Finance Honors Tri 2 Test 1

Learning objectives:

6.1 Understand basic bond terminology and apply the time value of money equation in pricing bonds. 

6.2 Understand the difference between annual and semiannual bonds and note the key features of zero-coupon bonds. 

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6.3 Explain the relationship between the coupon rate and the yield to maturity.

6.4 Understand bond ratings and why ratings affect bond prices. 

6.5 Appreciate the bond history and understand the rights and obligations of buyers and sellers of bonds. 

6.6 Price government bonds, notes, and bills

Bonds

• Long-term debt instruments

• Provide periodic interest income—annuity series

• Return of the principal amount at maturity—future lump sum

• Prices can be calculated using present value techniques such as discounting future cash flows

• Combination of the present value of an annuity and a lump sum

• Callback bond is a bond that can be paid off by a company at anytime

• Bond Rating Agencies

  • Apply a scoring mechanism to see how likely a company will pay back its debt.

• Premium Bond

  • Coupon Rate > YTM

  • Price > Par Value

• Par Value Bond

  • Coupon Rate = YTM

  • Price = Par Value

• Discount Bond

  • Coupon Rate < YTM

  • Price < Par Value

Coupon rate

• Rate used to calculate interest payments

• Annual Rate of interest paid

• A coupon is a regular interest payment received by the holder per year

• Ex:

  • The coupon = 2 rate is compounded and that is what is added

Yield to maturity (YTM)

• What should be expected to be received after the timer period is up

• Expected rate of return based on price of bond

• The maturity date is the expiration date of the bond when the par value(Face Value/lump sum) is paid back.

• Current Yield = $Coupon/Price

Semiannual Bonds and Zero-Coupon Bonds

• Most corporate and government bonds pay coupons on a semiannual basis

• Some companies issue zero-coupon bonds by selling them at a deep discount.

• The discount on a zero coupon bond is amortized over its life

• Interest earned is calculated for each 6 month's periods

  • Ex: 0.04 x $790.31 = $31.62

• Interest is added to the price to compute the ending price

• On zero coupon bonds, investors have to pay tax on annual price appreciation even though no cash is received

Zero coupon bond

• Known as “pure” discount bonds and sold at a discount from face value

• Do not pay any interest over the life of the bond

• At maturity, the investor receives the par value, usually $1,000

• The price of a zero coupon bond is calculated by merely discounting its par value at the prevailing discount rate or yield to maturity

Yields and Coupon Rates

• A bond’s coupon rate differs from yield to maturity

• Coupon rate by the company at the time of issue and is fixed(innovations which variable coupon rates)

• YTM is dependent on market, economic, and company-specific factors (bond rating) and is therefore variable

  • Company-specific factors

    • Bond rating

Relationship of Yield to Maturity and Coupon Rate

• The issuing firm gets the bond rated by a rating agency

• Then, based on the rating, there is a coupon rate equal to the expected yield, and sells the bond at par value

• Once issued, if investors expect a higher yield on the bond, its price will go down and the bond will sell below par or as a discount bond and vice versa

• YTM can be equal to, higher than, or lower than the coupon rate

• Bond prices fall when interest rates rise (Interest Rate %) (Bond Price $). 

The U.S. Government Bonds

• Include Bills, notes, and bonds sold by the Department of Treasury

• State bonds, issued by state governments

• Municipal bonds, issued by country, city, or local government agencies

• Treasury bills are zero coupon, pure discount securities with maturities ranging from 1-, 3-, and 6 months up to 1 year

• Treasury notes have been between 2 to 10-year maturities

• Treasury bonds have greater than 10-year maturities when first issued

Some bond history and more bond features

Corporate bond features have gone through some major changes over the years

• Bearer bonds

• Indenture or deed of trust

• Collateral

• Mortgaged

• Debentures

• Senior debt

• Sinking fund

• Protective covenants

Chapter 7: Stocks and Stock Valuation

Learning Objectives

7.1 Explain the basic characteristics of common stock

7.2 Define the primary market and the secondary market

7.3 Calculate the value of a stock given a history of dividend payments

7.4 Explain the shortcomings of the dividend pricing models

7.5 Calculate the price of preferred stock

7.6 Understand the concept of efficient markets

Characteristics of Common Stock

• Major financing vehicle for corporations

• Provides holders with an opportunity to share in the future cash flows of the issuer

• Holders have ownership in the company

• Unlike bonds, no maturity date and variable periodic income

Ownership

• Share in residual profits of the company.

• Claim to all its assets and cash flow once the creditors, employees, suppliers, and taxes are paid off

• Voting rights

  • Participate in the management of the company

  • Elect the board of directors which selects the management team that turns the companies day to day operations.

    • A = L+ OE

      • Liabilities (creditors fall under)

  • Stockholders are contacted about issues with a company and allowed to vote

Claim on Assets and Cash Flow (Residual Claim)

• In case of liquidation…

• Shareholders 

Vote (Voice in Management

• Standard voting rights

  • typically, one vote per share is provided to shareholders to vote in board elections and other key changes to the charter and bylaws

• This can be altered by issuing several classes of stock

  • Non-voting stock, which is usually for temporary periods

  • Super voting rights, which provide the holders with multiple votes per share, increasing their influence and control over the company

Dividends and their tax effect

• Companies pay cash dividends periodically (usually every quarter) to their shareholders out of net income

• Unlike coupon interest paid on bonds, dividends cannot be treated as a tax-deductible expense by the company

• For the recipient, however, dividends are considered to be taxable income

Authorized, Issued, and Outstanding Shares 

• Authorized shares: 

• Maximum number of shares that the company may sell, as per charter.

