Exam #2 (Chp 6-9 ) - Managerial Finance
Explain what is meant by horizon (terminal) date and horizon (continuing) value
Horizon (terminal) date: The date when the growth rate becomes constant. At this date, it is no longer necessary to forecast the individual dividends. Horizon (continuing) value: Value at horizon date of all dividends expected thereafter
what four factors affect the level of interest rates?
1. production opportunities 2. time preferences for consumption ( the preferences of consumers for current consumption as opposed to saving for future consumption). 3. risk 4. expected inflation
Perfect positive correlation means that _____.A. total diversification can be achievedB. there will be no diversification effectC. the correlation is equal to zeroD. none of the above
B. there will be no diversification effect
1. Suppose all stocks in Ariel's portfolio were equally weighted. Which of these stocks would contribute the least market risk to the portfolio? Makissi Corp. Zaxatti Enterprises Three Waters Co. Perpetualcold Refrigeration Co. 2. Suppose all stocks in the portfolio were equally weighted. Which of these stocks would have the least amount of stand-alone risk? Three Waters Co. Makissi Corp. Perpetualcold Refrigeration Co. Zaxatti Enterprises
1. Makissi Corp. 2. Zaxatti Enterprises Explanation: Standard deviation measures stand-alone risk, whereas the beta coefficient measures a stock's contribution to the risk of a well-diversified portfolio. The beta coefficient measures the risk of a given security relative to the overall market, which is considered to be a large, diversified portfolio. In this case, because the portfolio of four stocks does not represent a well-diversified portfolio, beta values represent the market risk, or systematic risk. Therefore, Zaxatti Enterprises has the least stand-alone risk, but Makissi Corp. actually has the least market risk. This means that Makissi Corp. contributes the least amount of market risk to the portfolio. market risk = beta ( Beta < 1 = less risky) standalone risk = standard deviation ( lower standard deviation = lower risk)
For any two assets, it's POSSIBLE for the correlation coefficient to be anywhere _______. A. between -1.0 to 0.0 B. between 0.0 and +1.0 C. between -1.0 and +1.0 D. between +0.3 and +0.7
C. between -1.0 and +1.0
If firm B had a 75% payout ratio but then lowered it to 25%, causing its growth rate to rise from 3% to 9%, would that action necessarily increase the price of its stock? Why or why not?
If all factors are constant (D1 and required rate of return), then the lower payout ratio would cause an increase in the stock's price
Characteristic This is the premium added to the real risk-free rate to compensate for a decrease in purchasing power over time. Inflation premium IP This is the rate for a riskless security that is exposed to changes in inflation. Nominal risk-free rate rRF It is based on the bond's marketability and trading frequency; the less frequently the security is traded, the higher the premium added, thus increasing the interest rate. Liquidity risk premium LP This is the rate for a short-term riskless security when inflation is expected to be zero. Real risk-free rate r* As interest rates rise, bond prices fall, and as interest rates fall, bond prices rise. Because interest rate changes are uncertain, this premium is added as a compensation for this uncertainty. Maturity risk premium MRP This is the premium added as a compensation for the risk that an investor will not get paid in full. Default risk premium DRP
r* is the real risk-free rate, referred to as the rate that would exist in an inflation-free world on a riskless security. US Treasury securities are considered to be riskless securities, since they are backed by the US government. Considering there is no inflation, the rate on a riskless US Treasury security would be considered as the real risk-free rate. This rate is not static but keeps changing based on the expected rate of return on productive assets traded among investors and borrowers. The real risk-free rate also depends on an investor's time preference for current versus future consumption. rRFrRF is the nominal risk-free rate, or quoted risk-free rate. Consider all risk-free rates as nominal risk-free rates unless otherwise noted. It is the rate on a riskless security that includes an inflation premium for expected inflation. It is calculated as follows: Treasury Inflation Protected Securities (TIPS) are considered to be free of most risks. TIPS are free of default, maturity, and liquidity risks and of risk due to changes in the general level of interest rates. Thus, the rates on TIPS are considered to be a good indicator of the risk-free rate. IP stands for the inflation premium that is added to the real risk-free rate to compensate for the expected increase in the value of goods and services due to inflation. The inflation premium is calculated based on the expected changes in inflation over the entire life of the security, not the rate of inflation in the past—but you can use past inflation rates to calculate the expected rate of inflation. DRP stands for the default risk premium. Default risk refers to the risk that a borrower will default, which means that the borrower will not make payments as committed. Based on the credit quality and chances of default, ratings are assigned to bonds. The higher the bond rating, the lower its default risk and added default risk premium, thus resulting in a lower interest rate. If a corporate bond has the same maturity and the same marketability as a US Treasury bond, its default risk premium will be the difference in the interest rate offered by the corporate bond and the interest rate on the US Treasury bond. LP refers to the liquidity premium. Some liquid assets can be converted into cash quickly at fair market value, and other assets have different levels of liquidity. Because an investor carries the risk of not being able to sell a security and convert it into cash quickly enough to prevent or minimize loss, a liquidity premium is added to the equilibrium interest rate. MRP is the maturity risk premium that reflects the risk associated with interest rate changes. Interest rate risk refers to the capital loss that an investor suffers when the value of a bond decreases due to an increase in interest rates. The longer the maturity of a bond, the higher the risk, thus causing a higher maturity risk premium for long-term bonds. Although long-term bonds are exposed to greater interest rate risks, short-term bonds face greater reinvestment rate risk; this means that if interest rates are low when short-term bonds mature, an investor might have to settle for a lower interest rate when reinvesting in bonds.
Larry also holds 2,000 shares of common stock in a company that only has 20,000 shares outstanding. The company's stock currently is valued at $41.00 per share. The company needs to raise new capital to invest in production. The company is looking to issue 5,000 new shares at a price of $32.80 per share. Larry worries about the value of his investment. Larry's current investment in the company is $ . If the company issues new shares and Larry makes no additional purchase, Larry's investment will be worth $. This scenario is an example of ________ . Larry could be protected if the firm's corporate charter includes a ___________ provision. If Larry exercises the provisions in the corporate charter to protect his stake, his investment value in the firm will become$ .
$82,000 $78,720 dilution preemptive right $98,400 Refer how to calculate. Larry is worried about the dilution of his investment if these new shares are issued. He currently has 2,000 shares worth $41.00 per share, or $82,000 ($41.00 per share x 2,000 shares), and the company's total market value is $820,000 ($41.00 per share x 20,000 shares). If the company issues the new shares, its market value will be calculated as follows: he company will now have 25,000 shares outstanding (20,000 "old" shares + 5,000 "new" shares). You can calculate the value of each share after the company issues new shares as follows: Therefore, Larry's investment will be worth $78,720 ($39.36 per share x 2,000 shares). His investment will be diluted by $3,280, and now he holds only 8.00% of the shares (2,000 shares/25,000 shares), compared to 10.00% (2,000 shares/20,000 shares) before the new share issue. If the company's charter has a preemptive right, Larry would have the opportunity to buy 500 of the new shares (10.00% of the new issue), because he currently holds a 10.00% stake in the firm. If Larry buys 500 new shares, his investment will be: If there is a preemptive right and Larry buys new shares, he will hold 2,500 shares/25,000 shares = 10.00% of the company. Thus, he will have averted dilution.
Portfolio managers pick stocks for their clients' portfolios based on the investment objective of the portfolio and several other factors. One key consideration is each stock's contribution to portfolio risk and its statistical relationship with the portfolio's other stocks. Based on your understanding of portfolio risk, identify whether each statement is true or false. 1. Because of the effects of diversification, the portfolio's risk is likely to be more than the average of all stocks' standard deviations. 2. The unsystematic risk component of the total portfolio risk can be reduced by adding negatively correlated stocks to the portfolio. 3. A portfolio's risk is likely to be smaller than the average of all stocks' standard deviations, because diversification lowers the portfolio's risk. 4. Portfolio risk will increase if more stocks that are negatively correlated with other stocks are added to the portfolio.
1. False 2. True 3. True 4. False When calculating the portfolio's risk, you have to consider the effect of the relationship between the security holdings in the portfolio. Thus, it cannot be calculated simply by taking the weighted average of the individual stocks' standard deviations. The portfolio's risk is likely to be smaller than the average of all stocks' standard deviations, because diversification lowers the portfolio's risk. Correlation is defined as the statistical relationship between two stocks. If two stocks move in the same direction, they are referred to as positively correlated stocks. The correlation coefficient (ρ) measures the degree to which two stocks are correlated. A ρ of +1.00 between the two means that both stocks will move in the exact same direction, and they are referred to as perfectly positively correlated stocks . A ρ of -1.00 between the two means that both stocks will move in the exact opposite direction, and they are referred to as perfectly negatively correlated stocks. A ρ of 0.00 means that returns of the two stocks are not related. Portfolio risk consists of market risk, also called systematic risk, and diversifiable risk, also called company-specific risk or unsystematic risk. Diversifiable risk represents the risk that is inherent to the stocks in the portfolio. It is risk associated with unexpected events that affect the returns associated with a particular stock. Some examples include lawsuits, strikes, or product failures. Market risk refers to the systematic risks in the equity markets that are affected by macroeconomic conditions and external factors. Diversifiable, or unsystematic, risk can be reduced by adding more securities to the portfolio. However, because systematic risk is associated with the entire market, risk can be reduced by investing in different markets through a process called hedging.
