Finance 325 EXAM TWO
The two stage growth model requires that the g2 be ________ than the discount rate (k)
be strictly less than g2 < k However the g1 can be greater than equal to or less than k
Why is the perpetual growth model the most popular dividend discount model?
because it is simple to use "simplify as much as possible, but no more"
Why are some of the answers to the examples under the value of the actual stock price?
because the dividend growth model relies on estimates of growth and discount rate. The value of a stock is extremely sensitive to such estimates. the slightest variation in growth or discount rates can lead to a large difference in the stock price.
Why is a free cash flow model said to be a better indication of company value?
because when comparing two companies that do everything the same EXCEPT for their depreciation method, the cash flows are equal from period to period, while the net income may be different due to changes in their depreciation method.
Why was the term structure of interest rates not observable until about 1987?
becuase defualt-ree pure discount instruments with maturities greater than on year did not exist
We can calculate the tbill ask price using the ask yeild which is a bonf equivalent yeild as follows
bill price = Face Value/ 1+bond Eq. Yeild + (days to mat/365)
What is Malkiel's First Theorem?
bond prices and bond yields move in opposite directions as a bond yield increase, the price decrease and vice versa
What are "tax exempts?
bonds issued by municipal governments coupon interest paymetns on most municipal bonds are tax exempt lower interest rates generally becuase tax exempt
what are plain vanilla Bonds?
bonds issued with a relatively standard set of features also know as bullet bonds
What are general obligation bonds?
bonds secured by the gernal power of issuing the municipality.
senior debentures?
bonds that have a higher claims on the firm's assets
Premium bonds?
bonds with a price GREATER than the par value When the YTM < Coupon Rate
Discount Bonds?
bonds with a price LESS than the par value When the YTM> coupon rate
unsecured debt?
bonds, notes or other issued with no specific collateral pledged as security for the bond issue. Also call debentures
What is another difference between valuing the equity using FCF versus DDM?
for the DDM we use the equity Beta for the FCF we need to use the asset beta
How can STRIPS be created?
from a coupon payment, treasury bond payment, treasury note principal payment,
Fundamental Analysis represents and examination of what?
fundamentals and other accounting statement based data used to assess the value of the company's stock
Equation for geometric average dividend growth rate?
g= [DN/D0]^1/N -1
What is the beneit of TIPS?
gaurantee a fixed rate of return in excess of the realized inflation pay a fixed coupon rate and adjust thier principal semiannually according to the most recent inflation rates
In practice most analysts prefer to use a _______ average dividend growth rate when calculation historical growth rates.
geometric
Which is easiest to calculate the geometric of the arithmetic dividend growth rate?
geometric an arithmetic average dividend growth rate requires that we first calculate each years growth rate separately and then we average them.
When CFPS>EPS
good quality earnings
Lower coupon bonds have ______ durations
higher
What are value stocks?
stocks with lower P/E ratios viewed s "cheap" compared to current earnings
When a bond is issued with one or more special features, stircly speaking, it is no longer a ______
stright bond BUT bonds with special features have a straight componenet
In chapter one we saw that the return we expect for a risky asset has two components, what are the components?
the "Wait" component and the "worry" component
How do we measure discount rates?
the CAPM model capital asset pricing model
why would an analyst use a EV ratio over a P/E ratio
the P/E ratio is an equity ratio because the numerator is ther price per share of stock and the denominator is the earnings per share of stock the EV ratio included both debt and equity
What is the PEG ratio and why is it used?
the PEG ratio provides investors with a better method to compare comapnies particularly those with differing growth rates, the PEG is calculated by dividing the P/E ratio by the expected earnings growth rate
What is the yield to maturity?
the more important yield measure for bonds YTM discount rate that equated the bond's price with the computed present value of future cash flows. promised yeild
How do we report yearly earnings per share?
the most recent quarter EPS * 4 of the sum of the past quarters EPS
What is cash flow in the context of the price cash flow ratio?
the net income + depreciation
How do we convert APR to EAR?
1+ EAR = (1 + APR/m)^m where m is the number periods in a year discount yeild < bond equivalent yeild < EAR
Residual Income Model
a stock evaluation model for the companies that do not pay dividends.
What is the most common type of bond?
a straight bond
What report does the wall street journal produce with the interest rates for the most important money market instruments?
"money rates report" also lists foreign prim rates for Canada, European Central bank, Japan, Switzerland, Great Britain, Australia, and Hong Kong
If a company's current div. is $4 per share, and the earnings per share is $10, the what is the payout and retention ratio?
$4/$10 = 0.4 or 40% 1-0.4 = 0.6 or 60% retained
What is the Macaulay Duration
% Change in bond price = -dur. * change YTM/ (1+YTM/2) described as the effective maturity units of years
suppose the Joe company paid the following dividends at the end of each of the years indicated '13: 2.20 '10: 1.75 '12: 2.00 '09: 1.70 '11: 1.80 '08: 1.50 Calculate the arithmetic average dividend growth rate?
'13 and '12 --> (2.20 - 2.00) /2.00 = 10% '12 and '11 --> (2.00-1.80) / 1.80 = 11.11% '11 and '10 --> (1.80 - 1.75) /1.75 =2.86% '10 and '09 --> (1.75-1.70)/1.70 =2.94% '09 and '08 --> (1.7-1.5)/1.5 = 13.33% Sum of all the growth rates - 40.24 divide by 5 average is 8.05%
The expecation theory suggests that on average the (1+r2)^2 will equal______
(1+r1)(1+ r1,1)
what is the sustainable growth rate formula for figures at the end of the period?
