Business Finance test 2

·      Comparing Rates: The effect of compounding periods

o   Semiannually: 10% compounded will have the investment pay 5% every 6 months. This will be more than 10%

o   Stated, quoted interest rate: 10%

o   Effective annual rate (EAR): 10.25 (from the double compounding)

APR (Annual Percentage Rate

·      equal to the interest rate per period multiplied by the number of periods in a year

o   Payday loans: short-term loans made to consumers usually 2-4 weeks

Annuity

finite series of equal payments that occur at regular intervals

ordinary annuity

If the first payment occurs at the end of the period:

annuity due

If the first payment occurs at the beginning of the period

o   Example: 200k you give to a company for payments of 5k over fixed period of time

§  Why:

·      Income

·      Protect initial investment

·      Predictable growth

·      Potential tax-deferred growth

Perpetuity

 finite series of equal payments

o   Interest rate and time period must match

§  Annual periods – annual rate

§  Monthly periods – monthly rate

Cash inflows

 positive

Cash outflows

negative

o   Effective annual rates (EAR)}

§  Interest rate expressed as if it were compounded once per year

§  Used to compare two alternative investments with different compounding periods

o   Annual percentage rate (APR) “nominal”

§  Annual rate quoted by law

§  APR = Periodic rate * Number of periods per year

§  Periodic rate = APR/Periods per year

·      Amortized loan with fixed payment:

o   Interested paid: beginning balance * rate

o   Principle paid total payment – Interest paid

o   Ending balance: beginning balance – principal paid

·      Bond

o   Debt contract vs stock = equity

o   Interest-only loans

§  Par value (face value) is about 1,000

·      Coupon rate

·      Coupon payment

·      Maturity date

·      yield to maturity (interest)

o   Coupon Interest Rate

§  Stated Interest rate

§  Usually (Yield to maturity) at issue

§  Multiply by par value to get the coupon payment

o   Maturity

§  Years until bond must be repaid

o   Yield to maturity (YTM)

§  The market required rate of return for bonds of similar risk and maturity

§  The discount rate used to value a bond

§  Reurun if bond held to maturity

§  Return if bond held to maturity

Usually equals the coupon

·      Bond value

§  As interest rates increase, present value decreases

§  As interest rates increase, bond prices decrease and vice versa

Example: ·     

Bond annual payment is 50, no matter its value, so if the rate increases 3% or drops 1% it still needs to equal 50 in yearly payments

·      Bond must always pay same annual payments

Bond Prices

Relationship between coupon and Yield

§  Discount bond

§  Selling at a discount to par value

§  Premium bond

Selling at a increase to par value

·      Interest Rate Risk: o   Price Risk

§  Change in price due to a change in interest rates

§  Long-term bonds have more price risk than short-term bonds

§  Low coupon rate bonds have more price risk than high coupon rate bonds

o   Reinvestment Rate Risk

§  Uncertainty concerning the rates at which cash flows can be reinvested

§  Short-term bonds have more reinvestment rate risk than long-term bonds

§  High coupon rate bonds have more reinvestment rate risk than low coupon rate bonds

·      As interest rate increases, value of the bond decreases

·      Computing Yield to Maturity

o   Market required rate of returned implied by the current bond price

o   Debt

§  Not an ownership interest, no voting rights, interest tax is deductible, creditors have legal recourse if payments are missed, Excess debt can lead to financial bankruptcy

o   Equity

§  Ownership interest, common stockholders vote to elect the board of directors on other issues, dividends are not tax deductible, dividends are not a liability of the firm until declared, stockholders have no legal recourse if dividends not declared

 

·      The bond indenture “deed of trust”

o   An indenture is a contract between the issuing company and bondholders that includes

o   An indenture is a contract between the issuing company and bondholders that includes

§  Basic terms of the bonds

§  Total amount of bonds issued

§  Secured bonds (collateral pledged)

§  Unsecured bonds (debentured – no collateral pledged)

§  Sinking fund provisions – account managed by the bond trustee for early bond redemption

§  Call provisions – details terms for bond redemption

Deferred call:

company is prohibited from early bond redemption

Call premium:

amount call price exceeds par value

§  Protective covenants

·      Limits the actions the company can take on during the term of the bond

·      Bond classification

o   Registered: registered name and payments made to the owners on record (Like a check)

Bearer Bond:

no name registered, payment made to the holder of the bond (like cash)

