Financial Analytics Exam #2
Bond Contract
Terms: coupon, face value, coupon rate, & maturity. These terms are fixed and don't change.
Coupon Rate
The annual coupon divided by the face value of a bond. (100/1000) = 10%
Preferred Stock
*higher priority than common stock. paid after debt but before common stock •Voting Rights - preferred shareholders have no voting rights •Dividends - fixed, at the discretion of the firm ••Cumulative - pay last year and this year dividends before common shareholders ••Non-cumulative - pay current dividends only. does not pay missed dividends •Stated/Liquidating Value - if the firm liquidates, they pay debt first, then preferred shareholders $100 per share of stock, then pay common shareholders if they still have money left •Preferred Stock and Debt (investing for the cash flows we receive)
Example: (Non-Constant Growth Stock) If the firm was unable to pay a dividend for the next 4 years, but then paid a $2 dividend which grew at a constant 3%, what would the price be today?
1) Draw a timelines & layout cash flows 2) Deal with the right hand side PV₅ = CF₆/r-g PV₅ = 2.06/0.1452-0.03 PV₅ = $17.8819 3) Bring it all back to zero PV₀ = FVₜ/(1+r)ᵗ PV₀ = 17.3611/(1.1452)⁴ PV₀ = $10,0937
Example: (Non-Constant Growth Stock) Yostmeister, Inc. just paid a $2 dividend. Dividends are expected to grow at 10% for the next two years after which they will grow at 4% for the foreseeable future. If investors require a return go 16% for stocks of this risk, what is the current price?
1) Draw the timeline & layout cash flows 2) Deal with right hand side PV₂ = CF₃/r-g PV₂ = 2.5168/.16-.04 PV₂ = $20.9733 3) Bring it all back to zero PV₀ = FVₜ/(1+r)ᵗ PV₀ = 2.20/(1.16)¹ +(2.42 + 20.9733)/(1.16)² PV₀ = $19.2816
The Growth Rate •How m might we estimate the dividend growth rate?
1) Historical Growth Rate (backward looking) 2) Accounting Measure (ex. Sustainable Growth Rate or Internal Growth Rate) (backward looking) 3) Analysts' Forecasts (forward looking)
Ferrari Case
1) With whom should we benchmark? What are the pros and cons of different groups of benchmark firms? -key challenge 2) -comparing luxury brand -enterprise value / EBITA 3) Calculate enterprise value of Ferrari EV/EBITA -cannot have a negative price per share 4) What are the pros and cons of using a market-multiples approach to valuation?
Bond Valuation: What is the value of the bond now if the yield to maturity is 10 percent? 7 percent? 13 percent?
10% N = 9 I/Y = 10% PMT = 100 FV = 1,000 PV = ? (1,000) 7% N = 9 I/Y = 7% PMT = 100 FV = 1,000 PV = ? (1,195.46) 13% N = 9 I/Y = 10% PMT = 100 FV = 1,000 PV = ? (846.05)
Example: A recently issued $1,000 par value bond has 10 years to maturity and currently sells for $1,163.51. It has a 6 percent coupon rate, paid semiannually. It is call-protected for 5 years, after which it pays a call premium equal to an annual coupon payment, steadily declining thereafter. What are the YTM, YTC, and current yield?
1000 x 6% coupon rate = $60 per year 60/2 = $30 per 6 months YTM: N = 20 I/Y = ? (2% x 2 bc semi = 4%) PMT = 30 FV = 1,000 PV = -1,163.51 YTC: N = 10 (bc 5 years for call bond x 2 for semi) I/Y = ? (1.7569% x 2 = 3.5137%) PMT = 30 FV = 1,000 PV = -1,163.51 Current Yield: = annual coupon payment / price of bond = 60/ 1,163.51 = 5.1568%
What is a current yield?
= annual coupon payment / price of bond (market) • return on bond, from CF's I receive
Redeemable Bonds
= bond holder is given option to sell the bond back to the firm at face value •Who benefits? = (investors)
Call Provisions
= gives them the right to buy back bond issue early if stated in contract •Call Premium (about an annual coupon payment) •Deferred Call (protection against being called) •Who benefits? = (the firm. they pay for it) *callable bonds will have higher YTM than other bonds*
Sinking Fund Provisions (Reduce Risk)
= requires firm to pay down a certain portion of debt each year •Lottery redemption at par •Purchase in the open market •Which should be chose? the option that is least costly
Debt vs. Equity
Debt •not an ownership interest •creditors do not have voting rights •interest is considered a cost of doing business and is tax deductible creditors have legal recourse if interest or principal payments are missed •excess debt can lead to financial distress and bankruptcy Equity •ownership interest •common stockholders vote for the board of directors and other issues •dividends are not considered a cost of doing business and are to tax deductible •dividends are not a liability of the firm and stockholders have no legal recourse if dividends are not paid •an all equity firm can not go bankrupt
Calculating Percent and Dollar Returns •On October 9, 2019, Home Depot stock closed at $228.94. It paid dividends of $1.36 per share on December 4, 2019 and $1.50 per share on March 11, June 3, and September 2, 2020. It is currently trading at $287.09. What is your dollar return over this period? What is your percent return?
