FIN 323 : Study Guides for Stock and Bond
FIN 323 : Study Guides for Stock and Bond FIN 323
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This 28 page Study Guide was uploaded by Winn on Monday March 7, 2016. The Study Guide belongs to FIN 323 at Marshall University taught by in Spring 2016. Since its upload, it has received 67 views. For similar materials see Principles of Finance in Business at Marshall University.
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Date Created: 03/07/16
Study Guide for FIN 323 Stock and Bond Explaining Important Bond Pricing Equation 0 0 nd Pricin Formula I Netetiein I P price ef the bend in I H number efperieds maturity in years gt 2 it C semiannual eeupen n i maturity value Title bend price is quotT i f 4 133 2 quot 3i quot quotI 1 1 JP 1 Jrquot 1 ff 1 gitTE Nate AN minute ate the 3 endpriemgferm Mitt l 1 mae xed exeeptfer 2 AS P 7 Z C 1 Jr EM ehengeg Se deee i1 1 3 1 y 1 12 With the Texas Instruments BAll plus we have n number of periods to maturity IN period interest rate y P PV present value bond value C PMT coupon payment FV M face value par value future value With the excel we have FV Rate Nper Pmt PV 01 gt calculate the face value PV Rate Nper Pmt FV 01 gt calculate the bond value RATE Nper Pmt PV FV 01 gt calculate the period interest rate lY NPER Rate Pmt PV FV 01 gt calculate the number of periods to maturity PMT rate nper pv fv 01 gt calculate coupon payment With 01 Ordinary annuity O default Annuity Due 1 Graphical Relationship between price and yieldtomaturity Bond Price Sensitivity to YTM Bend price 11800 Ceupen 100 V 20 years tn maturity meet 1 face value 1 14100 12m r ieid tcr maturity 4 F3 8 101 12 1 4 i 5 i t We Ira te Valuing a Discount bond with Annual Coupons Coupon rate 12 Annualcoupons Par 1000 Maturity 6 years YTM 15 88647 which include the bond price annuity and the lump sum gt B a When Valuing a Premium Bond with Annual Coupons Coupon rate 11 AnnualCoupons Part 1000 Maturity 7 years YTM 10 Igt B 104868 The Bond Pricing Equation Adjusted for Semiannual Coupons C Annual coupon payment gt C2 semiannual coupon YTM annual YTM as an APR gt YTM2 semiannual YTM t years to maturity gt 2t Number of 6month periods to maturity Interest rate risk Change in the bond price due to the changes in period interest rate Longterm bonds have more risk than shortterm bonds Low coupon rate bonds have more price risk than high coupon rate bonds Explaining if you have a bond that has a low coupon rate there is a higher chance that the market yield Will be higher than your coupon rate so if that s the case then all of a sudden your bond is trading at a discount Which in sense means you just lost a boat load of money assuming you started off at par but on the bright side is lower coupon means you have lower reinvestment risk because less of your cash ows are going to be rein vested at that prevailing market rate Bond isk interest rte risk a nd reinvestment rate risk Interest rate risk Rising rd causes ibend39is price to fall mere for it year i0 ibends titerI fer a year i0 bends Bend price Iquot end price Change rd iiyea r Change 500 117048 1 000 1386 1 749gt2s1 15 9 x 44 Debt versus Equity my will tr pitppany and haye a aay in the daily eperatiene and fer the atrategie izlireetipn pfthe aempany Lendere tie net require genera hip in a repmpany and thue haye np eay in eperatiena lnyeetera e ier mere than naneing Their ei pertiee anij Lea perien ee helpe while making atrategie deeiaiene and they may e er reen neetiena that will help grew the reempany Lenriere srle net prey iizle mu eh mere than the naneing In the atartup atage there ie new menthly payment be he marle te inyeetpre Thie maltee add itienal r39eaeh ayailaple tier puain eea izleyelepment If the veempany mpney er panhru pt there in ne epligatien tp repay the equity inyeetera Lendera requireat39pzerl menthly payment irree peetiye pf hear the pueineeze perfprme anrl haye a elaim te the plerlgerl aeeete if it taile Dietriputiene are typieally made f rem pre tte after taxes Intereet pay mente are tax derl u39etiple whieh rerl