FIN Test 2: Ch.6-9

What is the preemptive right, and what are the two primary reasons for its existence?

A preemptive right is a provision in the corporate charter or bylaws that gives common stockholders the right to purchase on a pro rata basis new issues of common stock. The purpose is to prevent the management from issuing a large number of additional shares and purchasing those shares itself. As well as, to protect stockholders from a dilution of value.

What is a proxy and why might a proxy fight occur?

A proxy is a document that gives one person the authority to act for another. A proxy fight may occur if performance is poor and stockholders are dissatisfied.

Indexed bond

A bond that has interest payments based on an inflation index so as to protect the holder from inflation.

Income bond

A bond that pays interest only if it is earned.

What is a call provision and when is a company more likely to call a bond? Why?

A call provision is a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal maturity date. Companies are not likely to call bonds unless interest rates have declined significantly since the bonds were issued.

Indenture

A formal agreement between the issuer and the bondholders

Debenture

A long-term bond that is not secured by a mortgage on specific property.

Beta Coefficient

A metric that shows the extent to which a given stocks returns move up and down with the stock market.

Maturity date

A specified date on which the par value of a bond must be repaid.

Inverted "Abnormal" yield curve

A yield curve that slopes downward.

Mortgage bond

A bond backed by fixed assets.

What is a bond?

A bond is a long-term contract that a borrower agrees to make payments of interest and principal on specific dates to the holders of the bond.

Do bond ratings adjust immediately to changes in credit quality? Explain.

Bond ratings do not adjust immediately to changes in credit quality, in some cases there can be a considerable lag between a change in credit quality and a change in rating.

Original issue discount bond (OID)

Any bond originally offered at a price below its par value.

Why are bond ratings important to firms and investors?

Bond ratings are important to firms and investors because if a firm's bonds fall below BBB, it will have a difficult time selling new bonds because many potential purchases will not be allowed to buy them.

Investment-grade bonds

Bonds rated triple-B or higher.

Convertible bond

Bonds that are exchangeable at the option of the holder for the issuing firm's common stock.

Subordinated debentures

Bonds that have a claim on assets only after the senior debt has been paid in full in the event of liquidation.

Zero coupon bonds

Bonds that pay no annual interest but are sold at a discount below par, thus compensating investors in the form of capital appreciation.

Floating-rate bonds

Bonds whose interest rate fluctuates with shifts in the general level of interest rates.

Fixed-rate bonds

Bonds whose interest rate is fixed for their entire life.

How does the price of capital tend to change during a boom? During a recession?

Boom: Firms are trying to catch up so they need capital which causes expansion and demand rises. Recession: Firms are in a decline so they need less capital which causes demand to go down.

What happens to market-clearing, or equilibrium, interest rates in a capital market when the supply of funds declines?

Supply funds decline, high risk securities decline->their interest rates increase, Low risk securities and interest rates decline.

Which is riskier to an investor, other things held constant, a callable bond or a putable bond? Explain.

Callable bonds are riskier because they give the issuer the right to retire the debt prior to maturity. If a bond is retired before maturity it does not reach, there is a higher change for loss to arise.

What are some reasons why a company might use classified stock?

Classified stock is given a special designation which will then meet special needs of the company. A company might use this because it allows the public to take a position without sacrificing income.

Explain why corporate bonds always yield more than Treasury bonds and why BBB-rated bonds always yield more than AA-rated bonds.

Corporate bonds always yield more because of their additional default and liquidity risk. BBB-rated bonds yield higher than AA rated bonds.

If short-term interest rates are lower than long-term rates, why might a borrower still choose to finance with long-term debt?

During recessions, the short-term rates tend to decline more sharply than the long-term rates. This occurs because the Fed operates in the short-term sector which causes there to be a strong effect there. Also, long term rates reflect the average expected inflation rate and this expectation generally does not change much. Short-term rates are more volatile than long-term rates.

Write out the equation for free cash flows.