Dividends: 1.36 + 1.50 + 1.50 + 1.50 = $5.86 CF Change in value: 287.09 - 228.94 = $58.15 Total Cash Return: $64.01 % Return = CFs + change in value / initial investment % Return = 64.01 / 228.94 = 27.96%
Bond Valuation: What was the price of the bond when it was issued if the yield to maturity was 10 percent?
N = 10 years I/Y = 10% (based on YTM) PMT = 100 PV = ? FV = 1000 PV = -1000
Payment Frequency: Now, assume that the bond makes semiannual coupon payments. What is the value of the bond now if the yield to maturity is 10 percent?
N = 18 (9 years, 18 semiannual) I/Y = 5% (10% YTM / 2 bc semiannual) PMT = 50 (100 / 2 bc semiannual) FV = 1,000 PV = ? (1,000)
EXAMPLE: Zero-Coupon Bonds •What is the price of a zero-coupon bond that has a face value of $1,000 and matures in 10 years, if the YTM is 8%? Assume semiannual compounding.
PV = CF/(1+r)ᵗ PV = 1,000 / (1.04)²⁰ PV = 456.39 (10 years x 2 = 20) (8% / 2 = 4%)
Example: (Zero Growth Stock) Keven Corp., just paid a $2 dividend, which it expects to maintain for the foreseeable future. If stocks of this risk require a return of 14.52 percent, what is the current price of the stock?
PV₀ = CF₁/r PV₀ = 2/.1452 PV₀ = $13.7741
Example: (Constant Growth Stock) If the firm expects to maintain a constant 3% growth rate in dividends, what would the price be today?
PV₀ = CF₁/r-g PV₀ = 2.06/(.1452-.03) PV₀ = 2.06/.1152 PV₀ = $17.8819
Maturity
Specific date on which the principal amount of a bond (ex. the face value) is repaid. (when bond expires & get face value back)
Difference between Corporate Bond Reporting and Government Bond Reporting
The most important difference is their risk profile. Corporate bonds usually offer a higher yield than government bonds because their credit risk is generally greater. •bid price = price the dealer will buy it for, price i am willing to sell •ask price = price dealer is willing to sell it for, the price I can buy it for
Face Value
The principal amount of a bond that is repaid at the end of the term. Also called par value. (assume $1000 if not told otherwise)
Yield to Maturity (YTM)
The rate required in the market on the bond. This is quoted as an APR and is often not the same as the coupon rate.
Coupon Bond
The stated interest payment made on a bond ($100)
Sample Variance
The variance of returns tells us how much the actual returns each year vary from the average return. In other words, it is a measure of the volatility of returns.
Example: •There are two $1,000 bonds identical (i.e. same risk) expect for their coupons and their prices. Both have 3 years to maturity and annual coupons. The first has an 8% coupon rate and sells for $974.69. What is its yield to maturity (YTM)? •The second bond has a 10% coupon rate. If it has the same YTM as the first bond, what is its price? •Which is better?
YTM BOND 1: N = 3 I/Y = ? (9%) PMT = 80 (1,000 x 8%) FV = 1,000 PV = -974.69 YTM BOND 2: (trade @ premium b/c paying 10% when market says 9%) N = 3 I/Y = 9% PMT = 100 (1,000 x 10%) FV = 1,000 PV = ? (1,025.31) •They are the same because they have the same 9% rate of return
Bond Valuation: When coupon rate is equal to YTM, the price of the bond (PV) is _____ to par value (face value).
equal
The price value of a share of stock is =
present value of the stock's future cash flows
The price of a bond is equal to the __________ of the bond's _______.
present value, future cashflows
When coupon rate < YTM
price of bond < par value (trading at discount price)
When coupon rate > YTM
price of bond > par value (trading at premium price)
What is yield to maturity?
return on bond if it's held until maturity
PMT and FV must have the same ______
sign
Term Structure of Interest Rates
the relationship between interest rates and time-to-maturity of a debt security •Upward slopping = pos. level of inflation •Downward slopping = neg. level of inflation
What is a yield to call?
the return a bondholder receives if the bond is held until the call date, which occurs sometime before it reaches maturity
The Rate of Return •What are the two components of our return? •Consider a constant growth stock...
