FIN 3403 Exam 2

Sinking fund

A sinking fund is an account managed by the bond trustee for the purpose of repaying the bonds. The company makes annual payments to the trustee, who then uses the funds to retire a portion of the debt. The trustee does this by either buying up some of the bonds in the market or calling in a fraction of the outstanding bonds

When is this model appropriate?

If a firm is in a mature phase of its life cycle and operates in a stable industry, as the economy grows, its earnings will grow and dividends can therefore grow all at a constant rate

Seniority

- In general terms, seniority indicates preference in position over other lenders, and debts are sometimes labeled as senior or junior to indicate seniority. Some debt is subordinated, as in, for example, a subordinated debenture. In the event of default, holders of subordinated debt must give preference to other specified creditors. Usually, this means that the subordinated lenders will be paid off only after the specified creditors have been compensated. However, debt cannot be subordinated to equity.

Required Return

- appropriate fair return for investing in a project with the risk of the project under consideration

Credit Spread

Default risk Liquidity risk Tax status

Straight Majority voting

Each shareholder has 1 vote per seat

Face amount of bonds

Issue size, total overall bonds

Yield Curve

chart of the relationship between rates on treasury securities and time to maturity Interest rake risk premium Inflation premium real interest rate

Coupon Rate

coupon quoted as a percent of face value of definition of floating rate Annual coupon/FV

Security

description of collateral assets Secure vs unsecure bonds Secure have assets backed to them 1st priority for payback

Liquidity risk

how frequently do their bonds trade (reason that public bonds have minimum issue size)

Conventional cash flows

o Negative cash outflow at time 0 Investment in or funding of the project o Cash flows are positive for each year of the project (all times after zero)

Fisher Effect

o Our discussion of real and nominal returns illustrates a relationship often called the Fisher effect (after the great economist Irving Fisher). Because investors are ultimately concerned with what they can buy with their money, they require compensation for inflation. Let R stand for the nominal rate and r stand for the real rate. The Fisher effect tells us that the relationship between nominal rates, real rates, and inflation can be written as: o Fisher effect The relationship between nominal returns, real returns, and inflation. o

PE Ratio

o P/E = price per share / earnings per share

Zero Coupon/ Pure Discount

o Pays no interest o Interest earned is difference between PV and FV o No periodic coupon payments o Interest expense equals the change in the amortized value of the bond, initially sold less than par

Proxy Voting

o proxy statement prior to election which states management's opinion and recommendation o fill out proxy and let management vote for you o Or another group can vote for you o Activist investors can advertise and solicit your proxy vote

Equity Capital

ownership money, money that owners have put in the business

Term structure of interest rates

relationship between nominal interest rates on default free pure discount bonds and maturity

Multiphase growth

• Assume phases of time with different dividend growth rates with a final constant or zero growth phase that lasts forever

Clean vs Dirty prices

• Treasury prices are quoted as a percentage of face value • If you buy a bond between coupon payment dates, the price you pay is usually more than the price you are quoted. The reason is that standard convention in the bond market is to quote prices net of "accrued interest," meaning that accrued interest is deducted to arrive at the quoted price. This quoted price is called the clean price. The price you actually pay, however, includes the accrued interest. This price is the dirty price, also known as the "full" or "invoice" price. • An example is the easiest way to understand these issues. Suppose you buy a bond with a 12 percent annual coupon, payable semiannually. You actually pay $1,080 for this bond, so $1,080 is the dirty, or invoice, price. Further, on the day you buy it, the next coupon is due in four months, so you are between coupon dates. Notice that the next coupon will be $60. • The accrued interest on a bond is calculated by taking the fraction of the coupon period that has passed, in this case two months out of six, and multiplying this fraction by the next coupon, $60. So, the accrued interest in this example is 2/6 × $60 = $20. The bond's quoted price (that is, its clean price) would be $1,080 − $20 = $1,060.

Debt vs Equity

1. Debt is not an ownership interest in the firm. Creditors generally do not have voting power. 2. The corporation's payment of interest on debt is considered a cost of doing business and is fully tax deductible. Dividends paid to stockholders are not tax deductible. 3. Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of the firm. This action can result in liquidation or reorganization, two of the possible consequences of bankruptcy. Thus, one of the costs of issuing debt is the possibility of financial failure. This possibility does not arise when equity is issued.

