FINC 322 - Exam #3

True or False? The appropriate discount rate for bonds is called the yield to maturity.

True.

True or False? The longer the maturity of a bond, the greater the impact on price to changes in market interest rates.

True.

True or False? The price of a bond is equal to the present value of all future interest payments added to the present value of the principal.

True.

True or False? The price of preferred stock is determined by dividing the fixed dividend payment by the required rate of return.

True.

True or False? The value of a share of stock is the present value of the expected stream of future dividends.

True.

True or False? Valuation of a common stock with no dividend growth potential is treated in the same manner as preferred stock.

True.

True or False? When the interest rate on a bond and its yield to maturity are equal, the bond will trade at par value.

True.

True or False? With a discount bond, bond price is greater than par value.

True.

True or False? You hold a long-term bond yielding ten percent. If interest rates fall shortly before you sell the bond, you will sell at a higher price than if interest rates had been constant.

True.

True or False? Long-term bonds have more price risk than short-term bonds.

True.

True or false? High coupon rate bonds have more investment rate risk than low coupon rate bonds.

True.

True or false? Under DGM, prices and dividends grow at an inverse rate.

False. Prices and dividends grow at g.

If a corporation "just paid" a dividend, should the dividend be labeled D0 or D1? What should the "next" dividend payment be labeled?

"just paid" = D0 "next = D1

True or False? The yield to maturity is always equal to the interest payment of a bond.

False.

equity - ownership interest? voting rights? tax deductible? do creditors have legal recourse if interest or principal payments are missed? can excess debt lead to financial distress and bankruptcy?

- Ownership interest - Common stockholders vote to elect the board of directors and on other issues - Dividends are not tax deductible - Dividends are not a liability of the firm until declared. Stockholders have no legal recourse if dividends are not declared - An all-equity firm cannot go bankrupt

debt - ownership interest? voting rights? tax deductible? do creditors have legal recourse if interest or principal payments are missed? can excess debt lead to financial distress and bankruptcy?

- not an ownership interest - no voting rights - interest is tax-deductible - creditors have legal recourse if interest or principal payments are missed - excess debt can lead to financial distress and bankruptcy

A taxable bond has a yield of 8% and a municipal bond has a yield of 6% •If you are in a 40% tax bracket, which bond do you prefer? •At what tax rate would you be indifferent between the two bonds?

-8%(1 - .4) = 4.8% -The after-tax return on the corporate bond is 4.8%, compared to a 6% return on the municipal When would you be indifferent? -8%(1 - T) = 6% -T = 25%

What are the three reasons why a share of common stock is more difficult to price than a band?

1. Not even the promised cash flows are known in advance 2. The life of the investment is essentially forever because common stock has no maturity. 3. There is no way to easily observe the rate of return that the market requires.

What are the three steps to calculate the present value of a non-constant growth model?

1. Split all cash flows into several groups 2. Find individual PVs and use "Riding the timeline" to find PV@t=0 3. Sum up all PVs

Constant growth model conditions 1. Dividend expected to grow at _____ forever. 2. ___________ price expected to grow at g forever 3. Expected dividend yield is ______________. 4. Expected CGY is constant and equal to _____. 5. Expected total return, R, must be _______ _______ g. 6. Expected total return (R): = _____________ yield + g.

1. g 2. stock 3. constant 4. g 5. greater than 6. dividend

True or False? There is a negative correlation between risk and the return the investors demand.

False.

A 10-year bond pays 8% on a face value of $1,000. If similar bonds are currently yielding 10%, what is the market value of the bond? Use semi-annual analysis. A) Less than $900 B) More than $900 and less than $1100 C) More than $1100 D) Not enough information to tell.

A

A 30-year zero-coupon bond that yields 12% percent is issued with a $1000 par value. What is the issuance price of the bond (round to the nearest dollar)? A) $30 B) $80 C) $8333 D) $none of the above

A

An issue of preferred stock is paying an annual dividend of $5. The growth rate for the firm's common stock is 14%. What is the preferred stock price if the required rate of return is 11%? A) $45.45 B) $41.67 C) $35.71 D) none of the above

A

Which bonds out of the following lists will have a higher coupon all else equal? In other words, which bonds are RISKIER, and therefore require higher coupons? Debenture vs. secured debt Subordinated debenture vs. senior debt A bond with a sinking fund vs. one without A callable bond vs. a non-callable bond

A debenture. Because debentures are unsecured, the issuer would be forced to raise the coupon in order to entice people to purchase. Subordinated debenture. Because preference is given to senior debt, subordinated debentures will be paid off afterward. One without a sinking fund. Bonds WITH sinking funds are more valuable because they allow for early redemption, so higher coupons are required for bonds WITHOUT sinking funds in order to entice people to purchase. Callable bond. Callable bonds are riskier because the issuer can buy back the bond as they desire to. Non-callable bonds are more security, so their coupons don't need to be as high as callable bonds.

