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- ACCT 2062 Homework #2
- finman
- Essentials of Corporate Finance - 4th AU Edition
- 141-0404
- Bonds Analysis
- Bond ifm
- 22452619 MB0029 Financial Management Fall 09
- Bonds
- Future Vaule App
- Trask v. Jacksonville, P. & MR Co., 124 U.S. 515 (1888)
- Financial Statement Analysis
- Basics of Bond Valuation
- Questions
- PFC_TermSheet
- The Valuation of Bonds Ppt @ Bec Doms Finance
- Financial Institutions
- Busn233Ch06
- valskafa
- Chap03_(1)
- Advanced Bond Concepts_ Bond Pricing _ Investopedia

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The principle of time value of money the notion that a given sum of money is

more valuable the sooner it is received, due to its capacity to earn

interest is the foundation for numerous applications in investment

finance.

The Five Components Of Interest Rates

Real Risk-Free Rate This assumes no risk or uncertainty, simply

reflecting differences in timing: the preference to spend now/pay back

later versus lend now/collect later.

Expected Inflation - The market expects aggregate prices to rise, and

the currency's purchasing power is reduced by a rate known as the

inflation rate. Inflation makes real dollars less valuable in the future and

is factored into determining the nominal interest rate (from the

economics material: nominal rate = real rate + inflation rate).

Default-Risk Premium - What is the chance that the borrower won't

make payments on time, or will be unable to pay what is owed? This

component will be high or low depending on the creditworthiness of the

person or entity involved.

Liquidity Premium- Some investments are highly liquid, meaning they

are easily exchanged for cash (U.S. Treasury debt, for example). Other

securities are less liquid, and there may be a certain loss expected if it's

an issue that trades infrequently. Holding other factors equal, a less

Real interest rate = nominal interest rate inflation rate

Real Interest Rate: Rate at which the purchasing power of an investment increases.

The real rate of interest is calculated by

1 + real interest rate =

____________________

1 + inflation rate

Effective Annual Interest Rate: Interest rate that is annualized using compound interest.

Theeffective annual yield represents the actual rate of return, reflecting all of the compounding

periods during the year. The effective annual yield (or EAR) can be computed given the

stated rate and the frequency of compounding.

Effective annual rate (EAR) = (1 + Periodic interest rate)m 1

Where: m = number of compounding periods in one year, and

periodic interest rate = (stated interest rate) / m

Example:Effective Annual Rate

Suppose we are given a stated interest rate of 9%, compounded monthly, here is what we

get for EAR:

Annual Percentage Rate (APR): Interest rate that is annualized using simple interest rate.

The effective annual rate is the rate at which invested funds will grow over the course of a

year. It equals the rate of interest per period compounded for the number of periods in a

year.

Keep in mind that the effective annual rate will always be higher than the stated rate if there

Future Value:

Definition: The value to which a beginning lump sum or Present Value (PV) will grow in a certain

number of periods, n, at a specified rate of interest, i.

Formula:

FV = PV (1 + i)n

Where: i = the stated rate of interest

n = number of years

(1 + i)n = the future value interest factor

Compound Interest: Interest earned on interest.

Simple Interest: Interest earned only on the original investment; no interest is earned on interest.

Example: In six years, Frank will be eligible for membership in the elite Flat lounger Club. A lifetime

membership will cost him $14,000. Frank currently has $11,000 in a savings account that

pays an annual interest rate of 4.2 percent. In six years, will he have enough money in the

account to pay his membership fees?

When compounding occurs more than once a year

Example: Jane has inherited $4,500 dollars, and she has decided to deposit it in her savings

account for six months before she decides how to spend/invest it. If Janes savings account

pays 3 percent compounded monthly, how much money will she have in six months?

Compound growth means that value increases each period by the factor (1 + growth rate).

The value after t periods will equal the initial value times (1 + growth rate)t. When money is

invested at compound interest, the growth rate is the interest rate.

The time line in the future and look back toward time 0 to see what was the beginning

amount.

Formula: PV= FV / ( 1+ r )n

Discount Rate: Interest rate used to compute present values of future cash flows.

Example: If I promised to give you one million dollars 50 years from now, what would it be

worth today if the discount rate is 15 percent compounded annually?