FCF= [EBIT(1-T)+Depreciation and amortization]-[ Capital expenditures + Net Operating working capital]

Explain whether the following statement is true or false. Only weak companies issue debentures.

False, debentures are not only issued by weak companies. There is no specific collateral as security for the obligation which is why debenture holders are general creditors whose claims are protected by property not otherwise pledged.

Junk Bonds

High-risk, high yield bonds.

How do risk and inflation impact interest rates in the economy?

Higher risk and Higher inflation lead to higher interest rates.

Explain what is meant by horizon (terminal) date and horizon (continuing) value.

Horizon by terminal date is the date when the growth rate becomes constant. While Horizon by continuing value is the value at the horizon date of all dividends expected thereafter.

If investors' aversion to risk increased, would the risk premium on a high-beta stock increase by more or less than that on a low-beta stick? Explain.

If an investors aversion to risk increases, the risk premium on high beta stock will increase more than on the low beta stock. This is because the change in the risk aversion is stronger on risky securities.

What happens when expected inflation increases or decreases?

If inflation were to increase the interest rates would also increase, vice versa if inflation were to decrease so would the interest rates.

If the inflation rate is expected to increase, would this increase or decrease the slope of the yield curve?

If the inflation is expected to increase this would increase the slope of the yield curve. This is because they are expecting/ planning for the increase.

Differentiate between Chapter 7 liquidation and Chapter 11 reorganizations. In general, when should each be used?

In a reorganization, the firm's creditors negotiate with management of the terms of a potential reorganization. Liquidation occurs if the company is deemed to be worth more "dead" than "alive". If the bankruptcy court orders a liquidation, assets are auctioned off and the cash obtained is distributed.

How does the correlation between returns on a project and returns on the firm's other assets affect the project's risk?

Individuals projects may have little to no impact on stockholders' risk this is when viewing it in the context of an entire company.

International factors

Interest rates are often influenced by interest rates in other countries. Because of this U.S. corporate treasures and others affected by interest rates should keep up with developments in the world economy.

Why do investors and managers need to understand how to estimate a firm's intrinsic value?

Investors and managers need to know how to estimate a firm's intrinsic value because they need to know how alternative actions affect stock prices. Managers should also consider whether their stock is significantly undervalued or overvalued before making certain decisions.

Write out the equation for the market value of a company's operations.

Market value of company's operations = V company's operations= PV of expected future free cash flow = FCF1 + FCF2 + ...+ FCF infinity (1+WACC)1 (1+WACC)2 (1+WACC) infinity

How do maturity risk premiums affect the yield curve?

Maturity risk premium is a premium that reflects interest rate risks. The higher the greater the years to maturity, is included in the required interest rate. Since MRPs are positive when other things are held constant, LT bonds have higher rates than ST bonds.

Why do most bond trades occur in the over-the-counter market?

Most bonds occur in over-the-counter markets because most bonds are owned by and traded among large financial institutions and these markets are relatively easy for over-the-counter bond dealers to arrange the transfer of large blocks of bonds among the relatively few holders of the bonds.

Should companies completely avoid high-risk projects? Explain.

No, a company should not completely avoid high risk projects. This is because of the possibility that projects could in turn create value. The only reason you should avoid a high-risk project is if you feel that the return will not exceed the cost of the capital.

In general, can the riskiness of a portfolio be reduced to zero by increasing the number of stocks in the portfolio Explain.

No, when stock is added the risk declines at a decreasing rate.

Explain why preferred stock is considered a hybrid security. How is the value determined?

Preferred stock is considered a hybrid because it is similar to a bond in some respects and to common stock in others.

List and define the four fundamental factors affecting the cost of money.

Production opportunities: are productive assets Time Preference: Looks at current consumption instead of saving for future consumption. Risk: The chance an investment will provide a low or negative return. Inflation: The amount prices increase over time.

How does risk aversion affect rate of return?

Risk averse investors dislike risk and require higher rates of return as an inducement to buy riskier securities.

