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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 bonds par value that will be paid annually,
typically in two equal semiannual payments, as interest.
bond indenture A
legal
document that specifies both
rights of the bondholders and
duties of the issuing
corporation.
The
standard debt
provisions in the bond
indenture specify certain
record-keeping and general
the
the
The
cost
of bond financing
is
generally greater
than the issuer
would
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 bonds 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 issuers 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 bonds
performance over a given period of time, typically 1 year. Because there are a
number of ways to measure a bonds 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
investors 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
years 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 Moodys or BB or lower by Standard & Poors.
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 yieldsoften 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 put the bond at specified times or when the firm takes certain actions, the bonds 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 investors home currency and sold in the investors 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
thereby
change the required return and bond value. Rising
rates, which result in decreasing bond values, are
of greatest concern.
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
firms 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 firms 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
perfect 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
behaviorists.
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.
book value per share The amount per share of common stock that would be
received if all of the firms 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 firms 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
firms share value; calculated by multiplying the firms 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.
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 securitys nondiversifiable risk and
diversifiable risk.
diversifiable risk The portion of an assets risk that is attributable to
firmspecific, random causes; can be eliminated through diversification. Also
called unsystematic risk.
nondiversifiable risk The relevant portion of an assets 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 assets return in response to a change in the
market return.
market return The return on the market portfolio of all traded securities.
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).
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 firms 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 fixeddollar 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 (extra) 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 firms
stock by increasing the number of shares belonging to each shareholder.
reverse stock split A method used to raise the market price of a firms stock
by exchanging a certain number of outstanding shares for one new share.