Call provision

A call provision allows the company to repurchase or "call" part or all of the bond issue at stated prices over a specific period. Corporate bonds are usually callable. Usually are deferred until later in the bond's life

Convertible bonds

A convertible bond can be swapped for a fixed number of shares of stock anytime before maturity at the holder's option. Convertibles are relatively common, but the number has been decreasing in recent years Would only convert if the value of stock exceeds the value of the bond

Call premium

Generally, the call price is above the bond's stated value (that is, the par value). The difference between the call price and the stated value is the call premium. The amount of the call premium may become smaller over time. One arrangement is to initially set the call premium equal to the annual coupon payment and then make it decline to zero as the call date moves closer to the time of maturity.

Price per share sales multiple

Price per share/ sales per share

Price per share

Sales multiple X sales per share

Constant Growth Model

The Current Value of a share of stock is the present value of a growing perpetuity of dividends: P0= D1/ (R-g) More generally, Pt= Dt+1 / (R-g) where R > g Next dividend is Dt+1 • Ex: If the current dividend paid by a stock is $2, the expected dividend growth rate is 5% and the required rate of return is 10%, what is the expected price today? In 4 years? P0= 2.10/ (.10-.05) = $42 P4= 2.55/ (.10-.05) = $51

Face value or par

The amount of dollars you buy when you purchase 1 bond, normally 1,000, principal repaid at the end of the loan

Note vs Bond

The term note is generally used for such instruments if the maturity of the unsecured bond is less than 10 or so years when the bond is originally issued. usually the only difference between a note and a bond is the original maturity. Issues with an original maturity of 10 years or less are often called notes. Longer-term issues are called bonds.

What is YTM/ Required return composed of? What determines Bond Yield

Treasury Rate Credit Spread

Unique types of Bonds

Zero coupon/pure discount Convertible bonds Private Placement Government and Sovereign bonds

Problem with YTM?

assumes coupons are reinvested at the YTM as received. Is this possible? No because rates fluctuate

Debt Capital

borrowings the company has made, have to pay back lenders at some point in the future

Protective covenants

conditions that limit the actions of firms (negative covenant/ positive covenant) A negative covenant is a "thou shalt not" type of covenant. It limits or prohibits actions the company might take. Here are some typical examples: 1. The firm must limit the amount of dividends it pays according to some formula. 2. The firm cannot pledge any assets to other lenders. 3. The firm cannot merge with another firm. 4. The firm cannot sell or lease any major assets without approval by the lender. 5. The firm cannot issue additional long-term debt A positive covenant is a "thou shalt" type of covenant. It specifies an action the company agrees to take or a condition the company must abide by. Here are some examples: 1. The company must maintain its working capital at or above some specified minimum level. 2. The company must periodically furnish audited financial statements to the lender. 3. The firm must maintain any collateral or security in good condition

Default risk

credit risk related to issuer, how likely it is that they will not repay

Debenture

debenture is an unsecured bond, for which no specific pledge of property is made.

Staggered elections

o Consistency of companies and management o Certain number of board members are replaced each year o Hurt shareholder's ability to change management

Dividend Yield

o Dividend yield = D1/P0

Cumulative voting

o For every seat up for election, shareholders can cast all their votes for 1 seat o Ex: 3 seats up for election, cast all 3 votes to one person o Gives minority shareholders a chance to elect someone

Private placement (not public bond)

o Issuance negotiated with only institutional investors o Not governed by SEC o Issue size can be smaller o Terms can be more tailored to the issuer

Government and Sovereign Bonds

o Issuer is government agency o Exempt from state taxes o Long term debt o Ex: Treasury bills, notes, and bonds issued by US federal government o Municipal bonds issued by a state or local government Don't pay federal taxes

Maturity

time until face value is paid, usually given in years

2 factors that affect Interest rate risk

• 1. The longer the time to maturity- farther out more of the cash flows will be affected for the same changes in market rates o 1 year bond less variability, less interest risk o 30 year bond more variability, more interest risk • 2. The lower the coupon rate- the greater the proportion of cash flows that come from the par value at maturity, the more pv will be affected for the same change in market rates o Higher coupon, less interest risk

Cross over point for comparing mutually exclusive projects

• An indifference point, representing the rate at which the 2 projects provide the same npv • To find it, calculate the differences between the cash flows of the 2 projects in each year and then find the IRR of these differences in cash flows

Interest rate effects on bond value

• As time passes, interest rates change in the marketplace. The cash flows from a bond, however, stay the same. As a result, the value of the bond will fluctuate. When interest rates rise, the present value of the bond's remaining cash flows declines, and the bond is worth less. When interest rates fall, the bond is worth more.

Bond coupon rate is...

