FINC 341 EXAM 2 THEORY COMPLETE QUESTIONS AND
VERIFIED SOLUTIONS LATEST UPDATE THIS YEAR
0% stream of cash flows - ANSWER-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 - ANSWER-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 - ANSWER-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 - ANSWER-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 - ANSWER-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 - ANSWER-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 - ANSWER-the price of bonds on the secondary market will
increase if interest rates fall
1
,investment grade - ANSWER-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 - ANSWER-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 - ANSWER-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 - ANSWER-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 - ANSWER-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 - ANSWER-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 - ANSWER-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
2
,market value of equity - ANSWER-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 - ANSWER-floating coupon bonds do pay annual interest
payments; floating coupon bonds always have a value equal to par
foreign bonds and stocks - ANSWER-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 - ANSWER-putable bonds contain provisions that allow the bonds'
investors to sell the bonds back to the company
rates of return - ANSWER-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 - ANSWER-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 - ANSWER-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
3
, debenture vs. mortgage - ANSWER-a debenture provides no specific collateral as
security for the obligation; whereas a mortgage bond is backed by fixed assets (as
security)
amortized loan - ANSWER-in an amortized loan, the payment of principal is
smallest in the first payment, and increases with each payment thereafter
value of perpetuity - ANSWER-the value of a perpetuity decreases when the
required rate of return increases
Fortune article - ANSWER-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 - ANSWER-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 - ANSWER-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 - ANSWER-Elect only 1/3 of the
directors each year; require 75% of stockholders to approve merger;
Interest - ANSWER-Coupon Rate x Par Value
4
VERIFIED SOLUTIONS LATEST UPDATE THIS YEAR
0% stream of cash flows - ANSWER-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 - ANSWER-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 - ANSWER-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 - ANSWER-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 - ANSWER-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 - ANSWER-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 - ANSWER-the price of bonds on the secondary market will
increase if interest rates fall
1
,investment grade - ANSWER-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 - ANSWER-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 - ANSWER-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 - ANSWER-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 - ANSWER-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 - ANSWER-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 - ANSWER-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
2
,market value of equity - ANSWER-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 - ANSWER-floating coupon bonds do pay annual interest
payments; floating coupon bonds always have a value equal to par
foreign bonds and stocks - ANSWER-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 - ANSWER-putable bonds contain provisions that allow the bonds'
investors to sell the bonds back to the company
rates of return - ANSWER-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 - ANSWER-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 - ANSWER-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
3
, debenture vs. mortgage - ANSWER-a debenture provides no specific collateral as
security for the obligation; whereas a mortgage bond is backed by fixed assets (as
security)
amortized loan - ANSWER-in an amortized loan, the payment of principal is
smallest in the first payment, and increases with each payment thereafter
value of perpetuity - ANSWER-the value of a perpetuity decreases when the
required rate of return increases
Fortune article - ANSWER-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 - ANSWER-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 - ANSWER-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 - ANSWER-Elect only 1/3 of the
directors each year; require 75% of stockholders to approve merger;
Interest - ANSWER-Coupon Rate x Par Value
4
