Corporate Finance Exam 2
NASDAQ Dealers
-Post bid and ask prices at which they accept and sell and buy orders -With each price quote, they also poster number of stock shares that they obligate themselves to trade at their quoted prices
The Fisher Effect
* Impact of inflation on interest rates -The relationship between nominal returns, real returns, and inflation -Fisher Effect -- 1+R = (1+r) x (1+h)
Callable Bond
-A bond which the issuer has the right to redeem prior to its maturity date, under certain conditions. -If a bond is called, the bondholder will be notified by mail and have no choice in the matter. The bond will stop paying interest shortly after the bond is called, so there is no reason to hold on to it. -Basically "We're no longer holding your bond"
Zero Growth Stock
-A share of common stock in a company with a constant dividend --Zero growth and constant over time -Much like a share of preferred stock
Electronic Communications Network (ECN)
-A website that allows investors to trade directly with each other -Investors buy and sell orders placed on ECNs are transmitted to NASDAQ and displayed along with market maker bid and ask prices -As a result, the ECNs open up NASDAQ by essentially allowing individual investors, not just market makers, to enter orders -As a result, the ECNs act to increase liquidity and competition
Current yield
-Bonds annual coupon ÷ Bond Price -For example, if a bond is priced at $95.75 and has an annual coupon of $5.10, the current yield of the bond is 5.33%.
Interest rate risk
-Change in the bond price as a result of the change in interest rate --The risk that arises for bond owners from fluctuating interest rates -Longer maturity and lower coupon rate
Bond Quote
-Is the bonds market price -Government are quoted in increments of 1/32nd -For instance, a corporate bond with a par value of $1000 quoted at 80.125 would have a market value of $1,000 * 0.80125 = $801.25.
Internal Rate of Return (IRR)
-The IRR is the discount rate that makes the estimated NPV of an investment equal to zero -The IRR rule is to take a project when its IRR exceeds the required return -IRR is closely related to NPV, and it leads to exactly the same decisions as NPV for conventional, independent projects -When project cash flows are not conventional, there may be no IRR or there be more than one -More seriously, the IRR CANNOT be used to rank mutually exclusive projects; the project with the highest ISS is not necessarily the preferred investment
Net Present Value (NPV)
-The NPV of an investment is the difference between its market value and its cost. -The NPV rule is to take a project if its NPV is positive -NPV is frequently estimated by calculating the present value of the future cash flows (to estimate market value) and then subtracting cost -NPV has no serious flaws; it is the preferred decision criterion
Profitability index (PI)
-The PI, also called the benefit-cost ratio, is the ratio of present value to cost. -The PI Rule is to take an investment if the index exceeds 1 -The PI measures the present value of an investment per dollar invested -It is quite similar to NPV; but, like IRR, it CANNOT be used to rank mutually exclusive projects. -However, it is sometimes used to rank projects when a firm has more positive NPV investments than it can currently finance
Constant Growth Stock
-The dividend for some company that always grows at a steady rate
Primary (new) market
-The market in which new securities are originally sold to investors -Makes up about 5% of all stocks
Secondary (used) market
-The market in which previously issued securities are traded among investors -Makes up about 95% of all stocks -Our main focus is here
Payback Period
-The payback period is the length of time until the sum of an investment's cash flows equals its cost -The payback period rule is to take a project if its payback is less than some cutoff -The payback period is a flawed criterion, primary because it ignores risk, the time value of money, and cash flows beyond the cutoff point
What determines the price of a bond?
The price of any bond is the present value of the interest payment, plus the present value of the par value
For example, suppose Peter purchased a share of XYZ for $100 and he later sells the share for $110. The capital gains yield for that investment would be?
110 - 100 / 100
Par Value (Face Value)
The principal amount of a bond that is repaid at the end of the term
Suppose we are interested in a six-year, 8% coupon bond, a broker quotes the price of $955.14. What is the yield to maturity? *The par value/face value is $1,000, thus we know the rate is greater than 8%...start by plugging in 9% in place of r
80 x (1-1/(1+.09)^6)/.09+1,000/(1+.09)^6 =995.14 YTM=9%
Yield to Maturity (YTM)
The rate required in the market on a bond
Specialist
A NYSE member acting as a dealer in a small number of securities on the exchange floor; often called a market maker
Divided yield
A stock's expected cash dividend / current price
Broker
An agent who arranges securities transactions among investors
Dealer
An agent who buys and sells securities from inventory
Growing Perpetuity
An asset with cash flows that grow at a constant rate forever
Member
As of 2011, a member is the owner of a trading license on the NYSE
Constant Growth Stock Formula
Dt = Dø x (1+g)ˆt
Coupon
The stated interest payment made on a bond
Yield To Maturity Formula
C x [1-1/(1+r)^t]/r+F/(1+r)^t
A firm evaluates all of its projects by applying the IRR rule. A project under construction has the following cash flows: Year 0 = -$28,000 Year 1 = $12,000 Year 2 = $15,000 Year 3 = $11,000 If the required return is 14%, what is the IRR for this project?