Gregory is an analyst at a wealth management firm. One of his clients holds a $10,000 portfolio that consists of four stocks. The investment allocation in the portfolio along with the contribution of risk from each stock is given in the following table: Gregory calculated the portfolio's beta as 0.890 and the portfolio's required return as 8.8950%. Gregory thinks it will be a good idea to reallocate the funds in his client's portfolio. He recommends replacing Atteric Inc.'s shares with the same amount in additional shares of Baque Co. The risk-free rate is 4%, and the market risk premium is 5.50%. According to Gregory's recommendation, assuming that the market is in equilibrium, how much will the portfolio's required return change? (Note: Do not round your intermediate calculations.) 0.9009 percentage points 1.3283 percentage points 1.1550 percentage points 1.4322 percentage points
1.1550 percentage points If Gregory changes the allocation in his client's portfolio, the weights of the stocks in the portfolio are going to change. The weight in Atteric Inc. will change to 0.00%, because Gregory intends to sell Atteric Inc.'s stock. Baque Co.'s portfolio weight will change from 30% to 65% (new weight = 30% + 35% = 65%). Using the new weights, first calculate the portfolio's new beta as follows: So, if Gregory sells Atteric Inc.'s stock and buys Baque Co.'s stock, he will decrease the market risk of the portfolio. You can verify this, because the portfolio beta decreases from 0.890 to 0.6800. Because Gregory is adding more of Baque Co.'s shares and reducing the risk in the portfolio, the required return from the portfolio will also decrease by 1.1550 percentage points (8.8950% - 7.7400%).
A stock has a beta of 1.2. Assume that the risk-free rate is 4.5%, and the market risk premium is 5%. What is the stock's required rate of return? (SML)
10.5%
A collection of financial assets and securities is referred to as a portfolio. Most individuals and institutions invest in a portfolio, making portfolio risk analysis an integral part of the field of finance. Just like stand-alone assets and securities, portfolios are also exposed to risk. Portfolio risk refers to the possibility that an investment portfolio will not generate the investor's expected rate of return. Analyzing portfolio risk and return involves the understanding of expected returns from a portfolio. Consider the following case: Andre is an amateur investor who holds a small portfolio consisting of only four stocks. The stock holdings in his portfolio are shown in the following table: What is the expected return on Andre's stock portfolio? 10.70% 8.03% 14.45% 16.05% Suppose each stock in Andre's portfolio has a correlation coefficient of 0.40 (ρ = 0.40) with each of the other stocks. The market's average standard deviation is approximately 20%, and the weighted average of the risk of the individual securities in the partially diversified four-stock portfolio is 34%. If 40 additional, randomly selected stocks with a correlation coefficient of 0.30 with the other stocks in the portfolio were added to the portfolio, what effect would this have on the portfolio's standard deviation (σpσp)? It would decrease gradually, settling at about 0%. It would gradually settle at about 35%. It would gradually settle at approximately 20%. It would gradually settle at approximately 50%.
10.70% It would gradually settle at approximately 20%. Whenever a portfolio's assets are not perfectly correlated with one other (ρ < 1), the portfolio can benefit from the process of diversification. Stocks are randomly selected and added to the portfolio. The stocks have a correlation coefficient of about 0.30 with the other stocks in the portfolio. Therefore, adding these randomly selected stocks will reduce the portfolio's standard deviation. The process of diversification will reduce the company-specific risk in the portfolio, but will not eliminate the systematic, or market, risk. Therefore, the portfolio's risk (σpσp) will decrease gradually until the σpσp is approximately 20%, the average standard deviation of the market return.
Walter Utilities is a dividend-paying company and is expected to pay an annual dividend of $2.25 at the end of the year. Its dividend is expected to grow at a constant rate of 6.00% per year. If Walter's stock currently trades for $17.00 per share, what is the expected rate of return? 692.65% 1,563.53% 612.49% 19.24%
19.24% use formula P0= d1/(r-g)
Suppose you read an article about the Golden Gate Bridge and Highway District bonds. It includes the following information: Bridge Bonds Series A Dated 7-15-2005 4.375% Due 7-15-2055 @100.00 What is the coupon interest rate of this bond? 0.435% 4.375%
4.375% Golden Gate Bridge and Highway District bonds, Series A, were issued on July 15, 2005, at an interest rate of 4.375%. The issuer promised to pay the par value of the bond on July 15, 2055, which is called the maturity date. Thus, these bonds have a maturity of 50 years. Note that the original years to maturity of the bond was 50 years—that is, the years to maturity at the time the bond was issued. With each passing year, the years to maturity will decrease.
The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 3% per year for each of the next three years and 2% thereafter. The maturity risk premium (MRP) is determined from the formula: 0.1(t - 1)%, where t is the security's maturity. The liquidity premium (LP) on all Nitreca Chemicals Inc.'s bonds is 0.55%. The following table shows the current relationship between bond ratings and default risk premiums (DRP): Nitreca Chemicals Inc. issues 12-year, AA-rated bonds. What is the yield on one of these bonds? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average. 7.50% 6.95% 5.25% 6.40%
7.50% You need to solve for the yield on a Nitreca Chemicals Inc. 12-year corporate security, so enter the data that you know and solve for the remaining data. The table tells you the default risk premium on Nitreca Chemicals Inc.'s bonds is 0.80%. The calculation is done as follows: rC-bond = = r* + IP + DRP + LP + MRP The first three years of inflation was 3% and 2% thereafter, so take the arithmetic average of the inflation over the entire life of the bond, which is 12 years. Solve for the inflation premium (IP) as follows: IP12 = = [3(3%) + (12 − 3) × (2%)]/12= 2.25% The bonds mature in 12 years (t = 12). Solve for the maturity risk premium as follows: MRP12 = = 0.1(t−1)%= 0.1(12−1)% = 1.10% Now, use the values of the inflation premium and maturity risk premium and apply them in the equation for calculating interest rates. Solve as follows: rC-bond, 12 = = r* + IP + DRP + LP + MRP = 2.8%+2.25%+0.8%+0.55%+1.10% = 7.50%7.50%
You can estimate the value of a company's stock using models such as the corporate valuation model and the dividend discount model. Which of the following companies would you choose to evaluate if you were using the discounted dividend model to estimate the value of the company's stock? A company that has been distributing a portion of their earnings every quarter for the past six years. A company that is in a high-growth stage and plans to retain all its earnings for the next few years to support its growth.
A company that has been distributing a portion of their earnings every quarter for the past six years. Managers need to make several decisions based on the true value of their company's assets and thus estimate the intrinsic value of its stock. To determine the intrinsic value of a stock, investors and managers use several models. The two basic models are the discounted dividend model and the corporate valuation model. The discounted dividend model uses future dividends that a company distributes to its stockholders. Dividends are a distribution of a portion of a company's earnings, given to a class of investors. The corporate valuation model uses free cash flows. Thus, you are likely to use the dividend discount model to estimate the intrinsic value of the stock for a company that has a stable distribution policy.
Generally, investors would prefer to invest in assets that have: A lower-than-average expected rate of return given its perceived risk. A higher-than-average expected rate of return given its perceived risk.
A higher-than-average expected rate of return given its perceived risk. As an investor, you want to maximize the returns from your total investments for the given level of risk. An investor has his or her own risk profile based on several factors. In general, investors like to receive as much expected return as possible for the perceived risk to which they are exposed. When the exposure to risk is high, expectations for return are also high. Thus, if you invest in an asset with high risk, you should expect a high rate of return.
A financial planner is examining the portfolios held by several of her clients. Which of the following portfolios is likely to have the smallest standard deviation? A portfolio with 10 randomly selected stocks from U.S. and international markets. A portfolio with 10 randomly selected U.S. stocks. A portfolio with 10 randomly selected international stocks.
A portfolio with 10 randomly selected stocks from U.S. and international markets. A single stock has a great deal of company-specific risk. If you add stocks, which are less than perfectly positively correlated, to the portfolio, you will reduce the risk (as measured by the standard deviation) of the portfolio. The benefits of diversification are greater when stocks are not highly correlated. Returns on stocks from the same sector are likely to have greater correlation than if you choose stocks from the different sectors. For that reason, you would expect a large portfolio of randomly selected stocks across many sectors and markets to have a lower standard deviation. Investors can further reduce risk by holding both U.S. stocks and stocks from the international markets in their portfolios. Because U.S. and international stocks are not perfectly correlated, adding international stocks to a portfolio helps diversify and reduce risk.
In November 2006, Citigroup's stock (NYSE: C) was trading at $49.59. Following the credit crisis of 2007-2008 and by the end of October 2009, Citigroup's stock price had plummeted to $4.27. Several banks went under, and others saw their stock prices lose more than 60% of their value. Based on your understanding of stock prices and intrinsic values, which of the following statements is true? The intrinsic value of a stock is based only on the perceived risk in the company. A stock's intrinsic value is based on the fundamental cash flows and the company's risk.
