-inflation

-risk

-liquidity preference

yield to maturity

(YTM)

represents the compound annual rate of return that an investor earns on a debt security assuming that the bond makes all promised payments and the investor holds the bond to maturity

YTM- vertical axis

Time to maturity- horizontal axis

Three theories that are frequently cited to explain the general shape of the yield curve:

1. Expectation theory--the yield curve reflects investor expectations about future interest rates; an expectation of rising interest rates results in an upward-sloping yield curve, and on expectation of declining rates results in a downward-sloping yield curve. 

2. Liquidity preference theory--suggests that long-term rates are generally higher than short term rates, upward sloping, bc investors perceive short-term investments to be more liquid and less risky that long-term investments. Borrowers must offer higher rates on long-term bonds to entice investors away from their preferred short-term securities. investors like shortterm; lenders like longterm. 

3.market segmentation theory--theory suggesting that the market for loans is segmented on the basis of maturity and that the supply of and demand for loans within each segment determine its prevailing interest rate. equilibrium bt suppliers and demanders of longterm funds, ex>real estate loans, determine prevailing longterm interest rates. 

a legal document that specifies both the rights of the bondholders and the duties of the issuing corporation; descriptions of the amnt and timing of all interest and principal payments. 

*The borrower must 1. maintain satisfactory accounting records in accordance with GAAP 2. periodically supply audited financial statements 3. pay taxes and other liabilities when due 4. maintain all facilities in good working order

1. current yield

2. yield to maturity (YTM)

3. yield to call (YTC)

a measure of a bond's cash return for the year; calculated by

bond's annual interest payment

 its current price. 

the process that links risk and return to determine the worth of an asset. Can be applied to expected streams of benefits from bonds, stocks, income properties, oil wells, etc. 

*Three key inputs:

1.cash flows (returns)

2.timing

3.a measure of risk, which determines the required return. 

cash flows 

(returns)

include all borrowing incurred by a firm, including bonds, and is repair according o a fixed schedule of payments. 

-do not receive voting privileges, rely on contractual obligations instead to be their vote; 

-Satisfying creditors claims on income and assets come before equityholders' 

-Tax deductibility of interest lowers the corporation's cost of debt financing

funds provided by the firm's owners (investors or stockholders) that are repaid subject to the firm's performance.

-Internally-retaining earnings rather than paying them out in the form of dividends to its stockholders

-Externally-selling common or preferred stock.

-Stockholders generally have voting rights

-Equityholders' claims on income and assets are secondary to the claims of creditors, thus they are expect greater returns from their investment in the firm's stock than the returns creditors require on the firm's borrowings. 

-permanent form of financing. equity liquidated only during bankrupcy.

-dividend payments are not tax deductible

Common Stock

(residual owners)

privately owned:the common stock of a firm is owned by private investors; not publicly traded.

publicly owned: the common stock of a firm is owned by public investors; traded publicly. 

Closely owned: the common stock of a firm is owned by an individual or small group of investors (family); usually privately owned companies; stocks generally not traded. 

Widely Owned: the common stock of a firm is owned by many unrelated individuals or institutional investors. Larger corporations; stocks traded in the broker or dealer markets

market value=unrelated to par value;

an arbitrary value established for legal purposes in the firm's corporate charter and which can be used to find the total number of shares outstanding by dividing it into the book value. 

Setting low par value is advantageous in states where corporate taxes are based on par value.

a reduction in each previous shareholder's fractional claim on the firm's earning resulting from the issuance of additional shares of common stock;

claims on the firm's earnings=diminished as a result of new shares being issued.

issued shares of common stock held by the firm; often these shares have been repurchased by the firm...no longer referred as outstanding shares.

-does not have voting rights; does not earn dividends; does not have a claim on assets in liquidation. 

each share of common stock entitles its holder to one vote in the election of directors and on special issues...bc many small stockholders do not attend the annual meeting to vote, sign proxy. 

a statement transferring the votes of a stockholder to another party. 

common stock that carries no voting rights; issued when the firm wishes to raise capital through the sale of common stock but does not want to give up its voting control. 

Class A=one vote

Class B=supervoting rights

American depositary shares

(ADSs)

American depositary receipts

(ADRs)

certain privileges make them senior to common stockholders. They are promised a fixed periodic dividend, either a percentage or a dollar amount. How the dividend is specified depends on the wether the preferred stock has a par value.

-considered quasi-debt because much like interest on debt, it specifies a fixed dividend. Unlike debt, has no maturity date; exposed to less risk; given preference over common stockholders in the asset liquidation process, coming after creditors. Not usually given a voting rights.

-Restrictive covenants. 

