FIN 3404 TEST 2
With corporate democracy, the "golden rule" prevails absolutely
"One share, one vote"
Debt securities can be
"Short-term" (with maturities one year or less) or "long-term" (with maturities of more than one year. Short term debt is sometimes called unfounded debt
Negative Covenant
"Thou shalt not" - limits or prohibits actions the company might take 1. The firm must limit the amount of dividends it pays according to some formula 2. The firm cannot pledge any assets to other lenders 3. The firm cannot merge with another firm 4. The firm cannot sell or lease any major assets without approval by the lender 5. The firm cannot issue additional long-term debt
Positive Covenant
"Thou shalt" - specifies an action the company agrees to take or a condition the company must abide by 1. The company must maintain its working capital at or above some specified minimum level 2. The company must periodically furnish audited financial statements to the lender 3. The firm must maintain any collateral or security in good condition
Staggering provides
"institutional memory"
Non constant Growth
"supernormal" growth rates over some finite length of time. Growth rate cannot exceed the required return indefinitely, but it certainly can do so for some number of years
Bonds issued by corporations or municipalities additional factors
- Credit risk, possibility of default - Investors demand higher yield as compensation for risk, called Default risk premium (Lower rating bonds have higher yields) - Investors demand extra yield on taxable bonds because municipal bonds are free from most taxes. This is compensation, otherwise known as Taxability premium, is for the unfavorable tax treatment.
Main differences between debt and Equity
1. Debt is not an ownership interest in the firm. Creditors generally do not have voting power 2. The corporation's payment of interest on debt is considered a cost of doing business and is fully tax deductible. Dividends paid to stockholders ARE NOT tax deductible 3. Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of the firm. This action can result in liquidation or reorganization, two of the possible on sequences of bankruptcy. Thus, one of the costs of issuing debt is the possibility of financial failure. This possibility does not arise when equity is issued
Two important factors about U.S. Treasury issues
1. Have no default risk because (we hope) the Treasury can always come up with the money to make the payments 2. Treasury issues are exempt from state income taxes (though not federal income taxes). In other words, the coupons you receive on a Treasury note or bond are taxed only at the federal level
Payback Period Disadvantages
1. Ignores the time value of money 2. Requires an arbitrary cutoff point 3. Biased against lone-term projects, such as research and development, and new projects
The trust company must
1. Make sure the terms of the indenture are obeyed 2. Manage the sinking fund 3. Represents the bond holder in default - that is, if the company defaults on its payments to them
Profitability Index disadvantages
1. May lead to incorrect decisions in comparison of mutually exclusive investments
Internal Rate of Return disadvantages
1. May result in multiple answers or not deal with nonconventional cash flows 2. May lead to incorrect decisions in comparisons of mutually exclusives investments.
Two key differences between the NYSE and NASDAQ
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 a DMM System
Average Accounting Return Disadvantages
1. Not a true rate of return; time value of money is ignored 2. Uses an arbitrary benchmark cutoff rate. 3. Based on accounting (book) values, not cash flows and market values
Common Stock Valuation (Why a share of common stock is more difficult to value in practice than a bond for three reasons)
1. Not even the promised cash flows are known in advance 2. The life of the investment is essentially forever because common stock has no maturity 3. There is no way to easily observe the rate of return that the market requires
Bond yields represent the combined effect of no fewer than six things
1. Real rate of interest - On top of the real rate are five premiums representing compensation for 1. Expected future inflation 2. Interest rate risk 3. Default risk 4. Taxability 5. Lack of liquidity
What determines the shape of the term structure? (3 components)
1. Real rate of interest (mostly influence the overall level of interest rates, not the shape) 2. Future rate of inflation (Inflation Premium) 3. Interest Rate risk Premium Extra component: Inflation premium (strongly influences the shape of the term structure
There are many different kinds of sinking fun arrangements, and the details would be spelled out in the indenture. For example:
1. Some sinking funds start about 10 years after the initial issuance 2. Some sinking funds establish equal payments over the life of the bond 3. Some high-quality bond issues establish payments to the sinking fund that are not sufficient to redeem the entire issues. As consequence, there is the possibility of a large "ballon payment" at maturity
Staggering has two basic effects:
