FIN 3404 TEST 2

With corporate democracy, the "golden rule" prevails absolutely

"One share, one vote"

Debt securities can be

"Short-term" (with maturities one year or less) or "long-term" (with maturities of more than one year. Short term debt is sometimes called unfounded debt

Negative Covenant

"Thou shalt not" - limits or prohibits actions the company might take 1. The firm must limit the amount of dividends it pays according to some formula 2. The firm cannot pledge any assets to other lenders 3. The firm cannot merge with another firm 4. The firm cannot sell or lease any major assets without approval by the lender 5. The firm cannot issue additional long-term debt

Positive Covenant

"Thou shalt" - specifies an action the company agrees to take or a condition the company must abide by 1. The company must maintain its working capital at or above some specified minimum level 2. The company must periodically furnish audited financial statements to the lender 3. The firm must maintain any collateral or security in good condition

Staggering provides

"institutional memory"

Non constant Growth

"supernormal" growth rates over some finite length of time. Growth rate cannot exceed the required return indefinitely, but it certainly can do so for some number of years

Bonds issued by corporations or municipalities additional factors

- Credit risk, possibility of default - Investors demand higher yield as compensation for risk, called Default risk premium (Lower rating bonds have higher yields) - Investors demand extra yield on taxable bonds because municipal bonds are free from most taxes. This is compensation, otherwise known as Taxability premium, is for the unfavorable tax treatment.

Main differences between debt and Equity

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

Two important factors about U.S. Treasury issues

1. Have no default risk because (we hope) the Treasury can always come up with the money to make the payments 2. Treasury issues are exempt from state income taxes (though not federal income taxes). In other words, the coupons you receive on a Treasury note or bond are taxed only at the federal level

Payback Period Disadvantages

1. Ignores the time value of money 2. Requires an arbitrary cutoff point 3. Biased against lone-term projects, such as research and development, and new projects

The trust company must

1. Make sure the terms of the indenture are obeyed 2. Manage the sinking fund 3. Represents the bond holder in default - that is, if the company defaults on its payments to them

Profitability Index disadvantages

1. May lead to incorrect decisions in comparison of mutually exclusive investments

Internal Rate of Return disadvantages

1. May result in multiple answers or not deal with nonconventional cash flows 2. May lead to incorrect decisions in comparisons of mutually exclusives investments.

Two key differences between the NYSE and NASDAQ

1. NASDAQ is a computer network and has no physical location where trading takes place 2. NASDAQ has a multiple market maker system rather than a DMM System

Average Accounting Return Disadvantages

1. Not a true rate of return; time value of money is ignored 2. Uses an arbitrary benchmark cutoff rate. 3. Based on accounting (book) values, not cash flows and market values

Common Stock Valuation (Why a share of common stock is more difficult to value in practice than a bond for three reasons)

1. Not even the promised cash flows are known in advance 2. The life of the investment is essentially forever because common stock has no maturity 3. There is no way to easily observe the rate of return that the market requires

Bond yields represent the combined effect of no fewer than six things

1. Real rate of interest - On top of the real rate are five premiums representing compensation for 1. Expected future inflation 2. Interest rate risk 3. Default risk 4. Taxability 5. Lack of liquidity

What determines the shape of the term structure? (3 components)

1. Real rate of interest (mostly influence the overall level of interest rates, not the shape) 2. Future rate of inflation (Inflation Premium) 3. Interest Rate risk Premium Extra component: Inflation premium (strongly influences the shape of the term structure

There are many different kinds of sinking fun arrangements, and the details would be spelled out in the indenture. For example:

1. Some sinking funds start about 10 years after the initial issuance 2. Some sinking funds establish equal payments over the life of the bond 3. Some high-quality bond issues establish payments to the sinking fund that are not sufficient to redeem the entire issues. As consequence, there is the possibility of a large "ballon payment" at maturity

Staggering has two basic effects:

1. Staggering makes it more difficult for a minority to elect a director because there are fewer directors to be elected at one time 2. Staggering males takeover attempts less likely to be successful because it makes it more difficult to vote in a majority of new directors

Bond indenture includes the following provisions

1. The basic terms of the bond 2. The total amount of bonds issued 3. A description of property used as security 4. The repayment arrangements 5. The call provisions 6. Details of the protective covenants

Special circumstances when we can come up with a clue for the stock

1. The dividend has a zero growth rate 2. The dividend grows at a constant rate 3. The dividend grows at a constant rate after some length of time

A majority of floaters have the following features:

1. The holder has the right to redeem the note at par on the coupon payment date after some specified amount of time. This is called a "put" provision 2. The coupon rate has a floor and ceiling, meaning the that the coupon is subject to minimum and a maximum. In this case, the coupon rate is said to be "capped," and the upper and lower rates are sometimes called the "collar"

IRR and NPV rules always lead to identical decisions as long as two very important conditions are met

1. The project's cashflows must be conventional, meaning that the first cash flows (the initial investment) is negative and all the rest are positive 2. The project must be independent, meaning that the decision to accept or reject this project does not affect the decision to accept or reject any other

In addition to the right to vote for directors, shareholders usually have the following rights:

1. The right to share proportionally in dividends paid. 2. The right to share proportinonally in assets remaining after liabilities have been paid in liquidation 3. The right to vote on stockholders matters of great importance, such as a merger. Voting is usually done at the annual meeting or a special meeting Stockholder also sometimes have the right to share proportionally in any new stock sold. This is called the preemptive right.

Treasury notes and bonds have three important features

1. They are Default free 2. They are taxable 3. They are highly liquid

Two drawbacks to bearer bonds

1. They are difficult to recover if they are lost or stolen 2. The company does not know who owns its bonds, it cannot notify bondholders of important event

Profitability Index advantages

1. closely related to NPV, generally leading to indentical decisions 2. Easy to understand and communicate 3. May be useful when available investment funds are limited

Internal Rate of Return advantages

1. closely related to NPV, often leading to identical decisions 2. Easy to understand and communicate

Average Accounting Return advantages

1. easy to calculate 2. needed information will usually be available

Payback Period Advantages

1. easy to understand 2. Adjusts for uncertainty of later cash flows 3. based toward liquidity

Discounted payback period advantages

1. includes time value of money 2. easy to understand 3. does not accept negative estimated NPV investments 4. Biased toward liquidity

Discount payback period disadvantages

1. may reject positive NPV investments 2. Requires an arbitrary cutoff point 3. Ignores cash flows beyond the cutoff date 4. Biased against long-term projects, such as research and development, and new projects

In general, if there are N directors up for election, then

1/(N+1) percent of the stock plus one share will guarantee you a seat.

Zero Coupon Bonds

A bond that pays no coupons at all must be offered at a price that is much lower that its stated value. Also called "zeroes"

call-protected bond

A bond that, during a certain period, cannot be redeemed by the issuer

Current Yield

A bond's annual coupon divided by its price

DMM's post

A fixed place on the exchange floor where the DMM operates

Net Present value profile

A geographical representation of the relationship between an investment's NPVs and various discount rates

Proxy

A grant of authority by a shareholder allowing another individual to vote his or her shares

Protective Covenants

A part of the indenture limiting certain actions that might be taken during the term of the loan, usually to protect the lender's interest

Treasury Yield Curve (Yield Curve)

A plot of the yields on Treasury notes and bonds relative too maturity

Straight voting

A procedure in which a shareholder may cast all votes for each member of the board of directors

Cumulative voting

A procedure in which a shareholder may cast all votes for one member of the board of directors

Mutually Exclusive investment decisions

A situation in which taking one investment prevents the taking of another

Electronic communications network (ECN)

A website that allows investors to trade directly with each other

The highest rating a firm's debt can have is

AAA or Aaa, and such debt is judged to be the best quality and have the lowest degree of risk

Sinking fund

An account managed by the bond trustee for early bond redemption

Broker

An agent who arranges security transactions among investors. They do not buy or sell securities for their own accounts. Facilitating trades by others is their business.