ueee taJi liapilitiee Eeetpfeapital ia typieally higher than tratlitienal hank naneing Intereet ratee are generally miner than the RBI rate required by inyeetere Perepnral liapility ef the feunaere ie a neniieaue unleee there ia mie management er fraurl en their part Lendere will require perapnal guarantee frem earn ere whieh e ppeiee perepnal aeeete tp alaime is like credit scores for people Who show the overall credit worthiness of your institution It represents to prospective investors the riskiness of loaning your college money through the sale of the bond The greater the risk of not being paid on time or at all the lower the credit worthiness and the higher the interest rate the school Will pay to borrow the funds Standard El Peede Beet Quality Hil39l delity Upper Medium Quality i A 1 1 milleall w Medium Grade lnqllnqllnq Explainning In determining the rating for your institution s bond the rating agency will evaluate several factors affecting your credit worthiness and the riskiness of the debt In general those factors are The economy Your current debt structure total obligation and the debt service Financial conditions Demographic factors Management practices of the organization and its administration Government bonds A general term referring to a bond note warrant certi cate of participation or other obligation issued by a state or local government or their agencies or authorities such as cities towns villages counties or special districts or authorities b Treasury Bills Tbills a shortterm debt obligation backed by the US government with a maturity of less than one year Tbills are sold in denominations of 1000 up to a maximum purchase of 5 million and commonly have maturities of one month four weeks hs 26 weeks months 13 weeks or six mont r n rT u rg v w 39 Y 7quotJ 37 J gz rw 77 I in I quotEquot l 39 I E FZE nl3rif nAnh 151 69117 I j mnw 101T055A I I r quot r 39 A 3 I3 quot r1 v ll misma gxri39 e i a l l I I r II I Ii 39 H I I I immim I I I Ii I H W H r H n L m quot391 39 nI n w I I r 7 1 4 I Tnmlmml BILL 5 II i 39 mi mmm39nmiarmlsxmusum ums TE39TIHE r I 39 39 TN KEWBHEH I T39ng UHWEE impTEES EH T39 Ful l I V 1 I r PEI153ml FI39EEI39EFWE HANK THE umrEE 5mm nil I ii l in ERIE IWILLL illiii THE EEMEW E quot I I II I I I I I r t l r I DME HUNDRED TH u AND39 nmmns F 1 m quot WIIHGUT li d l EHE T an TH aw Em rm3H I 39 t l39 5 spacmm mm WEA ELlK39F HILL 5 mammal UHDEH I l l quot mtm I39 K iF39YHE smear lLIBEI39Ii39IHi mu mmquot A5 I A I g I I AHEHQEEL m meannessTm wlrm JPN numtcf Tia uEIImn Mir m gt 2 I m mallards air TREAELrFII39 GEMEE I IEE GlFIGLil I 39 39 u l PI 3 quot unnauan nml mm Wltl h mg tngm I mm M I n I 3 I g 2 Pod A gunmen F mgr 5quotme as HELEI39EHE Mus PM 5r 19 g quot21 Ful39ul39uf39lquot HEI WITH 1 95th Eilift 39f 35 THDUEH l 15 E HEREiH 12 EQR I HL THIS arrInsqu BHLL 15 IEELIEEI I 575 m hmmm nst Mm can alibith Main31 h z w is quotm n quotremum AEEEFTEEI 5 ms EEGEEI39iFl l quot 39 quot WEEWW ECWEEHT r n r n r a quot39 I Wigwam quotI39FIEPEJHIFI39E I Iquot EHALI NEW In F39HIJI J39 mtgEr I i 1 q maul m an HAILHm mm lm IL39Pd 43 l 7 gquot i39 aw mgr39HY Er emg my irugurr JLELIEM 3 an 33923 W f w Fquot m EJP EJE g r I F j quot I 7 7 k 53 F t Hg EyckIquot 39 J m iH hmr quotquot quot IEHQHW39 39 I f I I I II I I m I I r V l 3 tquot Ff a mm mm i 39 Fir 3equot Sim2M x xa39fhrc quot lE A 7 39 quota n 39 31 39 quot J39u391 I39r 39 39V39 739 i hr39u quotI39d quot quot7quot 39 39quot39u1 V r L 39 39 77W 7 A A etable US government debt security with amarlt a xed interest rate and a maturity between one and 10 years Treasury notes can be bought either directly from the US government a marketable xedinterest US government debt security with a maturity of more than 10 years Treasury bonds make interest payments semiannually and the income that holders receive is only taxed at the federal level quot 4 77 1 A 395 quot 39 quot 39 quotTE39 7 r Eh 7 3ng I eE39w F quotK r 39 1 39 x r l i panama mmin 3313 iii a J mum SEETB PM TE 39I39HVE39 EEM39E EH I 311 3F K 3 I 39quot F 7 39 39L 7 J are sold at a substantial discount from the face