• Issued shares: 

• The number of shares that have already been sold by the company and are either currently available for public trading (outstanding shares) or held by the company for future uses such as rewarding employees (treasury stock).

  • Outstanding shares

    • A company's stock is currently held by all its shareholders.

Treasury Stock

• The issuing firm holds non-dividend paying, non-voting shares right from when they were first issued. 

  • OR 

• Shares that the issuing firm in the market has later repurchased. 

Pre-Emptive Rights

• Privileges allow current shareholders to buy a fixed percentage of all future issues before they are offered to the general public. 

  • Done so shareholders won't buy the stock at a lower value

• Enables current common stockholders to maintain their proportional ownership in the company

Stock Markets 

Stocks are traded in two types of markets

1. Primary or “first sale” market 

   1. The first issue market where the issuing firm is involved

      1. Initial public offering (IPO

      2. Prospectus 

         1. The document that outlines the class of shares being sold

         2. “Sales pitch”

      3. Due diligence

      4. Firm commitment 

      5. Best efforts

2. Secondary or “after-sale” market

   1. A forum where common stock can be traded among investors themselves.

   2. Provides liquidity and variety. 

   3. In the United States, three well-known secondary stock markets: 

      1. NYSE

         1. AMEX (purchased by NYSE)

      2. NASDAQ 

         1. Specialist 

         2. Ask price 

         3. Bid price 

         4. Bid-ask spread

Bull Markets and Bear Markets

• A Bull market: 

  • Prolonged rising stock market, coined on the analogy that a bull attacks with his horns from the bottom up.  

• A Bear market: 

  • Prolonged declining market, based on the analogy that a bear swipes with his paws from the top down. 

Stock Valuation Pt 1

• Value of a share of stock → the present value of its expected future cash flow… 

• Cash dividends paid (if any). 

• The future selling price of the stock. 

• The discount rate i.e., risk-appropriate rate of return to be earned on the investment. 

• No guaranteed cash flow information. 

• No maturity date 

• Valuation is more of an “art” than a science. 

Stock Valuation Pt 2

Stock Valuation Pt 3

Four variations of a dividend pricing model have been used to value common stock. 

1. The constant dividend model with an infinite horizon. 

2. The constant dividend model with a finite horizon. 

   1. Assumes that the stock is held over a finite period and then sold to another investor

   2. Constant dividends received over the investment horizon

   3. Price is estimated as the sum of the present value of an annuity (constant dividend) and that of a single sum (the selling price).

   4. Similar to a typical non-zero coupon, corporate bond. 

   5. Have to estimate the future selling price, since that is not a given value, unlike the par value of a bond

3. The constant growth dividend model with a finite horizon. 

4. The constant growth dividend model with an infinite horizon. 

   1. Known as the Gordon model (after its developer, Myron Gordon). 

   2. The estimate is based on the discounted value of an infinite stream of future dividends that grow at a constant rate, g

Bureau of Labor Statistics(BLA)

• The principal fact-finding agency for the Federal Government in the broad field of labor economics and statistics

Dividend Model Shortcomings

• Need future cash flow estimates and a required rate of return, therefore difficult to apply universally.

  • Erratic dividend patterns,

  • Long periods of no dividends,

  • Declining dividend trends 

• Need a pricing model that is more inclusive than the dividend model, one that can estimate expected returns for stocks without the need for a stable dividend history.

• The capital asset pricing model (CAPM), or the security market line (SML), which will be covered in Chapter 8, is one option. 

• SML can be used to estimate expected returns for companies based on their risk, the premium for taking on risk, and the reward for waiting and not on their historical dividend patterns. 

Preferred Stock

• Pays constant dividend as long as the stock is outstanding

• Typically has infinite maturity, but some are convertible into common stock at some predetermined ratio. 

• Have “preferred status” over common stockholders in the case of dividend payments and liquidation payouts.

• Dividends can be cumulative or non-cumulative.

• Price of preferred stock, we use the PV of a perpetuity equation, i.e. 

• Preferred Stock Calculation

  • Price₀ = PMT ÷ r

    • PMT = annual dividend (dividend rate x par value); and r = investors required rate of return

Efficient Markets

• Market in which security prices are current and fair to all traders.

• Transaction costs are minimal. 

• There are two forms of efficiency: 

1. Operational Efficiency

• Speed and accuracy with which trades are processed. 

• Ease with which the investing public can access the best available prices.

  • The NYSE’s SuperDOT computer system

    • Updated system (SuperDisplay Book SDBK) 

  • (NASDAQ’s SOES)

    • Updated system (Electronic Communications Network)

• Match buyers and sellers very efficiently and at the best available price.

• Therefore, they are very operationally efficient markets.

2. Informational Efficiency

   1. Speed and accuracy with which information is reflected in the available prices for trading.

   2. Securities would always trade at their fair or equilibrium value. 

   3. Diverse information — financial economists have come up with three versions of efficient markets from an information perspective:

      1. Weak form efficient markets

         1. Current prices reflect past prices and trading volume 

         2. Technical analysis—not useful 

      2. Semi-strong form efficient markets

         1. Current prices reflect price and volume information and all available relevant public information as well.

         2. Publicly available news or financial statement information is not very useful

      3. Strong form efficient markets

         1. Current prices reflect the price and volume history of the stock, all publicly available information, and even all private information. 

         2. All information is already embedded in the price—no advantage to using insider information to routinely outperform the market.

   4. These three forms make up what is known as the efficient market hypothesis (EMH). 

   5. The jury is still out, evidence is not conclusive!