390 Midterm - Ch 1-3, 8, & 11

Covariance

"Deviation" compares return in each state to the expected return. "Weighted" takes the product of the deviations multiplied by the probability of that state.

Bond concepts

Bond prices and market interest rates move in opposite directions. When coupon rate = YTM, price = par value When coupon rate > YTM, price > par value (premium bond) When coupon rate < YTM, price < par value (discount bond)

noncash items

Depreciation is the most apparent. No firm ever writes a check for "depreciation." Another noncash item is deferred taxes, which does not represent a cash flow. Thus, net income is not cash

value vs cost

Under generally accepted accounting principles (GAAP), audited financial statements of firms in the U.S. carry assets at cost. Market value is the price at which the assets, liabilities, and equity could actually be bought or sold, which is a completely different concept from historical cost.

Aftertax yield

should be willing to accept a lower stated yield on municipals because you do not have to pay taxes on the interest received. You will want to make sure the students understand why you are willing to accept a lower rate of interest. It may be helpful to take the example and illustrate the indifference point using dollars instead of just percentages. The discount you are willing to accept depends on your tax bracket.

Coverage ratios

times interest earned & cash coverage

primary goal of financial managers

increase value of the firm by 1. selecting value-creating projects 2. making smart financial decisions maxmize the current value per share of the existing stock

Six years ago, Goodwynn & Wolf Incorporated (G&W) sold a 17-year bond issue with a 12% annual coupon rate and a 7% call premium. Today, G&W called the bonds. The bonds originally were sold at their face value of $1000. Compute the realized rate of return for investors who purchased the bonds when they were issued and who surrender them today in exchange for the call price. Round your answer to two decimal places.

n=6 pmt=120 fv=1070 --> [ 7% call premium (1000)(1+7%) pv=-1000 cpt i/y --> 12.84%

corporate control

threat of a takeover may result in better management

managerial compensation

-Incentives can be used to align management and stockholder interests -The incentives need to be structured carefully to make sure that they achieve their intended goal the type of stock can affect the effectiveness of the stockholder

1. You just purchased a bond that matures in 5 years. The bond has a face value of $1000 and has an 8% annual coupon. The bond has a current yield of 8.21%. What is the bond's yield to maturity? Do not round intermediate calculations. Round your answer to two decimal places.

.0821 = 80/price à price= $974.42 N= 5 fv= 1000 pv=-974.42 pmt=80 à i/y = 8.65%

agency relationship

1. Principal hires an agent to represent his/her interest 2. Stockholders (principals) hire managers (agents) to run the company

Unsystematic risk vs systematic risk

1. Short-term interest rates increase unexpectedly = systematic 2. The interest rate a company pays on its short-term debt borrowing is increased by its bank = unsystematic 3. Oil prices unexpectedly decline= systematic 4. An oil tanker ruptures, creating a large oil spill= unsystematic 5. A manufacturer loses a multimillion-dollar product liability suit = unsystematic 6. A Supreme Court decision substantially broadens producer liability for injuries suffered by product users=systematic

forms of business organization

1. The Sole Proprietorship 2. The Partnership ◦General Partnership ◦Limited Partnership 3. The Corporation

Bonds and Bond Valuation

A bond is a legally binding agreement between a borrower and a lender that specifies the: ◦Par (face) value ◦Coupon rate ◦Coupon payment ◦Maturity date The yield to maturity is the required market interest rate on the bond.

Risk: systematic & unsystematic

A systematic risk is any risk that affects a large number of assets, each to a greater or lesser degree. An unsystematic risk is a risk that specifically affects a single asset or small group of assets. Unsystematic risk can be diversified away. Examples of systematic risk include uncertainty about general economic conditions, such as GNP, interest rates or inflation. On the other hand, announcements specific to a single company are examples of unsystematic risk.

Sources of information

Annual reports Wall Street Journal Internet ◦NYSE (www.nyse.com) ◦NASDAQ (www.nasdaq.com) ◦Textbook (www.mhhe.com) SEC ◦EDGAR 10K & 10Q reports

External financing and growth

At low growth levels, internal financing (retained earnings) may exceed the required investment in assets. As the growth rate increases, the internal financing will not be enough, and the firm will have to go to the capital markets for financing. Examining the relationship between growth and external financing required is a useful tool in financial planning.

