CHAPTER 6 (INTEREST RATE &
BOND VALUATION)
Interest rate- is usually applied
to debt instruments such as
bank loans or bonds; the
compensation paid by the
borrower of funds to the lender;
from the borrower’s point of
view, the cost of borrowing
funds.
Required return - is usually
applied to equity instruments
such as common stock; the cost
of funds obtained by selling an
ownership interest.
Several factors can influence
the equilibrium interest rate:
Inflation- rising trend in the
prices of most goods and
services.
Risk - leads investors to expect
a higher return on their
investment
Liquidity preference - the
general tendency of investors to
prefer short-term securities
Real rate of interest - is the rate
that creates equilibrium
between the supply of savings
and the demand for investment
funds in a perfect world,
without inflation, where
suppliers and demanders of
funds have no liquidity
preferences and there is no risk.
The real rate of interest
changes with changing
economic conditions, tastes,
and preferences.
Nominal rate of interest is the
actual rate of interest charged
by the supplier of funds and
paid by the demander. The
nominal rate can be viewed as
having two basic components: a reflects investor expectations
risk-free rate of return, RF, and about future interest rates
a risk premium, RP1
Liquidity preference theory-
(r1 = RF + RP1) suggests that long-term rates
are generally higher than short-
Risk-free rate - embodies the
term rates (hence, the yield
real rate of interest plus the
curve is upward sloping)
expected inflation premium.
because investors perceive
Inflation premium- is driven by short-term investments to be
investors’ expectations about more liquid and less risky than
inflation—the more inflation long-term investments.
they expect, the higher will be
Market segmentation theory-
the inflation premium, and the
suggests that the market for
higher will be the nominal
loans is segmented on the basis
interest rate.
of maturity and that the supply
Term structure of interest rates of and demand for loans within
- is the relationship between the each segment determine its
maturity and rate of return for prevailing interest rate.
bonds with similar levels of risk.
Bond - is a long-term debt
Yield curve- graphic depiction of
the term structure of interest
rates.
Yield to maturity- is the
compound annual rate of return
earned on a debt security
purchased on a given day and
held to maturity.
Normal yield curve- is an
upward-sloping yield curve
indicates that long-term interest
rates are generally higher than instrument indicating that a
short-term interest rates. corporation has borrowed a
certain amount of money and
Inverted yield curve -is a
promises to repay it in the
downward-sloping yield curve
future under clearly defined
indicates that short-term
terms.
interest rates are generally
higher than long-term interest Bond’s coupon interest rate - is
rates. the percentage of a bond’s par
value that will be paid annually,
Flat yield curve- is a yield curve
typically in two equal
that indicates that interest rates
semiannual payments, as
do not vary much at different
interest.
maturities
Expectations theory -is the
theory that the yield curve
Bond’s par value, or face value
- is the amount borrowed by the
company and the amount owed
to the bond holder on the
maturity date.
Bond’s maturity date-is the
time at which a bond becomes
due and the principal must be
repaid.
Bond indenture - is a legal
document that specifies both
the rights of the bondholders
and the duties of the issuing
corporation.
Standard debt provisions- are
provisions in a bond indenture
specifying certain record-
keeping and general business
practices that the bond issuer
must follow
Restrictive covenants- are
provisions in a bond indenture
that place operating and
financial constraints on the
borrower.
Stock purchase warrants- which
are instruments that give their
holders the right to purchase a
certain number of shares of the
issuer’s common stock at a
specified price over a certain
period of time. Occasionally
attached to bonds as
“sweeteners.”
The three most widely cited
yields are:
-Current yield
-Yield to maturity (YTM)
-Yield to call (YTC)
Companies and governments Interest rate risk- is the chance
that interest rates will change
and thereby change the
required return and bond value.
Yield to maturity (YTM)- is the
rate of return that investors
earn if they buy a bond at a
specific price and hold it until
maturity.
borrow internationally by
issuing bonds in two principal
financial markets:
Eurobond- is a bond issued by
an international borrower and
sold to investors in countries
with currencies other than the
currency in which the bond is
denominated.
Foreign bond-is a bond issued
in a host country’s financial
market, in the host country’s
currency, by a foreign borrower.
