Finance 301 - Exam 4

Bond

DEF: a security sold by governments and companies to raise money from investors in exchange for promised future payments

Bond Certificate

states the terms of the bond

Price (PV)

the cost of the bond today

Maturity Date

final repayment date

Term (N)

the time remaining until the repayment date

Coupon Payment (CF)

promised interest payments

Face Value or Par Value (FV)

notional amount used to compute the interest payments

Coupon Rate

determines the amount of each coupon payment, expressed as an APR

Yield to Maturity (YTM)

DEF: is the discount rate that sets the PV of the promised bond payments equal to the current market price of the bond

• the YTM is the annual interest rate that you would earn if you bought the bond and held it until it matured

  • is set by the market and influenced by market sentiment about rates

Debenture

a standard bond; typically unsecured

Subordinate (Junior Debt)

ranks lower than other debt the issuer may have

Callable

the issuer can repurchase debt before the maturity date

Retractable (Puttable)

the debt holder can demand repayment before the maturity date

Convertible

the debt can be converted into common stock instead of payment

Default Risk

• a bond is a promise to pay according to the terms laid out in the bond certificate

• if a company cannot pay its bondholders it is considered to be in default and the company could be forced to declare bankruptcy

Bond Ratings and Default Risk

• ratings reflect how likely to make a payment

• BBB (Baa) or better for investment grade = most likely to be paid

• High yield junk bonds are below investment grade - less likely to repay + have to offer a higher interest rate to convince people to buy your slightly more risky bonds

Bond Pricing

• the price of a bond is calculated by finding the PV of the future CF paid by the bond

• the YTM is the correct interest rate to use when calculating the price of a bond

Zero Coupon Bonds/Pure Discount Bonds

• does not make coupon payments

• always sells at a discount (a price lower than face value)

• 2 CF - initial cash outbound when you buy the bond and cash payment when the bond matures

• ex: treasury bills

What happens to a bond as it gets closer to maturity?

The price will increase. As a bond gets closer to maturity, its price will rise.

The closer to maturity date, the less opportunity you have to earn interest and the closer the bond price has to be to the par value.

What happens to a bond as rates changes?

Bond prices move in the opposite direction from interest rates. As rates increase, bond prices fall. As rates decrease, bond prices will rise.

Coupon Bonds

• make periodic interest payments over the life of the bond

• pay investors the face value at maturity

• is a type of interest only loan

Coupon Payments

• the periodic interest payment that a bond will pay

• is calculated from the coupon rate that is set as part of the terms of the bond

• coupon rate is determined by the risk of the company and prevailing market rates at the time that the bond is issued

Coupon Rate

the interest rate that determines the periodic interest payment associated with a bond

• DO NOT CONFUSE WITH THE YTM

  • which is the interest rate used when deterring the current price of a bond

Bond is Selling at a Discount to Par

• price of bond is less than face value

• YTM > coupon rate

Bond is Selling at a Premium to Par

• price of bond is higher than the face value

• YTM < coupon rate

Bond is Trading at Face Value

YTM = coupon rate

What happens as a coupon bond gets closer to maturity?

• number of coupon payments decreases, so the coupon portion of the bond will decrease in value over time

What happens to the price of a bond as time to maturity decreases?

The price of a bond will get closer to par as time to maturity decreases

• Premium bonds will decrease in price

• Discount bonds will increase in price

True or False: The longer a bond has to maturity, the more interest rate risk it has, the more volatility.

True

True or False: The higher the coupon rate, the less interest rate risk it has.

True

Stocks

a way to represent ownership of a company

Investors in Debt

• get a promise of repayment

• companies have to repay investors or risk bankruptcy

Investors in Equity

• receive ownership

• no guarantee of repayment

• the stock will increase in value when the company does well

• riskier than debt

Common Stock

• when you have shares of stock/the company

• public companies have annual shareholder meetings

• Shareholders will vote on board of directors

Preferred Stock

• stock issued by companies that appeals to investors due to its dividend payment

• have a higher claim n company assets in the event of bankruptcy

• usually does not have any voting rights associated with it

Secondary market

• where you buy shares of a publicly traded company

• investors buy shares from, and sell shares to, other investors

The Stock Market

• stocks are traded on exchanges

  • exchange is a place where buyers and sellers come together

  • NYSE and Nasdaq

Price of Stock

the cost to buy a single share of a company’s stock

Ticker

the 1-4 letter symbol that identifies the stock of a company

Market Cap

the price multiplied by all of the shares that a company has outstanding

Open and Close

the price of the stock at the start and end of the trading at respectively

9:30AM to 4PM

Volume

the number of shares that have been traded during the day

EPS (Earnings Per Share)

the Net Income of the company divided by the number of shares

Dividends

cash payments made to shareholders (usually quarterly)

Dividend Yield

• the current price divided by the annual dividend and is the return on investment that the investor expects from dividend payouts

Capital Gains Yield

• is the return that the investor expects from the profit when selling the stock

Total Return =

Dividend Yield + Capital Gains Yield

A firm could increase its dividend by

• increase its earnings (net income)

• increase its divided payout rate

Retention Rate

the percent of earnings that the firm will reinvest

What happens if return on new investment exceeds the equity cost of capital?

It will increase the FV of the firm and increase shareholder value

What happens if return on new investment is lower than the equity cost of capital?

Stock price will go down, and shareholders will lose value. essentially investing in negative net present value projects