Finance 301 - Exam 2
An investor just purchased a 10-year, $1,000 par value bond. The coupon rate on this bond is 8 percent annually, with interest being paid every 6 months. If the investor expects to earn a 10 percent simple rate of return on this bond, how much should she pay for it? (Round the answer to two decimal places.)
$875.38
A portfolio is made up of Stocks A, B, C, and D in the proportion of 20%, 30%, 25%, and 25% respectively. The nondiversifiable risks of the stocks as measured by their betas are 0.4, 1.2, 2.5, and 1.75 for Stock A, B, C, and D respectively. The expected returns of the stocks are 12%, 24%, 30%, and 28% respectively. Measure the beta of the portfolio.
1.5
Tony's Pizzeria plans to issue bonds with a par value of $1,000 and 10 years to maturity. These bonds will pay $45 interest every 6 months. Current market conditions are such that the bonds will be sold at net $937.79. What is the yield to maturity (YTM) of the issue as a broker would quote it to an investor? (Round the answer to the nearest whole number.)
10%
A stock has a beta coefficient, β, equal to 1.20.The risk premium associated with the market is 9 percent, and the risk-free rate is 5 percent. Application of the capital asset pricing model indicates that the stock's appropriate return should be _____.
15.8%
Cold Boxes Corporation has 100 bonds outstanding with a maturity value of $1,000. The required rate of return on these bonds is currently 10 percent, and interest is paid semiannually. The bonds mature in 5 years, and their current market value is $768 per bond. The annual coupon interest rate is: (Round the answer to the nearest whole number.)
4%.
Scubapro Corporation currently has 500,000 shares outstanding and plans to issue 200,000 more shares in a seasoned equity offering. The current shareholders have preemptive rights on any new issue of stock by Scubapro Corporation. How many shares of stocks would an investor with 20,000 shares, who exercises his preemptive rights on the new stock issue, have the right to buy?
8000
10% Coupon, 8% Current Int, 14-year, $1000 bonds compounded Semi-Annually
= $1,166.63
Which of the following statements is true about a zero coupon bond? a. A zero coupon bond is taxed as a capital gain at the time the bond matures. b. A zero coupon bond is issued at a substantial discount below its par value. c. A zero coupon bond is issued at a coupon rate that adjusts for inflation. d. The interest received every year on a zero coupon bond is taxed as interest income. e. The discount on the issue of a zero coupon bond is written off over its life in the investor's financial statement.
A Zero Coupon bond is issued at a substantial discount below par value
Rick bought a bond when it was issued by Macroflex Corporation 14 years ago. The bond, which has a $1,000 face value and a coupon rate equal to 10 percent, matures in six years. Interest is paid every six months; the next interest payment is scheduled for six months from today. If the yield on similar risk investments is 14 percent, the current market value (price) of the bond is: (Round the answer to two decimal places.)
$841.15
Assume that an investor wishes to purchase a 20-year bond with a maturity value of $1,000 and semiannual interest payments of $40. If the investor requires a 10 percent simple yield to maturity on this investment, what is the maximum price she should be willing to pay for the bond? (Round the answer to the nearest whole number.)
$828
Regarding Beta Coefficients, The entire market is
extremely well diversified (theoretically perfectly diversified), because it includes all investments (ie, Beta = 0)
Market value of a bond will always approach its par value as its
maturity date approaches, provided the firm does not go bankrupt
The principal value of debt
must be repaid at some point during the life of the debt to the investors.
Firm-Specific Risk(Unsystematic)
part of a security's risk associated with random outcomes generated by events, or behaviors, specific to the firm Eliminated by proper diversification AKA Diversifiable Risk
Increase in interest rates causes
prices of an outstanding bond to fall
Positively correlated stocks (r > 0) have rates of
return that consistently move in the same direction.
b = 1.0
stock has the same systematic risk as the average stock (same as the market).
b = 2.0
stock is twice as risky as the average stock
Investment Grade Bonds
the lowest-rated bonds that many banks and other institutional investors can legally hold
Investment Grade Bonds are
the lowest-rated bonds that many banks and other institutional investors can legally hold
A debt is said to be selling at par when:
the market value is equal to the face value of the debt
The expected rate of return of an investment =
the mean value of the probability distribution of possible returns
Decrease in interest rates causes
the price to rise
The face value of a debt is:
the principal value written on the face, or outside cover, of a debt contract.