Dealer

An agent who buys and sells securities from inventory

Call Provision

An agreement giving the corporation the option to repurchase a bond at a specified price prior to maturity

A bond is what kind of loan

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

Averaging Accounting Return (AAR)

An investment's average net income divided by its average book value

Debenture

An unsecured debt, usually with a maturity of 10 years or more

Note

An unsecured debt, usually with a maturity under 10 years

Debt rating

Are an assessment of the creditworthiness of the corporate issuer. The definition of creditworthiness used by Moody's and S&P are based on how likely the firm is to default and the protection creditors have interest event of a default

Mortgage securities

Are secured by a mortgage on the real property of the borrower

Member

As of 2006, a member is the the owner of a trading license on the NYSE

Investment-grade bonds are bonds rated

At least BBB by S&P or Baa by Moody's

Debt

At the crudest level, a debt represents something that must be repaid; it is the result of borrowing money

Debt securities are classified according to the

Collateral and mortgages used to protect the bond holder

Dividend Yield

D1/Po Expected cash dividend divided by the current price

Interest rate risk increase at a

Decreasing rate

Bonds that sells for less than face value is called a

Discount bond

The IRR on an investment is the required return that results in a zero NPV when it is used as the

Discount rate

As a general rule

Equity represents an ownership interest, and it is a residual claim. This means that equity holders are paid after debt holders. As a result of this, the risks and benefits associated with owning debt and equity is different

Securities issued by corporations

Equity securities and debt securities

Common Stock

Equity without priority for divided or in bankruptcy

A PE ratio that is based on estimated future earnings is called a

Forward PE ratio

Bond prices and interests always move

In opposite directions

Nominal Rates

Interest rates or rates of return that have NOT been adjusted for inflation

Real Rates

Interest rates or rates of return that have been adjusted for inflation

Supplemental liquidity providers (SLPs)

Investment firms that are active participants in stocks assigned to them. Their job is to make a one-sided market (i.e., offering to either buy or sell). They trade purely for their own accounts.

Collateral

Is a general term that frequently means securities (for example, bonds and stocks) that are pledged as security for payment of debt. Any asset pledge on a debt

One of the major differences between Western Financial practices and shariah (Islamic law and cultural traditions) is

Islamic law does not permit charging or paying ribs, or interest. Anyone following shariah cannot buy or issue conventional bonds

Two leading bond-rating firms are

Moody's and Standards & Popes (S&P)

State and local government notes and bonds that sold to borrow money are called

Municipal notes and bonds, or just "munis"

Floor Brokers

NYSE member who execute customer buy and sell orders

Designated Market Maker (DMM)

NYSE members who act as dealers in particular stocks. Formerly know as "Specialists"

Two Stage Growth

Non constant growth: The dividend will grow at a rate of g1 for t years and then grow at a rate of g2, thereafter forever.

Debt securities are typically called

Notes, debentures, or bonds

Bond ratings are concerned

ONLY with the possibility of default

Usually the only difference between a note and a bond is the

Original maturity. Issues with an original maturity of 10 years or less are often called notes. Longer-term issues are called bonds.

Price of stock as of time, t, is

P1 = Dt + 1 / R-g

Dividends start growing at a constant rate sometime in the future (in 5 years

P4 = D4 x (1+g) / (R-g) = D5 / (R-g)

P4 =

P4 = Po x (1+g)4

Dividends

Payments by a corporation to shareholders, made in either cash or stock

Blanket Mortgage

Pledges all the real property owned by the company

Per-share value is given by

Po = D/R R = required return

As long as the growth rate, g, is less than the discount rate, r, the present value of this series of cash flows can be written simply as

Po = D1 / R-g (Dividend Growth Rate)

