Finance exam 2 (chapters 7,8,9,10)

stand alone principle

Once we identify the effect of undertaking the proposed project on the firm's cash flows, we need focus only on the project's resulting incremental cash flows

a corporate bonds yield to maturity

changes over time and can be greater, equal to or less than the bonds coupon rate

straight voting

directors are elected one at a time

rate at which a stocks price is expected to appreciate

capital gains yield

maturity

number of years until the face value is paid

side effect of cash flows

A negative impact on the cash flows of an existing product from the introduction of a new product is called erosion - pay attention to after tax cash flows bc taxes are an outflow

debt vs equity

Debt is not an ownership interest in the firm, creditors generally do not have voting power corporation's payment of interest on debt is considered a cost of doing business and is tax deductible, dividends paid to stockholders are not tax deductible. one of the costs of issuing debt is the possibility of financial failure, this possibility does not arise when equity is issued.

IRR and NPVC

IRR and NPV rules always lead to identical decisions. as long as: - cash flows are conventional, meaning that the first cash flow (the initial investment) is negative and all the rest are positive - must be independent, meaning that the decision to accept or reject this project does not affect the decision to accept or reject any other

mutually exclusive investment decisions

If two investments, X and Y, are mutually exclusive, then taking one of them means that we cannot take the other. Two projects that are not mutually exclusive are said to be independent

face/par value

The amount that will be repaid at the end of the loan

current yield

a bond's annual coupon divided by its price

sunk cost

a cost we have already paid or have already incurred the liability to pay. Such a cost cannot be changed by the decision today to accept or reject a project - must exclude bc irrelevant

average accounting return rule

a project is acceptable if its average accounting return exceeds a target average accounting return

advantages & disadvantages of IRR

advantages: closely related to NPV which often leads to identical decisions and its easily understood & communicated disadvantages: may result in multiple answers and may lead to incorrect decisions in comparisons of mutually exclusive investments

call provision

allows the company to repurchase part or all of the bond issue at stated prices over a specific period -Corporate bonds are usually callable

payback rule

an investment is acceptable if its calculated payback period is less than some prespecified number of years.

Internal rate of return (IRR)

an investment is acceptable if the IRR exceeds the required return. It should be rejected otherwise. - required return that results in a zero NPV when it is used as the discount rate - sometimes called discounted cash flow

coupon rate

annual coupon divided by face value

when an investor sells a bond, the price received by a dealer is always the

bid price

a market is considered transparent if

its prices and trading volume are easily observed - stock market is more transparent

a zero coupon bond is a bond that

makes no interest payments

bonds time to maturity

number of years until the face value is due to be repaid

staggered elections

only a fraction of directors are up for election at a particular time - makes it more difficult for a minority to elect a director because there are fewer directors to be elected at one time - makes takeover attempts less likely to be successful because it makes it more difficult to vote in a majority of new directors

bond values and yields

over time, interest rates in the market change cash flows stay the same, causes the value of the bond to fluctuate -When interest rates rise: the present value of the bond's remaining cash flows declines, and the bond is worth less. - When interest rates fall: the bond is worth more

protective covenant

part of loan agreement that limits certain actions a company might wish to take during a loans term - negative: limits or prohibits actions - positive: specifies actions that the company must abide by

what is a corporate bonds YTM

prevailing market interest rate of bonds with similar features, expected return for an investor who buys the bond today and holds until maturity

capital gains yield

rate at which value of the investment grows

PE ratio

ratio of a stock's price per share to its earnings per share (EPS) over the previous year. - idea here is to have some sort of benchmark, which we then multiply by earnings to come up with a price

how to avoid the problem of having to forecast and discount an infinite number of dividends

require that the dividends start growing at a constant rate sometime in the future

opportunity cost

requires us to give up a benefit - out of pocket costs

profitability index

the present value of the future cash flows divided by the initial investment

The bond market requires a return of 9.8 percent on the 5-year bonds issued by JW Industries. The 9.8 percent is referred to as the

yield to maturity

what is a bond called that has a market price that exceeds par value

yield to maturity < coupon rate

how is a zero coupon bond different from a conventional bond

zero coupon bonds are always issued at a discount and make no interest payments

bid price and ask price

bid: represents what a dealer is willing to pay for a security ask: what a dealer is willing to take for it

secondary markets in sukuk are extremely liquid because most sukuk are

bought and held to maturity

dealer vs broker

dealer maintains an inventory and stands ready to buy and sell at any time broker brings buyers and sellers together but does not maintain an inventory

bonds

debt securities issued or sold to the public to borrow on a long term basis from either a corporation or the government - normally an interest-only loan, meaning that the borrower will pay the interest every period, but none of the principal will be repaid until the end of the loan

bond and debt ratings

debt: assessment of the creditworthiness of the corporate issuer, how likely a firm is to default & the protection creditors have in the event of a default bond: only deal with the possibility of default, constructed from info supplied by the corporation

3 important features of treasury bonds & notes

default-free, taxable, and highly liquid.

proxy

grant of authority by a shareholder to someone else to vote his or her shares

incremental cash flows

incremental cash flows for project evaluation consist of any and all changes in the firm's future cash flows that are a direct consequence of taking the project

DLQ Inc. bonds mature in 12 years and have a coupon rate of 6 percent. If the market rate of interest increases, then the

market price of the bond will decrease

net present value

measure of how much value is created or added today by undertaking an investment -should be accepted if positive, rejected if negative - preferred approach

3 reasons a common stock is more difficult to value than a bond (& special circumstances)

In common stock the promised cash flows are known in advance. The life of the investment is essentially forever because common stock has no maturity. There is no way to easily observe the rate of return that the market requires. - special circumstances: dividend has a zero growth rate, grows at a constant rate, and grows at a constant rate after some length of time

stock market: primary & secondary

In the primary, or new issue, market, shares of stock are first brought to the market and sold to investors. In the secondary market, existing shares are traded among investors

why does a bonds value fluctuate over time?

The coupon rate and par value are fixed, while market interest rates change.

The annual dividend yield is computed by dividing ________ annual dividend by the current stock price.

next years

nominal rate of return vs real rate of return on an investment

nominal is the rate that has not been adjusted for inflation real has been adjusted for inflation

three special case patterns of dividend growth include

non constant growth, constant growth and zero growth

Why is it more difficult to value common stock than it is to value bonds?

the life of a common stock is essentially forever, the rate of return required by the market is not easily observed and common stock cash flows are not known in advance

coupons

the regular interest payments that are promised to be paid on a bond

indenture

the written agreement between the corporation (borrower) and its creditor - includes: the basic terms of the bonds, total amount of bonds issued, description of property used as security, repayment arrangements, call provisions and details of the protective covenants

cumulative voting

total number of votes that each shareholder may cast is determined first. This is usually calculated as the number of shares (owned or controlled) multiplied by the number of directors to be elected