If the expected rate of return on a stock exceeds the required rate, it means that,
the stock is a good buy
Growth Rate Year 1-3: 20% Year 4 = 5% (Constant) Dividend(0) = $1.00 Required Rate of Return = 15% What is the Value of the Stock?
$15.1985
A share of common stock has a current price of $82.50 and is expected to grow at a constant rate of 10 percent. If you require a 14 percent rate of return, what is the current dividend on this stock?
$3.00
Recently, Ohio Hospitals Inc. filed for bankruptcy. The firm was reorganized as American Hospitals Inc., and the court permitted a new indenture on an outstanding bond issue to be put into effect. The issue has 10 years to maturity and a coupon rate of 10 percent, paid annually. The new agreement allows the firm to pay no interest for 5 years. Then, interest payments will be resumed for the next 5 years. Finally, at maturity (Year 10), the principal plus the interest that was not paid during the first 5 years will be paid. However, no interest will be paid on the deferred interest. If the required return is 20 percent, what should the bonds sell for in the market today? (Round the answer to two decimal places.)
$362.44
A firm expects to pay dividends at the end of each of the next four years of $2.00, $1.50, $2.50, and $3.50. If growth is then expected to level off at 8 percent, and if you require a 14 percent rate of return, how much should you be willing to pay for this stock?
$43.97
The last dividend on Spirex Corporation's common stock was $4.00, and the expected growth rate is 10 percent. If you require a rate of return of 20 percent, what is the highest price you should be willing to pay for this stock?
$44
An investor is contemplating the purchase of a 20-year bond that pays $50 interest every six months. The investor plans to hold the bond only for 10 years, at which time she will sell it in the marketplace. She requires a 12 percent annual return but believes the market will require only an 8 percent return when she sells the bond 10 years from now. Assuming she is a rational investor, how much should she be willing to pay for the bond today? (Round the answer to two decimal places.)
$927.68
Bond Rating Criteria
1. Financial Strength of the Company 2. Collateral Provisions 3. Seniority of the debt 4. Restrictive Covenants 5. Sinking Fund or Deferred Call 6. Provision 7. Litigation Possibilities 8. Regulation
What are Indexed (Purchasing Power) Bond
A bond with interest payments that are based on an inflation index; helps protect the bondholder from inflation
Bond Ratings indicate what?
A bond's rating is an indication of its default risk.
What is a bond?
A loan to a firm, a gov't, or an individual To Firm: Bond To Gov't: T-Bill, T-Note, T-Bond Individual: Mortgage, Auto-Loan
Define Bonds(Public Debt)
A long-term contract where a borrower agrees to make payments of interest during the life of the loan and then repay the principal amount borrowed at the end of the life of the bond.
Beta Coefficient, b
A measure of the extent to which the returns on a given stock move with the stock market, which represents an "average" stock
What is a sinking fund as a bond contract feature?
A required annual payment designed to pay off a bond or preferred stock issue.
Which of the following events would make it less likely for a company to choose to call its outstanding callable bonds?
An increase in interest rates
Going Rate of Interest (Rd) = Coupon Rate bond will sell at...
Bond will sell at it's par value
What are Zero (or Very Low) Coupon Bonds
Bonds that pay no annual interest; sold at a discount below par
Types of Unsystemic Risks
Business Financial Default
Which of the following ratings by Standard & Poor's (S&P) indicates speculative bonds?
CCC
2 Ways Firms handle sinking funds:
Call in for redemption a certain percentage of the bonds each year Buy the required amount of bonds in the open market
A(n) _____ can be exchanged for shares of equity at the owner's discretion.
Convertible Bond
Bond Yield =
Current Yield (I/Y) + Capital Gains Yield
Capital Asset Pricing Model
Determines the required return on an asset, based on the proposition that any asset's required rate of return should equal the risk-free return plus a risk premium that reflects the asset's nondiversifiable risk
If the bond pays 6% coupon, and the current interest rate is 7%, the bond will be trading at a
Discount
When Market Price< Par Value
Discount Bond
Treasury Bills are
Discounted securities issued by the US Gov't to finance operations
Which of the following is true about the payment of dividends by a firm? Dividends are paid only to the bondholders of the firm Common stockholders have priority to dividends Preferred stock will pay accumulated dividents only once Growth stocks pay little or no dividends and instead retain their earnings each year Common stockholders will receive a fixed amount of dividend every year
Growth stocks pay little or no dividends and instead retain most of their earnings each year
What conditions must hold in order for a stock to be evaluated using the constant growth model?