Bonds that sells for more than face value is called a

Premium bond - sells at a premium

The value of bond depends on the

Present value of its coupons and the present value of the face value

The two major forms of long-term debt are

Public-issue and privately places

R =

R = D1 / Po+g

The dividend growth model calculates total return as:

R = Dividend yield + Capital gains yield R = D1/Po (dividend yield) + g (Capital gains yield)

Over-the-counter (OTC) Market

Securities market in which trading is almost exclusively done through dealers who buy and sell for their own inventories

Proxy fight

Shareholders that are not satisfied with management, an "outside" group of shareholders can try to obtain votes via proxy. They can vote proxy in an attempt to replace management by electing enough directors.

As time passes, interest rates change in the marketplace. The cash flows from a bond, however, .....

Stay the same

Preferred Stock

Stock with dividend priority over common stock, normally with a fixed dividend rate, sometimes without voting rights

Islamic bonds

Sukuk

Call premium

The amount by which the call price exceeds the par value of a bond

Payback Period

The amount of time required for an investment to generate cash flows sufficient to recover its initial costs

Coupon rate

The annual coupon divided by the face value of the bond

When the interest rates fall, .....

The bond is worth more

Interest rate risk premium

The compensation investors demand for being interest rate risk

Debtor or borrower

The corporation borrowing the money

Net Present Value (NPV)

The difference between an investment's market value and it's cost

Bid-ask spread

The difference between the bid price and the asked price. It represents the dealers profit

Internal Rate of Return (IRR)

The discount rate that makes the NPV of an investment zero.

Zero growth

The dividend on a share of preferred stock has zero growth and thus is constant through time. Because the dividend is always the same, he stock can be viewed as an ordinary perpetuity with a cash flow equal to D every period.

Order Flow

The flow of customer orders to buy and sell securities

Bearer form

The form of bond issue in which the bond is issued without record of the owner's name; payment is made to whomever holds the bond

Registered form

The form of bond issue in which the registrar of the company records ownership of each bond; payment is made directly to the owner

All other things being equal, the longer the time to maturity,

The greater the interest rate risk

All other things being equal, the lower the coupon rate,

The greater the interest rate risks

Inside Quotes

The highest bid quotes and the lowest ask quotes for a security

Differences between public-issue and privately placed debt is

The latter is directly placed with a lender and not offered to the public

Discounted payback period

The length of time required for an investment's discounted cash flows to equal its initial cost.

Primary Market

The market in which new securities are originally sold to investors

Secondary Market

The market in which perviously issued securities are traded among investors

For example

The maximum reward for owning a debt security is ultimately fixed by the amount of the loan, whereas there is no upper limit to the potential reward form owning an equity interest.

The difference between nominal and real rates is important and bears repeating:

The nominal rate on an investment is the percentage change in the number of dollars you have. The real rate on an investment is the percentage chance in how much you can buy with your dollars - in other words, the percentage change in your buying power.

Creditor or Lender

The person or firm making the loan

Liquidity premium

The portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity

Taxability Premium

The portion of a nominal interest rate or bond yield that represents compensation for unfavorable tax status

Inflation Premium

The portion of a nominal interest rate that represents compensation for expected future inflation

Multiple rates of return

The possibility that more than one discount rate will make the NPV an investment zero

Profitability Index (PI)

The present value of an investment's future cash flows divided by its initial cost. Also called the benefit-cost ratio.

When interest rates rise, .....

The present value of the bond's remaining cash flows decline, and the bond is worth less

Bid Price

The price a dealer is willing to pay for a security

Asked Price

The price a dealer is willing to take for a security

Dirty price ("full" or "invoice" price)

The price of a bond including incurred interest. This is the price the buyer actually pays

Clean price

The price of a bond net of accrued interest; this is the price that is typically quoted

Face Value or Par Value

The principal amount of bond that is repaid at the end of the term (lump sum) Par Value is usually a $1,000 for corporate bonds, and a bond that sells for its par value is called a "par value bond"

Discounted cash flow (DCF) valuation

The process of valuing an investment by discounting its future cash flows

Yield to Maturity (YTM)

The rate required in the market on a bond. Sometimes called "yield" for short.

