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FSU FIN 3403 - Exam 2 Review

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FIN3403 Exam 2 ReviewChapter 7: Bond Valuation (3 conceptual, 5 computational)Chapter 8: Stock Valuation (3 conceptual, 5 computational)Chapter 9: NPV and Investment Criteria (2 conceptual, 7 computational)Different types of Government BondsGovernment Bonds-treasury securities-federal government debt-t-bills: pure discount bonds with original maturity of 1yr or less-t-notes: coupon debt with original maturity between 1-10yrs-t-bonds: coupon debt with original maturity 10+ years-municipal securities-debt of state and local governments-varying degrees of default risk, rated similar to corporate debt-interest received as tax-exempt at the federal levelZero Coupon Bonds-make no periodic interest payments (coupon rate =0%)-the entire yield to maturity comes from the difference between purchase price and the par value-cannot sell for more than par value-sometimes called zeroes, deep discount bonds, or original issue discount bonds (OIDs)-treasury bills and principal-only. Treasury strips. Floating-Rate Bonds-coupon rate floats depending on some index value-examples: adjustable rate mortgages and inflation-linked treasuries-there is less price risk with floating rate bonds-the coupon floats, so it is less likely to differ substantially from the yield to maturity-coupons may have a “collar”: the rate cannot go above a specified “ceiling” or below a specified “floor”Bond Definitions-Bond: long terms IOUs, usually interest only loans (interest is paid by the borrower every period with the principal repaid at the end of the loan)-par value(face value): principal, amount repaid at the end of the loan-coupon rate: coupon quoted as a percent of face value-coupon payment: the regular interest payments (if fixed amount-level coupon)-maturity date: time until face value is paid, usually given in years-yield or yield to maturity (YTM): the required rate or return, or rate that makes the discounted cash flows from a bond equal to the bond’s market priceYTM= coupon rate, then par value=bond priceYTM > coupon rate, then par value > bond priceprice below par value=discount bondYTM < coupon rate, then par value < bond priceprice above par value = premium value-indenture: written agreement between bond issuer and creditors (bondholders) detailing terms of borrowing. (also, deed of trust). Includes the following provisions:-the total face amount of bonds issued-a description of any property used as a security: debt securities are classified according to the collateral and mortgages used to protect the bondholder-the repayment arrangements: bonds can be repaid at maturity, at which time the bondholder will receive the face value of the bond; or they may be repaid in part or in entirety before maturity. Early repayment is more typical and is often handled through a sinking fund-sinking fund: an account managed by the bond trustee for early bond redemption. The company makes annual payments to the trustee, who then uses the funds to retire a portion of debt. -any call provisions: a call provision allows the company to repurchase or call part or all of the bond issue at stated prices over a specified period-any protective covenants: a protective covenant is that part of the indenture or loan agreement that limits certain actions a companymight otherwise wish to take during the term of the loan : indenture conditions that limit the actions of firms in order to protect bondholders-negative covenant: “thou shalt not” sell major assets, etc. -positive covenant: “thou shalt” keep working at or above $X, etc. Calculating the price, yield, and coupon of a bondN FV PMT I/Y PV(+) (+) (-)current yield: annual interest / current pricebond value: C [1-1/(1+r)^t]/ r+FV/(1+r)^tInterest Rate Dynamics-real rate of interest: change in purchasing power-nominal rate of interest: quoted rate of interest, change in actual number of dollars-the ex ante nominal rate of interest includes our desired real rate of return plus an adjustment for expected inflationThe Fisher Effect1+ nominal rate= (1 + real rate) (1 + inflation)Dividend Growth Model-dividends are expected to grow at a constant percent per periodPo= D1/(r-g) = [Do (1+g)}/(r-g), or more generally Pn=Dn-1/r-gR=(D1/Po) +gG= R- (D1/Po)Constant dividend-the firm will pay a constant dividend forever-this is like preferred stock-the price is computed using the perpetuity formulaPo=D/RConstant dividend growth -the firm will increase the dividend by a constant percent every period-the price is computed using the growing perpetuity modelPt =Pt+1/r-gSupernormal growth-dividend growth is not consistent initially, but settles down to constant growth eventually-the price is computed using a multistage modelZero Growth Model -dividends are expected at regular intervals forever, then this is a perpetuity and the PV of expected future dividends can be found using the perpetuity formulaPo=D/RCapital Gains vs. Dividend YieldCapital gains: gDividend yield: D1/PoDividend Characteristics-dividends are not a liability of the firm until a dividend has been declared by the board-consequently, a firm cannot go bankrupt for not declaring dividends-dividends and taxes-dividend payments are not considered a business expense; therefore, they are not tax deductible-the taxation of dividends received by individuals depends on the holding periodPreferred Stock-similar to debt. For tax purposes, preferred stock is equity and dividends are not tax deductible expense, unless they meet specific characteristics-has precedence over common stock in the payment of dividends and in liquidation-represents equity in the firm, but has many features of debt, including a stated yield (annuity payment), preference in terms of cash flows and liquidation, fixed liquidation value, lack of voting rights, and some issues are callable and/or convertible into common shares. d-Dividends-stated divided that must be paid before dividends can be paid to common stockholders-dividends are not a liability of the firm, and preferred dividends can be deferred indefinitely -usually, missed preferred dividends have to be paid before common dividends can be paid Common Stock-voting rights-proxy voting is similar to absentee ballots. A proxy is the grant of the authority by a shareholder to someone else to vote his or her shares. -different classes of stock can have different rights. Owners may want to issue a nonvoting class of stock if they want to make sure that they maintain control of the


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