FIN exam 2
three special case patterns of dividend growth include:
- zero growth - non-constant growth - constant growth
If you are holding a municipal bond that is trading at par to yield 6%, by how much will your after tax yield change if your income tax bracket increases from 15% to 20%. assume there are no state or local taxes
0% interest income from munis is exempt from federal income tax
NASDAQ has which of these features:
1. computer network of securities dealers 2. multiple market marker system
arrange the steps involved in the in the discounted payback period in order starting with the first step:
1. discount the cash flows using the discount rate 2. add the discounted cash flows 3. accept if the discounted payback period is less than some pre-specified number of years
staggering has two basic effects:
1. makes it more difficult for a minority to elect a director bc there are fewer directors to be elected at one time 2. makes takeover attempts less likely to be successful beause it makes it more difficult to vote in a majority of new directors
what is the total return for a stock that currently sells for $100, pays a dividend in one year of $2, and has a constant growth rate of 8%?
10% R = ($2/$100) + .08 = .10 or 10%
what will happen to the default risk premium during periods of economic uncertainty?
it will increase
if a $1000 par value bond is trading at a discount, it means that the market value of the bond is ____ $1000
less than if a $1000 par value bond is trading at a discount, its market value is less than $1000
if the PV of the interest payments on a bond is $320 and the PV of the par value to be paid at maturity is $900, the total value of the bond must be ___
$1220
Scott Corp does not pay dividends. the PE ratio for its industry is 13.3, and Scott's EPS were $1.47. At what price should Scott stock trade?:
$19.55 13.3 X 1.47 = 19.55
what is the price of a stock at the end of one year (P1) if the dividend for Year 2 (Div2) is $5, the price for Year 2 (P2) is $20, and the discount rate is 10 percent?
$22.73
if you purchase a bond costing $1143 with a par value of $1000 that pays a semi-annual coupon of 5%, how much will each coupon payment be?
$25
if you invest in a $1000 corporate bond that has a 9% coupon and makes semi-annual payments, you can expect to receive ___ each six months
$45 every 6 months
what is the NPV of a project with an initial investment of $95, a cash flow in one year of $107, & a discount rate of 6 percent?
$5.94 NPV = -$95 + ($107/1.06) - $5.94
A bond pays annual interest payments of $50, has a par value of $1000, and a market price of $1200. How is the coupon rate computed
$50/$1000
A firm decides to raise $ by issuing 5 million bonds with a par value of $5000 each for 10 years at a coupon rate of 7 percent. at the time of issue, the bonds were sold for $5500 each. what will the par value of the bonds be in year 5?
$5000 per bond
ABC Co. issued 1 million 6 percent annual coupon bonds that mature in 10 years. the FV is $1000 per bond. what are the expected cash flows from these bonds?
$60 in interest at the end of each year for 10 years and a $1000 repayment of principal at the end of 10 years
according to Graham and Harvey's 1999 survey of kdkfjkdsjflk
- NPV - IRR
A benchmark PE ratio can be determined using:
- The PEs of similar companies - a company's own historical PEs
A corporate bond's yield to maturity ___
- can be greater than, equal to, or less than the bond's coupon rate - changes over time
convertible bond:
- can be traded for a fixed # of shares of stock - can convert debt into equity in the company
which of the following are weakness of the payback method:
- cash flows received after the payback period are ignored - the cutoff date is arbitrary - time value of money principles are ignored
what is the aftertax yield on a US treasury bond yielding 7 percent if you are in the 20 percent tax brakcet?
5.6% .07 x (1 - 0.2) = 5.6
what will your aftertax yield be on a corporate bond that is currently trading at par and yiedling 8 % if you are in the 20 percent tax bracket?
6.4% .08 x (1 - 0.2)
if an investment appreciates by 7% while the rate of inflation is 2 percent, what is the nominal rate of return?
7% the nominal rate is the observed rate - in this case the appreciation is the observed rate. It includes inflation
what is the effective annual rate for a bond with a 7 percent yield to maturity that makes semi-annual interest payments?
7.12%
what is the IRR for a project with an initial investment of $250 and subsequent cash inflows of $100 per year for 3 years?
