Finance 409 Quiz 3

Bond

A long-term debt security where investors lend money to a firm in exchange for interest payments and repayment of face value at maturity

Par Value

The face value of a bond, usually $1,000, repaid at maturity

Coupon Rate

Stated annual interest rate on a bond used to calculate coupon payments

Coupon Payment

Annual interest payment = Coupon Rate × Par Value

Yield to Maturity (YTM)

The total return earned if a bond is held to maturity; also the market interest rate

Bond Price Formula

PV of coupon payments + PV of face value

Bond Price Keywords

“bond price”, “market value”, “selling for”, “currently worth”

Premium Bond

Coupon rate > YTM → price above par

Discount Bond

Coupon rate < YTM → price below par

Par Bond

Coupon rate = YTM → price equals $1,000

Interest Rate Risk

Risk that bond prices change when interest rates change

Highest Interest Rate Risk

Long maturity + low coupon bonds

Semiannual Bond Adjustment

Divide coupon and YTM by 2 and multiply years by 2

YTM Approximation

Used to estimate bond yield when price is given

YTM Keywords

“yield to maturity”, “return on bond”, “bond yield”

Preferred Stock

Stock with fixed dividends and priority over common stock, no maturity date

Dividend

Payment made to shareholders from company earnings

Dividend Keywords

“dividend paid”, “payout”, “shareholder payment”

Required Rate of Return

Minimum return investors require for investing in a stock

Growth Rate (g)

Constant rate at which dividends grow over time

Gordon Growth Model

Stock valuation model for constant dividend growth

Gordon Growth Formula

P0 = D1 / (rs − g)

D0

Dividend just paid (historical dividend)

D1

Dividend expected next year

Convert D0 to D1

D1 = D0(1 + g)

Stock Required Return Formula

rs = (D1 / P0) + g

Dividend Yield

D1 / P0 (income return from dividends)

Capital Gains Yield

g (price appreciation rate)

Preferred Stock Formula

P0 = D / rp

Preferred Stock Keywords

“fixed dividend”, “no growth”, “preferred stock”

Gordon Growth Keywords

“constant growth”, “grows forever”, “stable dividend growth”

Stock Valuation Keywords

“price of stock”, “value of share”, “worth today”

NPV

Measures value added by a project in today’s dollars

NPV Formula

PV of cash inflows − initial investment

NPV Decision Rule

Accept if NPV ≥ 0

NPV Keywords

“should we accept”, “project evaluation”, “value added”

Cash Flow (CFt)

Cash received in time period t

Initial Investment (CF0)

Upfront project cost (negative cash flow)

Discount Rate (r)

Cost of capital used to discount future cash flows

IRR

Discount rate that makes NPV = 0

IRR Decision Rule

Accept if IRR ≥ required return

IRR Keywords

“internal rate of return”, “project return”

Payback Period

Time required to recover initial investment

Payback Keywords

“how long to recover”, “break even time”, “return investment quickly”

Payback Weakness

Ignores time value of money and cash flows after payback

Expected Return

Probability-weighted average of possible returns

Expected Return Formula

Σ(Pi × Ri)

Expected Return Keywords

“probability”, “recession/boom”, “uncertain outcomes”

Mutually Exclusive Projects

Choosing one project prevents choosing another

Independent Projects

Projects that do not affect each other

Unsystematic Risk

Company-specific risk that can be diversified away

Diversification

Reduces unsystematic risk by combining multiple assets

Correlation (ρ)

Measures how two assets move together (-1 to +1)

Portfolio Return

Weighted average return of all assets in a portfolio

Portfolio Return Formula

Σ(wi × Ri)

Portfolio Beta

Weighted average beta of portfolio assets

Portfolio Beta Formula

Σ(wi × βi)

Beta

Measure of a stock’s sensitivity to market movements

Beta > 1

More volatile than market

Beta < 1

Less volatile than market

CAPM

Model used to calculate required return based on risk

CAPM Formula

Ri = Rf + β(Rm − Rf)

Risk-Free Rate

Return on safe asset (Treasury bonds)

Market Risk Premium

(Rm − Rf), extra return for investing in stocks

CAPM Keywords

“required return”, “cost of equity”, “risk-adjusted return”

Security Market Line (SML)

Graph showing relationship between beta and required return

Undervalued Stock

Expected return > required return (above SML)

Overvalued Stock

Expected return < required return (below SML)

Fairly Valued Stock

Expected return = required return (on SML)

EMH

Theory that prices fully reflect available information

Weak Form EMH

Past prices already reflected → technical analysis useless

Semistrong EMH

Public info reflected → fundamental analysis useless

Strong Form EMH

All info (public + private) reflected → even insiders cannot win

Standard Deviation

Measures total risk/volatility of returns

Standard Deviation Formula

√[Σ(Rt − R̄)² / (N − 1)]

Risk Keywords

“volatility”, “risk”, “variation in returns”

WACC Formula

(wd rd (1 − T)) + (wp rp) + (we re)

Debt Weight

wd = D / V

Equity Weight

we = E / V

Preferred Weight

wp = P / V

Total Value

V = D + P + E

Cost of Equity

CAPM or Gordon Growth model

Cost of Debt

YTM on bonds

Cost of Preferred

D / P

Tax Shield

Only applies to debt: rd(1 − T)

WACC Keywords

“discount rate for project”, “firm cost of capital”, “weighted average cost”