When compounding occurs more than once a year

Example : In our previous example, I asked what a million dollars would be worth 50 years from

now at 15 percent compounded annually. What would it be worth if the discount rate

were 15 percent compounded semiannually?

Example: Will Williams grandmother always gives him $200 on his birthday which is nine

months away. Will needs the money now in order to buy his finance text. Fred

Fredrickson has agreed to lend Will some money at 18 percent compounded quarterly. If

Will plans to pay back Fred in nine months with his birthday money, how much can he

borrow from Fred now?

Example: If you borrow $10,000 today and pay back $12,167 at end of 5 years what rate of

interest did you pay on the loan?

Example: Suppose you invest $2,000 at 4.5% and want your investment to grow to

$4,205. How long will it take?

Recall from your math classes that ln(xn)= n ln(x)

Perpetuity: Stream of level cash payments that never ends.

Present Value of a Perpetuity

A perpetuity starts as an ordinary annuity (first cash flow is one period from today) but

has no end and continues indefinitely with level, sequential payments

PV of a perpetuity =

annuity payment A

interest rate r

Example: perpetuity paying $1,000 annually at an interest rate of 8% would be worth?

Present value of t-year annuity = payment annuity factor

Future Value Annuity Factor = (1 + r)n - 1

r

Present Value Annuity Factor = 1 -1

(1 + r)n

r

Annuity Due: Level stream of cash flow starting immediately.

In only 50 more years, you will retire. (Thats rightby

the time you retire, the retirement age will be around 70

years. Longevity is not an unmixed blessing.) Have you

started saving yet? Suppose you believe you will need to

accumulate $500,000 by your retirement date in order to

support your desired standard of living. How much must

you save each year between now and your retirement to

meet that future goal? Lets say that the interest rate is

10 percent per year. You need to find how large the

annuity in the following figure must be to provide a future

value of $500,000:

We know that if you were to save $1 each year your funds would

accumulate to

Future value of annuity of $1 a year = (1 + r)t 1 = (1.10)50 1

_________

__________

= $1,163.91

r

0.10

Therefore, if we save an amount of $C each year, we will accumulate $C

1,163.91.

We need to choose C to ensure that $C 1,163.91 = $500,000. Thus C =

$500,000/1,163.91 = $429.59. This appears to be surprisingly good news.

Saving

$429.59 a year does not seem to be an extremely demanding savings

program. Dont

celebrate yet, however. The news will get worse when we consider the

Problems

Assume that it is now January 1, 1997 and you will need $ 1,000 on January 1,

2001. Your bank compounds interest at an 8% annual rate.

How much must you deposit on January 1, 1998, to have a balance of $

1,000 on January 1, 2001?

If you want to make equal payments on each January 1 from 1998 through

2001 to accumulate the $ 1,000, how large must each of the 4 payments

be?

If you have only $ 750 on January 1, 1998, what interest rate, compounded

annually, would you have to earn to have necessary $ 1,000 on January 1,

2001?

Suppose you can only deposits the stream of payments only $ 186.29 each

January 1 from 1998 through 2001, but you still need $ 1,000 on January 1,

2001. What interest rate compounded annually must you seek out to

achieve your goal?

Strategic Financial

Management

Bond Valuation

a legal document that states what the issuer can and cannot do, and

states the bondholders rights.Since there tends to be a ton of legalese

involved, the contract is managed by the corporate trustee who polices

the actions of the issuer to ensure the rights of the bondholder are upheld.

Affirmative Covenants

Affirmative covenants are what the issuer promises to do for the investor.

These promises include things such as paying interest and principle in a

timely manner; paying taxes and other expenses when due; maintaining

the assets backing the bond and issuing reports to the trustee to

ensurecompliance.

Negative Covenants

Negative convents are the restraints put on a borrower.These restraints

include issuing additional securities or taking on additional debt that may

harm the current bondholders.This is generally done without meeting

certain tests and/or ratios or receiving permission from the current

bondholders.

investors. Security that obligates the issuer to make specified

payments to the bondholder.

1.Maturity

2.Par Value

3.Coupon Rate

4.Redemption

5.Currency Denomination

6.Options Granted to the Issuer or Investors

Maturity

Maturity is the time at which the bond matures and the holder receives the

final payment of principal and interest.The term to maturity is the amount

of time until the bond actually matures.

