CHAPTER 6 INTEREST RATE FUNDAMENTALS The interest rate or required return represents the cost of money. It is the compensation that a supplier of funds expects and a demander of funds must pay. Usually the term interest rate is applied to debt instruments such as bank loans or bonds, and the term required return is applied to equity investments, such as common stock, that give the investor an ownership stake in the issuer. In fact, the meaning of these two terms is quite similar because, in both cases, the supplier is compensated for providing funds to the demander. A variety of factors can influence the equilibrium interest rate. One factor is inflation, a rising trend in the prices of most goods and services. Typically, savers demand higher returns (that is, higher interest rates) when inflation is high because they want their investments to more than keep pace with rising prices. A second factor influencing interest rates is risk. When people perceive that a particular investment is riskier, they will expect a higher return on that investment as compensation for bearing the risk. A third factor that can affect the interest rate is a liquidity preference among investors. The term liquidity preference refers to the general tendency of investors to prefer short-term securities (that is, securities that are more liquid). If, all other things being equal, investors would prefer to buy short-term rather than long-term securities, interest rates on short-term instruments such as Treasury bills will be lower than rates on longer-term securities. Investors will hold these securities, despite the relatively low return that they offer, because they meet investorsâ preferences for liquidity. real rate of interest The rate that creates equilibrium between the supply of savings and the demand for investment funds in a perfect world, without inflation, where suppliers and demanders of funds have no liquidity preferences and there is no risk. nominal rate of interest The actual rate of interest charged by the supplier of funds and paid by the demander. Investors generally demand higher rates of return on risky investments as compared to safe ones. Otherwise, there is little incentive for investors to bear the additional risk. Therefore, investors will demand a higher nominal rate of return on risky investments. term structure of interest rates The relationship between the maturity and rate of return for bonds with similar levels of risk. yield curve A graphic depiction of the term structure of interest rates. yield to maturity (YTM) Compound annual rate of return earned on a debt security purchased on a given day and held to maturity. inverted yield curve A downward-sloping yield curve indicates that short-term interest rates are generally higher than long-term interest rates. normal yield curve An upward-sloping yield curve indicates that long-term interest rates are generally higher than short-term interest rates. flat yield curve A yield curve that indicates that interest rates do not vary much at different maturities. expectations theory The theory that the yield curve reflects investor expectations about future interest rates; an expectation of rising interest rates results in an upward sloping yield curve, and an expectation of declining rates results in a downward-sloping yield curve. liquidity preference theory Theory suggesting that longterm rates are generally higher than short-term rates (hence, the yield curve is upward sloping) because investors perceive short-term investments to be more liquid and less risky than long-term investments. Borrowers must offer higher rates on long-term bonds to entice investors away from their preferred short-term securities. 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; the slope of the yield curve is determined by the general relationship between the prevailing rates in each market segment. Corporate bond A long-term debt instrument indicating that a corporation has borrowed a certain amount of money and promises to repay it in the future under clearly defined terms. coupon interest rate The percentage of a bondâs par value that will be paid annually, typically in two equal semiannual payments, as interest. bond indenture A legal document that specifies both the rights of the bondholders and the duties of the issuing corporation. The standard debt provisions in the bond indenture specify certain record-keeping and general business practices that the bond issuer must follow. Restrictive Provisions Bond indentures also normally include certain restrictive covenants, which place operating and financial constraints on the borrower. These provisions help protect the bondholder against increases in borrower risk. Without them, the borrower could increase the firmâs risk but not have to pay increased interest to compensate for the increased risk. The most common restrictive covenants do the following: 1. Require a minimum level of liquidity, to ensure against loan default. 2. Prohibit the sale of accounts receivable to generate cash. Selling receivables could cause a long-run cash shortage if proceeds were used to meet current obligations. 3. Impose fixed-asset restrictions. The borrower must maintain a specified level of fixed assets to guarantee its ability to repay the bonds. 4. Constrain subsequent borrowing. Additional long-term debt may be prohibited, or additional borrowing may be subordinated to the original loan. Subordination means that subsequent creditors agree to wait until all claims of the senior debt are satisfied. 