Finance Exam 3
Based on the dividend growth model, what are the two components of a stock's rate of return?
** constant growth rate plus dividend yield The firm will increase the dividend by a constant percent every period The firm will pay a constant dividend forever This is like preferred stock The price is computed using the perpetuity formula Constant dividends: zero growth: If dividends are expected at regular intervals forever, then this is like preferred stock and is valued as a perpetuity
What kind of problems existed in today's bond rating industry? Do you think these problems could be alleviated after new rating companies such as Kroll Bond Rating entered the market? Why?
-that companies are paying bond agencies for their ratings however this is also affected by the reputation of the company -aligning the interest of people and company by people paying for their bond ratings -how many people will really buy into this- isn't it better to have free information?
What are the advantages and disadvantages for a company to go public? Please use some specific examples to support your point.
Advantages More capital, Founders cash in, Incentives for employees through stocks Disadvantages Surrender of control, Pressure to meet investors' short-run expectation, Binds company resources during process
In our class discussion, we have talked about that there is an inverse relationship between the YTM and the price of a bond. Please explain briefly why this is the case?
As a bond's price increases, its yield to maturity falls. For example, if you purchased a bond with a par (face) value of $100, and a 10 percent annual coupon rate, its yield would be the coupon rate divided by the par value (10/100 = 0.10), or 10 percent. If the bond price fell to $90, the yield would become (10/90 = 0.11) or 11 percent- because the YTM is the coupon rate divided by the par value so if the value decreases the YTM increases
Why are bond issuers willing to pay fees for bond rating agencies to get their bonds rated?
Bond issues are willing to pay fees to bond rating agencies because it allows people to see their bond's riskiness and potentially help them get people to buy into their bonds-- potential conflict of interest with them paying for their rating
What are bond ratings and why are they important?
Bond ratings show the riskiness of bonds and the likelihood that they'll be paid back- important because you can make an informed investment decision
What is face value/par value/coupon rate/coupon payment/maturity date/yield to maturity of a bond?
Bond: Public debt securities issued by corporation or government. Usually interest is paid by the borrower every period, and the principal is repaid at the end of the loan. Par value (face value): The principal amount of a bond that is repaid at the end of the loan term. Coupon rate: The annual coupon of a bond divided by its face value is called the bond's coupon rate. Coupon payment: Stated interest payment made on a bond. Maturity date: Date on which the principal amount of a bond is paid. Yield or Yield to maturity (r): The rate required in the market on a bond.
How is bond market different from stock market? Please list out at least three differences.
Bond: lower risk, lower return, government, corporation or institute issues it, around $80-90T market size, treasury bonds: active, corporate bonds: not very active trading, not very transparent info, rely on rating agencies Stock: higher risk, higher return, corporation issues it, market size is $40-50T, 17,000 US companies issues it, most companies stocks are actively traded, transparent info 3- risk level, return level and where info comes from
What is capital gain? What is dividend yield?
Capital gain is an increase in the value of a capital asset (investment or real estate) that gives it a higher worth than the purchase price. The gain is not realized until the asset is sold. Dividend yield: A financial ratio that indicates how much a company pays out in dividends each year relative to its share price
What are the differences between common stocks and preferred stocks in terms of the rights of stockholders and dividend characteristics?
Common stock: Voting Rights, Proxy voting: grant of authority by a shareholder to somebody else to vote the shareholder's share, Classes of stock, Other Rights, Share proportionally in declared dividends, Share proportionally in remaining assets during liquidation, Preemptive right - first shot at new stock issue to maintain proportional ownership if desired Features of preferred stock: Preferred stock generally does not carry voting rights, Dividends, Stated dividend that must be paid before dividends can be paid to common stockholders, Dividends are not a liability of the firm and preferred dividends can be deferred indefinitely, Most preferred dividends are cumulative - any missed preferred dividends have to be paid before common dividends can be paid
How will the change in required return influence the price of a stock? How will the dividend growth rate influence the price of a stock?
Dividends = increased stock price
How do we find the value of a bond? How is this approach similar to the approach we use to find the value of a company or the price of a stock?
Finding the market price of a bond requires discounting the coupons and par value at the required rate of return (yield or yield to maturity, r ). Bond Value = PV of coupons + PV of par Bond Value = PV annuity + PV of lump sum Interest rate risk: The risk that arises from fluctuating interest rates. It depends on how sensitive the bond price is to interest rate changes. The greater portion of the bond's value comes from cash flow in the future, the more sensitive it is to interest rate changes. Based on ratings from rating agencies As with bonds, the price of the stock is the present value of these expected cash flows
What factors determine the required return on bonds?
