FIN 5352 Lecture 5 Chapter 8 Section 15.2 - 15.3 - Dr. Chittenden

The distinction between a debt and an equity security is important primarily because ______.

of tax implications

Typically, a corporation has ______ common stock outstanding and/but has _____ bond issues outstanding.

one; many

A network of dealers who buy and sell the stocks of corporations that are not listed on a security exchange is called ______.

over-the-counter market

The ask price is the price the investor will ______ if they transact with the dealer.

pay

A no-dividend firm can still pay off for an investor by ______.

paying high dividends in the future and being acquired in the future

The difference between the bond's call price and par value is known as the call ________.

premium

An objection to the _____ value analysis of stocks is that investors are too shortsighted to care about long-term dividends.

present

The current price per share divided by last year's earnings per share gives you ______.

price-earnings ratio

Arbitrage results in stock prices that are ___.

priced correctly

Inflation will _______ the value of a traditional bond's expected cash flows (interest and repayment of principal).

reduce

The term structure of interest rates examines the ____.

relationship between short-term and long-term interest rates

According to the Fisher effect hypothesis, the real rate of return ______ as inflation increases.

remains the same

Rationality implies that investors, when faced with new information about a stock, will ___.

reprice the stock rationally

The _____ ratio is the ratio of this year's retained earnings to net income.

retention

The ratio of this year's retained earnings to net income is called the ______ ratio.

retention

A sinking fund is used to ______.

retire debt

What differences might cause firms in the same industry to have different multiples?

risk levels, investment opportunities, and accounting treatments

The trading of existing shares occurs in the ______ market.

secondary

When the term structure of interest rates is downward sloping, ____.

short-term rates are higher than long-term rates

The assumption that independent deviations from rationality produce market efficiency implies that ____.

some investors may overreact to new stock price information and some investors may underreact to new stock price information

Historically, short-term rates are ______ higher than long-term interest rates.

sometimes

Bond ratings are constructed by information ______ by the corporation and ______ by the rating agency.

supplied; collected

_____ purposes are the main reason for the distinction between debt and equity.

tax

Which of the following are premiums determine the yield on a bond?

taxability, liquidity, expected future inflation, default risk, and interest rate risk

The taxability premium is the additional compensation demanded on ____.

taxable bonds

The _____ structure of interest rates plots the relationship between short-term and long-term interest rates.

term

Which is the largest security market in the world in terms of trading volume?

the U.S. Treasuries market

Bond ratings are based on the probability of default risk, which is the risk that ___.

the bond's issuer may not be able make all the required payments

Who are the parties to the bond indenture agreement?

the corporation and the bondholders

At maturity, bondholders are repaid ______.

the face value of the bond

What is included in the bond indenture?

the face value of the bond, the coupon rate, and the call provisions

In theory, which of the following models are best used to determine the value of a non-dividend-paying share of stock?

the firm cash flow model

In theory, which of the following models are mutually consistent and can be used to determine the value of a share of stock?

the free cash flow model, the dividend discount model, and the comparable method

For risk-free security, the promised and expected returns are equal because ______.

the probability of default is zero

Which six factors determine the yield on a bond?

the real rate of return, liquidity, interest rate risk, expected future inflation, taxability, and default risk

The determinants of a firm's growth rate include which factors?

the retention ratio and return on retained earnings

Which of the following are provisions of a bond indenture?

the total number of bonds issued, a description of property used as security, the call provisions, the repayment arrangement

A calculated stock price that discounts earnings instead of dividends will usually be ______.

too high

Growth opportunities may be lost if a firm pays out _________ in dividends

too much

Net investment is equal to the ______ minus ____.

total investment; less depreciation

True or false: If you invest in a bond that is rated AAA by S&P, you can be reasonably assured that your investment has very little default risk.

true

True or false: Interest earned on Treasury notes and bonds is taxable.

true

A designated market maker, or DMM, continually posts and updates bid and ask prices as he or she maintains a ____ market.

two-sided

If you buy common stock for $20, the maximum you can earn on this security is ______.

unlimited

What is the maximum reward for owning equity security?

unlimited

Markets are more likely to be efficient if the investors ___.

use relevant information to make a trade and are rational

Since estimation error may be high, what do some financial economists recommend when using the constant-growth dividend discount model?

use the industry average rate of return for R

Which cases should make one particularly skeptical when estimating the required rate of return?

when the growth rate is greater than or equal to the discount rate and zero dividend case

The coupon rate, par value, and maturity are all needed to compute the promised _____ on a bond.

yield

The real rate of return, expected inflation, and interest rate risk premium determine the Treasury _____ curve.

yield

A Treasury yield curve depicts the _____.

yields for different maturities of Treasury securities

If the growth rate (g) is zero, the capital gains yield is ____.

zero

A firm with an 8 percent dividend growth rate and a return on equity of 20 percent must have a retention ratio of ______ percent.