Valuation- is the process that
links risk and return to
determine the worth of an
asset.
3 key inputs to the valuation
process:
Cash flows (returns)
Timing
Measure of risk, which
determines the required return
CHAPTER 7 (STOCK
VALUATION)
Debt - all borrowing incurred by
a firm, including bonds, and is
repaid according to a fixed
schedule of payments.
Equity -consists of funds
provided by the firm’s owners
(investors or stockholders) that
are repaid subject to the firm’s
performance.
Debt financing- is obtained
from creditors and equity
financing is obtained from
investors who then become
part owners of the firm.
Creditors (lenders or
debtholders) -have a legal right
to be repaid, whereas investors
only have an expectation of
being repaid.
Par value of common stock -is
an arbitrary value established
for legal purposes in the firm’s
corporate charter, and can be
used to find the total number of
shares outstanding by dividing it
into the book value of common
stock.
Preemptive right- allows
common stockholders to
maintain their proportionate
ownership in the corporation
when new shares are issued,
thus protecting them from
dilution of their ownership.
Dilution of ownership- is a
reduction in each previous
shareholder’s fractional
ownership resulting from the
issuance of additional shares of
common stock.
Dilution of earnings -is a
reduction in each previous
shareholder’s fractional claim
on the firm’s earnings resulting
from the issuance of additional
shares of common stock.
Rights- are financial instruments
that allow stockholders to
purchase additional shares at a
price below the market price, in
direct proportion to their
number of owned shares.
Authorized shares-are the
shares of common stock that a
firm’s corporate charter allows
it to issue.
Outstanding shares-are issued
shares of common stock held by
investors, this includes private
and public investors.
Treasury stock -are issued
shares of common stock held by
the firm; often these shares
have been repurchased by the
firm.
Issued shares -are shares of
common stock that have been
put into circulation.
(Issued shares = outstanding
shares + treasury stock)
Generally, each share of
common stock entitles its
holder to one vote in the
election of directors and on
special issues.
Votes-are generally assignable
and may be cast at the annual
stockholders’ meeting.
Proxy statement -Is a statement
transferring the votes of a
stockholder to another party.
Proxy battle -is an attempt by a
nonmanagement group to gain
control of the management of a
firm by soliciting a sufficient
number of proxy votes.
Supervoting shares -is stock
that carries with it multiple
votes per share rather than the
single vote per share typically
given on regular shares of
common stock.
Nonvoting common stock- is
common stock that carries no
voting rights; issued when the
firm wishes to raise capital
through the sale of common
stock but does not want to give
up its voting control.
Dividends may be paid in cash,
stock, or merchandise.
American depositary receipts
(ADRs) -are dollar-denominated
receipts for the stocks of foreign
companies that are held by a
U.S. financial institution
overseas.
American depositary shares
(ADSs) -are securities, backed
by American depositary receipts
(ADRs), that permit U.S.
investors to hold shares of non-
U.S. companies and trade them
in U.S. markets.
Par-value preferred stock is
preferred stock with a stated
face value that is used with the
specified dividend percentage
to determine the annual dollar
dividend.
No-par preferred stock is
preferred stock with no stated
face value but with a stated
annual dollar dividend.
Cumulative preferred stock is
preferred stock for which all
passed (unpaid) dividends in
arrears, along with the current
dividend, must be paid before
dividends can be paid to
common stockholders.
Noncumulative preferred stock
is preferred stock for which
passed (unpaid) dividends do
not accumulate
Callable feature is a feature of
callable preferred stock that
allows the issuer to retire the
shares within a certain period
time and at a specified price.
Conversion feature is a feature
of convertible preferred stock
that allows holders to change
each share into a stated number
of shares of common stock.
Venture capital is privately
raised external equity capital
used to fund early-stage firms
with attractive growth
prospects.
Venture capitalists (VCs) are
providers of venture capital;
typically, formal businesses that
maintain strong oversight over
the firms they invest in and that
have clearly defined exit
strategies.
Angel capitalists (angels) are
wealthy individual investors
who do not operate as a
business but invest in promising
early-stage companies in
exchange for a portion of the
firm’s equity.
When a firm wishes to sell its
stock in the primary market, it
has three alternatives.