Debt vs Equity

Bondholders generally receive the first claim on the firm's cash flow. Stockholders' equity is the residual difference between assets and liabilities.

clean vs dirty prices

Clean price: quoted price Dirty price: price actually paid = quoted price plus accrued interest

The Efficient Set for Many Securities

Consider a world with many risky assets; we can still identify the opportunity set of risk-return combinations of various portfolios. The section of the opportunity set above the minimum variance portfolio is the efficient frontier.

Maturity and bond price volatility

Consider two otherwise identical bonds. The long-maturity bond will have much more volatility with respect to changes in the discount rate.

Solvency ratios

Deals with a company's financial leverage (debt). The degree to which a company relies on debt financing. Measures a company's ability to meet long-term obligations. • The larger the ratio, the less solvent the business. The leverage ratio measures the degree to which the business uses borrowed versus owner's money in the business. The debt to assets ratio measures the degree to which creditors are financing total assets

factors affecting required return

Default risk premium—remember bond ratings Taxability premium—remember municipal versus taxable Liquidity premium—bonds that have more frequent trading will generally have lower required returns (remember bid-ask spreads) Anything else that affects the risk of the cash flows to the bondholders will affect the required returns.

A stock has an expected return of 10.9 percent. its beta is .9, and the expected return on the market is 11.8 percent. What must the risk-free rate be?

E(R)= Rf + B(Rm-Rf) .109 = Rf + .90(.118-Rf) .109 = Rf + .1062 - .9Rf .0028=.1Rf à Rf= .0028/.1 = 2.8%

A stock has a beta of 1.15, the expected return on the market is 11.1 percent, and the risk-free rate is 3.8 percent. What must the expected return on this stock be?

E(R)= Rf + B(Rm-Rf) = .038 + {1.15(.11-.038)] = 12.195% MRP = Rm -Rf

CF management

Earnings can be manipulated using subjective decisions required under GAAP Total cash flow is more objective, but the underlying components may also be "managed" ◦Moving cash flow from the investing section to the operating section may make the firm's business appear more stable

Corporate bonds

Greater default risk relative to government bonds The promised yield (YTM) may be higher than the expected return due to this added default risk

Bond Ratings - investment quality

High Grade ◦Moody's Aaa and S&P AAA—capacity to pay is extremely strong ◦Moody's Aa and S&P AA—capacity to pay is very strong Medium Grade ◦Moody's A and S&P A—capacity to pay is strong, but more susceptible to changes in circumstances ◦Moody's Baa and S&P BBB—capacity to pay is adequate, adverse conditions will have more impact on the firm's ability to pay

CF of the firm

In finance, the most important item that can be extracted from financial statements is the actual cash flow of the firm. Since there is no magic in finance, it must be the case that the cash flow received from the firm's assets must equal the cash flows to the firm's creditors and stockholders. **this relation is just an application of the standard balance sheet identity**

Time and costs

In the short run, certain equipment, resources, and commitments of the firm are fixed, but the firm can vary such inputs as labor and raw materials. In the long run, all inputs of production (and hence costs) are variable. Financial accountants do not distinguish between variable costs and fixed costs. Instead, accounting costs usually fit into a classification that distinguishes product costs from period costs

Financial Models

Investment in new assets—determined by capital budgeting decisions Degree of financial leverage—determined by capital structure decisions Cash paid to shareholders—determined by dividend policy decisions Liquidity requirements—determined by net working capital decisions

bond ratings - speculative

Low Grade ◦Moody's Ba and B ◦S&P BB and B ◦Considered speculative with respect to capacity to pay. Very Low Grade ◦Moody's Caa, Ca and C ◦S&P CCC, CC, C, and D ◦Highly uncertain repayment and, in many cases, already in default, with principal and interest in arrears.

Zero coupon bonds

Make no periodic interest payments (coupon rate = 0%) The entire yield to maturity comes from the difference between the purchase price and the par value Cannot sell for more than par value Sometimes called zeroes, deep discount bonds, or original issue discount bonds (OIDs) Treasury bills and principal-only Treasury strips are good examples of zeroes

inflation-linked bonds

Most government bonds face inflation risk TIPS (Treasury inflation-protected securities), however, eliminate this risk by providing promised payments specified in real, rather than nominal, terms

Riskless Borrowing and Lending

Now investors can allocate their money across the T-bills and a balanced mutual fund. With a risk-free asset available and the efficient frontier identified, we choose the capital allocation line with the steepest slope.