A stock's intrinsic value is based on the fundamental cash flows and the company's risk. The intrinsic value of a company's stock, also known as its fundamental value, refers to the stock's true value based on expected future cash flows and the risks involved. The value perceived by stock market investors determines the market price of a stock. When a stock's intrinsic value equals its market value, or market price of the stock, it is considered to be in a state of equilibrium. Potential investors use their available information to estimate the stock's intrinsic value and to make trading decisions (whether to buy or sell) based on their estimate. If the intrinsic value estimate of the stock is less than the market price, the investor would sell, but if the intrinsic value estimate is greater than the market price, the investor would buy. In equilibrium, investors are buying and selling stocks that are neither overvalued nor undervalued; rather, they are fairly valued.
A stock is in equilibrium if its required return equals its expected return. In general, assume that markets and stocks are in equilibrium (or fairly valued), but sometimes investors have different opinions about a stock's prospects and may think that a stock is out of equilibrium (either undervalued or overvalued). Use the analyst's expected return estimates to determine if this analyst thinks that each stock in Wilson's portfolio is undervalued, overvalued, or fairly valued. Stock A, B, C ... Undervalued Fairly Valued Overvalued
A= Undervalued B= Undervalued C= Fairly Valued Here is one way to think about the issue: Investors in the market require a return of 6.5% for holding Stock A, but this analyst believes that the stock actually will return 7.5%. By the analyst's estimate, it sounds as if the stock is quite a bargain. You require only a 6.5% return, but you expect to get a 7.5% return instead; it sounds as if the stock is undervalued. You can see this on the graph, because at a beta of 0.5, the expected return (7.5%) is greater than the required return (shown by the SML). In fact, any asset that is plotted on this graph above the SML is thought to be undervalued, whereas assets below the SML are thought to be overvalued. An asset lying directly on the SML is said to be in equilibrium. Stock B's required return is 9.0% [rˆBr̂B = 4.0% + 1.0(5.0%) = 4.0% + 5.0% = 9.0%], and Stock C's required return is 14% [rˆCr̂C = 4.0% + 2.0(5.0%) = 4.0% + 10.0% = 14.0%]. Compare the stocks' required returns with their expected returns. Stock C is fairly valued, because its expected return is equal to its required return. Stocks A and B are undervalued, because their required returns are less than their expected returns. These conclusions are verified by the graph. Stock C lies on the SML, whereas Stocks A and B lie above it.
Bond values over time
At maturity, the value of any bond must equal its par value. If rd remains constant: 1. The value of a premium bond would decrease over time, until it reached $1,000. 2. The value of a discount bond would increase over time, until it reached $1,000. 3. A value of a par bond stays at $1,000. The price of bonds decrease when Interest rates increase. The price of bonds increase when interest rates decrease.
If the coupon interest rate is 4.375% for the first six months and changes to a rate equal to the 10-year Treasury bond rate plus 1.3% thereafter, the bond is called a floating-rate bond.
Bond issuers can choose to pay interest that is fixed, variable, or embedded in the maturity value of the bond. A bond that offers to pay a constant, or fixed, coupon interest rate throughout the life of the bond is a fixed-rate bond. A bond for which the interest rate changes based on a benchmark interest rate—such as the rate on Treasury bonds or the London Interbank Offered Rate (LIBOR)—is called a floating-rate bond. There is also a third kind of bond in which the issuer does not offer any interim interest payments—that is, the issuer does not offer to pay any interest. Instead, the issuer sells the bonds at a discounted price and promises to pay the bond's par value at maturity. Investors in these bonds don't receive any coupons; however, they buy the bonds at a discounted price, and they gain from capital appreciation when they receive the face value of the bond at maturity. These bonds are called zero coupon bonds, or zeros.
For example, assume Olivia wants to earn a return of 12.25% and is offered the opportunity to purchase a $1,000 par value bond that pays a 14.00% coupon rate (distributed semiannually) with three years remaining to maturity. The following formula can be used to compute the bond's intrinsic value:
Bond's semiannual coupon payment $70.00 Bond's par value $1,000 Semiannual required return 6.1250% Based on this equation and the data, it is unreasonable to expect that Olivia's potential bond investment is currently exhibiting an intrinsic value less than $1,000. A bond will trade at a premium (or its market price will exceed its intrinsic value) when its coupon rate exceeds the bondholder's required return. The same bond will trade at a discount, such that its market value is less than its intrinsic value, when its coupon rate is less than the bondholder's required return. When the bond's coupon rate and the bondholder's required return are equal, the bond's market price will equal its intrinsic value and the bond will trade at par. Remember, according to the theory of bond valuation, the intrinsic value of a bond is equal to the discounted value of the bond's expected future cash flows. In turn, those cash flows are based on the bondholder's semiannual required return (rd/2rd/2) as well as the bond's coupon or interest payment and its par value (usually $1,000 in the case of US corporate bonds). A = The bond's semiannual coupon payment, which is equal to $70.00 or one-half of the bond's annual coupon [($1,000 x 0.1400)/2].B = The bond's par value, which is usually equal to $1,000. It is paid to the bondholder when the bond matures; in this case, at the end of three years (or six semi-annual time periods).C = The bondholder's semiannual required return, which is equal to one-half of the bondholder's required return expressed on an annual basis [(12.25%/2) or 6.1250%].
A bond's coupon payment refers to the interest payment or payments paid by a bond. •A bond issuer is said to be in default if it does not pay the interest or the principal in accordance with the terms of the indenture agreement or if it violates one or more of the issue's restrictive covenants. •The contract that describes the terms of a borrowing arrangement between a firm that sells a bond issue and the investors who purchase the bonds is called an indenture . •A bond's call provision gives the issuer the right to call, or redeem, a bond at specific times and under specific conditions.
Bonds pay interest at a specified rate. The payment made toward this interest is called the coupon, or the coupon payment. The amount of the coupon or coupon payment is calculated by multiplying the bond's coupon rate by the par value of the bond: Annual Coupon Payment = Par Value x Coupon Rate. A borrowing company is said to be in default on its bond issue if it fails to meet its obligations in accordance with the terms of the indenture agreement. The borrower can default by either failing to make a scheduled payment of the issue's interest or principal or by violating one or more of the issue's restrictive covenants. Defaulting on its bond issue can cause the debt to be triggered, resulting in the issue's entire amount of principal and accrued interest becoming immediately due. In contrast, bankruptcy is a legal condition wherein a federal court determines that a borrower owes more than it can pay; in liquidation, the firm's assets are sold to generate the funds to repay its debt obligations. An indenture is a contract that describes the terms (obligations and responsibilities) of a borrowing arrangement between a firm that sells a bond issue and the investors who purchase the bonds. This document is a legally binding contract between the issuer and each bondholder. Among the terms specified in the indenture are the issue's maturity date, the timing and method of calculating its interest payments, and any covenants and provisions affecting the interests of the issuing company and its bondholders. A call provision gives the issuer the right to call, or redeem, a bond at specific times and under specific conditions. Most call provisions require the issuer to pay the bondholders an amount greater than the bond's par value. This additional amount, known as the call premium, often equals one year's interest. When a bond is called, the price at which the issuer redeems its bond is called the call price. Some call provisions allow the bond to be callable immediately. However, most are deferred calls, which require the issuer to wait some period of time before exercising the call provision. These bonds are said to have call protection.
Which feature of a bond contract allows the issuer to redeem a bond issue immediately in its entirety at an amount greater than par value prior to maturity? Deferred call provision Sinking fund provision Call provision Convertible provision
CALL PROVISION A call provision gives the issuer the right to call, and force the redemption of, a bond at specific times and under specific conditions. Most call provisions require the issuer to pay the bondholders an amount greater than the bond's par, or maturity, value. This additional amount, known as the call premium, often equals one year's interest. When the bond is called, the price paid to the bondholder is called the call price. Some call provisions allow the issuer to call the bond immediately, and others provide for increased call protection. This expanded call protection is provided by a deferred call provision, which requires the issuer to wait some period of time (usually several years), before exercising the call. With a convertible provision, bondholders (or sometimes issuers) may elect to convert their bonds into shares of common stock (subject to preset constraints) at some future date. A put provision is similar to a call provision except that it gives investors the right to sell their bonds back to the issuer under specified terms. A sinking fund provision requires a bond issuer to buy back a specified portion of the bond issue each year. The issuer is in default if it fails to meet the sinking fund requirement in any year. Issuers usually satisfy the sinking fund requirement by either redeeming shares at par (when rates are low) or buying back bonds on the open market (when rates are high). Issuers will choose the method that costs the lesser amount.
