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Modern Finance > Week 5- Valuing Bonds and Shares > Flashcards

Week 5- Valuing Bonds and Shares Flashcards

1
Q

Define perpetuity:

A

Perpetuity: Financial concept in which a cash flow is theoretically received forever.

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2
Q

How can we calculate the present value of a perpetuity?

A

present value = cash flow/Return
PV = 𝐶/R

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3
Q

Define an annuity

A

An asset that pays a fixed sum each year for a specified number of years.

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4
Q

How can we calculate the present value of an annuity

A

PV of annuity =𝑪×[𝟏- (𝟏/(𝟏+𝒓)^𝒕)]

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5
Q

What kind of loan is a bond normally?

A

Bond is normally an interest-only loan

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6
Q

Alpha plc wants to borrow £1,000 for 30 years & the interest rate on similar debt issued by similar corporations is 12%. Alpha will thus pay: 0.12 × 1,000 = £120 in interest every year for 30 years & at the end of 30 years it will repay the £1,000. What is the coupon?

A

The coupon is the stated interest payment made on a bond. (£120 in the example)

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7
Q

Alpha plc wants to borrow £1,000 for 30 years & the interest rate on similar debt issued by similar corporations is 12%. Alpha will thus pay: 0.12 × 1,000 = £120 in interest every year for 30 years & at the end of 30 years it will repay the £1,000. What is the face value?

A

The Face Value is the principal amount of a bond that is repaid at the end of the term. Also called par value. (£1000 in the example)

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8
Q

Alpha plc wants to borrow £1,000 for 30 years & the interest rate on similar debt issued by similar corporations is 12%. Alpha will thus pay: 0.12 × 1,000 = £120 in interest every year for 30 years & at the end of 30 years it will repay the £1,000. What is the Coupon Rate?

A

The coupon rate is the annual coupon divided by the face value of a bond. (£120/1,000=12% in the example).

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9
Q

Alpha plc wants to borrow £1,000 for 30 years & the interest rate on similar debt issued by similar corporations is 12%. Alpha will thus pay: 0.12 × 1,000 = £120 in interest every year for 30 years & at the end of 30 years it will repay the £1,000. What is the Maturity?

A

The maturity is the specified date on which the principal amount of a bond is paid. (30 years from now in the example)

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10
Q

Alpha plc wants to borrow £1,000 for 30 years & the interest rate on similar debt issued by similar corporations is 12%. Alpha will thus pay: 0.12 × 1,000 = £120 in interest every year for 30 years & at the end of 30 years it will repay the £1,000. What is the Yield to Maturity?

A

The Yield to Maturity is the interest rate required in the market on a bond.

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11
Q

In simple terms, how do you calculate a bond’s value?

A

Bond value = PV of coupons (ie annuity) + PV of the
face amount

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12
Q

If a bond has (1) a face value of F paid at maturity, (2) a coupon of C paid per period, (3) t periods to maturity, and (4) a yield of r per period, it is calculated how?

A

Bond value = 𝑪×[𝟏- (𝟏/(𝟏+𝒓)^𝒕)] + 𝑭/(𝟏+𝒓)^𝒕

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13
Q

What is it called if a bond sells for exactly its face value?

A

It is a par value bond

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14
Q

What will be true about a bond’s value if the YTM and the coupon rate are the same?

A

It will be a par value bond

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15
Q

What is a discount bond?

A

One that sells for below face value

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16
Q

What is a premium bond?

A

One that sells above its face value

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17
Q

Why would bonds sell at a discount?

A

To compensate investors for investing in the bond instead of other areas where they can gain a higher return, ie the market.

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18
Q

Why would bonds sell at a premium?

A

As they pay an interest rate which is higher than the market price, so to compensate the company it sells at a higher price.

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19
Q

What should the selling price of a bond equal?

A

The difference between the market selling price and face value = present value of losses/gains

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20
Q

What is a semi-annual coupon?

A

Where payments are made twice a year, ie, if an ordinary bond has a coupon rate of 14 per cent and a face value of £100,000, then the owner will get a total of £14,000 per year,
but this £14,000 will come in two payments of £7,000 each.

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21
Q

How are bond yields presented?

A

Bond yields are presented in the same way as quoted rates, which is equal to the actual rate per period multiplied by the number of
periods. Ie, with a 16 per cent quoted yield and semiannual payments, the true yield is 8 per cent per six months.

