Bond
Debt typically in increments of $1000
Face Value
the interest payments paid to the bondholder
1) Interest Payments
2) Maturity Values
What are bonds two cash flows?
Principal payment at maturity
present value of lump sum calculation
Coupon Payments
present value of an annuity
Market interest rate
used as the discount
Interest rate risk
bond prices fluctuate as market interest rate moves
*interest rates go up, bond prices go down (visa versa)
Bond selling at a premium
over face value
Bond selling at discount
under face value
Yield to Maturity (YTM)
*don't need to know math for test, just def.
interest rate earned if bond is held to maturity
Current Yield
annual coupon payments divided by the current bond price
*a near term measure (YTM is a longer- term measure)
**what is it yielding right NOW
How do you handle semi- annual coupon payments?
they are typical with bonds
*double periods, half the rate
Rate of return on a bond
total income per period per dollar invested
*coupon income + price change/investment (ex: price of bond at beginning of period)
Yield curve (also called "Term Structure of Interest Rates")
Plot of bond yields based on bond maturities
Nominal Rate
stated rate in market
Real interest rate
adjusted for inflation
*assuming inflation is positive, real interest rate is lower
Default Risk
risk that a bond issuer may default on its bonds
Default premium
the additional yield on a bond that investors require for bearing credit risk
Investment Grade
Good, high quality
*Rated by Moody's and Standard and Poor's
Junk Bond
Low grade, low quality, high risk
*Rated by Moody's and Standard and Poor's
Zero Coupon Bonds
Coupon rate= 0
Floating rate bonds
take a bond, tie it to a rate, every time that rate goes up or down, they adjust it (interest rate moves vs it being fixed)
Convertible Bonds
can convert into stock
Common Stock
ownership shares in a publicly held corporation
IPO (Initial Public Offering)
1st offering of stock to the general public
Primary Offering
Corporation sells share in the firm
*selling shares to the public
Primary Market
market for the sale of new securities by corporations
Secondary Market
market in which previously issued securities are traded among investors
Price- Earnings ratio
P/E= market price/ EPS (earnings per share)
Market value
market capitalization (current stock price) - "Going Concern
Book value
stockholder's equity balance on balance sheet (net worth)
Liquidation value
proceeds that could be realized by selling the firm's assets and paying creditors
Intrinsic Value
Present value of future cash payoffs from a stock or security
Dividend Discount Model
Price of Stock= PV of all the future dividends it was going to pay
Discounted Cash Flow Model
today's stock price equals the pv of all expected future dividends
No Growth" Model
all earnings are paid out as dividends so there is no growth
P= Div or EPS/r
Constant Growth Model
P = Div/r - g
Estimating Expected Rates of Return
r = Div/P + g
Nonconstant growth
simply pv of known/predicted cash flows or dividends
Payout Ratio
% of earnings paid as dividends
Plowback Ratio
% of earnings re-invested (not paid as dividends)
Sustainable Growth Rate
ROE x plowback ratio
PVGO- present value of growth opportunities
net present value of a firm's future investments
Technical Analysis of Stocks
invest looking at ups and downs (patterns)
Fundamental Analysis of Stocks
Analyze stocks, finds best investments (more classical)
Efficient Markets
Weak-form: past
Semistrong: public
Strong-form: price has already reacted to any information
Market indices
measure of the investment performance of the overall market
Dow Jones
30 blue-chip stocks (much more narrow)
S&P 500
portfolio of 500 large stocks
* Differences and characteristics as a "better measure
Maturity Premium
extra average return from investing in long-term vs. short-term securities
Risk premium
expected return in excess of the risk-free rate as compensation for risk
Risk equals?
volatility
Diversification
*Strategy designed to reduce risk by spreading the portfolio across many investments
*Can be accomplished with a relatively low number of stocks
Asset Risk
1 Asset
Portofolio Risk
2 or more stocks
* is not based on a weighted average - must calculate risk using portfolio returns
Portfolio rate of return
weighted average of asset returns (based on dollars invested)
Specific risk
risk factors affecting only that firm - this risk is diversifiable
Market risk
economy-wide or macroeconomic sources of risk that affect the overall stock market
Systematic risk is NOT what?
diversifiable
Treasury Note
more than a year, less than 10 years
Treasury Bond
greater than 10 years
Treasury Bills
short term, less than 1 year
Beta= 0
Market portfolio
use a broad stock market index to represent the market
*has a beta of 1.0
Beta
sensitivity of a stock's return on the market portfolio- measure of the market risk
Growth or aggressive stocks have bests...
greater than 1.0
Defensive stocks have betas
less than 1.0
Beta of a portfolio
weighted average of betas based on fraction of portfolio invested in the stock
Market risk premium
risk premium of the market portfolio beyond the risk-free rate
CAPM=
risk-free rate + B(market rate - risk-free rate)
*Risk-free rate covers the cost of holding someone's money
*The risk premium rewards the investor for risk that is assumed
The security market line
relationship between expected return and beta
1) Internally generated funds - plowback funds
2) Equity
3) Debt- internally generated funds are the most predominant
3 sources of funds for a corporation
Common Stock
ownership shares
Treasury stock
stock that has been repurchased by the company and held in its treasury
Issued Shares
Shares that have been issued by the company
Outstanding shares
shares that have been issued by the company and are held by investors
Authorized shares
maximum number of shares that the company is permitted to issue
Par value
value of security shown in the company's accounts
Additional paid in Capital
difference between issue price and par value of stock - also called capital surplus
Retained earnings
earnings not paid out as dividends
Board of Directors
top management and "outside directors
Majority voting
voting system in which each director is voted on separately
Cumulative voting
voting system in which all votes that one shareholder is allowed to cast can be cast for one candidate for the board of directors
*Favors minority investors trying to get some representation
Proxy contests
outsiders compete with the firm's existing management and directors for the control of the corporation
Preferred Stock (priority over dividends)
-stock that takes priority over common stock for dividends
-Cumulative means all back dividends must be paid before common stock dividends
-Tax preference for corporations - only 30% of dividends are taxable
-No voting privileges
-Floating rate preferred
Corporate Debt
-No ownership
-Interest is a deductible cost so it has a financial advantage over dividends
Prime rate
benchmark interest rate charged by banks to very good customers
London Inter Bank Offered Rate - international version of Prime rate
LIBOR
Funded debt
debt with more than 1 year remaining to maturity
* Unfunded debt is short-term or current liability (less than 1 year)
Sinking fund
-fund established to retire debt before maturity
-Provides lower rate and lower borrowing cost due to lower "default risk"
-Does not always exist
Callable bond
-bond that may be repurchased by firm before maturity at a specified price
-If interest rates fall, bond price will not rise above the "call price
Subordinated debt
-debt that may be repaid in bankruptcy only after senior debt is paid
-May require a higher rate for more default risk
*debt paid before going in
Secured Debt
-debt that has first claim on specified collateral in the event of default
-Mortgage is an example with a property as security
-Reduces risk by having collateral
Eurodollars
dollars held on deposit in a bank outside the US
Eurobond
bond that is marketed internationally
Public Placements
can sell to anyone, lots of disclosures
Private Placements
people you don't have to give a lot of information to, quicker because of less disclosures
Public bonds
sold to anyone who wishes to buy and freely trade in the securities markets
Private bonds
sold directly to a small number of banks, insurance companies or other investment institutions - cannot be resold to individuals
Protective Covenants restriction on a firm to protect bondholders
-Imposed by lenders, like banks
ex: require senior position, meet certain ratios