FINCL MANGE OF FIRM
FINCL MANGE OF FIRM FIN 3403
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This 7 page Class Notes was uploaded by Jeanne Daugherty on Thursday September 17, 2015. The Class Notes belongs to FIN 3403 at Florida State University taught by Steven Price in Fall. Since its upload, it has received 21 views. For similar materials see /class/205374/fin-3403-florida-state-university in Finance at Florida State University.
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Date Created: 09/17/15
Chapter 7 Definitions 0 bondsdebt securities issued by corporations or governments 0 coupon paymentan interest payment 0 facepar valuethe principal amount of a cong that is repaid at the end of the term 0 coupon ratethe annual coupon divided by the face value of a bond interest rate 0 maturity datethe specified date on which the principal amount of a bond is paid 0 yield to maturity YTMthe rate required in the market on a bond the market interest rate for bonds with similar features 0 discount bondsbonds that sell for less than face value 0 premium bondsbonds that sell for greater than face value Present value of cash flowsused to estimate a bond39s current market value bond price 0 calculate the annuity coupons and lump sum principle portions separately then add the results together ex A company issues 1000 bonds with 10 years to maturity and an annual coupon of 80 Similar bonds have a YTM of 8 What would this bond sell for lump sum N10 Y8 FV1000 CPT PV 46319 annuity N10 Y8 PMT80 CPT PV 53681 46319 100000 0 When interest rates increase the present value decreases Therefore when interest rates increase bond prices decrease and vice versa eX One year goes by 9 years to maturity and the market interest rate is now 10 What is the bond worth lump sum N9 Y10 FV1000 CPT PV 42410 annuity N9 Y10 PMT80 CPT PV 46072 42410 88482 0 Conclusion f YTM coupon rate then par value bond price f YTM gt coupon rate then par value gt bond price the discount will provide a yield above the coupon rate giving investors an initiative to buy the bond f YTM lt coupon rate then par value lt bond price the higher coupon rate causes the value of the bond to be above par Interest rate riskthe risk that arises for bond owners from fluctuating interest rates increases at a decreasing rate 0 Price risk All other things being equal the longer the time to maturity the greater the interest rate risk relates to the volatility of the present value of the face value All other things being equal the lower the coupon rate the greater the interest rate risk the smaller coupon rate makes the value of bond specifically the face value more sensitive to interest rates 0 Reinvestment rate riskuncertainty concerning rates at which cash flows can be reinvested All other things being equal the shorter the time to maturity the greater the risk All other things being equal the higher the coupon rate the greater the risk Computing YTM o done by trial and error without a calculator O with a calculator require N PV PMT and FV remember sign conventions 0 Ex A bond with a price of 92809 has a 10 annual coupon rate 15 years to maturity and a 1 000 face value What is the YTM NOTE the yield will be greater than the coupon rate because this is a discount bond N15 PV92809 PMT100 FV1000 CPT Y 0 EX A bond that sells for 110793 has a 10 coupon rate and semiannual coupons It has a face value of 1000 and 20 years to maturity What is the YTM NOTE the yield will be less than the coupon rate because this is a premium bond N2039 PV1 107 9339 PY2 PMT100250 FV1000 CPT Y 1r Bond Pricing Theorems 0 Bonds of similar risk and maturity will be priced to yield about the same return regardless of the coupon rate o If you know the price of one bond you can estimate its YTM and use that to find the price of the second bond indenturethe written agreement between the corporation and the lender detailing the terms of the debt issue basic terms of the bonds total amount of bonds issued description of property used as security collateralsecured by financial securities mortgagesecured by real property seniority debts can be labeled as senior or junior to indicate seniority in the event of default holders of subordinated debt must give preference to other specified creditors debt cannot be subordinated to equity repayment arrangements gm call p ovisions refinancingquot for a new interest rate good for companies bad for investors details of the protective covenants Bond classifications registered formthe form of bond issue in which the registrar of the company records ownership of each bond payment is made directly to the owner of record bearer formthe form of bond issue in which the bond is issued without the record of the owner39s name payment is made to whomever holds the bond debenture unsecured bondan unsecured debt usually with a maturity of 10 years or more notean unsecured debt usually with a maturity of under 10 years government bonds treasury securitiesfederal government debt Tbills pure discount bonds with original maturity of one year or less Tnotes coupon debt with original maturity between one and ten years Tbonds coupon debt