9.7%
security:
description of collateral assets
T or F: the discounted payback rule has an objective benchmark to use in decision making
False
T or F: A bond's value is not affected by changes in the market rate of interest:
False bond prices are inversely related to interest rates
if a project has multiple internal rates of return, which of the following methods should be used?
NPV MIRR
the dividend growth model calculates total return as:
R = dividend yield (D1/P0) + capital gains yield (g)
T or F: It ca be advantageous to have a staggered board bc it provides "institutional memory"
T
what is a corporate bond's yield to maturity (YTM)?
YTM is the prevailing market interest rate for bonds with similar features YTM is the expected return for an investor who buys the bond today and hold it to maturity
zero coupon bonds:
a bond that pays no coupons at all must be offered at a price that is much lower than its stated value
what is a premium bond?
a bond that sells for more than face value
current yield:
a bond's annual coupon divided by its price
a bond's YTM will exceed its current yield when the bond is selling at ____
a discount
note:
a financial security that generally has a longer term than a bill but a shorter term than a bond.
the internal rate of return is a function of ___
a project's cash flows
according to the avg accounting return rule, a project is acceptbale if its avg accounting return exceeds:
a target avg accounting return
debenture:
a type of debt instrument that is not secured by physical assets or collateral. Debentures are backed only by the general creditworthiness and reputation of the issuer.
a project should be ___ if its NPV is greater than zero
accepted
payback period tells the time it takes to break even in an __ sense. discounted payback period tells the time it takes to break even in an ___ or financial sesnse
accounting, economic
role of DMM:
acts as "specialists" -- deals in particular stocks each stock on the NYSE is assigned to a single DMM DMM continually posts and updates bid and ask prices
advantages and disadvantages of the internal ROR:
advantages: 1. closely related to NPV, often leading to identical decisions 2. easy to understand and communicate disadvantages: 1. may result in multiple answers or not deal with nonconventional cash flows 2. may lead to incorrect decisions in comparisons of mutually exclusive investments
advantages and disadvantages of the average accounting return:
advantages: 1. easy to calculate 2. needed info will usually be available disadvantages: 1. not a true rate of return; time value of money is ignored 2. uses an arbitraty cutoff rate 3. based on accounting (book) value, not cash flows & market values
advantages & disadvantages of the discounted payback period rule:
advantages: 1. includes time value of money 2. easy to understand 3. does not accept negative estimated NPV investments 4. biased towards liquidity disadvantages: 1. may reject positive NPV investments 2. requires an arbitrary cutoff point 3. ignores cash flows beyond cutoff date 4. biased against long-term projects, such as R&D and new projects
zero-coupon bond:
aka pure discount bonds - pays no interest - no periodic coupon payments - interest expense equals the change in the amortized value of the bond, initially sold less than par
call provision
allows company to repurchase part or all of an issue
call provision:
allows the company to repurchase or "call" part or all of the bond issue at stated prices over a specific period. corporate bonds are usually callable
sinking fund:
an account managed by the bond trustee for early redemption
debt ratings:
an assessment of the creditworthiness of the corporate issuer
the discounted payback rule:
an investment is acceptable if its discounted payback is less than some pre specified number of years
internal rate of return (IRR) or, the discounted cash flow or DCF return
based on the IRR rule, an investment is acceptable if the IRR exceeds the required return
bond market vs. equity markets:
bond market: where investors go to trade (buy and sell) debt securities, prominently bonds. equity market: a place where investors go to trade (buy and sell) equity securities like common stocks and derivatives
what is a discount bond?
bonds that sell for less than the face value
a corporate bond's yield to maturity _____
changes over time can be greater than, equal to, or less than the bond's coupon rate
stock that has no special preference either in receiving dividends or in bankruptcy:
common stock
inflation premium:
compensation for the loss in the form of higher nominal rates
protective covenants:
conditions that limit the actions of firms (negative covenant / positive covenant)
bond ratings:
constructed from information supplied by the corporation
coupon-rate:
coupon quoted as a percent of FV or definition of floating rate
which of the following terms apply to a bond? dividend yield coupon rate par value time to maturity
coupon rate par value time to maturity
the ___ is the rate at whcih the NPVs of two projects are equal
crossover rate
when interest rates in the market rise, we can expect the price of bonds to:
decrease while it is possible for prices to increase due to some other overwhelming factor (such as excessive speculation), we "expect" prices to decrease
all else constant, the dividend yield will increase if the stock price ____
decreases
NPV _____ cash flows properly:
discounts
the constant-growth models infers that ___
dividends change at a constant rate
which of the following represents the valuation of stock using a zero growth model?
