Finance Exam Study Guide
Essay by Casey Dupuis • September 13, 2016 • Study Guide • 1,766 Words (8 Pages) • 1,410 Views
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
- Current return or current yield: reflects the coupon interest payments only
= Annual INT or total annual coupon $ PMT / Price
- 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)
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