with original maturity greater than ten years municipal securitiesdebt of state and local governments similar to corporate bonds as related to varying degrees of risk zero coupon bondmakes no coupon payments and is thus initially priced at a deep discount YTMpurchase price par value Bond ratings 1 nveslment grade high grad medium grade Specutative quatity a luwgrade junk bands very tbw grade in defatm to mvetor for a pro t agent n auon and mterem rate reat quotInterem rate or rate of return tnat have been aduted for m auon nornrnat raterrmterem rate or rate of return tnat have NOT been aduted for m auon Tne Fuher Effectrrthe relauonmvp between nornrnat return reat return and m auon HR n nommal rate real rate expected m auon rate ex fwe requvre 510 reat return and We expect m auon to be 3 what I tne nornrnat rate7 1R111OE 1110E R1197119 R1BB terrn tructur of mterem rateyrthe retatronmrp between trrne to rnaturrtyandyretd an ebe bemg equat tne pure trrne value of money e e ect of dvfferent coupon rate default wk etc t vdvregarded yretd curverrgraphvcal repremntauon of tbe terrn Lructure Normair upwardrsioping Longrterm yields are higher than shortrterm yieids inverted r downwardrsloping iongrterm yieios are lower than shortrterm yieios o A Ilvwnrdslavlna wrm armrum Nummai Woven mla lnlm xnm nsun mlum inn on 9 mm lnicmsl 11m Rail rm r m is MW 3 Downwardsloping icnn simclum 2 E Nummai g mum inieicsi 2 premium We 5 Real rare rm to maturity hapter 8 a Value of a stockpresent value of expected cash flows 0 3 basic determinants of term structure 1 reai rat re 3 interes i i e of interest I i uences the overaii levei of rates A ifinfiation wiii rise longrterm rates wiii tend to be higher than shortrterrn rates B ifinfiation wiitratt lungrterm rates wiit tend to be Lower than shortrterrn ES 1 ra E risk est rate risk premiumwthe compensation investors demand for hearing inter st rate risk A interest rate risk is higher in longrterm bonos so Longrterm rates witt be higher than shortrterrn rates B expected decrease in in ation offsets 39 k es a a hence the curve NOTE if in ation decreases by oniy a srriaii amount the term structure wiLL stiii be upwardrsioping ex A st ck is expected to pay dividends of 2 at the end of year 1 210 at the end of 0 year two an d 2205 at the end o year fis estimate d to have a price of 515435 at the end of year 3 How much would you be willing to pay if you require a 20 return on investments of this risk 39 F2Z10 F21 CF3Z205154351764 2039 CPT NPV 1333 In essence the value of a stock is the present value of all of the future di 39 39 er Because it is impossible to forecast and discount an infinite number of dends an dividends you can39t compute the value of a stock except in these circumstances P0current price Ddividend Rrequi red return constant dividend zero growththe firm pays a constant dividend forever P0DIR ex Suppose stock is expected to pay a 050 dividend even quarter and the required return is 10 with quarterly compounding What is the price P05014 20 00 onstant di 39dend growththe firm will increase the dividend by a constant 39od c percent evew pen dividend growth model PoDo1gRg used when the current dividend paid is known PoDiR39g used when the expected or next dividend is known P0current pnce DDdividend just paid D1dividend paid at the end of period 1 Rrequired return ggrowth rate ex A company just paid a dividend of 050 It is expected to increases its dividend by 2 per year If the market requires a return of 15 on assets of this risk how much should the stock be selling for Po50102150250102135113 392 ex A company is expected to pay a 200 dividend in 1 year The dividend is expected to grow 5 per year and the required rate of return is 20 What is the price Po220052151333 ex A company is expected to pay a 4 dividend next period and dividends are expected to grow at 6 each year The required return is 16 What is the price Po416064000 ex continued from above example What is the expected price in year 4 Period 4 is now the initial year so 4 years is added to the subscripts 1 g is raised to the fourth to account for the growth of 4 periods P4D41gSRgDsRg P44106 16O6412635105049910 5050 supernormal growthdividend growth is not consistent initially but settles down to constant growth at some point in the future use the dividend growth model in steps ex Suppose a firm is expected to increase dividends by 20 in one year and by 15 in two years After that dividends will increase at a rate of 5 per year indefinitely If the last dividend was 1 and the required return is 20 what is the price of the stock Step 1 calculate dividends D1112120 D2120115138 D31381051449 Step 2 calculate expected future price P2D3Rg14492005966 Step 3 discount all cash flows to present value CF00 CF1120 F11 CF21389661104 F21 20 CPT NPV 867 Required return 0 N components dividend yieldD1Po a stock39s expected cash dividend by its current price capital gains yieldg the dividend growth rate or the rate at which the value of an investment grows Rdividend yieldcapital gains yield RD1Pog ex A firm39s stock is selling for 1050 It just paid a 1 dividend and dividends are expected to