Calculator: irr(-28000, {12000,15000,11000} = 17.18%
Staind, Inc., has 8% coupon bonds on the market that have 15 years left to maturity. The bonds make annual payments. If the YTM on these bonds is 11%, what is the current bond price (PV)?
Calculator: N=15 I%=YTM=11% PMT=(1,000)(.08)=80 FV=1,000 PV=784.27
What is the IRR of the following set of cash flows? Year 0 = -$16,400 Year 1 = $7,100 Year 2 = $8,400 Year 3 = $6,900
Calculator: irr(-16400,{7100,8400,6900} = 17.42%
Convertible bonds
Can be exchanged, at the option of the holder, for a specific number of shares of the company's preferred stock or common stock.
Common Stock
Equity without priority for dividends or in bankruptcy
Beta
How risky the stock is
A project that provides annual cash flows of $17,300 for nine years costs $79,000 today. What is the NPV for the project if the required return is 8 percent?
NPV= 17,300[(1 - (1 / 1.08^9)] / 0.08 = $108,071.16 $108,071.16 - $79,000 = $29,071.16
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.
Bond price and rate of return have what sort of relationship?
Inverse relationship
The real rate on an investment
Is the percentage change in how much you can buy with your dollars (percentage change in your buying power)
The nominal rate on an investment
Is the percentage change in the number of dollars you have
Commission Brokers
NYSE members who execute customer orders to buy and sell stock transmitted to the exchange floor
Interest rate risk, all other things being equal, the lower the coupon rate...
the greater the interest rate risk
Unicorn Corp. issued 17-year bonds 2 years ago at a coupon rate of 9.3%. The bonds make semi-annual payments. If these bonds currently sell for 98% percent of par value, what is the YTM?
N=15 (17-year bond - 2 years (ago)) PV=(1,000)(.98)=-980 PMT=(1,000)(.093)=93 FV=1,000 I%=YTM=9.55%
Grohl Co. issued 5-year bonds a year ago at a coupon rate of 7 percent. The bonds make semiannual payments. If the YTM on these bonds is 8 percent, what is the current bond price (PV)?
N=4*2=8 I%=8/2=4 PMT=(1,000)(.07)=70/2=35 FV=1,000 PV=966.34
Kiss the Sky Enterprises has bonds on the market making annual payments, with 6 years to maturity, and selling for $860. At this price, the bonds yield 11%. What must the coupon rate be on the bonds? (We're solving for PMT (annuity))
N=6 I%=11 PV=-860 FV=1,000 PMT=76.90 /1,000=7.69%
Capital Gains Yield
P1 - P0/ P0 Where: P0 = Original price of the security P1 = Current/Selling price of the security
Dividends
Payments by a corporation to shareholders, made in either cash or stock
Over-the-Counter (OTC) Market
Securities market in which trading is almost exclusively done through dealers who buy and sell for their own inventories
Outstanding Shares
Stock issued by a previous owner --Not selling it back to the company, but another person
Preferred stock
Stock with dividend priority over common stock, normally with a fixed dividend rate, sometimes without voting rights
Year 0 = -$5,000 Year 1 = $1,300 Year 2 = $1,500 Year 3 = $1,900 Year 4 = $1,400 What is the payback period for the set of cash flows given above ?
To calculate the payback period, we need to find the time that project has recovered its initial investment. After three years, the project has created: $1,300 + $1,500 + 1,900 = $4,700 in cash flows. The project still needs to create another: $5,500 - $4,700 = $800 in cash flows. During the fourth year, the cash flows from the project will be $1,400. So, the payback period will be three years, plus what we still need to make divided by what we will make during the fourth year. The payback period is: Payback = 3 + ($800 / $1,400) = 3.57 years
Coupon Rate
The annual coupon ÷ the principal amount of a bond that is paid
Spread
The dealers return on investment
Capital Gains Yield
The dividend growth rate, or rate at which the value of an investment grows.
If investors require a 10% real rate of return, and the inflation rate is 8, what must the approximate nominal rate? The exact nominal rate?
The nominal rate is approximately the sum of the real rate and the inflation rate From the fisher effect: 1+R = (1+r) x (1+h) = 1.10 x 1.08 =1.1889 = 18.89% Therefore, the nominal rate will actually be closer to 19%
E-Eyes.com Bank just issued some new preferred stock. The issue will pay an annual dividend of $20 in perpetuity, beginning 20 years from now. If the market requires a return of 5.8 percent on this investment, how much does a share of preferred stock cost today?
The price of a share of preferred stock is the dividend payment ÷ the required return. We know the dividend payment in Year 20, so we can find the price of the stock in Year 19, one year before the first dividend payment. Doing so, we get: P19 = $20 / .058 P19 = $344.83 The price of the stock today is the PV of the stock price in the future, so the price today will be: P0 = $344.83 / (1.058)ˆ19 P0 = $118.13
Stock Quote
The price of a stock as quoted on exchange
Staal Corporation will pay a $3.40 per share dividend next year. The company pledges to increase its dividend by 4.5 percent per year indefinitely. If you require a return of 11 percent on your investment, how much will you pay for the company's stock today? (Po)
Using the constant growth model, we find the price of the stock today is: D1 / (R - g) = P0 $3.40 / (0.11 - .045) = $52.31
The Sleeping Flower Co. has earnings of $1.75 per share. The benchmark PE for the company is 18. What is the benchmark PE were 21?
