FIN 201
there are two types of cash flows from a bond:
1. Coupon payment stream (an annuity) 2. Par (face) value repayment (a lump sum)
Which of the following statements about a bond are true?
A bond is a fixed-income security A bond acts like an interest-only loan
Dividends in arrears
A preferred stock characteristic where common stock dividends cannot be paid until the preferred dividends are paid.
perfered stock
A type of equity viewed as a hybrid security A hybrid security with elements like equity and others like debt.
Which of the following securities represents ownership in the firm?
A. Annuity B. Bond C. Preferred stock D. None of the above E. All of the above C) Preferred Stock
Which of the following securities represents ownership in the firm?
A. Common stock B. Preferred stock C. All of the above D. None of the above C) All of the above
Which one of the following does NOT describe preferred stock?
A. It has no maturity. B. It has the lowest priority to claim on firm assets in the case of bankruptcy. C. It has fixed dividends. D. Its dividends are cumulative. B) It has the lowest priority to claim on firm assets in the case of bankruptcy.
Which one of the following does NOT describe common stock?
A. It normally has voting and participating rights. B. It has fixed dividends. C. It has the lowest priority to claim the asset in case of bankruptcy. D. It has no maturity. B) It has fixed dividends
Which of the following statements correctly defines the difference between preferred stock and common stock?
A. Preferred shareholders have more of a claim to dividends than common stockholders B. Preferred shareholders do not have the voting rights that common stockholders have C. Common shareholders have more exposure to variable share prices than preferred shareholders D. All of the above E. None of the above D) All of the above
Day's Low (Lo):
Along the same lines, the day's low is the lowest price at which the stock traded today.
Annuity due
An annuity that pays at the beginning of each period.
Ordinary annuity
An annuity that pays at the end of each period.
APR
Annual Percentage Rate
Which is worth more
Annuity Due
Current interest rates are 8%. You want to buy a long-term bond with a face value of $1000 that pays a coupon rate of 10%. Which of the following prices is feasible?
Answer: $1,111.11 For this problem, you need to think conceptually. Since the YTM (8%) is smaller than the coupon rate (10%), the bond should be sold at premium. So the most feasible price out of the choices is $1,111.11.
A preferred stock pays a dividend of $1.79 in perpetuity. If the return required by shareholders is 8%, then the price per share for this preferred stock is:
Answer: $22.38 Price = 1.79/0.08 = $22.38
UHFD has just paid a dividend of $2.56 and is expected to increase the future dividends at a rate of 5% per year indefinitely. If you, as a share holder, require 15% per year, what is the current price per share?
Answer: $26.88 Price = (2.56 X 1.05)/(0.15 - 0.05) = $26.88
If a preferred stock pays a constant dividend of 5% of par, which is $50, and investors require a rate of return of 9%, what is the price of this preferred stock?
Answer: $27.78 D = 5% of $50 = .05×$50 = $2.50 Vps = (D / kps) = 2.50 / 0.09 = 27.78
Some Co. is planning to pay a dividend of $5.60 in the next year and expects to grow the dividend at a constant rate of 4% per year, indefinitely. If the required rate of return by shareholders is 13%, then the price of this stock should be:
Answer: $62.22 Price = 5.60/(0.13 - 0.04) = $62.22
(Preferred stock valuation) What is the value of a preferred stock where the dividend rate is 12% on a $100 par value? The appropriate discount rate is 18%.
Answer: $66.67 Vps = D / kps = (100 X 0.12) / 0.18 = $66.67
If a $1,000 face value bond is sold at $956.32 and has a coupon rate of 10%, which one of the following rate is the most feasible yield to maturity of this bond?
Answer: 10.83% For this problem, you need to think conceptually. Since the bond is sold at discount, its YTM should be larger than its coupon rate. Therefore, the most feasible YTM is 10.83%.
Cougar Creamery has decided to issue bonds to raise capital to feed more missionaries at the MTC for the recent age change. They were thinking to sell the bond at the par value of $1,000, but many mothers of the missionaries wanted to support the change so much that the creamery ended up selling them at $1,200. If the current yield to maturity is 8.93%, and the bond matures in 10 years and pays coupon semi-annually, what is the annual coupon rate?
Answer: 12.00% FV = 1,000, PV = -1,200, I = 8.93%/2 = 4.465%, N = 10 X 2 = 20. Solve for PMT = 60. Coupon Rate = Annual PMT/1000 = 60 X 2/1,000 = 12%
(Preferred stockholder expected return) Spaceman Corp's preferred stock is selling at $35.29 a share and pays a $2.26 dividend. What is the expected rate of return of Spaceman's stock?
