Exam 3

Term structure

The relationship between time to maturity and yields, all else equal

Treasury securities

U.S. government debt

Risk

Uncertainty

Debentures

Unsecured (I.O.U.), backed by ability of firm to repay debt - Most common

Normal yield curve

Upward-sloping - long term > short term

Par value

What you get paid at the end

Maturity

Years until bond must be repaid

Stock price sensitivity to dividend growth

g increases, present value increases

Capital budgeting

the process of analyzing projects and deciding which are acceptable investments and which acceptable investments should be purchased (to add value)

Broker

- Brings buyers and sellers together - Helps with the trade exchange

Disadvantages for IRR

- Can produce multiple answers - Cannot rank mutually exclusive projects - Reinvestment assumption flawed

Advantages of profitability index

- Closely related to NPV, generally leading to identical decisions - Easy to understand and communicate - Useful in capital rationing

Treasury notes

- Coupon debt - Original maturity between one and ten years

Treasury bonds

- Coupon debt - Original maturity greater than ten years

Advantages of payback

- Easy to understand - Adjusts for uncertainty of later cash flows - Biased toward liquidity

Constant dividend/zero growth

- Firm will pay a constant dividend forever - Like preferred stock - Price is computed using the perpetuity formula - Least amount of problems

Classes of common stock

- Founders' shares - Class A and Class B shares (different voting rights)

Disadvantages of payback

- Ignores the time value of money - Requires an arbitrary cutoff point (preset limit) - Ignores cash flows beyond the cutoff date - Biased against long-term projects, such as research and development, and new projects

Dealers

- Maintains an inventory - Ready to buy or sell at any time

Preferred dividends

- Must be paid before dividends can be paid to common stockholders - Not a liability to the firm (equity on bal. sheet) - Can be deferred indefinitely - Most preferred dividends are cumulative MOST FIRMS DONT HAVE THIS

Debt

- Not an ownership interest - Creditors do not have voting rights - Interest is considered a cost of doing business and is tax-deductible to the firm (means we pay less (cheaper)) - Creditors have legal recourse if interest or principal payments are missed - Excess debt can lead to financial distress and bankruptcy (Liquidating: selling everything or Refinancing)

Equity (no endpoint to ownership)

- Ownership interest - Common shareholders vote to elect the board of directors and on other issues - Dividends are not considered a cost of doing business and are not tax-deductible to the firm - 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

Advantages for IRR

- Preferred by executives - If the IRR is high enough, may not need to estimate the required return - Considers all cash flows - Considers time value of money

Other features of common stock

- Share proportionally in declared dividends - Share proportionally in remaining assets during liquidation (to add value) - Preemptive right: right of the first (refusal) to buy new stock issue to maintain proportional ownership if desired

Dividend characteristics

-Dividends are not a liability of the firm until a dividend has been declared by the Board -Consequently, a firm cannot go bankrupt for not declaring dividends

If you own a share of stock, you can receive cash in 2 ways

1. The company pays dividends (cash income - small return) 2. You sell your shares (capital gains or losses - big return)

Deferred call

A bond could have call protection where the issuer could not call the bond back for a period of time

Bond trustee (someone who you trust)

A trustee (ex: a bank) is usually appointed to represent the bondholders (in case something happens)

Medium grade (investment quality)

A: capacity to pay is strong, but more susceptible to changes in circumstances BBB: capacity to pay is adequate, adverse conditions will have more impact on the firm's ability to pay

High grade (investment quality)

AAA: capacity to pay is extremely strong - Most companies do not have an "AAA" rating - Cheapest interest rate (cheapest cost of borrowing) AA: capacity to pay is very strong

Decision rule for IRR

Accept the project if the IRR is greater than the required return

Call Provision

Allows the issuer to repurchase or "call" part or all of the bond issue at stated prices over a specific period - Usually when rates have fallen or issuer wants to pay down debt early - Ex: student loan, car loan, etc.