Interest Rate risk

Price Risk ◦Change in price due to changes in interest rates ◦Long-term bonds have more price risk than short-term bonds ◦Low coupon rate bonds have more price risk than high coupon rate bonds. Reinvestment Rate Risk ◦Uncertainty concerning rates at which cash flows can be reinvested ◦Short-term bonds have more reinvestment rate risk than long-term bonds. ◦High coupon rate bonds have more reinvestment rate risk than low coupon rate bonds.

Bond markets

Primarily over-the-counter transactions with dealers connected electronically Extremely large number of bond issues, but generally low daily volume in single issues Makes getting up-to-date prices difficult, particularly on a small company or municipal issues Treasury securities are an exception

Bond valuation

Primary Principle: ◦Value of financial securities = PV of expected future cash flows Bond value is, therefore, determined by the present value of the coupon payments and par value. Interest rates are inversely related to present values (i.e., bond prices).

Determinates of growth

Profit margin—operating efficiency Dividend policy—choice of how much to pay to shareholders versus reinvesting in the firm Financial leverage—choice of optimal debt ratio Total asset turnover—asset use efficiency

What are the reasons for using ratio analysis

Ratio analysis helps you analyze and gauge the financial health of your business. Ratio analysis helps you better understand and guide the financial affairs and decision making of your business. You can see how your business is doing by checking your most recent ratios against previous ratios on a regular basis. You can check your ratios against ratios of other firms in your industry. This will tell you if your business is performing better or worse than other business firms in the industry. Ask yourself what the ratio is trying to measure and why that information is important.

inflation and interest rate

Real rate of interest—change in purchasing power Nominal rate of interest—quoted rate of interest, change in purchasing power and inflation The ex ante nominal rate of interest includes our desired real rate of return plus an adjustment for expected inflation.

The DuPont Identity

Return on Equity = NI / TE Multiply by 1 and then rearrange: ◦ROE = (NI / TE) (TA / TA) ◦ROE = (NI / TA) (TA / TE) = ROA × EM Multiply by 1 again and then rearrange: ◦ROE = (NI / TA) (TA / TE) (Sales / Sales) ◦ROE = (NI / Sales) (Sales / TA) (TA / TE) ◦ROE = PM × TAT × EM ◦Profit margin is a measure of the firm's operating efficiency—how well it controls costs. ◦Total asset turnover is a measure of the firm's asset use efficiency—how well it manages its assets. Equity multiplier is a measure of the firm's financial leverage.

Financial Planning ingredients

Sales Forecast—many cash flows depend directly on the level of sales (often estimate sales growth rate) Pro Forma Statements—setting up the plan as projected (pro forma) financial statements allows for consistency and ease of interpretation Asset Requirements—the additional assets that will be required to meet sales projections Financial Requirements—the amount of financing needed to pay for the required assets Plug Variable—determined by management decisions about what type of financing will be used (makes the balance sheet balance) Economic Assumptions—explicit assumptions about the coming economic environment

Determinants of bond yields

Term structure is the relationship between time to maturity and yields, all else equal. It is important to recognize that we pull out the effect of default risk, different coupons, etc. Yield curve—graphical representation of the term structure ◦Normal—upward-sloping, long-term yields are higher than short-term yields ◦Inverted—downward-sloping, long-term yields are lower than short-term yields

Regulation

The Securities Act of 1933 and the Securities Exchange Act of 1934 ◦Issuance of Securities (1933) ◦Creation of SEC and reporting requirements (1934) Sarbanes-Oxley ("Sarbox") ◦Increased reporting requirements and responsibility of corporate directors

The internal growth rate

The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing.

GAAP

The matching principle of GAAP dictates that revenues be matched with expenses. Thus, income is reported when it is earned, even though no cash flow may have occurred.

Statement of CF

The statement of cash flows is the addition of cash flows from operations, investing activities, and financing activities

CF from operating activites

To calculate cash flow from operating activities, start with net income, add back noncash items like depreciation and adjust for changes in current assets and liabilities (other than cash).