Interest rate risk and time to maturity - Benchmark: Treasury bonds Default risk and some bond features -Municipal bonds and corporate bonds
How do mortgage-backed securities (MBS) work? Please use your own language to explain briefly.
MBS - mortgages bought by investment banks that are then sold to individuals- as homeowners pay off their home loan the MBS holders receive payments like a bond, risks can vary based on riskiness of homeowner
Why there tends to be big pops of prices on the first days of IPOs?
Oligopoly investment banking industry Reward to close clients Uncertainty in primary market valuation Future seasoned offering -investment bankers make money but don't want too big of a pop or company was undervalued
What is a par/discount/premium bond? Under what circumstance will a bond be traded at par/discount/premium and why?
Par bond: if coupon rate = YTM, then bond price = par value Discount bond: if coupon rate < YTM, then bond price < par value (selling at a discount premium bond: if coupon rate > YTM, then bond price > par value (selling at a premium)
Among the following types of investments, small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, and U.S. Treasury bills, small-company stocks had a risk premium of 12.6 percent for the period 1926-2008. What does the term "risk premium" mean? Is the risk premium on small-company stocks considered to be relatively high or relatively low when compared to other investment classes? Explain why.
Risk-free component: Treasury bills are considered to be risk-free Risk Premium component: the "extra" return earned for taking on risk Small stocks had a relatively high risk premium compared to other investments- based on past performance future is unknown but this results in a high average return
Among the following types of investments, small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, and U.S. Treasury bills, which type of investment provided the largest average return from 1926 to 2008? Which provided the lowest average return?
Small companies had the highest return and U.S. treasury bills had the lowest
What does standard deviation measure? Which type of investment discussed in class has had the highest standard deviation?
Standard deviation measures how risky stocks are and large company stocks had the highest SD The historical total risk can be measured by standard deviation of past returns
What type of risk is relevant to determining the expected return? And why?
Systematic risk is more relevant in determining expected return- multiply beta
What does a stock's beta tell? What is CAPM? What is CAPM used for?
The capital asset pricing model (CAPM) defines the relationship between risk and return- if we know an asset's systematic risk, we can use the CAPM to determine its expected return
Some companies, such as Google, have created classes of stock with little or no voting rights at all. Why would investors buy such stock? What are the pros and cons of such dual-share structure?
The pros of a dual-share structure are that the top executives in the company do not have to lose control. They are free to focus on long term goals; rather than short term profits is they chose. The downside to this structure is that investors may not want to invest in a project where they have less power to decide what direction the company goes in.
Please rank the following types of bonds based on their average yields (from the lowest to the highest yield): a BBB rating 10-year corporate bond; an AAA rating 10-year corporate bond; and a 10-year Treasury bond.
The riskiness of a bond is reflected in the bond's yields; the riskier the bond, the higher the yield. A BBB rated 10-year corporate bond would have the highest risk, and an annual yield of 6.25%. The AAA rated 10-year corporate bond have an average yield of 5.26% and are between a BBB and treasury bond in riskiness. Lastly, the 10-year treasury bond is the safest, with an annual yield of 3.73%.
What is the total risk of a stock? What is systematic risk? and unsystematic risk? Please give some examples of each type. What are the other names for systematic and unsystematic risk? Which risk is measured by standard deviation and which is measured by beta?
Total risk = company specific risk + systematic risk The standard deviation of returns is a measure of total risk Specific risk: outcome influenced by temporary factors, such as time spend, health, forget to bring calculator Company specific risk, fluctuation of performance generated from such company specific things as labor strikes, part shortages, price fluctuation of raw materials etc.- also called diversifiable risk or unsystematic risk Systematic risk: Often considered the same as undiversifiable risk: the fluctuation of performance is generated from such things as changes in GDP, inflation, interest rates, etc. Systematic risk: (ability coefficient)×(average score of the class) We use the beta coefficient to measure systematic risk, or how sensitive a specific stock is relative to the movements of the benchmark We define the overall market, the benchmark, has a beta=1 A beta < 1 implies the asset has less systematic risk than the overall market A beta > 1 implies the asset has more systematic risk than the overall market
What kind of investment is considered to be risk-free?
U.S. Treasury Bills
Please briefly explain the difference between the coupon rate and the required return on a bond.
coupon rate is the amount that is payed annually to the bond holder- if the coupon rate is higher than the required return you should take it