Term structure of interest rates

The relationship between nominal interest rates on default-free, pure discount securities and time to maturity; that is, the pure time value of money. Basically tells us the pure time value of money for different lengths of time

Fisher Effect (after the great economist Irving Fisher)

The relationship between nominal returns, real returns, and inflation

Interest rate risk

The risk that arises for bond owners from fluctuating interest rates

Maturity

The specified date on which the principal amount of a bond is paid

Coupon

The stated interest payment made on a bond (annuity component) When the coupon is constant and paid every year, the type of bond is sometimes called "level coupon bond"

One reason that corporations try to create a debt security that is really equity is to obtain

The tax benefits of debt and the bankruptcy benefits of equity

The only difference between the term structure and yield curve is

The term structure is based on our discount bonds, whereas the yield curve is based on coupon bond yields

Interest rate risk sensitivity depends on two things:

The time to maturity and the coupon rate

Indenture

The written agreement between the corporation and the lender detailing the terms of the debt issue. Sometimes referred to as the deed of trust

When the government wishes to borrow money for more than one year, it sells what are known as

Treasury notes and bonds to the public (in fact, it does so every month). Currently, outstanding Treasury notes and bonds have original maturities ranging from 2 to 30 years

Bonds

When a corporation or government wishes to borrow money from the publib on a long-term basis, it usually does so by issuing or selling debt securities

Deferred call provision

a call provision prohibiting the company from redeeming a bond prior to a certain date

Similar to interest rate risk, interest rate risk premium increases at

a decreasing rate

Dividend Growth Rate

can get any stock price at any point in time, not just today.

To calculate present value of stock with dividends not zero and all different first few years (3), you need to

compute the present value of the stock price three years down the road and then add in the present value of the dividend that will be paid between now and then

Shareholders control the corporation through the right to elect the

directors

The most intriguing thing about munis is that their coupons are exempt from

federal income taxes (though not necessarily state income taxes)

The value of the stock is the present value of all the

future dividends

An asset with cash flows that grow at a constant rate forever is called a

growing perpetuity

If the constant growth rate exceeds the discount rate, then the stock price is

infinitely large

Usually a trustee (a bank, perhaps)

is appointed by the corporation to represent the bond holder

Crossover rate

is the discount rate that makes the NPVs of two projects equal

When short-term rates are higher, we say

it is downward sloping

Discount nominal cash flows at a

nominal rate

Financial rates, such as interest rates, discount rates, and rates of return, are almost always quoted in

nominal terms

Staggered elections

only a fraction of directorships (often one-third) are up for election at a particular time. Thus if only two directors are up for election at any time, it will take 1/(2+1)=33.33% of the stock plus one share to guarantee a seat.

A bond issued with a very low coupon rate (as opposed to a zero coupon rate) is an

original-issue discount (OID) bond

The term structure is "humped" when

rates increase at first, but then begin to decline as we look at longer- and longer-term rates

Discount real cash flows at a

real rate

State and local governments also borrow money by

selling notes and

State and local governments also borrow money by

selling notes and bonds

When long-term rates are higher than short-term rates, we say

that the term structure is upward sloping

Floating-rate bonds

the coupon payments are adjustable

Constant Growth

the dividend for some company always grows at a steady rate

Capital gains yield

the rate at which the value of the investment grows

Treasury bond yields depend on the three components that underline the term structure -

the real are, expected future inflation, and the interest rate risk premium

When you hear that long-term interest rates rose, what is really being said is that

the yield on this bond went up (and its price went down)

Some firms have more than one class of common stock. Often the classes are created with

unequal voting rights

The most common shape of the term structure, particularly in modern times, is

upward sloping; but the degree of steepness has varied quite a bit

Munis have

varying degrees of default risk and almost always are callable