Balance sheet analysis

When analyzing a balance sheet, the financial manager should be aware of three concerns: 1.Liquidity 2.Debt versus equity 3.Value versus cost

characteristics of individual securities that are of interest

expected return variance & standard deviation covariance & correlation

You just purchased a bond that matures in 5 years. The bond has a face value of $1000 and has an 8% annual coupon. The bond has a current yield of 8.21%. What is the bond's yield to maturity? Do not round intermediate calculations. Round your answer to two decimal places.

find price first: .0821 = 80/price price= $974.42 find ytm: n=5 fv=1000 pmt= 80 pv = -974.42 cpt i/y --> 8.65%

Absalom Energy's 14% coupon rate, semiannual payment, $1000 par value bonds that mature in 30 years are callable 3 years from now at a price of $1075. The bonds sell at a price of $1352.47, and the yield curve is flat. Assuming that interest rates in the economy are expected to remain at their current level, what is the best estimate of the nominal interest rate on new bonds issued in 3 years? Do not round intermediate calculations. Round your answer to two decimal places.

n= 6 fv= 1075 pv= -1352.47 pmt= 70 cpt i/y --> 1.9166 YTC: 1.9166% * 2 = 3.83% The bond is selling at a large premium. This means that the coupon rate is much higher than the interest rate. Therefore, the bond is likely to be called. Calculate the YTC

Absalom Energy's 14% coupon rate, semiannual payment, $1000 par value bonds that mature in 30 years are callable 3 years from now at a price of $1075. The bonds sell at a price of $1352.47, and the yield curve is flat. Assuming that interest rates in the economy are expected to remain at their current level, what is the best estimate of the nominal interest rate on new bonds issued in 3 years? Do not round intermediate calculations. Round your answer to two decimal places.

n= 6 fv= 1075 pv= -1352.47 pmt= 70 à i/y = 1.9166% à *2 = 3.83% YTC

income statement

operations section: reports revenues and expenses from principal operation nonoperating section: financing costs such as interest expense separate sections report the amount of taxes levied on income 3 things to keep in mind when analyzing 1. GAAP 2. noncash items 3. time and costs

agency problem

◦Conflict of interest between principal and agent

A stock has an expected return of 10.4 percent. the risk-free rate is 3.8 percent, and the market risk premium is 7 percent. What must the beta of this stock be?

.104 = .038 + B(.07) B = .94

A stock has an expected return of 12.7 percent, its beta is 1.20, and the risk-free rate is 4.2 percent. What must the expected return on the market be?

.127 = .042 + 1.20(MRP) = 7.08% Rm = 7.08% + 4.2% = 11.28%

What are the five areas that ratio analysis covers

1. liquidity 2. profitability 3. solvency 4. efficiency 5. market value

1. The Garraty Company has two bond issues outstanding. Both bonds pay $100 annual interest plus $1000 at maturity. Bond L has a maturity of 15 years, and Bond S has a maturity of 1 year. 1a. What will be the value of each of these bonds when the going rate of interest is 6%? Assume that there is only one more interest payment to be made on Bond S. Round your answers to the nearest cent. 1b. What will be the value of each of these bonds when the going rate of interest is 8%? Assume that there is only one more interest payment to be made on Bond S. Round your answers to the nearest cent 1c. What will be the value of each of these bonds when the going rate of interest is 13%? Assume that there is only one more interest payment to be made on Bond S. Round your answers to the nearest cent. 2. Why does the longer-term (15-year) bond fluctuate more when interest rates change than does the shorter-term bond (1 year)? I. Longer-term bonds have more reinvestment rate risk than shorter-term bonds. II. Shorter-term bonds have more interest rate risk than longer-term bonds. III. Longer-term bonds have more interest rate risk than shorter-term bonds.

1a. Bond L: pmt=100 fv=1000 n=15 i/y=6 cpt pv --> $1388.49 Bond S: pmt=100 fv=1000 n=1 i/y=6 cpt pv --> $1037.74 1b. Bond L=$1171.90 Bond S=$1018.52 1c. Bond L=$806.13 Bond S= $973.45 2. III

The Brownstone Corporation's bonds have 4 years remaining to maturity. Interest is paid annually, the bonds have a $1000 par value, and the coupon interest rate is 9%. 1a. What is the yield to maturity at a current market price of $859? Round your answer to two decimal places. 1b. What is the yield to maturity at a current market price of $1093? Round your answer to two decimal places. 2. Would you pay $859 for one of these bonds if you thought that the appropriate rate of interest was 13% - that is, if rd = 13%. I. You would buy the bond as long as the yield to maturity at this price is less than your required rate of return. II. You would buy the bond as long as the yield to maturity at this price equals your required rate of return. III. You would buy the bond as long as the yield to maturity at this price does not equal your required rate of return. IV. You would buy the bond as long as the yield to maturity at this price is greater than your required rate of return.

1a. 13.82% 1b. 6.30% 2. IV

Bond pricing theorems

Bonds of similar risk (and maturity) will be priced to yield about the same return, regardless of the coupon rate. If you know the price of one bond, you can estimate its YTM and use that to find the price of the second bond. This is a useful concept that can be transferred to valuing assets other than bonds.