5. Limit the firmâs annual cash dividend payments to a specified percentage or amount. sinking-fund requirement A restrictive provision often included in a bond indenture, providing for the systematic retirement of bonds prior to their maturity. Trustee A paid individual, corporation, or commercial bank trust department that acts as the third party to a bond indenture and can take specified actions on behalf of the bondholders if the terms of the indenture are violated. COST OF BONDS TO THE ISSUER The cost of bond financing is generally greater than the issuer would have to pay for short-term borrowing. The major factors that affect the cost, which is the rate of interest paid by the bond issuer, are the bondâs maturity, the size of the offering, the issuerâs risk, and the basic cost of money. Impact of Bond Maturity Long-term debt pays higher interest rates than short-term debt. The longer the maturity of a bond, the less accuracy there is in predicting future interest rates, and therefore the greater the bondholdersâ risk of giving up an opportunity to lend money at a higher rate. In addition, the longer the term, the greater the chance that the issuer might default. Impact of Offering Size The size of the bond offering also affects the interest cost of borrowing but in an inverse manner: Bond flotation and administration costs per dollar borrowed are likely to decrease with increasing offering size. On the other hand, the risk to the bondholders may increase, because larger offerings result in greater risk of default. Impact of Issuerâs Risk The greater the issuerâs default risk, the higher the interest rate. Some of this risk can be reduced through inclusion of appropriate restrictive provisions in the bond indenture. Bondholders must be compensated with higher returns for taking greater risk. Bond buyers rely on bond ratings to determine the issuerâs overall risk. Impact of the Cost of Money The cost of money in the capital market is the basis for determining a bondâs coupon interest rate. Generally, the rate on U.S. Treasury securities of equal maturity is used as the lowest-risk cost of money. To that basic rate is added a risk premium that reflects the factors (maturity, offering size, and issuerâs risk). BOND ISSUE FEATURES conversion feature A feature of convertible bonds that allows bondholders to change each bond into a stated number of shares of common stock. call feature A feature included in nearly all corporate bond issues that gives the issuer the opportunity to repurchase bonds at a stated call price prior to maturity. call price The stated price at which a bond may be repurchased, by use of a call feature, prior to maturity. call premium The amount by which a bondâs call price exceeds its par value. stock purchase warrants Instruments that give their holders the right to purchase a certain number of shares of the issuerâs common stock at a specified price over a certain period of time. BOND YIELDS The yield, or rate of return, on a bond is frequently used to assess a bondâs performance over a given period of time, typically 1 year. Because there are a number of ways to measure a bondâs yield, it is important to understand popular yield measures. The three most widely cited bond yields are (1) current yield, (2) yield to maturity (YTM), and (3) yield to call (YTC). Each of these yields provides a unique measure of the return on a bond. High-quality (high-rated) bonds provide lower returns than lower-quality (low-rated) bonds. Eurobond A bond issued by an international borrower and sold to investors in countries with currencies other than the currency in which the bond is denominated. CONTEMPORARY BOND TYPES Zero- (or low-coupon bonds) Issued with no (zero) or a very low coupon (stated interest) rate and sold at a large discount from par. A significant portion (or all) of the investorâs return comes from gain in value (that is, par value minus purchase price). Generally callable at par value. Because the issuer can annually deduct the current yearâs interest accrual without having to pay the interest until the bond matures (or is called), its cash flow each year is increased by the amount of the tax shield provided by the interest deduction. Junk bonds -Debt rated Ba or lower by Moodyâs or BB or lower by Standard & Poorâs. Commonly used by rapidly growing firms to obtain growth capital, most often as a way to finance mergers and takeovers. High risk bonds with high yieldsâoften yielding 2% to 3% more than the best-quality corporate debt. Floating-rate bonds Stated interest rate is adjusted periodically within stated limits in response to changes in specified money market or capital market rates. Popular when future inflation and interest rates are uncertain. Tend to sell at close to par because of the automatic adjustment to changing market conditions. Some issues provide for annual redemption at par at the option of the bondholder. Extendible notes Short maturities, typically 1 to 5 years, that can be renewed for a similar period at the option of holders. Similar to a floating-rate bond. An issue might be a series of 3-year renewable notes over a period of 15 years; every 3 years, the notes could be extended for another 3 years, at a new rate competitive with market interest rates at the time of renewal. Putable bonds Bonds that can be redeemed at par (typically, $1,000) at the option of their holder either at specific dates after the date of issue and every 1 to 5 years thereafter or when and if the firm takes specified actions, such as being acquired, acquiring another company, or issuing a large amount of additional debt. In return for its conferring the right to âput the bondâ at specified times or when the firm takes certain actions, the bondâs yield is lower than that of a nonputable bond. foreign bond A bond that is issued by a foreign corporation or government and is denominated in the investorâs home currency and sold in the investorâs home market. Valuation The process that links risk and return to determine the worth of an asset. Cash Flows (Returns) The value of any asset depends on the cash flow(s) it is expected to provide over the ownership period. To have value, an asset does not have to provide an annual cash flow; it can provide an intermittent cash flow or even a single