Finance 341 2

What is the Security Market Line?

'The return line that reflects the attitudes of investors regarding the minimum acceptable return for a given level of systematic risk associated with a security.

How do you calculate Monthly Holding Return?

(Price at end of month/price at beginning of month) - 1

How do you calculate the Required Return on Security?

(Risk Free Rate of Return) + ((Beta for security X (Required Return on market portfolio - Risk Free Rate of Return)

What are Eurobonds? What are the primary attractions of them?

1) A bond issued in a country different from the one in which the currency of the bond is denominated 2) Favorable Rates; Relative lack of Regulation (Not registered with the SEC); Less-rigorous disclosure than the SEC; and can be issued quickly. 3) They cant be offered to US Citizens and residents

What are Mortgage Bonds?

1) A bond secured by a lien on real property

What is a Subordinated Debenture?

1) A debenture that is subordinated to other debentures in terms of payments in case of insolvency 2) The claims of this are only honored after the claims of secured debt and unsubordinated debentures are satisfied

What are Convertible Bonds?

1) A debt security that can be converted into a firm's stock at a pre-specified price.

What are Bond Ratings affected by?

1) A greater reliance on equity as opposed to debt in financing the firm 2) Profitable Operations 3) A low variability in past earnings 4) Large Firm size 5) Little use of subordinated debt

In terms of Retirement Provisions, What is a Call Provision? What is a Sinking-Fund Provision?

1) A provision that entitles a corporation to repurchase its preferred stock from investors at stated prices over specified periods. (Usually requires buyers to pay an initial premium of approx. 10% above par or issuing price.) 2) A protective provision that requires firms to periodically set aside an amount of money for the retirement of its preferred stock. The money is then used to purchase preferred stock on the open market, or through use of the call provision, whichever is cheaper.

What is the Intrinsic (Economic) Value?

1) Also called fair value 2) The present value of an asset's expected future cash flows 3) This is the value that the investor considers to be fair given the amount, timing, and riskiness of future cash flows.

What is a Preemptive Right?

Entitles the common shareholder to maintain a proportionate share of ownership in the firm.

What is a Debenture? What is a risk? What is an advantage?

1) Any unsecured long-term debt 2) More risky than a secured bond and in return must provide investors with a higher yield 3) No property has to be secured by them, this allows the firm to issue debt and still preserve some future borrowing power.

How is preferred stock similar to common stock?

1) Both have no fixed maturity date 2) If a firm does not pay dividends, it does not bring on bankruptcy 3) Dividends are not deductible for tax purposes

What is CAPM?

1) Capital Asset Pricing Model 2) an equation that equates the expected rate of return on a stock to the risk free rate + a risk premium for the stock's systematic risk.

What 3 elements are involved in valuing a bond?

1) Cash flow information 2) Term to Maturity 3) Investors required rate of return

What are the characteristics of common stock?

1) Claim on Income 2) Claim on Assets 3) Limited Liability 4) Voting Rights 5) Preemptive Rights

What are important terms and characteristics you may hear about bonds?

1) Claims on Assets and Income 2) Par Value 3) Coupon Interest Rate 4) Maturity 5) Call Provision 6) Indenture 7) Bond Ratings

What are the 6 types of investments that date back to 1926 that are continuing?

1) Common Stocks of large companies 2) Common Stocks of small firms 3) Long-term corporate bonds 4) Long-term US government bonds 5) Intermediate-term US government bonds 6) US Treasury Bills (short-term government securities)

What is Claim on Income of common stock? What are advantages and disadvantages?

1) Common shareholders have the right to residual income after creditors and preferred stockholders have been paid. 2) A: Potential Return is limitless 3) D: If the bond and preferred stock claims on income totally absorb earnings, common shareholders receive nothing.

What are some examples of a Bond?

1) Debentures 2) Subordinated Debentures 3) Mortgage Bonds 4) Eurobonds 5) Convertible Bonds

What are the typical components to the "blended rate?" (WACC)

1) Debt 2) Equity Financing

What is the difference between discount and premium bonds?