You own a stock portfolio invested 20 percent in Stock Q, 30 percent in Stock R, 15 percent in Stock S, and 35 percent in Stock T. The betas for these four stocks are .75, 1.90, 1.38, and 1.16, respectively. What is the portfolio beta?

Bp = .20(.75)+.3(1.90)+.15(1.38)+.35(1.16) Bp = 1.33

You own a portfolio equally invested in a risk-free asset and two stocks. If one of the stocks has a beta of 1.61 and the total portfolio is equally as risky as the market, what must the beta be for the other stock in your portfolio?

Bp = 1/3(1.61)+1/3(0)+1/3(x) Bp = 1 1=.5367+ 1/3x X= 0.4633(3) = 1.39

CF from investing activities

Cash flow from investing activities involves changes in capital assets: acquisition of fixed assets and sales of fixed assets (i.e., net capital expenditures).

CF from creditors

Cash flows to and from creditors and owners include changes in equity and debt.

coupon rates and bond prices

Consider two otherwise identical bonds. The low-coupon bond will have more volatility with respect to changes in the discount rate.

Diversification and portfolio risk

Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns. This reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another. However, there is a minimum level of risk that cannot be diversified away, and that is the systematic portion.

Portfolio Expected Return You own a portfolio that has $3,100 invested in Stock A and $4,600 invested in Stock B. If the expected returns on these stocks are 9.8 percent and 12.7 percent, respectively, what is the expected return on the portfolio?

E(Rp) = (3,100/(3,100+4,600))*.098 + (4,600/(3,100+4,600)) * .127 = 11.53%

You own a portfolio that is 20 percent invested in Stock X, 45 percent in Stock Y, and 35 percent in Stock Z. The expected returns on these three stocks are 10.5 percent, 16.1 percent, and 12.4 percent, respectively. What is the expected return on the portfolio?

E(Rp) = .20(10.5%) + .45(16.1%) + .35(12.4%) = 13.69%

You have $10,000 to invest in a stock portfolio. Your choices are Stock X with an expected return of 12.7 percent and Stock Y with an expected return of 9.1 percent. If your goal is to create a portfolio with an expected return of 11.2 percent, how much money will you invest in Stock X? In Stock Y?

E(Rp) = Wx(Rx) + Wy(Ry) = .112 = Wx(.127) + (1-Wx)(.091) .112 = .127Wx + .091-.091Wx .021 = .127Wx - .091Wx .021 = .036Wx à Wx=.021/.036 = 58.3% Investment in X = $5,833 à (10,000*58.3%) Investment in Y = 10,000 - 5,833 = $4,167

Some Caveats Regarding Financial Planning Models

Financial planning models do not indicate which financial polices are the best. Models are simplifications of reality, and the world can change in unexpected ways. Without some sort of plan, the firm may find itself adrift in a sea of change without a rudder for guidance.

Heath Food Corporation's bonds have 7 years remaining to maturity. The bonds have a face value of $1000 and a yield to maturity of 8%. They pay interest annually and have a 9% coupon rate. What is their current yield? Do not round intermediate calculations. Round your answer to two decimal places.

Find Price first: N=7 FV=1000 I/Y=8 PMT=90 CPT PV --> $1052.0637 90/1052.0637 = 8.55%

management goals

Management goals may be different from shareholder goals -Expensive perquisites -Survival -Independence Increased growth and size are not necessarily equivalent to increased shareholder wealth

Liquidity ratios

Measures how easily you can turn assets into cash. The larger the ratio, the more liquid the business. The working capital ratio measures a company's cash flow position. The current ratio measures the degree to which current assets can be used to pay current debt obligations. The quick ratio measures the degree to which very liquid current assets can be converted to cash to meet current debt obligations. The cash ratio is a conservative look at a company's ability to pay its liability. The interval measure ratio measures the number of days a company could operate only on the cash it has on hand.