Explain how to find the value of a non-constant growth stock.
A call provision gives bondholders the right to demand, or "call for," the repayment of a bond. Typically, calls are exercised if interest rates rise, because when rates rise the bondholder can get the principal amount back and reinvest it elsewhere at higher rates. True or False
False
As junk bonds are such high-risk instruments, the returns on such bonds aren't very high. True or False
False
If ABC tech co. is trading at a P/E of 35 while the technology industry is trading at a P/E of 30, the ABC stock is considered undervalued. True or False
False
If we view P/E ratios as measures of payback, all else equal, higher earnings multipliers are better True or False
False
Systematic risk is diversifiable, so it is an investment's relevant risk. Unsystematic risk is nondiversifiable risk and therefore not relevant. True or False
False
Which of the following statements about beta is correct? a. Firms with greater systematic risk volatilities than the market have betas that are less than 1.0, and firms with smaller systematic risk volatilities than the market have betas that are greater than 1.0. b. Firms with greater systematic risk volatilities than the market have betas that are greater than 1.0, and firms with smaller systematic risk volatilities than the market have betas that are less than 1.0. c. Firms with greater systematic risk volatilities than the market have betas that are less than zero, and firms with smaller systematic risk volatilities than the market have betas that are greater than zero. d. Firms with greater unsystematic risk volatilities than the market have betas that are less than 1.0, and firms with smaller unsystematic risk volatilities than the market have betas that are greater than 1.0. e. Firms with greater unsystematic risk volatilities than the market have betas that are greater than 1.0, and firms with smaller unsystematic risk volatilities than the market have betas that are less than 1.0.
Firms with greater systematic risk volatilities than the market have betas that are greater than 1.0, and firms with smaller systematic risk volatilities than the market have betas that are less than 1.0. (b)
Which of the following types of bonds protects a bondholder against increases in interest rates?
Floating-rate bonds
What are Junk Bonds
High-yield, high-risk bonds generally used to finance mergers, leveraged buyouts, and troubled companies
A bond that only pays interest if the firm has sufficient earnings to cover the interest payments is called a(n):
Income Bond
What is Risk-Return
Increase in potential return with an increase in risk. Low uncertainty = Low return High Uncertainty = High Return
On January 3, 2016, the stock price of a firm was $25 and on January 4, 2016, it reduced to $19. Which of the following is a probable reason for the decrease in the stock price?
Increased rate of return
Most bonds are purchased by?
Institutional Investors who are legally restricted to investment-grade securities (Baa or higher).
Types of Systemic Risk
Interest Rates Inflation Maturity Liquidity Exchange Rate Political
Price Per Earnings Ratio
Market Price Per Share of Common Stock/Earnings Per Share
Define Term Loans(Private Debt)
Loans obtained from a financial institution, on which the borrower agrees to make a series of payments, consisting of interest and principal, on specific dates.
Suppose that you were offered a 10-year, 8 percent coupon, $1,000 par value bond at a price of $875. Interest from this bond is paid semiannually. What is this bond's YTM?
N = 20 I/Y=? PV = -875 PMT = 40 FV = $1000 I/Y = 5% is the six-month rate or return. YTM = 5% × 2 = 10% = Annual rate of return
Suppose that the bond can be called in four (4) years at a call price of $1,080.
N = 8 I/Y=?? PV = -$875 PMT = $40 FV = $1080 = 6.87*2 =13.74%
Repurchase Agreements are
One firms sells assets to another firm with the promise to repurchase the securities later at a higher price
Federal Funds are
Overnight loans from one bank to another (required reserve)
Bond Value =
PV of Int + PV of M
When Market Price = Par Value
Par Bond
Define Market Risk
Part of a security's risk that cannot be eliminated through
What is a convertible feature as a bond contract feature? What's One-Way Conversion?