(ROE * retention ratio)/ [1 - (ROE * retention ratio)]
What is the EV to EBITDA ratio
(equity +debt-cash) / EBITDA companies in the same industry should have similar EBITDAS
Summary of the properties of duration for straight line bonds
1. all else the same, the longer the longer the bond's maturity, the longer the duration. 2. all else the same, a bond's duration increases at a decreasing rate A maturity lengthens 3. All else the same, the higher the bond coupons, the shorter the duration. 4. All else the same, a higher yield to maturity implies a shorter duration.
disadvantages to the constant dividend growth model?
1. not usable for firms nor paying dividends 2. not usable when growth rate > discount rate 3. it is sensitive to the choice of growth rate and discount rate 4. discount rates and growth rates may be difficult to estimate accurately 5. unrealistic to assume perpetual constant growth
what is the market average beta?
1.0 so if your stock has beta of 1.50 then it has .5 or 50% more risk if your stock has beta 0.5, then it has .5 of 50% less risk then the average stock
When did the highest interest rates in US history occur?
1970s to 1980s around 14% have declined since then
What are normal maturities fro bonds?
2 to 30 years by 50 to 100 exist too
What formula is used to convert a bank discount yield to a bond equivalent yield?
365 * dis. yeild / 360-days to mat. *disc. yeild correct or maturities of 6 months or less
How many days do we use to calc. bond equivalent yeilds during a leap year?
366 days
Over the past 80 years, what as been about the average risk premium in the US?8.5 percent
8.5 percent this can be the risk premium for bearing the average mount of stock market risk but based on recent years 7% is more applicable
What is the economic value added?
A financial performance measure based on the difference between a firms actual earnings and required earnings.
An ask yield for a US treasury Strip is the _____
APR 2* semiannual rate
The yield on a bond is an _____ and therefore it understates is effective annual rate
APR calculated as 2 * semiannual yeild
the bond equivalent yeild on a tbill less than six months to mat. is an ____
APR this means it understates the true interest rate
What does AEP stand for?
American Electric Power traded on the New York Stock Exchange
The Second part of the Dupont Formula (Sales/Assets)
Asset efficiency or asset turnover measure how much sales a firm gets from each dollar in assets. increase the asset turnover, increase ROE and increase sustainable growth.
How can you find an asset beta given and equity beta?
B equity = B asset * [ 1+ Debt/Equity (1-t)] when debt = zero the asset beta= equity beta
What does the graph of interest rates for bills and bonds tell us?
Bills (short term) bonds are long term looking at the graph interest rates have generally been in a range of 6-8%
How do we calculate the bond price of a straight line bond?
Bond Price = C/YTM [1 - 1/(1+YTM/2)^2m + FV / (1+YTM/2)] where C is the annual coupon (sum of the semiannual coupons) FV is the face value M is the maturity in years YTM is the Yield to maturity
Par Bonds?
Bonds that sell at face value YTM = Coupon rate
What is the clean surplus relationship?
CSR an accounting relationship in which earnings minus dividends equals the change in the book value per share using this relationship we can prove that the Residual Income Model is equal to the Constant Perpetual Growth Model BUT the RIM can be applied to ALL companies
What is the variations to the straight line formula that allows us to calculate YTC?
Callable Bond Price= C/YTC [ 1- 1/(1+YTC/2)^2T] + CP/(1+YTC/2)^2T C --> constant annual coupon CP--> Call price of the bond T-> time in years until the earliest possible call date YTC ---> Yeild to call assuming semiannual coupons
How does value line calculate its relative P/E ratio?
Current P/E ratio / median P/E ratio of all stocks under review at value line
What is the formula to calculate the current price for a money market instrument if given the bank discount basis rate?
Current Price = Face Value * (1- Days to mat./360 * discount yield) the discount yeilf is the quoted interest rates the bigger the discount the lower the price
What is the P/E ratio?
Current Stock Price / Earnings per Share
Price sales ratio
Current Stock Price/ annual sales per share focuses on companys aility to generate slaes growth a high P/S indicates high slaes growth while low is the opposite cannot be compared in isolation from other inforation
what is the formula for the CAPM model?
Discount rate = US T-bill rate + (stock beta * stock market risk premium)
what does Dt denote?
Dividend to be paid at time t
What is the formuala for general bonds duration (bonds not selling at par value?)
Duration = 1+YTM/2/YTM - [(1+ytm/2)+M(CPR-YTM)]/ [YTM + CPR (1+ytm/s)^2m -1 )] CPR is the constant annual coupon rate M is the bond maturity in years YTM is the yield on semiannual basis
How does CSR mathematically prove RIM= Constant perpetual growth?
EPS1 - D1 = B1-B0 this means D1= EPS1+B0-B1 D1= EPS1+B0-B0(1+g) D1= EPS1+B0*g PLUGGING THE EXPRESSION IN FOR D1 P0 = EPS1+B0*g/k-g = D1/k-g
What is residual income sometimes known as?
Economic Value Added (EVA)
The Third Part of the Dupont Formula ( Assets/Equity)
Equity Multiplier captures the amount of debt or leverage the firm uses if it equals one the firm doesn't have debt increase the equity multiplier, increase ROE and increase sustainable growth.
What are the formulas to calculate the expected price based off these ratios?
Expected Price = Hisotrical P/E ratio * projected EPS* (1+ projected EPS growth rate) Expected Prices = Hisotrical P/CF ratio * projected CFPS* (1+ projectedCFPS growth rate) Expected Prices = Hisotrical P/S ratio * projected SPS* (1+ SPS growth rate)
What is the formula for Free Cash Flow?