Efficiency Ratios

Measures the degree to which a company is effectively utilizing its resources in generating sales and profits for the business. The larger the ratio, the more efficient the business. The total asset turnover ratio measures the degree to which the total assets of the firm are being used to generate sales. The inventory turnover ratio measures how well the business's inventory is being managed. The 'days' sales in inventory' ratio measures long it took to sell the inventory off. The times interest earned ratio measures how well a company can meet its interest obligations. The receivables turnover ratio measures how many times a company collected its receivables. The 'days' sale in receivables' ratio measures how often a company collects its credit sales. The net working capital turnover ratio measures the turnover in WC per year. **Not unusual for TAT<1, especially if a firm has a large amount of fixed assets**

Profitability ratios

Measures the degree to which a company is profitable. The larger (more positive) the ratio, the more profitable the company. Return on equity measures the return on funds invested by the owners of a company. Return on assets measures how efficiently profits are being generated from assets used in a company. Return on sales or net profit margin is a measure of how successful a company is.

Market Value ratios

Measures the market value of the company's investments to their historical costs (market-to-book ratio). A value of less than one (1) indicates that the company has not been successful in generating value of shareholders. The price-earnings ratio tells us how much investors are willing to pay per dollar of earnings. A PE ratio of $25 tells us that investors are willing to pay $25 for every $1 of a company's earnings. **If a company has a PE ratio that is higher than the industry average, this tells us that the market is expecting huge growth (in the company) in the future. A company with a high PE ratio will eventually have to live up to the high rating by substantially increasing its earnings, or the stock price will fall.**

A bond that matures in 10 years sells for $1190. The bond has a face value of $1000 and a yield to maturity of 9.7489%. The bond pays coupons semiannually. What is the bond's current yield? Do not round intermediate calculations. Round your answer to two decimal places

N= 20 pv= -1190 fv= 1000 i/y= 4.87445 à pmt= 63.83 CY = [63.83(2)] / 1190 = 10.73%

Jackson Corporation's bonds have 12 years remaining to maturity. Interest is paid annually, the bonds have a $1000 par value, and the coupon interest rate is 8%. The bonds have a yield to maturity of 9%. What is the current market price of these bonds? Do not round intermediate calculations. Round your answer to the nearest cent.

N=12 FV=1000 PMT=80 I/Y=9 CPT PV --> $928.39

Wilson Corporation's bonds have 12 years remaining to maturity. Interest is paid annually, the bonds have a $1000 par value, and the coupon rate is 10%. The bonds sell at a price of $850. What is their yield to maturity? Round your answer to two decimal places.

N=12 Fv=1000 PMT=100 PV=-850 CPT I/Y --> 12.48%

1. Six years ago, Goodwynn & Wolf Incorporated (G&W) sold a 17-year bond issue with a 12% annual coupon rate and a 7% call premium. Today, G&W called the bonds. The bonds originally were sold at their face value of $1000. Compute the realized rate of return for investors who purchased the bonds when they were issued and who surrender them today in exchange for the call price. Round your answer to two decimal places.

N=6 PMT= 120 PV= -1000 FV= 1070 à i/y= 12.84%

Using financial statements

Ratios are not very helpful by themselves: they need to be compared to something Time Trend Analysis ◦Used to see how the firm's performance is changing through time Peer Group Analysis ◦Compare to similar companies or within industries ◦SIC and NAICS codes - SIC used to ID industries and allow for comparison with industry averages & have no kept up to pace with rapid change NACIS created to help with some of these problems

liquidity

Refers to the ease and quickness with which assets can be converted to cash—without a significant loss in value Current assets are the most liquid. }Some fixed assets are intangible. The more liquid a firm's assets, the less likely the firm is to experience problems meeting short-term obligations. Liquid assets frequently have lower rates of return than fixed assets.

portfolios with various correlations

Relationship depends on correlation coefficient. -1.0 < r < +1.0 If r = +1.0, no risk reduction is possible. If r = -1.0, complete risk reduction is possible.

Risk When holding the market

Researchers have shown that the best measure of the risk of a security in a large portfolio is the beta (b) of the security. Beta measures the responsiveness of a security to movements in the market portfolio (i.e., systematic risk). -Clearly, your estimate of beta will depend upon your choice of a proxy for the market portfolio.

