Chapter 19 - Long-Term Investments Flashcards
(67 cards)
The return objective for most capital markets investments is comprised of which two things?
Current income (coupon payments)
Capital gains
Many bonds, preferred stock, and common stock are valued using what?
Present value of cash flows
If the present value is above the investment’s price, what will usually happen? What if it is below?
Above = buy investment
Below = sell investment
A bond’s market price is comprised of what?
The present value of the stream of coupon payments plus the present value of the par value
Yield-to-Maturity (YTM)
Interest rate the market is demanding over the remaining life of the bond at any one particular point in time
If the calculated YTM is above the required rate of return, what will happen? What if it is below?
Above = buy investment
Below = sell investment
Yield-to-Call (YTC)
Yield that the bond would provide if the issuer calls the bond prior to maturity
Yield-to-Worst (YTW)
All possible YTC values are determined and the lowest of the potential values
May be multiple scenarios if there are multiple call dates
Lowest possible yield that can be received on a bond without the issuer actually defaulting
How does the YTM influence the price of a bond?
It is the discount rate utilized for the stream of cash flows that determine market price
Which type of security is considered a hybrid security?
Preferred stock
How is a security that is considered perpetuity valued?
Perpetual cash flow is simply divided by the required rate of return on the security
Which rate is typically lower, the YTC or the YTM? Why?
The YTC since callable bonds are usually only called if interest rates have fallen
A call date compresses the total return into a shorter period, and the investor loses the premium paid over a shorter timeframe, which decreases the annualized yield
The present value of preferred stock is (inversely/directly) related to the market’s required return?
Inversely
What is one of the primary advantages of common stock as it relates to earnings?
(from the investor’s perspective)
There is a growth potential for earnings and dividends
Gordon Growth Model / Dividend Discount Model
Valuation model for common stock that incorporates a growth factor for dividends and incorporates the required rate of return
Absolute/intrinsic valuation model
Absolute or Intrinsic Model
A model that considers only one company’s financial performance
When is it best to apply the Gordon Growth Model? What are its downsides?
Best to use for larger companies that pay a steadily growing dividend
Has high degree of sensitivity to required rate of return and/or the growth rate
Required Criteria for using Gordon Growth Model
Required return must exceed the dividend growth rate
Dividend growth rate must be expected to be constant in perpetuity
Downside to the Earnings Multiplier approach for valuing common stock
The EPS value is either historical and doesn’t take into account the present/future
The EPS value is a forecasted value that relies upon certain assumptions
Why do opportunities to generate returns arise when it comes to valuation of common stock?
There are multiple different valuation techniques, so not all investors have the same expectations of current and future value
What is the starting point for determining the optimal asset allocation in an investment portfolio?
Determining the investor’s risk tolerance
The investor’s return objective in an investment policy can take three general formats, which include:
Absolute return
General goal
Relative benchmark return
Bond prices are (directly/inversely) related to interest rates?
Inversely
Duration
Sensitivity of a bond’s price in relation to interest rate changes
