FIN3403 Conceptual Questions Exam 2
What are the cash flows associated with a bond?
- Coupons- the stated interest payment made on a bond - Face value- principle amount of a bond that is repaid at the end of the term, par value - Coupon rate- annual coupon divided by the face value of a bond Maturity- number of years until the face value is paid
What six components make up the bonds yield?
1. Real rate of interest 2. Expected future inflation 3. Interest rate risk 4. Default risk 5. Taxability 6. Lack of liquidity
Why is preferred stock called preferred?
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What is a junk bond?
A bond that is rated below investment grade corporate bonds.
What is a proxy?
A grant of authority by a shareholder allowing another individual to vote his or her shares.
What is the Treasury yield curve?
A plot of the yields on Treasury notes and bonds relative to maturity.
What is a sinking fund?
An account managed by the bond trustee for the purpose of repaying the bonds.
What is the difference between a nominal and a real return? Which is more important to a typical investor?
Real rates have been adjusted for inflation. Nominal rates haven't been adjusted for inflation. An investor will be more concerned with the real rate.
What is the term structure of interest rates? What determines its shape?
Relationship between short- and long-term interest rates. Real rate of interest, rate of inflation, and the interest rate risk determine the shape.
What rights do shareholders have?
Right to vote Right to sell stock Right to receive dividends ?
What is the indenture? What are protective covenants? Give some examples.
The indenture is a written agreement between the corporation and its creditors. A protective covenants is 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. Examples: Firm cannot merge with another firm (negative covenant); firm must maintain any collateral or security in good condition (positive covenant).
What is the Fisher effect?
The relationship between nominal returns, real returns, and inflation.
Why might an income bond be attractive to a corporation with volatile cash flows? Can you think of a reason why income bonds are not more popular?
An income bond might be attractive to a corporation with volatile cash flows since the company makes payments of interest to bondholders if th company has sufficient amount of income to pay. The volatility of income is the reason it may not become popular.
What is the general expression for the value of a bond
Bond Value = PV of the coupons + PV of the face value Bond value = C (1-1/(1+r)^t)/r + F/(1+r)^t
What are the distinguishing features of debt compared to equity?
Debt = has to be repaid; can make the company result in bankruptcy Equity: Lenders have ownership of the firm; residual owners (last to get paid).
What do you think would be the effect of a put feature on a bond's coupon? How about a convertibility feature? Why?
Force issuer to buy the bond, this is a risk for issuer so that they give lesser coupons. ???
What are the relevant cash flows for valuing a share of common stock?
Future dividends
Does the value of a share of stock depend on how long you expect to keep it?
It depends on the dividend growth pattern of the company.
Is it true that only risk associated with owning a bond is that the issuer will not make all the payments?
No
What does a bond rating say about the risk of fluctuations in a bond's value resulting from interest rate changes?
Nothing! Bond ratings are only concerned with the possibility of default.
What is the value of a share of stock when the dividend grows at a constant rate?
P0=D1/R-g