Erik is an investor with $5,000 available for investment. He has the following three investment possibilities from which to choose: Suppose Erik cares about the risk involved in options 2 and 3, and decides to select option 1 because it has no risk. Which of the following statements would be true about Erik? He is risk-averse. He is risk-neutral. He is risk-loving. None of these descriptions is accurate. Later, while examining the same investment alternatives, Erik's brother, Devin, clearly expressed a preference for option 1. Which of the following statements is true about Devin? He is risk-averse. He is risk-neutral. He is risk-loving. None of the above
Erik = He is risk-averse. Although the three alternatives have the same expected value, they have different levels of risk (standard deviation). A risk-averse investor requires a greater expected value for assuming additional risk. Both options 2 and 3 expose Erik to more risk but do not provide a greater expected value in exchange for that increased risk. Therefore, Erik, as a risk-averse investor, would prefer option 1. Notice that option 1 is risk free and provides a guaranteed $5,000 payoff in one year. Devin = He is risk-averse. Devin is risk averse. The three options offer the same expected payoff but exhibit differing levels of risk. By preferring option 1, the risk-free investment, Devin prefers the investment offering the smallest risk exposure for the same level of return expected. Devin would only prefer options 2 or 3 if he is offered additional return to compensate for their increased levels of risk. Also note, Devin would prefer a greater return for holding option 3 than option 2 since option 3 has the greater standard deviation.
Suppose the Federal Reserve (the Fed) decides to tighten credit by contracting the money supply. Use the following graph by moving the black X to show what happens to the equilibrium level of borrowing and the new equilibrium interest rate.
Explanation: If the Fed contracts the money supply, less capital is available to be invested. As a result, firms are competing for fewer funds to invest in their production opportunities (The Investment opportunities in productive cash generating assets) . The supply of capital decreases, and the supply curve shifts to the left. The new equilibrium shows that $3 billion of capital will be available and borrowed at an interest rate of 12.0%.
Given the preceding data (historical data) the average realized return on FF's stock is.... the standard deviation of FF's historical returns is... If investors expect the average realized return from 2014 to 2018 on FF's stock to continue into the future, its coefficient of variation (CV) will be... Hint: Use calc to find standard deviation
Given the preceding data, the average realized return on FF's stock is11.43% . the standard deviation of FF's historical returns is5.14% . If investors expect the average realized return from 2014 to 2018 on FF's stock to continue into the future, its coefficient of variation (CV) will be0.45
Use the constant growth model to calculate the appropriate values to complete the following statements about Super Carpeting Inc.: •If SCI's stock is in equilibrium, the current expected dividend yield on the stock will be9.75% per share. •SCI's expected stock price one year from today will be$36.30 per share. •If SCI's stock is in equilibrium, the current expected capital gains yield on SCI's stock will be6.50% per share.
If a stock is in equilibrium, its intrinsic value equals its current stock price. A stock's expected dividend yield (DY) equals its expected dividend one year from now divided by the current stock price, which can be calculated as follows: Thus, the dividend yield on SCI's stock is 9.75% per share. Use the standard constant growth stock formula. The stock price one year from today will be the expected dividend in the following year (D₂) divided by the difference between the stock's required return (rss) and its expected dividend growth rate (g). Calculate the expected dividend in year 2 as follows: You also could have solved for P₁ using its current price and its expected dividend growth rate. Remember that a constant growth stock's expected dividend growth rate equals its expected stock price growth rate and its expected capital gains yield (the expected change in price over the next year). Thus, SCI's stock price one year from now will be $36.30 per share. Another approach to calculate SCI's stock price one year from today is to use capital gains yield. A stock's expected capital gains yield (CGY) equals its expected change in price over the next year divided by its current stock price. The calculation is as follows: Thus, the capital gain on SCI's stock in one year will be 6.50% per share. Remember that the required rate of return on a stock is equal to the sum of its expected dividend yield and expected capital gains yield. If you add 9.75% and 6.50%, you'll get 16.25%. Thus, if markets are in equilibrium, the expected rate of return will be equal to the rate of return on a stock: rˆsr̂s = rss.
What would happen to the SML graph if expected inflation increased or decreased?
If expected inflation increased, the risk free rate of return would rise. The increase in rRf leads to an equal increase in the rates of return on all risky assets because the same inflation premium is built into required rates of return on both riskless and risky assets
What would the SML look like if investors were indifferent to risk, that is, if they had zero risk aversion?
If rRF (risk free rate of return) was 6%, risky assets would also have a required return of 6% because if there were no risk aversion, there would be no risk premium. In that case, SML would plot as a horizontal line.
What would happen to a stock's price if the "marginal investor" examined a stock and concluded that its intrinsic value was greater than its current market price?
If the "marginal investor" examined a stock and concluded that its intrinsic value was greater than its current market price, then the stock price will increase because it is undervalued
Based on an upward-sloping normal yield curve as shown, which of the following statements is correct? Inflation must be expected to increase in the future. There is a positive maturity risk premium. Pure expectations theory must be correct. If the pure expectations theory is correct, future short-term rates are expected to be higher than current short-term rates.
If the pure expectations theory is correct, future short-term rates are expected to be higher than current short-term rates. The pure expectations theory of interest rates merely states that you can infer expected future short-term rates by comparing spot short- and long-term rates. Pure expectations theory does not depend on the yield curve being either upward or downward sloping. An upward-sloping yield curve can be an indication of expected increases in inflation. However, it also can be an indication of a positive maturity risk premium. For example, if inflation and the real risk-free rate were constant, a positive maturity risk premium would likely increase over time, which would lead to an upward-sloping yield curve. An upward-sloping yield curve could indicate a positive maturity risk premium, but it also could indicate increased inflation expectations. If there is no maturity risk premium, expectations about future short-term interest rates determine the yield curve's shape. The upward slope indicates that future short-term rates are expected to be greater than current short-term rates.
Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true? The yield on an AAA-rated bond will be higher than the yield on a BB-rated bond. In theory, the yield on a bond with a longer maturity will be higher than the yield on a bond with a shorter maturity.
In theory, the yield on a bond with a longer maturity will be higher than the yield on a bond with a shorter maturity. If you a hold a bond for a longer time period, you would also be exposed to interest rate risks for a longer time period. The higher the risk, the higher the return will be. Because you are taking on more risk over the life of the security, you will be compensated for a longer time period, thus having a higher yield rate. Rating agencies, such as Standard & Poor's and Moody's, assign ratings to bonds based on several factors, including the ability of the issuing entity to pay back its investors—that is, the risk of default. The higher the risk, the higher the return will be. An AAA-rated bond has less investment risk than a BB-rated bond. Because the default risk premium is less in AAA-rated bonds, their yield is lower than BB-rated bonds.
Which of the following statements is true? Increasing dividends will always decrease the stock price, because the firm is depleting internal funding resources. Increasing dividends will always increase the stock price. Increasing dividends may not always increase the stock price, because less earnings may be invested back into the firm and that impedes growth.
Increasing dividends may not always increase the stock price, because less earnings may be invested back into the firm and that impedes growth. It's true that dividends are in the numerator of the equation, and all else being equal, an increase in dividends would cause Pˆ0P̂0 to increase. However, a firm can't simply increase its dividends without affecting other factors. Firms face the fundamental decision of paying out earnings as dividends or retaining them for future investment. If a firm increases its dividends, it is retaining less earnings for future investment. Therefore, an increase in current dividends might jeopardize future dividends—that is, the dividend growth rate might decrease. There are two competing forces here: Higher dividends increase stock prices, but lower growth rates decrease stock prices. A firm's specific situation will determine whether a dividend increase will raise the stock price. Thus, the correct statement in the options given is "Increasing dividends may not always increase the stock price, because less earnings may be invested back into the firm and that impedes growth."
Credit ratings affect the yields on bonds. Based on the scenario described in the following table, determine whether yields will increase or decrease and whether it will be more expensive or less expensive, as compared to other players in the market, for a company to borrow money from the bond market. Impact on Yield Cost of Borrowing Money from Bond Markets A car manufacturing company loses 40% of its market share and has a declining investment in new product development. Increase More expensive A start-up company is struggling with finances for its projects.Increase More expensive A company's interest coverage ratio improves.Decrease Less expensive A company's credit rating was upgraded from AA to AAA. Decrease Less expensive
Investors will perceive a company that has lost 40% of its market share and has a declining investment in new products to have relatively less growth prospects as compared to other players in the industry. The risk factor will be high, and investors will expect compensation for their risk. Thus, yields on such a company will increase, and it will be more expensive for the company to borrow money from bond markets. A start-up company that is struggling to finance its projects is perceived as a company with high default risk, and investors will expect compensation for their risks. Thus, yields will be higher, and it will be more expensive for a company to borrow money from bond markets. An upgrade from AA to AAA will qualify a company's bonds to be among the highest-quality bonds, and investors will expect lower default risk premiums. Thus, it will be less expensive for the company to raise money from bond markets, and yields on its bonds will decrease . If a company's interest coverage ratio improves, it means that the company's ability to pay off debt is improving. Investors will be more confident that the issuer is capable of making committed payments. Thus, yields will decrease and it will be less expensive for the company to borrow money from bond markets.
Each bond has 10 years until maturity and the same level of risk. Their yield to maturity (YTM) is 9%. Interest rates are assumed to remain constant over the next 10 years. Using the previous information, correctly match each curve on the graph to it's corresponding issuing company. (Hint: Each curve indicates the path that each bond's price, or value, is expected to follow.) Curve A Johnson Corporation Curve B Smith Incorporated Curve C Irwin, LLC Based on the preceding information, which of the following statements are true? Check all that apply. The expected capital gains yield for Johnson Corporation's bonds is greater than 12%. The bonds have the same expected total return. The expected capital gains yield for Johnson Corporation's bonds is negative. Irwin, LLC's bonds have the highest expected total return.