1) Discount: a bond that sells at a discount or below par value 2) Premium: a bond that is selling above par value

What is a Proxy? What are Proxy fights?

1) Gives a designated party the temporary power of attorney to vote for the signee at the corporation's annual meeting. 2) Battles between rival groups for Proxy votes

What is Claim on Assets of common stock?

1) Have residual claim on assets in case of liquidation 2) When bankruptcy occurs the claims usually go unsatisfied because debt holders and preferred stockholders have 1 and 2nd claim on assets.

What are junk bonds?

1) High-risk debt, with rating BB or below 2) The lower the rating the higher the chance of default 3) CC is the lowest rating

What are the characteristics of Preferred Stock?

1) Multiple series of preferred stock 2) Preferred stock's claim on assets and income (has priority over common stock, firm must pay preferred dividends before common stock dividends) 3) Cumulative Dividends 4) Protective Provisions 5) Convertibility 6) Retirement Provisions

What determines cash flows associated with a bond?

1) Par Value 2) Coupon Interest Rate

What are some restrictive provisions provided in the indenture?

1) Prohibiting the sale of the firm's accounts receivable 2) Limiting common stock dividends 3) Restricting the purchase or sale of the firm's fixed assets 4) Setting limits on additional borrowing by the firm

What are Protective Provisions?

1) Protect the investor's interest 2) The provisions generally allow for voting rights in the event of nonpayment dividends, or they restrict the payment of common stock dividends if preferred stock payments are not met for if the firm is in financial difficulty.

What are Cumulative Features?

1) Related to cumulative dividends 2) It requires all past, unpaid preferred stock dividends be paid before any common stock dividends are declared.

What are the 2 primary advantages of CAPM?

1) Simple; easy to understand and implement 2) the model does not rely on dividends or any growth rate assumption, so it can be applied to companies that do not currently pay dividends or are not expected to experience a constant rate of growth in dividends.

What is the principal advantage and primary drawback of the dividend growth model as a basis for calculating a firm's cost of capital as it relates to common stock?

1) Simplicity of the model 2) Applicability or appropriateness of the valuation model

Which factors drive a wedge between the investor's rate of return and the cost of capital (what makes them not the same)?

1) Taxes 2) Flotation Costs (costs firm incurs when it raises funds by issuing a particular type of security

What 3 elements affects value?

1) The amount and timing of the asset's expected cash flows 2) The riskiness of these cash flows 3) The investor's required rate of return for undertaking the investment

What is Portfolio Beta? How do you calculate it?

1) The average of individual stock betas 2) (percentage of portfolio invested in asset 1 x beta for asset 1) + (% of portfolio in asset 2 x beta for asset 2) + etc.

What is Divisional WACC (Weighted Average Cost of Capital)? What are the advantages of using it?

1) The cost of capital for a specific business unit or division 2) It provides different discount rates that reflect differences in the systematic risk of the projects evaluated by different divisions 3) It entails only one cost of capital estimate per division, thereby minimizing time and effort of estimating cost of capital 4) The use of common discount rate throughout division limits the managerial latitude and the attendant influence costs

What are key factors that drive the cost of capital?

1) The fact that investors demand compensation for inflation 2) The fact that investors prefer earlier cash flows to later cash flows 3) The fact that investors demand compensation for taking on risk

What is an indenture?

1) The legal agreement between the firm issuing the bonds and the trustee who represents the bondholder. 2) Provides specific terms of the loan agreement, description of the bond, rights of the bondholders and issuing firm, and responsibilities of trustee. 2) May run 100 or more pages in length

What is Beta?

1) The slope of the characteristic line 2) the relationship between an investment's returns and the market's returns. 3) A measure of the investment's nondiversifiable risk

What are the 3 Bond Valuation Relationships?