FCF = EBIT (1-tax rate) + depreciation - capital spending - change in net working capital
REVIEW
FV = Pv (1+r)^n r is the periodic interest rate and N is the number of periods interest rate must be express as interest rate PER PERIOD rearranging the equation you get PV = FV /(1+r)^n
What does Franny Mae and Freddy Mac stand for?
Federal National Mortgage Asscoiation (FNMA) and Federla home loan mortaga corporation (FHLMC)
What is malkiels fourth theorem?
For a given absolute change in the bond's yield to maturity , the magnitude of the price increase caused by a decrease in yield is greater than the price decrease caused by the increase in yield
What is Malkiels' Second theorem?
For a given change in a bond's yield to maturity, the longer the term to maturity of the bond, the greater will be the magnitude of the change in the bond' price
What is malkiels third theorem?
For a given change in a bond's yield to maturity, the size of the change in the bond's price is inversely related to the bonds coupon rate
who sets the benchmark/ is the leading issuer of commericial paper?
General Electric Capital the interest rate they pay on their commercial paper is the benchmark. Many other institutions go slightly higher than the benchmark.
What is Ginny Mae?
Governemtn National Mortagae Association active mortgage repackager interest rates correspond to index rom many mortagae pools
Why are their four different rates for the federal fund rates?
High day the high rate during the day low day the low rate of the day the other two rates are snapshot at the end of the day" bid represents the rate to borrow and offer represents the rate to lend
For Intel the prices of stock ranges from about 32-$40 but the actual price is $26 why could this be?
Intel had a large drop in P/E ratio from 2002 to 2012 meaning that historical average price may be inaccurate
CHAPTER NINE
Interest Rates
What is the formula for modified duration?
Mod. Duration = macaulay Duration/ (1+ YTM/2) Percentage change in bond price = - mod. duration * change in YTM
Are P/E ratios stable?
NO
What is the formula for return on equity? ROE?
Net Income / Equity
Who said "prediction is difficult, especially about the future"
Niels Bohr
suppose the Joe company paid the following dividends at the end of each of the years indicated '13: 2.20 '10: 1.75 '12: 2.00 '09: 1.70 '11: 1.80 '08: 1.50 Calculate the geometric average dividend growth rate?
Notice that between 2013 and 2008 is five years. so for geometric --> 2.20 = 1.50(1+g)^5 g= 7.96%
If we assume that AEP paid dividends of $1.88 in mid 2014, the yield to maturity for T-bonds is 2.75% and the growth rate is 2% what is the P0?
P0 = $1.88 (1+0.02) / (0.0475 - 0.02) P0 = $1.2 / .0275 P0= $69.73
What is the formula for the perpetual growth rate?
P0 = D0(1+g) / k-g g<k But because D1 = D0 (1+g) we write P0= D1/ k-g where g<k
What is the Dividend Discount Model Formula?
P0 = D1/ (1+k) + D2/ (1+k)^2 + D3/ (1+k)^3 + ..... Dt/ (1+k)^t
Formula for two stage dividend growth model?
P0 = [D0(1+g1)/k-g1] (1 - (1+g1/1+k)^t) + (1+g1/1+k)^t)(D0(1+g2)/k-g2)
Using the residual income model, what the two parts to stock evaluation you must include? what assumptions must be made?
P0= B0 + EPS1 - B0*k/(1+k)^1 + EPS2 - B1*k/(1+k)^2 .... etc. the first part (B0) is the book value of the firm (what is currently invest in the firm) The second portion is the present value of all the future residual earnings Make the assumption that earnings grow at a constant rate of g
A company is currently not paying dividends. in five years it will pay diviends of 0.5 per share. the growth rate of the dividedn will be 10% indefinitely. the required return on companies such as this one is 20%. What is the price of the stock?
P4 = D4(1+g)/ (k-g) P4 = D5 /(k-g) P4 = 0.50 /(.20-.10) $5 In four years the stock is worth $5 so discount back to today $5/1.2^4 = $2.41
What is the formula for Par Value Bond duration?
Par Value Bond Duration = (1+YTM/2)/YTM [1- 1/(1+YTM/2)^2m M is the bond maturity in years YTM is the yeild to maturity assuming semiannual coupons
Suppose that the growth rate is g=4% and k=9% and the D0= $10 what is the Po?
Po = $10(1+.04) / (.09-.04) = $208
What is the relationship between YTM Coupon rate and current yeild for discount bonds bonds
Price < Par Value Coupon Rate < Current Yield < YTM
What is the relationship between YTM Coupon rate and current yeild for par value bonds?
Price = par coupon rate = current yield = YTM
What is the relationship between YTM Coupon rate and current yeild for premium bonds
Price > Par value Coupon rate > Current Yeild > YTM
What are US treasury STRIPS?
Pure discount securities create by stripping the coupons and principal payments f treasury notes and bonds into separate parts and then selling them separately.
What is the formula for required earnings per share set but a stockholder (REPS)
REPS = Bt-1 * k where Bt-1 stands for the book euqity per share at the beginning of a period that ends at time t wher k stands for the require return on investment rate
what is the formula for residual income?
RIt = EPSt - REPSt which would be RIt = EPSt - (Bt-1*k)
What is the sustainable growth rate formula for figures at the beginning of the period?
ROE * retention ratio ROE * (1-payout ratio) Net Income / Equity * (1- dividends/earnings per share)
What is the Dupont formula?
ROE = Net Income / Sales * Sales /Assets * Assets/Equity
What formula is used to calculate the price of strips?
STRIPS = face value / (1 + YTM/2)^2m where m is the number of periods
what does STRIPS stand for?
Separate Trading of Registered Interest and Principal Securities
For investor wanting long term protection agasint inlation along with safety of US treasury bonds, _________
TIPS are the perfect investment
What is the difference between the free cash flow model and the dividend discount model.