Percentage of sales approach

Some items vary directly with sales, others do not. Income Statement ◦Costs may vary directly with sales—if this is the case, then the profit margin is constant ◦Depreciation and interest expense may not vary directly with sales—if this is the case, then the profit margin is not constant ◦Dividends are a management decision and generally do not vary directly with sales—this affects additions to retained earnings Balance Sheet ◦Initially assume all assets, including fixed, vary directly with sales. ◦Accounts payable also normally vary directly with sales. ◦Notes payable, long-term debt, and equity generally do not vary with sales because they depend on management decisions about capital structure. ◦The change in the retained earnings portion of equity will come from the dividend decision. External Financing Needed (EFN) ◦The difference between the forecasted increase in assets and the forecasted increase in liabilities and equity. Can be calculated by: project sales (1-d) project sales measures increase in assets. (1-d) capture an increase in liabilities and equity

Financial Statement Analysis

Standardized statements make it easier to compare financial information, particularly as the company grows. They are also useful for comparing companies of different sizes, particularly within the same industry. Common-Size Balance Sheets ◦Compute all accounts as a percent of total assets Common-Size Income Statements ◦Compute all line items as a percent of sales

Corporate firm

The corporate form of business is the standard method for solving the problems encountered in raising large amounts of cash.

taxes

The one thing we can rely on with taxes is that they are always changing ◦Tax Cuts and Jobs Act of 2017 ◦See the IRS website for current information Average versus marginal tax rates ◦Average = the tax bill / taxable income ◦Marginal: the percentage paid on the next dollar earned Other taxes Important component of the decision making process. laws are changing. utilize specialists when making decisions with taxes involved

Announcements, Surprises, & expected returns

The return on any security consists of two parts. ◦First, the expected returns ◦Second, the unexpected or risky returns Any announcement can be broken down into two parts, the anticipated (or expected) part and the surprise (or innovation): ◦Announcement = Expected part + Surprise The expected part of any announcement is the part of the information the market uses to form the expectation, __R__, of the return on the stock. }The surprise is the news that influences the unanticipated return on the stock, U.

sustainable growth rate

The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio.

The accounting statement of CF

There is an official accounting statement called the statement of cash flows. This helps explain the change in accounting cash, which for U.S. Composite is $41 million in 2019. The three components of the statement of cash flows are: ◦Cash flow from operating activities ◦Cash flow from investing activities ◦Cash flow from financing activities **accounting CF and actual CF as calculated earlier are different values**

Potential problems with ratio analysis

There is no underlying theory, so there is no way to know which ratios are most relevant. Benchmarking is difficult for diversified firms. Globalization and international competition make comparison more difficult because of differences in accounting regulations. Firms use varying accounting procedures. Firms have different fiscal years. Extraordinary, or one-time, events

Are ratios used internally or externally

They are used externially and internally

Dupont Identity

This tells us that the return on equity is affected by operating efficiency, asset use efficiency and financial leverage. ROE = PM * TAT * EM *Profit margin (PM) is a measure of the firm's operating efficiency - how well it controls costs *Total asset turnover (TAT) is a measure of the firm's asset use efficiency - how well does it manage its assets *Equity multiplier (EM) is a measure of the firm's financial leverage

What are the portfolio weights for a portfolio that has 145 shares of Stock A that sell for $47 per share and 130 shares of Stock B that sell for $86 per share?

Total Value = (145*$47)+(130*$86) = 17,995 Wa = (145*$47)/17,995 = 37.87% Wb = (1- .3787) = 62.13%

Total risk

Total risk = systematic risk + unsystematic risk The standard deviation of returns is a measure of total risk. For well-diversified portfolios, unsystematic risk is very small. Consequently, the total risk for a diversified portfolio is essentially equivalent to the systematic risk

Government and Corporate Bonds

Treasury Securities ◦Federal government debt ◦T-bills—pure discount bonds with original maturity less than one year ◦T-notes—coupon debt with original maturity between one and ten years ◦T-bonds—coupon debt with original maturity greater than ten years Municipal Securities ◦Debt of state and local governments ◦Varying degrees of default risk, rated similar to corporate debt ◦Interest received is tax-exempt at the federal level

Suppose your firm earns $4 million in taxable income. ◦What is the firm's tax liability? ◦What is the average tax rate? ◦What is the marginal tax rate? If you are considering a project that will increase the firm's taxable income by $1 million, what tax rate should you use in your analysis?

Under the old (2017) tax code, the tax liability would be: .15(50,000) + .25(75,000 - 50,000) + .34(100,000 - 75,000) + .39(335,000 - 100,000) + .34(4,000,000 - 335,000) = $1,360,000 Average rate: 1,360,000 / 4,000,000 = .34 or 34%Marginal rate comes from the table, and it is 34%. We should use the marginal rate with an expected additional $340,000 in taxes.

Market Equilibrium

With the capital allocation line identified, all investors choose a point along the line—some combination of the risk-free asset and the market portfolio M. In a world with homogeneous expectations, M is the same for all investors. Where the investor chooses along the Capital Market Line depends on her risk tolerance. The big point is that all investors have the same CML.

