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Bonds and Stocks

  1. Summarize the characteristics of a Corporate Bond.

Bonds have number of characteristics which helps to determine its value. These characteristics are:

 Par Value/Face value: When matures, an amount which bond holder gets back is called face value of bond. Newly issued bonds are normally sold at par value and they have usually a par value of $1000.  

Coupon or interest rate: This amount which bond holder will receive as interest payment. Since, sometimes, there are physical coupons on the bond, therefore, they are called coupons.

Maturity: This is the date on which the investors will be repaid and they range from one day to 100 years.    

 

  1. List and describe the basic types of Bonds (discussed in class and in the chapter). i.e. Debenture Bonds, Mortgage Bonds, etc.

Different types of bonds are:

Government Bonds: Bonds issued by the government of US with securities maturing in 10 years are called government bonds. They come with a promise to pay periodic interest payments and repay the FV on the maturity date. These are least risky bonds with no chance of default.

Municipal Bonds: Known as Munis are riskier than government bonds and are issued by states, cities and countries to fund day to day obligations and to finance local projects such as schools etc. They are often free from federal tax and mostly local governments make them non-taxable for its residents.  

Corporate Bonds: Bonds issued by the companies are called Corporate bonds and are characterized by high yields, though, they are risky as company can default but they are most rewarding fixed income investments.

Debenture Bonds: It is an unsecured bond whose holder has claim of general creditor on all the assets of issuer however; it is not pledged to secure the other debt specifically. They are typically bought on belief that bond issuer is not likely to default.

Mortgage Bonds: It is the bonds which is backed by pool of mortgages in real estate assets such as house and are usually secured with pledge of specific assets called mortgage bonds. They can pay interest monthly, semi0annually and quarterly. 

 

 

  1. When it gets issued, you purchase a 10 year bond in XYZ Corporation with a coupon rate of 6%. The Yield to Maturity = 10%.

 

  1. How much do you pay for it on Day 1?

 

  1. You hold the bond for 4 years, then sell it. At the time of the sale, the YTM = 8%. How much will you sell it for?

Years

10

 

Coupon rate

6%

 

YTM

10%

 

Priceof Bond

?

 
     

YTM

[(Face value/Bond price)^1/time period]-1

10%

(1000/P)*1/10

-1

 

0.1

 

P^1/10

1000^1/10/10%-1

 
 

19.95262315

-1

P^1/10

18.95262315

 

by taking  exponent of 1/10 pn both sides

 

P

189.5262315

 

b.

   

YTM

[(Face value/Bond price)^1/time period]-1

10%

(1000/P)*1/4

-1

 

0.1

 

P^1/4

1000^1/10/10%-1

 
 

13.18256739

-1

 

12.18256739

 

by taking  exponent of 10 on both sides

   

P^1/4

12.18256739

 

Selling price

48.73026954

 

 

  1. What’s the purpose and importance of a Call Provision for a company?

Call provision allows the bond issuer to repurchase and retire the bonds.  If there is a call provision in the company, it comes with the window under which bond can be called upon and company defines the accrued interest and the price which is to be paid to bondholders is required is also defined. It is important to companies because they exercise it when the interest rate are falling and  it helps the company in issuing new debt at lower rate of interest and reduces the cost of borrowing for the company.  Therefore, it helps the company in reducing the effective rate on the borrowing. This way company can have more cash which can be used in making reinvestments elsewhere.  

 

  1. The XYZ company just paid a $2.00 dividend on its common shares of stock. The dividends expect to grow at a constant rate of 2% per year indefinitely. If investors require a 10% return on this stock, what is the current price? What will the price equal in 3 years from now?

 

                                                       Data

 

Current Dividend = 2

Growth 0f Dividend = 2%

Return = 10%

 

D3

2^3

8

P3

8(1.02)/(.10-0.02)

P3

102

 

 

 

  1. Why does the value of a share of stock often depend on dividends? Explain.

The value of stock is dependent on dividend because the stable growth in dividend rate helps the company in improving its value of a share of a stock. Since, dividend is the primary method to share the company’s profits with its shareholders, and investors rely on these payments to pat for their living expenses, therefore, increasing or steady dividend payment increases the likelihood of increase in stock value. In addition, it is signal to potential buyers that company is operating in adequate manner and it is the signal of internal strength of the company. Besides, it boosts the confidence of potential buyers and when outlook is strong, value of stock increases

  1. Summarize the characteristics of a Preferred Stock.

Preferred stocks are considered a hybrid security, since; they offer both the characteristics of common stock and bonds. For example, it is similarto common stockbecause preferred stock holders, receives dividend unless declared bythe companies andits fixed percentage dividend features indicate that they are like bonds. They can also be used as a substitute to proposition of talking additional debt. They are classified on company’s balance sheet and in case of company liquidities, the preferred stock holders are the first ones to get paid. The holders of the bonds have no voting rights and are mostly cumulative and in case if dividend is not paid in current years, it accumulates and goes into the balance sheet of next year and is paid in future. They are risky than common stocks.

 

  1. JBF’s Restaurant considers the installation of a new computerized pressure cooker that will cut annual operating costs by $20,000. The system will cost $45,000 to purchase and install. This system expected to have a 4-year life and will be depreciated to zero using straight-line depreciation. What is the amount of the earnings before interest and taxes for this project? 

 

Reduction in Annual operating cost

20,000

 

Pressure cooker price and Ins

45000

 

Year

4

 

Salvage value

0

 

EBIT

?

 
     

Depreciation per Annum

(B26-0)/4

11250

Accumulated dep.

45000

 

Profit

20,000

 

Accumulated dep.

-45000

 

EBIT

-25,000

 

 

 

 

  1. In the context of Capital Budgeting, what is Opportunity Cost?

In the context of capital budgeting, opportunity cost refers to value of asset or other input which will be used in the projects. Therefore, it will be what will be the cost to acquire the relevant cost is what will be the asset or input worth today. In addition, in context of capital budgeting, it is the value of most valuable alternative which must be given up, in case, if the proposed investment is undertaken.     

 

  1. Summarize the purpose of MACRS.

Firms decide to use MACRS because it provides for larger depreciation deductions earlier. These large deductions tend to reduce the taxes; however, it results in no other cash consequences. Firms decide to use MACRS because of the time value issue. In addition, though depreciation is same for any firm using straight line method or MACRS but time differs.

 

 

  1. Summarize the Efficient Market Hypothesis.

Efficient market Hypothesis (EMH) is an investment theory which states that it is impossible to beat the market because relevant information available in the market is reflected in the existing share prices of the market as they tend to incorporate them.  In addition, according to EMH stocks trade at fair value on stock exchanges and this makes it impossible for investors to neither sell the stocks at inflated prices nor purchase undervalued stocks. Therefore, according to EHM, it becomes difficult for traders to outperform the overall market. In addition, the only realistic way to outperform the market is by purchasing the riskier investments.     

 

  1. Suppose a stock had an initial price of $72 per share, paid a dividend of $3 per share during the year, and had an ending share price of $82. Compute the $ total return and the % total return.

 

Total Stock Return = (P1-P0) + D

                                    P0

(82-72) + 3

10.04167

72

 

Total return= 10.04

Percentage total return = (82-72)/72 = 13.88%

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