40 (Retention ratio = 0.08/0.2 = 0.4, or 40%.)

If an investment appreciates by 7 percent while the rate of inflation is 2 percent, what is the nominal rate of return?

7%

What is the difference between CoCo bonds and NoNo bonds?

CoCo bonds make coupon payments, while NoNo bonds do not make coupon payments.

What conditions must be met for a firm to increase value?

Earnings must be retained to fund projects and Projects must have positive net present values.

For investors in the stock market, dividends from stocks are fixed and guaranteed, while capital gains are variable and not guaranteed.

False

Nasdaq officials have recently created an advertisement campaign to promote the Nasdaq market as a purely OTC exchange.

False

True or false: A market order allows the investor to choose the price they will transact at.

False

True or false: An asset's value is determined by the most recent cash flows.

False

True or false: If you invest in junk bonds, there is a high likelihood that you will earn a very high return.

False

True or false: Independent deviations from rationality mean markets are inefficient.

False

True or false: Plain vanilla bonds are exotic bonds with unique features.

False

True or false: The inflation premium will be higher if the rate of inflation is low.

False

True or false: The real rate of return will generally be higher than the nominal rate of return.

False

True or false: There has been no change in the popularity of convertible bonds.

False

True or false: Trades on Nasdaq occur on a trading floor.

False

What are some reasons why the bond market is so big?

Federal government borrowing activity in the bond market is enormous, Many corporations have multiple bond issues outstanding, and Various state and local governments also participate in the bond market.

What are some features of the OTC market for bonds?

The OTC has no designated physical location and OTC dealers are connected electronically.

What is the bid price?

The bid is the price at which a dealer is willing to buy securities.

When a corporation raises capital by issuing bonds, how are the corporation and the bondholders classified?

The corporation is a debtor and the bondholders are creditors.

What does the AAA rating assigned by S&P mean?

The firm is in a strong position to meet its debt obligations

Which of the following conditions will cause market efficiency according to Andrei Shleifer?

arbitrage, rationality, and independent deviations from rationality

One objection to the present value analysis of stocks is that investors _____.

are shortsighted

Collateral refers to any ______.

asset pledged on a debt

If a $1,000 face value U.S. Treasury bond is quoted at 99.5, then the bond can be purchased _____.

at 99.5 percent of face value plus any accrued interest

In general, why is the yield on a corporate bond higher than the yield on a government bond?

because corporate bonds have default risk

When an investor sells a bond, the price received is always the ____.

bid price

The _____ - _____ spread represents the dealer's profit.

bid-ask

Protective covenants are designed to protect the interests of the ______.

bondholders

What are municipal bonds?

bonds that have been issued by state or local governments

Which of the following help facilitate trades without necessarily maintaining an inventory?

broker

Which of the following could be mortgaged?

building, equipment, and land

The bid price is the price the dealer is willing to ______.

buy at

If there is a deferred call provision, whereby the corporation is prohibited from recalling the bonds, the bonds are said to be ______.

call protected

What type of bonds can be redeemed before the maturity date by the issuing corporation?

callable bonds

A callable bond ______.

can be called and redeemed by the corporation before the maturity date

Which of the following are cash flows to investors in stocks?

capital gains dividends

Junior debt cannot be subordinated to ______.

common stock

What are the three components of the nominal rate of return?

compensation for the inflation effect on the original investment, compensation for the inflation effect on the investment earnings, and real rate of return

A zero-growth model for stock valuation is distinguished by a ____.

constant dividend amount

Plain vanilla bonds are ______.

conventional bonds with typical bond features

Which of the following bonds have default risk?

corporate bonds and municipal bonds

Most bond trading takes place over the _____ (OTC).

counter

What "floats" in a floating rate bond?

coupon payments

The dividend yield is determined by dividing next year's expected cash dividend by the ____.

current stock price (Dividend yield = Div1/P0.)

