Finance Final Exam

    Cards (96)

    • Bond
      A long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond
    • Bond
      • Par value - face amount of the bond, which is paid at maturity
      • Coupon interest rate - stated interest rate (generally fixed) paid by the issuer
      • Maturity date - years until the bond must be repaid
      • Issue date - when the bond was issued
      • Yield to maturity - rate of return earned on a bond held until maturity
    • Bond markets
      Primarily traded in the over-the-counter (OTC) market<|>Most bonds are owned by and traded among large financial institutions<|>The Wall Street Journal reports key developments in the Treasury, corporate, and municipal markets
    • Call provision
      Allows issuer to refund the bond issue if rates decline (helps the issuer, but hurts the investor)<|>Borrowers are willing to pay more, and lenders require more, for callable bonds<|>Most bonds have a deferred call and a declining call premium
    • Sinking fund
      Provision to pay off a loan over its life rather than all at maturity<|>Similar to amortization on a term loan<|>Reduces risk to investor, shortens average maturity<|>Not good for investors if rates decline after issuance
    • How sinking funds are executed
      1. Call x% of the issue at par, for sinking fund purposes
      2. Buy bonds in the open market
    • Convertible bond
      May be exchanged for common stock of the firm, at the holder's option
    • Warrant
      Long-term option to buy a stated number of shares of common stock at a specified price
    • Putable bond
      Allows holder to sell the bond back to the company prior to maturity
    • Income bond
      Pays interest only when interest is earned by the firm
    • Indexed bond

      Interest rate paid is based upon the rate of inflation
    • Opportunity cost of debt capital
      The discount rate (ri) is the opportunity cost of capital, and is the rate that could be earned on alternative investments of equal risk
    • Valuing a 10-year, 10% annual coupon bond with rd = 10%
      PV = $90.91 + $38.55 + ... + $1,000 / (1.10)^10
    • Using a financial calculator to value a bond
      N=10, I/YR=10, PMT=100, PV=-1000, FV=1000
    • Valuing a 10-year, 13% annual coupon bond with rd = 10%

      PV = $130 * (1 - (1+10%)^-10) / 10% + $1,000 / (1+10%)^10
    • Valuing a 10-year, 7% annual coupon bond with rd = 10%

      PV = $70 * (1 - (1+10%)^-10) / 10% + $1,000 / (1+10%)^10
    • At maturity, the value of any bond must equal its par value
    • If rd remains constant: the value of a premium bond would decrease over time, the value of a discount bond would increase over time, and the value of a par bond stays at $1,000
    • Finding the YTM on a 10-year, 9% annual coupon, $1,000 par value bond, selling for $887
      PV = $90 * (1 - (1+rd)^-10) / rd + $1,000 / (1+rd)^10 = $887
    • Using a financial calculator to solve for the YTM
      N=10, I/YR=10.91, PMT=90, PV=-887, FV=1000
    • Finding the YTM if the bond price is $1,134.20
      N=10, I/YR=7.08, PMT=90, PV=-1134.2, FV=1000
    • Current yield (CY)
      Annual coupon payment / Beginning price
    • Capital gains yield (CGY)

      Expected change in price / Beginning price
    • Expected total return

      Current yield + Capital gains yield
    • Interest rate risk is the concern that rising rd will cause the value of a bond to fall
    • A 10-year bond has more interest rate risk than a 1-year bond

      The 10-year bond is more sensitive to interest rate changes
    • CGY
      Change in price
    • Capital
      Price
    • Current yield (CY)
      Annual coupon payment
    • Current yield
      10.15%
    • An Example
      • Current and Capital Gains Yield
    • Find the current yield and the capital gains yield
      For a 10-year, 9% annual coupon bond that sells for $887, and has a face value of $1,000
    • Capital gains yield
      0.76%
    • YTM
      Current yield + Capital gains yield
    • Interest rate (or price) risk
      The concern that rising rd will cause the value of a bond to fall
      1. year bond
      Has less interest rate risk than a 10-year bond
    • 10-year bond
      Is more sensitive to interest rate changes, and hence has more interest rate risk
    • Reinvestment rate risk
      The concern that rd will fall, and future CFs will have to be reinvested at lower rates, hence reducing income
    • Reinvestment Rate Risk Example
      • Investing $500,000 in either a 10-year bond or a series of ten 1-year bonds, both currently yielding 10%
    • Nothing is riskless!
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