FIN3403 - Test 2 Study Guide

a. How frequently are corporate coupons paid? What compounding period is used when valuing corporate bonds?

Corporate coupons are usually paid TWICE a YEAR, w/ SEMI-ANNUAL compounding!

Define bond certificate, indenture, par value

*Bond Certificate* - States the terms of a bond as well as the amounts and dates of all payments to be made. *Par Value* - The notional amount of a bond used to compute its interest payments. The face value of the bond is generally due at the bond's maturity. *Indenture* - Included in a prospectus, it is a formal contract between a bond issuer and a trust company, which represents the bondholders' interests.

What are the 2 sources of return from investing in a bond?

(1) any difference between the purchase price and the principal value (2) its periodic coupon payments

Describe the different types of stock. What are the voting rights of each type?

*Common Stock* - A share of ownership in the corporation, which confers rights to any common dividends as well as rights to vote on election of directors, mergers, and other major events. *Preferred stock* - Stock with preference over common shares in payment of dividends and in liquidation. *Cumulative preferred stock* - Preferred stock where all missed preferred dividends must be paid before any common dividends can be paid. *Non-cumulative preferred stock* - Preferred stock where missed dividends do not accumulate. Only the current dividend is owed before common dividends can be paid.

What is the Dividend-Discount Model? What are the limitations of this model?

*Dividend-Discount Model* - A model that values shares of a firm according to the present value of the future dividends the firm will pay. Limitations: its reliance on dividend forecasts and lack of applicability to non-dividend-paying stocks

Define face value, face amount, coupon, coupon rate

*Face Value* - The notional amount used to compute the interest payment. It is usually repaid on the maturity date. Also called par value. *Coupons* The promised interest payments of a bond. Usually paid semiannually, but the frequency is specified in the bond certificate. They are determined by the coupon rate, which is stated on the bond certificate. The amount paid is equal to: Coupon Rate × Face Value / Number of Coupon Payments per Year *Coupon Rate* - Determines the amount of each coupon payment of a bond. The coupon rate, expressed as an APR, is set by the issuer and stated on the bond certificate

How does inflation affect interest rates? How do changes in inflation impact interest rates?

*Inflation is a general increase in prices, or an erosion of buying power.* In general, as *interest rates are lowered*, more people are able to borrow more money. The result is that consumers have more money to spend, causing the economy to grow and *inflation to increase*. The opposite holds true for rising interest rates. As *interest rates are increased*, consumers tend to have less money to spend. With less spending, the economy slows and *inflation decreases*.

Define the following: nominal interest rates, real interest rates, risk-free interest rates.

*Nominal Interest Rates* are the observed rates. The rates that are stated, the rates that we observe. -The rate at which your money will grow if invested for a certain period *Real interest rates* are the interest rates that are received after considering inflation. - The rate of growth of your purchasing power, after adjusting for inflation The *risk-free rate of return* is the interest rate at which money can be borrowed or lent without risk over a given period.

Compare and contrast public bonds and private placements

*Public bonds* - Securities made available for sale on the public market, also a way of raising capital! Usually have FEW covenants and are going to be pay back! In addition, no leverage ratios! *Private placements* - The sale of securities to a relatively SMALL number of SELECT investors as a way of raising CAPITAL. (Does not have to be registered with the SEC)

Define security, protective covenant, seniority

*Security* - A security, in a financial context, is a certificate or other financial instrument that has monetary value and can be traded. *Protective covenant* - A part of an indenture or loan agreement that limits certain actions a company may take during the term of the loan to protect the lender's interests. *Seniority* - A bondholder's priority, in the event of a default, in claiming assets not already securing other debt.

With respect to corporate bond coupons, what is the common base rate? What is a credit spread? What are components of each?

*common base rate* -The rate of interest that is set by a central bank, and which is the lowest rate at which it lends money to other banks. This rate affects the interest rates which are then charged to customers by the banks *credit spread* - The yield spread between securities with the same currency and maturity structure but with different associated credit risks. With the yield spread rising as the credit rate worsens.

Explain why minority shareholders might prefer cumulative voting over straight voting

*cumulative voting* Voting for directors where each shareholder is allocated votes equal to the number of open spots multiplied by his or her number of shares.

What is the discounted free cash flow model? Why do you use this instead of the dividend discount model?

*discounted free cash flow model* - A method for estimating a firm's enterprise value by discounting its future free cash flow. The dividend-discount model values a single share of stock. In the total payout model, we first value the firm's equity, rather than just a single share. The discounted free cash flow model goes one step further and begins by determining the total value of the firm to all investors—both equity holders and debt holders.

Define sinking fund, call provision, put provision, debenture, note

*sinking fund* - A method for repaying a bond in which a company makes regular payments into a fund administered by a trustee over the life of the bond. These payments are then used to repurchase bonds, usually at par. *Call provision* - A provision on a bond or other fixed-income instrument that allows the original issuer to repurchase and retire the bonds. *Put provision* - A provision in some bonds which allows the bondholder to resell a bond back to the bond's issuer at par or the face value of the bond before the bond matures. *Debentures* - A type of unsecured corporate debt with maturities of 10 years or longer. *Note* - A type of unsecured corporate debt with maturities of less than 10 years.

What is the WACC? How does it differ from the equity cost of capital?

*weighted average cost of capital (WACC)* - The cost of capital that reflects the risk of the overall business, which is the combined risk of the firm's equity and debt. It is the cost of capital that reflects the risk of the overall business, which is the combined risk of the firm's equity and debt. We interpret rwacc as the expected return the firm must pay to investors to compensate them for the risk of holding the firm's debt and equity together. If the firm has no debt, then rwacc=rE.

What are characteristics of equity?

