Finance Exam 2

Yield to Maturity (YTM):

discount rate that sets PV (promised payments= market price -always express YTM as APR -YTM same as bond IRR

cost of capital=

dividend yield +capital gains rate

Which. bond is seen as less advantageous for tax purposes?

discount bonds

Earnings growth rate will equal dividend growth rate, g, if payout rate is ________________

constant

Discount bond has built in....

capital gain

Why do zero coupon bonds have less reinvestment risk?

since they have no interim coupon payments.

A 10-year zero coupon bond has par value of $1,000 and YTM of 6%. Assuming annual compounding, what is its price?

$558.39 N=10 I/YR= 6% PMT=0 PV=? FV=1000

TRUE OR FALSE: If the market exhibited weak-form efficiency, trading strategies that were based on past price-patterns would be profitable.

False

TRUE OR FALSE: Market efficiency implies that no one can beat market in the short or long term

False

Coupon rate:

% of par value paid in coupon payments each year (expressed as APR)

Non-Constant Growth (Two-stage dividend growth model):

*wall street If dividends grow @ abnormal rate for first N years 1.Estimate dividends up to time N 2.Estimate price @ time N using no-growth or constant dividend growth formula; set that as time N cash flow 3.Find PV0(cash flows)

Basis points:

-A measurement unit for rates of return (alternative to %) -100 basis points = 1% (i.e. 1 basis point = 0.01%)

Treasury securities:

-Government-issued debt securities (bills, notes & bonds) -Safest security (usually)

Credit Spread:

-The difference between a bond's YTM and the YTM of treasury securities with the same maturity

Three possible risks for corporate bonds?

-default risk -interest rate risk -reinvestment risk

cash flows from bond:

1) buying it (outflow) 2) coupon payment 3) selling the bond at later date (inflow)

Higher bonds have:

1) lower discount rates (YTM) 2) higher prices

TRUE OR FALSE: Premium bonds are bad investments and discount bonds are good investments

False

Limitations of Constant Growth

1. Growth rates may change over time -Young firms often pay little or no dividends -Older firms often pay high dividends 2. Uncertainty in assessing dividend growth

Stock price can be viewed as having 2 components:

1. Value of assets in place 2.Value of growth opportunities

A firms earnings go to:

1. shareholders (dividends are paid out)(payout rate) (DPS/EPS) 2. New Investment (earnings are retained and reinvested)(retention rate=1-payout rate)

2 reasons stocks are difficult to value:

1.Difficult to estimate all future cash flows 2.Difficult to estimate a discount rate

Shareholders realize cash flows in two ways:

1.Dividends •Portion of earnings that are returned to investors 2.Cash received from selling stock •Selling rights to future dividends

Dividend discount model always hold consider these very simple special cases:

1.Expected future dividends are constant 2.Expected future dividends grow @ constant rate

Earnings growth will depend on:

1.How much is retained; the retention rate 2.Return on new equity investments

TRUE OR FALSE: market efficiency implies that stock prices cannot deviate from true values.

False

Your firm has credit rating of A. You notice that credit spread for 10-year maturity A-rated debt is 90 basis points (0.90%). Your firm's 10-year debt has coupon rate 5%. New 10-year treasury notes are being issued @ par w/ coupon rate 4.5%. What is YTM of your firm's debt?

5.40% 4.50% + .90%= 5.40%

A company releases a five-year bond with a face value of $1000 and coupons paid semiannually. If market interest rates imply a YTM of 6%, what should be the coupon rate offered if the bond is to trade at par?

6% No need for calculator because it mentions that the coupon will be offered to trade at par. That means it is the same percent as YTM

What is the yield to maturity of a one-year, risk-free, zero-coupon bond with a $10,000 face value and a price of $9,400 when released?

6.383% N=1 I/YR= ? PMT=0 PV=-9400 FV=10000 (zero coupon bond means pmt 0)

Bond par $1000, semi-annual coupon 4%, discount rate 10%, maturity in 10 years. PV?