Relevant risk

Risk that remains once a stock is in a diversified portfolio is its contribution to the portfolios market risk.

Which fluctuate more long-term or short-term interest rates?

Short term rates fluctuate the most.

What is the difference between a stock's price and its intrinsic value?

Stock price is the current market price and is easily observed while intrinsic value represents the "true" value of the company's stock.

Assume that you have a short investment horizon (less than 1 year). You are considering two investments: a 1-year Treasury security and a 20-year security. Which of the two investments would you view as being riskier? Explain.

The 20-year treasury security is the riskier of the two. This is because you would most likely have to sell the security within a year and the likelihood of getting the price you paid for it or more is not high.

How does the correlation between two stocks affect the risk and return of portfolios that combine them?

The correlation between two stocks has no effect on the expected return. However, in regard to volatility the lower the correlation then the lower the volatility of the portfolios.

Differentiate between a stock's expected return and the required rate of return.

The expected return is the weighted average of the expected returns on the assets held in the portfolio. The required rate of return is the minimum return an investor accepts for owning a company's stock.

Par value

The face value of a bond.

What role do interest rates play in allocating capital to different potential borrowers?

The firms that have the most profitable investment opportunities are more willing to pay for capital.

List and discuss the four main issuers of bonds?

The four main issuers of bonds are, treasury bonds, corporate bonds, municipal bonds, and foreign bonds. Treasury bonds are issued by the federal government, these bond prices decline when interest rates rise, and they are not completely riskless. Corporate bonds are issued by business firms; these bonds have different levels of default risk which is dependent on the issuing company's characteristics. Municipal bonds are issued by state and local governments. These bonds are exposed to some default risks but an advantage they have is that they are exempt from federal taxes and from state taxes if the holder is a resident of the issuing state. Finally, foreign bonds, these are issued by a foreign government or a foreign corporation. All of these bonds are exposed to default risk.

Briefly explain the fundamental trade-off between risk and return.

The fundamental trade-off between risk and return are meant to entice investors to take on more risk, there must be higher expected returns. This concept is also important because it helps companies who are trying to create value for their shareholders.

What key assumptions underlie the pure expectations theory?

The key assumptions that underlie the pure expectations theory assume that bonds traders establish bond prices and interest rates. This is because they do not view long-term bonds as being riskier than ST bonds.

Level of business activity

The level of business activity can impact the interest rates. For example, interest rates decline during recessions.

Diversifiable risk

The part of a securities risk associated with random events.

If interest rates rise after a bond issue, what will happen to the bond's price and YTM? Does the time to maturity affect the extent to which interest rate changes affect the bond's price? Explain.

The price of a bond will fall while its YTM rises when the interest rates rise.

Putable bonds

These are bonds with a provision that allows investors to sell them back to the company prior to maturity at a prearranged price.

What is the pure expectations theory? What effect does it have on the yield curve?

The pure expectations theory is a theory that says the shape of the yield curve depends on investors' expectations about future interest rates. Most investors expect interest rates to rise which is why there tends to be an upward slope of the yield curve.

What is the nominal or quoted risk-free rate?

The quoted interest rate is composed of a real risk-free rate plus several premiums that reflect inflation, the securities risk, its liquidity, and the years to its maturity.

Reinvestment rate risk

The reinvestment rate risk is a decline in interest rates that lead to lower income when bonds mature and funds are reinvested.

Federal reserve policy

The reserve holds if the fed tightens the money supply. The money supply affects the level of economic activity, inflation, and interest rates.

Market risk

The risk that remains in a portfolio after diversification has eliminated all company specific risk.

What do the slopes of the risk-return lines illustrated in Figure 8.1 in the textbook indicate?

The slopes indicate how much additional return an individual investor requires in order to take on a higher level of risk.

Coupon interest

The stated annual interest rate on a bond.

