Finance exam 2 (chapters 7,8,9,10)
stand alone principle
Once we identify the effect of undertaking the proposed project on the firm's cash flows, we need focus only on the project's resulting incremental cash flows
a corporate bonds yield to maturity
changes over time and can be greater, equal to or less than the bonds coupon rate
straight voting
directors are elected one at a time
rate at which a stocks price is expected to appreciate
capital gains yield
maturity
number of years until the face value is paid
side effect of cash flows
A negative impact on the cash flows of an existing product from the introduction of a new product is called erosion - pay attention to after tax cash flows bc taxes are an outflow
debt vs equity
Debt is not an ownership interest in the firm, creditors generally do not have voting power corporation's payment of interest on debt is considered a cost of doing business and is tax deductible, dividends paid to stockholders are not tax deductible. one of the costs of issuing debt is the possibility of financial failure, this possibility does not arise when equity is issued.
IRR and NPVC
IRR and NPV rules always lead to identical decisions. as long as: - cash flows are conventional, meaning that the first cash flow (the initial investment) is negative and all the rest are positive - must be independent, meaning that the decision to accept or reject this project does not affect the decision to accept or reject any other
mutually exclusive investment decisions
If two investments, X and Y, are mutually exclusive, then taking one of them means that we cannot take the other. Two projects that are not mutually exclusive are said to be independent
face/par value
The amount that will be repaid at the end of the loan
current yield
a bond's annual coupon divided by its price
sunk cost
a cost we have already paid or have already incurred the liability to pay. Such a cost cannot be changed by the decision today to accept or reject a project - must exclude bc irrelevant
average accounting return rule
a project is acceptable if its average accounting return exceeds a target average accounting return
advantages & disadvantages of IRR
advantages: closely related to NPV which often leads to identical decisions and its easily understood & communicated disadvantages: may result in multiple answers and may lead to incorrect decisions in comparisons of mutually exclusive investments
call provision
allows the company to repurchase part or all of the bond issue at stated prices over a specific period -Corporate bonds are usually callable
payback rule
an investment is acceptable if its calculated payback period is less than some prespecified number of years.
Internal rate of return (IRR)
an investment is acceptable if the IRR exceeds the required return. It should be rejected otherwise. - required return that results in a zero NPV when it is used as the discount rate - sometimes called discounted cash flow
coupon rate
annual coupon divided by face value
when an investor sells a bond, the price received by a dealer is always the
bid price
a market is considered transparent if
its prices and trading volume are easily observed - stock market is more transparent
a zero coupon bond is a bond that
makes no interest payments
bonds time to maturity
number of years until the face value is due to be repaid
staggered elections
only a fraction of directors are up for election at a particular time - makes it more difficult for a minority to elect a director because there are fewer directors to be elected at one time - makes takeover attempts less likely to be successful because it makes it more difficult to vote in a majority of new directors
bond values and yields
over time, interest rates in the market change cash flows stay the same, causes the value of the bond to fluctuate -When interest rates rise: the present value of the bond's remaining cash flows declines, and the bond is worth less. - When interest rates fall: the bond is worth more
protective covenant
part of loan agreement that limits certain actions a company might wish to take during a loans term - negative: limits or prohibits actions - positive: specifies actions that the company must abide by
what is a corporate bonds YTM
prevailing market interest rate of bonds with similar features, expected return for an investor who buys the bond today and holds until maturity
capital gains yield
rate at which value of the investment grows
PE ratio
ratio of a stock's price per share to its earnings per share (EPS) over the previous year. - idea here is to have some sort of benchmark, which we then multiply by earnings to come up with a price
how to avoid the problem of having to forecast and discount an infinite number of dividends
require that the dividends start growing at a constant rate sometime in the future
opportunity cost
requires us to give up a benefit - out of pocket costs
profitability index
the present value of the future cash flows divided by the initial investment
The bond market requires a return of 9.8 percent on the 5-year bonds issued by JW Industries. The 9.8 percent is referred to as the
yield to maturity
what is a bond called that has a market price that exceeds par value
yield to maturity < coupon rate
how is a zero coupon bond different from a conventional bond
zero coupon bonds are always issued at a discount and make no interest payments
bid price and ask price
bid: represents what a dealer is willing to pay for a security ask: what a dealer is willing to take for it
secondary markets in sukuk are extremely liquid because most sukuk are
bought and held to maturity
dealer vs broker
dealer maintains an inventory and stands ready to buy and sell at any time broker brings buyers and sellers together but does not maintain an inventory
bonds
debt securities issued or sold to the public to borrow on a long term basis from either a corporation or the government - normally 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
bond and debt ratings
debt: assessment of the creditworthiness of the corporate issuer, how likely a firm is to default & the protection creditors have in the event of a default bond: only deal with the possibility of default, constructed from info supplied by the corporation
3 important features of treasury bonds & notes
default-free, taxable, and highly liquid.
proxy
grant of authority by a shareholder to someone else to vote his or her shares
incremental cash flows
incremental cash flows for project evaluation consist of any and all changes in the firm's future cash flows that are a direct consequence of taking the project
DLQ Inc. bonds mature in 12 years and have a coupon rate of 6 percent. If the market rate of interest increases, then the
market price of the bond will decrease
net present value
measure of how much value is created or added today by undertaking an investment -should be accepted if positive, rejected if negative - preferred approach
3 reasons a common stock is more difficult to value than a bond (& special circumstances)
In common stock the promised cash flows are known in advance. The life of the investment is essentially forever because common stock has no maturity. There is no way to easily observe the rate of return that the market requires. - special circumstances: dividend has a zero growth rate, grows at a constant rate, and grows at a constant rate after some length of time
stock market: primary & secondary
In the primary, or new issue, market, shares of stock are first brought to the market and sold to investors. In the secondary market, existing shares are traded among investors
why does a bonds value fluctuate over time?
The coupon rate and par value are fixed, while market interest rates change.
The annual dividend yield is computed by dividing ________ annual dividend by the current stock price.
next years
nominal rate of return vs real rate of return on an investment
nominal is the rate that has not been adjusted for inflation real has been adjusted for inflation
three special case patterns of dividend growth include
non constant growth, constant growth and zero growth
Why is it more difficult to value common stock than it is to value bonds?
the life of a common stock is essentially forever, the rate of return required by the market is not easily observed and common stock cash flows are not known in advance
coupons
the regular interest payments that are promised to be paid on a bond
indenture
the written agreement between the corporation (borrower) and its creditor - includes: the basic terms of the bonds, total amount of bonds issued, description of property used as security, repayment arrangements, call provisions and details of the protective covenants
cumulative voting
total number of votes that each shareholder may cast is determined first. This is usually calculated as the number of shares (owned or controlled) multiplied by the number of directors to be elected