Finance: Bond Valuation & Bond Markets, NPV & Alternatives, DCF Analysis

5.0(1)
learnLearn
examPractice Test
spaced repetitionSpaced Repetition
heart puzzleMatch
flashcardsFlashcards
Card Sorting

1/52

flashcard set

Earn XP

Description and Tags

Finance

Study Analytics
Name
Mastery
Learn
Test
Matching
Spaced

No study sessions yet.

53 Terms

1
New cards
Required Returns
Required return is linked to uncertainty (risk) about future cash flows; the more uncertain the cashflows, the higher the risk; higher risk results in Higher Required Return
2
New cards
As cashflow estimates increase
market prices increase
3
New cards
As investor required returns increase
market prices decline
4
New cards
Bonds trade in prices
investors estimate future cashflows and discount them using require return to establish the price
5
New cards
Bond
financial asset issued when some institution wants to borrow money; loans linked to particular security
6
New cards
Primary Market
first time bond is sold; one time CF to borrower (ex. auctions/treasuries, investment banks)
7
New cards
Secondary Markets
transferring right to future CF of bond (ex. OTC markets, dealers & brokers)
8
New cards
Maturity Date
redemption date โ€“ last payment
9
New cards
Principal/Face Value/Par Value
value that the Issuer agrees to repay, this is the amount on which interest is generally calculated ( large amount repaid on maturity date)
10
New cards
Coupon Rate
determines the CF dollar amounts, interest rate paid, usually the same as the market rate; fixed until maturity
11
New cards
If the discount rate increases
the price (value) of the bond decreases
12
New cards
Yield to maturity
single discount rate used to calculate the market price of the bond; expected return; assumes the bond is held to maturity and different than coupon rate
13
New cards
"discount bond"
coupon rate < yield โ€“ price < face value
14
New cards
"premium bond"
coupon rate > yield โ€“> price > face value
15
New cards
"par bond"
coupon rate = yield โ€“> price = face value, most bonds issued at par
16
New cards
Interest Rate Risk
risk increases as maturity increases; as rates change, prices will change; longer bond periods respond greater than short maturity
17
New cards
Effect of Time on Bond Prices
"pull to par/face value", price approaches face value; there is a coupon rate difference where you are willing to pay more closer to coupon payment; willing to pay more for higher coupon
18
New cards
Default premium
difference between treasury YTM and corporate YTM; higher the perceived risk in the corporate bond, the higher the YTM, so corporate issuers need to offer higher YTM (lower price today, higher future yield)
19
New cards
Bond Ratings
Lower risk (AAA), higher risk of default (AA-BBB) (BB-CCC), already defaulting (CC-D)
20
New cards
Callable Bonds
"callability" bonds where a right (option) is granted to the issuer to buy back the bond, usually at face value before maturity date; choice is with issuer; might choose to call if interest rates lowering or could refinance to pay lower rate
21
New cards
Convertible Bonds
bonds where a right (option) is granted to the investor to exchange the bond for some other specified security, usually common stock before maturity date; willing to pay more than identical, regular bond; choose to convert when high YTM โ€“> low price relative to value of equity
22
New cards
Zero-Coupon Bonds
no coupons (rate is 0%), treasury bills (
23
New cards
Price =
PV(all the bonds CF discounted at yield)
24
New cards
For ALL potential projects, if required return increases, NPV will...
maybe increase, maybe decrease
25
New cards
NPV
best evaluation method; measuring value created today by considering all cash flows; PV(benefits)-PV(costs), projects should be accepted if NPV is positive (following this rule increases firm value); maximization of shareholder value
26
New cards
Cost of Capital
(discount rate/required return) best available expected return offered on an investment of comparable risk and term (timing)
27
New cards
Internal Rate of Return (IRR)
interest rate that makes project equal to 0; accept the project if IRR is greater than cost of capital used to calculate the NPV [intuitive]
28
New cards
Challenges of IRR
IRR and NPV are not always equivalent rules, (1) are we lending or borrowing (2) multiple IRRs [certain CF can generate NPV=0 at two different discount rates (3) mutually exclusive projects [only reasonable compare with same initial investments]
29
New cards
MIRR fixes issues with the IRR method including...
multiple IRRs and lending/borrowing issue (NOT issue of scale)
30
New cards
Modified Internal Rate of Return (MIRR)
modify CF to deal with the problem of multiple IRRs, rearranges so there is only one sign change of CFs (if there's only two CF you can explicitly calculate)
31
New cards
Profitability Index (PI)
incorporating NPV into limited resource idea; want it to be positive; firms choose the set of projects with the largest profitability indices until it runs out of resources, NPV projects that create the greatest total value for stockholders
32
New cards
Payback Period
length of time until you make your money back; quicker is better and accept if payback is less than some pre-specified number of years (firm discretion)
33
New cards
Advantages of Payback
simple to use, no need to estimate cost of capital, and is a crude measure of liquidity (ease & speed to access cash)
34
New cards
Drawbacks of Payback
how is cut off supposed to be determined?, bias against long term projects, ignores time value of money (NPV), ignores cash flows after cut off point (what happens after payback period), and inconsistent with maximization of shareholder value (might take negative NPV projects) BETTER OPTION: DISCOUNTED PAYBACK
35
New cards
Discounted Payback
takes into account liquidity
36
New cards
Incremental Cash Flows
(relevant CF) for project valuation, any changes in future CF that are a direct consequence of accepting project; CF w/ project โ€“ CF without
37
New cards
Sunk Costs
a cost that is already paid and cannot be recovered
38
New cards
Opportunity cost
cost of lost options; ex. renovating projects
39
New cards
Erosion (side effect)
negative impact on CFs of an existing product from the introduction of a new product; substitute
40
New cards
Spillover (side effect)
positive impact on CFs of an existing product from the introduction of a new product; complement
41
New cards
Net Working Capital (NWC)
(inventory) investment needed to start operations; initial investment in inventories, AR to cover credit sales, AP to pay for credit purchases; always recovered at the end of the project for finite lived projects
42
New cards
Marginal Tax Rate
the percentage paid on the next dollar earned, can move around, "what we care about"
43
New cards
Average Tax Rate
tax bill divided by taxable income
44
New cards
Depreciation
affects taxable income and book value, capitalized asset, straight-line depreciation = (initial cost โ€“ salvage value)/number of years
45
New cards
After-Tax Salvage
Salvage โ€“ Tax(salvage โ€“ book value); tax effect if there is difference from book value
46
New cards
Financing costs
not included in our evaluations, financing activities should have NPV = 0
47
New cards
How do we know NPV is accurate?
Capital rationing, sensitivity, scenario, simulation, and breakeven analysis
48
New cards
Sensitivity Analysis
testing various individual assumptions to see the result on NPV; identifies critical assumptions; various CF's assumptions are optimistic, expected, and pessimistic
49
New cards
Scenario Analysis
testing particular combinations of assumptions to measure change in NPV (interrelated assumptions); alternative business environment
50
New cards
Simulation Analysis
expanded version of scenario analysis using statistical tools to test multiple scenarios to look at possible outcomes, probability distribution; identifies risk not apparent using traditional scenario analysis, but requires definition of probability distribution of inputs and model that defines interactions of various assumptions
51
New cards
Break-even Analysis
level of sales (or other variable) at which the company "breaks even", performance target
52
New cards
Accounting Break-Even
point where Net Income becomes positive; annual revenue โ€“ variable costs โ€“ fixed costs โ€“ depreciation = 0
53
New cards
Economic Break-Even
point where NPV is greater than zero; this one we use; NPV = 0