626.1 FV = 1000 PMT = 20 = 1000*4%/2 I/Y = 5% = 10%/2 N = 20 = 10*2 Calculate for: PV = -626.1

The stock of Cooper Motor Co has expected return of 7% and its dividends are expected to grow by 1.5% each year. Cooper Motor Corporation has just paid a dividend of $2 per share. What is price of Cooper Motor Co? A.$36.91 B.$28.57 C.$36.36 D.$29.00

A. $36.91 We apply the formula for a growing perpetuity: P = Div / (r-g) = 2*1.015 / (.07-.015) = 36.91

Suppose you purchase a 10-year bond with 6% annual coupons. You hold the bond for 4 years, and sell it immediately after receiving fourth coupon. If YTM=5% when you bought & sold bond, what are the prices @ which you bought & sold at, per $100 face value? What is the effective yield? A. 5% B. 6% C. 7% D. None of the above

A. 5%

A stock is priced at $20 today. If you expect it to sell for $22 in one year, immediately following its next annual dividend payment, and its discount rate is 12%, what is the stock's next dividend payment expected to be? A.$0.36 B.$2.00 C.$0.40 D.Dividend cannot be determined

C. $.40 P = (Div + Sell Price)/(1+r) 20 = (Div + 22)/ (1+.12) So we get Div = 40 cents

A perpetual cash flow pays $10 every year, forever, starting in 10 years. The discount rate is 10%. What is the present value today? A. $10/0.10 B. $10/0.10 but discounted for 9 years, [$10/0.10]*[1/1.109] C. $10/0.10 but discounted for 10 years, [$10/0.10]*[1/1.1010] D. None of the above

B. $10/0.10 but discounted for 9 years, [$10/0.10]*[1/1.109] because we have Pv (as of year 9) of the perpetual to be 10/1 as a of year 9

You make monthly payments on your car loan. It has a quoted APR of 5% (monthly compounding). What percentage of the outstanding principal do you pay in interest each month? A. 5% B. 0.417% C. 0.40% D. None of the above

B. 0.417% 5%/12= .417 because we have apr is annual and we need to reflect it by month

Crane Sporting Goods expects to have earnings per share of $6 in the coming year. Rather than reinvest these earnings & grow, firm plans to pay out all of its earnings as a dividend. With these expectations of no growth, Crane's current share price is $60. What is Crane's equity cost of capital? A.11.00% B.10.00% C.12.00% D.1.00%

B. 10.00% Here we need to solve for r, when given the EPS, g=0, and current share price. P = Div/(r-g) Note that here we have a payout of 100%. Therefore EPS=DPS. So we have P = Div/(r-g) = EPS / (r-g) = 6/r Now we know P=60. So: 60 = 6/r, therefore r must 10%. Alternatively, rE = Div. Yield + g = DPS/P + g = 6/60 + 0= .10 or 10%.

Gremlin Industries will pay a dividend of $1.90 per share this year's end. It is expected that this dividend will grow by 4% per year each year in the future. The current price of Gremlin's stock is $23.50 per share. What is Gremlin's equity cost of capital? A. 11% B. 12% C. 14% D. 16%

B. 12% $1.90/ $23.50 + 0.04 = 0.12 or 12%.

Security: Yield % Treasury: 5.2% AAA Corporate: 5.4% BBB Corporate: 6.8% B Corporate: 7.2% The above table shows the yields to maturity on two-year, zero-coupon securities. What is credit spread on two-year, zero-coupon corporate bond w/ B rating? A. 2.4% B. 2.0% C. 2.8% D. 1.6%

B. 2.0% 7.2%-5.2%= 2% credit spread is the difference in YTM between treasury and BBB corporate bond

Merk Inc. announces to public that it faces a decline in earnings forcing it to pay $25 million less in dividends for each of the next 5 years than it had previously intended. Merk's shares react immediately to this announcement by decreasing to fully reflect the reduction in dividends. We can deduce from this that market: A. Exhibits weak-form efficiency B. Exhibits semi-strong-form efficiency C. Exhibits strong-form efficiency D. Is not efficient

B. Exhibits semi-strong form efficiency

At maturity, the only cash flow from a bond is the repayment of its entire par value. A. True B. False

B. False At maturity, the cash flows consist of the final coupon payment as well as the repayment of the part value

Blitzu plans to pay $2 per share in dividends in coming year. Dividends are expected to grow by 5%. If discount rate 7%, value of Blitzu stock? A. $28.57 B. $40.00 C. $100.00 D. $105.00

C. $100.00 This is because the value of the stock is: Div / (rE-g) = $2/ (0.07 - 0.05) = $100

Cloudera pays out all its earnings and has a share price of $37. In order to expand, Cloudera decides to cut its dividend from $3.00 to $2.00 per share and reinvest the retained funds. Once the funds are reinvested, they are expected to grow at a rate of 13%. If the reinvestment does not affect Cloudera 's equity cost of capital, what is the expected share price as a consequence of this decision? A. $36.67 B. $41.90 C. $52.38 D. $62.86