cash flow over the period. Timing. Risk and Required Return The level of risk associated with a given cash flow can significantly affect its value. In general, the greater the risk of (or the less certain) a cash flow, the lower its value. Greater risk can be incorporated into a valuation analysis by using a higher required return or discount rate. The higher the risk, the greater the required return, and the lower the risk, the less the required return. Discount The amount by which a bond sells at a value that is less than its par value. Premium The amount by which a bond sells at a value that is greater than its par value. interest rate risk The chance that interest rates will change and thereby change the required return and bond value. Rising rates, which result in decreasing bond values, are of greatest concern. CHAPTER 7 STOCK VALUATION Debt Includes all borrowing incurred by a firm, including bonds, and is repaid according to a fixed schedule of payments. Equity Funds provided by the firmâs owners (investors or stockholders) that are repaid subject to the firmâs performance. privately owned (stock) The common stock of a firm is owned by private investors; this stock is not publicly traded. publicly owned (stock) The common stock of a firm is owned by public investors; this stock is publicly traded. closely owned (stock) The common stock of a firm is owned by an individual or a small group of investors (such as a family); these are usually privately owned companies. widely owned (stock) The common stock of a firm is owned by many unrelated individual or institutional investors. par-value common stock An arbitrary value established for legal purposes in the firmâs corporate charter and which can be used to find the total number of shares outstanding by dividing it into the book value of common stock. preemptive right Allows common stockholders to maintain their proportionate ownership in the corporation when new shares are issued, thus protecting them from dilution of their ownership. dilution of ownership A reduction in each previous shareholderâs fractional ownership resulting from the issuance of additional shares of common stock. dilution of earnings A reduction in each previous shareholderâs fractional claim on the firmâs earnings resulting from the issuance of additional shares of common stock. Rights Financial instruments that allow stockholders to purchase additional shares at a price below the market price, in direct proportion to their number of owned shares Authorized Shares Shares of common stock that a firmâs corporate charter allows it to issue. Outstanding Shares Issued shares of common stock held by investors, including both private and public investors. Treasury stock Issued shares of common stock held by the firm; often these shares have been repurchased by the firm. Issued shares Shares of common stock that have been put into circulation; the sum of outstanding shares and treasury stock. Proxy statement A statement transferring the votes of a stockholder to another party. Proxy battle The attempt by a nonmanagement group to gain control of the management of a firm by soliciting a sufficient number of proxy votes. Supervoting shares Stock that carries with it multiple votes per share rather than the single vote per share typically given on regular shares of common stock. Nonvoting common stock 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. American depositary shares (ADSs) Dollar-denominated receipts for the stocks of foreign companies that are held by a U.S. financial institution overseas. American depositary receipts (ADRs) Securities, backed by American depositary shares (ADSs), that permit U.S. investors to hold shares of non- U.S. companies and trade them in U.S. markets. Par-value Preferred Stock Preferred stock with a stated face value that is used with the specified dividend percentage to determine the annual dollar dividend. No-par Preferred Stock Preferred stock with no stated face value but with a stated annual dollar dividend. cumulative (preferred stock) Preferred stock for which all passed (unpaid) dividends in arrears, along with the current dividend, must be paid before dividends can be paid to common stockholders. Noncumulative (preferred stock) Preferred stock for which passed (unpaid) dividends do not accumulate. Callable Feature (preferred stock) A feature of callable preferred stock that allows the issuer to retire the shares within a certain period of time and at a specified price. conversion feature (preferred stock) A feature of convertible preferred stock that allows holders to change each share into a stated number of shares of common stock. venture capital Privately raised external equity capital used to fund early stage firms with attractive growth prospects. Venture Capitalists (VCs) Providers of venture capital; typically, formal businesses that maintain strong oversight over the firms they invest in and that have clearly defined exit strategies. Angel Capitalists (angels) Wealthy individual investors who do not operate as a business but invest in promising early-stage companies in exchange for a portion of the firmâs equity. When a firm wishes to sell its stock in the primary market, it has three alternatives. It can make (1) a public offering, in which it offers its shares for sale to the general public; (2) a rights offering, in which new shares are sold to existing stockholders; or (3) a private placement, in which the firm sells new securities directly to an investor or group of investors. Here we focus on public offerings, particularly the initial public offering (IPO), which is the first public sale of a firmâs stock. IPOs are typically made by small, rapidly growing companies that either require additional capital to continue expanding or have met a milestone for going public that was established in a contract signed earlier in order to obtain VC funding. Investment