- Bond's Current Yield = annual coupon / price
- Bid price = what a dealer is willing to pay for a security
- Ask price = what a dealer is willing to sell a security for
- Difference between bid and ask price = spread = dealer's profit
- Prices are quoted in 32nds [Ask price = 135:22 => (135 + 22/32)% of face value]
- Quoted price = "clean price"
- price you pay includes accrued interest = "dirty price" (full or invoice price)
- Pay $1080 for a bond, next coupon of $60 due in 4 months (due every 6 months)
- Accrued interest = (2/6 months)*($60) = $20 => Clean price = 1080 - 20 = $1060
- (1 + Nominal) = (1 + Real) * (1 + inflation) => (1 + R) = (1 + r)*(1 + h)
Term Structure of Interest Rates - relationship between short and long-term interest rates
- Upward Sloping = Long-term rates are higher than short-term (most common)
- determined by:
- real rate of interest
- inflation premium = investors demand higher nominal rates
if expected inflation
- interest rate risk premium = investors demand higher nominal rates for
longer-term securities
- Govt bonds are default-free, less taxable, and highly liquid, but corporate bonds are not
- default risk premium, taxability premium, and liquidity premium
- Takeaways from Efficiency:
- Accounting choices should not affect stock price if enough information is provided and the market is
efficient in a semi-strong form (i.e. this information is used)
- Financial managers cannot time stock and bond sales to beat the market
- however, stock prices generally fall after IPO/SEOs and rise after stock repurchase
- suggests that market is inefficient in the semistrong form
- Prices reflect underlying value
- Managers can't profitably speculate in foreign currencies
- Stock prices can also give managers information about their own firm
- e.g. if a merger is announced and price drops by much more than 5%, then the market
is telling you that the merger is bad for your firm
- Stock price can also give information about CEO performance
- Evidence against Market Efficiency:
- Limits to Arbitrage - near term risk because a irrational market may continue to be irrational
- Prices adjust slowly to earnings surprises
- Investors exhibit conservatism and are slow to adjust to new information
- Size: On average, returns of stocks with small market capitalization are higher than
those of stocks with large market capitalization
- Value vs. Growth: Value stocks (high book value to stock price ratio) outperform
growth stocks (low book value to stock price ratio)
- Crashes and Bubbles - overreactions and representativeness
- MM Proposition I: a firm cannot change the total value of its outstanding securities by changing its
capital structure
- MM Proposition II: expected return on equity is positively related to leverage because the risk to equity
holders increases with leverage
- VU =
- VL = VU + tc*B
or
VL =
- R0 = cost of capital for unlevered firm =
(= RWACC w/ no taxes)
- Rs = R0 + (R0 - RB)(1 - tc)
- RWACC = Rs + RB (1 - tc) (decreases as B/V increase)
- NPVLoan = + Amount Borrowed - PV of after-tax interest payments - PV of loan repayment
- APVproject = All-equity value - flotation costs of debt + NPVloan
= risk or volatility
equity = asset(1 +
) [no tax case] equity = Unleveredfirm (1 +
) [with tax case]
s = v + (1 - tc)( v - B)
firm =
B +
S or firm =
U +
- Forward Rate: given an 8% 1-year spot rate and a 10% 2-year spot rate:
(1.10)2 = (1.08) * (1 + f2)
fn =
-1
- Expectations Hypothesis: f2 = spot rate expected over year 2 (assuming risk-neutrality)
- Liquidity Preference Hypothesis: f2 > spot rate expected over year 2 (assuming risk-averseness)
APV Approach - adjusted present value: APV = NPV + NPVF = NPV + tc*B
- Value of a project = Value of project to unlevered firm + Financing Side Effects
- tax subsidy to debt (largest effect)
- costs of issuing new securities
- costs of financial distress
- subsidies to debt financing
Flow to Equity Approach
- PV =
(numerator = LCF)
- UCF - LCF = (1 - tc)*RB*B
- Rs = R0 + (R0 - RB)(1 - tc)
- NPV = PV - (Investment not borrowed)
Weighted Average Cost of Capital Method
- NPV =
- Initial Investment
- or for a perpetuity, NPV =
- Initial Investment
Suggested Guideline:
- Use WACC or FTE if the firm's target debt-to-value ratio applies to the project over its life
- Use APV if the project's level of debt is known over the life of the project
Rs = (Riskless Interest Rate) + (Beta)(Market Risk Premium)
- Flotation costs are paid immediately but deducted from taxes by amortizing on a straight-line over the
life of the loan
- These amortized flotation costs create a tax shield