C. $52.38 Step 1. Initially the firm pays out 100% of its earnings Since initially Cloudera pays out 100% of its earnings, dividend yield is 3/37 and since there is zero retention, dividend growth of is zero. Therefore rE = dividend yield + growth will be = $3/$37 + 0% = 0.08108108 or 8.108% Step 2. After dividend cut, i.e., next year, payout of earnings in the form of dividends is as follows: Earnings = $3, Dividend = $2, therefore Payout is 2/3 = 0.666, and retention is 1-Payout = 0.333. So, g = 0.333 × 0.13 = 0.0429; And P0 = $2 / (0.08108108 - 0.0429) = $52.38

Which of these bonds has the greatest interest rate risk if they are otherwise identical? A. A 20-year 8% coupon bond B. A 5-year zero coupon bond C. A 20-year zero coupon bond D. A 5-year 6% coupon bond

C. A 20-year zero coupon bond

Which of the following statements is true of bond prices? A. A fall in bond prices causes interest rates to fall. B. A fall in interest rates causes a fall in bond prices. C. A rise in interest rates causes bond prices to fall. D. Bond prices and interest rates are not connected.

C. A rise in interest rates causes bond prices to fall.

Suppose Crane Sporting Goods decides to cut its dividend payout rate to 75% to invest in new stores, as before. But now suppose that the return on these new investments is 8%. Given its expected earnings per share this year of $6 and the same equity cost of capital as before, how will share price be affected? A.Increase to $75.00 B.Decrease to $18.75 C.Decrease to $56.25 D.Increase to $112.50

C. Decrease to $56.25 Note that g = .25 * .08 = 0.02 rE = 10% New Dividend = 0.75*$6=$4.5. So, the Price is P = 4.5/(.1-0.02) = 56.25$.

Which of the following is a limitation of the dividend-discount model? A. It cannot handle negative growth rates. B. It requires accurate dividend forecasts, which is not possible. C. It requires growth rate < required rate of return, which is not realistic. D.It does not consider past earnings & performance.

C. It requires growth rate< required rate of return, which is not realistic

"The Gordon Growth Model"

Constant dividend growth •Year 1 dividend of D_1 grows by rate g every year •Stock is a growing perpetuity of dividends

Suppose OpenDoor has EBIT = 10m, Tax = 40%, CapEx = 1m, Depreciation = 1m, Change in NWC = 2m and Debt is 20m. These cash flows start next year and will continue forever. If the equity cost of the capital is 15%, the firm assets' cost of capital is 10% and the firm has 100,000 shares, what is the anticipated share price for OpenDoor? A.$10 B.$16.36 C.$36.36 D.$200

D. @ year 1: EBIT = 10m Tax = 40% CAPEX = 2m Depr = 1m Change in NWC = 1m Debt (net) = 20m rE=15%, but the discount for the assets of the firm is rA=10% So Firm Value = FCFF/.10 = (10-4+1-2-1)/0.10 = 40m There are 100,000 shares, therefore the price is ($40m-$20m)/100,000 = (EV - Debt)/# shares, which is $200 per share.

Krell Industries has a share price of $22.00 today. If Krell is expected to pay a dividend of $0.88 this year and its stock price is expected to grow to $23.54 at the end of the year, what is Krell's dividend yield and equity cost of capital? A. 4% B. 7% C. 10% D. 11%

D. 11% Dividend Yield = 0.88/22.00 = 4% Capital Gain Rate = (23.54 - 22.00)/22.00 = 7% Total Expected Return = rE = 4% + 7% = 11%

A firm with earnings of $8.00 intends to pay out $1.00 in dividends and retain the remainder for reinvestment. It expects to maintain this policy going forward. Expected return on new investments is 15%, & expected return (discount rate) for stock is 16%. What is expected growth rate for future dividends? A.14.00% B.1.88% C.2.00% D.13.13%

D. 13.13% So, we know that g = Retention Rate * Growth on New Investments. Retention rate = 1 - Div. Payout rate. Div. Payout = Dividends / EPS = 1/8 = 0.125. So Retention Rate = 0.875. So g = 0.875 * 0.15 = .13125. So the correct answer is D.

Suppose Crane could cut its dividend payout rate to 75% for the foreseeable future and use retained earnings to open new stores. The return on investment in these stores is expected to be 12%. If we assume that the firm's equity cost of capital is unchanged, what effect would this new policy have on Crane's stock price? A.Increase to $85.71 B.Decrease to $21.43 C.Decrease to $45.73 D.Increase to $64.29

D. Increase to $64.29 Note that g = .25 *. 12 = 0.03 rE = 10% New Dividend = 0.75*$6=$4.5. So, the Price is P = 4.5/(.1-0.03) = 64.29$.