1. Staggering makes it more difficult for a minority to elect a director because there are fewer directors to be elected at one time 2. Staggering males takeover attempts less likely to be successful because it makes it more difficult to vote in a majority of new directors
Bond indenture includes the following provisions
1. The basic terms of the bond 2. The total amount of bonds issued 3. A description of property used as security 4. The repayment arrangements 5. The call provisions 6. Details of the protective covenants
Special circumstances when we can come up with a clue for the stock
1. The dividend has a zero growth rate 2. The dividend grows at a constant rate 3. The dividend grows at a constant rate after some length of time
A majority of floaters have the following features:
1. The holder has the right to redeem the note at par on the coupon payment date after some specified amount of time. This is called a "put" provision 2. The coupon rate has a floor and ceiling, meaning the that the coupon is subject to minimum and a maximum. In this case, the coupon rate is said to be "capped," and the upper and lower rates are sometimes called the "collar"
IRR and NPV rules always lead to identical decisions as long as two very important conditions are met
1. The project's cashflows must be conventional, meaning that the first cash flows (the initial investment) is negative and all the rest are positive 2. The project must be independent, meaning that the decision to accept or reject this project does not affect the decision to accept or reject any other
In addition to the right to vote for directors, shareholders usually have the following rights:
1. The right to share proportionally in dividends paid. 2. The right to share proportinonally in assets remaining after liabilities have been paid in liquidation 3. The right to vote on stockholders matters of great importance, such as a merger. Voting is usually done at the annual meeting or a special meeting Stockholder also sometimes have the right to share proportionally in any new stock sold. This is called the preemptive right.
Treasury notes and bonds have three important features
1. They are Default free 2. They are taxable 3. They are highly liquid
Two drawbacks to bearer bonds
1. They are difficult to recover if they are lost or stolen 2. The company does not know who owns its bonds, it cannot notify bondholders of important event
Profitability Index advantages
1. closely related to NPV, generally leading to indentical decisions 2. Easy to understand and communicate 3. May be useful when available investment funds are limited
Internal Rate of Return advantages
1. closely related to NPV, often leading to identical decisions 2. Easy to understand and communicate
Average Accounting Return advantages
1. easy to calculate 2. needed information will usually be available
Payback Period Advantages
1. easy to understand 2. Adjusts for uncertainty of later cash flows 3. based toward liquidity
Discounted payback period advantages
1. includes time value of money 2. easy to understand 3. does not accept negative estimated NPV investments 4. Biased toward liquidity
Discount payback period disadvantages
1. may reject positive NPV investments 2. Requires an arbitrary cutoff point 3. Ignores cash flows beyond the cutoff date 4. Biased against long-term projects, such as research and development, and new projects
In general, if there are N directors up for election, then
1/(N+1) percent of the stock plus one share will guarantee you a seat.
Zero Coupon Bonds
A bond that pays no coupons at all must be offered at a price that is much lower that its stated value. Also called "zeroes"
call-protected bond
A bond that, during a certain period, cannot be redeemed by the issuer
Current Yield
A bond's annual coupon divided by its price
DMM's post
A fixed place on the exchange floor where the DMM operates
Net Present value profile
A geographical representation of the relationship between an investment's NPVs and various discount rates
Proxy
A grant of authority by a shareholder allowing another individual to vote his or her shares
Protective Covenants
A part of the indenture limiting certain actions that might be taken during the term of the loan, usually to protect the lender's interest
Treasury Yield Curve (Yield Curve)
A plot of the yields on Treasury notes and bonds relative too maturity
Straight voting
A procedure in which a shareholder may cast all votes for each member of the board of directors
Cumulative voting
A procedure in which a shareholder may cast all votes for one member of the board of directors
Mutually Exclusive investment decisions
A situation in which taking one investment prevents the taking of another
Electronic communications network (ECN)
A website that allows investors to trade directly with each other
The highest rating a firm's debt can have is
AAA or Aaa, and such debt is judged to be the best quality and have the lowest degree of risk
Sinking fund
An account managed by the bond trustee for early bond redemption
Broker
An agent who arranges security transactions among investors. They do not buy or sell securities for their own accounts. Facilitating trades by others is their business.