Using the equation to calculate the price of share of stock with the PE ratio: P = Benchmark PE ratio of 18, we find: P = 18($1.75) = $31.50 And with a PE ratio of 21, we find: P = 21($1.75) P = $36.75
The next dividend payment by Blue Cheese, Inc., will be $1.89 per share. The dividends are anticipated to maintain a growth rate of 5 percent forever. If the stock currently sells for $38 per share, what is the required return? (R)
We need to find the required return of the stock. Using the constant growth model, we can solve the equation for R. Doing so, we find: (D1 / P0) + g = R ($1.89 / $38.00) + 0.05 = .0997, 0r 9.97%
An investment project has cash inflows of $3,200, $4,100, $5,300, & $4,500, & a discount rate of 14 percent. What is the discounted payback period for these cash flows if the initial cost is $5,900. What if the initial cost is $8,000? What if the initial cost is $11,000?
When the use discounted payback, we need to find the value of all cash flows today. The value today of the project cash flows for the first four years is: -Value today of Year 1 cash flow = $3,200 / 1.14 = $2,807.02 -Year 2 cash flow = $4,100 / 1.14ˆ2 = $3,154.82 -Year 3 cash flow = $5,300 / 1.14ˆ3 -Year 4 cash flow = $4,500 / 1.14ˆ4 = $2,664.36 To find the discounted payback, we use these values to find the payback period. The discounted first year cash flow is $2,807.02, so the discounted payback for a $5,900 initial cost is: Discounted payback = 1 + ($5,900 - $2,807.02) / $3,154.82 = 1.98 years For 8,000, Discounted payback = 2 + ($8,000 - $2,807.02 - $3,154.82) / $3,577.35 = 2.57 years *Notice the calculation of discounted payback. We know the payback period is between two and three years, so we subtract the discounted values of the Year 1 and 2 cash flows from the initial cost. This is the numerator, which is the discounted amount we still need to make to recover our initial investment. We divide this amount by the discounted amount we will earn in year 3 to get the fractional portion of the discounted payback. If 11,000, Discounted payback = 3 + ($11,000 - $2,807.02 - $3,154.82 - $3,577.35) / $2,664.36 = 3.55 years
A firm evaluates all of its projects by applying the NPV decision rule. A project under construction has the flowing cash flows Year 0 = $28,000 Year 1 = $ 12,000 Year 2 = $15,000 Year 3 = $11,000 What is the NPV of the project if the required return is 11%, and should the firm accept this project?
npv(11,-28000,{12000,15000,11000} = 3,028.25 yes *Note: if the NPV is a negative value, we would reject the project.
Interest rate risk, all other things being equal, the longer the time to maturity...
the greater the interest rate risk
Capital Budgeting
-The process in which a business determines whether projects such as building a new plant or investing in a long-term venture are worth pursuing. -Oftentimes, a prospective project's lifetime cash inflows and outflows are assessed in order to determine whether the returns generated meet a sufficient target benchmark.
NASDAQ Operations
-The second largest stock exchange -The market is a computer network of securities dealers and others that disseminates timely security price quotes to computer screens world wide
NonConstant/Supernormal Growth rate
-When a stock or bond reaches a high point of return due to situations affecting the country's economic status. -For example, if an engineering firm experiences a stock boom during a growth in the construction industry.
The two differences between the NASDAQ and NYSE
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 specialist system
Required Return
Discount Rate, R
Grohl Co. issued 5-year bonds a year ago at a coupon rate of 7%. The bonds make semi-annual payments. If the YTM on these bonds is 8%, what is the current bond price?
N = 4 (5-year bond - 1 year (ago))*2 = 8 I% = YMT= 8/2 = 4 PMT = (1,000)(.07) = 70/2 = 35 FV=1,000 Calculating PV, PV=966.34
Ashes Divide Corporation has bonds on the market with 14 year to maturity, a YTM of 8.4%, and a current price of $1,276.50. The bonds make semi-annual payments. What must the coupon rate be on these bonds?
N =14*2 = 28 I% = YTM =8.4/2 =4.2 PV = -1,276.50 FV = 1,000 PMT = 58.98 (58.98)(2) = 117.96 117.96/2 = .11796 .1179 = 11.80
Dividend
Return on your money—one way to calculate future stock price
New York Stock Exchange (NYSE)
-It is the largest stock market in the world -trading done by humans
Price of bond equals?
-Par value -"Bond is priced at PAR"
Red, Inc., Yellow Corp., and Blue Company each will pay a dividend of $2.65 next year. The growth rate in dividends for all three companies is 5 percent. The required return for each company's stock is 8 percent, 11 percent, and 14 percent, respectively. What is the stock price for each company?
We can use the constant dividend growth mode, which is: Pt = Dt x (1+g) / (R-g) So the price of each stock today is: Red stock price = $2.65 / (.08 - .05) Yellow stock price = $2.65 / (.11 - .05) Blue stock price = $2.65 / (.14 - .05)