dividends/discount rate
what is a difference between debt and equity?
equity is publicly traded while debt is not
the price of a share of c/s is equal to the present value of all _____ future dividends
expected
T or F: If you invest in junk bonds, there is a high likelihood that you will earn a very hight return
false
t or f: the discounted payback rule has an objective benchmark to use in decision making
false
T or F: the inflation premium will be higher if the rate of inflation is low
false the inflation premium will be lower if the rate of inflation is low
a limitation of bond ratings is that they ___
focus exclusively on default risk
A PE ratio that is based on estimated future earnings is called a ___
forward PE ratio
An asset's value is determined by the present value of its ____ cash flows
future
longer-term bonds have _____ interest rate sensitivity bc a large portion of a bond's value comes from the $1000 face amount
greater
the value of a firm is the function of its ____ rate and its ____ rate
growth; discount
A bond with a BBB rating has a ___ than a bond with an A rating
higher risk of default
put provision:
holders can redeem for par at their discretion
creditworthiness:
how likely the firm is to default and the protection creditors have in the event of a default
a(n) ____ project does not rely on the aceptance or rejection of another project
independent
seniority:
indicates preference in position over the other lenders, and debts are sometimes labeled as senior or junior to indicate seniority
the PV of all cash flows (after the initial investment) is divided by the __ to calculate the profitability index
initial investment
the most important alternative to NPV is the ___ method
internal ROR
the point at which the NPV profile crosses the horizontal axis is the :
internal rate of return
stock price reporting has increasingly moved from traditional print media to the ___ in recent years
internet
default risk premium
investors recognize that issuers other than the Treasury may or may not make all the promised payments on a bond, so they demand a higher yield as compensation for it
face amount:
issue size
the federal gov't can raise money from financial markets to finance its deficits by:
issuing bonds
IRR continues to be very popular in practice, partly bc
it gives a ROR rather than a dollar value
which is true about a multi-year typical bond's coupon?
it is a fixed annuity payment
One common reason for having 2 classes of C/S with different voting rights is:
it is easier for insiders such as founding families to maintain control of the company
the reason that interest rate risk is greater for ____ term bonds than for ____ term bonds is that the change in rates has a greater effect on the PV of the ____ than on the PV of the ____
long short FV coupon payments
all else held constant, the yield on a highly liquid bond will be ____ the yield on an illiquid bond
lower than
Most voting in large corporations is done by proxy bc:
most small shareholders do not attend the annual meeting
WinWin corporation has 5 board members, and each shareholder gets on vote per share. the company uses a straight board voting procedure. How does this arrangement affect minority shareholders?
no minority shareholder would have enough votes to win any seat on the board
when voting for the board of directors, the number of votes a shareholder is entitled to is generally determined as follows:
one vote per share held
the constant growth formula calculates the stock price:
one year PRIOR (year t) to the first dividend payment (D t+1)
fundamentally, the business of the NYSE is to attract and process _____
order flow
member:
own "seats" on the exchange, and collectively the members of the exchange were also the owners
which of these is included in the calculation of a bond's yield to maturity?
par value coupon rate current price
which of these are required to calculate the current value of a bond? par value coupon rate time remaining to maturity price at the time of bond issue applicable market rate
par value coupon rate time remaining to maturity applicable market rate
this capital budgeting method allows lower management to make smaller, everyday financial decisions effectively:
payback method
for a project with conventional cash flows, the NPV is ___ if the ROR is less than the IRR, and it is __ if the ROR is greater than the IRR
positive, negative
in capital budgeting, the net __ determines the value of a project to the company:
present value
par value (face value):
principal repaid at the end of the loan (most commonly $1000 per bond)
according to the basic IRR rule, we should:
reject a project if the IRR is less than the required return
dividends:
represent a return on the capital directly or indirectly contributed to the corp. by the shareholders
interest rate risk:
risk that arises for bond owners from fluctuating interest rates
NPV accounts for the size of the prject and thus mitigates the effects of:
scale
equity securities & debt securities
securities issued by corporations
average accoutning return:
some measure of average accounting profit / some measure of average accounting value average NI / average BV
the NYSE member who acts as a dealer in a small number of securities is called a(n):
specialist
Mota Motors has 8 directors on its board, two of whom go up for election each year. This is an example of a:
staggered board
municipal notes:
state and local gov'ts also borrow money by selling notes and bonds
the goal of many successful organizations is a(n) ____ rate of growth in dividends
steady
the payback period rule ___ a project if it has a payback period that is less than or equal to a particular cutoff date
suggests accepting
coupon:
the annual interest paid on the face value of a bond. It is expressed as a percentage.