amount For example a bond with a face amount of 20000 maturing in 20 years with a 55 coupon may be purchased for roughly 6757 At the end of the 20 years the investor will receive 20000 The difference between 20000 and 6757 represents the interest that compounds automatically until the bond matures Floating Rate Bonds 39 Coupon rate liloats depending on some index value Examples a aiustahle rate mortgages and intllatiionliinllte Treasuries 39 There is less price nislk with l loating rate lbonds i The coupon floats so it is less likely to differ substantially from the yieldtomaturity 39 Coupons may have a collar E tlhe rate cannot go above a speci ed ceiling or lbelow a speci ed tlloor TAU Figure 2 Floating rate funds saw its largest in ows on record i 000 900 83900 YOU 6 00 500 400 300 200 100 U 1 00 USrnn ilun3tl Jul 21 Augii Sep l Step 22 Oct 13 Nov3 Nov 2394 Dec 15 Jan5 l Weekly Dollar Flows US Floaling Rate USSrlm Source EPFlR What is the chance that the borrower won39t make payments on time or will be unable to pay what is owed This component will be high or low depending on the creditworthiness of the person or entity involved A premium that investors will demand when any given security can not be easily converted into cash and converted at the fair market value When the liquidity premium is high then the asset is said to be illiguid which will cause prices to fall and interest rates to rise All else being equal a bond obligation will be more sensitive to interest rate uctuations the longer to maturity it is In general When in ation is on the rise bond prices fall When in ation is decreasing bond prices rise That s because rising in ation erodes the purchasing power of What you ll earn on your investment In other words When your bono matures the return you ve earned on your investment Will be worth less in today s dollars is an economic theory proposed by economist Irving Fisher that describes the relationship between in ation and both real and nominal interest rates The Fisher effect states that the real interest rate equals the nominal interest rate minus the expected in ation rate Therefore real interest rates fall as in ation increases unless nominal rates increase at the same rate as in ation llll ll Leneterm nerei nel intereet rate r L ll eepeetetl in etien de etien lreel interest rate m restated u 3 r 1 t E Iquot 1LT efletlen L ll reeeeted rate elf de etten eepteee ee e n tingterm nemitleintereet rate P39D 39ltwe mmh j reel interest rate 2 Bonds are a form of longterm debt in which the issuing corporation promises to pay the principal amount at a speci c date Stocks or shares of stock represent an ownership interest in a corporation Stock markets are Nasdaq Dow SampP 500 and AMEX These markets are regulated by the Securities Exchange Commission SEC DwnErs hi p En EfitE frEml thE growth En EfiE frEnrl thE intErEst Elf ti39iE EElnrl pie ny El mlEuunE plea i ti fElll39 thE IElE n iil39ltEl39EEt payrnrlEnE El rE nrlE tiE in thE fErnrl Ef EElu EllDH paynrlEnE F39rEfiE El rE pEiti Elut in thE for in Elquot ti i vi ti E n tis Bonds the companycorporation pays you every single period by coupon payment and gets a lump sum in the end of contract lower risk gt less money Stocks you earn the money by interest rate dividend increaseddecreased in certain period of time higher risk gt more money What is dividend a sum of money paid regularly typically quarterly by a company to its shareholders out of its pro ts or reserves OnePeriod example to calculate stock You want to purchase stock of Marshall Company you expect to earn 2 dividend and you think that you will sell at the price of 20 at that time If you require a return of 20 on the investments of this risk what is maximum you would be willing to pay We have 2 future value D1 2 P1 14 Calculate back to today by using nance calculator by the method of calculating future value back to present value we will have Do167 and Po 1167 gt Sum 1334 T woperiod example Right now you wait until 2 years to sell stock and I already have dividend at year 1 and you expect a dividend of 21 in