1. public offering

2. a rights offering

3. private placement

initial public offering

(IPO)

the first public sale of a firm's stock.

-prospectus:a portion of a security registration statement that describes the key aspects of the issue, the issuer, and its management and financial position

financial intermediary that specializes in selling new security issues and advising firms with regard to major financial transactions. Their main activity...=

underwriting--bearing the risk of reselling, at a profit, the securities purchased from an issuing corporation at an agreed-on price.

efficient-market hypothesis 

(EMH)

the most common statistical indicator of an asset's risk; it measures the sidpersion around the expected value

the higher the s.d. the greater the risk. 

coefficient of variation

(CV)

a measure of relative dispersion that is useful in comparing the risks of assets with differing expected returns:

stdev

expected rate of return

*higher coefficient of variation means that an investment has more volatility relative to its expected return

a statistical measure of the relationship between any two series of numbers

positively correlated:describes two series that move in the same direction +1

negatively correlated:opposite directions -1; **whenever assets are perfectly negatively correlated, some combination of the two assets exists such that the resulting portfolio's returns are risk free. 

describes two series that lack any interactin and therefore have a correlation coefficient close to 0. Combining uncorrelated assets can reduce risk like combining negatively correlated assets.

capital asset pricing model

(CAPM)

the combination of a security's nondiversifiable risk and diversifiable risk.

Total risk = nondiv risk(one asset) + divers risk(assets in a portfolio)

the portion of an asset's risk that is attributable to firm-specific, random causes; can be eliminated through diversification. Also called unsystematic risk. Attributable to strikes, lawsuits, loss of key accounts.

*gradually disappears as the number of stocks in the portfolio increases. 

a relative measure of nondiversifiable risk. An index of the degree of movement of an asset's return in response to a change in the market return.

market return: a return on the market portfolio of all traded securities.

1) risk-free rate of return- the required return on a risk-free asset, typically a 3-month U.S. Treasury Bill

2) U.S. Treasury Bills (T-bills)-short term IOUs issued by the U.S. Treasury; considered the risk-free asset.

the premium the investor must receive for taking the average amount of risk associated with holding the market portfolio of assets. 

(rm - Rf)

represents the firm's cost of financing and is the minimum rate of return that a project must earn to increase firm value. Major link bt the firm's long term investment decisions and the wealth of the firm's owners as determined by th emarket value of their shares.

*estimated at a given point in time and reflects the expected average future cost of funds over the long run.

funds actually received by the firm from the sale of a security. Total proceeds are reduced by the...

 flotation costs---the total cost of issuing and selling a security; applies to all public offerings of securities-debt, preferred stock, and common stock. Includes:

1) underwriting costs: compensation earned by investment bankers for selling the security

2)admistrative costs: issuer expenses such as legal, accounting, and printing

the ratio of the preferred stock dividend to the firm's net proceeds from the sale of preferred stock.

*net proceeds represents the amnt of money to be received minus any flotation costs.

the rate at which investors discount the expected dividends of the firm to determine its share value. relies on either the constant-growth valuation model, or CAPM.

*The CAPM differs from the constant growth model in that it directly considers the firm's risk, as reflected by beta in determining the required return or cost of common stock equity. The constant growth models uses the market price, Po, as a reflection of the expected risk-return.

the same as the cost of an equivalent fully subscribed issue of additional common stock, which is equal to the cost of common stock equity, rs.

rs=rr

weighted average cost of capital

(WACC)

an outlay of funds by the firm that is expected to produce benefits over a period of time greater than 1 year. Ex: fixed assets outlays

Companies make capital expenditures to expand operations, to replace or renew fixed assets, or to obtain some other , less tangible benefit over a long period. 

1.proposal generation

2.review and analysis

3.decision making

4.implementation

5.follow-up

the amount of time required for a firm to recover its initial investment in a project, as calc from cash inflows.  Less sophisticated capital budgeting technique, bc does consider TVM.

If pb period<max acceptable pb period=accept

If pb >max acceptable pb period=reject

*Measure of risk exposure. The short the payback period, the smaller the risk exposure.

Net Present Value

(NPV)

a sophisticated capital budgeting technique, found by subtracting a project's initial investment from the present value of its cash inflows discounted at a rate equal to the firm's cost of capital.

*when used to make accept-reject decisions:

If NPV> $0, accept

If NPV< $0, reject

internal rate of return

(IRR)

the discount rate that equates the NPV of n investment opportunity with $0 (because the present value of cash inflows equals the initial investment); it is the rate of return that the firm will earn if it invest in the project and receives the given cash flows. 

If IRR>the cost of capital=accept

If IRR<the cost of capital=reject