·      Bond security

o   Collateral – secured by financial securities

o   Mortgage – secured by real property, normally land or buildings

o   Debentured – unsecured

o   Notes – unsecured debt with original maturity less than 10 years

·      Seniority

o   Senior versus junior

o   Sequence of how paid off senior, junior, subordinated

o   High grades

§  Moody’s Aaa and S&P AAA: Capacity to pay is very strong

§  Mood’s Az and S&P AA: capacity is pay is strong

·      No preference

o   Medium grade

§  Moody’s A and S&Ps A: capacity to pay is strong but more susceptible to change and circumstances

§  Moodys Baa and S&Ps BBB: capacity to pay is adequate, adverse conditions will have more impact on firm’s ability to pay

·      Higher interest rate

o   Low grade

§  Moody’s Ba, B, Caa, and Ca

§  S&P: BB, B, CCC, CC

·      Considered speculative with respect to capacity. B is the lowest degree of speculation

o   Very low grade

§  Moody’s C and S&P C: income bond with no interest being paid

§  Moody’s D and S&P D: default with principal and interest in arrears

·      Part of the financial crisis, packaged as AAA

§  HIGH Yield = “Junk”

o   Municipal securities

§  Debt of state/local governments

§  Varying degrees of default risk, rated similar to corporate debt

§  Interest received is tax-exempt at the federal level

§  Interest is usually exempt from state tax in the issuing state

§  Recall: must compare on a like tax basis on taxable bonds

·      You will pay capital gains tax though

o   Treasury securities: federal government debt

§  T-Bills

·      Pure discount bonds

·      Original maturity of one year or less

§  Treasury notes

·      Coupon debt

·      Original maturity between one and 10 years

§  Treasury bonds

·      Coupon debt

·      Original maturity greater than 10 years

·      Example

o   The taxable bond yield of 8% and the municipal bond has a yield of 6%

o   If you are in a 40% tax bracket, which bond do you pick

o   8(1-.4) = 4.8%

§  The after-tax return on a corporate bond is 4.8%, compared to a 6% return on the municipal.

o   At what tax rate would you be indifferent?

§  8%(1-t) = 6%

·      T = 25%

·      Zero-coupon bonds

o   Make no periodic interest payments (coupon rate = 0)

o   The entire YTM comes from the difference between the purchase price and the Par value

o   Cannot sell for more than the par value

o   Sometimes called zeroes, or deep discount bonds

§  Treasury bills and U.S. savings bonds are good examples

·      Floating rate bonds

o   Coupon rate floats depending on some index value

§  Adjustable-rate mortgages and inflation-linked treasuries

·      Less price risk with floating rate bonds

o   Coupon floats so is less likely to differ substantially from YTM

o   Coupons may have a “collar: the rate cannot go above a specific ceiling or below a specific floor

Quoted bond prices =

o   “clean” price

§  Net of accrued interest

§  Quoted price

Invoice price

“dirty” or “full” price

§  Price actually paid

§  Includes accrued interest

o   Accured interest

§  Interest earned since the last coupon payment is owed to the bond seller at the time of sale

Real rate of interest:

Interest rates adjusted for inflation

Nominal rates of interest:

 interest rates that have no been adjusted for inflation

·      The Fisher Effect

o   The Fisher effect defines the relationship between real rates, nominal rates, and inflation

·      The Yield Curve

o   Graphical representation of the term structure

§  Normal = upward-sloping

§  Inverted = downward sloping

o   Term structure of interest rates = the relationship between short and long-term interest rates

Cumulative voting:

cast all votes for 1 member of the board

Straight board:

cast all votes for each member of the board

·      Staggered re-election dates

o   Harder for total board replacement

o   Perseveres institutional memory

Proxy voting:

allows someone else to vote for you

o   Classes of stock vary, with different influences on voting

§  Founders’ shares

§  Class A and Class B

·      Preemptive right

o   Right of first refusal to buy new stock issued to maintain proportional ownership if desired

·      Dividend Characteristics

o   Not a liability of the firm until declared by the board of directors

§  A firm cannot go bankrupt for not declaring dividends

o   Dividends and Taxes

§  Dividends are not tax deductible for the firm, paid out of after-tax profit

§  Taxes as ordinary income if non-qualified

§  Taxes as capital gains if qualified

·      Features of Preferred Stock

o   Dividends are usually fixed

o   Stated fixed “par value” or liquidation value

o   Must be paid before dividends can be paid to common stockholders

o   Not a liability of the firm

o   Can be deferred indefinitely; does this create an incentive to defer dividends?