Answer: 6.40% kps = D / Vcs = 2.26 / 35.29 = 6.40%
(Preferred stockholder expected return) You own 252 shares of Global Services' preferred stock, which currently sell for $18.12 and pay annual dividends of $1.19 per share. What is your expected return?
Answer: 6.57% kps = D / Vcs = 1.19 / 18.12 = 6.57%
A junk bond refers to:
Answer: A bond that is speculative.
Which of the following S&P ratings applies to the most risky investment grade bonds? BBB CCC AA BB
Answer: BBB Investment grade bonds are graded between AAA and BBB, BBB being the lowest or most risky grade.
Suppose the two bonds below are issued by the same firm, have equal risk, and equal yields to maturity (YTM) that are expected to remain constant for the foreseeable future. Assume also that the bonds are in "equilibrium." That is, they are priced so there is no incentive to buy one and sell the other to take advantage of mispricing. The yield to maturity of these bonds should be:
Answer: Between 5% and 8%. Both bonds have the same YTM while Bond A is sold at premium (YTM < coupon rate) and Bond B is sold at discount (YTM > coupon rate). So the YTM of these bonds should be between 5% and 8%.
Suppose the two bonds below are issued by the same firm, have equal risk, and equal yields to maturity (YTM) that are expected to remain constant for the foreseeable future. Assume also that the bonds are in "equilibrium." That is, they are priced so there is no incentive to buy one and sell the other to take advantage of mispricing. Which bond has the higher current yield?
Answer: Bond A Current yield = Annual coupon payment/price. Bond A = 80/1,050 = 7.62% and Bond B = 50/950 = 5.26%.
Bonds A and B have equal risk and are in equilibrium so there is no opportunity to take advantage of mispricing. They also have the same number of years until maturity. However one bond sells at a premium and the other sells at a discount. If the current yields for Bonds A and B are 4.69% and 6.97%, respectively, which bond sells at a discount?
Answer: Bond A Since one bond is sold at premium and the other is sold at discount. Both bonds have the same YTM, therefore one sold at premium should have a higher coupon rate than its YTM while the other should have a lower coupon rate than its YTM. From the current yields, Bond A's coupon rate is lower than Bond B's and the YTM should be between the current yields. Thus Bond A should be sold at discount and Bond B should be sold at premium.
A bond is sold at $1,031.88 which has a face value of $1,000 and a coupon rate of 9% paid semi-annually. It will mature in 10 years. If your required rate of return on this bond is 8.6%, should you buy or sell the bond?
Answer: Sell the bond because the yield to maturity of the bond is lower than your required rate of return. First, solve for the YTM. PV = -1.031.88, FV = 1,000, PMT = 1,000 X 9%/2 = 45, N = 10 X 2 = 20. Solve for I = 4.26%, so YTM = 4.26% X 2 = 8.52%. Since the YTM is less than the require rate of return, the bond is overvalued; thus you should sell the bond.
Currently a bond is sold at the price of $1,302.68 or the yield to maturity of 6.78%. If the default risk of this bond increases, then you would expect:
Answer: The bond price to decrease and the YTM to increase. The YTM is the same as the discount rate, which primary includes three components: inflation, risk and opportunity cost. If the risk goes up, then the rate goes ups; thus the price goes down.
If the investors' required rate of return is constant all the time, then the shorter the time to maturity,:
Answer: The lower the price of the bond if the bond is sold at premium. As time to maturity shortens, the bond price goes down while the YTM stays the same if the bond is sold at premium, and the bond price goes up if the bond is sold at discount.
T/F An investor who buys shares of common stock becomes a part-owner of the firm.
Answer: True Common stock represents equity, or ownership, in a firm. When an investor holds stock, they literally become a partner or part-owner of that company. Along with this ownership comes the right to vote. The majority of common stock includes these voting rights. For example, this means that if the company is going to change its corporate charter, it has to allow the shareholders to vote on that change. As a stockholder in the company, an investor has the right to participate in that vote.
(Preferred stockholder expected return) You own 252 shares of Global Services' preferred stock, which currently sell for $18.12 and pay annual dividends of $1.19 per share. If you require a 10% return, given the current price, would you be interested in selling or buying more stock?
Answer: You should sell the stock since it is overvalued by $6.22. Vps = D / kps = 1.19 / 0.10 = $11.90, so you should sell the stock since it is overvalued
Microsoft only has to pay taxes on 20% at a rate of 40%, meaning MSFT pays only .4 × 20 = 8 cents in taxes on $1 of dividends. Why?