Thatcher Corporation's bonds will mature in 20 years. The bonds have a face value of $1000 and a 12% coupon rate, paid semiannually. The price of the bonds is $850. The bonds are callable in 5 years at a call price of $1050. Do not round intermediate calculations. Round your answers to two decimal places.

YTM: n=40 fv=1000 pmt=60 pv=-850 cpt i/y --> 7.144% YTM = 7.144% * 2 = 14.29% YTC: n=10 fv = 1050 pv = -850 pmt = 60 cpt i/y --> 8.6347% ytc = 8.6347% * 2 = 17.27%

computing yield to maturity

Yield to maturity is the rate implied by the current bond price. Finding the YTM requires trial and error if you do not have a financial calculator, and it is similar to the process for finding r with an annuity. If you have a financial calculator, enter N, PV, PMT, and FV, remembering the sign convention (PMT and FV need to have the same sign, PV the opposite sign).

A 10-year, 12% semiannual coupon bond with a par value of $1000 may be called in 4 years at a call price of $1060. The bond sells for $1100. (Assume that the bond has just been issued.) a. What is the bond's yield to maturity? Do not round intermediate calculations. Round your answer to two decimal places. b. What is the bond's current yield? Do not round intermediate calculations. Round your answer to two decimal places. c. What is the bond's capital gain or loss yield? Capital loss yield, if any, should be indicated by a minus sign. Do not round intermediate calculations. Round your answer to two decimal places. d. . What is the bond's yield to call? Do not round intermediate calculations. Round your answer to two decimal places.

a. n= 20 pmt=60 fv=1000 pv=-1000 cpt i/y --> 5.1849% ytm= 5.1849% * 2 = 10.37% b. 120/1100 = 10.91% c. 10.37% = 10.91% + CGY CGY = (.54%) d. n= 8 fv=1060 pv= -1100 pmt= 60 cpt i/y --> 5.0748% YTC: 5.0748%* 2 = 10.15%

Bond Yields and Rates of Return A 10-year, 12% semiannual coupon bond with a par value of $1000 may be called in 4 years at a call price of $1060. The bond sells for $1100. (Assume that the bond has just been issued.) a. What is the bond's yield to maturity? Do not round intermediate calculations. Round your answer to two decimal places. b. What is the bond's current yield? Do not round intermediate calculations. Round your answer to two decimal places. c. What is the bond's capital gain or loss yield? Capital loss yield, if any, should be indicated by a minus sign. Do not round intermediate calculations. Round your answer to two decimal places. d. What is the bond's yield to call? Do not round intermediate calculations. Round your answer to two decimal places.

a. N=20 pmt=60 fv= 1000 pv= -1100 à i/y= 5.1849% à *2 = 10.37% b. =120/1100 à 10.91% c. 10.37% = 10.91% + x X= (.54%) à capital loss of .54% d.

The Brownstone Corporation's bonds have 4 years remaining to maturity. Interest is paid annually, the bonds have a $1000 par value, and the coupon interest rate is 9%. a. What is the yield to maturity at a current market price of $859? Round your answer to two decimal places. What is the yield to maturity at a current market price of $1093? Round your answer to two decimal places. b. Would you pay $859 for one of these bonds if you thought that the appropriate rate of interest was 13% - that is, if rd = 13%. c. explain your answer

a. PV= -859 N=4 FV=1000 PMT= 90 à CPT i/y= 13.82% PV=-1093 N=4 FV= 1000 PMT=90 à i/y = 6.29% b. yes c. You would buy the bond as long as the yield to maturity at this price is greater than your required rate of return

Ratio Analysis

allow for better comparison trough time or between companies categories: ST solvency (liquidity) LT solvency (financial leverage) Asset management (turnover) profitability market value

A bond that matures in 10 years sells for $1190. The bond has a face value of $1000 and a yield to maturity of 9.7489%. The bond pays coupons semiannually. What is the bond's current yield? Do not round intermediate calculations. Round your answer to two decimal places.

n=20 pv= -1190 fv= 1000 i/y = (9.7489/2) cpt pmt --> 63.83 current yield: [(63.20*2)]/1190 = 10.73%

Renfro Rentals has issued bonds that have an 8% coupon rate, payable semiannually. The bonds mature in 11 years, have a face value of $1000, and a yield to maturity of 10.5%. What is the price of the bonds? Round your answer to the nearest cent.

pmt=40 n=22 fv=1000 i/y=5.25 cpt pv --> $839.15