Finance 3332 - Exam 2 Review Points (Chapters 5, 6, & 7)

Investors with a _________ will demand a higher rate of return

Higher time preference for consumption

The change in the market value of an asset over some time period is called the _______

Capital gain

If the Federal Reserve tightens the money supply, other things held constant, short-term interest rates will be pushed upward, and this increase will probably be greater than the increase in the long-term market. [T/F]

True

Open market operations are operations in which:

The Federal Reserve buys or sells Treasury securities to expand or contract the U.S. money supply

The Federal Reserve purchases U.S. Treasury securities to:

Loosen the money supply

Firms with the most profitable investment opportunities are willing and able to pay the most for capital, so they tend to attract it away from less efficient firms or from those whose products are not in demand [T/F]

True

Your uncle would like to restrict his interest rate risk and his default risk, but he would still like to invest in corporate bonds. What bond best satisfies this critera?

An AAA bond with 5 years to maturity

The value of an asset is the future value of the future cash flows that the asset is expected to generate during its life [T/F]

False
The value of an asset is the present value of the future cash flows that the asset is expected to generate during its life. The cost of money is used as the discounting factor to calculate the present value of future cash flows,

The higher the perceived risk, the higher the required rate of return [T/F]

True
Four fundamental factors that affect the cost of money: (1) production opportunities , (2) time preferences for consumption, (3) risk, (4) inflation
The higher the chance that an investor will not earn the return promised, the higher the expected ret

Which of the following bonds has the highest default risk for a given return?

A CCC corporate bond with a 10-year maturity
This is because it has the poorest rating, highest interest rate risk, and the longest time to maturity. Longer maturity increases maturity risk.

Andrew purchased a stock for $175 and sold it for $250. If he earned a dividend income of $30, the stock's yield is =

60%
Yield/rate = Amt/ received / amt paid

Which of the rates indicates the rate that will exist in an inflation-free world?

Real risk-free rate
(Nominal rate = Rate w/out inflation)
(Real rate = Rate net of inflation):
Real rate = Nominal rate - inflation rate

The existence of an upward sloping yield curve proves that the _______ is correct, because an upward sloping curve necessarily implies that lenders will lend short-term funds at lower rates than they lend long-term rates

Liquidity preference theory

If the nominal rate on a bond is 10% and the real risk-free rate is 6%, then the inflation premium is _______.

4%

During the past couple decades, the U.S. has generally run a foreign trade deficit, which means that, everything else equal:

The amount of goods imported into the U.S. exceeds the amount of goods exported to foreign countries.

Everything else equal, interest rates increase:

When consumers' preference for current consumption increases
The higher the preference for current consumption, the higher the interest rates as there will be less funds available to borrow

Liquidity preference theory

Long-term bonds normally yield more than short-term bonds, primarily because MRP > 0, and MRP increases with time to maturity

Expectations theory

The shape of the yield curve depends on the expectations concerning future inflation rates
The yield curve should be upward sloping when investors expect inflation and interest rates rates to increase, and vice versa

Market Segmentation theory

The slope of the yield curve depends on supply/demand conditions in long/short-term markets
Provides that every borrower and every lender has a preferred maturity

Risk free rate includes:

The real-risk free return and an adjusted risk premium

If the supply of funds increases, the interest rates decrease [T/F]

True

If the supply of funds decreases, the interest rates increase [T/F]

True

If the supply of funds in the economy increases, the interest rates in the financial markets should decrease [T/F]

True

If the supply of funds in the economy decreases, the interest rates in the financial markets should increase [T/F]

True

Which action is taking by the Federal Reserve during expansion?

The Federal Reserve sells securities to increase interest rates
The sell of securities reduces the money supply in the economy and increases the interest rates

Prime rate

The lowest rate of interest at which money may be borrowed commercially

Federal Reserve

-Controls money supply and interest rates
-Set the discount rate through open market operations (buy/sell US T-bills)
-sets federal funds rate
-sets prime rate

Risk free rate

Cost of a guaranteed return

2 components of risk-free rate

1 - rate
2 - inflation premium

Generally, long term interest rates are ________ than short term interest rates

Higher

Higher interest rate, ______ profits

Lower

Lower interest rate, ______ profits

Higher

3 features of debt

1 - Principal amount that must be repaid
2 - Interest payments
3 - Time to maturity
[Ex.]
$1000 bond (principal)
10 yrs (time to maturity)
8% interest rate = $80 (interest payments)