Irwin, LLC's coupon rate (6%) is less than its YTM (9%), so it sells at a discount. A discount bond's current price is below the par value ($1,000) and rises over time until maturity (when its value is $1,000). Therefore, the bottom curve on the graph represents Irwin, LLC's price over time. Johnson Corporation's coupon rate (12%) exceeds its YTM (9%), so it sells at a premium. A premium bond's current price is above the par value ($1,000) and falls over time until maturity (when its value is $1,000). Therefore, the top curve on the graph represents Johnson Corporation's price over time. Smith Incorporated's coupon rate (9%) equals its YTM (9%), so it sells at par. A par value bond's current price equals the par value ($1,000), and it is expected to stay constant over time until maturity. Therefore, the middle curve on the graph represents Smith Incorporated's price over time. The bonds have the same expected total return. The expected capital gains yield for Johnson Corporation's bonds is negative. A bond's expected total return is its YTM (9%). These three bonds have the same YTM, so they have the same expected total return. Johnson Corporation's bonds are premium bonds, so their price is expected to fall over time. Therefore, the expected capital gains yield on Johnson Corporation's bonds is less than 0% (negative).
Walter's dividend is expected to grow at a constant growth rate of 6.00% per year. What do you expect to happen to Walter's expected dividend yield in the future? It will stay the same. It will increase. It will decrease.
It will stay the same. The stock's dividends are expected to grow at a constant rate of 6.00% per year, but the stock's price also will increase by 6.00% per year. Remember that for a constant growth stock the expected dividend growth rate equals the expected stock price growth rate and the expected capital gains yield. Because both dividends and the stock price are expected to increase at a constant rate of 6.00%, the dividend yield is expected to remain constant.
These bonds are collateralized securities with first claims in the event of bankruptcy. Senior mortgage bonds These bonds are not backed by any physical collateral. They are backed by the reputation and creditworthiness of the issuing company. Debentures These bonds are considered the riskiest of all corporate bonds and thus offer the highest interest rates. Subordinated debentures
Mortgage bonds are backed by fixed physical assets such as mortgages, real estate, property, and equipment. They are considered to be very secure, thus offering relatively low interest rates compared to other corporate bonds. In the event of bankruptcy, senior mortgages—also termed first mortgages—have the first claim against property. Junior mortgages, also termed second mortgages, are lower in priority to the claims of senior mortgages. Debentures are not collateralized by any physical assets but are backed by the reputation and creditworthiness of the issuer. They are riskier than mortgage-backed securities and thus offer higher interest rates. Subordinated debentures are the least secure among all corporate bonds. In the case of default, subordinate bondholders wouldn't get paid until all senior bondholders have made their claims. Thus, they are the riskiest and offer the highest interest rates among other corporate bond offerings.
If a bond is selling for a price much lower than its par value, it is most likely that the bond is an outstanding bond.
Newly issued bonds generally sell at prices very close to par, but the prices of outstanding bonds can deviate widely from their par value. Except in the case of floating-rate bonds, the coupon payments of fixed-rate bonds are constant; this means that when economic conditions change (such that market interest rates change), then the price of outstanding bonds will change as well.
Should companies completely avoid high-risk projects?
No they should not because they must pay higher yields on their bonds to compensate bondholders for the additional default risk
In general can the riskiness of a portfolio be reduced to zero by increasing the number f stocks in the portfolio? Explain.
No. As stock is added, risk declines at decreasing rate. After 40-50 stocks, additions will do little to bring down the risk. diversifiable risk goes down with additional stock. Market risk remains even if all stocks are included in a portfolio.
Suppose, based on the earnings consensus of stock analysts, Gregory expects a return of 6.24% from the portfolio with the new weights. Does he think that the required return as compared to expected returns is undervalued, overvalued, or fairly valued? Undervalued Overvalued Fairly valued
Overvalued As an analyst, Gregory will need to compare the portfolio's required and expected returns to answer this question. Based upon the market risk, the portfolio has a required rate of 7.7400%. This means that, according to his estimates, investors would require a return of 7.7400% for investing in the portfolio. However, other analysts estimate that investors expect a return of 6.24%, which means that investors expect to get a lower rate of return than existing investors require. Thus, based on all calculations and data, Gregory would think that the stock is overvalued.
Super Carpeting Inc. (SCI) just paid a dividend (D₀) of $3.12 per share, and its annual dividend is expected to grow at a constant rate (g) of 6.50% per year. If the required return (rss) on SCI's stock is 16.25%, then the intrinsic value of SCI's shares is $34.08 per share.
P0 = D0(1+g)/(r-g)
Explain the following statement. Preferred stock is a hybrid security
Preferred stock is a hybrid security because it is similar to a bond in some respects and to common stock in others. Like bonds, preferred stock has a par value and a fix dividend that must be paid before dividends can be paid on the common stock. However, the directors can omit (or "pass") the preferred dividend stock calls for a fix payment
The following graph shows the value of a stock's dividends over time. The stock's current dividend is $1.00 per share, and dividends are expected to grow at a constant rate of 4.50% per year. The intrinsic value of a stock should equal the sum of the present value (PV) of all of the dividends that a stock is supposed to pay in the future, but many people find it difficult to imagine adding up an infinite number of dividends. Calculate the present value (PV) of the dividend paid today (D₀) and the discounted value of the dividends expected to be paid 10, 20, and 50 years from now (D10, D20, D50D10, D20, D50). Assume that the stock's required return (rss) is 5.40%. Note: Carry and round the calculations to four decimal places.
Refer to calc functions
A stock's contribution to the market risk of a well-diversified portfolio is called ________ risk. It can be measured by a metric called the beta coefficient, which calculates the degree to which a stock moves with the movements in the market. Based on your understanding of the beta coefficient, indicate whether each statement in the following table is true or false: 1. Beta coefficients are generally calculated using historical data. 2. Higher-beta stocks are expected to have higher required returns. 3. Stock A's beta is 1.0; this means that the stock has a negative correlation with the market.
Relevant 1. True 2. True 3. False A well-diversified portfolio will exhibit a minimum of unsystematic, or company-specific risk. The portfolio's remaining risk represents market risk, which cannot be diversified away with addition of more assets. Each stock's contribution to market risk is termed relevant risk. The beta coefficient is a statistical measure of the stock's relation with the market—that is, the extent to which the return on a stock rises and falls with the changes in the market's return. Analysts generally use historical data to calculate the beta and use it as an estimate of the stock's volatility relative to the market. An average stock is said to have a beta of 1.0, which means that on average it moves in the same direction and with the same magnitude as movements in the market. This means that the average stock is positively correlated with the market. If a stock has a beta that is greater than 1.0, it means that the stock's positive and negative returns will be greater than the market's returns. Investors should expect a higher rate of return from stocks with higher betas.
Which tend to be more volatile, short- or long-term interest rates? Short-term interest rates Long-term interest rates
Short Term Interest rates Explanation: Short-term interest rates reflect expectations of short-term inflation, but they also respond to current economic conditions; long-term interest rates reflect long-run expectations of inflation. As a result, long-term interest rates tend to be smoother than short-term rates. Short-term interest rates are more volatile because they respond to short-term shocks to the economy.
You invest $100,000 in only one stock. To which kind of risk will you primarily be exposed? Portfolio risk Stand-alone risk
Stand-alone risk Risk refers to all chances that things could go wrong, leading to a loss or damage. As an investor, if you hold a single asset, you bear the risk of things going wrong with that particular asset. This kind of risk is referred to as stand-alone risk. Stand-alone risk measures the undiversified risk of an individual asset.
Why is it argued that beta is the best measure of a stock's risk?
Stock's beta coefficient determines how the stock affects the riskiness of a diverse portfolio.
Differentiate between a stock's: expected, required, and realized returns. Which would have to be larger to induce you to buy the stock expected or required, would any typical be the same or different? Explain.
Stocks expected return: What is expected Stocks required return: if the expected is less than the required than investor will not purchase. Stocks realized return: After the fact, investor will not know at the time of purchasing the stock The required rate needs to be higher than expected in order to induce buyers. If the required and expected are the same the investor will be indifferent.
Identify whether each of the following statements is true or false. If inflation is expected to decrease in the future and the real rate is expected to remain steady, then the Treasury yield curve is downward sloping. (Assume MRP = 0.) All else equal, the yield on new bonds issued by a leveraged firm will be less than the yield on the new bonds issued by an unleveraged firm. The yield curve for an AA-rated corporate bond is expected to be above the US Treasury bond yield curve. Yield curves of highly liquid assets will be lower than yield curves of relatively illiquid assets.