o   Most preferred dividends are cumulative

§  Missed preferred dividends have to be paid before common dividends can be paid

§  Dividends not paid in a particular year are carried forward in arrears

o   Preferred stock generally does not carry voting rights

Primary Market

new issue market – IPO (initial public offering)

Secondary Market

Existing shares traded among investors: think stocks sold on the NYSE or NASDAQ

Dealer:

·      Maintains an inventory (Like a car dealer)

o   Ready to buy or sell at any time

An individual financial service company that trades

Broker:

§  brings buyers and sellers together

·      An individual/financial services company that trades securities for others

·      Real estate broker

·      NYSE (New York Stock Exchange)

o   Members that make the market function

§  Buy a trading license (own a seat)

§  Designated market makers, DMMs (dealers)

§  Floor Brokers – in the “pit”

§  Supplemental liquidity providers (SLPs)

·      Make a one-sided market (buy or sell)

·      Trade for own account

·      Create high-frequency automated/algorithmic trading

o   NYSE operations

§  Operational goal: attract order flow

·      It is the flow of customers’ orders to buy and sell securities

§  Payment for order flow: Payment received by a broker for routing trades to a particular DMM

·      Issues? Robinhood?

§  NNYSE DMMs = Dealers

§  Assigned broker/dealer

o   Trading takes place between customer orders placed with the DMMs and “the crowd.”

§  Crowd: floor brokers and SLPs

·      NASDAQ

o   Computer-based quotation system

o   Multiple Market makers

o   Electronic Communication Networks

o   Three levels of information

§  Level 1: median quotes, registered representatives

§  Level 2: View quotes, brokers, and dealers

§  Level 3: view and update quotes, dealers only

o   A large portion of technology stocks

·      Cash flows for stockholders

o   If you own a share of stock, you can receive cash:

§  The company pays dividends

§  You sell your shares, either to another investor in the market or back to the company

o   As with bonds, the price of the stock is the present value of these expected cash flows

§  Dividends -> cash income

§  Sell in the open market or let go until maturity

·      Developing the Model

o   You can continue to push back when you would sell the stock

o   You would find that the price of the stock is really just the present value of all expected future dividends

o   Surprised?

o   Why is the price the same no matter the timeframe in which you sell

·      Estimating Dividends Special Cases

o   Constant dividends/zero growth

o   Like a preferred stock

o   Price is computed using the perpetuity formula

·      Constant dividend growth

o   The firm will increase the dividend by a constant precent every period

·      Zero growth

o   Dividends expected at regular intervals forever = perpetuity

o   P0 =D/R

o   Suppose a stock is expected to pay a .50 dividend every quarter and the required return is 10% with quartile compounding, what is the price

§  P0 = 0.50/(.10/4) = 20

·      Constant growth model conditions

o   Dividends expected to grow at g forever

o   Stock price expected to grow at G forever

o   Expected dividend yield is constant

o   Expected capital gains yield is constant and equal to G

o   Expected total return, R, must be >G

o   Expected total return (R)

·      Constant growth stock

o   D1 = D0(1+G)^1

o   D2 = D0(1+G)^2

o   Dt = D0(1+G)^t

§  D0 = dividends just paid

§  D1 to Dt = Expected dividends

§  G = growth rate

·      Stock price sensitivity to dividend growth G

o   As the Growth rate increases, the stock price will increase as well

§  As G gets greater, you get a smaller detonator

·      Stock price sensitivity to required Return, R

o   As R (required return) gets larger the stock price will decrease

·      Constant growth model conditions

o   Dividends expected to grow at g forever

o   Stock price expected to grow at g forever

o   Expected dividend yield is constant

o   Expected capital gains yield is constant and equal to g

o   Expected total return, R, must be > g

o   Expected total return (R)

·      Valuation using multiples

o   For stocks that don’t pay dividends or have erratic dividend growth rates, we can value them using the price to earnings (PE) ratio and/or he price-sales ratio:

§  Price at time t=p(t)

·      =benchmark PE ratio * Earning per share(t)

§  Price at time t=p(t)

·      = benchmark price-sales ratio * sales per share(t)

§  Benchmark

·      Industry comparable

·      Similar companies