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CH 6 Finance
| if market interest rates rise... | Long-term bonds will decline in value more than short-term bonds. |
| What is the term for a graphical representation of the relationship between interest rates and the maturities of debt securities? | Yield curve |
| Protective covenants are typically included in a bond contract to protect | bondholders from managerial decisions that benefit only the firm's shareholders. |
| If the required return is greater than the coupon rate, a bond will sell at | a discount |
| A bond matures in 20 years, at which time it pays the owner $1,000. It also pays $70 at the end of each of the next 20 years. If similar bonds are currently yielding 8%, what is the market value of the bond? (relative to 1,000) | under 1,000 |
| _____are claims that are not satisfied until those of the creditors holding certain (senior) debts have been fully satisfied. | subordinated debentures |
| The _________ value of a bond is also called its face value. Bonds which sell at less than face value are priced at a _________, while bonds which sell at greater than face value sell at a _________. | par, discount, premium |
| Coupon rate = | annual coupon/face value |
| maturity: | number of years until face value is paid |
| face value/par value: | amount repaid at end of loan |
| when interest rates decline what happens to value of bond? | worth more, goes up |
| to determine value of bond at a particular point in time, we need to konw what 4 things? | 1. # of period til maturity 2. face value 3. coupon 4. market interest rate for bonds with similar feature |
| yeild to maturity: | the rate required in the market on a bond |
| when bond sells less than its face value (interest rate is higher than market) | Discounted Bonds |
| when interest rates are lower and sells higher than face value | Premium bonds |
| Bond Value = | PV of coupons + PV of face amounts |
| for semi annual coupons... | split quoted rate in 1/2 |
| effective annual rate/yeild= | (1.08)*2 - 1 |
| longer time to maturity means.... | greater risk |
| the lower the coupon.... | the greater the risk |
| current yeild = | bond's annual coupon / price |
| So for a premium bond....the current yeild... | would be higher |
| differences between debt and equity: | debt is not ownership interest in the firm. creditors do not have voting power. corperation's pmt is fully tax deductable. if debt is not paid, creditors can legally take assets. no possibility of financial failure in equity |
| Equity represents.... | ownership interest and is a residual claim. |
| Long term debt has two catagories: | public issue & private issue |
| written agreement b/w corporations and creditiors | indenture |
| trust companies do what three things: | make sure terms of indenture are obeyed, manage the sinking fund, represent bondholders in default |
| face value = | principal value |
| any asset pledged on a debt | collateral |
| all property is pledged with... | mortgage securities |
| debenture: | when no specific pledge of property is pledged |
| note: | when maturity is less than 10 yrs |
| sinking fund: | account managed by bond trustee for early bond redemption |
| call provision: | agreement giving the corporation option to repurchase the bond at a specific price prior to maturity |
| call price relation to state price.... | call price is usually higher |
| call premium: | difference b/w call price and state value |
| amount of call premium usually beomes ___ over time | smaller |
| call provisions don't usually operate when? | beginning of bond's life |
| (deferred call provision) | prohibited from calling for 10 yrs |
| call prices are higher when interest rates... | are lower |
| protective covenants do what | prohibit actions under loan. "do & do not" |
| bond ratings tell you what? | how likely firm is to default. protection for creditors have in the event of a default. concerned only with possibility of default. DO NOT ADDRESS INTEREST RATE. |
| HIGHER RATING for bond ratings mean... | lower risk |
| Bond ratings go from | a-d. d meaning default |
| Characteristics of US Treasury Bond | no default risk (bc they can print money) exempt from state income taxes. |
| when state and local gvnts borrow money by selling notes and bonds | municipal notes and bonds |
| characteristics of municipal bonds | risk of default, most always callable, TAXES EXEMPT, Yeilds are lower |
| Characteristics of Zero Coupon Bond | must be offered at a price much lower, no interest payments are made, still imaginary deductions for tax purposes |
| Characteristics of Floating Rate Bond ex) inflation linked bond | coupon payments adjustable (tied to interest rate index) 1. coupon rate has floor and ceiling 2. has right to redeem note at par 3. |
| where do most bonds take place? | over the counter |
| what have more issues? bonds or stocks | bonds |
| bonds have little or no.... | transparency (can't easily observe) privately negociated, no reporting |
| us treasury market is... | largest in the world |
| bid ask spread- | dealer's profit |
| if you buy bond between coupon pmt dates, price you pay | is more than price quoted |
| "clean price" | accrued interest is deducted to arrive at quoted price |
| price you actually pay | dirty price |
| A callable bond... | may be structured to pay bondholders the current value of the bond on the date of call. |
| primary market | issuer recieves proceeds. initial issuance, Us Treasuries (auction), Corporations (OTC) |
| Secondary Market | "pre-owned" bonds. seller receives proceeds. OTC!! |
| Standard debt provisions: | in the indenture specify certian record keeping and general business procedures that the issuer must follow |
| restrictive debt provisions: | contractual clauses in a bond indenture that place operating and financial constraints on the borrower *designed to lower the risk that the issuer will default |
