Unit 6

What are the two major forms of long-term debt?

-private issue -public issue

As a general rule, which of the following are true of debt and equity?

Equity represents an ownership interest. The maximum reward for owning debt is fixed.

For investors in the stock market, dividends from stocks are fixed and guaranteed, while capital gains are variable and not guaranteed.

False

True or false: Common stock has a set maturity.

False

What is the equation for approximating the nominal rate of return? R = the nominal rate of interest r = the real rate of interest h = the inflation rate

R = r + h

Which of the following ratios might be used to estimate the value of a stock?

The Price/Sales ratio The Price/Earnings ratio

If you are holding two bonds - one with a 5% coupon rate and the other with an 8% coupon rate - which one is more sensitive to interest rate risk, all other things being equal?

The bond with a 5% coupon rate

Which of the following defines the primary market?

The primary market is where stocks are issued for the first time.

What are the three components that influence the Treasury yield curve?

The real rate of return Expected future inflation The interest rate risk premium

If a $1,000 face value U.S. Treasury bond is quoted at 99.5, then the bond can be purchased _____.

at 99.5 percent of face value plus any accrued interest

If unpaid preferred dividends must be "caught up" before any common dividends can be paid, they are called _________ dividends.

cumulative

Someone who maintains an inventory of stocks and buys and sells those stocks is known as a ____.

dealer

All else constant, the dividend yield will increase if the stock price ____.

decreases

A key difference between interest payments and dividend payments is?

dividends are not tax deductible interest is tax deductible

Which three of the following are common shapes for the term structure of interest rates?

downward sloping upward sloping humped

A limitation of bond ratings is that they ____.

focus exclusively on default risk

A PE ratio that is based on estimated future earnings is known as a ____________ PE ratio.

forward

The value of a firm is derived using the firm's ______ rate and its _______ rate.

growth; discount

A bond with a BB rating has a ______ than a bond with an BBB rating.

higher risk of default

The nominal rate is found by adding the _____ and the real rate of return.

inflation

Stock price reporting has increasingly moved from traditional print media to the ______ in recent years.

internet

Which of the following may increase the yield on corporate bonds as compensation to investors but will not impact Treasury bond yields?

liquidity premium default risk premium

The interest rate risk premium is the additional compensation demanded by investors for holding ____ bonds.

longer-term

The fundamental business of the New York Stock Exchange is to attract _______.

order flow

Equity represents a(n) _____ interest of a firm

ownership

Initial public offerings of stock occur in the ____ market.

primary

The trading of existing shares occurs in the ______ market.

seconday

Which type of debt is given preference in the event of default?

senior

New York Stock Exchange Designated Market Makers (DMMs) were formerly called ________ .

specialists

Earnings over the coming year are expected to be $3 and a benchmark PE of 15 applies to earnings over the previous year. The _____, or forecast, price over the coming year is $45.

target

The term structure of interest rates describes ________.

the pure time value of money the relationship between nominal rates and time to maturity

The degree of interest rate risk depends on ____.

the sensitivity of the bond's price to interest rate changes

Junk bonds have the following features:

they are rated below investment grade bonds

True or false: Investors require a premium for the risk that issuers other than the Treasury may not make all promised payments on the issued bonds.

true

True or false: Long-term debt has maturities greater than one year.

true

True or false: Low-grade bonds may not be rated by major rating agencies.

true

True or false: The government sells Treasury notes and bonds to the public every month.

true

True or false: Total return is calculated by adding the dividend yield and the capital gains yield.

true

The US government borrows money by issuing:

Treasury bonds Treasury notes

True or false: All else being equal, a one-year bond's price is less sensitive to interest rate changes as compared to that of a ten-year bond's price.

True

True or false: The price you actually pay to purchase a bond will generally exceed the clean price.

true

A bond's coupon payment is:

a fixed amount of interest that is paid annually or semiannually by the issuer to its bondholders

A person who brings buyers and sellers together is called a(n) ______. investor

broker

True or false: Daily stock prices can only be found by looking up the stock in newspapers.

false

If a bond is selling at a discount from its par value, the YTM must be _____ the coupon rate.

greater than

Which of the following are reasons that make valuing a share of stock more difficult than valuing a bond?

Dividends are unknown and uncertain The required rate of return is unobservable Stock has no set maturity

Which one of the following is true about dividend growth patterns?

Dividends may grow at a constant rate.

R = ______

Dv1/Pv0 + g

Pv1 = (__ + Pv2)/(1 + R)

Dv2

What does a Treasury yield curve show?

It shows the yield for different maturities of Treasury notes and bonds

Pv0 = (Dv1 + Pv1)/(1 + __)

R

A debenture is a(n) _____ bond, for which no specific pledge of property is made.

unsecured

If the growth rate (g) is zero, the capital gains yield is ____.

zero

A provision in the bond indenture giving the issuing company the option to repurchase the bonds before maturity is termed a _________________.

call provision

A corporate bond's yield to maturity:

changes over time is usually not the same as a bond's coupon rate

What is a real rate of return?

-it is a rate of return that has been adjusted for inflation -it is a percentage change in buying power

Crossover bonds can also be called _____ bonds.

5B

What is a premium bond?

A bond that sells for more than face value

What are crossover bonds?

Bonds that have both an investment grade and a junk bond rating

What are "fallen angel" bonds?

Bonds that have dropped from investment grade to junk bond status

Which of the following are cash flows to investors in stocks?

Capital gains Dividends

What information do we need to determine the value of a stock using the zero growth model?

Dividend Discount rate

Which three components determine the shape of the term structure of interest rates?