year 2 and at the stock price of 16 Now how much will you be willing to pay At this point we have D1 2 D2 dividend at year 2 21 and P2 16 Same as oneperiod solution use the nance calculator to calculate back to today We will have D0 167 146 dividend from year 2 and P0 1111 gt Sum 1424 To know the future dividends when given the growth rate of those dividends whether the growth is zero constant or unusual rst and then levels off to a constant growth rate So how to compute the future dividends we will have 3 cases a constant dividend zero growth b dividends change by a constant growth rate c unexpected growth periods and then calculate the constant growth rate P D Firm will pay a constant dividend forever 0 Z 1quot P0 2 Price Like preferred stock What IS preferred D 2 D ividend stock stock that entitles the holder to a xed r D iscoum Rate dividend whose payment takes priority over that of commonstock dividends Common Stock Valuation ConstantGirth Model The ennstant grnwth model is a wideily eited dividend aaliuatien appm aeh that assumes that dividends Wiii g1de at a eanstant 1731C but a rate that is iless than the required lfeturn D x i D a 1 zi D i 2 i i 115 U V If jg E f l i 33 1 3 i l at Pg The Garden media is a E l39i mi l name for the eenstantgrearth Inadeli that is Wideliy eited in diaid end valuation e f Wis g m m iPE depth 2012 Pearson Edueation 7249 Rate is less than the required return c Unusual Growth Then Constant Growth popular one hardest one to calculate Hi A 5392 53 H4 391 ik 1 H f1kjil 1 2 F Mach yawn E1 Emma 1 1 g is s wimsEm alum Suihla mnekmm GOOD LUCK A El El H TwPerlgot l DEM E 4 1 LH r I 5 J El THE MultiPeri l DUE Fm 5 n 1 lElf39 Emmy35 gl njm Example The current dividend on a stock is 2 per share and investors require a rate of return of 12 Dividends are expected to grow at a rate of 20 per year over the next three years and then at a rate of 5 per year from that point on Find the price of the stock There are 3 years of no constant growth thus T 3 Before substituting into the formula given above it is necessary to calculate the expected dividends for years 1 through 4 using the provided growth rates D1 3i13333333 1E 333i1333333 D3 333i1333 33333 D4 3333133j333333 333 333 3333 33333 3 D 131331 13132 13133 13415 113j 3 33333 1 When you refer to a bond s coupon you are referring to which one of the following A difference between the purchase price and the face value which means between PV and FV B Annual interest divided by the current bond price unde ned formula C Difference between the bid and ask price D Annual interest payment E Principal amount of the bond because the annual interest payment affect to the bond s coupon if the interest payment increase the bond s coupon increased also 2 A broker is an agent who A Trades on the oor of an exchange for himself or herself B Buys and sells from inventory C Offers new securities for sale to dealers only D ls ready to buy or sell at any time E Brings buyers and sellers together a broker is like an individual person that arranges transactions between a buyer and a seller for a commission when the deal is executed A broker who also acts as a seller or as a buyer becomes a principal party to the deal 3 A real rate of return is de ned as a rate that has been adjusted for which one of the following A In ation B Interest rate risk C Taxes D Liquidity E Default risk because A real rate of return is the annual percentage return realized on an investment which is adjusted for changes in prices due to in ation or other external effects This method expresses the nominal rate of return in real terms which keeps the purchasing power of a given level of capital constant over time 4 A sixyear semiannual coupon bond is selling for 99138 The bond has a face value of 1000 and a yield to maturity of 919 percent What is the coupon rate A 45 B 46 C 600 D 900 E 919 because we have PV 99138 FV par value 1000 W yield to maturity 919 2 because of semiannual N 6 years x 2 12 periods gt use nancial calculator we have PMT C 45 gt 45 semiannual cgt C45x2 900annua 5 Vegan Delite stock is valued