Exam 2 BUS340

7,8,10

**How bonds prices are determined** 

Based on its coupon rate and yield rate. C>Y = Premium, C

**Relationship between interest rates & bond prices** 

Inversely proportional to one another.

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Interest rates rise, bond value decreases.

**How does a bond’s price change over time as it approaches maturity?** 

* Premium = decrease to maturity 
* Discount = increase to maturity. 

If an issuer defaults,

investors will receive less than promised return

No Default Risk

Treasury Bonds

Default Risk

Corporate Bonds

Some default risk

Municipal Bonds

Default Risk

Foreign Bonds

Call Provision

Issuer gives right to call the bonds for redemption**.** Have higher risk to investors.

Issuer must pay bondholder an amount _ than par value if they are called

greater

Zero Coupon Bonds pay

No annual Interest

Zero Coupon Bonds are sold at

a discount below par

The higher a security’s risk

The higher the required return

Aversion Risk

gives rise to a risk premium

Risk Premium

consists of an expected **extra** return that investors require to be compensated for the risk of holding stocks.

Diversifiable Risk

Unsystematic events

Diversifiable Risk

Caused by lawsuits

Diversifiable Risk

Caused by strikes

Diversifiable Risk

Caused by successful & unsucessful marketing

Diversifiable Risk

__**Firm**__ specific, **can be eliminated through diversification.**

Market Risk

Caused by Systematic Events

Market Risk

Caused by war

Market Risk

Caused by inflation

Market Risk

Caused by recession

Market Risk

caused by high interest rates

Market Risk

Caused by macro factors

Market Risk

Cannot be eliminated by diversification

Beta

the extent to which a given stock’s return moves up & down with the stock market.

Beta measures

The market risk

The value of the **common shareholders’ claim** is…

embodied by future cash flows they are __**entitled to receive.**__

The **value** of the **firm’s common stock** is…

**driven by its expected cash flows (**__returns__) and **risk** (__certainty of the expected cash flows__). 

Debt

No voice in management

Debt

Senior to equity in regard to claims on income & assets

Debt

Maturity is stated

Debt

Taxed

Debt

Interest deducted

Equity

Does have voice in management

Equity

Subordinate to debt, in regard to claims on income & assets.

Debt-holders get paid _ with claims on income & assets.

First

Shareholders get paid _ with claims on income & assets

Second

Equity

No maturity

Equity\*

No tax __**interest**__ deduction/are __**not tax deductible***__

Preferred stock is like a

Hybrid security \[Common & Bonds\]

Common Stock

In the equity section of the Balance Sheet

Common Stock

Pay dividends

Dividend Payments \[Common Stock\]

Are not legally required

Dividend Payments \[Common Stock\]\*\*

No tax __**interest**__ deduction/are __**not tax deductible****__

Common Stock

No maturity dates

Bonds

Have no voting rights

Bonds

Fixed rate for dividends

Bonds

__**Priority**__ over common shareholders in event of **bankruptcy**

The primary goal for managers of a corporation is to…

Maximize long-term shareholders’ wealth.

Capital structure is a mix of

Debt & Equity

Stocks are harder to value than bonds because they

Do not have constant fixed payments.

Interest rate increase

Bonds price and value decrease

Default

Earn less than promised return

Reinvestment risk

**decline in interest rates,** __decline in income from a bond portfolio.__

Decrease in interest

also hurts bondholders

Price Risk

**increase in interest rates,** __decline in bond’s value.__

A company is more likely to call a bond if the price is

Above Par

Longer Maturity Bonds

High Price risk, Low reinvestment risk

Higher Coupon Bonds

Low Price risk, High reinvestment risk

Treasury

an issuer of a bond

Corporation

an issuer of a bond

State & Local governments

an issuer of a bond

Zero coupons compensating investors in the form of

capital appreciation

Debentures

long-term bonds, not secured by mortgage.

No collateral.

Subordinated debentures

Bonds having claims on assets **after senior debt paid in full in event of liquidation.** 

Indenture

Legal, rights of bondholder & corporation

A call provision gives the _ the right to demand, or “call for” repayment of bond.

**Issuer**

Companies call bonds if

Interest rates rise

Companies don’t call bonds if

Interest rates decline

The less certain a cash flow

the __**higher**__ the ==__**risk**__==__**,**__ the ==__**lower**__== the PV of the cash flow.

The lower the bond’s default risk

the lower the interest rate is on the bond.

Cost of long-term debt is generally

greater than short term debt

Bonds sold at less than face value

is a discount

Bonds sold at greater than face value

is a premium

Asset risk is considered in 2 ways,

Stand-alone bases or Portfolio context

CAPM (Chapter 8)

Considered when stocks and assets are held in __**portfolios.**__

CAPM Is (Chapter 8)

__**Risk**__ remaining after __**diversifiacation**__

Stocks are

riskier than bonds

An investor that requires greater return when **risk increases**

A risk averse investor

An efficient portfolio:

Maximizes return for a given level of risk.

Common Stock is valued at:

Present value of its **expected future** __**dividend stream.**__

Common stocks are dependent on

Firm’s earnings

Common Stocks are…

not specified by a contract.

Discount Dividend Model

This model values a __**common stock**__ as the PV of its expected future cash flows at the firm’s required return on equity.

Corporate Valuation

Values a __**firm**__ , especially one that does __**not pay dividends**__ or is privately held.

Discount Dividend Model Calculates

This model calculates **the firm’s stock price** as the present value of the __**expected future dividends**__ at the firm’s req rate of return on equity.

Corporation Valuation Model Calculates

Firm’s stock price as the present value of **the** __**expected FCF’s at the firm’s**__ ***weighted average cost of equity.***

An investors goal is to purchase stocks that are…

Undervalued, with a price BELOW stock’s intrinsic value

Discount Dividend Model is useful for…

Mature, stable companies, growth rate dividends

Corporate Valuation Model is useful for..

Flexible, companies who don’t pay dividends, dividend are hard to predict.

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High growth stage of life cycles, project future financial statements before estimating future dividends.

The value an investor assigns to a share of stock is dependent on …

Future Cash Flow Generation ability

Cash flows associated with common stock are…

More difficult to estimate than a bond.

Common stock is a _

Residual claim against the company

Bonds are a _

Contractual obligation

Interest paid to bondholders is…

tax deductible

Capital Provided by investors

Interest bearing debt, preferred stock, common equity.

After-tax cost of debt is used in WACC…

interested in maximizing the **value of the firm’s stock.**