What is a bond?
A loan from an investor
What is a stock?
The investor becomes part owner
What is the principal for a bond?
Face value of the bond. Typically $1,000
What is the principal of a stock?
The price of the stock
How does interest work with a bond?
The firm has a legal obligation to pay the investor
How do dividends work for a stock?
Stock investors receive dividends from the corporation at the discretion of the firm.
How does maturity work with bonds?
It is a specified date in the future that the firm will pay the investor.
Does a stock have a maturity date?
No
What is face value of a bond?
Dollar amount of the corporate debt to the investor. Usually around $1,000.
What is the coupon rate of a bond?
Percent used to calculate annual interest payments to the investor. Coupon rate x face value = annual interest payment
What are interest payment dates with a bond?
Schedule of days for interest payments. Usually semi-annually
What are a bond's price and yield set by?
Supply and demand in financial market trading
At the par price of a bond, what happens?
The yield and the coupon rate are equal.
If the price of the bond increases what happens?
The the yield decreases
If the price of the bond decreases what happens?
The yield increases
What is duration when related to a bond?
The percentage drop in price caused by 1% increase in yield.
Which has more risk a short term or a long term bond?
Long Term Bond
A bond's required return is the yield necessary to what?
Compensate for risk
What is treasury yield?
Corporate bonds trade at a "yield spread" over treasury.
What is bond credit risk?
AAA-Rated bonds have lower yields than BBB-Rated bonds, but also have lower risk
What is an economy risk with bonds?
Probability of bankruptcy is greater in a recession. The risk premium increases.
What is a risk with a term in a bond?
Long term bonds have more risk, but higher yields.
What is collateral with bonds?
The corporation gives collateral to the investor just in case the company goes bankrupt.
What is the tax risk with bonds?
Tax-exempt municipal bonds have lower yields.
If a firm issued a 5 year $1,000 semi-annual pay bond with a coupon rate of 5%, how much interest would have been paid after 2 years and 6 months?
Principal x rate x years. 1000 x .05 x 2.5 = 125
What is common stock?
Ownership of EPS (Earnings per share). Receive dividends at discretion of the corporation. Voting rights to elect Board of Directors. No maturity Date.
What is preferred stock?
Priority of claims over common stock holders in bankruptcy. Fixed dividend amount. Fixed dividend payment date. In Arrears. The dividend payment is delayed. You have no voting rights. No maturity date.
How to find the value of a bond?
PV of interest payments + PV of return of principal at maturity = value of bond.
How to find value of stock?
PV of dividend payments + PV of Sell price in future = value of stock
What are the four analytical frameworks for Stock?
1. Actual return to investor. 2. Single holding period stock value. 3. Gordon growth model stock value. 4. Capital Asset Pricing Model (CAPM)
What is Actual Return to Investor?
You bought a stock in the past, you sold it, and look and see how much profit you made.
What is Single Holding Period Stock Value?
You buy a stock, hold it for a year, and the dividend is constant. What is the price of the security? PV of expected cash flows.
What is the Gordon Growth Model?
Dividend increases over time. To determine the price of expected cash flows.
What is Capital Asset Pricing Model (CAPM)?
Used to determine the required return on a specific share of stock with a specific level of risk.
What are the key words to know when to use Actual Return?
Buy & Sell. Looking back at the past. You use the 5 white keys
What are the key words to know when to use Single Holding Period?
One Year. Use the 5 white keys.
Key words to know when to use Gordon Growth Model?
Growth. Use the Sidebar Formula.
Key words to know when to use CAPM?
Beta. Use the sidebar formula
Actual Return to Stock Investor: An investor expecting a 15% return buys a stock for $40, receives a $2 dividend, and sells the stock for $50 after a year. What is the actual return?
Return % = (Dividend + Capital Gain) / Investment. 2 PMT. 1 N. 40 +/- PV. 50 FV. CPT I/Y = 30%
Single Holding Period. Value of stock with $2 dividend, $90 price in 1 Year, & 12% yield?
1 N. 12 I/Y. 2 PMT. 90 FV. CPT PV
Formula for Gordon Growth Model?. Assumes that Dividends Increase Over Time.
Stock Price = Expected Dividend / (Required Return - Growth Rate)
Expected Dividend = Last Dividend x (1 + Growth Rate)
Required Return = (Expected Dividend / Price) + Growth Rate
What is expected dividend?
The one to be paid at the end of the year.
What is Last Dividend?
The one that has already been paid.
What does stock price depend on?
Depends on expected flow of income & dividends for years into the future.
Gordon Growth Model Example. If a stock recently paid a $2 dividend, has a required return of 12%, and dividends are expected to grow by 3%, what is the stock price?
Expected Dividend = 2 x 1.03 = 2.06.
Stock Price = 2.06 / (.12 - .03)
= 2.06 / .09 = 22.09
What is the formula for Required Return with the Gordon Growth Model?
(Expected Dividend / Price) + Growth Rate
How to calculate Expected Dividend?
Last Dividend x (1 + Growth Rate)
What is a PE ratio?
Ratio of a share / price of stock divided by the earnings per share.
What is the Earnings-per-Share ratio?
Net income / Shares outstanding
What does PE reflect?
The firm's expected growth rate of earnings and dividends.
What is the market risk premium?
The difference between the market return for a stock and the required return for a treasury.
What is the Market Return?
The average Required Return on a stock.
What is Beta in the Capital Asset Pricing Model (CAPM)?
Goes from the average stock to a specific stock. Beta is an index.
What is the required return formula for CAPM?
Risk Free Rate + (Beta x Market Risk Premium)
What is the average for Beta?
1.0
What is Beta?
Relative Volatility of a stock price.
If the ACME Corp has a BETA of 1.5, market return is 12%, and the Treasury rate is 3%, what is the required return? Find Market Risk Premium first, then use that to find the Required Return for CAPM.
12% - 3% = 9%. 3 + (1.5 x 9) = 16.5
Key Factors affecting price of a stock?
Risk Free Rate, Market Risk Premium, Beta, and Growth Rate.
What is WACC?
weighted average cost of capital
What is the formula for WACC?
(Equity/MV) x Cost + (Debt/MV) x Cost x (1-tax rate). MV = Equity value + Debt Value
WACC Problem: If a firm's debt is valued at $200 million and has a market yield of 6% while the firm's equity has a market value of $300 million and an expected yield of 12%, what is WACC if the tax rate is 20%?
Table version: 200 + 300 = 500. 40% x 6% x 80% = 1.92%
60% x 12% x 1 = 7.20%
1.92% + 9.12%.
Plug in formula: .4 x .06 x .8 + .6 x .12 = .0912
How to calculate the expected return on stock investment?
Prob (recession) x Return (recession) + Prob (expansion) x Return (expansion)