Finance Chapters 7 & 8
The rate of return on any security is based on
1) risk free rate, 2) rate of inflation and 3) risk of default
Second Relationship
1. If the bondholder's required rate of return (current interest rate) equals the coupon interest rate, the bond will sell at par, or maturity value. 2. If the current interest rate exceeds the bond's coupon rate, the bond will sell below par value or at a "discount." 3. If the current interest rate is less than the bond's coupon rate, the bond will sell above par value or at a "premium."
Calculate the value of preferred stock:
= Annual dividend / required rate of return
Mortgage Bond
A bond secured by a lien on real property
First Relationship
A decrease in interest rates (required rates of return) will cause the value of a bond (regardless of maturity and coupon interest rate) to increase; on the other hand, an interest rate increase will (regardless of maturity and coupon interest rate) cause a decrease in value.
Ratings by standard and poor's:
AAA, AA, A, BBB, BB, B, CCC, CC, C, D
Announcement Effect
Announcement of a positive news would cause the stock price to increase because the required ror is likely to decrease and the growth rate in future dividends to increase
Debentures
Any unsecured long-term debt, no collateral of any kind
Third Relationship
As the interest rate changes, longer term bonds are more affected than short term bonds, therefore, a bondholder owning a long-term bond is exposed to greater interest rate risk than when owning a short-term bond.
Dividend Valuation Method
Common stock value = expected dividend in year 1 / (required rate of return - growth rate)
Types of Bonds
Debentures Mortgage Bonds Zero and Very Low Coupon Bonds Junk Bonds (High-Yield Bonds) Convertible bonds
Economic Value
Finance theory suggests that the current value of any bond is based upon the PV of the principal and the PV of bond's interest payment; also called fair value
Junk Bonds
High risk debt with ratings of BBB- or below by Standard & Poor's; High yield — typically pay 3%-5% more than AAA grade long-term bonds.
Claim on assets
In the case of insolvency, claims of debt, including bonds are honored before those of preferred or common stock.
Limited Liability
Liability of the shareholder is limited to the amount of their investment. Limited liability feature aids the firm in raising funds.
Convertibility
May allow the investor to exchange the bond for a predetermined number of the firm's shares of common stock. More desirable than other bonds
Which one is riskier (rank them from highest to lowest): Debentures , subordinated debentures, Mortgage bonds?
Subordinated debentures, debentures, mortgage bonds
Indenture
The legal agreement between the firm issuing the bond and the trustee who represents the bondholders, Provides for specific terms of the loan agreement.
Maturity
The length of time until the bond issuer returns the par value to the bondholder and terminates or redeems the bond. It is usually $1,000 per bond.
Premium
The market value of a bond will be above the par or face value when the investor's required rate is lower than the coupon interest rate. The bond will sell at a premium or above face value. When the bond sells at a premium the coupon rate is larger than the current yield and larger than the YTM.
Discount
The market value of a bond will be below the par or face when the investor's required rate is greater than the coupon interest rate. The bond will sell at a discount or below face value. Here the YTM would be larger than the current yield and larger than the coupon rate.
Intrinsic Value
To buy or not to buy depends upon the intrinsic (calculated) value of the bond. Two investors can have different intrinsic values. If you decide not to buy the bond, it implies your intrinsic value is larger than the person whose value is lower.
Common stocks
True owners of the firm, has no maturity date, no upper or lower limit on dividends, dividend payments must be declared each period (usually quarterly) by the firm's board of directors.
Bonds
Type of debt or long-term promissory note, issued by a borrower, promising to its holder a predetermined and fixed amount of interest per year.
Three kinds of stocks...
a) no growth, b) constant growth, and c) differential growth stock (in this class we would not be working on differential growth stock).
Subordinated Debentures
are honored only after the claims of secured debt and unsubordinated debentures have been satisfied; are the riskiest of all bonds and carry a higher yield to maturity.
Rights
certificates issued to the existing shareholders giving them an option to purchase a stated number of new shares of stock at a specified price during a two- to ten-week period
Riskiest factor from highest to lowest
common stocks, preferred stocks, bonds.
Common stock holders receive two types of income:
dividends and capital gains/loss (appreciation/depreciation in price),
Zero Bonds
don't pay interest every period. Sells at a substantial discount prior to maturity from the $1,000 face value with a zero coupon. Return comes from appreciation of the bond
Preemptive Right
entitles the existing common shareholders to maintain a proportionate share of ownership in the firm
Convertible bonds (CVs)
have a par value of $1,000, market value could be larger or smaller than $1,000. these bonds can be converted into pre-specified shares at the market value.
Callable bonds
if the prevailing interest rate declines, the firm may want to pay off the bonds or call early and reissue at a more favorable interest rate.
AAA
indicates a strong capacity to pay principal and interest and low probability of default
Preferred Stock
is often referred to as a hybrid security because it has many characteristics of both common stock and bonds. The value of a preferred stock is the present value of all future dividends.
Coupon interest rate
is the percentage of the par value of the bond that will be paid out annually in the form of interest, e.g.; 7% bond means the investor gets $70 (.07 x 1000) per year
Expected rate of return
is the required rate of return of investors who are willing to pay the market price for the security. The expected ror differs from investor to investor.
Selling at discount
means trading at less than the face value, if sells at a discount, the ror to the bondholder is above the coupon rate of the bond.
Selling at premium
means trading at more than the face value. If the bonds sells at a premium, the investors' or holders' ror is below the coupon rate of the bond.
Par Value
same as Face value or principal of the bond, returned to the bondholder at maturity, corporate bonds are issued at denominations of $1,000.
If the market price of a bond decreases...
the YTM increases and vice a versa.
If the interest rates are historically high for the past few years...
the best strategy is to invest in long term bonds to avoid interest rate risk
If the interest rates are historically low for the past few years...
the best strategy is to invest in short term bonds to avoid interest rate risk
With the change in interest rates...
the coupon rate and the par value don't change, the only thing that changes is the market price of bonds.
Liquidation Value
the dollar sum that could be realized if an asset were sold individually
The poorer the bond rating:
the higher the rate of return
The larger the risk...
the larger the rate of return
As market interest rates rise..
the long term bonds suffer more in value than short term bonds
If ror is greater than coupon rate...
the market value of a bond will be less than the par value
If ror is less than coupon rate...
the market value will be above par value
Market Value
the observed value for the asset in the marketplace, could be different from the par value
If interest rates decrease...
the value of all bonds increase longer term bonds gain more in value than shorter term bonds
if market interest rate increases...
the value of all bonds to decreases but the long term bonds lose more in value than short term bonds
Book Value
value of an asset as shown on a firm's balance sheet