Finance #2

  1. The ... earned by an investor can be divided into two categories:
    1. income paid by the issuer of the financial asset (either ... on debt or ... from equity)
    2. The change in value of the financial asset in the financial market (capital gains) over some time period
    • Dollar Return
    • Interest or Dividends
  2. is the dollar return stated as a percentage of the dollar amount that was originally invested
  3. What do we call the price or cost of debt capital?
    Interest Rate
  4. What do we call the price or cost of equity capital?
    Return on Equity = Dividends + Capital Gains
  5. The returns available within an economy from an investment in productive (cash generating) assets
    Production Opportunities
  6. The preferences of consumers for current consumption as opposed to saving for future consumption
    (want money now or buy bond for the future)
    Time preferences for consumption
  7. In a financial market context, the chance that a financial asset will not earn the return promised (chance of default)
  8. The tendency of prices to increase over time
  9. A premium for expected inflation that investors add to the real risk-free rate of return
    Inflation Premium - IP
  10. The return on ... is often used as the risk free rate because they represent Short term debt of the U.S. government that is very liquid and free of most risks
    U.S. Treasury Bills
  11. DRP+LP+MRP - The return that ... the risk-free rate of return, and thus represents payment for the risk associated with an investment
    Risk Premium or RP - exceeds
  12. The difference between the interest rate on a U.S. Treasury bond and a ... bond of eual maturity and marketability.
    Reflects the chance that the borrower (the issuer of the sevurity) will not pay the debt's interest or principal on time.
    DRP Default Risk Premium - Corporate
  13. A premium added to hte rate on a security if the security cannot be converted to cash on short notice at a price that is close to the original cost
    Reflects the fact that some investments are more easily converted into cash on short notice at a "reasonable price" than are other securities
    Liquidity Premium - LP
  14. A premium that reflects ... rate risk
    Bonds with longer maturities have greater interest rate risk
    Maturity Risk Premium - MRP - interest
  15. the risk of capital losses to which investors are exposed because of changing interest rates (part of MRP) - Long Term Bonds
    Interest Rate Risk
  16. The risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested
    Although Long Term bonds are heavily exposed to interest rate risk, short term investments are more vulnerable to this
    Reinvestment Rate Risk
  17. r* = ... risk free rate The rate of interest that would exist on default free U.S. Treasury secutities if no ... were expected
    t-bill rate is example
    fluctuates between ...% to ...% normally in the U.S.
    real - inflation - 2 - 4
  18. changes over time depending on economic conditions especially:
    On the rate of return corporations and other borrowers are willing to pay to borrow funds
    On people's time preferences for current versus future consumption
    r*= real risk free rate
  19. r = any ... rate aka quoted or stated
  20. rRF= rate on T-securities: risk free
    r* + IP
  21. The relationship between interest rates ( or yields) and maturities of securities
    Term Structure of Interest Rates
  22. A graph of the term structure showing the relationship between yields and maturities of securities is called the
    yield curve
  23. An upward slopind yield curve
    Normal yield curve
  24. A downward sloping yield curve
    Inverted ("abnormal") yield curve
  25. Equation for Short Term Treasury Bonds
    r* + IP
  26. Equation for Long Term Treasury Bonds
    r* + IP + MRP
  27. Equation for Short Term Corporate Bonds
    r* + IP + DRP + LP
  28. Equation for Long Term Corporate Bonds
    r* + IP + DRP + MRP + LP
  29. All else equal lenders prefer to make ... loands rather than ... loans because they are less subject to interest rate risk and are thus more easily bought or sold in the market.
