Flashcards in Exam 2 Deck (113):

1

## Interest rate levels

### Price of capital. Borrows are willing to pay and lenders are going to recieve

2

## What are the four factors that affect interest rates?

### Production opportunities, time preferences for consumption, risk, and expected inflation

3

## Time preferences for consumption

### Supply side. More in future high supply =lower interest rate

4

## Risk

### Higher risk=higher interest

5

## Expected inflation

### High inflation = high IR

6

## R*

### Real risk free rate of interest

7

## Rrf

### The nominal rate of interest on treasury securities

8

## Rrf=

### R*+IP

9

## Interest rate equation

### R*+IP+DRP+LP+MRP

10

## R

### Required return on a debt security

11

## DRP

### Default risk premium. Chance for borrower not to make payment

12

## LP

### Liquidity premium. Convertibility to cash at fair market value

13

## MRP

### Maturity risk premium. Price of long term bonds changes over time as interest rate changes. Risk of capital loss

14

## Short term treasury

### IP

15

## Long term treasury

### IP and MRP

16

## Short term corporate

### IP DRP LP

17

## Long term corporate

### IP MRP DRP LP

18

## Term structure

### Relationship between interest rates and maturities

19

## Yeild curve step one

### Find the average expected inflatiob rate over years

20

## Yeild curve step two

### Find the appropriate maturity risk premium. .1%(t-1)

21

## Yeild curve step 3

### Add the premiums to r*

22

## Upward sloping yeild curve

### Due to an increase in expected inflation and MRP

23

## Corporate yeild curves

### Are higher than that of treasury securities though not parallel to t-curve

24

## The spread between corporate and treasury yeild curves

### Widens as fhe corporate bond rating decreases

25

## Since corporate yields include a DRP and LP the yield spread can be calculated as

###
Corporate bond yield-Treasury bond yield

DRP+LP

26

## Investment grade bonds

### BBB and higher. Investment companies can only invest in these

27

## Junk bond

### BB and lower

28

## Pure expectations theory

### Contends that the shape of the yield curve depends on investors expectations about future interest rates. IR increase LT rates will be higher than ST rates

29

## Assumptions of pure expectations

### MRP for T-securities is zero, LT rates are an average of current and future ST rates, use to guess future rates

30

## Macro factors that influence IR

### Federal reserve policy, federal budget deflicits or surpluses, international factors, level of business activity

31

## Federal reserve policy

###
Short term: money increases IR decreases

Long term: inflation increases IR increases

32

## Bonds are primarily traded in the

### Over the counter market

33

## Most bonds are owned by and teades among

### Large financial institutions

34

## Par value

### Face amount paid at maturity

35

## Coupon rate

### Stated interest rate

36

## Yield to maturity

### Rate of return earned on a bond held until maturity

37

## Call provision

### Allows issuer to refund the bond if rates decline, bond premium, deferred call and declining call

38

## Sinking fund

### Provision to pay off a loan over its life rather than all at maturity. Reduces risk to investor. Investors have reinvestment risk

39

## Convertable bond

### May be exchanged for common stock of the firm at the holders option

40

## Warrant

### Long term option to buy a stated number of shares of common stock at a specific price

41

## Putable bond

### Allows holder to sell the bond back to the company prior to maturity

42

## Income bond

### Pays interest only when interest is earned by the firm

43

## Indexed bond

### Interest paid is based upon the rate of inflation CPI+%

44

## Opportunity cost of debt capital

### Discount rate. Rate that could be earned on alternative investments of equal risk

45

## If Rd remains constant

### The value of prmium bond will decrease, value of discount bond will increase, par value stays the same

46

## Current yield

### Annual coupon payment/ current price

47

## Capital gains yield

### Change in price/ begining price

48

## Expected total return

### YTM= expected CY+ expected CGY

49

## The longer the bond

### The higher the price risn

50

## Reinvestment risk

### The concern that the rd will fall and the future CFs will have to be reinvested at lower rates

51

## Short term/high coupon bonds

### Low price risk, high reinvestment risk

52

## Long term/ low coupon

### High price risk, low reinvestment risk

53

## Semiannual bonds

###
Period: 2N

Periodic rate: rd/2

PMT= annual rate/2

54

## Callable bonds YTM or YTC

### If YTC

55

## When is a call more likely to occur?

### Market

56

## Default risk

### Influenced by the issuers finanacal strength and the terms of the bond contract

57

## Mortgage bonds

### Backed by fixed assets

58

## Debenture bonds

### Bond with no collateral

59

## Subordinated debenture

### 3rd tear

60

## Liquidation

### Assets are auctioned off to obtain cash that is then distrubuted to creditors

61

## Priority claims of liquidation

### Secured creditors, trustee costs, wages, taxes, unfunded pensions, unsecured creditors, preferred stock, common stock