• Bond coupon rate is: o Higher for lower rating o Based on market rates at the time of issuance

Book value vs Market Value

• Book value= common stock + additional paid in capital + retained earnings (NI-Div) • Market value= price per share in market trade o Price per share X shares outstanding • Market value is greater than book value

Capital budgeting

• Capital budgeting- is a decision of what the company is going to invest in • Decisions involving acquisition of fixed assets and investment in projects • The biggest decisions for the firm- collectively determine the type(s) of businesses the firm engages in • Wisdom in this area is necessary for the firm to be profitable • Key concerns are the size, timing, and riskiness of future cash flows

2 Sources of return on a Bond

• Capital gains yield= The portion ignored by the current yield o Yield from change in bond price relative to the purchase price o If hold to maturity? At par= 0 o If sell before maturity? Market price compared to selling price • Current yield= interest payments • The reason the current yield is too low is that it considers only the coupon portion of your return; it doesn't consider the built-in gain from the price discount. For a premium bond, the reverse is true, meaning that current yield would be higher because it ignores the built-in loss.

NPV Profile

• Chart that shows NPV of a project at various discount rates • As DR goes up, NPV goes down

Premium vs Discount

• Coupon rate > market rate = premium • Coupon rate < market rate = discount

Profitability Index

• Present value of future cash flows divided by the initial investment • If a project has a positive NPV, then the PI will be greater than 1, so can provide the same accept/reject decision as NPV o PI > 1 is the same as NPV > 0 • Facilities ranking of projects if a firm is constrained by capital rationing • However, PI provides incorrect rankings with mutually exclusive projects, so must use npv to rank instead

Internal Rate of Return

• Discount rate that gives a project a $0 NPV (the rate that makes the present value of the future cash flows equal to the initial cost or investment) • Decision rule- the investment is acceptable if its IRR exceeds the required return • NPV and IRR comparison: If a projects cash flows are conventional and if the project is independent, then NPV and IRR will give the same accept or reject decision Problems with IRR • Non-conventional cash flows can produce multiple IRRs for projects with multiple sign changes in cash flows (NPV rule still works fine in this situation) • Can rank projects incorrectly, leading to wrong mutually exclusive choices (taking on one excludes another) • Can be tricked by packaging of projects • Calculation implicitly assumes firm is reinvesting funds at IRR- may lead to misrepresentative reinvestment rate assumption

Discount rate

• Discount rate- appropriate rate of interest= the rate the "market" requires to earn if the bond is bought

Benchmark PE ratio

• Expected P/E rather than actual P/E share value = Benchmark P/E ratio X EPS • Ex: XYZ analysts think that a fair P/E ratio for a firm the size of XYZ and in their industry is 19.5 and consensus forecast earnings for 2015 are 2.91 per share. What price would analysts target as the value for share of XYZ stock? Target share price= 2.91 (19.5) = $56.75

Zero Growth Model

• Good model to value preferred stock • Dividend cash flow is always the same, therefore the stream of dividends is a perpetuity or: D1= D2= D3= D4 • Share price is the pv of a perpetuity, using dividend as C o PV p ann = C/R o P0= D1/R o P1= D2/R • Ex: Suppose a stock has paid a $2 dividend each period, this is expected to continue forever, and the required return is 10% what is the stock worth? P0= 2/.10= $20

Public Bonds

• Highly structured interest only loan to a corporation (semiannual interest payments) o Only payments that occur over the life of the loan are interest payments until maturity when principle is paid back • Boilerplate terms and legal language so bonds are easily sold • Issue size greater than $250,000 (Liquidity in secondary markets) o If they decide to sell, they want to be sure someone will buy it • Registered with securities and exchange commission of US government

Bond Ratings

• How likely that a company will be able to pay interest and principal • AAA through D (default) • Investment quality are issued by strong companies (AAA-BB) • Low quality/Junk/Speculative bonds might not have the ability to pay back (BB-D) o Have higher interest rates

Decision tools are expected to:

• Identify good projects (provide the ability to accept/ reject individual projects) • Rank a group of available projects on relative attractiveness (how much wealth each creates) • Identify the best option from competing (mutually exclusive) projects

Discounted payback period

• Length of time until accumulated discounted cash flows equal or exceed the initial investment • Always longer than the PP • Decision rule: investment is acceptable if it is calculated payback is less than some pre-specified number of years • Negatives: o The arbitrary decision making cut off period may eliminate projects that would increase firm value o If there are negative cash flows after the cutoff period, the rule may indicate that acceptance of a project that has a negative NPV- gives inconsistent rankings o Can be tricked by packaging of projects • Acceptable for use as a liquidity measure for projects: o Interpretation- a project that recoups its investment faster is less risky, so for projects with equal NPVs, DPP can be used as a tie breaker (don't need a cutoff)

Payback Period

• Length of time until the accumulated cash flows equal or exceed the original investment • Decision rule- investment is acceptable if its calculated payback is less than some pre specified number of years o Hard to know what number of years should be • Negatives: o Ignores TVM, giving too much weight to distant earnings o Ignores cash flows after end of payback period (biased toward short term investments) o Gives inconsistent rankings o Can be tricked by packaging of projects o Doesn't consider risk differences o How do we determine the ideal cutoff point for decisions making since it is undefined and arbitrary?