Suppose you purchase a 30-year, zero coupon bond with a yield to maturity of 6%. You hold the bond for five years before selling it. If the bond has no chance of default, is your investment subject to any risk(s)?

D. Reinvestment rate risk and interest rate risk risk exists even for long-term zero coupon bond you didn't hold until maturity

: the return that is anticipated to any stock is composed of:

DIVIDEND YIELD & CAPITAL GAINS RATE.

• Issue date:

Date when bond issued.

How will bond price change if YTM increases? Increase or decrease

Decrease

If firm can only affect its future earnings by reinvesting current earnings, how does payout decision affect stock price?

Depends on return on new investments

Constant Dividend:

Dividends are same every year

some formulas and names:

EPS growth= retention rate x roe (new investment) ROE= return of equity dividend yield= DPS1/Po dividend payout= DPS/EPS Po= price per share DPS1= dividend per share EPS= earnings per share

AAA bonds have a higher interest rate than BBB bonds. A.True B. False

False

The credit spread of a bond shrinks if it is perceived that the probability of the issuer defaulting increases. A.True B.False

False (when the credit spread increases it does so to reflect greater credit risk, i.e.. a greater chance of a default event)

TRUE OR FALSE: At maturity, the only cash flow from a bond is the repayment of its entire par value

False At maturity we anticipate both the last coupon payment and the principal repayment.

TRUE OR FALSE: treasury bonds (t-bills) have longer maturities than Treasury bonds

False T-bill: 6 months-1 yr T-note: 5-10 yrs T-bond: 20-30 years

TRUE OR FALSE: If a bonds yield to maturity is greater than its coupon rate, its price will fall as it approaches maturity if the yield remains constant

False discount bonds can only increase overtime

TRUE OR FALSE: If a bond's yield-to-maturity is less than its coupon rate, its price will rise as it approaches maturity if the yield stays constant.

False if ytm<coupon rate----> premium bond price has to decrease as maturity approaches zero

TRUE OR FALSE: If a bond has no chance of default, there is no risk involved in investing in the bond with the goal of selling the bond before maturity.

False interest rate risk exists if you plan to sell the bond prior to its maturity

TRUE OR FALSE: Stocks that do not pay a dividend must have a value of $0.

False stock payouts: dividends and/or repurchases can also have money in repurchases

Total Payout Model

Firms can also return cash to shareholders by repurchasing shares from shareholders How do we value stock here? •Consider total payout to shareholders (dividends + repurchases)

What happens if a bond sells at par?

If a bond sells at par (at its face value), the only return investors will earn is from the coupons that the bond pays. Therefore, the bond's coupon rate will exactly equal its yield to maturity.

Bond characteristic: 1. Longer term to maturity 2. Higher coupon payments Effect on interest rate risk: 1. increase 2. decrease

Longer term to maturity & Increase Higher coupon payments & decrease

Coupon payments:

Periodic payments made while bond outstanding -Name came from physical coupons -Typically once every 6 months

•Interest Rate Risk:

Price moves indirectly with interest rates (YTM) •Varies with certain bond characteristics: 1.Longer-term bonds have greater interest rate risk 2.Lower-coupon bonds have greater interest rate risk

Bond Valuation:

Stream of Cash Flow for owner 2 things: -risk free bonds -risky bonds Components: -coupon payments (annuity) -repayment of principal @ maturity(single CF)

Face (par) value:

The amount of the debt to repaid at some future date (maturity) -Aka "Par value", typically $1,000 -known as FV sometimes

Dividends:

The more you out out (in dividends), the lower the growth rate and you retain less

Reinvestment Rate Risk:

The risk that CFs will have to be reinvested in future @ lower rates, reducing income. higher if: -maturity of bond is shorter -coupon payment to bond is higher -Reinvestment risk is the chance that an investor will not be able to reinvest cash flows from an investment @ a rate equal to the investment's current rate of return.

Bonds with a high risk of default generally offer high yields. A.True B.False

True

TRUE OR FALSE: Stock prices are based on the constant dividend growth model.

True

Zero coupon bonds always sell at a discount (before maturity)? True or False

True

TRUE OR FALSE: Forecasting dividends requires forecasting the firm's earnings, dividend payout rate, and future share count.

True 3 elements included with a dividend

TRUE OR FALSE: A firm can either pay its earnings to its investors, or it can keep them and reinvest them.