banker Financial intermediary that specializes in selling new security issues and advising firms with regard to major financial transactions. Underwriting The role of the investment banker in bearing the risk of reselling, at a profit, the securities purchased from an issuing corporation at an agreed-on price. Underwriting syndicate A group of other bankers formed by an investment banker to share the financial risk associated with underwriting new securities. Selling group A large number of brokerage firms that join the originating investment banker(s); each accepts responsibility for selling a certain portion of a new security issue on a commission basis. Efficient-market hypothesis (EMH) Theory describing the behavior of an assumed âperfectâ market in which (1) securities are in equilibrium, (2) security prices fully reflect all available information and react swiftly to new information, and (3), because stocks are fully and fairly priced, investors need not waste time looking for mispriced securities. Behavioral finance A growing body of research that focuses on investor behavior and its impact on investment decisions and stock prices. Advocates are commonly referred to as âbehaviorists.â zero-growth model An approach to dividend valuation that assumes a constant, nongrowing dividend stream. Gordon growth model A common name for the constant growth model that is widely cited in dividend valuation. Variable-growth model A dividend valuation approach that allows for a change in the dividend growth rate. free cash flow valuation model A model that determines the value of an entire company as the present value of its expected free cash flows discounted at the firmâs weighted average cost of capital, which is its expected average future cost of funds over the long run. book value per share The amount per share of common stock that would be received if all of the firmâs assets were sold for their exact book (accounting) value and the proceeds remaining after paying all liabilities (including preferred stock) were divided among the common stockholders. liquidation value per share The actual amount per share of common stock that would be received if all of the firmâs assets were sold for their market value, liabilities (including preferred stock) were paid, and any remaining money were divided among the common stockholders. price/earnings multiple approach A popular technique used to estimate the firmâs share value; calculated by multiplying the firmâs expected earnings per share (EPS) by the average price/earnings (P/E) ratio for the industry. CHAPTER 8 RISK AND REQUIRED RATE OF RETURN Portfolio A collection, or group, of assets. Risk A measure of the uncertainty surrounding the return that an investment will earn or, more formally, the variability of returns associated with a given asset. total rate of return The total gain or loss experienced on an investment over a given period of time; calculated by dividing the assetâs cash distributions during the period, plus change in value, by its beginning-of-period investment value. risk averse The attitude toward risk in which investors would require an increased return as compensation for an increase in risk. risk neutral The attitude toward risk in which investors choose the investment with the higher return regardless of its risk. risk seeking The attitude toward risk in which investors prefer investments with greater risk even if they have lower expected returns. scenario analysis An approach for assessing risk that uses several possible alternative outcomes (scenarios) to obtain a sense of the variability among returns. Range A measure of an assetâs risk, which is found by subtracting the return associated with the pessimistic (worst) outcome from the return associated with the optimistic (best) outcome. Probability The chance that a given outcome will occur. probability distribution A model that relates probabilities to the associated outcomes. bar chart The simplest type of probability distribution; shows only a limited number of outcomes and associated probabilities for a given event. continuous probability distribution A probability distrib ution showing all the possible outcomes and associated probabilities for a given event. standard deviation (delta r) The most common statistical indicator of an assetâs risk; it measures the dispersion around the expected value. expected value of a return (r bar) The average return that an investment is expected to produce over time. normal probability distribution A symmetrical probability distribution whose shape resembles a âbell-shapedâ curve. coefficient of variation (CV) A measure of relative dispersion that is useful in comparing the risks of assets with differing expected returns. efficient portfolio A portfolio that maximizes return for a given level of risk. correlation A statistical measure of the relationship between any two series of numbers. positively correlated Describes two series that move in the same direction. negatively correlated Describes two series that move in opposite directions. correlation coefficient A measure of the degree of correlation between two series. perfectly positively correlated Describes two positively correlated series that have a correlation coefficient of +1. perfectly negatively correlated Describes two negatively correlated series that have a correlation coefficient of -1. Uncorrelated Describes two series that lack any interaction and therefore have a correlation coefficient close to zero. political risk Risk that arises from the possibility that a host government will take actions harmful to foreign investors or that political turmoil will endanger investments. capital asset pricing model (CAPM) The basic theory that links risk and return for all assets. total risk The combination of a securityâs nondiversifiable risk and diversifiable risk. diversifiable risk The portion of an assetâs risk that is