1) The value of a bond is inversely related to changes in the investor's required rate of return. 2) The market value of a bond will be less than the par value if the required rate of return of investors is above the coupon interest rate 3) Long-term bonds have greater interest rate risk than short-term bonds

Which questions should we consider in the study of risk?

1) What is risk? 2) How do we know the amount of risk associated with a given investment? (How do we measure risk) 3) If we choose to diversify our investments by owning more than one asset, will such diversification reduce the riskiness of our combined portfolio of investments?

When does the size disparity problem occur? What other problems happen?

1) When mutually exclusive projects of unequal size are examined. 2) Time disparity problem 3) Unequal lives problem

What is asset allocation?

1) diversifying among different kinds of assets 2) Identifying and selecting the asset classes appropriate for a specific investment portfolio and determining the proportions of those assets within the portfolio.

What is an Investor's required rate of return? How do you calculate it?

1) minimum rate of return necessary to attract an investor to purchase or hold a security. 2) risk-free rate of return + risk premium

What is a Market or Systematic risk?

1) results from factors that affect all stocks 2) cannot be eliminated through diversification

What is Risk Premium? How do you calculate it?

1) the additional return expected for assuming risk 2) Investors required rate of return - risk free rate of return

What is a realized rate of return? What is it also known as?

1) the rate of return earned on an investment (Dollar Gain/amount invested) 2) Historical or Holding-Period Return

What is Current Yield and how do you calculate it?

1) the ratio of a bond's annual interest payment to its market place 2) (Annual interest payment/current market price of the bond)

What is a company-unique or unsystematic risk?

1) the risk related to an investment return that can be eliminated through diversification. 2) Issues are uniquely related to the firm

What is Book Value?

1) the value of an asset shown on the firm's balance sheet. It represents historical cost of the asset rather than its current market value or replacement cost. 2) The depreciated value of a company's assets (original Cost - accumulated depreciation) - outstanding liabilities

What are the 3 principal reasons for imposing a capital-rationalizing constraint?

1)Managers think market conditions are temporarily adverse. 2) There may be a shortage of qualified managers to direct new projects. 3) There may be intangible considerations

How many different securities must be owned to essentially diversify unsystematic risk?

20

What are Zero Coupon Bonds?

A bond issued at a substantial discount from its face value and that pays little or no interest

What is a Fixed Bond Rate?

A bond that pays a fixed amount of interest to the investor each year

What is Par Value?

A bond's face value, the stated amount that the firm is to repay upon the maturity date.

What is Common Stock?

A certificate that indicates ownership in a corporation.

What is a call protection period?

A pre-specified time period during which a company cannot recall a bond.

What is limited liability in common stock?

A protective Provision whereby the investor is not liable for more than the amount he or she has invested in the form.

What is a Bond?

A type of debt or long-term promissory note, issued by the borrower, promising to pay its holder a predetermined and fixed amount of interest per year and the face value of the bond at maturity.

What is Opportunity Cost?

The cost of making a choice defined in terms of the next best alternative that is foregone.

What is a Callable (Redeemable) Bond?

An option available to a company issuing a bond where the issuer can call (redeem) the bond before it matures. This is usually done if interest rated decline below what the firm is paying on the bond.

Why is it difficult to find an exceptionally profitable project?

Because competition is brisk and will push down prices and profits.

Why are junk bonds also called high yield bonds?

Because of the high interest rates they pay the investor

What form do expected benefits (returns of most investments) come in?

Cash Flows

What is the relevant variable a financial manager uses to measure returns?

Cash Flows

What are Rights?

Certificates issued to the shareholders giving them an option to purchase a stated number of new shares of stick at a specified price during a 2-10 week period.

What are Voting Rights?

Common Shareholders are entitled to elect the board of directors and in general the only security holders given a vote.

What is Majority Voting?

Each share of stock allows the shareholder one vote and each position on the board of directors is voted on separately.

What is Cumulative Voting?

Each share of stock allows the stockholder a number of votes equal to the number of directors being elected.