Principal value of debt

Amount owed to the lender, which must be repaid at some point during the life
- Most times it is paid at maturity date

Principal value is AKA

-maturity value
-face value

When the market value of debt is the same as the principal (face, maturity) value, it is said to be selling at par

Principal amount AKA par value

Par value, face value, maturity value, principal value

Are all the same, do not change

Coupon rate

Interest charged by investors, does not change

Price of bond

-Changes over life of bond
-Is the Present Value of cash flows
-Changes due to interest rates

To generate positive cash flow, some non-interest paying debts must sell for less than their par, or maturity values, these are known as ______ ________

Discounted securities

Corporate debt owners must be paid before stockholders are paid [T/F]

True

Corporate debt owners do not have corporation voting rights, but they can place restrictions on uses of the funds [T/F]

True

Short term debt has original maturity of _______

1 year or less

Most long term debts _______

pay interest

Most short term debts _____

do not pay interest (sold as discounted securities)

T-bills (Treasury)

-SHORT TERM DEBT
Price determined by auction process
-face values of $1000-$5,000,000
-maturities of few days > 52 weeks

Federal funds

-SHORT TERM DEBT
-loans from one bank to another
-interest rate on these is known as federal funds rate

Other SHORT-TERM DEBT instruments

-repurchase agreements
-banker's acceptances
-commercial paper
-certificates of deposit
-eurodollar deposits
-money market mutual funds

Long-Term Debt

-debt instruments with maturity over 1 year
-receive periodic interest payments

Bonds

-LONG TERM DEBT
-interest payments determined by coupon rate > represents total interest paid each year, stated as a % of the bond's face value

Common bonds

-LONG TERM DEBT
-government bonds
-municipal bonds
-corporate bonds
-mortgage bonds
-debenture
-subordinated debenture

LONG-TERM DEBT instruments

-term loans
-income bonds
-putable bonds
-indexed bonds
-floating rate bonds
-zero coupon bonds
-junk bonds

Indenture

A formal agreement (contract) between the issuer and holder of a bond, spells out the legalities
-SEC approves these

Call provision

A provision in a bond contract that gives the issuer the right to redeem the bond under specified terms prior to maturity date

Sinking fund

Facilitates orderly retirement of a bond
Required annual payment designed to amortize a bond issue

Conversion feature

Permits bondholder to exchange their investment for a fixed number of shares of common stock
-Conversion ratio = price of bond / shares
[Ex.]
$1000 convertible bond with a conversion ratio of 20
Conversion price = $50 ($1000/20)

Bonds are assigned quality ratings that reflect their probability of defaulting
There are 2 major rating agencies: ____ & ______

Moody's
S&P

High quality, low risk

Moody's > Aaa / Aa
S&P > AAA / AA

Investment grade quality, medium risk

Moody's > A / Baa
S&P > A / BBB

Substandard quality, high risk
(Junk bond)

Moody's > Ba / B
S&P > BB / B

Speculative quality, extremely high risk
(Junk bond)

Moody's > Caa / C
S&P > CCC / D

Greater default risk =

#NAME?

At the time of a new bonds issuance, the coupon rate of interest is normally set equal to the _______ ______

Market yield

The coupon rate is generally initially set at a level that will cause the market price of the bond to _____ its par value

equal

The value of a bond is determined by computing ______

Present value of interest payments (ordinary annuity) & present value of maturity value (lump-sum)

To find the bond value in calculator when:
15 year, 10%, $1000 bond

N = 15
I/Y = 10
FV = 1000
PMT = 100
CPT PV = $ -1,000

Bond value, when semi-annual compounding 1 year after issue in calculator when:
15 year, 8%, $1000 bond

I/Y = 8%/2 = 4
N = 28 (14 years x 2)
PMT = 50 (100/2)
FV = 1000
CPT PV = $ -1,166.63

Yield to maturity

If you buy a bond and hold it until it matures, YTM is the average rate of return you earn per year

YTM in calculator when:
10 year, 8% coupon, $1000 par value, interest paid semi-annual

