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Bonds: is a debt instrument issued by governments or corporations to raise money

The successful investor must be able to:

Understand bond structure

Calculate bond rates of return

Understand interest rate risk

Differentiate between real and nominal returns

Components:

Bond – Security that obligates the issuer to make specified payments to the bondholder.

Face Value – Payment at the maturity of the bond. Also called “principal ” or “par value ”

Coupon – The interest payments paid to the bondholder.

Coupon Rate – Annual interest payment as a percentage of face value.

Asked Price – The price that investors need to pay to buy the bond.

Bid Price – The price asked by an investor who owns the bond and wishes to sell it.

Spread – The difference between the bid price and the asked price.

The spread is how a seller of a bond makes a profit.

Note: While Treasury bonds are quoted in 32nds, corporate bonds are quoted in decimals.

Calculating yields

Bond Pricing: The value of a bond is the present value of all cash flows generated by the bond (coupons and repayment of face value), discounted at the required rate of return.

Current Yield:

Yield to Maturity:

Relationship of interest rates and bond prices

When the interest rate rises, the present value of the payments to be received by the bondholder falls and bond prices fall.

When the interest rate decreases, the present value of the payments to be received by the bondholder increases and bond prices rise.

Interest rate risk – The risk in bond prices due to fluctuations in interest rates.

Risks of bonds, Credit Rating, Default Risk and how they affect yield

Default Risk – The risk that a bond issuer may default on his bonds.

Companies compensate investors for bearing this added risk in the form of higher interest rates on their bonds.

Default Premium – The additional yield on a bond that investors require for bearing default risk.

Usually the difference between the promised yield on a corporate bond and the yield on a U.S. Treasury bond with the same coupon and maturity.

Credit agency – An agency that rates the safety of most bonds.

Investment-grade bonds – Bonds rated Baa or above by Moody’s or BBB or above by Standard & Poor’s.

Junk bond – Bond with a rating below Baa or BBB

Types of Bonds :

Zero-Coupon Bonds – Bonds that are issued well below face value with no coupon payment. At maturity investors receive $1,000 face value for the bond.

Are corporate bonds the only bonds which can be offered as zero-coupon bonds?

Floating-Rate Bonds – Bonds with coupon payments that are tied to some measure of current market rates. A common example would be a bond with coupon rate tied to the short-term Treasury rate plus 2%.

Convertible Bonds – Bonds that allow the holder to exchange the bond at a later date for a specified number of shares of common stock.

Yield to Maturity – Interest rate for which the present value of the bond’s payments equals the price.Current Yield – Annual coupon payments divided by bond price.

Stocks:

Terminology:

Primary market – Market for the sale of new securities by corporations.

Secondary Market – Market in which previously issued securities are traded among investors.

Initial Public Offering (IPO) – First offering of stock to the general public.

Primary Offering – Occurs when a corporation sells shares in the firm.

Market cap (market capitalization) – The total value of a company’s outstanding shares.

P/E Ratio – Ratio of stock price to earnings per share.

Dividend Yield – The ratio of dividends paid and share price. Tells the investor how much dividend income they can expect for every $1 invested in the stock.

Dividend discount model (continuous & uneven growth)

Dividend Discount Model – Discounted cash-flow model which states that today’s stock price equals the present value of all expected future dividends.

Dividend Yield

Sustainable Growth Rate

Payout Ratio – Fraction of earnings paid out as dividends.

Plowback Ratio – Fraction of earnings retained by the firm

Note: Plowback Ratio = 1 – Payout Ratio

g (sustainable growth rate) – The firm’s growth rate if it plows back a constant fraction of earnings, maintains a constant return on equity, and keeps its debt ratio constant.

Technical Analysis – Investors who attempt to identify undervalued stocks by searching for patterns in past stock prices.

Fundamental Analysis – Investors who attempt to find mispriced securities by analyzing fundamental information, such as accounting performance and earnings prospects.

Note: In a market with many talented and competitive analysts, any bargains will be quickly eliminated.

Random walk – Security prices change randomly, with no predictable trends or patterns.

They are equally likely to offer a high or low return on any particular day, regardless of what has occurred on previous days.

Net Present Value:

NPV (calc and rule)

Opportunity Cost of Capital – Expected rate of return given up by investing in a project

Net Present Value – Present value of cash flows minus initial investments.

Net Present Value Rule – Managers increase shareholders’ wealth by accepting all projects that are worth more than they cost. Therefore, they should accept all projects with a positive net present value.

Payback Period – Time until cash flows recover the initial investment of the project.

RULE: Says a project should be accepted if its payback period is less than a specified cutoff period.

Discounted Payback Rule – This is the number of periods before the present value of prospective cash flows equals or exceeds the initial investment.

IRR (definition & rule/how to use)

Definition: The discount rate that gives the project a zero NPV is known as the project’s internal rate of return, or IRR . It is also termed the discounted cashflow (DCF) rate of return.

RULE: IRR Rule – Managers increase shareholders’ wealth by accepting all projects which offer a rate of return that is higher than the opportunity cost of capital.