Finance Exam 2

Disadvantages of Payback

-Ignores the time value of money -Requires an arbitrary cutoff point -Ignores cash flows beyond the cutoff date -Biased against long-term projects, such as research and development, and new projects

Advantages of Discounted Payback

-Includes time value of money -Easy to understand -Does not accept negative estimated NPV investments when all future cash flows are positive -Biased towards liquidity

Disadvantages of Discounted Payback

-May reject positive NPV investments -Requires an arbitrary cutoff point -Ignores cash flows beyond the cutoff point -Biased against long-term projects, such as R&D and new products

Which bonds will have the higher coupon, all else equal? 1) Secured debt versus a debenture

1) Debenture Debenture: secured debt is less risky because the income from the security is used to pay it off first

cumulative voting

A procedure in which a shareholder may cast all votes for one member of the board of directors.

sinking fund provisions

A provision that requires a bond issuer to set aside money at periodic intervals for the specific purpose of repaying a portion of its existing bonds each year

Long-term bonds have (more/less?) price risk than short-term bonds

MORE!

Low coupon rate bonds have (more/less?) price risk than high coupon rate bonds

MORE!

callable bond

May be called for early retirement at the option of the issuer.

Upward-Sloping Yield Curve Characteristics

Normal - upward-sloping; long-term yields are higher than short-term yields

Another common valuation approach is to multiply a benchmark ____ by earnings per share (EPS) to come up with a stock price. The benchmark _____ is often an industry average or based on a company's own historical values. The price-sales ratio can also be used

PE ratio;PE ratio

_____- first shot at new stock issue to maintain proportional ownership if desired

Preemptive right

Change in price due to changes in interest rates

Price Risk or Interest Rate Risk

bondholder can force the company to buy the bond back prior to maturity Lower required return

Put bond

What is the most important alternative to NPV?

Internal Rate of Return

Downward-Sloping Yield Curve Characterisitcs

Inverted - downward-sloping; long-term yields are lower than short-term yields

Disaster bond

issued by property and casualty companies. Pay interest and principal as usual unless claims reach a certain threshold for a single disaster. At that point, bondholders may lose all remaining payments Higher required return

Payback Period Decision Rule: Accept if the payback period is ____ than some preset limit

less

long-term bonds have (more/less?) reinvestment rate risk than short-term bonds

less

Zero Growth Stocks: If dividends are expected at regular intervals forever, then this is a ____ and the present value of expected future dividends can be found using the perpetuity formula

perpetuity

NPV Decision Rule: A ____ NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.

positive

What is the dirty price?

price actually paid = quoted price plus accrued interest

A bond with a provision that allows its investors to sell it back to the company prior to maturity at a prearranged price.

putable bond

Clean price is the what?

quoted price

Nominal rate of interest

quoted rate of interest, change in actual number of dollars

The Fisher Effect defines

the relationship between real rates, nominal rates, and inflation

Income bonds

coupon payments depend on level of corporate income. If earnings are not enough to cover the interest payment, it is not owed. Higher required return

The annual coupon divided by the face value of a bond

coupon rate

What are the distributions of either cash or stock to shareholders by a corporation called? a. Coupon payments. b. Capital payments. c. Retained earnings. d. Dividends. e. Diluted profits.

d. Dividends.

The bond market requires a return of 9.8 percent on the five-year bonds issued by JW Industries. The 9.8 percent is referred to as which one of the following? a. Call rate. b. Coupon rate. c. Face rate. d. Yield to maturity. e. Current yield.

d. Yield to maturity.

Advantages of Payback

-Easy to understand -Adjusts for uncertainty of later cash flows -Biased toward liquidity

If YTM < coupon rate, then

par value < bond price Why? Higher coupon rate causes value above par Price above par value, called a premium bond

If YTM = coupon rate, then

par value = bond price

If YTM > coupon rate, then

par value > bond price Why? The discount provides yield above coupon rate Price below par value, called a discount bond

T/F The ask price is always bigger than the bid price.

True

A bond that is not registered in the investor's name.

Bearer Bond Domestically issued bearer bonds will become obsolete in the near future. Since bearer bonds are not registered with the corporation, it is easier for bondholders to receive interest payments without reporting them on their income tax returns. In an attempt to eliminate this potential for tax evasion, all bonds issued in the US after July 1983 must be in registered form. It is still legal to offer bearer bonds in some other nations, however. Some foreign bonds are popular among international investors particularly due to their bearer status.

Certificate issued by a government or company promising to pay back a borrowed sum with interest.

Bond

Which bonds will have the higher coupon, all else equal? 3) A bond with a sinking fund versus one without

Bond without sinking fund: company has to come up with substantial cash at maturity to retire debt, and this is riskier than systematic retirement of debt through time

Treasury securities

Bonds issued by the United States Treasury to investors when the federal government borrows money. (Treasury bills have maturity of one year or less. Treasury notes have maturity of one to ten years. Treasury bonds have maturity of more than 10 years.)

Which bonds will have the higher coupon, all else equal? 4) A callable bond versus a non-callable bond

Callable - bondholders bear the risk of the bond being called early, usually when rates are lower. They don't receive all of the expected coupons and they have to reinvest at lower rates.

Security bonds

Collateral: secured by financial securities. Mortgage: secured by real property (land/buildings). Debentures: unsecured. Notes: unsecured debt with original maturity less than 10 yrs.

Which type of dividend? Dividends are expected to grow at a constant percent per period.