The DDM looks at solely the dividends as the relevant cash flows that will be paid directly to stockholders and the valued the equity The FCF looks at the free cash flows that are used to pay both dividends and debt collectors. This values the entire company rather than just the equity.
What is the assumption we make when calculating yields?
The investor will be able to reinvest the coupon interest payments at equalt rates to the YTM only if the investor holds the bond to matutitys and if all the coupon interest payments are are reinvested at a rate = to the YTM
ROE, net income divided by equity, can be broken down into _____ parts. This decomposition is so important it is called the ___________.
Three Dupont Formula
What are TIPS?
Treasury Inflation Protected Securities
What are the components of the CAPM formula?
U.S. T-bill rate --> return on a 90day us treasury bill Stock beta --> risk relative tot he average stock Stock risk premium --> risk for an average stock
what are Eurodollars?
U.S. dollar denominated deposits at foreign banks or foreign branches of U.S. Bank
The leading world market for debt securities is the market for _____
US treasuries securities these interest rates are closely watch throughout the world the WSJ places the rates in the "credit market" columns
Today, the term structure can be easily examined by looking at yields or ______
US treasury STRIP
What is a good example of stright bonds?
US tresury bonds used to finance nations debt
What is the formula for valuing firm based on Free Cash Flow model?
Vfirm = FCF1/k-g = FCF0(1+g)/k-g the growth is the growth in FCF NOT dividends the k is the discount rate based on asset beta not equity beta
Treasury Bill Qoutes
WSJ online give "treasury repots" gives the bid and ask discounts for each bill issued
What is the Yield to Call
YTC measure of return that assumes a bond will be redeemed at the earliest call date can us the straight line bond price formula with a few variations
Does the EV ratio have any advantage over the PE ratio?
Yes allows for comparison of companies by ther various degress of leverage
What is the coupon rate?
a bond annual coupon divided by its par value. coupon yield or nominal yield annual coupon/Par value coupn expressed as % of face value
What are callable bonds?
a bond is callable if the issuer can buy back before it matures
What is the hallmark of a good analyst?
a cautious attitude and a willingness to probe further and deeper before committing to a final investment recommendation
Why do companies with negative earnings still have value?
a company with negative earnings may still have value because of the positive cash flow net income takes into account deprecation, which is an expense but not a cash flow
What is frequently taken as an estimate of future dividend growth in a constant growth rate model?
a company's historical average dividend growth rate (sometimes this is provided in public information about the company)
What is the two stage dividend growth model?
a dividend discount model that assumes a firm will temporarily grow at a rate different from its long-term growth rate used because companies experience temporary periods of unusually high or low growth, with growth eventually converging to an industry average or economywide average. assumes that a firm will initially grow at rate g1 fro T years and then grow at g2 during a perpetual second stage of growth
What is the sustainable growth rate?
a dividend growth rate that can be sustained by a company's earnings involves using company earnings to estimate growth
What is the treasury Yield curve?
a graph of the treasury yields plotted against the maturities maturities ate on the horizontal while yields are on the vertical
What are asset and equity beta?
a measure of risk in the company the asset betas across an industry and relatively standard the equity betas across and industry can be very different
what is the bank discount basis?
a method o quoting interest rates on money market instruments. often call discount yeild NOT to be confused the the Federal Reserve discount rate
private placement?
a new bond issue sold to one or more parties in a private transactions not avaiable to public
what is bankers acceptance?
a postdated check on which a bank has guaranteed payment. commonly used to finance international trade transactions. stamp "accepted" an acceptance rate is the interest rate for the acceptances issued by the largest commercial banks
What are US t bills?
a short term Us govenmetn debt instrument issued by the us treasury world largest market for short term debt securities of one year or less to maturity lead all other credit markets in determining ther general level of short-term interest rates Money Rates reports the tbill rate set during the most recent weekly Tbill auction
What is the constant perpetual growth model?
a version of the dividend discount model in which dividens grow forever at a constant rate, and the growth is strictly less than the discount rate. (g<k) we assume the firm will pay dividends that grow at a constant rate forever.
What is duration?
a widely used measure of a bonds sensitivity to changes in bond yeilds % Change in bond price = -dur. * change YTM/ (1+YTM/2)
What has been the average return on US t bills over time?
about 4%
what has caused the interest rates to be so low in recent years? "flight to quality"
actions of FED the crash of 2008 caused more investors to switch from riskier investments, to more stable investment with lower interest rates. Because mor stable investments were in high demand, the price went up. as the prices rise, the interst rates will fall
what is a straight bond?
an IOU that obligates the issuer to pay the bondholder a fixed sum of money ath the maturity along with periodic, constant interest paymetns called coupons
How does the FED use the discount rate to affect monetary policy?
an announced change in the discount rate is often interpreted as a signla o the feds intention regarding monetary policy inc --> tight money policy. to control budding inflation pressure dec --> loose money policy, to stimulate economic activity however sometimes a change in interest is just the FED trying to catch up and be the lead goose
What is the fischer hypothesis?
an assertion that states the general level of nominal interest rates follows the general level of inflation because interest rates are in general > then inflation it logically follows that short term interest rates reflect current inflation while long term interest rates reflect invest expectations of future inflation
What is the forward rate?
an expected future interest rate implied by the current interest rates f1,1 = [(1+ r2)^2 / 1+ r1] -1 accurate predictor o r1,1 to be realized one year in the future.
pure discount bonds
an interest bearing asset that makes a single payment of face value at maturity with no paymetns becfore maturity
What is the current yield?
annual coupon/current price of bond when the price is higher than FV, then Curr. Yield < Coupon Rate when the price is higher than FV, then Curr. Yield > Coupon Rate
Today ____ note or bond is stippable
any
Historically, would a long term rate of 4% be considered low?
anything under about three percent would be considered low histroically, but many analysts feel that 4% is too low.