Average Accounting Return

• Measure of accounting profit/ measure of average accounting value • Not a rate of return o Uses accounting numbers rather than cash flows o No risk adjustment o It isn't clear what is being measured

Corporate Debt

• Money loaned to a company • An accounting liability to the company • Lenders/ creditors have no ownership rights • Can be structured various ways (collateral, when principle and interest due, other terms) • Structure governed by a negotiated legal document • Interest payments- tax deductible expenses to the company • Lenders/creditors may have the ability to force behavior or restrict actions in certain circumstances • Missed payments and other defined events place the company in default and subject it to legal action o Not that they missed the payment, but they actually can't pay

Nominal vs Real Rates

• Nominal rates- rates that include the effect of inflation (all we have discussed so far) • Real rates- rates with the inflation effect removed • If R is the nominal rate, r the real rate, and h, the expected inflation rate: (1+R) = (1+ r) (1+h)

Interest Rate risk

• Or "Bond price risk" due to internal rate changes • Measured as the percentage change in the bond price for a given move in market rates • Financial risk is not looked at as one sided, but as variability from expectations o Make more or less • Bond prices change as market interest rates change • What is the risk? o If you invest in bonds and need to sell prior to maturity, what you earn will be different than YTM • If you hold to maturity, you will make a different than current market return

Common stock dividends

• Payment of dividends is at the discretion of the board • Dividends are not tax deductible for the paying firm o Dividends have to be taxed • Dividends received by individuals are taxed based on the holding period of the stock (ordinary income vs. capital gains)

Preferred stock

• Precedence over common stock in payment of dividends and liquidation • Kind of debt, but $ doesn't have to be paid back • Somewhere between equity and debt • Company is obligated to pay dividends to preferred before common stock • Dividend is usually fixed (stated as percent of par value- standard par $100) • Usually no voting rights • Most commonly pay cumulative dividends

Common stock rights

• Proportional ownership of company • Primary right- elect corporate directors who set corporate policy and select operating management • Other rights o 1. Share proportionally in dividends paid o 2. Share proportionally in any liquidation value Liquidation value- company files for bankruptcy, company is sold and liquidated, liquidation value is amount of money left over after debtors have been paid o 3. Vote on matters of importance- annually and one time (ex: auditors, mergers) • Possible right o 4. Preemptive right- the right to purchase a pro rata share of any new stock issuance

Current Yield

• Representation of return from coupon payments = Annual coupon/current bond price

NPV

• Should be relied on the most • Measure of wealth created by investing in a project NPV is the best because... o It clearly measures the value added to shareholder wealth o It correctly accounts for the time value of money o It adjusts for project risk by using opportunity cost of capital as the discount rate o It is not fooled by "packaging" with another project NPV (A+B)= NPV (A) + NPV (B)

Put provision

• The holder has the right to redeem the note at par on the coupon payment date after some specified amount of time.

Bond Indenture

• The indenture is the written agreement between the corporation (the borrower) and its creditors. It is sometimes referred to as the deed of trust.3 Usually, a trustee (a bank, perhaps) is appointed by the corporation to represent the bondholders. The trust company must (1) make sure the terms of the indenture are obeyed, (2) manage the sinking fund (described in the following pages), and (3) represent the bondholders in default—that is, if the company defaults on its payments to them • it generally includes the following provisions: 1. The basic terms of the bonds. 2. The total amount of bonds issued. 3. A description of property used as security. 4. The repayment arrangements. 5. The call provisions. 6. Details of the protective covenants

Holding Period Yield

• The return that a bond holder will earn if the bond is sold for the current market price, given the initial price paid and the coupons earned while it was owned How much was earned will you owned the bond

Yield to Maturity

• The return that the buyer of a bond will earn if the current market price is paid for the bond and the bond is owned until maturity

Yield to first call

• The return the buyer of a bond with a call provision will earn if the current market price is paid for the bond and the bond is called at the first point the indenture allows Sometimes a premium will be added to the FV if called