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22
Q

How do we calculate the effective annual yield?

A

The same way as EAR is caculate, ie [(1+r)^n] -1

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23
Q

Is the effective rate or annual rate higher? Why?

A

Effective Rate ≥ Quoted Rate due to compounding. It is equal if the interest is paid on an annual basis.

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24
Q

What does a bond’s sensitivity to interest rate changes directly depend on?

A
  1. Time to maturity.
  2. Coupon rate.
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25
Q

All other things being equal, what is the effects of a longer time to maturity or lower coupon rate on interest rate risk?

A
  1. The longer the time to maturity, the greater the interest rate risk.
  2. The lower the coupon rate, the greater the interest rate risk.
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26
Q

What is Interest Rate Risk?

A

Interest Rate Risk is the risk that arises for bond owners from fluctuating interest rates. and the degree of interest rate risk a bond has depends on its sensitivity to interest rate changes.

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27
Q

Why is a bond with a higher coupon, less sensitive to changes in the discount?

A

Bond value = 𝑪×[𝟏- (𝟏/(𝟏+𝒓)^𝒕)] + 𝑭/(𝟏+𝒓)^𝒕

The bond with the higher coupon has a larger cash flow early in its life, so its value is less sensitive to changes in the discount rate.

28
Q

What is the difference between a YTM and current yield?

A

Current yield: measures only the cash income provided by the bond as a percentage of bond price and ignores any prospective capital gains or losses. The YTM accounts for both.

29
Q

For premium bonds, what is highest, coupon rate, current yield or YTM?

A

For a premium bond: coupon rate > current yield > YTM.

30
Q

For discount bonds, what is the highest, coupon rate, current yield or YTM?

A

For a discount bond: coupon rate < current yield < YTM.

31
Q

Who are the main 2 bond rating agencies?

A

Moody’s and Standard & Poor’s
(S&P)

32
Q

What are bond’s ratings an assessment of?

A

Firms often pay to have their debt rated, with ratings serving as an assessment of the creditworthiness of the corporate issuer.

33
Q

Definitions of creditworthiness used by Moody’s and S&P are based on what?

A

How likely the firm is to default and the protection creditors have in the event of a default.

34
Q

Do bond ratings change?

A

Ratings can change as the issuer’s financial strength changes.

35
Q

What are corporate bond ratings determined by?

A

Financial risk, the ability of the firm to meet its debt requirements, other firm-level
factors, and macroeconomic factors.

36
Q

What are government bond ratings determined by?

A

Government bond ratings are determined by: political risk, economic strength and growth prospects, government debt, and monetary and fiscal flexibility.

37
Q

Do ratings agencies always agree?

A

No, these are called “crossover” bonds.

38
Q

What are zero coupon bonds?

A

Zero coupon bonds, or zeroes, are bonds that make no coupon payments and are thus initially priced at a deep discount.

39
Q

What is strange about the taxation element of zero coupon bonds

A
  • For tax purposes, the issuer of a zero coupon bond deducts interest every year even though no interest is actually paid
  • Similarly, the owner must pay taxes on interest accrued every year, even though no interest is actually received
  • Hence they are attractive investment for tax-exempt investors with long-term dollar-denominated liabilities (e.g., pension funds) because the future dollar value is known with relative certainty
40
Q

What does the Fisher Effect describe?

A

The relationship between nominal returns, real returns and inflation

41
Q

Let 𝑅 stands for the nominal rate, 𝑟 stands for the real rate, and ℎ stand for the inflation rate; Fisher effect can be written as?

A

1 + 𝑅 = (1 + 𝑟 ) × (1 + ℎ)

42
Q

The term structure of interest rates tells us what?

A
  • The term structure of interest rates tells us what nominal interest rates are on default-free, pure discount securities; that is, the pure time value of money.
43
Q

When long-term rates are higher than short-term rates, we say that the term structure is?

A

Upward Sloping

44
Q

When short-term rates are higher than long-term rates, we say the term structure is?

A

Downward Sloping

45
Q

Why can term structures be “humped”?

A

Term structure can also be “humped”, which is usually because rates increase at first, but then begin to decline as we look at longer- and longer-term rates.

46
Q

What 3 things determine the rate of the term structure?

A
  • Real Interest Rate (the compensation that investors demand for forgoing the use of their money)
  • Inflation premium (the portion of a nominal interest rate that represents compensation for expected future inflation.)
  • Interest Rate Risk Premium (the compensation investors demand for bearing interest rate risk.)
47
Q

What may an upward-sloping term structure reflect?