attributable to firmspecific, random causes; can be eliminated through diversification. Also called unsystematic risk. nondiversifiable risk The relevant portion of an assetâs risk attributable to market factors that affect all firms; cannot be eliminated through diversification. Also calledsystematic risk. beta coefficient (b) A relative measure of nondiversifiable risk. An index of the degree of movement of an assetâs return in response to a change in the market return. market return The return on the market portfolio of all traded securities. risk-free rate of return, (RF ) The required return on a riskfree asset, typically a 3-month U.S. Treasury bill. U.S. Treasury bills (T-bills) Short-term IOUs issued by the U.S. Treasury; considered the risk-free asset. security market line (SML) The depiction of the capital asset pricing model (CAPM) as a graph that reflects the required return in the marketplace for each level of nondiversifiable risk (beta). CHAPTER 14 Payout Policy payout policy Decisions that a firm makes regarding whether to distribute cash to shareholders, how much cash to distribute, and the means by which cash should be distributed. date of record (dividends)Set by the firmâs directors, the date on which all persons whose names are recorded as stockholders receive a declared dividend at a specified future time. ex dividend A period beginning 2 business days prior to the date of record, during which a stock is sold without the right to receive the current dividend. payment date Set by the firmâs directors, the actual date on which the firm mails the dividend payment to the holders of record. open-market share repurchase A share repurchase program in which firms simply buy back some of their outstanding shares on the open market. tender offer repurchase A repurchase program in which a firm offers to repurchase a fixed number of shares, usually at a premium relative to the market value, and shareholders decide whether or not they want to sell back their shares at that price. Dutch auction repurchase A repurchase method in which the firm specifies how many shares it wants to buy back and a range of prices at which it is willing to repurchase shares. Investors specify how many shares they will sell at each price in the range, and the firm determines the minimum price required to repurchase its target number of shares. All investors who tender receive the same price. dividend reinvestment plans(DRIPs) Plans that enable stockholders to use dividends received on the firmâs stock to acquire additional sharesâeven fractional sharesâat little or no transaction cost. residual theory of dividends A school of thought that suggests that the dividend paid by a firm should be viewed as a residualâthe amount left over after all acceptable investment opportunities have been undertaken. dividend irrelevance theory Miller and Modiglianiâs theory that in a perfect world, the firmâs value is determined solely by the earning power and risk of its assets (investments) and that the manner in which it splits its earnings stream between dividends and internally retained (and reinvested) funds does not affect this value. clientele effect The argument that different payout policies attract different types of investors but still do not change the value of the firm. dividend relevance theory The theory, advanced by Gordon and Lintner, that there is a direct relationship between a firmâs dividend policy and its market value. bird-in-the-hand argument The belief, in support of dividend relevance theory, that investors see current dividends as less risky than future dividends or capital gains. informational content The information provided by the dividends of a firm with respect to future earnings, which causes owners to bid up or down the price of the firmâs stock. dividend policy The firmâs plan of action to be followed whenever it makes a dividend decision. excess earnings accumulation tax The tax the IRS levies on retained earnings above $250,000 for most businesses when it determines that the firm has accumulated an excess of earnings to allow owners to delay paying ordinary income taxes on dividends received. catering theory A theory that says firms cater to the preferences of investors, initiating or increasing dividend payments during periods in which high-dividend stocks are particularly appealing to investors. dividend payout ratio Indicates the percentage of each dollar earned that a firm distributes to the owners in the form of cash. It is calculated by dividing the firmâs cash dividend per share by its earnings per share. constant-payout-ratio dividend policy A dividend policy based on the payment of a certain percentage of earnings to owners in each dividend period. regular dividend policy A dividend policy based on the payment of a fixed-dollar dividend in each period. target dividend-payout ratio A dividend policy under which the firm attempts to pay out a certain percentage of earnings as a stated dollar dividend and adjusts that dividend toward a target payout as proven earnings increases occur. low-regular-and-extra dividend policy A dividend policy based on paying a low regular dividend, supplemented by an additional (âextraâ) dividend when earnings are higher than normal in a given period. extra dividend An additional dividend optionally paid by the firm when earnings are higher than normal in a given period. stock dividend The payment, to existing owners, of a dividend in the form of stock. small (ordinary) stock dividend A stock dividend representing less than 20 percent to 25 percent of the common stock outstanding when the dividend is declared. stock split A method commonly used to lower the market price of a firmâs stock by increasing the number of shares belonging to each shareholder. reverse stock split A method used to raise the market price of a firmâs stock by exchanging a certain number of outstanding shares for one new share.