who declares a dividend?
the board of directors
the amount by which the call price exceeds the par value of the bond:
the call premium
debt capital:
the capital that a business raises by taking out a loan. It is a loan made to a company that is normally repaid at some future date. borrowed money obtained through loans of various types
debtor/borrower
the corporation borrowing the money
net present value (NPV):
the difference between an investment's market value and its cost basically how much value is added or created today by undertaking an investment
when the stock being valued does not pay dividends:
the dividend growth model can still be used
What does the AAA rating assigned by S&P mean?
the firm is in a strong position to meet its debt obligations
proxy:
the grant of authority by a shareholder to someone else to vote his or her shares
discounted payback period:
the length of time until the sum of the discounted cash flows is equal to the investment the time it takes to breakeven in an economic or financial sense
what kind of investment is the best?
the one with the largest NPV
credit risk
the possibility of default
when the US gov't wants to borrow money for the long-term (more than one year) it issues:
treasury bonds treasury notes
T or F: interest earned on Treasury notes and bonds is taxable
true
t or f: 2 challenges with the irr approach when comparieng 2 mutally exclusive prjects are scale and cash flow timing
true
t or f: some projects, such as mines, have cash outflows followed by cash inflows, whcih are then followed by cash outflows, giving the project multiple rates of return
true
when valuing a stock, the advantage to considering the stock price in the distant future (rather than a more near-term price) as a cash flow is that:
when discounted to PV, a stock price is in the distant future is nearly zero
problems with IRR:
when the cash flows are not conventional or when we are trying to compare 2 or more investments to see which is best
treasury notes & bonds:
when the gov't wishes to borrow money for more than one year
if the growth rate (g) is zero, the capital gains yield is ___
zero
the irr is the discount rate that makes the NPV of a project equal to _
zero
three important features of treasury notes & bonds:
- default free - taxable - highly liquid
three different types of license holders:
- designated market makers (DMMs) - floor brokers - supplemental liquidity providers (SLPs)
which of the following are expected cash flows to investors in stocks?: - dividends - interest - fees - capital gains
- dividend - capital gains
which of the following are advagntages of ARR:
- easy to compute - needed info is always available
when cash flows are conventional, NPV is ___
- equal to 0 when the discount rate equals the IRR - negative for discount rates above the IRR - positivie for discount rate below the IRR
role of job floor broker:
- execute trades for customers, with an emphasis on getting the best price possible - interaction between floor brokers and DMMs is the key to non electronic trading on the NYSE
what are the advantages of the payback period method for managemetn:
- it allows lower level managers to make small decisions effectively - the payback period method is ideal for short projects - the payback period method is easy to use
which of the following is a feature of C/S?: -it receives interest semi-annually - it receives dividends every quarter - it has no special preference in bankruptcy - it has no special preference in receiving dividends - it generally has voting rights
- it has no special preference in bankruptcy - it has no special preference in receiving dividends - it generally has voting rights
sovereign bond:
- long-term debt issued by a gov't entitiy - treasury bills, notes, & bonds issued by US federal gov't - municipal bonds issued by a state or local gov't
the discounted paybakc period has which of these weaknesses?
- loss of simplicity as compared to the payback method - arbitrary cutoff date - exclusion of some cash flows
the irr rule can lead to bad decisions when...
- projects are mutually exclusive - cash flows are not conventional
what are usually some rights of common shareholders?