    Liquidity Preference Theory - Short Term - Long Term

    Thus Short term rates should be low and the yield curve should be sloped upward
  30. -Every borrower and lender has a prefered maturity
    -The slope of the yield curve depends on the supply of and demand for funds in the Long Term market relative to the Short Term markety (yield curve should be flat, upward, or downward sloping)
    Market Segmentation Theory
  31. Explanation for the shape of the yield curve
    -Shape of the yield curve depends on investors' expectations about future inflation rates
    -If inflation is expected to increate, short term rates will be ... Long term rates ... and vice versa, thus the yield curve can slope up or down
    • Expectations Theory
    • low high
  32. Operations in which the fderal reserve buys or sells treasury securities to expand or contract the U.S. money supply
    -Distorts the ...
    -contract -
    - expand -
    • Open Market Operations
    • yield curve
    • fed buys
    • fed sells
  33. The larger the federal deficit the ... the level of interest rates
  34. When trade deficits occur, they must be financed, and the main source of financing is debt. This has the effect of ... interest rates
    driving up
  35. Inflationary peridos vs. Recessionary periods
    as business booms rates jump, recession rates drop encourage business
    Business Activity
  36. The higher the rate of interest the ... a firms profit PV= FV/(1+r)^t
  37. affect the level of economic acticity, and economic activity affects coporate profits
    Interest rates
  38. Interest rates influence stock prices because of competition in the market place between stocks and bonds:
    -If interest rates rise shaprly, investors can obtain ... returns in the bond market which induces them to sell stocks and transfer funds from the stock market to the bond market. A massive sale of stocks in repsonse to rising interest rate obviously would depress stock prices.
    -As interest rates decline, the ... market generally is the "hot" investment
    • highter
    • stock
  39. The value of an asset is a function of:
    -the ... it is expected to generate in the future and
    -the ... at which investors are willing to provide funds to purchase the investment
    --when the cost of money increases the value of an asset ...
    • cash flows
    • rate of return
    • decreases
  40. The interest rate lenders charge borrowers.
    Cost of Money
  41. Determined by the supply of funds and the demand for those funds
    How the cost of money is determined
  42. production opportunities, time preferences for consumption, risk, inflation
    factors that affect interest rates
  43. A snapshot of relaitonship between short and long term interest rates at a particular time
    Yield Curve
  44. Government borrowing exerts pressure on the demand for fudns and may inflate interest rates
    How governement actions and business activity affect interest rates
  45. When rates increase value of assets decrease which would you prefer if they both decrease
    How does the level of interest rates affect the calues of stocks and bonds
  46. A loan to a firm, government, or individual
    ex. home mortgages, commercial paper, term loans, bonds, secured and unsecured notes, marketable and nonmarketable debt
  47. The amount owed to the lender, which must be repaid at some point during the life of the debt
    Principal Value, Face Value, Maturity Value, and Par Value
  48. Securitites selling for less than PAr Value, usually occurs on debt instruments which do not offer interest payments
    Discounted Securities
  49. The date on which the principal amount of debt is due
    Maturity Date
  50. Interest on debt is paid before stock dividedns are distributed, and any outstanding debt must be repaid before stockholders can receive any proceeds from liquidation of the company
    Priority to Assets and Earninds
  51. Voting rights are not offered with debt, therefore debtholders cannot attain this
    Control of the firm
  52. Discounted short term debt instruments issued by the U.S. government to finance operations
    Treasury Bills
  53. An arrangement in which one firm sells some of its financial assets to another firm with a promise to repurchase the securities at a higher price at a later date
    Repurchase Agreement
  54. Overnight loans from one bank to another
    Federal Funds
  55. Aninstrument issued by a bank that obligates the bank to pay a specified amount at some future date( a postdated check)
    Banker's Acceptance
  56. A type of promissory note or legal IOU issued by large financially sound firms at a discount
    Commercial Paper
  57. An interest-earning time deposit at a bank or other financial intermediary