Someone who maintains an inventory of stocks and buys and sells those stocks is known as a ____.

dealer

The bid-ask spread represents the ___.

dealer's profit

On a balance sheet, notes, debentures, and bonds are classified as ______.

debt

What are the two main types of securities issued by a corporation?

debt securities and equity securities

If the liquidity of a bond increases, then the bond's yield will _____.

decrease

All else constant, the dividend yield will increase if the stock price ____.

decreases

Earnings next year are a function of which factors?

earnings this year, retained earnings this year, and return on retained earnings

If new information reaches the market and stock prices instantly and fully reflect the new information, the market has reacted ______.

efficiently

Most trades on the NYSE occur ____.

electronically without human intervention

The promised yield and the expected return for risk-free security will be ______.

equal

Which of the following are examples of collateral?

equipment, building, and common stock

A convertible bond can be swapped for ______.

equity

The two main types of securities issued by a corporation are debt securities and ______ securities.

equity

Who generally enjoys voting rights in a corporation?

equity holders

A 10-year AAA corporate bond is most apt to have a yield that ____ the yield on a 10-year AAA state government bond.

exceeds

CoCo and NoNo bonds are examples of ______.

exotic bonds

The price of a share of common stock is equal to the present value of all ______ future dividends.

expected

In an efficient market, firms should expect to receive ______ value for securities they sell.

fair

True or false: If the term structure of interest rates is downward sloping, short-term rates will be lower than long-term rates.

false

Companies with differential growth have dividends that grow _____ in the near term than in the long term.

faster

The interest from a municipal bond is exempt from ____ income taxes.

federal

A provision that the annual coupon payment will equal the yield on 30-year Treasury bond plus 2 percent is an example of a(n) ______ ______ bond.

floating rate

A limitation of bond ratings is that they ____.

focus exclusively on default risk

When computing the PE ratio, using _____ earnings is merely using forecasts.

forward

An asset's value is determined by the present value of its ______ cash flows.

future

When the growth rate is _____ than or equal to the discount rate, one should be particularly skeptical.

greater than

The ______ can be interpreted as the capital gains yield.

growth rate

The value of a firm is the function of its ______ rate and its _____ rate.

growth rate, discount rate

The value of a firm is the function of its ______ rate and its _______ rate.

growth; discount

A firm may choose to forgo dividends today if growth opportunities are _____.

high

Initial public offerings of stock occur in the ____ market.

high

Higher growth opportunities create ______ value today.

higher

A bond's call price is generally _____ ______ the bond's par or stated value.

higher than

A bond's call price is generally _____ ______ the bond's par or stated value. Multiple choice question.

higher than

In a stock price quote, the ask price is ______ the bid price.

higher than

An efficient market is one in which any change in available information will be reflected in the company's stock price ___.

immediately

A humped term structure of interest rates indicates that interest rates are expected to _____ as the time to maturity increases.

increase and then decline

If new, negative information reaches the market and stock prices slowly decrease, the market has reacted ______.

inefficiently

Over time, the purchasing power of the cash flows from a bond decreases due to _____.

inflation

The difference between the yield on a 10-year TIPS and the yield on a 10-year Treasury bond reflects the market's expected annual rate of ______ over the next 10 years.

inflation

The inflation premium is the additional return demanded by investors to compensate for _____.

inflation

Which of these is the least important component of the nominal rate of return?

inflation loss on investment earnings

An efficient market is one that fully reflects all available ______.

information

What are the sources of information for generating bond ratings?

information collected by bond rating agency and information from the corporation being rated

It is not uncommon for IPOs to ______ experience large gains.

initially

For corporations, ______.

interest expense is tax-deductible, while dividends are not tax-deductible

What are the three components of the Treasury yield curve?

interest rate risk premium, the real rate of return, and expected inflation

The Fisher effect hypothesizes that the real rate of return ____.

is invariant to the rate of inflation

For corporations, interest expense ______ tax-deductible and/while dividends ______ tax-deductible.

is; are not

The expected return may not be accurate because ______.

it is difficult to accurately assess the probability of default

If the growth rate exceeds the discount rate, then dividends _____.

keep getting bigger

The U.S. Treasuries market is the ______ security market in the world (based on trading volume).

largest

A creditor is also known as a:

lender

All junk bonds typically have which of these features?

less than investment-grade rating and high probability of default

Electronic communication networks increase _____ and _____ in a market.

liquidity and competition

All else held constant, the yield on a highly liquid bond will be ____ the yield on an illiquid bond.

lower than

In a stock price quote, the number of shares outstanding multiplied by the current price per share is known as the ____.