T F T T Remember, the yield on corporate bonds is calculated using the following equation: Corporate Bond Yield = r*t+IPt+DRPt+MRPt+LPt Remember, US Treasury yields are composed of the real risk-free rate, expected inflation (short term), and the maturity risk premium.(long term) Whether there is a maturity risk premium (MRP > 0) or not (MRP = 0), actions of traders are consistent with a predominant expectation that inflation will fall because of the downward-sloping nature of the yield curve. When a leveraged firm issues new bonds, it is adding more debt to its existing debt. As compared to an unleveraged firm, the risk of default in such a firm increases. Because an unleveraged firm is issuing bonds for the first time, its ability to make committed payments is more than that of a leveraged firm. Thus, the yield on new bonds issued by a leveraged firm will be more than the yield on the new bonds issued by an unleveraged firm. Corporate bonds have more risk than US Treasury securities, because they have some risk of default (DRP > 0), and bonds from smaller companies are likely less liquid than US Treasury securities. Therefore, a corporate bond of equal maturity has the same real risk-free rate, inflation premium, and maturity risk premium, but it also has a default risk premium and maybe a liquidity premium. So a corporate bond yield is always going to be higher than a US Treasury yield at every maturity. Therefore, an AA-rated corporate yield curve lies above the US Treasury yield curve. Assets of equal maturity will have the same real risk-free rate, inflation premium, and maturity risk premium. Even if both have the same default risk premium, they could have different liquidity premiums if one asset is more liquid than the other. A highly liquid asset will have less liquidity risk and a lower premium. Therefore, the yield curve of a liquid asset is lower than the yield curve of an illiquid asset.
A security with higher risk will have a higher expected return. A bond's risk level is reflected in its yield, but understanding the different risks involved when investing in bonds is important. The curves on the following graph show the prices of two 10% annual coupon bonds at various interest rates. Based on the graph, which of the following statements is true? Neither bond has any interest rate risk. The 10-year bond has more interest rate risk. The 1-year bond has more interest rate risk. Both bonds have equal interest rate risk.
The 10-year bond has more interest rate risk. Explanation: The large drop in value that results from an increase in the interest rate graph—as reflected on the 10-year bond's curve—indicates that the bond's value (price) is very sensitive to changes in interest rates. At an interest rate of 10%, the two bonds have the same price, but for a given change in interest rate, the 10-year bond's price changes a lot more than the one-year bond's price. This implies that, all else being equal, as a bond's maturity lengthens, its interest rate risk increases.
New York City issued a general obligation bond for a canal in 1812. It was the first formal debt instrument with a fixed repayment schedule issued by a city. Who is the issuer of the bonds? The New York City government Federal Reserve Bank of New York Bank of New York
The New York City government New York City issued bonds for a canal project in 1812. These bonds had a fixed repayment schedule and were issued as general obligation bonds, which meant that the New York City government made the committed payments by using the tax revenues it collected.
If RTE Inc. issued new bonds today, what coupon rate must the bonds have to be issued at par?7.36%
The YTM on RTE Inc.'s existing bonds reflects the rate of return that investors require for holding debt securities issued by RTE Inc. If RTE Inc. is to issue new bonds at par, the new bonds must pay a coupon equal to their current YTM (7.36%). As a result, the new bonds also will have a YTM of 7.36%.
Juan owns a two-stock portfolio that invests in Falcon Freight Company (FF) and Pheasant Pharmaceuticals (PP). Three-quarters of Juan's portfolio value consists of FF's shares, and the balance consists of PP's shares. Each stock's expected return for the next year will depend on forecasted market conditions. The expected returns from the stocks in different market conditions are detailed in the following table 1. The expected rate of return on Falcon Freight's stock over the next year is.... 2. The expected rate of return on Pheasant Pharmaceutical's stock over the next year is... 3. The expected rate of return on Juan's portfolio over the next year is... Remember, the expected value of a probability distribution is a statistical measure of the average (mean) value expected to occur during all possible circumstances. To compute an asset's expected return under a range of possible circumstances (or states of nature), multiply the anticipated return expected to result during each state of nature by its probability of occurrence.
The expected rate of return on Falcon Freight's stock over the next year is 3.51% . •The expected rate of return on Pheasant Pharmaceutical's stock over the next year is 5.13% . •The expected rate of return on Juan's portfolio over the next year is 3.92% .
Based on your understanding of P/E ratios, in which of the following situations would the average trailing P/E ratio (current price divided by earnings per share over the previous 12 months) of the S&P 500 Index be higher? The outlook for the economy and the markets is for an improvement. The outlook for the economy and the markets is for a downturn.
The outlook for the economy and the markets is for an improvement. If the outlook for the economy and the markets improves, the P/E ratio will be higher. A high P/E ratio means that investors expect higher growth in the future. Because investors expect to receive more EPS in the future, they will be willing to pay more for each dollar that the companies earned per share in the prior four quarters. Thus, the average P/E ratio for S&P 500 companies will be higher when investors expect economic growth in the future.
Which of the following describe the reason(s) why maximization of intrinsic stock value benefits society? Check all that apply. The owners of stock are society. Consumers benefit when companies rise prices beyond reasonable levels. Successful companies attract more talent. Workers prefer companies that minimize operating costs.
The owners of stock are society. Successful companies attract more talent. When a firm maximizes its intrinsic stock value, in general, it is good for society. For example, successful companies are able to attract, develop, and retain talented people which is highly correlated with the company's ability to create value for shareholders. Thus, successful companies get the cream of the employee crop, and skilled, motivated employees are one of the keys to corporate success. Also, to a large extent, the owners of stock are society. Seventy-five years ago, most stock ownership was concentrated in the hands of a relatively small segment of society consisting of the wealthiest individuals. Since then, there has been explosive growth in pension funds, life insurance companies, and mutual funds. These institutions now own more than 61% of all stock, which means that most individuals have an indirect stake in the stock market. Thus, most members of society now have an important stake in the stock market, either directly or indirectly. Therefore, when a manager takes actions to maximize the stock price, this improves the quality of life for millions of ordinary citizens. However, in a competitive economy, prices are constrained by competition and consumer resistance. If companies, in their efforts to raise profits and stock prices, increase product prices and gouge the public, they will soon lose their market share. This benefits neither investors nor employees.
Yield to maturity (YTM) is the rate of return expected from a bond held until its maturity date. It is the "promised" rate of return. It holds up when : the probability of default is 0 and the bond cannot be called. can be solved by finding I/YR. However, the YTM equals the expected rate of return under certain assumptions. Which of the following is one of those assumptions? The bond is callable. The probability of default is zero.
The probability of default is zero. If a bond issue does not specify restrictions on early call, then it would be referred to as a callable bond. If a company calls its bonds, or if the bond issuer defaults, investors will not receive all the expected payments; thus, the realized yield is likely to be different from the promised yield (that is, the YTM). If the bond defaults, then investors will not yield the returns that they expect. Thus, if the probability of default is zero, the yield to maturity will equal the expected rate of return.
Which of the following best explains why a firm that needs to borrow money would borrow at long-term rates when short-terms rates are lower than long-term rates? A firm will only borrow at short-term rates when the yield curve is downward-sloping. The firm's interest payments will be the same whether it uses short-term or long-term financing, so it is essentially indifferent to which type of financing it uses. The use of short-term financing over long-term financing for a long-term project will increase the risk of the firm.
The use of short-term financing over long-term financing for a long-term project will increase the risk of the firm. When a firm uses short-term debt, it will have to renew its loan every year. The interest rate charged on each new loan will reflect the then-current short-term rate. It is possible for short-term interest rates to increase, which would result in higher interest payments. Higher interest payments would cut into and possibly eliminate the firm's profit. The reduced profitability could increase the firm's risk to the point where its bond rating was lowered, causing lenders to increase the risk premium built into the firm's interest rate. This would further increase the firm's interest payments, which would reduce the firm's profitability even more. Eventually, lenders could perceive the firm to be so risky that they would not be willing to renew the firm's loan and demand its repayment. At that point, the firm might have to sell its assets at a loss, which could result in bankruptcy. Bankruptcies increase dramatically when interest rates rise, primarily because many firms use so much short-term debt. A firm can reduce its risk by matching its financing term with the expected life of the project it is financing.
Why might the calculated intrinsic value differ from the stock's current market price? Which would be "correct" and what does "correct" mean?
They might differ because there are assumptions embedded in the corporate model. The "correct" value would be the one closest to market equilibrium.
Your accountant has convinced you that you should invest your bonus from this year into your retirement account—instead of buying a new sports car—because of the high expected return on the investment. Determine which of these fundamental factors is affecting the cost of money in the scenario described: Time preferences for consumption Inflation Risk
Time preferences for consumption Your accountant made you take your time preference for consumption into account. He convinced you that you would rather save for future consumption instead of using your bonus for current consumption.
True or False: Assuming all else is equal, long-term securities are exposed to higher interest rate risk than short-term securities. True False
True Interest rate risk relates to the value of the bonds in a portfolio. The value of bonds decreases with an increase in market interest rates. The longer a bond has until it matures, the more sensitive the bond's price is to a change in interest rates. Therefore, bonds with long-term maturities face higher interest rate risk than bonds with shorter maturities. Reinvestment risk relates to the income the portfolio generates. If you hold short-term securities, your investment income will increase or decrease depending upon the interest rates available when you reinvest the securities' coupons or maturity payments. This means that short-term securities are exposed to higher reinvestment risk than securities with longer maturities.
Based on your understanding of bond ratings and bond-rating criteria, which of the following statements is true? BBB bonds usually have the lowest yields in the bond markets. US government bonds usually have the lowest yields in the bond markets.