Constant dividend growth

bonds can be converted into shares of common stock at the bondholders discretion Lower required return

Convertible bonds

The stated interest payment made on a bond.

Coupon

Which of the following bonds has the most price risk? A. 7-year bonds with a 5% coupon B. 1-year bonds with a 12% coupon C. 3-year bonds with a 5% coupon D. 15-year zero coupon bonds E. 15-year bonds with a 10% coupon

D. 15-year zero coupon bonds

Debt or Equity? -Not an ownership interest -Creditors do not have voting rights -Interest is considered a cost of doing business and is tax deductible -Creditors have legal recourse if interest or principal payments are missed -Excess debt can lead to financial distress and bankruptcy-

Debt

Municipal securities

Debt of state and local governments Varying degrees of default risk, rated similar to corporate debt Interest received is tax-exempt at the federal level

Debt or Equity? -Ownership interest -Common stockholders vote for the board of directors and other issues -Dividends are not considered a cost of doing business and are not tax deductible -Dividends are not a liability of the firm, and stockholders have no legal recourse if dividends are not paid -An all equity firm can not go bankrupt merely due to debt since it has no debt

Equity

The principal amount of a bond that is repaid at the end of the term.

Face value (par value)

Uncertainty concerning rates at which cash flows can be reinvested

Reinvestment Rate Risk

_____ does not permit the charging or paying of interest

Shariah

Which bonds will have the higher coupon, all else equal? 2) Subordinated debenture versus senior debt

Subordinated debenture Subordinated debenture: will be paid after the senior debt

____ are typically bought and held to maturity, and are extremely illiquid

Sukuk

____are bonds which have been created to meet a demand for assets that comply with Shariah, or Islamic law

Sukuk

____ is the relationship between time to maturity and yields, all else equal

Term structure

Contract between the company and the bondholders that includes The basic terms of the bonds The total amount of bonds issued A description of property used as security, if applicable Sinking fund provisions Call provisions Details of protective covenants

The Bond Indenture

Real rate of interest

The nominal rate of interest minus the anticipated rate of inflation. change in purchasing power

_____ is the graphical representation of the term structure

Yield curve

The rate required in the market on a bond.

Yield to Maturity (YTM)

straight voting

a procedure in which a shareholder may cast all votes for each member of the board of directors

Jason's Paints just issued 20-year, 7.25 percent, unsecured bonds at par. These bonds fit the definition of which one of the following terms? a. Callable. b. Note. c. Debenture. d. Zero-coupon. e. Discounted.

c. Debenture.

Which one of the following premiums is compensation for the possibility that a bond issuer may not pay a bond's interest or principal payments as expected? a. Default risk. b. Interest rate risk. c. Taxability. d. Liquidity. e. Inflation.

a. Default risk.

Rosita paid a total of $1,189 to purchase a bond that has 7 of its initial 20 years left until maturity. This price is referred to as the: a. Dirty price. b. Quoted price. c. Call price. d. Clean price. e. Spread price.

a. Dirty price.

A sinking fund is managed by a trustee for which one of the following purposes? a. Early bond redemption. b. Paying bond interest payments. c. Converting bonds into equity securities. d. Paying preferred dividends. e. Reducing bond coupon rates.

a. Early bond redemption.

You cannot attend the shareholder's meeting for Alpha United so you authorize another shareholder to vote on your behalf. What is the granting of this authority called? a. Voting by proxy. b. Cumulative voting. c. Indenture voting. d. Straight voting. e. Alternative voting.

a. Voting by proxy.

debenture

an unsecured debt, usually with a maturity of 10 years or more

While the ____ price is the lowest price a prospective seller is willing to accept, the ____ price is the highest price that a prospective buyer is willing to pay for the security.

ask; bid

All else constant, a bond will sell at _____ when the coupon rate is _____ the yield to maturity. a. a discount; higher than b. a discount; less than c. a premium; equal to d. a premium; less than e. par; less than

b. a discount; less than

The difference between the bid and ask prices is called the _____and it is how the dealer makes money.

bid-ask spread

Floating-Rate Bonds

bonds with coupon rates periodically reset according to a specified market rate

A $1,000 face value bond can be redeemed early at the issuer's discretion for $1,030, plus any accrued interest. The additional $30 is called the: a. Redemption discount. b. Original-issue discount. c. Call premium. d. Redemption value. e. Dirty price.

c. Call premium.

As interest rates increase, present values ______

decrease

Which one of the following is the price at which a dealer will sell a bond? a. Bid-ask spread b. Bid price c. Par value d. Call price e. Asked price

e. Asked price

A bond has a market price that exceeds its face value. Which one of these features currently applies to this bond? a. Yield to maturity equal to the current yield. b. Currently selling at par. c. Current yield greater than coupon rate. d. Discount bond. e. Yield to maturity less than the coupon rate.

e. Yield to maturity less than the coupon rate.

The unsecured bond has a higher or lower YTM?

higher

Seniority bond

holders of subordinated or junior bonds don't get priority until seniority creditors are taken care of.

Proxy voting

if you are not present, you give your vote to the chairman and your vote is their vote

The number of years until the face value is paid is called the bond's time to ____

maturity

High coupon rate bonds have (more/less?) reinvestment rate risk than low coupon rate bonds

more

The ex ante nominal rate of interest includes

our desired real rate of return plus an adjustment for expected inflation

Discounted Payback Period Decision Rule: Accept the project if it pays back on a discounted basis within the specified ____

time