What are Eurodollar rates?
are interest rates paid for large denomination Eurodollars certificiates o deposit the Cds are negotiable and traded
What are yankee bonds?
are issued by foreign corporations or sale in the United States. denominated in US dollars
What is the value of an asset based on?
assertion of finance holds that the value of an asset is based on the present value of its future cash flows. thus finance attempts the difficult task of predicting the future
The simpler the examination technique the more _____ on should be.
cautious
What is the dollar value of an 01?
change in the bond price resulting from a change in yield to maturity of one basis point. one basis point is 1% of 1% or .01% (0.0001) the dollar value 01 is also known as the value basis point
Yield value of a 32nd?
change in the yield to maturity that would lead to 1/32 change in the bond price. used as a measure of interest rate risk 1/ 32* dollar value of an 01
The overnight repurchase or "repo" rate is essentially the rate charged on overnight loans that are __________ by US treasury securtiries
collaterized
What is one of the most challenging tasks in stock evaluation?
common stock evalution
At maturity, the price of both premium and discount bonds ________ to the par value
converge
what are special features on a bond?
conversion --> ability to convert bond to stock in a company putable --> grants bondholders thr right to sell their bond back to the issuer at a pre-specified price
What is market segmentation theory?
debt markets are segmented by maturity, with the result that interest rates for various maturities are determined separately in each segment
what are money market instruments?
debt obligations that have a maturity of less than one year from when they were originally issued.
What are agency securities?
debt with over 20 year maturities often has a premium over treasury debt subjected to state taxes
overtime, as they get closed and closer to maturity, the price of the premium bond _____ and the price of the discount bond ______
declines and rises
indenture summary?
description of the contractual terms of a new bond issue include in a bond's prospectus
pure discount bonds sell at a ______ relative to their ace value
discount
what is the geometric average dividend growth rate?
dividend growth rate based on a geometric average of the historical dividends
what is the arithmetic average dividend growth rate?
dividend growth rate based on an arithmetic average of the historical dividends
prospectus?
document prepares as part of a security offering detailing information about a company's financial position, its operations and investment places
r2 < r1
downward slope
what are the fundamentals of fundamental analysis?
earnings per share cash flow book equity value sales they describe on a basic level a specific firms operations and profits
what are retained earnings?
earnings that are kept in the company to finance growth
How does value line calculate dividend yeild?
estimated dividends for coming year/current stock price
What is fundamental analysis?
examination of a firm's accounting statements and other financial information to assess the economic value of the company's stocck
At maturity of TIPS what does the investor receive?
final adjusted principal amount and he/she had adjusted coupon payments throught the bonds lifer
When a premium bond and a disount bond both hace the same YT< the premium bond has _______ current yield
higher but this higher current yeild is offset but the decline in price to the par value the disadvantage of the lower current yield for discount bonds is offest by the increase of price to par value
What is the relationship between the expectations theory and the fisher projections?
if expected future inaltion is higher than current inlation then we are likely to see an upward sloping term structure where long term interest tates are higher thatn short term i future infaltion rates are lower then current level we see a down slope for term structure where long term interst rates are lower than short term taken together the expectation and fisher state that with an upward sloping term structure, the market expects that nominal interest rates and inflation are likely to be higher in the future.
Which is bigger the YTC or the YTM
if the bond is callable at par value then the YTM> YTC for Premium bond and YTM <YTC for discount bond the lower of the two (YTC or YTM is usually reported)
what if a company had a one time write-off that reduces earnings, which caused their P/E ratio to increase , should the stock price be higher?
if this is truly a one time write off, then the stock price should remain stable. the increase in the P/E would be faux A high or low P/E is not necessarily good or bad, more information is needed
In the very recent past STRIPS prices were qouted how?
in dollars and thiry-seconds of dollars 84:08 would be 84 and 8/32 so $84.25
Why is the EBITDA used in the denominator?
in the P/E ratio the equity is not affected by interest because it is subtracted before EPS is calculated Because Ev involves debt and equity and the EBITDA has interest included, the EBITDA has to be on the bottom in order for interest rates not to affect the ratio
What is the federal funds rate?
interest rate that banks charge each other for overnight loans $1million or more
What is the EuroLIBOR rate?
interest rate that rrefers to deposits denominated in the euro based largely on interest rates rom banks in the European union interbank market
What are real interest rates?
interest rates adjusted or the effect of inflation, calculated as nominal interest rate less the rate of inflation
What are nominal interest rates?
interest rates as they are normally observed and quoted, with no adjustment for inflation reported in WSJ all the ones in the chapter thus far have been nominal
What is Hibor?
interest rates based in the Hong Kong market
What are london interbank offered rates? (LIBOR)
interest rates that international banks charge one another for overnight eurodollars used to represent london money market bank lending rates are often LIBOR + premium
what are bellwether rates?
interest rates that serves as a leader or as a leading indicator of future trends interest rates as bellwether o inflation
What are the limitations of the RIM?
is makes the assumptions that the company has positive earnings?
the bond is called at the convenience of the ______
issuer
what is a limitation of the constant perpetual growth model?
it can only be applied to companies with stable dividend and earnings growth
when the debt increase what happens to equity beta?
it increases when companies take on more debt, there is increased risk for the shareholders
What does a large difference between the geometric and arithmetic average dividend growth rate indicate?