Collateral

An asset pledges on a debt - Not usual/not good - Ex: your car

Low grade (speculative: junk bonds)

BB, B, CCC, and CC - Considered speculative with respect to capacity to pay - "B" ratings are the lowest degree of speculation

As interest rates increase (2)

Bond prices decrease and vice versa

Price risk

Bond value decreases, price increases Bond value increases, price decreases

Registered Bonds

Bonds that you buy today - Payment is made directly to the owner of registered bonds - Most common

Very low grade

C: income bonds with no interest being paid D: in default with principal and interest in arrears - May never get a coupon rate but still have value!!

Nominal rate of interest (quoted rate of interest)

Change in actual number of dollars - Not adjusted for inflation

Real rate of interest

Change in purchasing power - After inflation - Can be negative

Security bonds

Collateral, mortgage, and debentures

Reinvestment approach

Compound all CFs except the first one forward to end

Bond indenture (a list of the features)

Contract between issuing company and bondholders and includes: - Basic terms of the bonds - Total amount of bonds issues - Description of property used as security - Repayment arrangements - Call provisions - Details of protective covenants

Modified internal rate of return (MIRR)

Controls for some problems with IRR - IF MIRR > required return, accept

Coupon rate < YTM Price < Par

Discount bond

Discounting approach

Discount future outflows to present and add to CF0

Combination approach

Discount outflows to present; compound inflows to end

Internal rate of return (expected return)

Discount rate that makes the NPV equal 0

Supernormal growth

Dividend growth is not consistent initially, but settles down to constant growth eventually

D0

Dividend just paid

Perpetuity (P0)

Dividends expected at regular intervals forever

Inverted yield curve

Downward-sloping - long term < short term

Voting rights of common stock

Each 1 share of common stock owned provides you with voting rights of 1 / total shares issued by the company - Cumulative voting: can cast all of your votes for the elections to just one candidate - Straight voting: one vote for each available stock - Proxy voting: allows another entity to vote your shares

Secondary markets

Existing shares traded among investors

D1, D2, D3, etc.

Expected dividends

Constant dividend growth

Firm will increase the dividend by a constant percent every period - Low growth firms mostly use this

Contract (interest) payment

Fixed every period

Call premium

Generally a higher price than face value is paid

Yield curve

Graphical representation of the term structure

Bearer Bonds

Have no ownership record - Usually a sketchy person will want this

Payback period

How long does it take to recover the initial cost of a project?

Coupon rate

How much of the par value you are paying back - Fixed - Think of interest

Net present value (NPV)

How much value we believe from undertaking an investment? - If NPV is positive, accept the project

Repayment

If there is a sinking fund (forces them to pay back earlier), some of the bond issue will be paid off each year instead of all of it repaid at maturity - Used more for municipal bonds

Municipal securities "munies"

Interest received is tax-exempt at the federal level (higher taxed individuals will benefit from this)

What is a bond?

Long-term Debt contract

Disadvantages of profitability index

May lead to incorrect decisions in comparisons of mutually exclusive investments (can conflict with NPV)

Profitability index

Measures the benefit per unit cost, based on the time value of money - If PI > 1.0, accept

Government bonds

Municipal and treasury

Primary markets

New-issue market

g

One whose dividends are expected to grow forever at a constant rate

Coupon rate = YTM Price = Par

Par bond

Protective covenants (restrictions)

Part of the indenture that limits certain actions a company might otherwise wish to take during the term of the loan

Seniority (liquidation)

Positive for an investor: Senior has the first claim in default - Get a lower rate, but less risky Negative for a (special) investor: Subordinated has last claim in default

Coupon rate > YTM Price > Par

Premium bond

As interest rates increase (1)

Present value decreases

Bond markets

Primarily over-the-counter (not exchange trading) transactions with dealers connected electronically - Extremely large numbers of bond issues but generally low daily volume in single issues - Getting up-to-date prices difficult, particularly on small company or municipal issues - Treasury securities are an exception

Stock price sensitivity to required return

Rate increases, present value decreases

Mortgage

Secured a real property, normally land or buildings

Treasury bills (t-bills)

Shot-term U.S. debt - Pure discount bonds (pay less today to get more) - Original maturity of one year or less

Yield to maturity (YTM)

The market required rate of return for bonds of similar risk and maturity - The discount rate used to value a bond