True or False? Most bonds promise both a periodic return and a lump-sum payment.

True.

An issue of common stock is selling for $57.20. The year end dividend is expected to be $2.32 assuming a constant growth rate of 6%. What is the required rate of return? A) 10.3% B) 10.1% C) 4.1% D) none of the above

B

The growth rate for the firm's common stock is 7%. The firm's preferred stock is paying an annual dividend of $5. What is the preferred stock price if the required rate of return is 8%? A) $5 B) $62.5 C) $500 D) none of the above

B

True or False? Preferred stock is compensated for not having ownership privileges with a fixed dividend stream supported by a binding contractual obligation.

False.

True or False? The higher the yield to maturity on a bond, the closer to par the bond will trade.

False.

If the Beck Corporation wants to borrow $1,000 for 30 years and the interest rate is 12%, how much will Beck Corporation pay in interest every year? How much of the principal will Beck have to repay at the end of the thirty years?

Beck Corporation will pay $120 regular interest payments: 12% * $1,000 = $120 in interest Beck Corporation will repay the $1,000 at the end of the 30-year period.

A 15-year bond pays 11% on a face value of $1,000. If similar bonds are currently yielding 8%, what is the market value of the bond? Use semi-annual analysis. A) Between $1,000 and $1,200 B) Under $1,000 C) Over $1,200 D) Not enough information to tell.

C

A ten-year bond, with par value equals $1000, pays 10% annually. If similar bonds are currently yielding 6% annually, what is the market value of the bond? Use semi-annual analysis. A) $1,000.00 B) $1127.50 C) $1297.85 D) $2549.85

C

An issue of common stock has just paid a dividend of $3.75. Its growth rate is 8%. What is its price if the market's rate of return is 16%? A) $25.01 B) $46.88 C) $50.63 D) none of the above

C

True or False? In estimating the market value of a bond, the coupon rate should be used as the discount rate.

False.

The Beck Corporation wants to borrow $1,000 for 30 years and the interest rate is 12%. Identify the bond's coupons, face value, coupon rate, and time to maturity.

Coupon = $120 (12% * $1,000) Face Value = $1,000 Coupon Rate = 12% ($120 ÷ $1,000) Maturity = 30 years

A ten-year bond pays 11% interest on a $1000 face value semi-annually. If it currently sells for $1,195, what is its approximate yield to maturity? A) 9.33% B) 7.12% C) 12.66% D) 8.12%

D

What is the approximate yield to maturity for a seven-year bond that pays 11% interest on a $1000 face value annually if the bond sells for $952? A) 10.59% B) 10.61% C) 11.25% D) 12.03%

D

True or False? The prices of financial assets are based on the expected value of future cash flows, discount rate, and past dividends.

False.

How do default risk, taxability, liquidity, and maturity affect required return?

Default risk - bond ratings Taxability - municipal vs taxable Liquidity - bonds that have more frequent trading will generally have lower required returns Maturity - longer term bonds will tend to have higher required returns

What are some factors affecting required return?

Default risk, Taxability, Liquidity, and Maturity

True or False? An increase in yield to maturity would be associated with an increase in the price of a bond.

False.

True or False? As time to maturity increases, bond price sensitivity decreases.

False.

True or False? A bond is normally an interest-only loan, meaning that the borrower will pay interest every period and the principal will be repaid in increments throughout the life of the loan.

False. The borrower will pay interest every period, but none of the principal will be repaid until the END of the loan.

True or False? With a premium bond, bond price is greater than par value.

False. Bond price is less than par value.

True or False? High coupon rate bonds have more price risk than low coupon rate bonds.

False. High coupon rate bonds have LESS price risk than low coupon rate bonds.

True or false? Short-term bonds have less reinvestment rate risk than long-term bonds.

False. Short-term bonds have MORE reinvestment rate risk than long-term bonds.

Suppose the Xanth Co. were to issue a bond with 10 years to maturity. The Xanth bond has an annual coupon of $80. Similar bonds have a yield to maturity of 8%. The Xanth bond will pay $80 per year for the next ten years in coupon interest. In 10 years, Xanth will pay $1,000 to the owner of the bond. What would this bond sell for? What would the bond sell for if a year has gone by, and now there is only 9 years until maturity with a 10% yield instead of an 8% yield?