Because we're taxing at the corporate level—it has already been taxed once; it's to avoid double taxation.
Which of the following statements is correct regarding preferred stock and the common stock?
Both preferred and common stocks do not have fixed maturities like bonds.
If a company skips a dividend payment to preferred shareholders, then the company _____________.
Cannot pay any dividends to common shareholders until the preferred dividend is paid
Gordon Growth Model =
Constant Dividend Growth Model Common stock dividends grow at a constant rate forever.
What is a bond that is unsecured called?
Debentures
Net Income =
Dividends + Change in Retained Earnings
Dividend Yield Percent (Yld %):
Dividing the dividend in the fourth column by the closing price of the stock (column 10) gives the dividend yield percent, or the return on investment that investors will receive this year through dividends paid. In the case of IBM the dividend yield percent is $0.80/$105 ≈ 0.8%. When investors purchased the stock one or two years ago, it may have been selling for $90 or $95. Today they can sell that stock for $105. That $10 or $15 increase in price gives investors the return they require and makes up for the return that doesn't come totally through dividends.
Ticker symbol (Sym):
Each stock is listed and identified by its own unique symbol. Typically these symbols are three to four characters long and may include letters and/or numbers. Three character tickers are normally associated with the New York Stock Exchange and the American Stock Exchange. Four character tickers are associated with the Nasdaq.
EBIT
Earnings Before Interest and Taxes,
Two-Stage Growth Model
Estimate cash flows for two different growth stages: Stage 1: dividends grow at above-average rates Stage 2: dividends grow at the industry average rate
Present value = PV =
FV / (1 + i)n
Future value =
Future value = present value × ( 1 + i )^n where: i = discount rate. where: n = number of compounding periods.
Growing perpetuity
Grows at a constant rate through time
A 20-year bond you purchased 10 years ago is currently traded at $1,053.42. The bond has a coupon rate of 8% paid annually and a face value of $1,000. The bond was priced at $1,132.13 when you purchased it. If your choice is either sell it now or hold it until the maturity to gain the most of it, what should you do?
Hold the bond till the maturity.
Compounding
Moving a sum of money further into the future (from left to right on the timeline)
What are bonds issued by cities, counties, or states called?
Municipal Bonds
Muni-bonds are:
Often exempt from federal taxation
New RE =
Old RE + Change in RE
New RE =
Old RE + Net Income - Dividends
first, find the present value of an annuity of $100/year for 3 years and second, find the present value of a lump sum of $1,000 in 3 years. The calculations are as follows:
PMT = $100, fv = $1,000, i/y = 10%, n = 3
For the AT&T bond the four known values are
PMT = coupon rate × par value = $100 FV = par value = $1000 I/YR = required rate of return = 12 N = 3 Solving for the fifth value, PV, gives a current bond price of -$951.96.
PV perpetuity =
PMT/i
PVIFA
Present value investment factor of an annuity.
SEC
Securities and Exchange Commission
52 Week Low (Lo):
Similarly, the 52 week low lists the lowest value that the stock has had over the past 52 weeks.
Duration is the measure which tells us how much the price moves (as a percent) based upon each one percent change in market interest rates.
So if a bond has a duration of 2.2, it would indicate that for every 1% change in the interest rate, the price of the bond would move the opposite direction by 2.2%. Duration follows the familiar price-yield inverse relationship. As interest rates increase, prices decrease and vice versa.
residual claim
Stockholders are the last in line of all those who have a claim on the assets and income of the corporation Each year after the company pays for its operations and pays its creditors, any residual or remaining earnings belong to the shareholders. If the company had 100 shares of stock outstanding, and you owned one of those, you would have claim to 1% (or 1/100) of the residual earnings
What Is Equity?
Synonyms with Stock Ownership in an asset such as a company. Often another name for stock Equity = Stock = Ownership in a Firm
52 Week High (Hi):
The 52 week high gives the highest value that the stock has attained in the past 52 weeks. This value is updated daily and the 52 weeks are counted back from the current day.
PE Ratio (PE):
The PE, or Price to Earnings, ratio is the dominant "Price-to-X" ratio. When we set out to price or value a stock, we are really asking about the earning power of the stock or company. The PE ratio is directly related to this idea. It compares the stock price to company earnings, and is calculated as price/share divided by earnings/share. Consider a simple example. Suppose that we want to purchase a supplement shop and find one for sale that made $10,000 in earnings last year. How much are we willing to pay for that shop? If we were paying a PE ratio of 18 (or $18 for every dollar of earnings), we would pay 18 × $10,000 = $180,000. If instead we used a PE ratio of 54 to value the shop (as in the case of Microsoft), we would pay 54 × $10,000 = $540,000 for the shop (and free supplements to boot)!