    Certificate of Deposit
  58. Certificate of deposit that can be traded to other investors prior to maturity; redemption is made by the investor who owns the CD at maturity
    Negotiable CD
  59. A deposit in a foreign bank that is denominated in U.S. dollars
    Eurodollar Dposit
  60. Investment funds pooled and managed by investment companies that are primarily invested in short term financial assets
    Money MArket Mutual Funds
  61. A loan generally obtained from a bank or insurance company on which the borrower agrees to make a series of payments consisting of interest and principal on specific dates to the lender - principal is paid back throughout the life of the loan
    Term Loans
  62. A long term contract under which a borrower agrees to make payments of interest and principal on spevific dates to the bondholder (investor)
    Principal is paid back at the end of the loan
    Coupon rate used
  63. Interest paid on a bond or other debt instrument stated as a percentage of it face or maturity value; represents the total interest paid each year
    Coupon Rate
  64. Debt Issued by federal state or local governments -- treasury notes or bonds
    Government Bond
  65. Bonds issued by state or local governments including revenue bonds and general obligation bonds
    Government Bond
  66. A municipal bond that generates revenue, which in turn can be used to make interest payments and repay the principal
    Revenue Bonds
  67. A municipal bond backed by the local government's ability to impose taxes
    General Obligation Bond
  68. Long term debt instruments issued by corporations
    Corporate Bonds
  69. A bond backed by fixed assets. First motgage bonds are senior in priority to claims of second mortgage bond
    Mortgage Bond
  70. A long term bond that is not secured by a mortgage on specific property
  71. A bond that has a claim on assets olny after the senior debt has been paid off in the event of liquidation
    Subordinated Debenture
  72. A bond that pays interest to the holder only if the interest is earned by the firm
    Income Bond
  73. A bond that can be redeemed at the bondholder's option when certain circumstances exist
    Putable Bond
  74. A bond that has interest payments based on an inflation index to protect the holder from inflation
    Indexed (purchasing power) bond
  75. A bond whose interest rate fluctuates with shifts in the general level of interest rates
    Floating rate bond
  76. A bond that pays no aannual interest but is sold at a discount below par, thus providing compensation to investors in the form of capital appreciation
    Zero Coupon Bonds
  77. A high-risk high-yiled bond used to finance mergers, leveraged buyouts, and troubled companies
    Junk Bond
  78. A formal agreement or contract between the issuer of a bond and the bondholders
    Bond indenture
  79. an official who ensures that the bondholders' interests are protected and that the terms of the indenture are carried out
  80. A provision in debt contract that constrains the actions of the borrower
    Restrictive Covenant
  81. A provision in a bond contract that gives the issuer the right to redeem the bond uner specified terms prior to the normal maturity date
    Call Provision
  82. Retiring an existing bond issue with the proceeds of a newly issued bond
  83. A required annual payment designed to amortize a bond issue
    may handle by
    -call in for redemption a certain percentage of the bonds each year or
    -buy the required amount of bonds on the open market
    Sinking Fund
  84. Permits bondholders to exchange their investments for a fixed number of shares of common stock, cannot be reversed
    Convertible stock
  85. A bond rated A or triple B - the lowest rated bonds that many banks and other institutional investors may hold by law
    Investment grade bond
  86. A bond's rating is an indicator of its default risk
    Most bonds are purchased by institutional investors who are legally restricted to investment grade securities
    Changes in ratings affect a firm's ability to borrow long term capital and the cost of that capital
    Importance of Bond Ratings
  87. Restructuring to reduce the financial charges to a level that the firm's cash flows can support
  88. If bankruptcy court orders a liquidation, proceeds are distributed in this order
    • 1. Secured creditors
    • 2. Wages and taxes
    • 3. Unsecured creditors, preferred stockholders, and common stockholders
  89. Refunding Questions:
    Would it be profitable to call an outstanding issue now and to replace it with a new issue?
    Even if refunding is profitable, would it be better to call now or to postpone the refunding to a later date?