First, at the going rate of 8%, the present value of the $1,000 paid in 10 years is: PV = $1,000 ÷ 1.08^10 = $463.19 Second, the bond offers $80 per year for 10 years; the present value of this annuity stream is: Annuity present value = $80 * (1 - 1 ÷ 1.08^10) ÷ 0.08 = $536.81 Add the values together to get the bond's value. Total bond value = $463.19 + $536.81 = $1,000 This bond sells for EXACTLY its face value, $1,000. To solve for 9 years and 10% interest rate, PV = $1,000 ÷ 1.10^9 = $424.10 Annuity present value = $80 * (1 - 1 ÷1.10^9) ÷ 0.10 = $460.72 Total bond value = $424.10 + $460.72 = $884.82 This bond is priced to yield 10% at $885.

investment grade

Higher price, lower yield to maturity, BBB- bonds and up

You are considering buying a share of stock today. You plan to sell the stock in one year. You somehow know that the stock will be worth $70 at that time. You predict that the stock will also pay a $10 per share dividend at the end of the year. If you require a 25 percent return on your investment, what is the most you would pay for the stock? In other words, what is the present value of the $10 dividend along with the $70 ending value at 25 percent

If you buy the stock today and sell it at the end of the year, you will have a total of $80 in cash. At 25 percent: P0 = (D1 + P1)/(1 + R) Present value = ($10 + 70)/1.25 = $64 $64 is the price that you would assign to the stock today.

When computing YTM using a financial calculator, what sign conventions must be attached to each of the following values, and which value do you compute? PMT, FV, PV, I/Y

PMT and FV must have the same sign (+) PV the opposite sign (-) Compute I/Y for the yield

"Convergence" Property

Premium bond will go down to par price when nearing maturity Discount bond will go up to par price when nearing maturity The bond values will approach face value over time

Asset pricing based on DCF approach

Price = PV of all future cash flows at time of pricing. CF@t=0 is not relevant to pricing

What is the difference between public-issue and private-issue bonds?

Private-issue bonds are directly placed with a lender and not offered to the public.

What are the relevant cash flows of bond pricing? What is the discount rate?

Relevant cash flows: coupons and face value Discount rate: yield to maturity

What are the relevant cash flows of stock pricing? What is the discount rate?

Relevant cash flows: dividends Discount rate: required return

Is a bond rated BB+ an investment grade bond or a speculative grade bond?

Speculative grade bond

Briefly describe the three types of Treasury securities (federal government debt) and what lengths of time they are meant to last.

T-bill: pure discount bonds; less than one year T-note: coupon debt; between one year and ten years T-bond: coupon debt; more than ten years

True or False? Preferred stock would be valued the same as a common stock with a zero dividend growth rate.

True.

True or False? The valuation of a financial asset is based on the concept of determining the present value of future cash flows.

True

True or false? Current yield + capital gains yield = yield to maturity

True

True or False? A share of common stock is more difficult to value in practice than a bond.

True.

True or False? High-risk corporate bonds are as risky as junk bonds.

True.

True or false? Ratings AAA (Aaa) and AA (Aa) are considered to be high grade, ratings A and BBB (Baa) are considered to be medium grade, ratings BB (Ba), B, CCC (Caa), and CC (Ca) are considered to be low grade, and ratings C and D are considered to be very low grade.

True.

True or false? The coupons our receive on a Treasury note or bond are only taxed at the federal level.

True.

True or false? The price of stock is really just the present value of all expected dividends.

True.

bearer form

a bond issued without record of the owner's name; payment is made to whomever holds the bond the certificate is the basic evidence of ownership, and the corporation will "pay the bearer". ownership is not otherwise recorded, and the holder of the bond certificate detaches the coupons and sends them to the company to receive payment. used to be the dominant type but are now much less common in the US than registered bonds.

zero coupon bonds

a bond that makes no coupon payments, and thus is initially priced at a deep discount for tax purposes, the issuer of a zero coupon bond deducts interest every year even though no interest is actually paid. The owner must pay taxes on interest accrued every year, even though no interest is actually received. •Make no periodic interest payments (coupon rate = 0%) •Entire yield-to-maturity comes from the difference between the purchase price and the par value (capital gains) •Cannot sell for more than par value •Sometimes called zeroes, or deep discount bonds •Treasury Bills and U.S. Savings bonds are good examples of zeroes

collateral

a general term that frequently means securities (e.g. bonds and stocks) that are pledged as security for payment of debt; or commonly used to refer to any asset pledged on a debt; secured by dinancial securities e.g., collateral trust bonds often involve a pledge of common stock held by the corporation

fallen angel bond

a speculative bond that was issued as an investment bond at time of issuance

What happens to the relationship between bond price and par value in each of the following situations? Which bond is selling at a premium, at par, and at a discount? a) If Coupon Rate = YTM . . . b) If Coupon Rate > YTM . . . c) If Coupon Rate < YTM . . .