- Right to income - Claim of Assets - Right to Control - Voting Rights - Limited liability

Explain characteristics of dividends

- Usually paid quarterly. - Payment of dividends is at the discretion of the BoD. - Dividends are not tax deductible for the paying firm. - Dividends received by individuals are taxed based on the holding period of the stock (ordinary income v. capital gains)

Discuss the structure of a corporation (shareholders, board of directors, management)

1) SHAREHOLDERS- elect board members 2) BOARD OF DIRECTORS- collectively make decisions on how to operate the company 3) MANAGEMENT- Responsible for increasing stockholder's equity, reporting to the board!

What is unique about U.S. Treasury securities? Municipal bonds?

?? *Municipal bonds* - Bonds issued by state and local governments. They are not taxable at the federal level (and sometimes not at the state or local level either) and so are sometimes also referred to as tax-exempt bonds.

What is a zero-coupon bond?

A bond that makes only one payment at maturity.

What is the P/E ratio? Discuss the different types.

A firm's P/E ratio is equal to the share price divided by its earnings per share.

What is a PE ratio?

A way to value a company that does not pay dividends. PE ratio = price per share/ earnings per share

What is a proxy?

A written authorization for someone else to vote your shares.

Describe the relationships that exist between the market interest rate, coupon rate, yield to maturity, and current yield for a bond trading at both a discount and a premium

At any point in time, changes in market interest rates affect the bond's yield to maturity and its price (the present value of the remaining cash flows). If a bond *sells at par* (at its face value), the only return investors will earn is from the *coupons* that the bond pays. Therefore, the bond's coupon rate will exactly *equal its yield to maturity*. If the bond trades at a *discount*, an investor who buys the bond will earn a return both from receiving the *coupons* and from receiving a *face value that exceeds the price paid* for the bond. As a result, if a bond trades at a discount, its *yield to maturity will exceed its coupon rate*. A bond that pays a coupon can also trade at a *premium* to its face value (trading above par). Imagine what would have happened in our example if interest rates had gone down to 7% instead of up to 9%. Then, the holder of the existing 8% bond would not part with it for $1000. Instead, its price would have to rise until the yield to maturity from buying it at that price would be 7%. In this case, an investor's return from the coupons is diminished by receiving a face value less than the price paid for the bond. Thus, a bond trades at a premium whenever its *yield to maturity is less than its coupon rate*.

How are bond prices quoted (corporate vs. Treasury)?

Bonds are often quoted in terms of a clean price, which is the bond's cash price less an adjustment for accrued interest, the amount of the next coupon payment that has already accrued

What are the 2 sources of return from investing in common stock?

Dividends yield and Capital gains yield

Explain the conditions that would need to exist for the Treasury yield curve to be downward and upward sloping

Downward sloping- Nominal interest rate decreasing over time. Inflation premium decreasing. Upward sloping- Nominal interest rate increasing. Inflation premium increasing.

What is equity capital?

Money received in exchange for ownership of the company.

What are characteristics of debt?

Money that a company must pay back + any accrued interest. a liability to the company. interest payments are tax deductible to the company. boilerplate- similar from company to company.

Describe the differences between APR, EAR, and simple interest. Which is used in loans? Why?

The *Effective Annual Rate (EAR)*, also known as the Annual Percentage Yield (APY) is the total amount of interest that will be earned, or paid at the end of one year, and is subject to compounding periods. An *annual percentage rate (APR)* is the annual rate charged for borrowing or earned through an investment. APR is expressed as a percentage that represents the actual yearly cost of funds over the term of a loan. *Simple interest* is when the interest on a loan or investment is calculated only on the amount initially invested or loaned.

Term structure of interest rates? The yield curve? What are the 3 components of the term structure?

The *relationship between the investment term and the interest rate* is called the term structure of interest rates. We can plot this relationship on a graph called the *yield curve*. The term structure of interest rates has 3 characteristics: 1. The change in yields of different term bonds tends to move in the same direction. 2. The yields on short-term bonds are more volatile than long-term bonds. 3. The yields on long-term bonds tend to be higher than short-term bonds.

What is the federal funds rate? How does it affect other interest rates?

The Federal Reserve determines very short-term interest rates through its influence on the *federal funds rate, which is the rate at which banks can borrow cash reserves on an overnight basis*. All other interest rates on the yield curve are set in the market and are adjusted until the supply of lending matches the demand for borrowing at each loan term. As we shall see, expectations of future interest rate changes have a major effect on investors' willingness to lend or borrow for longer terms and, therefore, on the shape of the yield curve.

What is opportunity cost of capital?

The best available expected return offered in the market on an investment of comparable risk and term to the cash flow being discounted

What is a dividend yield?

The expected annual dividend of a stock divided by its current price; the percentage return an investor expects to earn from the dividend paid by the stock.

What is a retention rate? Be able to use this to compute growth rates.

The fraction of a firm's current earnings that the firm retains.

What is the relationship between the term structure and the yield curve?

The relationship between the investment term and the interest rate is called the *term structure* of interest rates. We can plot this relationship on a graph called the *yield curve*.

What tools does the Federal Reserve use to try and influence the economy? Did it work following the financial crisis? Why or why not?

• *Lowering* the federal funds short-term interest rate, the primary policy instrument, *stimulates the economy*. • *Raising* the federal funds rate generally *slows the economy*. • Buying and selling short-term U.S. Treasury securities through open market operations is standard practice. One effective, innovative tool, the Term Auction Facility ( TAF ), stimulated the economy by providing cheap and readily available term funding to banks, large and small, on the front lines of the economy, thus encouraging them to extend credit to businesses and consumers. After reducing the policy rate to near zero to help revive the economy, the Fed instituted two Quantitative Easing (QE) programs--special purchases of government and agency securities--to increase money supply, promote lending, and according to some proponents, increase prices of riskier assets.