    • Have rates gone down or up? If up no if down yes
    • If expected to continue to go down
  90. Debt issued by a foreign borrower but denominated in the currency of the country in which it is sold
    Foriegn Debt
  91. Debt issued in a country other than the one in whose currency the debt is denominated: Eurocredits, euro-commercial paper, Euronoes
  92. the interest rate offered by the best london banks on deposits of other large very creditworthy banks
    LIBOR London InterBank Offer Rate
  93. The average rate of return earned on a bond if it is held to maturity
    Yield to Maturity
  94. The average rate of return earned on a bond if it is held until the first call date
    Yield to Call
  95. The price a frim has a pay to recall a bond; generally equal to the principal amount plus some interest
    Call Price
  96. Because the cash flows associated with the bond-- that is interst payments and principal repayment -- remain constant, the value of a bond will ... when interest rates...
    • decrease
    • increase
  97. A bond that sells below its par value. This occurs whenever the going rate of interest rises above the coupon rate
    Discount Bond
  98. A bond that sells above its par value. This occurs whenever the going rate of interest falls below the coupon rate
    Premium Bond
  99. The risk of changes in bond prices to which investors are exposed due to changing interest rates
    Interest Rate Price Risk
  100. The risk that income from a bond portfolio will vary because cash flows must be reinvested at current market rates
    Interest Rate Reinvestment Risk
  101. Interest rate risk is ... for bonds that have longer maturities and lower coupon rates
  102. Reinvestment risk is ... for bonds that pay high coupon rates- or for bonds with shorter maturities
  103. What is debt?
    Debt represents a loan
  104. What are bond ratings?
    Ratings give an indication of the default risk associated with a bond
  105. How are bond prices determined?
    Computed as the present value of the cash flows the bond is expected to pay during its life
  106. What is the relationship between bond prices and interest rates?
    When interest rates increase, bond prices decrease and vice versa
  107. The nominal or face value of a stock or bond
    -establishes the amount due to preferred stockholders in the event of ...
    -the preferred dividend generally is stated as a perventage of the this
    • Par Value
    • liquidation
  108. any preferred dividends not paid in previous peridos must e paid before common dividends can be distributed(dividedns in arrears)q
    Cumulative Dividends
  109. Dividends must be paid on preferred stock before they can be paid on common stock, and in the even of bankruptcy, the claims of preferred stockholders must be satisfied boefre the common stockholders receive anything
    Priority to Assets and Earnings
  110. Almost all preferred stock is
    non voting stock
  111. Most stock can be converted to...
    Common Stock - receive more common stock for preferred
  112. gives the issuing corporation the right to call in the preferred stock for redemption
    Call Provision
  113. The amount in excess of par value that a company must pay when it calls a security
    call premium
  114. call for the repurchase and retirement of a given percentage of the stock each year- plan for calling- making sure they have enough money to buy it
    sinking fund
  115. ... with the common stock in sharing firms earnings - typically occurs when the dividend declared for common stock exceeds that which is paid to the preferred stockholders
  116. legally represents a stockholder's minimum financial obligation in the event the corporation is liquidated - not required and does not determine the market value of common stock or vice versa
    Par Value
  117. The firm has ... to pay common stock dividends
    no legal obligation
  118. stocks of firms that traditionally pay little or no dividedns so as to retain earnings to help fund growth opportunities
    growth stocks
  119. common stockholders have the ... to elect the firms directors and to vote on shareholder's proposals. mergers, and changes in the firms charter
  120. a document giving one person the authority to act for another typically the power to vote shares of common stock
  121. an attempt by a person or group of peopld to gain control of a firm by getting its stockholders to grant that person or group the authority to vote their shares so as to change the management team
    proxy fight
  122. an action whereby a person or group succeeds in ousting a firms managememnt and taking control of the company
  123. a provision in the coproate charter or bylaws that gives existing common stockhodlers the right to purchase on a pro rata basis any additional shares of stock sold by the firm
    preemptive right
  124. common stock that is given a special designation to meet special needs of the company
    classified stock
  125. a class of stock owned by the firm's founders who have sole voting rights
    founder's shares
  126. certificates created by banks that represent ownership in stocks of foriegn countries
    american depository receipts
  127. stock issued by foreign companies and traded in the united states
    yankee stock
  128. stock traded in countries other than the "home" country of the company not including the U.S.