a) Bond price = par value Par bond b) Bond price > par value Discount bond c) Bond price < par value Premium bond

Municipal bonds (munis)

debt of state and local governments, \tax exempt at the federal level, usually tax exempt at the state level, varying degrees of default risk and rated similar to corporate debt

a bond is normally a(n) _____________________ loan a) interest-only b) par value c) coupon-only d) present value

a) interest-only

When interest rates increase, the bond prices:

decrease and will be worth less, and vice versa. Interest rates and bond prices have an inverse relationship. The present value of the bond's remaining cash flows will inversely react to the fluctuations of the interest rate.

As interest rates increase, present value and bond prices ________________.

decrease; and vice versa

subordinated debt

holders of subordinated debt must give preference to other specified creditors subordinated lenders will be paid off only after the specified creditors have been compensated debt cannot be subordinated to equity

put bond

allows the holder to force the issuer to buy back the bond at a stated price; the reverse of the call provision

sinking fund

an account managed by the bond trustee for early bond redemption for the purpose of repaying the bonds trustee can either buy up some of the bonds in the market or call in a fraction of the outstanding bonds

Structured notes

bonds that are based on stocks, bonds, commodities, or currencies

callable bonds

bonds that may be repurchased by the issuer at a specified call price during the call period

putable bonds

bonds with a provision that allows investors to sell them back to the company prior to maturity at a prearranged price

Which of the following types of cash flows is NOT good for pricing? a) single cash flow b) ordinary annuity c) annuity due d) perpetuity e) growing perpetuity

c) annuity due Annuity due is NOT good for pricing because the first cash flow is at time zero. Any cash flows at time zero are irrelevant.

convertible bond

can be swapped for a fixed number of shares of stock anytime before maturity at the holder's option

price risk

change in price due to changes in interest rates

bond

debt contract; interest-only loan

How does a corporation or government go about borrowing money from the public?

issuing debt securities, or, selling bonds

speculative grade (junk bonds)

lower price, higher yield to maturity, BB+ bonds and lower

mortgage securities

secured by a mortgage on the real property of the borrower (usually real estate, land, or buildings)

seniority

seniority indicates preference in position over other lenders, and debts are sometimes labeled as senior or junior to indicate seniority

coupon rate

the annual coupon divided by the face value of a bond; ACR ÷ F; stated interest rate; usually equal to YTM at issuance; multiply by par value to get coupon payment

face value (par value)

the principal amount of a bond that is repaid at the end of the term (maturity); represented by "F"; assume $1,000 for corporate bonds; "lump sum"

yield to maturity (YTM)

the rate required in the market on a bond; the market required rate of return for bonds of similar risk and maturity; the discount rate used to value a bond; return if bond is held to maturity; usually equal to coupon rate at issuance; quoted as an APR

registered form

the registrar of a company records who owns each bond, and bond payments are made directly to the owner of record corporate bonds are usually in registered form

maturity

the specified date on which the principal amount of a bond is paid; years until bond must be repaid

coupon

the stated interest payment made on a bond; represented by "C"; "annuity"

indenture (deed of trust)

the written agreement between the corporation and the lender detailing the terms of the debt issue includes: -Basic terms of the bonds -Total amount of bonds issued - a description of property used as security - the repayment arrangements -Secured versus Unsecured -Sinking fund provisions -Call provisions •Deferred call •Call premium -Details of protective covenants

what are two drawbacks to bearer bonds?

they are difficult to recover if they are lost or stolen because the company does not know who owns the bonds, it cannot notify bondholders of important events

Reinvestment rate risk

uncertainty concerning rates at which cash flows can be reinvested; short-term bonds have more reinvestment rate risk than long-term bonds; high coupon rate bonds have more reinvestment rate risk than low coupon rate bonds

debenture

unsecured debt, usually with a maturity of ten years or more debenture holders only have a claim on property not otherwise pledged, in other words, the property that remains after mortgages and collateral trusts are taken into account

note

unsecured debt, usually with an original maturity of under 10 years