| Common restrictive covenants include provisions that specify: | constraints on subsequent borrowing, limitations on cash dividends |
| Violations of restrictive covenants give bondholders the right to... | demand immediate repayment |
| If coupon rate = yeild to maturity then... | PV will always equal principal amount |
| if coupon rate is higher than YTM .... | price will be higher than par |
| coupon rate < YTM means... | par will be higher than price |
| the rate of return an investor must earn on an investment to be fully compensated for its risk | required rate of return |
| ___ is the correct rate to discount a bond's cash flows to determine its present value (price) | the rate of required return |
| cost of borrowing | interest rate |
| required return = | interest rate on a loan |
| why do banks charge different interest rates on loans to different customers? | want to get compensated for more riskier |
| Required Return on investment formula | required return on investment = risk free rate + risk premium for investment |
| Risk-Free rate consists of... | real rate of return +expected inflation premium |
| rate that creates an equilibrium between the supply of savings and the demand for investment funds in a perfect world | real interest rate. where no inflation, all outcomes are certain |
| what determines the real rate of interest? | supply-demand for funds |
| Risk Free rate of interest typically measured by what.... | 3 month US Treasury bill. compensates investors ONLY for real rate of interest and expected rate of inflation |
| change in purchasing power | real rate of interest |
| nominal rate of interest | quoted rate of interest, change in actual number of dollars |
| if real rate is higher then nominal... | you lost money |
| The conversion feature of convertible bonds allows bondholders... | to exchange their bonds for a specified number of shares of common stock |
| the only time conversion feature of convertible bonds is available is when.... | the market price of the stock is greater than the conversion price |
| what do stock purchase warrants do? | give the bondholder the right to purchase a certain number of shares of the same firm's common stock at a specified price during a specified period of time. |
| Including stock purchase warrants typically allows firm.... | to raise debt capital at a lower cost than would be possible in their absence |
| Riskey borrowers pay ____ interest rate to compensate for risk | higher |
| default premium: | additional yeild investors require for bearing credit risk |
| yeild = | return |
| Bonds with longer maturity exposed more to.. | interest rate risk |
| most corporate bonds are issued.. | semiannually (divide interest rate/ytm IN HALF |
| for TVM what two things must be same size? | PMT and FV |
| Term structure is the relationship b/w... | time to maturity and yields (all else equal) |
| Yield curve is.. | graphical representation of the term structure |
| Normal yeild curve: | upward sloping; long term yields are higher than short term yeilds |
| Inverted yield curve: | downward sloping; long term yields are lower than short term yields |
| treasury securities are used to construct ____ _____ since all have zerio risk of default | yield curves |
| bonds that have more frequent trading will generally have lower required returns | liquidity premium |
| nominal interest rate means... | stated interest rate |
| Supply and Demand of Funds | Suppliers of funds (lenders, investors) give r (the price of money) to those who demand, demanders of funds, (borrowers and entreprenuers) |
| ignoring risk factors, the cost of funds is closely tied too... | inflationary expectations |
| Real rate of interest: | change in purchasing power |
| Nominal Rate of Interest: | quoted rate of interest, change in actual number of dollars |
| The ex ante nominal rate of interest includes... | our desired real rate of return plus an adjustment for expected inflation |
| who monitors compliance? | trustee (bank( |
| when issuer defaults on loan | bankruptcy |
| What happens when bankruptcy? | bondholers become creditors, (owners of the company) |
| 4 parts to bond indenture | standard provisions, covenants, sinking fun requirements, trustee monitors |
| conversion feature of convertible bonds allows: | bondholders to exchange their bonds for a specified number of shares of common stock |
| When will bondholders exercise converstion feature of convertible bonds? | when market price of stock is greater than conversion price |
| what do stock purchase warrants do? | make them more attractive to investors. give bondholer the right to purchase a certain number of shares of the same firm's common stock at a specified price during a specified time |
| what does including warrants typically allow firm to do? | raise debt capital at a lower cost than would be possible in their absence |
| the value of an asset = | the present value of all future cash flows associated with that asset |
| coupon payment = | coupon * par value |
| premium bond is when interest is... | lower than before |
| discount bond is when interest is.. | higher than before |
| interest rate risk: | chance that interest rates will change required return of bonds |
| with term structure we pull out: | effect of default risk, different coupons, etc |
| the term structure of interest rates relates: | the interest rate to the time of maturity for securities with a common default risk profile |
| treasury securities are used to contrust _____ since why? | yield curves since all have zero risk default |
| yeild curves can also be constructed with ____ ____ other than treasury securities | aaa or bbb corporate bonds |
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cl579544