FINC 341 EXAM 2 QUESTIONS & ANSWERS
0% stream of cash flows - Answers - if a stream of cash flows is discounted back to t=0
using a 0% discount rate, then the PV of the cash flow stream is simply the sum of the
cash flows
stock value - Answers - the current value of a share of stock is unrelated to the length of
time that an investor plans to hold the stock
SEC change - Answers - the SEC changed the rules in 1993 in order to allow large
investors to work together to force management changes and increase the focus on
stock price maximization
reinvestment rate risk - Answers - if interest rates fall, bondholders of callable bonds are
more exposed to reinvestment rate risk; if interest rates fall, bondholders of callable
bonds are also more exposed to interest rate risk
zero coupon bonds - Answers - zero coupon bonds are more attractive to investors in
high tax brackets; they pay no coupons at all, but are offered at a substantial discount
below their par values and hence provide capital appreciation rather than interest
income
Treasury-bond - Answers - a long-term Treasury bond with 8 years left will have the
same maturity risk premium as a corporate bond with 8 years left; long-term Treasury
bond prices fluctuate when interest rates change because the U.S. Treasury has some
risk of defaulting; a long-term Treasury bond will have the same maturity risk as a
corporate bond even though T-bonds are backed by the federal government
price of bonds - Answers - the price of bonds on the secondary market will increase if
interest rates fall
investment grade - Answers - a pension fund is only allowed to invest in BBB bonds or
higher; not allowed to invest in BB or lower (junk)
investor playing the bond market - Answers - an investor playing the bond market would
want to buy bonds when the going rate is high (buy at a discount) and then sell the
bonds when the rate goes low (sell at premium) in order to get the highest rate
sensitivity to interest rates - Answers - the price of a bond with 9 years left to maturity
has more sensitivity to a change in the interest rates than a bond with 5 years left
par value bond - Answers - any time the coupon rate on a bond matches the current
going rate (market rate) on that type of bond, the bond's value is par; no matter how
long is left on the life of a bond, when the going rate of return on bonds of that risk level
equals that bond's current rate, that bond's current value will be par
,capital gain - Answers - if the current Kd (yield to maturity) for bonds stays constant
from now until a particular bond matures, and that bond is currently selling at a premium
on the secondary market, that particular bond will have a negative capital gain each
year until it matures; bonds selling at a discount have positive capital gains each year if
constant
market risk - Answers - market risk (also known as systematic risk) stems from factors
such as war, recessions, and other macro factors, and cannot be eliminated
P/E ratio - Answers - a high P/E ratio does not necessarily mean a stock is overvalued;
one drawback of using the P/E Multiple approach is that it depends on reported
accounting earnings
market value of equity - Answers - it follows that a company's market value of equity
would be equal to the company's book value plus the present value of all future EVAs
floating bonds - Answers - floating coupon bonds do pay annual interest payments;
floating coupon bonds always have a value equal to par
foreign bonds and stocks - Answers - foreign bonds have default risk, liquidity risk,
exchange rate risk, and maturity risk; when U.S. investors purchase foreign stocks, they
hope 1) that the foreign stock prices will increase in the foreign country's local market
and 2) that the foreign currency will strengthen relative to the U.S. dollar
putable bonds - Answers - putable bonds contain provisions that allow the bonds'
investors to sell the bonds back to the company
rates of return - Answers - if the expected rate of return is less than the required rate of
return, stockholders will want to sell the stock and there will be a tendency for the stock
price to decrease
