Financial Management Exam 3

inflation premium

compensation investors demand for loss of purchasing power

default risk premium (DRP)

possible failure to pay by issuer of the bond

maturity risk premium (MRP)

how long it will take for the bond to be repaid

liquidity premium

compensation for difficulty selling your investment (in secondary market)

indenture

legal contract specifying the rights and responsibilities of each party

par/face value

amount the issuer promises to pay back to bondholders

coupon rate

annual interest rate that a bond issuer pays to a bondholder; can be paid annually or semiannually

coupon rate types

fixed, variable, TIPS (Treasury Inflation-Protected Securities)

callable bond

right of issuer to pay back the principal before maturity (usually when interest rates drop or to change their capital structure/lower debt)

call premium

extra amount (previously agreed upon) that issuers pay if the bond is called back before maturity (typically 6 or 12 months of interest with the coupon rate)

Call Price

Par + Call Premium

call protection

bond issuers cannot call bonds before maturity during this time period

collateral

if the bond is secured

convertible bond

hybrid financial instrument that pays periodic interest like a standard corporate bond, but gives the holder the option to exchange it for a predetermined number of shares of the issuing company’s common stock

sinking fund

requires the issuing corporation or municipality to periodically set aside a pool of money into a dedicated fund managed by a trustee to gradually retire a portion of the debt before or upon maturity

zero-coupon bonds

bonds that do not pay interest during their life to maturity; par value repaid at maturity

zero-coupon bond advice

trade at below par (deep discount), save for a goal

zero-coupon bond drawbacks

very volatile in prices (no coupon to cushion losses)

no cash inflow (taxes every year)

rate of return for holding period

PV of purchase price

FV of current market price

n of time held

when interest rates increase

bond prices decrease (increasing yields)

perpetual bond

bonds with no maturity date; issuer never has to repay principal

preferred stock

guaranteed dividend (fixed percentage); no par value with preferred stock (it changes)

other corporate rate pieces

increases if callable

decreases if convertible

decreases if there is a sinking fund

decreases if collateralized

credit ratings

related to DRP

required for public issuance

determined by quantitative (D-to-E, TIE, etc.) and qualitative (management, etc.)

assumptions for constant growth model

company pays dividends

dividends and earnings grow at a constant rate (g)

floatation costs

expenses related to selling securities to the public (underwriter’s spread, legal fees, fees to investment banks)

when are there no floatation costs with common stock

if the company is reliant on retained earnings

assumptions

most investors DRIP (dividend reinvestment plan)

investors have diversified portfolios (because government mandates that each 401k must be invested in mutual funds, already diversified)

investors are not rational