Dealer
An agent who buys and sells securities from inventory
Call Provision
An agreement giving the corporation the option to repurchase a bond at a specified price prior to maturity
A bond is what kind of loan
An interest-only loan, meaning that the borrower will pay the interest every period, but none of the principal will be repaid until the end of the loan
Averaging Accounting Return (AAR)
An investment's average net income divided by its average book value
Debenture
An unsecured debt, usually with a maturity of 10 years or more
Note
An unsecured debt, usually with a maturity under 10 years
Debt rating
Are an assessment of the creditworthiness of the corporate issuer. The definition of creditworthiness used by Moody's and S&P are based on how likely the firm is to default and the protection creditors have interest event of a default
Mortgage securities
Are secured by a mortgage on the real property of the borrower
Member
As of 2006, a member is the the owner of a trading license on the NYSE
Investment-grade bonds are bonds rated
At least BBB by S&P or Baa by Moody's
Debt
At the crudest level, a debt represents something that must be repaid; it is the result of borrowing money
Debt securities are classified according to the
Collateral and mortgages used to protect the bond holder
Dividend Yield
D1/Po Expected cash dividend divided by the current price
Interest rate risk increase at a
Decreasing rate
Bonds that sells for less than face value is called a
Discount bond
The IRR on an investment is the required return that results in a zero NPV when it is used as the
Discount rate
As a general rule
Equity represents an ownership interest, and it is a residual claim. This means that equity holders are paid after debt holders. As a result of this, the risks and benefits associated with owning debt and equity is different
Securities issued by corporations
Equity securities and debt securities
Common Stock
Equity without priority for divided or in bankruptcy
A PE ratio that is based on estimated future earnings is called a
Forward PE ratio
Bond prices and interests always move
In opposite directions
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
Supplemental liquidity providers (SLPs)
Investment firms that are active participants in stocks assigned to them. Their job is to make a one-sided market (i.e., offering to either buy or sell). They trade purely for their own accounts.
Collateral
Is a general term that frequently means securities (for example, bonds and stocks) that are pledged as security for payment of debt. Any asset pledge on a debt
One of the major differences between Western Financial practices and shariah (Islamic law and cultural traditions) is
Islamic law does not permit charging or paying ribs, or interest. Anyone following shariah cannot buy or issue conventional bonds
Two leading bond-rating firms are
Moody's and Standards & Popes (S&P)
State and local government notes and bonds that sold to borrow money are called
Municipal notes and bonds, or just "munis"
Floor Brokers
NYSE member who execute customer buy and sell orders
Designated Market Maker (DMM)
NYSE members who act as dealers in particular stocks. Formerly know as "Specialists"
Two Stage Growth
Non constant growth: The dividend will grow at a rate of g1 for t years and then grow at a rate of g2, thereafter forever.
Debt securities are typically called
Notes, debentures, or bonds
Bond ratings are concerned
ONLY with the possibility of default
Usually the only difference between a note and a bond is the
Original maturity. Issues with an original maturity of 10 years or less are often called notes. Longer-term issues are called bonds.