    Euro Stock
  129. Growth that is expected to continue into the forseeable future
    normal (constant) growth
  130. the part of the life cycle of a firm in which its growth is either much faster or much slower than that of the economy as a whole
    nonconstant growth
  131. the ... the p/e ratio the more investors are willign to pay for each dollar earned by the firm- gives an indication of a stock's payback period
  132. the ... the EVA the better management is making decisions to beneift of the stockholders
  133. prices move ... to changes in rates of return
  134. prices move in the ... as changes in cash flows expected from the stock in the future
    same direction
  135. the value of assets that are owned minus the amount of debt that is owed
  136. ...change because ivestors change their expectations about the returns the firm will generate in the future
    stock prices
  137. the stock price is equal to the ... of the dividend stockholders expect to reveive during the company's life
    present value
  138. are based on the dividend the company pays and the change in the market value of the stock during hte year
    stock returns
  139. what techniques do investors use to value stocks
    • P/E ratio
    • EVA
  140. the chance that an unexpected outcome will occur
  141. a listing of all possible outcomes with a probability (chance of occurence) assigned to each outcome
    probability distribution
  142. In a continuous probability distribution the number of possible outcomes is
    unlimited or infinite
  143. in a discrete probability distribution - number of possible outcomes is
    limited or finite
  144. -a standardized measure of the risk per unit of return
    -useful where investments differ in risk and expected returns
    -calculated as the standard deviation divided by the expected return
    coefficient of variation
  145. risk adverse investors require higher rates of return to invest in
    higher risk securities
  146. The portion of the expected return that can be attributed to an investment's risk beyond a riskless investment
    equals the difference between the expected rate of return on a given risky asset and that on a less risky asset
    risk premium
  147. -the return that is actually earned
    realized rate of return
  148. -measures the degree of relationship between two variables
    correlation coefficient
  149. Perfectly or positvely correlated stocks have rates of return that move in the ... direction roe=1
  150. negatively correlated stocks have rates of return that move in ... directions roe=-1
  151. combining stocks that are not perfectly correlated will reduce the portfolio risk through
    -the riskiness of a portfolio is reduced as the number of stocks in the portfolio increases
    -the smaller the positive corelation the lower the risk
  152. that part of a security's risk associated with random outcomes generated by events, or behaviors, specific to the firm
    -can be eliminated through proper diversivication
    • Firm Specific risk
    • AKA unsystematic or diversifiable
  153. that part of a security's risk that cannot be eliminated through diversification because it is associated with economic, or market factors that systematically affect all firms
    -relevant risk is the risk of a security that cannot be diversified away, or its mrket risk-
    • Market Risk
    • AKA Relevant, Systematic, or Non-Diversifiable
  154. the risk of a security that cannot be diversified away or its market risk
    reflects a security's contribution to a portfolio's total risk
    relevant risk
  155. A measure of the extent to which the returns on a given stock move with the stock market
    beta coefficient
  156. The beta of any set of securities is the .... average of the individual securities betas
  157. a theoretical model used to determine the required return on an asset which is based on the proposition that any asset's return should be equal to the risk free return plus a risk premium that reflects the asset's nondiversifiable risk
    Capital Asset Pricing Model (CAPM)
  158. The addicitional return over the risk free rate needed to compensate investors for assuming an average amount of risk
    Market Risk Premium
  159. The line that shows the relationship between risk as measured by beta and the required rate of return for individual securities - result of CAPM
    Secuirty Market Line
  160. In increase in expected inflation would ... the nominal risk free rate
  161. The slope of the SML reflects the extent to which investors are
    averse to risk
  162. An increase in risk aversion ... the risk premium and ... the slope
    • increases
    • increases
  163. the condition under which the expected return on security is equal to its required return
  164. Riskiness of corporate assets is only relevant in terms of its ... on the stock's risk
Card Set
Finance #2
Chapter 5-8