FNCE20001 Lecture Notes - Lecture 3: Interest Rate, United States Treasury Security, Investment

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orchidgnu53

27 Jul 2018

School

University of Melbourne

Department

Finance

Course

FNCE20001

Professor

josh

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Document Summary

Future cash flows, and dates, are specified in the contract. Pre-agree on future cash flows and future days. Mature within the year typically 90 and 180 days. Issuer has contractual obligation to make promised payments (e. g. ) treasury bill, bank bills. Interest is going to be implicit in the discount. Based on the difference between price paid and face value. May or may not promise a regular interest payment coupon. Issuer has contractual obligation to make all promised payments. Expressed as a % of the face value. Interest rate promised by the issuer specified on contract. Future expected cash flows face value and/or coupons. Yield to maturity or required rate of return. The price of a security today is the present value of all future expected cash flows discounted at the appropriate required rate of return (or discount rate). Buyers/sellers will only agree on the pv discounted at the appropriate discount rate, no other price.

Related Questions

QUESTION 1 The largest investors in corporate bonds are life insurance companies and pension funds. True False 5 points QUESTION 2 Most secondary market transactions for corporate bonds take place through dealers in the over-the-counter (OTC) market. True False 5 points QUESTION 3 The value (or price) of a bond is the present value of its expected future cash flows. True False 5 points QUESTION 4 Bond prices decline when the interest rate decreases. True False 5 points QUESTION 5 The face or par value for bonds is the amount paid to bondholders at maturity and is usually equal to $1,000. True False 5 points QUESTION 6 The yield to maturity of a bond is the discount rate that makes the present value of the coupon and principal payments equal to the price of the bond. True False 5 points QUESTION 7 Zero coupon bonds have no coupon payments so they sell for more than their par value. True False 5 points QUESTION 8 Interest rate risk is the risk that bond prices will fluctuate when the interest rate changes. True False 5 points QUESTION 9 US Treasury securities are considered risky investments because the coupon payments are unpredictable. True False 5 points QUESTION 10 Bonds are very difficult to value because their future cash flows are very difficult to predict. True False 5 points QUESTION 11 If the bond's coupon rate is equal to the market rate then the bond will sell at a price equal to its face value greater than its face value less than its face value equal to its foreign currency value, e.g., its price in British pounds 5 points QUESTION 12 When calculating the price of a bond that pays a semiannual coupon one needs to use double the number of years until maturity for the number of payments use half the annual coupon payment use half the annual rate of return as the discount rate all of the above 5 points QUESTION 13 The yield to maturity of a bond is the discount rate that makes the present value of the coupon and principal payments more than the price of the bond equal to zero equal to the price of the bond less than the price of the bond 5 points QUESTION 14 Which one of the following statements is true? All else equal long-term bonds have lower price volatility than short-term bonds. There is an inverse relation between bond prices and market interest rates. All else equal short-term bonds are more risky than long-term bonds. All else equal US government bonds are more risky than corporate bonds. 5 points QUESTION 15 An investor owns a 10-year US government bond with a 9 percent coupon rate. If the yield-to-maturity on the bond is 8 percent then this bond is selling for its par value. a discount. a premium. its face value. 5 points QUESTION 16 BA Corp is issuing a 10-year bond with a coupon rate of 8 percent and a par value of $1,000. The market interest rate on similar bonds is currently 6 percent. If the coupon payments are made annually, what is the value of this bond? 5 points QUESTION 17 Knight, Inc. has issued a 3-year bond with a $1,000 par value and an annual coupon rate of 6 percent. The current market rate of interest is 5 percent. What is the value of this bond if the coupon payments are made semiannually? 5 points QUESTION 18 Diane Carter is interested in buying a 5-year zero coupon bond with a face value of $5,000. If the market interest rate on these types of bonds is currently 9 percent, what is the current price of this bond? 5 points QUESTION 19 Rudy Sandberg wants to invest in 4-year bonds that are currently priced at $933.76. The bonds have a coupon rate of 6 percent and annual coupon payments. If the par value of the bonds is $1,000, what is the bond's yield-to-maturity? 5 points QUESTION 20 You own a 5-year bond with a face value of $1,000 and a coupon rate of 5 percent with annual payments. The bond is currently worth $810.46. If market interest rates remain unchanged, what will be the value of the bond next year when there are 4 years left until maturity?

The (-Select- A. discount B. premium C. par) value of a bond is its stated face value or maturity value, and its coupon interest rate is the stated annual interest rate on the bond. The maturity date is the date on which the par value must be repaid. A (-Select- A. call B. redemption C. sinking) provision gives the issuer the right to redeem the bonds under specified terms prior to their normal maturity date, although not all bonds have this provision. Some bonds have (-Select- A. redemption fund B. sinking fund C. call fund) provisions which require the issuer to systematically retire a portion of the bond issue each year. Because sinking fund provisions facilitate their orderly retirement, bonds with these provisions are regarded as being (-Select-A. riskier B. safer C. equivalent) so they will have (-Select- A. lower B. equivalent C. higher) coupon rates than similar bonds without these provisions.