Inflation premium Real interest rate Interest rate risk premium

What is the nominal rate of return on an investment?

It is the actual percentage change in the dollar value of an investment unadjusted for inflation.

Which of the following are rights of common stock holders?

The right to share proportionally in any residual value in the event of liquidation. The right to vote on matters of importance. The right to share proportionally in any common dividends paid.

Which of these correctly identify differences between U.S. Treasury bonds and corporate bonds?

Treasury bonds are considered free of default risk while corporate bonds are exposed to default risk. Treasury bonds are issued by the US government while corporate bonds are issued by corporations. Treasury bonds offer certain tax benefits to investors that corporate bonds cannot offer.

Which of the following represents the valuation of stock using a zero growth model?

Dividend/Discount rate = D/R

Websites that allow investors to trade directly with one another are termed _______.

ECNs

Which of the following is not a difference between debt and equity?

Equity is publicly traded while debt is not

NASDAQ has which of these features?

Multiple market maker system Computer network of securities dealers

The two most important stock markets in the U.S. are the New York Stock Exchange and ______.

NASDAQ

Which of the following is true of zero coupon bonds?

No coupon payments are made on the bonds

What are the cash flows involved in the purchase of a 5-year zero-coupon bond that has a par value of $1,000 if the current price is $800? Assume the market rate of interest is 5 percent.

Pay $800 today and receive $1,000 at the end of 5 years

What is the definition of a bond's time to maturity?

It is the number of years until the face value is paid off

Which of the following are true about a bond's face value?

It is the principal amount repaid at maturity. It is also known as the par value.

What is the formula for the present value of a growing perpetuity where C1 is the net cash flow, R is the required return and g is the growth rate?

P = Cv1/(R-g)

What will happen to a bond's time to maturity as the years go by?

it will decline

True or false: Current yield = Annual coupon payment/Price

True

True or false: Bonds that have dropped into junk territory are called "trash" bonds.

false

The model that precisely specifies the relationship between the nominal rate and the real rate is: R = the nominal rate r = the real rate h = the rate of inflation

(1 + R) = (1 + r)×(1 + h)

If you are holding a municipal bond that is trading at par to yield 6%, by how much will your after-tax yield change if your federal income tax bracket increases from 15% to 20%. Assume there are no state or local taxes

0%

The sensitivity of a bond's price to interest rate changes is dependent on which of the following two variables?

Coupon rate Time to maturity

What is a bond's current yield?

Current yield = Annual coupon payment/Price

What is the inflation premium?

It is the additional return demanded by investors to compensate for expected inflation

What does a bond's rating reflect?

The ability of the firm to repay its debt and interest on time

What does the AAA rating assigned by S&P mean?

The firm is in a strong position to meet its debt obligations

True or false: Longer-term bonds have greater interest rate sensitivity because a large portion of a bond's value comes from the face amount.

True

What are the two unique features of a U.S. federal government bond?

U.S. Treasury issues are exempt from state income taxes. U.S. Treasury issues are considered to be default-free.

What is a corporate bond's yield to maturity (YTM)?

YTM is the expected return for an investor who buys the bond today and holds it to maturity. YTM is the prevailing market interest rate for bonds with similar features.

Three special case patterns of dividend growth discussed in the text include:

Zero growth Non-constant growth Constant growth

A benchmark PE ratio can be determined using:

a company's own historical PEs the PEs of similar companies

The NYSE differs from the NASDAQ primarily because the NYSE has:

a face-to-face auction market a physical location

The ___ price is also called the "full" or "invoice" price.

dirty

Preferred stock has preference over common stock in the:

distribution of corporate assets payment of dividends

The constant-growth model assumes that _________.

dividends change at a constant rate

The price of a share of common stock is equal to the present value of all ______ future dividends.

expected

True or false: A debenture is a bond secured with collateral.

false

True or false: Bond ratings are concerned only with the possibility of price changes.

false

True or false: The dirty price does not include accrued interest.

false

The ______ can be interpreted as the capital gains yield.

growth rate

The bonds of a firm in financial distress may have a market value that is _______ than the face value at maturity

less

When using trial and error to compute the yield to maturity (YTM) for a 6 percent coupon bond that trades at a premium, the process can be shortened if the initial guess is ____ 6 percent.

lower than

If a company's growth for Years 1 through 3 is 20% but stabilizes at 5% beginning in Year 4, its growth pattern would be described as _______.

non-constant

This type of growth describes a company that grows quickly at first, then slower in future years.

non-constant

When voting for the board of directors, the number of votes a shareholder is entitled to is generally determined as follows:

one vote per share held

Shares of stock are first brought to the market and sold to investors in the ______ market

primary

A part of the indenture limiting certain actions during the term of the loan are termed ________.

protective convenants

The term structure of interest rates examines the ____.

relationship between short-term and long-term interest rates

Using a benchmark PE ratio against current earnings yields a forecasted price called a _______ price.

target

Bond ratings are based on the probability of default risk, which is the risk that _____

the bond's issuer may not be able make all the required payments

The relationship between nominal rates, real rates and inflation is called ________ .

the fisher effect

Debt cannot be subordinated to ____

equity

Bonds issued by state and local governments are called _______ ______.

municipal bonds

True or false: A PE ratio that is based on estimated future earnings is called a regressive PE ratio.

false

The dividend yield is determined by dividing the expected dividend (D1) by:

the current price (Pv0)

Match the following terms relating to stock valuation. Pv1 Dv1 R Pv0 Dv0

Price in one year Next expected Dividend Discount Rate Price Today Dividend just paid

In the dividend growth model, the expected return for investors comes from which two sources?

Dividend Yield Growth rate