it indicates that the dividend grew erratically which calls into question the use of a constant divided growth model
What are advantages of the two stage dividend growth model?
it is more realistic bc it accounts for high low and zero growth it is usable when the first stage of growth is less than the discount rate
What are CDs? (certificate of deposit)
large denomination deposits o 100,000 or more commercial banks or a specified term. the interest rate varies according to the term for example a six month CD may pay a higher rate than a three month CD
finally when we look at a particular stock, we rec. it may be more or _____ ______ then an average stock
less risky
The duration on a bond with coupons is always ____ then its maturity
less than
Because home mortgages are _______ they are not _____ but they have a considerable influence on money market activity
long term obligations money market rates
What do fixed income securities include?
long-term debt contract rom a wide variety o issuers the largest single category of fixed income securities is debt issued the US government the second largest is mortgage debt issued to finance real estate
what is the maturity preference theory?
long-term interest rates contain a maturity premium necessary to induce lenders into making longer terms loans borrowers like long term becasue it means secure financing lenders like short becuase money isnt tied up o forever can coexist with the fisher hypothesis and expectations theory
what is the federal reserve in charge of?
managing interest rates money supply inflation and promote economic stability
In practice, many stock that look cheap may actually be at a fair price, why?
many stocks that look cheap may in fact be at the correct price due to factors that are not apparent to the analyst
Price-Book ratio
market value of a company's common stock/by the book value of the equity P/B market-book ratio appealing because book values represent historical costs measures what equity is worth today relative to what it costs ratio > 1 indicated the firm has created value Ratio < 1 indicates the firm has lost value difficult to interpret due to the chaning accounting book values
Enterprise Value Ratios (EV)
market value of the firms equity + market value of debt - cash EBITDA earnings before interest taxes depreciation and amoritization
Money market securites typically make a single payment of ace value at maturity and make no payments beore ____
maturity
Historical growth rates may or _______ be an reasonable estimate of future dividend growth. Many analysts _______ their estimates to reflect information available to them, for example, whether the growth rate appears to be _______
may not adjust sustainable
What is a stock's beta?
measures of a single stocks risk relative to a ave. stock
What is the dividend discount model? (DDM)
method of estimating the value of a share of stock as the present value of all expected future dividend payments values a share of stock as the sum of all expected future dividend payments, where the dividends are adjusted for the risk and the time value of money
Formula for dollar value of 01?
modified duration * bond price * 0.0001
What are the two forms of interest bearing assets
money market instruments and fixed income securities
Non constant growth model?
more flexible when firms don't pay dividends but still sensitive to growth and discount rates
How does value line calculate P/E ratio?
most recent stock price/ latest six months EPS + EPS estimated for the next six months
How are these ratios used to estimate furtue values of stock?
multiplying histroical average prcie ratios by and expected future vlaues fro the price ratio demominator varibale.
Are treasury bonds pure?
no they pay coupons every 6 months
do market participants always qoute interest rates the same way?
no it vaires. when we wish to compare we must put into a common form
Do all bonds experience the same interest rate risk?
no, it depends on the senesitivity of the bonds to interest rates. when we have bonds on with a 20 year matuirty and another with a 10 year maturity, all else being the same we find that when interest rates drop, both bond prices increases, but long term bond prices increase by more interest rates increase, both bond prices decrease, but the 20 year decrease but more
The estimate for AEP is well above the mid-2012 price of $38.45. Does this mean the stock was undervalued?
not necessarily. We estimate/assumed the growth and discount rate, and that the dividend grew steadily. if either of these changes, then the price of the stock can change as well.
what is the ask yield?
not quoted on discount basis "bond equivalent yeild" assumes a 365 day calendar principally used to compare yeilds on T-bills with yeilds on other money market instruments
what are bonds with maturities under 10 years called?
notes
How does the wall street journal report earnings per share?
of the sum of the past quarters EPS
How are money markets that are not quoted on a discount basis usually quoted?
on a simple interest basis calculated just like the APR annual percentage rate
What are negotiable CDS?
ones that are large deposits that can be bought and sold among investors. different the the small denomination CDs which are from banks to retail consumers. these usually have higher interest rates compared to small denomination CDs
What type of companies can the perpetual growth model be used for?
only companies that are relatively stable in earnings and that expect dividends to continue in the distant furture
what are bond without maturities called?
perpetuities or consols
What does the second term (1+g1/1+k)^t)(D0(1+g2)/k-g2) represent?
present value of all the subsequent dividends
What does the first term[D0(1+g1)/k-g1] (1 - (1+g1/1+k)^t) represent?
present value of the dividends for T years
What is the prototypicla example of a straight bond?
principal/ face value of $1000 and constant, periodic semiannual interest payments
what is a payout ratio?
proportion of earnings paid out as dividends dividends / earnings per share
what is the retention ratio?
proportion of earnings retained for reinvestment because anything not paid out is retained in the company, the retention ratio is 1- payout ratio
What do Franny Mae and reddy Mac do?
purchase large blocks of home mortgages and combine them into mortgage pools, where each mortgage pool may represent several tens of millions of dollars of home mortgages
What are zero coupon bonds?
pure discount bonds that have more than one year to maturity bond with zero coupons
when is cash flow per share reported?
quarterly can be obtained by taking the last quarterly cash flow figure and multiply by four to obtain annual cash flow
Today how are STRIPS prices?
quoted to three decimal places 93.668 is a Price of $93.668
What is Euro commercial paper?
refers to papre denominated in euros rather than dollars
What is the term structure of interest rates?
relationship between time to maturity and interest rates fir default-ree, pure discount instruments
What are we valuing of the company using the FCF model?
remember Assets = Liabilities + Equity The FCF values the company as a whole. it can however measure just equity by subtracting debt Value Firm = Value Equity + Value Of Debt so Value of Equity = Value of Firm - Value of Debt
Revenue bonds?
secured by revenues generated from specific projects, such as toll roads, airports or user ees or services.