classified stock - Answers - the use of classified stock enables the company's founders
to maintain control over the company without having to own a majority of the common
stock; most firms do not have classified shares
poison pill provision - Answers - a poison pill provision allows the stockholders of a firm
that is taken over by another firm to sell shares in the second firm at a lower price
debenture vs. mortgage - Answers - a debenture provides no specific collateral as
security for the obligation; whereas a mortgage bond is backed by fixed assets (as
security)
amortized loan - Answers - in an amortized loan, the payment of principal is smallest in
the first payment, and increases with each payment thereafter
,value of perpetuity - Answers - the value of a perpetuity decreases when the required
rate of return increases
Fortune article - Answers - the US savings rate is the lowest of any industrial nation; the
ratio of US workers to retirees is now 3.2 to 1, compared to 17 to 1 in 1950, and will be
2 to 1 after the year 2020; people earning 85,000 today will have trouble maintaining
their standard of living in retirement
JC Penny - Answers - On 9-26-13 price of JCP stock was $10.50; on 9-27-13 price was
down to $9.50. They accounted issue of $84m in new stock - lowers EPS and price by
20%, shares are up 1/3
Importance of bond ratings - Answers - 1) since the bond's rating is an indicator of its
default risk, the rating affects the bond's interest rate and the firm's cost of debt capital;
2) since most bonds are purchased by institutional investors that are restricted to
investment grade securities, a firm will have a difficult time selling new bonds if it's
bonds fall below BB
Management's attempts to block takeovers - Answers - Elect only 1/3 of the directors
each year; require 75% of stockholders to approve merger;
Interest - Answers - Coupon Rate x Par Value
M - Answers - Par Value (Maturity value)
Treasury Bonds - Answers - issued by the federal government; no default risk or LP but
do have maturity risk (interest rate risk)
Corporate Bonds - Answers - issued by corporations, have default risk and maturity risk
(DRP & MRP)
Municipal Bonds - Answers - (munis) issued by state and local governments; have
default risk (DRP); most are exempt from federal taxes so carry lower interest rates
Foreign Bonds - Answers - issued by foreign governments or corporations; Have DRP,
MRP and Exchange Rate Risk (fluctuation)
Par Value - Answers - Stated face value of the bond; usually $1000 in this class
Coupon Interest Rate - Answers - "CR"; designates coupon payment (CR * Par)
Maturity - Answers - any maturity is allowed; most range from 10-40 years
Call Provision - Answers - These provisions give the issuing entity the right to all in a
bond for redemption prior to the original maturity. A call premium is generally paid when
, a bonds is called. The call premium is usually equal to one year's interest if called in the
first year then declines by INT/N each year after; May have deferred call protection.
Sinking Fund Provision - Answers - Facilitiates orderly retirement of the bonds
1. Certain percentage of randomly chosen bonds retired each year OR 2. certain
amount bought on the open market.
If Rates have Risen - Answers - Bond prices will fall and firms will buy bonds in the
open market at a discount
If Rates have Fallen - Answers - The firm will call the bonds.
Convertible Bonds - Answers - convertible into shares of common stock, at a fixed price
at the option of the bondholder; lower coupon rate.
Bonds with Warrants - Answers - similar to convertibles; options which permit the
bondholder to buy stock for a stated price; lower coupon rate
Putable Bonds - Answers - allows investors to sell bonds back to the company. (Lower
Coupon Rate)
Income Bond - Answers - Pays interest only if the interest is earned (higher coupon
rate)
Indexed (purchasing power) Bond - Answers - a bond that has interest payments based
on an inflation index to protect the holder from inflation
The discount rate used is affected by: - Answers - 1. The riskiness of the cash flows:
default risk, maturity risk, and liquidity risk.
2.The level of interest rates in the current economy.