Day's High (Hi):
The day's high is the highest value at which the stock was sold or purchased during the current day's trading.
Dividend (Div):
The fourth column lists the most recent quarterly dividend annualized by multiplying it by four.
Net Day's Change (Net Chg):
The net change in price is calculated as the difference between today's closing price and the closing price of the previous day. It shows the cumulative effects of today's trading on the price of the stock. For IBM, the day was a positive one: the stock is up two dollars from yesterday's closing price.
Discounting
The opposite, moving a sum from the future back toward the present (or right to left on the timeline)
The first way is to increase future cash flows through either increasing sales or lowering expenses.
The other way is to decrease the denominator of the discounted cash flow (DCF) model, or the cost of capital, that the firm uses to discount future cash flows. It is by coming up with an optimal mix of financing vehicles—debt, common stock, and preferred stock—that management lowers company cost of capital and increases company value.
Maturity
The period of time for which a bond remains outstanding
What is the value of a bond?
The present value of its cash flows
Corporate Governance can be defined as:
The rules and regulations for managers of the firm
Corporate Governance
The structure, rules, and regulations for owners and managers of a firm.
Day's Closing Price (Close):
This is the price at which the stock closed today at the end of trading, or the last price at which the stock was bought and sold before the market closed.
If interest rates increase then bond prices will decrease
True
Final Stock / Firm Value
Value = PV(Stage 1) + PV(Stage 2)
Round Lots Traded (Vol 100s):
Values in this column show the amount of trading activity in a particular company's stock. The volume of shares traded is expressed in round lots. Each round lot is equal to 100 shares. For IBM, 54,970 round lots, or 5,497,000 shares, traded on the exchange that day.
common stock
Variable-return securities: Securities that are not fixed-income securities Dividends may increase or decrease at management's discretion, depending on market conditions and how the company itself fares.
If the bond currently sells at a premium, what is the relationship between YTM, current yield and the coupon rate?
YTM < Current Yield < Coupon Rate
The required rate of return on a bond is called the:
Yield to maturity
What is a bond called that has no coupon payments?
Zeros
current yield
a separate yield measure calculated by dividing the annual coupon payment by the current price of the bond. It is an estimate of the YTM, but it ignores the time value of money = Annual Coupon/Current Market Price of Bond. = 95/848.58 = 0.112 or 11.2% Current Yield = Annual Coupon Payment/Price = 70/950.32 = 7.37%
Which of the following securities is considered a hybrid security?
a. Common Stock b. Preferred Stock c. Bond d. Annuity e. None of the above B) Preferred Stock
Which of the following statements about bonds is true?
a. If market interest rates are below a bond's coupon interest rate, then the bond will sell above its par value. b. Long-term bonds have more interest rate risk than do short-term bonds (all else equal). c. Bond prices move in the opposite direction of market interest rates. ALL of the above
An annuity is
an equally spaced sequence of equal cash flows. Annuities are particularly common in lending relationships, such as car loans, mortgages, and bonds, as well as in financial contracts, such as insurance contracts and rental agreements
A perpetuity is
an infinite stream of equally spaced, equal cash flows
The single holding period model assumes that
an investor buys a stock today, holds it for one year and then sells it in the market. During that process, the investor potentially generates a return from two sources, dividends and an increase in the price of the stock (capital gain).
When a bond sells at a discount, its YTM will always be higher than its coupon yield
because investors not only receive the coupon payments that make up the coupon yield but also the increase in price over time
Discount Rate=
risk free rate + risk premium= Rf + risk premium
If coupon rate < discount rate,
the bond will sell for a discount.
If coupon rate > discount rate,
the bond will sell for a premium if the coupon rate of a bond is greater than its discount rate, the bond will sell for more than its par value.
If coupon rate = discount rate,
the bond will sell for par value.
The amount for the final cash flow that a bondholder will receive is
the last coupon payment + the face value
The intrinsic value of an asset =
the present value of the stream of expected cash flows discounted at an appropriate required rate of return.
3 Basic forms to help estimate the value of the future cash flows of a share of stock.
the single period model for both preferred and common stock the constant growth (aka Gordon Growth) model for mature firms the two-stage model for younger or growth companies.