What is a bond?
security that offers a seried pf fixed interest payments during its life along with a fixed payment of principal at maturity
What are disadvantages of the two stage dividend growth model?
sensitive to growth and discount rates not useable when firm does not pay dividends
How do banks determine the Fed funds rate?
set by a continuous bidding among banks, where banks wishing to lend funds quote "offer up rates" at which they are willing to lend" and banks wishing to borrow quote "bid rates" at which they are willing to buy.
What is commercial paper?
short-term unsecured debt issued to large corporations dominated by banks, insurance companies, financial subsidaries, of large corporations
Advantages of the constant dividend growth model?
simple to compute
Let r1 be the current interest rate on one year investment Let r2 be the current interest rate on two year investment and let r1,1 be the interest rate on one year investment in one year
so I could invest in a two year investment and in two years get Pv(1+r2)^2 or I could invest in the one year and for the first year get Pv (1+r1), then if i reinvest I would get Pv (1+r1,1) if we expect interest rate r1,1 > r2 we might choose strategy two Strategy two has more uncertainty
For most firms the dividend policy is relatively ______. Thus, major changes in sustainable growth come form changes in _____. Thus, an understanding of ______ is critical when analyzing a stock price.
stable ROE ROE
What are growth stocks?
stocks with a high P/E ratio companies with higher earning growth expectancy will have higher P/E ratios Ex. Starbucks
What is the actual rate and why does it differ from the YTM
the actual rate earned on the ban can be lower or higher then the YTM it depends on how long the investor holds the bond and the rate at which the coupon payments are reinvested differs from the Yield to maturity because the bondholder reinvests at differnt rates.
what does k denote?
the appropriate risk-adjusted discount risk
When the a company's historical average dividend growth rate is not provided in public information about the company, what are the two ways to calculate it?
the arithmetic dividend growth rate average or the geometric dividend growth rate average
What are prime rates?
the basic interest rates on short-terms loans that largest commercial banks charge to their most creditworthy corporate customers.
What is the value line investment survey?
the best one page company summaries for individual companies
What is the federal reserve?
the central bank o the United States
What is the price cash flow ratio?
the company's current stock price divided by its annual cash flow per share
A particular useful and simple form of Dividend growth model is ______
the constant perpetual growth model
what is the coupon?
the constant, periodic interest payments on the bonds
What two factors are needed to estimate sustainable growth?
the dividend payout ratio and ROE
What is the duration of a zero coupon?
the duration of a zero coupon bond is equal to the maturity
What is an example of a industry/company that the perpetual growth model could be used for?
the electric utility industry
What is residual income?
the excess of actual earnings over required earnings. value created by the firm in period t the difference between the actual Earnings per share and the Require earnings per share in a period
What are the two components of the bond pricing formula?
the first component is the PV of all the coupon payments the second component is the PV of the principal payment at maturity
what would a growth rate the was bigger than the discount rate imply? (g >k)
the formula is not valid implies infinite value because the present value of the dividends keeps getting bigger and bigger No security can have infinite value, the requirement of g<k makes economic sense
for discount bond, when holding the coupon rate and yield to maturity constant the longer the term to maturity of the bond ________
the greater the discount is from par
for premium bonds, when holding the coupon rate and yield to maturity constant the longer the term to maturity of the bond ________
the greater the premium over par value
What is the H-model?
the growth rate is most likely to start at a high level and then OVER TIME decrease to a steady growth rate the H-model assume linear decline over time to reach the new, steady growth rate.
How is the duration for a bond with multiply cash flows calculated?
the individual cash flows are weighted by their maturities the weight are proportionate to the PV of each cash flow
What is the call money rate?
the interest rate brokerage firms pay for call money loans, which are bank loans to brokerage firms. This rate is used as the basis for customer rates on margin loans Brokers charge the customer the call money rate + a premium
How do we caluclate APR?
the interest rate per period * the number o periods so if the interest rate is 1% per month, then the APR is 12%
What is the federal reserve discount rate?
the interest rate the Fed oers to commercial banks or overnight reserve loans pivotal or commercial banks who need money supply to maintain sufficient capital for their deposits. closely linked to the federal funds rate
How does the government subsidize debt?
the interest rates paid on loans by a company are tax deductible as an expense thus the cost of debt is partially subsidized
what does the treasury yield curve represent?
the interest rates that financial markets are charging to the world's largest debtor with the world's highest credit rating The US government represents the interest rates for default-free lending across the maturity spectrum
What is the earning yeild ratio?
the inverse of the P/e ratio Earnings Per Share/ Current Stock Price
When the EPS is relatively large compare to the CFPS?
the is a signal that the earnings were no Quality earnings, this means there was not much cash flow
what does call at par me?
the issuer call the bond and paid par to buy it back
What other information is also examined in the process?
the management quality products product markets
Consider the case of a company that is currently not paying dividends, we predict that in five years the company will begin to pay dividends for the first time? what model should we use to calculate the price of the stock?
the non constant growth model
what is the bond principle?
the par value, stated value, or face value fixed sum of money paid at maturity
what is the call protection period?
the period during which a callable bond cannot be called. Also called a call deferment period example who be a 20 year bond that is not callable until after the intital 5 years.
What impacted the low interest rates for short term bills from 1930 to 1960?
the policies put in place by the federal reserve board. proved disasterous now the FED focuses on controlling inflation.