A

Upward-sloping term structure may reflect anticipated increases in inflation, while a downward-sloping term structure probably reflects the belief that inflation will be falling in the future.

48
Q

What does interest rate risk premium increase with?

A

Interest rate risk premium increases with maturity, but it increases at a decreasing rate

49
Q

What does the shape of the Treasury yield curve reflect?

A

Treasury yield curve is a plot of the yields on Treasury notes and bonds relative to maturity
* Shape of yield curve reflects the term structure of interest rates.
* Term structure is based on pure discount bonds, whereas the yield curve is based on coupon bond yields.

50
Q

Are bonds default-free, taxable and liquid?

A

Recall Treasury notes and bonds are default-free, they are taxable, and they are highly liquid. However, this is not true for corporate bonds.

51
Q

Define default risk, taxability and liquidity premiums.

A
  • Default risk premium is the portion of a nominal interest rate or bond yield that represents compensation for the possibility of default (Lower-rated bonds have higher yields)
  • Taxability premium is the portion of a nominal interest rate or bond yield that represents compensation for unfavourable tax status (Recall, municipal bonds are free from most taxes)
  • Liquidity premium is the portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity
52
Q

Give 3 reasons why it is more difficult to value shares of common stock than it is to value bonds.

A
  • With common stock, not even the promised cash flows are known in advance.
  • Life of the investment is essentially forever because common stock has no maturity
  • No easy way to observe the rate of return that the market requires
53
Q

What is the PV of a stock today equal to?

A

The present value of all the future dividends

54
Q

How do we calculate the per-share value of a zero-growth stock? (ie dividend is constant over time)

A

P0 = D/r

55
Q

How do we calculate the dividend t periods into the future of a constant-growth stock? (ie dividend is constant over time)

A

Dt = D0 x (1+g)^t, where:
- D0 is the dividend just paid
- g is the steady growth rate of the dividend

56
Q

How do we calculate the per-share value as of time t of a constant-growth stock? (ie dividend is constant over time)

A

Pt = Dt x (1+g)/(r+g)

57
Q

Why would we consider the case of non-constant growth?

A

To allow for “supernormal” growth rates over some finite period of time

58
Q

How do we calculate the per-share value as of time t of a non constant-growth stock? (ie dividend is constant over time)

A
  • Find the value of the stock at the end of its last term of non constant growth and add in the PV of dividends that will be paid between now and then
59
Q

What is the primary stock market?

A

The market in which new securities are originally sold to investors. The company benefits from the sale and the cash flow from the sale of new shares can be used to invest in the company’s operations.

60
Q

What is the secondary stock market?

A

The market in which previously issued securities are traded among investors. The company does not directly benefit from the
sale or purchase because money changes hands only between investors.

61
Q

What is a “blue chip” stock?

A

Blue chip has become a colloquial term meaning “high quality”. Some define blue chips as firms with a long, uninterrupted history of dividend payments.

62
Q

What are “income” stocks?

A
  • Income stocks are those that historically have paid a larger-than-average percentage of their net income as dividends
    – The proportion of net income paid out as dividends is the payout ratio
    – The proportion of net income retained is the retention ratio
63
Q

What are “cyclical” stocks?

A
  • Cyclical stocks are stocks whose fortunes are directly tied to the state of the overall national economy
  • Examples include steel companies, industrial chemical firms, and automobile producers.
64
Q

What are “defensive” stocks?

A
  • Defensive stocks are the opposite of cyclical stocks.
    – They are largely immune to changes in the macroeconomy and have low betas
    Examples include retail food chains, tobacco and alcohol firms, and utilities.
65
Q

What are “growth” stocks?

A
  • Growth stocks do not pay out a high percentage of their earnings as dividends.
    – They reinvest most of their earnings into investment opportunities
66
Q

Are categories of stock mutually exclusive?

A

No, stocks can be say both blue chip and income

67
Q

What are “speculative” stocks?

A

Speculative stocks are those that have the potential to make their owners rich quickly.
– Speculative stocks carry an above-average level of risk.
– Most speculative stocks are relatively new companies with representation in the technology, bioresearch, and pharmaceutical industries. These industries have a high
potential for dramatic success or failure.

Modern Finance (9 decks)

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