated bond must have a higher YTM (or lower price) in order to compensate investors for the additional risk. Issue size: The larger issue might be more liquid, thus requiring a lower liquidity premium. Coupon rate: Similar bonds (same time to maturity, bond rating, options) have the same YTM, independent of their coupon rates. Therefore, different coupon rates cannot explain differences in YTM. Original time to maturity is irrelevant for the YTM. Time to maturity: Since the yield curve is normally upward sloping, bonds with longer time to maturity usually have higher yields than shorter-term bonds.

Which of the following statements is true about free cash flow valuation models? 1. In practice, the intrinsic value based on free cash flow models is always the same as the one from dividend-discount models. 2. In contrast with dividend discount models, free cash flow models don't include the terminal value of the company. 3. Free cash flows are discounted at WACC in order to determine the value of the company. 4. Free cash flows are discounted at the risk-free rate in order to determine the intrinsic value.

3. Free cash flows are discounted at WACC in order to determine the value of the company. In the free cash flow model, the value of a company equals the present value of its future free cash flows. There are two variations of this valuation approach: The first approach involves discounting projected free cash flow to the firm (FCFF) at the weighted average cost of the capital (WACC) to find the total company value and the second approach involves discounting future free cash flow to equity (FCFE) at the required return on equity to find the company value.

Which of the following statements is true about the sensitivity of a bond's price to a change in market interest rates? 1. Corporate bonds are more sensitive than Treasuries. 2. High-coupon bonds are more sensitive than low-coupon bonds. 3. Long-term bonds are more sensitive than short-term bonds. 4. Short-term bonds are more sensitive than long-term bonds.

3. Long-term bonds are more sensitive than short-term bonds. Bonds with more time to maturity are more sensitive to changes in interest rates than bonds with a shorter time to maturity.

Why would an investor buy an unsecured corporate bond instead of a comparable secured corporate bond? 1. The unsecured bond is more liquid and thus easier to sell. 2. The unsecured bond has a higher face value. 3. The unsecured bond offers a higher yield to maturity. 4. The unsecured bond has higher priority in the case of bankruptcy.

3. The unsecured bond offers a higher yield to maturity. The unsecured bond is riskier than a secured bond. To compensate investors for the greater risk of default, the company offers a higher yield to maturity.

The non-constant growth dividend valuation model is most appropriate for companies that are _____. 1. unchanging 2. declining 3. new 4. mature

3. new New companies, such as startups, often grow very quickly initially before their business matures and their growth rate settles down to a value that is approximately constant.

Which bond has the highest risk of default? 1. A bond with an AAA rating 2. A bond with an A rating 3. A bond with a BBB rating 4. A bond with a B rating

4. A bond with a B rating AAA is the highest (most secure) bond rating, followed by AA, A, BBB, BB, B, C and D.

Which of the following statements is correct? 1. If companies are more likely to default on their bonds, interest rates are likely to decrease. 2. If companies borrow more money, interest rates are likely to decrease. 3. If individuals save more, interest rates are likely to increase. 4. If expected inflation increases, interest rates are likely to increase.

4. If expected inflation increases, interest rates are likely to increase, as new investors want to be compensated for the erosion of purchasing power.

Which term has a meaning different from the other ones? 1. Amount to be repaid on the maturity date 2. Par value 3. Face value 4. Price

4. Price The price of a bond fluctuates over time, while the face value or par value is fixed and represents the amount to be repaid on the maturity date of the bond.

The term structure of interest rates refers to the relationship between _____. 1. a bond's time to maturity and its coupon rate 2. a bond's age since issue and its coupon rate 3. a bond's age since issue and its yield 4. a bond's time to maturity and its yield

4. a bond's time to maturity and its yield Typically, bonds with longer times to maturity have higher yields, giving rise to an upward-sloping yield curve. The yield curve is the graphical representation of the term structure of interest rates.

A callable bond is a bond that _____. 1. can be repurchased by the issuer on the maturity date 2. can be sold back to the issuer before the maturity date 3. can be sold back to the issuer on the maturity date 4. can be repurchased by the issuer before the maturity date

4. can be repurchased by the issuer before the maturity date A callable bond is a bond that can be repurchased by the issuer before the maturity date. The price at which the bond can be repurchased is the call price, which is usually above the par value. The difference between the call price and the par value is the call premium. A bond issuer has an incentive to call a bond if market interest rates have fallen significantly since the issue date, allowing the issuer to issue a new bond with a lower coupon rate and paying off the old bond.

When market interest rates (i.e., yields) increase, the price of existing bonds _____. 1. increases 2. moves sideways 3. is unaffected 4. decreases

4. decreases Since the yield to maturity is the rate used to discount all future payments from a bond, rising yields lead to lower present values and thus a lower bond price. Alternatively, a rise in market interest rates makes existing bonds with fixed coupon rates less attractive, thus leading to lower prices.

The P/E ratio measures 1. the price equivalent of $1 of earnings 2. the expected capital gain 3. the growth rate of dividends 4. the price an investor pays for $1 of earnings

4. the price an investor pays for $1 of earnings The P/E ratio is defined as the ratio of stock price over earnings per share (P/EPS). As such, it shows how much money a stock investor has to pay for each dollar of earnings per share. Higher P/E ratios are typically associated with faster expected growth in earnings per share.

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HOMEWORK 6

HOMEWORK 6