Exam 2 Test Questions (Concepts)

Question 1

What are bond ratings?

Answer 1

This is when bonds from companies with similar risk and characteristics are grouped together into categories

i.e AAA, AAA, A, BBB, BB, B, CCC, D

In this example AAA is the highest quality bond and D being the lowest.

Question 2

All bonds in the same bond market and having the same maturity have the same market interest rate - True or false

Answer 2

True

Question 3

What does it mean to sell a bond at par?

Answer 3

This means the bond is being trading at its face value.

Question 4

What does it mean to sell a bond at discount?

Answer 4

A bond that is issued for less than its par (or face) value, or a bond currently trading for less than its par value in the secondary market.

Question 5

What does it mean to sell a bond at a premium?

Answer 5

This means that the bond is being sold above its face value or at par value.

Question 6

What is the interest rate relationship with bond prices?

Answer 6

The relationship that bond prices and interest rates have is an inverse relationship. Meaning

Question 7

How is a bond price affected by maturity.

Answer 7

The further a bond is from maturity, the greater will be the difference between the purchase price and the redemption value at maturity. Let’s look at an example.

Question 8

What is the capital gains yield?

Answer 8

This is the capital gains(loss) due to changes in Rd. This is how much you earn when you sell a bond.

Question 9

For firms when market interest rates are falling you should…?

Answer 9

Have an inventory of long term bonds to sell

I.e when rd decrease bond value s rise

Question 10

When market interest rates bottom out and start to rise it is better to deal in…?

Answer 10

Short term bonds.

When Rd increases bond prices fall

Question 11

Why is bond market rate is the required ROR for bond investing?

Answer 11

Because if your ROR is bond market rate it means you are at least making par on your investment..

look this one up.

Question 12

What is a bond indenture?

Answer 12

An indenture is a legal and binding contract between a bond issuer and the bondholders. The indenture specifies all the important features of a bond, such as its maturity date, timing of interest payments, method of interest calculation, callable/convertible features if applicable and so on.

Question 13

What is a bond convenant?

Answer 13

A bond covenant is a legally binding term of an agreement between a bond issuer and a bond holder. Bond covenants are designed to protect the interests of both parties. Negative or restrictive covenants forbid the issuer from undertaking certain activities; positive or affirmative covenants require the issuer to meet specific requirements

Question 14

What is a bond provision?

Answer 14

A call provision is a provision on a bond or other fixed-income instrument that allows the original issuer to repurchase and retire the bonds. If there is a call provision in place, it will typically come with a time window under which the bond can be called, and a specific price to be paid to bondholders and any accrued interest are defined.

Question 15

What is interest rate risk?

Answer 15

This is the uncertainty concerning the future value of a bond due to changes in Rd.

Question 16

What is reinvestment risk?

Answer 16

This is the income from a bond portfolio will vary because cash flows have to be reinvested at current market rates. When a bond matures they may not be able to reinvest the face value of that bond at a rate least favorable than the one currently being paid by that bond.

Question 17

Who sells stock ?

Answer 17

Stock is initially sold by the firm.

Question 18

What are share of stock used for?

Answer 18

to buy capital assets

Question 19

TRUE OR FALSE:

Large quantities of stock are usually only issued once by a firm.

Answer 19

True

Question 20

What is the equation for stock realized return?

Answer 20

Realized Return = Realized Gain/Cost of investment x 100

Question 21

How do you determine the fair market value of a stock?

Answer 21

“The value of any financial asset is determind by discouting all future cash flows to the present(i.e find the PV @ t=0) and adding them up.

Question 22

What is the equation to find expected total yield?

Answer 22

Expected Dividend Yield+expected capital gains yield

Question 23

What is the cost of stock in essences?

Answer 23

A management goal

Question 24

The Cost of stock- Know this word for word:Total Yield = EAR(rCPN) + Capital Gains Yield

Answer 24

“As Previously mentioned Rs (Required ROR from invesors perspectve) is also the cost of stock from a firms perspective The cost of stock is in essence a mangement goal:

Management must run the firm such that its value continues to improve
THis means that a firms Mgt must try to make stock total yield ( dividents & cap gains) match investors required ROR
If no investors buy less of the firsm outstanding sotck the stock falls in price due to ecreased emand the firm becomes more vulnerable to take over

Question 25

When it comes to bond valuation what does m mean?

Answer 25

The number of compounding periods/payments per year

Question 26

What is the coupon payment (CPN)?

Answer 26

This is the interest payment (periodic or simple)

Question 27

What does yield to maturity mean (YTM)?

Answer 27

The average rate of return earned on a particular bond if it is bought at its current price and held to maturityTotal Yield = EAR(rCPN) + Capital Gains Yield

Question 28

What is the equation to find a bonds total yield for the year?

Answer 28

Total Yield = EAR(rCPN) + Capital Gains Yield

Question 29

A firm can feasibly influence it's WACC by doing what?

Answer 29

Attempting to buy back out standing stock

Question 30

What are factors of WACC a firm CANNOT control

Answer 30

Debt market interest rates Stock market interest rates Stock market risk premium Tax rates

Question 31

What are factors of the WACC a firm can control?

Answer 31

Capital structure policy (potion of debt and portion of equity) Dividend policy (affects firms ability to meet investors RS) It's own risk position This affects bonds rating affects Rs (firm specific risk components) Measured by financial rations and other metric s

Question 32

Is the WACC the required rate of return for a Firm?

Answer 32

YES

Question 33

Why is the WACC the required rate of return.

Answer 33

The ROR must be equal to the cost of financing, otherwise the firm loses money. Since the WACC Is the cost of financing for the firm it is used as the ROR for the firm. ROA=ROR(firm)=WACC

Question 34

Discounting all future class flows to T=0 and adding them up tells the current value of any financial asset. Why is this true?

Answer 34

This is the process to achieve the financial valuation principle. The present value of any financial asset depends on usable after tax cash flow, it is expected to produce in the future. Due to TVM we have to discount those expected future cash flow in order to convert them into today's dollars

Question 35

A mortgage bonds interest rate incorporates an insufficient default risk premium

Answer 35

TRUE

Question 36

How does a firm with publicly traded stock meet the cost of stock?

Answer 36

A Management Goal: Mangers are in charge or creating value for the company. They must make total stock yield equal to investors required ROR. If not, investors will sell their share of stock and new investors won't buy stock which in turn will drive down the price/value of stock of the firm. This makes the firm vulnerable to a hostile takeover.

Question 37

Failure to meet the cost of stock is more disastrous and permanent than failure to meet the cost of debt.

Answer 37

Failure to meet the cost of debt is more immediate but recoverable - most firms can recover from bankruptcy. However, the failure to meet the cost of stock (required ROR) can result in stock holders selling their share of stock and new investors will not buy new stock. If this causes a hostile takeover you can not recover from that.