62

## Reprganization

### Emerges from bankruptcy with lower debts reduced interest and a chance for success. Unsecured creditors more willing to participate

63

## Investment risk

### The chance that unfavorable events will occur from an investment. Probability that earn low or negative return

64

## Stand alone risk

### Investing in one companys stock

65

## Portfolio risk

### Investing in multiple companys stock

66

## Probability distributions

### Narrower is lower risk. Wider is higher risk

67

## Stocks are said to provide

### Relativly higher return with higher risk. Trade off

68

## High tech relative to economy

### Moves with the economy and has positive correlation

69

## Collections relation to economy

### Is countercyclical and has negative correlation

70

## Expected rate of return calculation

### Weighted average of all probablities

71

## Standard deviation for each investment

### Weighted average of expected returns minus actual returns

72

## Larger SD

### The lower the prob that actual returns will be closer to expected returns. Associated with a wider prob distribution of returns

73

## Corfficient of variation

### A standardized measure of dispersion about the expected value that shows the risk per unit of return. SD/expected return

74

## Risk aversion

### Assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities

75

## Risk premium

### The difference between the return on a risky asset and riskless asset which serves as compensation for investors to hold riskier securites

76

## A portfolios expected return is

### A weighted average of the returns of the portfolios component assets

77

## Correlation

### A tendency of 2 variables to move together

78

## SD for average stock

### 35%

79

## Most stocks are

### Positivley correlated with the market

80

## Correlation that is very low or negative

### Reduces risk

81

## Stand alone risk =

### Market risk + diversifiable risk

82

## Market risk

### Portion of a securitys stand alone risk that cannot be eliminated through diversification. Measured by beta

83

## Diversifiable risk

### Portion of a securitys stand alone risk that can be eliminated through proper disverification

84

## Capital asset pricing model

### Model linking risk and required returns

85

## CAPM suggests

### That there is a security market line that states a stocks required return equals the risk free return plus a risk premium

86

## Primary conclustion for CAPM

### The relevant riskiness of a stock is its contributiob to the riskibess of a well diversified portfolio. Not to the riskiness of added specific asset

87

## Beta

### Measures a stocks market risk and shows voliatiliy relatice to the market. Indicates how risky a stock is if held in difersified

88

## Beta equation

### Ri/rm

89

## Beta=1

### The security is just as risky as the average stock

90

## Beta>1

### Riskier than average

91

## Beta<1

### Less risky than average

92

## SML equation

### Ri= Rrf+ (Rm-Rrf) b

93

## Market risk premium

### Additional return over risk free needed to compensate investors for assuming an average amount of risk (Rm-Rrf)

94

## Fed stimilates

### R* decreases causing a decrease in Rrf and SMl decreases

95

## Facts about common stock

### Represent ownership, implies control, elect directors, directs elect management, management max stock price

96

## Stocks with price below intrinsic value

### Undervalued

97

## Discounted dividend model

### Value of a stock is the present value of the future dividends expected to be generated

98

## Stock price equation DDM

### D1/rs-g

99

## Growth factor is

### Comes feom the RE and reinvestment. The increased % of RE means increased g

100

## Dividend yield

### D1/Po (dividends/stock price)

101

## Capital gains yield stock

###
P1-po/po

%change in stock price

102

## Total return stock

### Dividend yield-capital gains yield

103

## If g=0

### Would be perpetuity. Pmt/r

104

## Negitive growth stock

### Do(1+g)/(rs-g)

105

## Corporate valuation model

### Free cash flow method. Suggest the value of the entire firm equals the present value of the firms free cash flows

106

## Free cash flows equation

### (Ebit(1-T)+dep)-(capital expenditures+change in working captial)

107

## Applying CVM

###
1) find pv of FCF

2) subtract debt anf preferred stock

3) divide by # of shares

108

## Issues CVM

### Used when firm doesnt pay dividends, assumes fcf growth constant, horizon value is point growth becomes constant

109

## Firm multiples method

### Analysts often us the following multiples to value stocks:p/e, p/cf, p/sales. Multiply but expected earnings

110

## Economic value added approach

### Find EVA, add future values to BV of equity, divide by # of shares

111

## EVA

### Equaity capital(ROE-cost of equity)

112

## Preferred stock

### Hybrid security, fixed dividends that must be paid before common stock, dont have to pay

113