Permits the bondholder to convert the bond into shares of common stock at a fixed price Investors Cannot Convert the stocks back to bonds
Money Market Mutual Funds Are
Pooled funds that are invested in money market instruments and managed by investment companies
Which of the following is included in the call provision of a preferred stock? Preferred stockholders can elect members of the board and vote on corporate issues Preferred stockholders have priority over common stockholders with regard to assets of the firm Preferred stockholders have the right to receive dividends not previously paid, to be disbursed before any common stock dividend can be paid Preferred stock can be redeemed by incorporating a maturity option to a preferred stock issue Preferred stock can participate with the common stock in sharing the firm's eaernings
Preferred stock can be redeemed by incorporating a maturity option to a preferred stock issue.
When Market price > Par Value
Premium Bond
What is refunding as a Bond Contract Feature?
Retiring an existing bond issue using the proceeds of a newly issued bond
Negatively correlated stocks (r < 0) have rates of
Return that consistently move in opposite directions
Required Rate of Return =?
Risk Free Premium + Premium for Risk Risk Free + (Return on the Market - Risk Free)
Coefficient of Variation = CV =
Risk/Return STD.Dev/Expected Return
What is a Coupon Payment
The specified number of dollars of interest paid each period on a bond, generally each 6 months
Higher P/E? Stock is? (Compared with Industry) Investors pay ___ for company's earnings ______ Stock
Stock is OVERVALUED Investors pay MORE GROWTH Stock
Lower P/E Stock is_____? Investors pay ___ for company's earnings? _____ Stock
Stock is UNDERVALUED Investors pay LESS VALUE stock
b = 0.5
Stock is only half as volatile, or risky, as the average stock.
Define Face Value, Par Value (FV)
The amount of money the firm borrows and promises to repay at some future date (maturity).
Portfolio Beta Coefficients
The beta of any set of securities is the weighted average of the individual securities' betas
What are Floating-rate bonds
The bond's rate "floats" with market interest rates rather than with the inflation rate.
Define Yield To Maturity (TYM)
YTM is the average rate of return earned on a bond if it is held to maturity
Interest Rate Price Risk
The risk of changes in bond prices to which investors are exposed due to changing interest rates
Interest Rate Reinvestment Rate Risk
The risk that income from a bond portfolio will vary because cash flows have to be reinvested at current (perhaps lower) market rates.
Types of Combined Risk
Total Corporate
Draw the Bonds Rating Chart
Triple-A and Double-A bonds are extremely safe
Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average market risk will tend to be more volatile than an average stock, and it will have a beta which is greater than 1.0. True or False
True
Regardless of the size of the coupon payment, the price of a bond moves in the opposite direction to interest rate movements. For example, if interest rates rise, bond prices fall. True or False
True
Restrictive covenants are designed to protect both the bondholder and the issuer even though they may constrain the actions of the firm's managers. Such covenants are contained in the bond's indenture. True or False
True
The standard deviation is calculated as the weighted average of all the deviations from the expected value, and it indicates how far above or below the expected value the actual value is expected to be. True or False
True
There is an inverse relationship between bond ratings and the required return on a bond. The required return is lowest for AAA rated bonds, and required returns increase as the ratings get lower (worse). True or False
True
Which kind of risk is eliminated by diversification
Unsystematic Risk (Business Decisions)
Measure of Risk is?
Volatility
Portfolio Return
Weighted Average Return on the stocks held to the portfolio
What are the two components of most stocks' expected total return?
Write out and explain the valuation formula for a constant growth stock. (D(1+g))/(r+g)
Yield to Call
YTC is the average rate of return earned on a bond if it is held until the first call date.
Changes in ratings affect
a firm's ability to borrow long-term capital and the cost of using that capital.
Define Indenture
a formal agreement (contract) between the issuer of a bond and the bondholders.
What is a Call Provision as a bond contract feature
a provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal maturity date.
What is a Restrictive Covenant
a provision in a debt contract that constrains the actions of the borrower.
Define Trustee
an official who ensures that the bondholders' interests are protected and the terms of the indenture are carried out.
Changes in stock prices move in the same direction as
changes in cash flows expected from the stock in the future
Changes in stock prices move...
changes in stock prices move opposite to changes in rates of return.
Risk Reduction is done by
combining stocks that are not positively correlated (Smaller number of + correlation = Better) increasing number of stocks The greater the negative correlation of a stock with a portfolio, the greater the diversification effect of adding it to the portfolio.