Financial Management Chapter 5 and 6 - Discounted Cash Flow Valuation and Interest Rates & Bond Valuation

Annuity

A level stream of cash flows for a fixed period

of time

Annuities have a finite series of ____ payments that occur at ____ intervals

Equal, Regular

Ordinary Annuity

Cash flows occur at the END of each period

Annuity Due

Cash flows occur at the BEGINNING of each period

Annuity Due Formula

PV or FV of ordinary annuity * (1 + r)

Which annuity has a higher present value? (Ordinary or Due)

Annuity Due

Increasing the payment amount would ____ the present value of an Annuity

Increase

Increasing the number of time periods would ____ the present value of an Annuity

Increase

Increasing the discount rate would ____ the present value of an Annuity

Decrease

Decreasing the annuity amount would ____ the present value of an Annuity

Decrease

Which type of annuity is more common?

Ordinary Annuities

Perpetuity

Annuities where cash flows continue forever

Examples of Perpetuities

Common stock, College endowment

Why does a perpetuity have finite present value?

Each payment gets more heavily discounted over time

Compounding Period

Tells how often interest is added to an investment

More frequent compounding leads to a ____ final value

Higher

Annual Percentage Rate (APR)

The stated or quoted rate

Calculating APR Formula

Periodic Rate * # Of periods per year

Periodic Rate Formula

APR / Periods per year

Effective Annual Rate (EAR)

The interest rate expressed as if it were compounded once per year

Which rate is used to compare different investments?

Effective Annual Rate (EAR)

Pure Discount Loan

The borrower receives money today and repays a single lump sum at some time in the future

Interest Only Loan

The borrower pays interest each period and repays the entire principal at some point in the future

Amortized Loan

The borrower makes regular interest payments plus regular reductions in the principal

Capital Structure

The way a company finances its assets through debt and equity

Leverage Ratios

Represent the proportion of a firm's capital that is obtained through debt

Total Debt Ratio

Debt/Assets

Debt to Equity Ratio

Debt/Equity

Equity Multiplier

Assets/Equity

Bank Loans

• Relationship is with a bank

• More suitable for short-term needs

• May be only option for small and medium

size companies

• Tend to have restrictive covenants

• Repayment includes interest and a portion of

principal

• Typically floating-rate

• Not a tradeable security

Corporate Bonds

• Relationship is with a group of investors

• More suitable for longer-term investments

• Need to be an established company with a

track record of profits

• Repayment is interest only until the maturity

date

• Interest rates tend to be lower than bank

loans

• Typically fixed-rate

• Securities regulated by the SEC

A _____ is more suitable for short-term needs

Bank Loan

____ are usually the only options for small and medium size companies

Bank Loans

____ tend to have restrictive covenants

Bank Loans

_____ payments include interest and part of the principal

Bank Loan

____ are typically floating rate

Bank Loans

____ are not a tradable security

Bank Loans

____ are more suited for long-term investments

Corporate Bonds

You must be an established company with a track record of profits in order to get a ____

Corporate Bond

For ____, you only pay interest until the maturity date

Corporate Bonds

____ are typically fixed rate

Corporate Bonds

____ are regulated by the SEC

Corporate Bonds

Bond

A debt contract between a borrower (Corporate or Government) and an investor

Bonds are also called

Fixed Income Securities

Par (Face) Value

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

Coupon Payment

The stated interest payment of the bond

Coupon Rate

The annual coupon divided by the face value of a bond

Maturity

The specified date on which the principal amount of a bond is paid

Yield to Maturity

The rate of return that the market

requires for bonds of similar risk and maturity

Price of the bond

How much the buyer will pay for the bond today

Municipal Securities

Debt of state and local governments

Interest received on ____ is tax exempt at the federal level

Municipal Securities

Treasury Securities

Bonds issued by the US Government

Pure Discount Bonds

Bonds that have no interest or coupon rate

Pure Discount Bonds are also called ____

Zero Coupon Bonds

____ can't be sold for more than their par value

Pure Discount Bonds

Discount Bond

A bond selling at lower than its par (face) value

Premium Bond

a bond selling for greater than its par (face) value

Par Value Bond

A bond that sells for its par value

A Bond is premium when

Coupon Rate > YTM

Price > Par Value

A Bond is at par value when

Coupon Rate = YTM

Price = Par Value

A Bond is at a discount when

Coupon Rate < YTM

Price < Par Value

If interest rates increase, then the present value of bonds will ____

Decrease

If interest rates increase, then the price of bonds will ____

Decrease

If interest rates decrease, then the present value of bonds will ____

Increase

If interest rates decrease, then the price of bonds will ____

Increase

Current Yield

A bond's annual coupon divided by its market price

The coupon rate is based on a bond's ____ while current yield is based on a bond's ____

Face Value, Current Market Price

If Yield to Maturity decreases, the present value of a bond will ____

Increase

Interest Rate Risk

The risk that arises for bond owners from fluctuating interest rates

Long-term bonds have ____ price risk than short term bonds

More

High coupon rate bonds have ____ price risk than low coupon rate bonds

Less

The Fisher Effect

Defines the relationship between nominal rates, real rates, and inflation

Default Risk

The risk to bondholders resulting from a company not paying the interest and principal on their bonds