• 1) the CFs we receive and 2) the price change = total return -CFs are known as current yield or dividend yield -price change is known as the capital gains • r = CF₁/PV₀ + g (CF₁/PV₀ ) dividend yield ( g) capital gains yield
Stock Markets
• Primary vs. Secondary Markets -Primary = firm selling new securities and receiving cash from doing so. where securities are created (ex. IPO, SEO, Private placement) -Secondary = transactions upon investors. where securities are traded by investors • Dealers vs. Brokers -Dealers = people buying and selling from their own inventory -Brokers = brings together a buyer and a seller • NYSE vs. NASDAQ -NYSE = auction market, electronically -NASDAQ = dealer market
Reinvestment Rate Risk •What is it? •How is it minimized?
• Risk we face when reinvesting cash flows (When rates go down, we earn a lower rate of return by reinvesting cash flows) • Minimize it by investing in long-term bonds
Interest Risk Rate •What is it? •How is it minimized?
• The risk that the value of bond changes when interest rate changes • Minimize by investing in short-term bonds (rate increase, value decreases)
Stock Market Equilibrium
• What happens when expectations change? -price changes -expectations increases, price of stock increase -expectations decrease, price of stock decrease • The Efficient Markets Hypothesis -stock prices reflect information quickly & accurately 3 Levels of Market Efficiency • Weak Form Efficiency = (stock prices reflect past information, there are no patterns meaning stock prices are unpredictable) • Semi-Strong Form Efficiency = (stock prices reflect all public information) • Strong Form Efficiency = (stock prices reflect ALL public & private information)
•Less risk, ____ rate of return •More risk ____ rate go return
• lower • higher
Other Types of Bonds
•Convertible = convertible into shares of stick (equity) •Income = coupon payments are set but generated on our income •Inflation Indexed = designed to help protect investors from inflation (interest rates rise & fall with rate of inflation)
Type of Bonds
•Coupon vs. Zero-Coupon •Corporate •Treasury ••Bonds - maturities of 10+ years ••Notes - maturities under 10 years ••Bills - short-term zero coupon bonds •Municipal - issued by local government •Foreign - bonds issued by other countries
The Bond Contract
•Indenture = physical contract w/ details on bonds) •Restrictive Covenants = to protect investment •Seniority = specifies which bond holder gets paid first ••Mortgage bonds (First, Second or Senior, Junior) ••Debentures (debentures and subordinated debentures)
Reality Check
•Is stock valuation really this easy? -mechanically yes. what makes it difficult is the uncertainty of values •Stock Valuation vs. Company Valuation -same thing. The value of the company is the PV of the future CFs. -challenges: estimating the growth rate and the required rate of return •What about market multiples? -ex. PE ration = Price/EPS
Types of Common Stock
•Non-publically Traded Shares - private company, not traded on public market, held by a few individuals •Publically Traded Shares •Classified Stock - enhanced voting rights or dividend rights, class A or B stocks. Specific privileges accorded to each type of stock •Tracking Stock - tracks a particular segment of the firm rather than the whole firm - trade in open market •Preferred stock (not common stock)
3 things to help financial distress
•Out-of court Restructuring = financially troubled company & creditors reach an agreement for adjusting the company's obligations •Chapter 11 Reorganization = sell of the firm, not assets •Chapter 7 Liquidation = enter court process and liquidate the assets of the firm
Yield on Bonds
•Real Interest Rate (US Treasury Bond) •Inflation Premium (US Treasury Bond) •Interest Rate Risk Premium (US Treasury Bond) •Default Risk Premium (Corporate Bond) •Liquidity/Marketability Premium (Corporate Bond)
Zero-Coupon Bonds
•They pay zero coupon bonds •Calculate them by PV = CF/(1+r)ᵗ •ALWAYS tase @ discount
Rights of Common Shareholders
•Voting •Dividends (if declared) •New Shares (preemptive right) •The Proxy Statement (document sent to shareholders on how to vote and what to vote for. proxy vote = give vote to someone else)
Common Stock
•Voting Rights ••Majority Voting or Straight Voting - 1 vote per share, per item ••Cumulative Voting - 1 vote per share, per item. Cumulate votes to one item. (ex. give 2 votes and you decided where the votes go. 2 votes to president or 1 votes to each President and VP) •Dividends - firm's decision. at the discretion of the firm, not obligated to pay shareholders at the end of the period.
Stock Valuation
•Zero Growth - stock that pays dividend each year but dividends don't grow. (perpetuity) PV₀ = CF₁/r •Constant Growth - stock pays dividend every period, period after period. Dividends grow at a constant growth rate (growing perpetuity) *only when r > g PV₀ = CF₁/r-g •Non-constant Growth - high growth rate for period of time then low growth rate 1. Draw timeline and layout cash flows 2. Deal with the right-hand side 3. Bring it all back to zero
The Risk-Return Trade-Off
•assets with higher expected returns entail greater risk •lower risk, lower returns •all else equal, people like returns •all else equal, people dislike risk
When r ↓, PV ?
↑
When r ↑, PV?
↓