True EPS: retain earnings to re-invest and dividend 2 possible outcomes

TRUE OR FALSE: The Valuation Principle states that the value of a stock is equal to the present value (PV) of both the dividends and future sale price of that stock which the investor will receive.

True PV= sum of dividend (look at formula sheet)

TRUE OR FALSE: The ownership in a corporation is divided into shares of stock, which carry rights to a share in the profits of the firm through future dividend payments.

True Po= discounted stream of future anticipated dividends and potential future sales price 3 rights given from a stock

TRUE OR FALSE: Cutting a firm's dividend to increase investment will raise the firm's stock price only if the return on the new investments exceeds the firm's equity cost of capital.

True ROE>rE Po increases if re-invest more in new project

TRUE OR FALSE: Downward yield curves almost always precede recessions

True almost all recessions were preceded by an inverted (or downward sloping) yield curve

Covenants:

Various contractual commitments ('promises') issuer makes to bondholder.

Maturity:

Years until bond must be repaid. Declines through time.

What is the value of Con Edison's stock if instead dividends are expected to grow by 2% per year in the future? a. $2.30/(0.07+.02) b. $2.30/(.07-.02)

b. 2.30/ (.07-.02)=$46

Con Edison plans to pay $2.30 per share in dividends starting next year, forever. If discount rate 7%, estimate value of Con Edison stock? a. $2.30/0.07 b. $2.30/(1+.07)

a. 2.30/.07=$32.86

Which of the following is NOT a way that a firm can increase its dividend? A. increasing its retention rate B. decreasing its shares outstanding C. increasing its earnings (net income) D. increasing its dividend payout rate

a. increasing its retention rate This is because a firm can increase its dividend by decreasing the number of shares outstanding, increasing the earnings, and increasing the dividend payout rate.

If ROE (new investment) >rE distributing dividends what happends?

becomes costly (i.e., price will decline)

Zero-coupon bond

bond pays no coupons: coupon rate =0% single CF: par value repayment @ maturity

Security: Yield % Treasury: 5.2% AAA Corporate: 5.4% BBB Corporate: 6.6% B Corporate: 6.9% The above table shows the yields to maturity on three-year, zero-coupon securities. What is price per $100 of face value of three-year, zero-coupon corporate bond w/ BBB rating? A. $99.06 B. $115.57 C. $82.55 D. $66.04

c. $82.55 N=3 PMT=0 I/YR=6.6.% FV=100 Pv=?

Borrowers willing to pay more, & lenders require more, on_____________________________

callable bonds.

Premium bond has built in...

capital loss

What do firms assets generate?

cash flows

The Valuation Principle

implies that to value any security, we must determine the expected cash flows that an investor will receive from owning it.

If maturity rate is longer then...

interest rates will be higher

If coupon rates are high then...

interest rates will be less

What can still happen if we cut dividends:

long term growth price still ca go up even though we cut dividends

Zero-Coupon Yield Curve

longer maturity=higher yield (higher interest rates) shorter maturity=lower yield

Bond Ratings

lowest/low risk: -AAA(best), AA, A, Aaa, Aa, A Medium risk: -Baa, BBB Highrisk: -Ba, B, BB, Caa, Ca, CCC, CC, C In default: -Caa/Ca/C, D

Suppose instead that bond shall be held till maturity. What kind of risks exist then?

only reinvestment risk exists

Common stock=

ownership share in firm

Price @ maturity=

par

Scenarios: YTM=coupon rate YTM> coupon rate YTM < coupon rate

par value sells @ discount sells @ premium

stock price=

present value of these cash flows

Suppose you purchase a 30-year, zero-coupon bond with a yield to maturity of 6% You hold the bond for 30 years before selling it. If the bond has no chance of default, is your investment subject to any risk(s)?

reinvestment risk

shareholders are....

residual claimants

Default risk=

risk issuer wont make payments as specified in contract =not paying full amount =not paying @ appropriate time

KNOW THIS: rp>rd>rf

rp: promise yield (written in contract/credit agreement) rd: ytm for a bond (expected by market) rf: risk free rate between rp and rd: bankruptcy risk between rd and rf: systematic risk

The sum of the dividend yield and the capital gain rate is called what?

the total return of the stock. - The total return is the expected return the investor will earn for a one-year investment

TRUE OR FALSE: Bond yields only for risk-free securities

true they are securities back by the U.S. treasury

When is value of growth opportunities positive?

•When expected return on new investments exceeds equity cost of capital (i.e., positive NPV)

An Investor has different holding periods:

•You may hold a stock for 1 year. •Another investor may hold same stock for 2 years, collect 2 dividends & sell stock @ year 2 end