FIN3403 Exam 2 Review Chapter 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 Bonds Government 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 level Zero 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 price YTM coupon rate then par value bond price YTM coupon rate then par value bond price price below par value discount bond YTM coupon rate then par value bond price price 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 they may be repaid in part or in entirety before repayment is more typical and is often bond or maturity Early handled through a sinking fund payments portion of over a sinking fund an account managed by the bond trustee for early bond redemption The company makes annual to the trustee who then uses the funds to retire a debt any call provisions a call provision allows the company to repurchase or call part or all of the bond issue at stated prices specified period any protective covenants a protective covenant is that part of the indenture or loan agreement that limits certain actions a company might 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 bond N FV PMT I Y PV current yield annual interest current price bond value C 1 1 1 r t r FV 1 r t Interest 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 inflation The Fisher Effect 1 nominal rate 1 real rate 1 inflation Dividend Growth Model dividends are expected to grow at a constant percent per period Po D1 r g Do 1 g r g or more generally Pn Dn 1 r g R D1 Po g G 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 formula Po D R Constant dividend growth period the firm will increase the dividend by a constant percent every the price is computed using the growing perpetuity model Pt Pt 1 r g Supernormal growth dividend growth is not consistent initially but settles down to constant growth eventually the price is computed using a multistage 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 Zero Growth Model perpetuity formula Po D R Capital Gains vs Dividend Yield Capital gains g Dividend yield D1 Po Dividend Characteristics Preferred Stock 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 period 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 dividends are not a liability of the firm and preferred dividends can usually missed preferred dividends have to be paid before common common stockholders be deferred indefinitely 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 firm Various Stock Market Players Brokers a broker matches buyers and sellers transactions of equity securities They perform the search function for a fee commission They hold an inventory of
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