US government bonds usually have the lowest yields in the bond markets. US government bonds are backed by the full faith and credit of the US government and are considered to be default risk free. All corporate bonds and municipal bonds have some default risk. Because the risk is least for US government bonds, the yields are also the lowest.
Companies that have preferred stock outstanding promise to pay a stated dividend for an infinite period. Preferred stock is treated like a perpetuity if the payments last forever. Preferred stocks are considered to be a hybrid of a common stock and a bond. For example, one of the major differences between preferred shares and bonds is that the issuing companies can suspend the payment of their preferred dividends without throwing the company into bankruptcy. However, similar to bonds, preferred stockholders receive a fixed payment—their dividend—before the company's residual earnings are paid out to its common stockholders and, as with common stock, preferred stockholders can benefit from an appreciation in the value of the firm's stock securities. Consider the following case of International Imports (I2): International Imports (I2) pays an annual dividend rate of 10.20% on its preferred stock that currently returns 13.67% and has a par value of $100.00 per share. What is the value of I2's preferred stock? $111.92 per share $74.62 per share $89.54 per share $100.00 per share
Vp= dp/rp
Issuers can gradually reduce the outstanding balance of a bond issue by using a sinking fund account into which they deposit a specified amount of money each year. To operationalize the sinking fund provision of an indenture, issuers can (1) purchase a portion of the debt in the open market or (2) call the bonds if they contain a call provision. Under what circumstances would a firm be more likely to buy the required number of bonds in the open market as opposed to using one of the other procedures? When interest rates are higher than they were when the bonds were issued When interest rates are lower than they were when the bonds were issued
When interest rates are higher than they were when the bonds were issued A shareholder wealth-maximizing issuer will employ a sinking fund bond-retirement procedure that reduces the required number of bonds each year at the lowest cost. An increase in market interest rates from the time when the bonds were issued decreases the market price of the bonds. This allows the issuer to repurchase each bond for less than its $1,000 par value. This is less expensive than either paying the call price if the bonds are callable or depositing a fixed amount or fixed percentage of the bond issue in a sinking fund escrow account each year. Remember that a call price is equal to the par value of the bonds plus the required call premium, which is usually equal to one year's worth of interest.
Now, consider the situation in which Olivia wants to earn a return of 17%, but the bond being considered for purchase offers a coupon rate of 14.00%. Again, assume that the bond pays semiannual interest payments and has three years to maturity. If you round the bond's intrinsic value to the nearest whole dollar, then its intrinsic value of $932 (rounded to the nearest whole dollar) is less than its par value, so that the bond is trading at a discount . Given your computation and conclusions, which of the following statements is true? A bond should trade at par when the coupon rate is less than Olivia's required return. When the coupon rate is less than Olivia's required return, the bond should trade at a discount. When the coupon rate is less than Olivia's required return, the bond should trade at a premium. When the coupon rate is less than Olivia's required return, the intrinsic value will be greater than its par value.
When the coupon rate is less than Olivia's required return, the bond should trade at a discount. financial calculator n = 6 i = 8.5 fv= 1000 pmt = 70 pv= -932
Which of the following statements is true about the constant growth model? When using a constant growth model to analyze a stock, if an increase in the required rate of return occurs while the growth rate remains the same, this will lead to a decreased value of the stock. When using a constant growth model to analyze a stock, if an increase in the required rate of return occurs while the growth rate remains the same, this will lead to an increased value of the stock.
When using a constant growth model to analyze a stock, if an increase in the required rate of return occurs while the growth rate remains the same, this will lead to a decreased value of the stock. One key assumption of the constant growth model is that dividends will grow at a constant rate until infinity. There is no terminal year when using this model. The dividend growth rate must be less than the required return. If it were equal to the required return, the denominator of the constant growth formula would be zero, and you can't divide by zero. If it were greater than the required return, the denominator would be negative, and the stock value that you would calculate would be negative. For these reasons, the expected dividend growth rate must be less than the stock's required return. Expected return is the sum of dividend yield and growth rate, so the required rate of return will be higher than the growth rate. Also, the model makes the assumption that dividends will grow at a constant rate until infinity, but if the company were to grow more quickly than the expected rate of return in perpetuity, then the company would grow more quickly than the market and at some point become larger than the entire market. This is impossible. Thus, the growth rate is lower than the required rate of return. The constant growth formula can even be used to value negative and zero growth stocks, because in both cases the growth rate is constant and less than the required return. When using the constant growth model, if the growth rate (g) remains constant and the required rate of return (rss) increases, the value of (rss - g) will increase. Because the value of the denominator increases, the value of Pˆ0P̂0 will decrease. If the required rate of return (rss) remains constant and the growth rate (g) increases, the value of (rss - g) will decrease. Because the value of the denominator decreases, the value of Pˆ0P̂0 will increase.
RTE Inc. has 9% annual coupon bonds that are callable and have 18 years left until maturity. The bonds have a par value of $1,000, and their current market price is $1,160.35. However, RTE Inc. may call the bonds in eight years at a call price of $1,060. What are the YTM and the yield to call (YTC) on RTE Inc.'s bonds? Value YTM7.36% YTC6.91% If interest rates are expected to remain constant, what is the best estimate of the remaining life left for RTE Inc.'s bonds? 8 years 5 years 13 years 10 years
You need to calculate the rate of return that investors would expect if they held the bonds until maturity, which is the YTM. The YTM is the interest rate that equates the bond's price (PV = -1,160.35) with a promised cash flow of 9% (PMT = 9% x $1000) for 18 years (N = 18). The face value of the bond is $1,000 (FV = 1,000). Using a financial calculator, solve for I (YTM) as follows: The YTC on RTE Inc.'s bonds is 6.91%, which means that investors expect a return of 6.91% on RTE Inc.'s bonds if the firm calls the bonds in eight years. 8 = N 1060 = FV -1160.35 = PV 90 = PMT 6.91 = I 8 years The YTC is less than the YTM on RTE Inc.'s bonds. If interest rates remain constant, the firm will call the bonds. The bonds then have an expected remaining life of eight years. Remember that the YTM and YTC may not be what the investor receives, but they are what the issuer pays, so if the YTC is greater than the YTM, the issuer would not call the bonds, because doing so would be more expensive than just waiting for the bond to mature. The bond will only be called when the YTC is less than the YTM.
YTM and bonds
bond price decreases, YTM increases bond price increases, YTM decreases the longer the time to maturity the less the price of the bond will be. the less the time to maturity the more the price of the bond will be.
The graph's yield curve is referred to as a normal yield curve. Based on the yield curve shown, which of the following statements is true? Interest rates on short-term maturities are lower than rates on long-term maturities. Corporate bond yield curves are lower than US Treasury bond yield curves.
explanation: When the interest rate in the short term is lower than in the medium and long terms, and when rates in the medium term are lower than in the long term, the graph represents a normal, or upward-sloping, yield curve. This means that interest rates in the future are likely to increase. US Treasury bills, notes, and bonds are considered to be the least risky among all debt securities, because they are backed by the US government. Corporate bonds of equal maturity will have the same risk-free rate, inflation premium, and maturity risk premium as US Treasury bonds. Corporate bonds, however, are riskier and have a default risk premium. Thus, a corporate bond's yield curve will be higher than that of a US Treasury bond.
What do the slopes of the risk-return lines illustrated in Figure 8.1 indicate?
how much additional return is needed in order for an individual investor to take on greater risk levels. Steeper line = greater risk-averse investor. Flatter line = investor more comfortable with risk.
Suppose instead of replacing Atteric Inc.'s stock with Baque Co.'s stock, Gregory considers replacing Atteric Inc.'s stock with the equal dollar allocation to shares of Company X's stock that has a higher beta than Atteric Inc. If everything else remains constant, the portfolio's risk would increase decrease
increase It is important to remember that the expected return on a portfolio is the weighted average of the expected returns on the stock in the portfolio. In a portfolio, a stock's beta reflects the stock's contribution to the portfolio's riskiness. If the risk-free rate and market risk premium remain unchanged, the required returns on stock will increase if its beta increases. If Gregory replaces Atteric Inc.'s stock with a stock that has a higher beta, the portfolio's overall risk will also increase. As the portfolio's risk increases, the required return on the portfolio also increases, because investors will seek more returns for the additional risk.
The entity that promises to make the interest and maturity payments for a bond issue is called the.... issuer investor guarantor
issuer A bond is a long-term debt instrument; think of it as an IOU (I Owe You) in which you lend money to the entity offering the bonds. The entities that make the interest and maturity payments for a bond issue ( borrower, needing capital )are called the issuers of the bond. Bonds are usually issued by governments, corporations, municipalities, and agencies. Investor = the one loaning the money, (lender, bondholder, supplier of capital.
In January 2009, American electronics retailer Circuit City Inc. closed all of its stores and sold all of its merchandise. This is an example of: Reorganization Liquidation
liquidation Circuit City Inc. shut down, closed all of its stores, sold all of its merchandise, and ceased to operate. When a business's assets are sold off and the proceeds are used to pay creditors, with leftovers going to shareholders, it is referred to as a liquidation. When companies are reorganized, sometimes the management structures change, and/or their debt is restructured—termed restructuring of debt. This is only done if the decision makers—federal administrators of bankruptcy statutes—are convinced that the value of the reorganized firm will be more than the value of its assets if liquidated.