Yield to Maturity - Answers - Current Yield + Capital Gains Yield
(CY + CGY)
Junk Bonds (high yeild) - Answers - BB, B, CCC, D
Promoted by Michael Milken. Used by Ted Turner to finance the development of CNN
and Turner Broadcasting. The junk bond market collapsed in the early 1990s but
rebounded later. lots of risk
Bond Rating Criteria - Answers - Financial Ratios, Bond Contract Terms, Miscellaneous
Qualitative Factors
Two components of an Asset's Risk - Answers - 1. Diversifiable risk- Company specific
risk
2. Market Risk - Non Diversifiable ex: 9/11 market dive, 08 crisis
0% stream of cash flows - Answers - if a stream of cash flows is discounted back to t=0
using a 0% discount rate, then the PV of the cash flow stream is simply the sum of the
cash flows
stock value - Answers - the current value of a share of stock is unrelated to the length of
time that an investor plans to hold the stock
SEC change - Answers - the SEC changed the rules in 1993 in order to allow large
investors to work together to force management changes and increase the focus on
stock price maximization
reinvestment rate risk - Answers - if interest rates fall, bondholders of callable bonds are
more exposed to reinvestment rate risk; if interest rates fall, bondholders of callable
bonds are also more exposed to interest rate risk
zero coupon bonds - Answers - zero coupon bonds are more attractive to investors in
high tax brackets; they pay no coupons at all, but are offered at a substantial discount
below their par values and hence provide capital appreciation rather than interest
income
Treasury-bond - Answers - a long-term Treasury bond with 8 years left will have the
same maturity risk premium as a corporate bond with 8 years left; long-term Treasury
bond prices fluctuate when interest rates change because the U.S. Treasury has some
risk of defaulting; a long-term Treasury bond will have the same maturity risk as a
corporate bond even though T-bonds are backed by the federal government
price of bonds - Answers - the price of bonds on the secondary market will increase if
interest rates fall
investment grade - Answers - a pension fund is only allowed to invest in BBB bonds or
higher; not allowed to invest in BB or lower (junk)
investor playing the bond market - Answers - an investor playing the bond market would
want to buy bonds when the going rate is high (buy at a discount) and then sell the
bonds when the rate goes low (sell at premium) in order to get the highest rate
sensitivity to interest rates - Answers - the price of a bond with 9 years left to maturity
has more sensitivity to a change in the interest rates than a bond with 5 years left
par value bond - Answers - any time the coupon rate on a bond matches the current
going rate (market rate) on that type of bond, the bond's value is par; no matter how
long is left on the life of a bond, when the going rate of return on bonds of that risk level
equals that bond's current rate, that bond's current value will be par
,capital gain - Answers - if the current Kd (yield to maturity) for bonds stays constant
from now until a particular bond matures, and that bond is currently selling at a premium
on the secondary market, that particular bond will have a negative capital gain each
year until it matures; bonds selling at a discount have positive capital gains each year if
constant
market risk - Answers - market risk (also known as systematic risk) stems from factors
such as war, recessions, and other macro factors, and cannot be eliminated
P/E ratio - Answers - a high P/E ratio does not necessarily mean a stock is overvalued;
one drawback of using the P/E Multiple approach is that it depends on reported
accounting earnings
market value of equity - Answers - it follows that a company's market value of equity
would be equal to the company's book value plus the present value of all future EVAs
floating bonds - Answers - floating coupon bonds do pay annual interest payments;
floating coupon bonds always have a value equal to par
foreign bonds and stocks - Answers - foreign bonds have default risk, liquidity risk,
exchange rate risk, and maturity risk; when U.S. investors purchase foreign stocks, they
hope 1) that the foreign stock prices will increase in the foreign country's local market
and 2) that the foreign currency will strengthen relative to the U.S. dollar
putable bonds - Answers - putable bonds contain provisions that allow the bonds'
investors to sell the bonds back to the company
rates of return - Answers - if the expected rate of return is less than the required rate of
return, stockholders will want to sell the stock and there will be a tendency for the stock
price to decrease
classified stock - Answers - the use of classified stock enables the company's founders