at 12420 a share The company pays a constant annual dividend of 880 per share What is the total return on this stock 662 percent 00 percent 09 percent 49 percent 8 A B C D E 2 percent 7 7 7 7 because we have a constant dividend we use the formula P DR gt We have R 12420 880 0079 gt 709 6 Which one of the following will increase the current value of stock A Decrease in the dividend growth rate B Increase in the required return C Increase in the dividend growth rate D Decrease in the expected dividend for next year because we have a formula Po D R with R is the return on stock so if D dividend increases the Po will increase 7 Changes in interest rates affect bond prices Which one of the following compensates bond investors for this risk A Taxability risk premium B Default risk premium C Interest rate risk premium D Real rate of return E Bond premium interest rate risk premium because change in price due to changes in interest rates longterm bonds have more price risk than shortterm bondslow coupon rate bonds have more price risk than short term bonds 8 The price of a stock at year 4 can be expressed as A DoRg4 B Do x 1R5 C D1 x 1R5 D D4Rg E D5Rg because of the formula Po D1 Rg Do 1 g Rg 9 When a bond s yield to maturity is less than the band s coupon rate the bond A Had to be recently issued B is selling at a premium C has reached its maturity date D is priced at par E is selling at a discount let me give you an example Coupon rate 11 AnnualCoupons Part 1000 Maturity 7 years YTM 10 gt B 104868 gt When YTM lt Coupon rate gt bond price gt par value quotPremium Bondquot 10 Donuts Delite just paid an annual dividend of 110 a share The rm expects to increase this dividend by 8 percent per year the following three years and then decrease the dividend growth to 2 percent annually thereafter Which one of the following is the correct computation of the dividend for year 7 A 11 108 x 3 102 x 4 B 11108 x 3 102 x 3 C 11 108 3 102 4 D 11 108 3 1023 E 11 1083 1022 because we have the formula Year 0 today 11 Year 1 2 3 with 8 percent 108 3 Year 45 6 7 with 2 percent 102 4 11 The yield to maturity on a discount bond is a equal to the coupon rate b greater than the coupon rate c less than the coupon rate discount bond means they need to pay you more When we have the yield to maturity gt Coupon rate gt price bond lt par value 12 The dividend growth model can be used to value the stock of rms which pay which type ofdividends I constant annual dividend ll annual dividend with a constant increasing rate of growth Ill zero dividend A only B ll only C l and II only D I II and Ill only Answer C Based on the basic formula Po Do 1 g Rg DJ Rg 13 Which one of the following bonds is the least sensitive to changes in market interest rates A Zero coupon 10 year B 6 percent annual coupon 10 year C Zero coupon 4 year D 8 percent annual coupon 4 year E 6 percent annual coupon 4 year Answer D rst With longer duration gt higher risk and the coupon higher gt get money back soon That is the Whole idea 14 What is the name given to the model that computes the present value of a stock by dividing next year s annual dividend amount by the difference between the discount rate and the rate of change in the annual dividend amount A Stock pricing model B Equity pricing model C Capital gain model D Dividend growth model E Present value model Answer D 15 Municipal bonds are A generally purchased by taxexempt investors B riskfree C issued by federal state and local government bodies D zero coupon bonds Answer C 16 The common stock of The Garden of Eden is selling for 42 a share The company pays a constant annual dividend and has a total return of 58 percent What is the amount of the dividend A 102 B 204 C 244 D 370 E 681 Answer C apply the formula P D R 17 The R in the Fisher effect formula represents the A current yield B real return C coupon rate D in ation rate E nominal return Answer E sher effect 1R 1r1i 18 Solar Energy Inc will pay an annual dividend of 185 next year The company just announced that future dividends will be increasing by 2 percent annually How much are