New York City issued a general obligation bond for a canal in 1812. It was the first formal debt instrument with a fixed repayment schedule issued by a city. What type of bonds are these? Corporate bonds Municipal bonds Treasury bonds
municipal bonds Because the issuer is New York City, which is a local government of the state of New York, its bonds would be referred to as municipal bonds, also called munis. If the investor is a resident of the issuing state, the interest earned on municipal bonds is exempt from federal and state taxes.
Frank Barlowe is retiring soon, so he's concerned about his investments providing him with a steady income every year. He's aware that if interest rates increase , the potential earnings power of the cash flow from his investments will increase. In particular, he is concerned that a decline in interest rates might lead to less annual income from his investments. What kind of risk is Frank most concerned about protecting against? Reinvestment risk Interest rate risk
reinvestment risk Reinvestment risk is the risk that a decline in interest rates will lead to a decline in the income generated by a bond portfolio. If rates fall, investors will have to reinvest cash flows from existing assets at lower rates than they previously could. For investors concerned about portfolio income (such as retirees), reinvestment risk is a primary concern because it directly affects the income that the portfolio generates.
In December 2008, Hawaiian Telcom took action to strengthen its balance sheet by reducing debt. Although the company continued to operate, its creditors could not collect their debts or loan payments that were due prior to the legal action that the company took. However, on November 30, 2009, the company had $75 million in cash on hand. This is an example of: Reorganization Liquidation
reorganization This is an example of reorganization. Hawaiian Telcom restructured its debt, continued to be in operation, and managed to have $75 million in cash on hand by November 30. When companies are reorganized, sometimes the management structures change or their debt is restructured—termed restructuring of debt. This is only done if the decision makers—federal administrators of bankruptcy statutes—are convinced that the value of the reorganized firm will be more than the value of its assets if liquidated. When a business's assets are sold off and the proceeds are used to pay creditors, with leftovers going to shareholders, it is referred to as a liquidation.
Is the equation used to value preferred stock more like the one used to value a bond or the one used to value a "normal" constant growth common stock? Explain.
It is similar to a "normal" constant growth common stock because the value equals the dividend over the required rate of return (Vp = Dp / Rp)
Which of the following statements accurately describes the relationship between earnings and dividends when all other factors are held constant? Long-run earnings growth occurs primarily because firms retain earnings and reinvest them in the business. Dividend growth and earnings growth are unrelated. Paying a higher percentage of earnings as dividends will result in a higher growth rate.
Long-run earnings growth occurs primarily because firms retain earnings and reinvest them in the business. Long-run earnings growth occurs primarily because firms retain earnings and reinvest them in the business. Therefore, the higher the percentage of earnings retained, the higher the growth rate. Dividends are paid out of earnings, so growth in dividends requires growth in earnings.
Larry Nelson holds 1,000 shares of General Electric's (GE) common stock. The annual stockholder meeting is being held soon, but as a minor shareholder, Larry doesn't plan to attend. Larry did not sell his shares but gave his voting rights to the management group running General Electric (GE). Larry must have signed a _______ that gives the management group control over his shares.
Proxy A proxy is a document that gives a person or group the authority to act on behalf of another—in this case, it transfers shareholder voting rights to management. A poison pill is a provision that management might include in the corporate charter that makes the firm less attractive to prospective acquirers. The poison pill allows the target firm's shareholders to buy the firm's additional shares at below-market prices, which increases the number of shares outstanding and thus makes the takeover expensive for the acquiring firm. A corporate charter is a document that outlines the rights of shareholders and the firm. A preemptive right is a provision that gives shareholders the right to buy new shares in any new share issuance in proportion to their existing stake in the company.
What is meant by perfect positive correlation, perfect negative correlation, and zero correlation?
We see then that when stocks are perfectly negatively correlated (ρ = −1.0), all risk can be diversified away; however, when stocks are perfectly positively correlated (ρ = +1.0), diversification does no good. Zero correlation: returns of two stocks are not related to one another.
solving for yield to maturity (YTM)
YTM < Coupoun Rate = bond sells at a premium. YTM > Coupoun rate = bond sells at a discount.
Briefly explain the fundamental trade-off between risk and return.
to get investors to take on more risks, there must be greater expected returns
What are the differences between the relative volatility graph, "betas are made", and SML graph, "betas are used"? Explain how graphs are constructed and information they convey.
"Betas are made": Volatility or Risk graph is constructed using the returns of stocks and the return on the market. We determine the riskiness of the portfolio using the beta coefficient. "Betas are used": SML (Security Market Line) graph is constructed using the required rate of return and the beta coefficient conveys the degree of risk aversion in the economy.
Assume that a $1,000,000 par value, semiannual coupon US Treasury note with five years to maturity has a coupon rate of 3%. The yield to maturity (YTM) of the bond is 8.80%. Using this information and ignoring the other costs involved, calculate the value of the Treasury note: $653,988.93 $484,721.21 $769,398.74 $923,278.49
$769,398.74 The Treasury note pays a semiannual coupon payment, so the YTM will need to be adjusted. Rather than a five-year bond, think of this as a 10-year bond that makes annual interest payments at half the coupon rate. The Treasury note makes 10 payments of $15,000.00 [(3% x $1,000,000)/2 = $15,000.00]. The YTM used for discounting the cash flows will be 8.80%/2 = 4.4000%. Using the semiannual YTM as the discount rate, $15,000.00 as the interest payment, and $1,000,000 as the par value,
Suppose the yield on a two-year Treasury security is 5.83%, and the yield on a five-year Treasury security is 6.20%. Assuming that the pure expectations theory is correct, what is the market's estimate of the three-year Treasury rate two years from now? (Note: Do not round your intermediate calculations.) 6.53% 7.10% 6.69% 6.45%
6.45%
Based on the information just given, what will be Robert's forecast of PAMC's growth rate? 9.90% 6.60% 11.35% 5.48%
6.60%
Remember, a bond's coupon rate partially determines the interest-based return that a bond will pay, and a bondholder's required return reflects the return that a bondholder would like to receive from a given investment
A bond's coupon (or interest payment) is computed by multiplying the bond's coupon rate by its par, or maturity payment; that is: coupon = coupon rate x par value. A bond's interest-based return is partially based on its coupon rate and represents (in the absence of the issuer's default) a return that a bond will pay and the bondholder will receive. In contrast, a bondholder's required return reflects the percentage return that a bondholder would like to receive from a bond investment. The mathematical relationship between these two values—a bondholder's required return and a bond's coupon rate—provides insights into a bond's intrinsic value compared to its par value.
Perfect negative correlation means that ______. A. total diversification can be achieved B. there will be no diversification effect C. the correlation is equal to zero D. none of the above
A. total diversification can be achieved
Based on the graph's information, which of the following statements is true? Company A has lower risk. Company B has lower risk.
Company A Company A has a tighter probability distribution. This means its actual returns are more likely to be close to its expected return. Thus, there is less risk associated with Company A than with Company B.
If the inflation rate was 3.00% and the nominal interest rate was 4.60% over the last year, what was the real rate of interest over the last year? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average. Round intermediate calculations to four decimal places. 1.84% 1.60% 1.36% 2.00%
The nominal interest rate consists of the real rate of interest and inflation. In this case, the nominal interest rate is 4.60%, and the inflation rate is 3.00%. So the real rate of interest is 4.60% - 3.00% = 1.60%.
What happens to the SML graph when risk aversion increases or decreases?
The steeper the slopes of the line, the more the average investor requires as compensation for bearing risk. The market risk premium would rise, causing the required rate of return on a portfolio to increase by the same amount. The returns on other risky assets also rise, and the effect of this shift in risk aversion is pronounced on riskier securities.
When valuing a semiannual coupon bond, the time period variable(N) used to calculate the price of a bond reflects the number of 6-month periods remaining in the bond's life.
The value of a bond is the sum of the present values of its expected future cash flows. When calculating the value of a bond, the time period variable (N) represents the number of 6-month (rather than annual) periods remaining in the bond's life.
How can a firm influence the size of its beta (market risk)?
Through changes in the composition of its assets and through changes in the amount of debit it uses.
Explain the following statement: An asset held as part of a portfolio is generally less risky than the same asset held in isolation.
True an asset is less risky held in a portfolio because risk is diversified.
What is an average-risk stock? What is the beta of such a stock?
it moves up and down with in step with the general market. Its beta is 1.0.
Suppose that there is high unemployment, which causes interest rates to fall, which in turn pulls the preferred stock's yield to 8.20%. The value of the preferred stock will increase .
refer to picture for explanation
Does the average investor's willingness to take on risk vary over time? Explain.
yes. before the crisis, people were putting their money into risky investments. After the crisis, they tended toward safer investments.
Interest rates - what we need to know
• The interest rate is determined by a number of factors, how you should be compensated for loaning your money • Default risk up, cost of borrowing up, yield up • Expectations theory means we can figure out what future interest rates are expected to be • Relationship between yield curve and future rates