N = 20
PV = -875
INT = 40
FV = 1000
CPT I/Y = 5% x 2 = 10%

Yield to call in calculator when:
call price is $1080, 8 year, suppose call provision kicks in 4 yrs from today, bond is callable 6 yrs before maturation
and is semiannual

n = 8
pv = -875 (Cash flow if you buy bond)
fv = 1080
pmt = 40
CPT I/Y = 6.87% x 2 = 13.7% annual

Interest rates and bond values:
assume 15 yr maturation, 10% coupon, market interest rate 10%, price of bond on issue day is $1000
assume after you purchase bond, Interest rate goes from 10% to 12%, the bond value decreases as Interest rate increases

If market rates increase from 10% to 12%, value of bond drops to $863.78:
N = 15
I/Y = 12
PMT = 100
FV = 1000
CPT PV = $-863.78
If market rate decreases from 10% to 8%, value increases to $1,171.19
N = 15
I/Y = 8
PMT = 100
FV = 1000
CPT PV = $1,171.19

Market yield = coupon rate

Bond sells at par value

Market yield > coupon rate

Bond sells at less than par value (discount)

Market yield < coupon rate

Bond sells at greater than par value (premium)

The principal value of debt

Must be repaid at some point during the life of the debt to the investors

A firm's rating by a rating agency is based on

no precise formula

Typically, debentures have higher interest rates than mortgage bonds primarily because mortgage bonds are backed by assets while debentures are unsecured [T/F]

True
A debenture is an unsecured bond, being that it provides no lien or claim, against specific property as security for the obligation.
With a mortgage bond, the corporation pledges certain tangible assets as security, or collateral, for the bond

Because short-term interest rates are much more volatile than long-term rates, an investor would, in the real world, be subject to much more interest rate price risk if he or she purchased a 30-day bond than if he or she bought a 30-year bond [T/F]

False

A certificate of deposit represents

A time deposit at a bank or other financial intermediary

_______ bonds are often called by the firm prior to maturity

Callable

IPO

Initial public offering

Stock

Represents ownership
Selects board of directors
Receive value through growth and dividends

Two types of stock

Common Stock
Preferred Stock

Common shareholders have a claim on earnings of the company

After debt/bond-holders have been paid

Preferred stock

Hybrid security
Any preferred dividends not paid in previous periods must be paid before common dividends can be distributed
Preferred dividends are paid after interest on debt is paid
Must be paid before common dividends are paid
Non-voting stock
Convert

The value of a stock is based on the ______ ______ of expected future cash flows

Present Value

Dividend discount model

Discounts the value of the dividends in perpetuity

Constant growth stock

Growth that is expected to continue into the foreseeable future at about the same rate as that of the economy as a whole
g = constant growth (stated as decimal)

Expected rate of return =

Expected dividend yield + expected growth rate, or capital gains yield

Non-constant growth stock

The part of the life cycle of a firm in which its growth is either much faster or much slower than that of the economy as a whole

The higher the P/E ration the more investors are willing to pay for each dollar earned by the firm

P/E = market price per share of common stock / earnings per share

Which of the following is true about a growth stock?

It generally pays little or no dividends so as to retain earnings to help fund developmental opportunities

A preferred stock can be exchanged for a certain number of shares of common stock at the ____ _____

conversion price

Which type of security has the highest priority with regard to earnings and assets of a firm?

corporate bonds

According to the convertibility provision, a common stock can be converted to a certain number of preferred stock at the conversion price [T/F]

False

Which of the following is considered as a Euro stock?

A German company selling stock in Japan
Stocks traded in countries other than the home country of the company, not including the US, is called Euro stock

Considering the economic value added (EVA) of a firm, which of the following increases the firm's value?

EVA > 0

Growth stocks pay little or no dividends and instead retain most of their earnings each year [T/F]

True

What is the formula to calculate P/E ratio?

Market price per share / earnings per share

If the expected rate of return on a stock exceeds the required rate, it means that _____

the stock is a good buy

Stock prices move _____ of changes in rates of return

Opposite
[Ex.] If the expected value of a stock is $32, and investors move from demanding a 8% return to a 10% return, THE STOCK PRICE WILL DECREASE

If investors demand higher returns to invest in stocks, then prices should fall

If investors demand lower returns to invest in stocks, then prices should increase

If investors expect their investments to generate lower future cash flows, then prices should also fall

If investors expect their investments to generate higher future cash flows, then prices should also increase