Price of stock as of time, t, is
P1 = Dt + 1 / R-g
Dividends start growing at a constant rate sometime in the future (in 5 years
P4 = D4 x (1+g) / (R-g) = D5 / (R-g)
P4 =
P4 = Po x (1+g)4
Dividends
Payments by a corporation to shareholders, made in either cash or stock
Blanket Mortgage
Pledges all the real property owned by the company
Per-share value is given by
Po = D/R R = required return
As long as the growth rate, g, is less than the discount rate, r, the present value of this series of cash flows can be written simply as
Po = D1 / R-g (Dividend Growth Rate)
Bonds that sells for more than face value is called a
Premium bond - sells at a premium
The value of bond depends on the
Present value of its coupons and the present value of the face value
The two major forms of long-term debt are
Public-issue and privately places
R =
R = D1 / Po+g
The dividend growth model calculates total return as:
R = Dividend yield + Capital gains yield R = D1/Po (dividend yield) + g (Capital gains yield)
Over-the-counter (OTC) Market
Securities market in which trading is almost exclusively done through dealers who buy and sell for their own inventories
Proxy fight
Shareholders that are not satisfied with management, an "outside" group of shareholders can try to obtain votes via proxy. They can vote proxy in an attempt to replace management by electing enough directors.
As time passes, interest rates change in the marketplace. The cash flows from a bond, however, .....
Stay the same
Preferred Stock
Stock with dividend priority over common stock, normally with a fixed dividend rate, sometimes without voting rights
Islamic bonds
Sukuk
Call premium
The amount by which the call price exceeds the par value of a bond
Payback Period
The amount of time required for an investment to generate cash flows sufficient to recover its initial costs
Coupon rate
The annual coupon divided by the face value of the bond
When the interest rates fall, .....
The bond is worth more
Interest rate risk premium
The compensation investors demand for being interest rate risk
Debtor or borrower
The corporation borrowing the money
Net Present Value (NPV)
The difference between an investment's market value and it's cost
Bid-ask spread
The difference between the bid price and the asked price. It represents the dealers profit
Internal Rate of Return (IRR)
The discount rate that makes the NPV of an investment zero.
Zero growth
The dividend on a share of preferred stock has zero growth and thus is constant through time. Because the dividend is always the same, he stock can be viewed as an ordinary perpetuity with a cash flow equal to D every period.
Order Flow
The flow of customer orders to buy and sell securities
Bearer form
The form of bond issue in which the bond is issued without record of the owner's name; payment is made to whomever holds the bond
Registered form
The form of bond issue in which the registrar of the company records ownership of each bond; payment is made directly to the owner
All other things being equal, the longer the time to maturity,
The greater the interest rate risk
All other things being equal, the lower the coupon rate,
The greater the interest rate risks
Inside Quotes
The highest bid quotes and the lowest ask quotes for a security
Differences between public-issue and privately placed debt is
The latter is directly placed with a lender and not offered to the public
Discounted payback period
The length of time required for an investment's discounted cash flows to equal its initial cost.
Primary Market
The market in which new securities are originally sold to investors
Secondary Market
The market in which perviously issued securities are traded among investors
For example
The maximum reward for owning a debt security is ultimately fixed by the amount of the loan, whereas there is no upper limit to the potential reward form owning an equity interest.
The difference between nominal and real rates is important and bears repeating:
The nominal rate on an investment is the percentage change in the number of dollars you have. The real rate on an investment is the percentage chance in how much you can buy with your dollars - in other words, the percentage change in your buying power.
Creditor or Lender
The person or firm making the loan
Liquidity premium
The portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity
Taxability Premium
The portion of a nominal interest rate or bond yield that represents compensation for unfavorable tax status
Inflation Premium
The portion of a nominal interest rate that represents compensation for expected future inflation
Multiple rates of return
The possibility that more than one discount rate will make the NPV an investment zero
Profitability Index (PI)
The present value of an investment's future cash flows divided by its initial cost. Also called the benefit-cost ratio.
When interest rates rise, .....
The present value of the bond's remaining cash flows decline, and the bond is worth less
Bid Price
The price a dealer is willing to pay for a security
Asked Price
The price a dealer is willing to take for a security
Dirty price ("full" or "invoice" price)
The price of a bond including incurred interest. This is the price the buyer actually pays
Clean price
The price of a bond net of accrued interest; this is the price that is typically quoted
Face Value or Par Value
The principal amount of bond that is repaid at the end of the term (lump sum) Par Value is usually a $1,000 for corporate bonds, and a bond that sells for its par value is called a "par value bond"
Discounted cash flow (DCF) valuation
The process of valuing an investment by discounting its future cash flows
Yield to Maturity (YTM)
The rate required in the market on a bond. Sometimes called "yield" for short.