Bonds can be (-Select- A. floating B. zero C. fixed) -rate bonds with a constant coupon rate over the life of the bond, or they can be (-Select- A. floating B. zero C. fixed) -rate bonds with a coupon rate that varies over time depending on the level of interest rates. (-Select- A. Annual coupon B. Zero coupon C. Fixed coupon) bonds pay no annual interest but are sold at a (-Select- A. premium above B. price at C. discount below) par, thus compensating investors in the form of capital appreciation. An original issue discount (OID) bond is any bond originally offered at a price (-Select- A. above its B. below its C. equal to) par value.

(-Select- A. Convertible B. Perpetual C. Putable) bonds are exchangeable at the option of the holder for the issuing firm's common stock. Bonds can be issued with warrants giving the holder the option to purchase the firm's stock for a stated price, thereby providing a capital gain if the stock's price rises. (-Select- A. Income B. Convertible C. Putable) bonds contain a provision that allows holders to sell them back to the company prior to maturity at a prearranged price. (-Select- A. Income B. Default C. Preferred) bonds pay interest only if the firm has earnings, while an indexed (purchasing power) bond bases interest payments on an inflation index to protect the holder from inflation.

Mortgage bonds are backed by (-Select- A. current assets B. fixed assets C. marketable securities) . First mortgage bonds are senior in priority to claims of second mortgage bonds. Debentures are long-term bonds that are not secured by a mortgage. Subordinated debentures are bonds having claims on assets only after senior debt has been paid in full in the event of liquidation. (-Select- A. Secured-debenture B. Investment-grade) bonds are rated triple B or higher, and many banks and other institutional investors are legally limited to only holding these bonds. In contrast, junk bonds are high-risk, high-yield bonds.

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1a- What are the direct costs and indirect costs of financial distress, from default that leads to bankruptcy? Explain in a well-stated description and discussion, not over a page in length.

1b- What are the impacts of the following on BECA Corporation's value, given the following information? SHOW ALL CALCULATIONS, and make a summary about the impact on equity owners between leveraged and unleveraged capital structures, and the impact on firm value from Financial Distress Costs.

BECA Corporation faces an uncertain future in a challenging business environment. Due to increased competition from foreign imports, its revenues have fallen dramatically in the past year. BECA's managers hope that a new product in the company's pipeline of new products will restore its fortunes. While the new product represents a significant advance over BECA's competition, whether that product will be a hit with consumers remains uncertain. If it is a hit, revenues and profits will grow, and BECA will be worth $200 million at the end of the year. If it fails, BECA will be worth only $130 million at the end of the year.

BECA Corporation may employ one of two alternative capital structures at the beginning of the year to provide the funding for this new project: (1) it can use all equity financing or (2) it can use debt that matures at the end of the year with a total of $150 million due.

Look first at the consequences of these capital structures when the new product succeeds, and when the new product fails, in a setting of perfect capital markets. Calculate what the debt and equity values will be for success and for failure, in both the unlevered and levered capital structures, at the end of the year. Show the totals to all investors (debt + equity) as well.

Now, since it has been assumed that BECA Corporation is operating in a perfect capital market, according to the M&M Proposition I, the investors (debt and equity total) will NOT be worse off because BECA may have some leverage at the beginning of the year. In other words, the value of BECA will be the same whether it has incurred the $150M of debt or not.

So, you are to show if that is indeed the case for BECA Corporation, under the following scenario.

Suppose the risk-free rate is 5%, and BECA's new product is equally likely to succeed or to fail. For simplicity, suppose that BECA's cash flows are unrelated to the state of the economy (i.e., the risk is diversifiable), so that the project has a Beta coefficient of 0 and the cost of capital is the risk-free rate. Compute the value of BECA's securities (that means both debt and equity, as applicable) at the beginning of the year with and without the $150M debt, and show whether or not the M&M Proposition I holds. That is, show if the value of the securities with or without leverage (the debt of $150M) have the same total value or not.

Now, to "get at" the value, VL or VU of the BECA Corporation, you have to discount the value of the cash flows to investors, per equation 9.23 in Chapter 9. But, what you need to know about the M&M Propositions is they assumed that the entire earnings (EBIT) in each year are paid out to the shareholders in the form of dividends or to the debtholders in the form of interest. So, regardless, the owners of the firm receive all the cash flows. So, for equation 9.23, you only have one year of FCFs, and the discount rate is 5%. What is the FCF? Since it is all of the cash flows with no taxes existing, and all of it is paid out to the equity and debt holders in a perfect capital market, what you find out is that the numerator is nothing more than the equity or debt values you calculated above. This is illustrated in Example 16.1 on page 554 of the texbook (I just provided an explanation of why the equity and debt values are used in the numerator instead of cash flows...in this case, they are the same).

2.Suppose you are a rational investor and looking at the following tax rates:

Year	Capital Gains Rate	Ordinary Income Rate	Dividend Rate
1997-2000	20%	40%	40%
2001-2002	20%	39%	39%
2003-2012	15%	35%	15%

(The 2012 tax rates were revised in 2013 by the U.S. Congress, and signed into law by the President, but that is for information only). The tax rates shown are for financial assets held for one year or more. For assets held less than one year, capital gains are taxed at the ordinary income tax rate (currently 35% for the highest bracket); the same is true for dividends if the assets are held for less than 61 days.

Your assignment: What is the effective dividend tax rate for a buy and hold individual investor in 2006 ?

Show all of your calculations.

FNCE20001 Lecture Notes - Lecture 3: Interest Rate, United States Treasury Security, Investment

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