grow at 5 per year What is the required return R1105105005105 1Do Therefore D11105 Stock features Common stockequity without priority for dividends or in bankruptcy O voting rightsthe right to elect the board of directors proxy votinga grant of authority by a shareholder allowing another individual to vote his or her shares classes of stockgenerally create unequal voting rights in order for certain share holders to maintain control of a firm share proportionally in dividends paid dividend characteristics not a liability firms cannot go bankrupt for not declaring a dividend no a business expense and therefore not tax deductable dividends received by individuals are taxable share proportionally in assets remaining after liabilities in a liquidation preemptive rightfirst shot at new stock issue to maintain proportional ownership if desired 0 Preferred stockstock with dividend priority over common stock normally with a fixed dividend rate generally without voting rights rights to a stated dividend that must be paid before dividends can be paid to common stockholders dividends are not a liability of the firm and preferred dividends can be deferred indefinitely most preferred dividends are cumulativeany missed preferred dividends have to be paid before common dividends can be paid Stock market 0 primary marketthe market in which new securities are originally sold to investors o secondary marketthe market in which previously issued securities are traded among investors O dealeran agent who buys and sells securities from inventory 0 brokerand agent who arranges security transactions among investors 0 New York Stock Exchange NYSE largest stock market in the world 1366 members owners of trading licenses on the NYSE o NASDAQ computer based quotation system electronic communications network ECNa web site that allows investors to trade directly with each other large portion of technology stocks growth rate must be less than the discount rate Chapter 9 Capital budgeting decision making 0 Net present value NPVthe difference between an investment39s market value and its cost represents the dollar change in the firm39s value resulting from undertaking a project Steps estimate future cash flows estimate required return for investments of that risk find the present value of the future cash flows and subtract the initial investment Decision rule f NPV lt 0 the investment will not reach shareholder expectations and should not be taken on f NPV 0 the investment meets shareholder expectations and should be treated indifferently f NPV gt 0 the investment exceeds shareholder expectations and should be taken on NOTE NPV account for risk by adjusting the discount rate high raterisky investment low ratesafe investment ex A project is estimated to have the following cash flows CFO 165000 CF1 63120 CF2 70800 CF3 91080 If the required rate of return is 12 should the investment be taken on CFO 165000 CF1 63120 CF2 70800 CF3 91080 Y12 CPT NPV 1262741 YES 0 Payback periodthe amount of time required for an investment to generate cash flows sufficient to recover its initial cost Steps estimate cash flows subtract the future cash flows from the initial cost until the initial investment has been recovered Decision rule f payback is lt some preset time the investment should not be taken on f payback is some preset time the investment should be treated indifferently f payback is gt some preset time the investment should be taken on ex A project is estimated to have the following cash flows CFO 165000 CF1 63120 CF2 70800 CF3 91080 If the required payback period is 2 years should the investment be taken on Year 1 165000 initial investment 63120 CF1 101880 still to recover Year 2 101880 70800 31080 Year 3 31080 91080 60000 310809108003412 The investment pays off in 234 years NO Discounted payback periodthe length of time required for an investment39s discounted cash flows to equal its initial cost Steps estimate cash flows compute the present value of each cash flow subtract the present value of the future cash flows from the initial cost until the initial investment has been recovered Decision rule f discounted payback is lt some preset time the investment should not be taken on f discounted payback is some preset time the investment should be treated indifferently f discounted payback is gt some preset time the investment should be taken on eX A project is estimated to have the following cash flows CFO 165000 CF1 63120 CF2 70800 CF3 91080 If the required discounted payback period is 2 years and the required rate of return is 12 should the investment be taken on Year 1 165000 N1 Y12 FV63120 CPT PV 56357 108643 Year 2 101643 5644145202 Year 3 45202 6482919627 452026482906972 The investment pay off on a discounted rate in 270 year NO Internal rate of return IRRthe discount rate that makes the NPV of an investment zero important alternative to NPV Steps input cash flows since IRR is independent of interest rates found elsewhere a trial and error process is required to find the rate that makes NPV0 a financial calculator does this for you Decision rule
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