market cap

The stock will be sold at (or near) the current market price in a _____ order.

market order

Debt _____ is the length of time the debt remains outstanding with some unpaid balance.

maturity

What information is needed to compute the promised yield on a bond?

maturity, par value, and coupon rate

Firms in the same industry ______ have the same multiples

may not

Enterprise value is equal to the market value of a firm's equity plus the market value of a firm's debt _____.

minus cash

Registered bonds are ______ common than bearer bonds in the United States today.

more

A firm with growth opportunities should sell for ____ a firm without growth opportunities.

more than

Retained earnings this year, return on retained earnings, and earnings this year determine earnings _____ year.

next

When calculating the promised yield, one assumes ______.

no default

Nasdaq differs from the NYSE primarily because Nasdaq has ____.

no physical location and multiple market makers rather than DMMS

The rates on financial securities are generally quoted as _____ rates.

nominal

The rates on financial securities are generally quoted as ______.

nominal rates

A major implication of the efficient markets hypothesis (EMH) is that investors will only receive a(n) ______ rate of return.

normal

The default risk premium refers to the extra compensation demanded by investors for the possibility that the issuer might ____.

not make all the promised payments

What are some commonly used names for debt securities?

notes, bonds, and debentures

Which of the following has a physical trading floor?

NYSE

The two most important stock markets in the United States are the New York Stock Exchange and ______.

Nasdaq

Which of the following occurs in the primary market?

Newly issued stocks are initially sold.

If the current market price is $21, a limit order to buy shares at $17 will be filled at what price?

$17 or less

If the current market price is $42, a limit order to buy shares at $35 will be filled at what price?

$35 or less

What is the price of a U.S. Treasury bond listed at 122 if the par value is $5,000?

$6,100 ($5,000 × 122% = $6,100)

Which one of these correctly specifies the relationship between the nominal rate and the real rate?

(1 + R) = (1 + r) × (1 + h)

Long-term debt securities have maturities of more than ______.

1 year

At what tax rate will you be indifferent between a muni that yields 7 percent and a comparable corporate bond yielding 9 percent?

22.22%(t = 1 − (0.07/0.09) = 22.22%.)

In the 24-year prior to 1999, how many companies doubled, or more than doubled, in value on the first day of trading?

39

If you are in the 15 percent tax bracket, what will be your after tax yield on a U.S. Treasury bond that is currently priced at par and yielding 5 percent?

4.25%(0.05 × (1 − 0.15) = 4.25%.)

How is a floating rate bond different from a conventional bond?

A floating rate bond's coupon payment varies while a conventional bond's coupon payment is fixed.

Which of the following is true about the IPO market during 1999 and 2000?

Almost 200 IPOs doubled in value on their first day.

Which of the following are differences in the return earned by bondholders versus common stock holders?

Bondholders are paid a fixed dollar amount, while common stockholders generally earn a variable dollar amount and Bondholders are paid before the common stockholders.

Which of the following is more typical with regard to the repayment of corporate bonds?

Bonds are partially repaid before maturity.

__________ act as two-sided dealers in particular stocks.

DMMs

Debentures commonly pledge which type of property as security?

Debentures do not pledge specific properties.

Which one of the following represents valuation of stock using a zero-growth model?

Dividend/Discount rate

What are some differences in the income received by common stockholders and the income received by bondholders?

Dividends are not fixed, but interest is generally a fixed dollar amount, Common stock pays dividends, while bonds pay interest, and Dividends are not based on the par value of stock, but interest is generally based on a bond's par value.

Which of the following are true of convertible bonds?

If the bond is converted, conversion must take place before the bond matures; Conversion of bonds to stocks can be done at the bondholder's discretion; and Convertible bonds can be converted to a fixed number of shares.

Which of the following are implications of the efficient markets hypothesis (EMH)?

Investors should expect only a normal rate of return and Securities sellers will receive a fair price that reflects the present value of the security.

Why do stocks that pay no dividends sell at positive prices?

Investors speculate on capital returns if the firm is sold and Investors count on future dividends.

What is a sinking fund?

It is a fund set up for the repayment of bonds.

What is a real rate of return?

It is a percentage change in buying power and It is a rate of return that has been adjusted for inflation.

How are short-term debt securities defined?

It is debt with a maturity of less than 1 year.

What is the maturity of a debt instrument?

It is the length of time the debt remains outstanding with some unpaid balance.

What is a protective covenant?