Name the major rating agencies and list some factors that affect bond ratings

The three major rating agencies are Moody's investors service, standard & poor's corporation, and Fitch Investors service. Moody's and S&P rating designations are triple As.

What are two commonly used approaches for estimating a stock's intrinsic value? How do they differ in their roles?

The two approaches are the discounted dividend model and the corporate valuation model. The dividend model focuses on dividends and the corporate model focuses on sales, costs, and free cash flow.

List and define the two parts of most stock's expected total return.

The two parts are dividend yield and capital gains yield.

Yield curve

The yield curve is a graph that shows the relationship between bond yields and maturities.

Explain why corporate bonds' default and liquidity premiums are likely to increase with their maturity.

There is more default and liquidity risk on long term bonds than short term bonds.

Warrants

These are long term options to buy a stated number of shares of common stock at a specified price.

Discuss the similarities and differences between the discounted dividend and corporate valuation models.

These two models are used when valuing mature, dividend-paying firms. The differences are that the discounted model calculates the firm's stock price as the present value of the expected future dividends at the firm's required rate of return on equity. The corporate model calculates the firm's stock price as the present value of the expected free cash flows at the firm's weighted average cost of equity.

What is the capital asset pricing model? Write out its equation.

This is a model which is based on the proposition that any stock's required rate of return is equal to the risk-free rate of return plus a risk premium that reflects only the risk remaining after diversification.

What is a sinking fund provision and how does it reduce risk to the investor?

This is a provision in a bond contract that requires the issuer to retire a portion of the bond issue each year. This fund protects investors by ensuring that the bonds are retired in an orderly fashion, these funds work to the detriment of bondholders if the bond's coupon rate is higher than the current market rate.

"Normal" yield curve

This is an upward sloping yield curve.

structure of interest rates

This is the relationship between bond yields and maturities. It describes the relationship between long- and short-term rates.

Interest rate risk

This is the risk of capital losses investors are exposed to because of the changing interest rates.

Humped yield curve

This is when the interest rates on intermediate-term maturities are higher than rates on both the short- and long-term maturities.

List at least three measures of stand-alone risk discussed in the chapter.

Three measures of stand-alone risk are, statistical measures, standard deviation, and using historical data. Statistical measures consist of various items. Some items that fall under this category are probability distributions which are listings of possible outcomes or events with a probability assigned to each outcome. As well as expected rate of return which is the rate of return expected to be realized from an investment; the weighted average of the probability distribution of possible results. Standard deviation is useful to measure risk for comparative purposes. Historical data is used as an estimate of future risk.

Federal budget deficits or surpluses

When the government spends more than it takes in as taxes, it runs a deficit. This deficit must be covered by additional borrowing or by printing money. If the government borrows, this increases the demand for funds and pushes up the interest rates.

Explain the difference between the yield to maturity (YTM) and yield to call (YTC)?

YTM, the rate of return earned on a bond if it is held to maturity. YTC, the rate of return earned on a bond when it is called before its maturity date. The main difference between the two is that one focuses on a bond before its maturity date while the other focuses on the bond once its met maturity.

Does the average investor's willingness to take on risk vary over time? Explain.

Yes, the average investor's willingness to take on risk varies over time. This is due to an investors goal being to earn returns that are more than sufficient to compensate for the perceived risk of the investment.

To which type of risk are holders of long-term bonds more exposed? Short-term bondholders?

portfolio will decline if interest rates rise. If you hold short-term bonds, you will not be exposed to much price risk, however you will be exposed to significant reinvestment risk.

Write out the equation for the quoted interest rate. Explain each of the components.

r=r* + IP + DRP + LP + MRP r is the quoted rate on a given security r* is the real risk-free rate this is the rate that exists on riskless security in a world where no inflation was expected. IP this is the inflation premium DRP this premium reflects the possibility that an issuer will not pay the promised interest at the stated time. LP this is charged by lenders to reflect the fact that some securities cannot be converted to cash. MRP these are exposed to a significant risk of price declines due to increases in inflation and interest rates.