Finance Exam Study Guide

Exam 3 Finance

Section 1: Bonds

What are bonds? A bond is a long term contract under which a borrower agrees to make payments of interest and principal on specific dates to the holders of the bond

• Promissory notes: issues to borrow money, pay back face value (FV) at maturity (M)
• Interest: bonds and notes pay fixed periodic interest (“coupons”), bills and commercial paper are ‘pure discount’, Interest is paid on a periodic date
• Principal is paid at maturity

Issuer can be: corporate, municipal, foreign, treasury; company, state, or country

*borrowing contract between a lender and a borrower*

Maturity Lengths: Company has to pay back the principal in that amount of time

Bonds: > 10 years     Notes: 1-10 years     Treasury bills: < 1 year (very liquid)     Commercial paper: <270 days

Coupon: ($INT) periodic interest payments $, the size of the coupon payment can be figured out from calculating the coupon rate

Coupon rate = Annual interest payment or annual interest PMT / par or face value FV

Tells you how much interest you will get within a year, Coupon rate is expressed as a percentage

Face Value or Par Value (FV) or (M): the principal to be paid when the bond matures (the amount that will be repaid as principal @ maturity)

Maturity (N): the date/time period that the principal/par value will be paid back within, also tells you how many coupon payments you will get/pay

Bond Return: two types of returns can be calculated

1. Current return or current yield: reflects the coupon interest payments only

= Annual INT or total annual coupon $ PMT / Price

1. Yield to Maturity (YTM) or internal rate of return (IRR): annual rate, annual return, how much return you will get in a given year. Tells you about the discount rate/required annual return

Pb = INT/YTM [1 – (1/(1+YTM)^N] + (M/(1+YTM)^N)

PMT = coupon payment → coupon rate x face value, if semiannual then /2

FV= face value at maturity, if not stated use $1000

1/Y= discount rate → annual return/times per year .. if semi-annual then /2

N= how many coupon payments you have

Annual coupon PMT = coupon rate x par (face) value

ALWAYS ASSUME:

• Bonds make payments semi-annually unless started otherwise
• The PV is always the price of the bond if you are given that info (what it sells as)

Bond Risk: default risk is the biggest risk; the change that the issuer will not be able to pay coupon interest and par value when promised; risk increases the required return for bonds

Bond ratings → greater risk, lower letter (prime AAA, high AA, upper medium A, medium BBB, junk BB B CCC CC C, in default D: company missed a payment and is in default)

The price/return relationship

• Prices and returns on bonds are inversely related
• The greater the denominator the lower the price

Interest rate sensitivity risk: As Maturity is longer/increases, interest rate sensitivity risk increases/is higher. Higher coupon rate causes lower IRSR. (Lower coupon rate, higher IRSR)

Duration and Interest rate sensitivity: sensitivity of price depends on time to maturity and the pattern of cash flows up to maturity

Duration: measures sensitivity of price to r

[[SUM (t * INT) / (1 + r)^t] + (N * M)/(1+r)^N] / price    where r=discount rate and INT= interest paid at maturity

Interpretation: the average date of receipt of future cash flows → the duration of a coupon bond is shorter than its maturity

Duration of a zero coupon bond is equal to its maturity in years, to calculate, only factor in the first part of the equation

Duration = [(t * (INT + FV))/(1+r)^t] / price

Bond Valuation: bond characteristics

Par/Face value: amount paid back at maturity; assume $1000 unless otherwise stated

Coupon rate: determines periodic PMTs, annual coupon/par value

Maturity: date at which par value is paid back and periodic payments cease

Risk: the chance that the issuer will not be able to pay coupon interest and par value when promised

Price = PV of all coupon payments + PV of par value

Current yield = annual coupon/price

YTM = discount rate that equates the present value of all cash flows to the bond price

If coupon rate = current yield = YTM then price = par → a par bond

If coupon rate > current yield > YTM then price > par → a premium bond

If coupon rate < current yield < YTM then price < par → a discount bond

Section 2: Stock

Why consider stocks? Limited liability- as a shareholder you are a part owner, but if the company goes broke, you can only lose the amount you invested

• Over time, common stocks out perform all other investments
• Stocks reduce risk through diversification =
• Stocks are very liquid

Shareholder (Stockholder) Rights

• Claim on income- as a shareholder you have the right to any earnings of the company after all other obligations are met. Dividends are declared and then paid quarterly if any earnings remain
• Claim on assets- common shareholders can claim their assets only after debtors and preferred stock holders have been paid

Book Value: Calculated by subtracting the firm’s liabilities from their assets, as given on a balance sheet; A historical number based on the value of assets when purchased

Total assets = total liabilities + equity

Total equity = total assets – total liabilities    (dive equity by # of shares to get book value)