you willing to pay for one share of this stock if you require a 14 percent return a 1578 b 1542 c 1514 d 1662 e 1612 Answer B P 185 014 002 19 Suppose that a small rural city in the countryside of North Dakota plans to issue 150000 worth of 10year bonds Which one of the following components of the band s yield will be affected by the fact that no active secondary market is expected for these bonds A Real rate B Liquidity premium C interest rate risk premium D in ation premium E Taxability premium Answer B liquidity means nding buyer and seller easily 20 Santa Klaus Toys just paid its annual dividend of 140 The required return is 8 percent and the dividend growth rate is 1 percent What is the expected value of this stock ve years from now A 2082 B 2123 C 2206 D 2345 E 2378 Answer B D6 Do 1 g quot 6 14 101quot6 1486 gt P5 1486 007 21 A bond has a 1000 face value a market price of 1045 and pays interest payments of 60 every year What is the coupon rate A 676 B 700 C 712 D 800 E 814 Answer D 80 1000 22 The common stock of Sweet Treats is valued at 1080 a share The company increases its dividend by 8 percent annually and expects its next dividend to be 040 per share What is the total rate of return on this stock A 8 B 1107 C 1117 D 1170 E 1200 AnswerDwe haveP DR g gt R0401080008 23 The price of a bond is 1000 It has a yield to maturity of 65 percent The bond matures in seven years has a face value of 1000 and pays semiannual interest payments What is the amount of each coupon payment A 3000 B 3500 C 6000 D 6500 E 7000 Answer D Using the nancial calculator we have IY 65 2 PV 1000 FV 1000 N 7 x 2 24 Business Solutions Inc is expected to pay its rst annual dividend of 100 per share three years from now Starting in year 6 the company is expected to start increasing the dividend by 2 percent per year What is the value of this stock today at a required return of 12 percent A 770 B 809 C 829 D 903 E 934 Answer A 25 The 1000 face value bonds of Shonesy International have a 75 percent coupon and pay interest annually Currently the bonds are quoted at 9527 and mature in 35 years What is the yield to maturity A 788 B 802 C 898 D 919 E 949 we use the nancial calculator we have PMT 75 FV 1000 PV950N3gtY 26 The next dividend payment by Swenson Inc will be 180 per share The dividends are anticipated to maintain a 55 percent growth rate forever If the stock currently sells for 4850 per share what is the required return A 820 B 888 C 921 D 974 E 1002 Answer C use the formula R 18 4850 0055 27 You own two bonds Both bonds pay annual interest have 8 percent coupons 1000 face values and currently have 8 percent yields to maturity Bond 1 has 9 years to maturity and Bond 2 has 6 years to maturity If the market rate of interest rises unexpectedly to 9 percent Bond will be the most volatile with a price decrease of percent A A 573 B A608 C A794 D B339 E B451 rst of all we use the nancial calculator to nd ForbondAwehaveC60 FV1000N12lY7 cgt Bond A 92057 gt Price change in bond A 92057 1000 1000 794 ForbondBwehaveC60FV1000N4lY7 cgt Bond B 96613 gt Price change in bond B 96613 10001000 339 28 The stock price of Russell Inc is 81 Investors require a 14 percent rate of return on similar stocks If the company plans to pay a dividend of 420 next year what growth rate is expected for the company39s stock price a 799 percent b 800 percent c 812 percent d 837 percent e 881 percent g0144281 29 Last year you earned a rate of return of 1237 percent on your bond investments During that time the in ation rate was 36 percent What was your real rate of return A 630 percent B 760 percent C 775 percent D 847 percent E 870 percent Answer B sher effect 1R 1r1i with i in ation rate gt r101237100361 30 Granger Corp stock currently sells for 4829 per share The market requires a 13 percent return on the rm39s stock If the company maintains a constant 55 percent growth rate in dividends what was the most recent annual dividend per share paid on the stock A 343 B 357 C 390 D 415 E 436 AnswerAPo D1R ggt D1 4829XO13055 Do1 002 gtDo
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