How does an investor receive a return from a zero or very low coupon bond?

From the appreciation of the bond

What is considered the goal of capital budgeting?

Identify Projects that add the most to the firm's value

What is the Coupon Interest Rate?

Indicates the percentage of the par value of the bond that will be paid out annually in the form of interest.

For our purposes, what is the value of an asset?

Its intrinsic or present value of its expected future cash flows.

Which of the 6 investment portfolios are the least risky and why?

T-bills because they have a short term maturity date and the price is less volatile than that of an intermediate or long-term government security.

What is an Efficient Market?

Market where the values of all securities fully recognize all available public information.

Is accurately measuring future cash flows easy?

No because the world is full of uncertainty.

What is a firm's cost of capital sometimes referred to?

Opportunity Cost

What is risk?

Potential variability in future Cash Flows.

What is Convertibility Preferred Stock?

Preferred Shares that can be converted into a predetermined number of shares of common stock, if investors so choose.

How do you calculate holding period dollar gain?

Price at end of period+ cash distribution (dividend) - price at beginning of period

What are mutually exclusive projects?

Projects that if undertaken, would serve the same purpose. Thus, accepting one will necessarily mean rejecting the others.

What is internal growth?

Requires that managers retain some or all of the firm's profits for reinvestment in the firm resulting in the growth of future earnings and hopefully the value of common stock.

What is Interest Risk?

The Variability in a bond's value by changing interest rates

What is Liquidation Value?

The dollar sum that could be realized if an asset were sold individually and not as part of a going concern

What is Behavioral Finance?

The field of study examining when investors act rationally or irrationally when making investment decisions.

What is Maturity of a Bond?

The length of time until the bond issuer returns the par value to the bondholder and terminates or redeems the bond.

How is an investor's required rate of return related to an opportunity cost?

The opportunity costs represents the investor's return on the next best investment that is foregone should the project under consideration be accepted and thus must equal the investor's required rate of return.

What is a firm's financial policy?

The policies regarding the sources of financing it plans to use and the particular mix (Proportions) in which they will be used.

What is the relationship between Bond ratings and interest rate?

The poorer the bond rating the higher the interest rate demanded by investors.

What is Capital Budgeting?

The process of decision making with respect to investments made in fixed assets. (that is should the proposal be accepted or rejected?)

What is Yield to Maturity?

The rate of return a bondholder will receive if the bond is held to maturity. (equivalent to expected rate of return)

What is the Cost of Common Equity?

The rate of return that must be earned on the common stockholders investment in order to satisfy their required rate of return.

What is the risk free rate of return?

The required amount of return, or discount rate, for risk-less investments.

What is the Market Value?

The value observed in the marketplace

Why are Treasury Bills risk free assets?

They have short term maturity dates, their prices are less volatile, and there is no chance of default on them.

What do bond ratings do for financial managers?

They provide an indicator of default risk that in turn affects the interest rate that must be paid on borrowed funds.

Should firms that own and operate multiple businesses with very different risk characteristics use business-specific divisional costs of capital?

They should calculate divisional costs of capital for use in evaluating each division's investment opportunities.

When does it make sense to use standard discount rates across different lines of business?

When systematic risk across different lines of business are the same.

When will a bond sell at a discount?

When the market interest rate rises above the stated interest rate of a bond.

What is a net present value profile?

a graph showing how a project's NPV changes as the discount rate changes

What is risk premium?

additional compensation required for assuming greater risk

What are sunk costs?

costs that have already been incurred that cannot be recovered.

How can a firm's market risk be estimated?

estimating the beta coefficient of the characteristic line using the regression method

What is capital rationing?

placing a limit on the dollar size of the capital budget

What is the characteristic line?

the line of best fit through a series of returns for a firm's stock relative to market returns.

What is payback period?

the number of years it takes to recapture a project's initial outlay.

What is Capital structure?

the proportions of each source of financing used by the firm.