It is the part of the bond indenture that protects bondholders by limiting the actions of the corporation.

Which is the promised yield on a bond?

It is the yield based on the current price and expected cash flows, assuming no default.

What is the likely impact on the real rate if the economy is declining?

It will decline.

What is the likely impact on the real rate if the economy is growing?

It will increase.

What will happen to the default risk premium during periods of economic uncertainty?

It will increase.

Which of the following is true about the IPO market?

Large initial gains in stock prices often occur.

NASDAQ has which of these features?

Multiple market maker system and Computer network of securities dealers

What is a note?

Notes are debentures with a maturity of less than 10 years.

Which of the following occurs in the secondary market?

Outstanding shares are resold, Issuers repurchase shares, and Shareholders gift shares to charities.

How are TIPS different from traditional bonds?

Promised payments are specified in real terms

______ bonds are the most common type of bond in the United States today.

Registered

Which of the following are not assumptions of market efficiency?

SEC oversight

_______ indicates preference in position over other lenders.

Seniority

What does historical data suggest about the nature of short-term and long-term interest rates?

Sometimes short-term rates are higher and sometimes long-term rates are higher.

The goal of many successful organizations is a(n) ______ rate of growth in dividends.

Steady

The difference between the yield on a 10-year _____ and the yield on a 10-year ______ reflects the market's expected annual rate of inflation over the next 10 years.

TIPS; Treasury bond

Calculating the promised yield on a corporate bond is the same as calculating the yield to maturity on a government bond because ______.

The promised yield assumes no default.

How is the real rate of return different from the nominal rate of return?

The real rate of return adjusts the nominal rate to remove the effects of inflation.

What is the main role of the company registrar?

The registrar records the ownership of each bond and any changes in ownership.

What is the expected return on a bond?

The return based on the current price and future cash flows adjusted for default risk.

How popular are convertible bonds?

They are fairly common but their popularity has been decreasing.

Which of the following characterizes newer companies?

They are fast-growing companies, They have negative earnings, and They don't pay dividends.

Which of the following are features of municipal bonds?

They are issued by state and local governments and The interest on municipal bonds is exempt from federal taxes.

A Treasury yield curve depicts the yields for different maturities of _____ securities.

Treasury

What does TIPS stand for?

Treasury Inflation Protected Securities

True or false: A benefit of trailing earnings is that the reflect what actually happened.

True

True or false: If the growth rate is larger than the discount rate, the dividend growth model with constant growth does not work.

True

The price-earnings ratio is found by dividing the current price per share by last year's ______.

earnings per share

What is a registered bond?

a bond that is registered in the name of a specific bondholder

Bonds that are less liquid will have ______ required return than a more liquid bond, all else equal.

a higher

Taxable bonds have ______ rate of return than non-taxable bonds, all else equal.

a higher

What is the legal document that describes a mortgage?

a mortgage trust indenture

A website that allows investors to trade directly with one another is called ______.

an ECN

When enterprise value is calculated, cash is subtracted from the market value of debt and equity because ____.

an EV ratio should reflect the ability of productive assets to create cash flow and many firms hold more cash than necessary

Floating-rate bond coupon payment adjustments are typically tied to ______.

an interest rate index

What is a debenture?

an unsecured bond

What are three important features of Treasury notes and bonds?

default-free, taxable, and highly liquid

A provision whereby the corporation is prohibited from calling the bonds for a stipulated time is known as a(n) ______ call provision.

deferred

When a corporation is prohibited from calling bonds for 7 years, it is subject to a(n) ______.

deferred call provision

The liquidity premium compensates investors based on a bond's ____.

degree of marketability

Net investment is equal to the total investment minus ____.

depreciation

Which type of growth describes a company that grows quickly at first but then grows slower in later years?

differential growth

It is _____ to assess the probability of default.

difficult

Which of these factors are used in predicting stock values using the dividend discount model?

discount rate and growth

Common stockholders receive ______ income, while bondholders receive ______ income.

dividend; interest

A no-dividend firm can pay off for an investor by paying ______in the future.

dividends

A no-dividend firm can pay off for an investor by paying _____in the future.

dividends

For many companies, steady growth in _____ , is an explicit goal.

dividends

The cash flows of common stock are ______.

dividends

Investors select a stock based on the cash they expect to receive from that stock. That cash comes in the form of ____.

dividends and the future sales price

Generally, debtholders ______ voting power.

do not have

Market efficiency ______ require rational individuals.

does not