- the right to a proportional share of dividends paid - voting rights - the right to purchase a proportional share of new stock issued
the three attributes of NPV are that it:
- uses all the cash flows of a project - discounts the cash flows properly - uses cash flows
characteristics of debt:
- viewed as low risk - debt holders don't have voting rights - no dilution of control when debt is issued - usually involves payment of interest
use your calculator to find the YTM on a 20 year, $1000 par value bond that pays coupons of 4.5% semi-annually and currently sells for $1104.89
3.75% N= 40 (20x2) PMT= 22.5 (.045X1000/2) PV= -1104.89 FV= 10000 sole for I/Y and multiply by 2 bc this is a semi-annual rate
public bond vs. private placement:
public bond: the issuer publicizes the upcoming bond issue, provides the timeframe and platform for which bids will be accepted, and provides any additional guidelines or details related to the bond issue. private placement: provides funding through direct negotiation with one or a select number of private financial institutions.
what are some common protective covenants?
- the firm must limit dividends to equity holders - the firm cannot merge with any other firm - the firm must maintain working capital at or above a specified level
which of the following are features of municipal bonds?
- the interest on municipal bonds is exempt from federal taxes - they are issued by state and local gov'ts
which of the following are reasons why it is more difficult to value C/S than it is to value bonds?
- the life of a C/S is essentially forever - C/S cash flows are not known in advance - the rate of return required by the market is not easily observed
what is usually included in a bond's indenture?
- the total amount of bonds issued - the repayment arrangements
the US gov't borrows money by issuing:
- treasury bills - treasury notes - treasury bonds
when you can come up with a value for stcok what simplifying assumptions do you have to make:
1. the dividend has a zero growth rate 2. the dividend grows at a constant rate 3. the dividend grows at a constant rate after some length of time
A share of c/s is more difficult to value in practice than a bond for at least what three reasons:
1. with C/S, not even the promised cash flows are known in advance 2. the life of the investment is essentially forever bc C/S has no maturity 3. there is no way to easily observe the rate of return that the market requires
what is the current yield on a $1000 par value bond that sells for $900 if the coupon rate is 10 percent?
11.11% (.10 x $1000)/$900
which of the following are common shapes for the term structure of interest rates?
- humped - upward sloping - downward sloping
How is investing in US Treasury bonds different from investing in corporate bonds?
- interest from US treasuries is exempt from taxes at the state level but corporate interest is not - treasury issues have no default risk
the NYSE differs from the NASDAQ primarily bc the NYSE has:
- specialists - an auction market - a physical location
what are three important features of Treasury notes and bonds?
- taxable - highly liquid - default free
which two prices can be found in the Wall Street Journal's daily Treasury bond listing?
- the bid price - the asked price
about treasury bonds:
- have no default risk bc the Treasury can always come up with the money to make the payments - Treasury issues are exempt from state income taxes
how is a conventional bond different from a zero coupon bond?
- conventional bonds can sell at par, at a discount from par, or at a premium over par while zeroes can not - a conventional bond pays periodic interest whiles zeroes make no interest payments
what is a real rate of return?
a rate of return that has been adjusted for inflation
one requirement of the dividend growth model is:
g<R
what is the most important source of risk from owning bonds?
market interest rate fluctuations
which of the following variables are required to calculate the value of a bond? market yield remaining life of bond coupon rate original issue price of bond
market yield remaining life of bond coupon rate
there is a ___ relationship b/w market interest rates and bond values:
negative
protective covenants can be classified into two types:
negative covenants ("thou shalt not" type of covenant) & positive (affirmative) covenants ("thou salt" type of covenant)
what are the cash flows involved in the purchase of a 5 year zero coupon bond that has a par value of $1000 if the current price is $800 ? assume interest rate is 5%
pay $800 today and receive $1000 at the end of 5 years
creditor/lender
person or firm making the loan
protective covenant:
that part of the indenture or loan agreement that limits certain actions a company might otherwise wish to take during the term of the loan
the two most important stock markets in the US are the NYSE and _____
the NASDAQ
which quote, asked or bid, would you expect to pay if you were buying a bond?
the asked price
what's the definition of a bond's time to maturity?:
the number of years until the FV is due to be repaid
capital gains yield:
the rate at which the value of the investment grows
the degree of interest rate risk depends on ___
the sensitivity of the bond's price to interest rate changes
indenture (deed of trust)
the written agreement between the corporation (the borrower) and its creditors