What is interest rate risk?
the possibility that changes in interest rates will result in losses in a bond's value
Consider that a dividend yield of a common stock (large company) may be 2%, what doe this imply? Why doe valuing a stock necessarily involve predicting the future?
the present value of dividends to be paid over the next ten years constitutes only a portion of the current stock price. much of the value of a stock is derived from dividends to be paid more than 10 years away.
what does P0 denote?
the present value of future cash dividend streams
What is a make whole price?
the present value of the bond's remaining cash flows the discount rates used to caluclate the present value is often the yield of a comparable maturity treasury bond plus a pre-specified premium this is to compensate for the fact that when a bond is called, the bondholder no longer receives interest payments
what is the dirty price?
the price of the bond including accrued interest, also known as the full or invoice price. This is the price the buyer actually pays what i actually pay
what is the clean price?
the price of the bond net of accrued interest, this is the price that is typically quoted purely qouted conventions
what is the call price?
the price the issuer of a callable bong must pay to buy it back often equal to face value but can be higher
The most popular ratio used to assess the value of common stock is ____
the price-earnings ratio (P/E ratio)
What is the handle?
the quantity to the left of the decimal place when stating interest rates
What does the real interest rate measure?
the real change in purchasing power
What is the "worry" componenet?
the risk premium the greater the risk, the more the return and the greater the risk premium
What is the expectations Theory?
the term structure o interest rates is a relection of financial market beliefs regarding future interest rates up slope --> increase Down slope --> decrease No slope --> no change in rates
What does t denote?
the time based in the TERMINAL, or last dividend to be paid
What does one of the fundamental principles of finance say in regards to stock evaluation?
the value of a security equals the sum of the FUTURE cash flows, where the cash flows are adjusted for the risk and the time value of money (aka discounted back to present value and added up)
What is the realized yeild?
the yield actually earned or realized on a bond, almost never exactly equal to yeild to maturity due to flucations in interest rates a bonds realized yield= promised yield iff there is not a change in interst rates over the time of the bond
what is a common problem with sustainable growth rates?
they are very sensitive to year-to-year fluctuations in earnings. security analysts routinely adjust sustainable growth rate estimates to smooth out the effects of earnings variations
what can be done with a company's earnings?
they can be paid out to shareholders in the form of dividends of they can be put back into the company in retained earnings
How Do managers use the Dupont Formula to make finance decisions within the company?
they can increase the firms sustainable growth rate by: payout a smaller percent of earnings increase profitability or asset efficiency increase debt causing an increase in the equity multiplier Anyway that increase ROE will also increase the sustainable growth rate
When the EPS is not significantly large the the Cash flow per share, what is this a signal off?
this is a good signal of good quality earnings "quality" meaning the earnings had actual cash flows
The first part of the Dupont Formula (Net Income /Sales)
this is the net profit margin. measure the amount of income the company generates from each dollar of sales. increase the net profit margin, increase ROE and increase sustainable growth.
interest rates reported for Tax exempt based on what indexes?
those for high-quality municipal bonds corresponding to maturities of 712 years and 2-22 years for General obligation bonfs
What is the "wait" component?
time value of money component can be measure as the return we earn from essentially riskless investment. here we use the 90 day t-bill
why do companies generally issue bonds at par?
to avoid having to amortize the bonds to par over time picks a coupon rate the matches the required return on the bond when the bond is issued
What is the purpose of stock evaluation?
to identify undervalued "cheap" stock to purchase and overvalued "rich" stock to sell.
Why are simply techniques to stock evaluation require more cautious action/decisions?
too simple techniques that rely on widely available information are not likely to yield systematically superior investment results. In fact, the could be unnecessarily risky investment decisions.
What is important about interest rates?
trillions of dollars in t interest-bearing assets are outstanding and thus interest rates play a pivotal role in the health of our financial and economic economy. Interest rates are key determinants of asset values higher rates higher values
i r2 > r1
upword slope term sturture
almost all other domestic interest rates are determined in respect to what?
us treasury interest rates
the bill ask discount?
used by treasury bill dealers to state what they are willing to accept to sell a tbill
the bill bid discount?
used by treasury bill dealers to state what they are willing to pay for each bill issue
Who said "if a business is worth a dollar and I can buy it for 40 cents, something good may happen t0 me"
warren buffet
How can we simplify P0= B0 + EPS1 - B0*k/(1+k)^1 + EPS2 - B1*k/(1+k)^2 ....
we can make it P0 = B0 + (EPS0 (1+g) - B0*k)/(k-g) writing both terms with a common denominator you get P0 = {EPS1 - B0* g] /(k-g)
What is the effective annual rate?
what a money market is really going to pay you, the REAL interest rate annually
when would an issuer call a bond?
when there is a drop in market interest rates allows them to refinance and sell new bonds that pay lower coupons
What is a basis point?
with regard to interest rates or bond yeilds, one basis point is one percent of one percent if interest rate increases from 5.82, to 5,94 it increased by .94-.82= .12 or 12 basis points
Does looking at history help to determine a suitable level of interest rates?
yes, we can compare today interest rates to graphs like that see in figure 9.1 on page 333
What is the difference between the yield curve and the term structure of interest rates?
yield curve is base on coupon bonds whereas the term structure is based on pure discount instruments the term structure is sometimes called the zero coupon yield curve
what is the the rule of thumb for determining the risk-adjusted rate of an electric utility company?
yield to maturity of the T-Bond + 2%
what does an upward yield curve predict?
yields will be higher inthe future
what does a downward yield curve predict?
yileds will be lower int he uture because lower interest rates are associated with recessionary conditions, some market watchers view an inverted curve as a negative signal