to maintain control over the company without having to own a majority of the common
stock; most firms do not have classified shares
poison pill provision - Answers - a poison pill provision allows the stockholders of a firm
that is taken over by another firm to sell shares in the second firm at a lower price
debenture vs. mortgage - Answers - a debenture provides no specific collateral as
security for the obligation; whereas a mortgage bond is backed by fixed assets (as
security)
amortized loan - Answers - in an amortized loan, the payment of principal is smallest in
the first payment, and increases with each payment thereafter
,value of perpetuity - Answers - the value of a perpetuity decreases when the required
rate of return increases
Fortune article - Answers - the US savings rate is the lowest of any industrial nation; the
ratio of US workers to retirees is now 3.2 to 1, compared to 17 to 1 in 1950, and will be
2 to 1 after the year 2020; people earning 85,000 today will have trouble maintaining
their standard of living in retirement
JC Penny - Answers - On 9-26-13 price of JCP stock was $10.50; on 9-27-13 price was
down to $9.50. They accounted issue of $84m in new stock - lowers EPS and price by
20%, shares are up 1/3
Importance of bond ratings - Answers - 1) since the bond's rating is an indicator of its
default risk, the rating affects the bond's interest rate and the firm's cost of debt capital;
2) since most bonds are purchased by institutional investors that are restricted to
investment grade securities, a firm will have a difficult time selling new bonds if it's
bonds fall below BB
Management's attempts to block takeovers - Answers - Elect only 1/3 of the directors
each year; require 75% of stockholders to approve merger;
Interest - Answers - Coupon Rate x Par Value
M - Answers - Par Value (Maturity value)
Treasury Bonds - Answers - issued by the federal government; no default risk or LP but
do have maturity risk (interest rate risk)
Corporate Bonds - Answers - issued by corporations, have default risk and maturity risk
(DRP & MRP)
Municipal Bonds - Answers - (munis) issued by state and local governments; have
default risk (DRP); most are exempt from federal taxes so carry lower interest rates
Foreign Bonds - Answers - issued by foreign governments or corporations; Have DRP,
MRP and Exchange Rate Risk (fluctuation)
Par Value - Answers - Stated face value of the bond; usually $1000 in this class
Coupon Interest Rate - Answers - "CR"; designates coupon payment (CR * Par)
Maturity - Answers - any maturity is allowed; most range from 10-40 years
Call Provision - Answers - These provisions give the issuing entity the right to all in a
bond for redemption prior to the original maturity. A call premium is generally paid when
, a bonds is called. The call premium is usually equal to one year's interest if called in the
first year then declines by INT/N each year after; May have deferred call protection.
Sinking Fund Provision - Answers - Facilitiates orderly retirement of the bonds
1. Certain percentage of randomly chosen bonds retired each year OR 2. certain
amount bought on the open market.
If Rates have Risen - Answers - Bond prices will fall and firms will buy bonds in the
open market at a discount
If Rates have Fallen - Answers - The firm will call the bonds.
Convertible Bonds - Answers - convertible into shares of common stock, at a fixed price
at the option of the bondholder; lower coupon rate.
Bonds with Warrants - Answers - similar to convertibles; options which permit the
bondholder to buy stock for a stated price; lower coupon rate
Putable Bonds - Answers - allows investors to sell bonds back to the company. (Lower
Coupon Rate)
Income Bond - Answers - Pays interest only if the interest is earned (higher coupon
rate)
Indexed (purchasing power) Bond - Answers - a bond that has interest payments based
on an inflation index to protect the holder from inflation
The discount rate used is affected by: - Answers - 1. The riskiness of the cash flows:
default risk, maturity risk, and liquidity risk.
2.The level of interest rates in the current economy.
Yield to Maturity - Answers - Current Yield + Capital Gains Yield
(CY + CGY)
Junk Bonds (high yeild) - Answers - BB, B, CCC, D
Promoted by Michael Milken. Used by Ted Turner to finance the development of CNN
and Turner Broadcasting. The junk bond market collapsed in the early 1990s but
rebounded later. lots of risk
Bond Rating Criteria - Answers - Financial Ratios, Bond Contract Terms, Miscellaneous
Qualitative Factors
Two components of an Asset's Risk - Answers - 1. Diversifiable risk- Company specific
risk
2. Market Risk - Non Diversifiable ex: 9/11 market dive, 08 crisis