Public offering, in which it
offers its shares for sale to the
general public.
Rights offering, in which new
shares are sold to existing
shareholders.
Private placement, in which the
firm sells new securities directly
to an investor or a group of
investors.
Initial public offering (IPO),
which is the first public sale of a
firm’s stock.
The company must file a
registration statement with the
SEC.(GOING PUBLIC)
Prospectus is a portion of a
security registration statement
that describes the key aspects
of the issue, the issuer, and its
management and financial
position.
Red herring is a preliminary
prospectus made available to
prospective investors during the
waiting period between the
registration statement’s filing
with the SEC and its approval.
investment banker is a financial
intermediary that specializes in
selling new security issues and
advising firms with regard to
major financial transactions.
Underwriting is the role of the
investment banker in bearing
the risk of reselling, at a profit,
the securities purchased from
an issuing corporation at an
agreed-on price.
underwriting syndicate is a
group of other bankers formed
by an investment banker to
share the financial risk
associated with underwriting
new securities.
Selling group is a large number
of brokerage firms that join the
originating investment
banker(s); each accepts
responsibility for selling a
certain portion of a new
security issue on a commission
basis.
Efficient market hypothesis
(EMH) is a theory describing the
behavior of an assumed
“perfect” market
Behavioral finance is a growing
body of research that focuses
on investor behavior and its
impact on investment decisions
and stock prices. Advocates are
commonly referred to as
“behaviorists.”
Constant-growth model is a
widely cited dividend valuation
approach that assumes that
dividends will grow at a
constant rate, but a rate that is
less than the required return.
Gordon model is a common
name for the constant-growth
model that is widely cited in
dividend valuation.
Variable-growth model is a
dividend valuation approach
that allows for a change in the
dividend growth rate.
Book value per share is the
amount per share of common
stock that would be received if
all of the firm’s assets were sold
for their exact book
(accounting) value and the
proceeds remaining after paying
all liabilities (including preferred
stock) were divided among the
common stockholders.
Liquidation value per share is
the actual amount per share of
common stock that would be
received if all of the firm’s
assets were sold for their
market value, liabilities
(including preferred stock) were
paid, and any remaining money
were divided among the
common stockholders.
Price/earnings multiple
approach is a popular technique
used to estimate the firm’s
share value; calculated by
multiplying the firm’s expected
earnings per share (EPS) by the
average price/earnings (P/E)
ratio for the industry.
CHAPTER 10 (CAPITAL
BUDGETING TECHNIQUES)
PayBack Period- “how long (in
years and/or months) it takes to
recover the initial investment.”
-The maximum acceptable
payback period is determined
by management.
If the payback period < the
maximum acceptable payback
period = ACCEPT the project.
If the payback period > the
maximum acceptable payback
period, REJECT the project.
Advantages of Payback Periods
-The payback method is widely
used by large firms to evaluate
small projects and by small
firms to evaluate most projects.
-It is simple, intuitive, and
considers cash flows rather
than accounting profits.
-It also gives implicit
consideration to the timing of
cash flows and is widely used as
a supplement to other methods
such as NPV & IRR
Weakness Economic Value Added
(EVA) - method begins the
-The appropriate payback
same way that NPV does—by
period is a subjectively
calculating a project’s net
determined number.
cash flows.
-Payback fails to fully consider
the time value of money. However, the EVA approach
subtracts from those cash
-It also fails to consider the flows a charge that is
principle of wealth
designed to capture the
maximization because it is not
return that the firm’s
based on discounted cash flows
and thus provides no indication
investors demand on the
as to whether a project adds to project.
firm value.
EVA calculates whether a
Decision Criteria project generates positive
cash flows above and beyond
If NPV > 0, accept the project
what investors demand. If so,
If NPV < 0, reject the project then the project is worth
undertaking.
If NPV = 0, technically
indifferent
Internal Rate of Return (IRR)- is
the discount rate that will
equate the present value of the
outflows (Initial Investment)
with the present value of the
inflows.”
Decision Criteria
If IRR > k, accept the project
If IRR < k, reject the project
If IRR = k, technically
indifferent
Conflicting rankings between
two or more projects using NPV
and IRR sometimes occurs
because of differences in the
timing and magnitude of cash
flows.