Term structure of interest rates
The relationship between nominal interest rates on default-free, pure discount securities and time to maturity; that is, the pure time value of money. Basically tells us the pure time value of money for different lengths of time
Fisher Effect (after the great economist Irving Fisher)
The relationship between nominal returns, real returns, and inflation
Interest rate risk
The risk that arises for bond owners from fluctuating interest rates
Maturity
The specified date on which the principal amount of a bond is paid
Coupon
The stated interest payment made on a bond (annuity component) When the coupon is constant and paid every year, the type of bond is sometimes called "level coupon bond"
One reason that corporations try to create a debt security that is really equity is to obtain
The tax benefits of debt and the bankruptcy benefits of equity
The only difference between the term structure and yield curve is
The term structure is based on our discount bonds, whereas the yield curve is based on coupon bond yields
Interest rate risk sensitivity depends on two things:
The time to maturity and the coupon rate
Indenture
The written agreement between the corporation and the lender detailing the terms of the debt issue. Sometimes referred to as the deed of trust
When the government wishes to borrow money for more than one year, it sells what are known as
Treasury notes and bonds to the public (in fact, it does so every month). Currently, outstanding Treasury notes and bonds have original maturities ranging from 2 to 30 years
Bonds
When a corporation or government wishes to borrow money from the publib on a long-term basis, it usually does so by issuing or selling debt securities
Deferred call provision
a call provision prohibiting the company from redeeming a bond prior to a certain date
Similar to interest rate risk, interest rate risk premium increases at
a decreasing rate
Dividend Growth Rate
can get any stock price at any point in time, not just today.
To calculate present value of stock with dividends not zero and all different first few years (3), you need to
compute the present value of the stock price three years down the road and then add in the present value of the dividend that will be paid between now and then
Shareholders control the corporation through the right to elect the
directors
The most intriguing thing about munis is that their coupons are exempt from
federal income taxes (though not necessarily state income taxes)
The value of the stock is the present value of all the
future dividends
An asset with cash flows that grow at a constant rate forever is called a
growing perpetuity
If the constant growth rate exceeds the discount rate, then the stock price is
infinitely large
Usually a trustee (a bank, perhaps)
is appointed by the corporation to represent the bond holder
Crossover rate
is the discount rate that makes the NPVs of two projects equal
When short-term rates are higher, we say
it is downward sloping
Discount nominal cash flows at a
nominal rate
Financial rates, such as interest rates, discount rates, and rates of return, are almost always quoted in
nominal terms
Staggered elections
only a fraction of directorships (often one-third) are up for election at a particular time. Thus if only two directors are up for election at any time, it will take 1/(2+1)=33.33% of the stock plus one share to guarantee a seat.
A bond issued with a very low coupon rate (as opposed to a zero coupon rate) is an
original-issue discount (OID) bond
The term structure is "humped" when
rates increase at first, but then begin to decline as we look at longer- and longer-term rates
Discount real cash flows at a
real rate
State and local governments also borrow money by
selling notes and
State and local governments also borrow money by
selling notes and bonds
When long-term rates are higher than short-term rates, we say
that the term structure is upward sloping
Floating-rate bonds
the coupon payments are adjustable
Constant Growth
the dividend for some company always grows at a steady rate
Capital gains yield
the rate at which the value of the investment grows
Treasury bond yields depend on the three components that underline the term structure -
the real are, expected future inflation, and the interest rate risk premium
When you hear that long-term interest rates rose, what is really being said is that
the yield on this bond went up (and its price went down)
Some firms have more than one class of common stock. Often the classes are created with
unequal voting rights
The most common shape of the term structure, particularly in modern times, is
upward sloping; but the degree of steepness has varied quite a bit
Munis have
varying degrees of default risk and almost always are callable