There are 3 basic classes of maturity:

A. Short-Term Maturity One to five years in length

B.Intermediate-Term Maturity Five to twelve years in length

C.Long-Term Maturity Twelve years or more in length

2.Par Value

Par value is the dollar amount the holder will receive at the bond's maturity.It

can be any amount but is typically $1,000 per bond.Par value is also known

as principle, face, maturity or redemption value.Bond prices are quoted as a

percentage of par.

Imagine that par for ABC Corp. is $1000, which would =100.If the ABC

Corp. bonds trade at 85 what would the dollar value of the bond

be?What if ABC Corp. bonds at 102?

Answer:

At 85, the ABC Corp. bonds would trade at a discount to par at $850.If

ABC Corp. bonds at 102, the bonds would trade at a premium of $1,020.

3.Coupon Rate

A coupon rate states the interest rate the bond will pay the holders each

year.To find the coupon's dollar value, simply multiply the coupon rate

by the par value.The rate is for one year and payments are usually made

on a semi-annual basis.Some asset-backed securities pay monthly, while

many international securities pay only annually.The coupon rate also

affects a bond's price.Typically, the higher the rate, the less price

sensitivity for the bond price because of interest rate movements.

4.Currency Denomination

Currency denomination indicates what currency the interest and principle

will be paid in.

Other currency denomination structures can use various types of

currencies to make payments.

Because the provisions for redeeming bonds and options that are

granted to the issuer or investor are more complicated topics, we will

discuss them later in this LOS section.

Let's take a look at an example of a bond with the features we've

discussed so far, within a bond table format you'd see in a paper.

ABC Corp 7.00% 6/1/10 at 90.

The issuer is ABC Corp.

Thematurity is 2010 with aterm to maturity of roughly 5 years.

Par valueis 1,000 per bond or 100

Coupon rateis 7%.

Coupon Payment is $70 per year (coupon=coupon rate* par value = .

07 *$1,000 = $70

Trading Price in dollars is $90

ABC Corp is a U.S. company and all payments of interest ant principle

are in USD.

Zero-Coupon Bonds - These instruments pay no interest to the holder

and are issued at a deep discount.As the bond nears maturity, its

price increases to reach par value.At maturity, the bondholder will

receive the par price.The interest earned is the difference between

the purchase price of the bond and what the holders receives at

maturity.

Floating-Rate Bonds - These bonds have coupon rates that reset at

predetermined times.The rate is usually based on an index or

benchmark with some sort of spread added or subtracted to the

benchmark.

Assume the coupon rate of a floating-rate bond is based on the Federal

Funds rate plus 25 basis points at three-month intervals.If the Federal

Funds are at 3%, what would the coupon rate for this bond be?

Coupon rate = Reference Rate + influencing variable.

Answer:

Coupon rate = 3% (Fed Funds) + 25 basis points.

Coupon rate = 3.25%

The coupon rate for this bond would be 3.25% until the next reset

date.Floating- rate securities come in many forms.Other forms of floatingratesecurities involve caps and floors; these are discussed in detail below.

Caps and Floors

Some floating-rate securities have restrictions placed on how high or how

low the coupon rate can become.

Even though the formula states a 4% coupon should be paid this

period, the cap holds the coupon at 3.90%.

Example: Floors

Now lets add a floor of 2% and assume that Fed Funds are trading at

1.50%

Answer: Coupon rate = 1.50% (Fed Funds) + 25 basis points

Coupon rate = 1.75

Even though the formula states a 1.75% coupon should be paid, there is a 2%

floor in place, which means that the investor will receive 2% instead of the

1.75% derived from the formula.

Bond prices are usually expressed as a percentage of their face value. Thus

we can

say that our 6 percent Treasury bond is worth 101.077 percent of face

value, and its

price would usually be quoted as 101.077, or about 101 232.

Did you notice that the coupon payments on the bond are an

annuity? In other words, the holder of our 6 percent Treasury

bond receives a level stream of coupon payments of $60 a

year for each of 3 years. At maturity the bondholder gets an

additional payment of $1,000. Therefore, you can use the

annuity formula to value the coupon payments and then add

on the present value of the final payment of face value:

PV = PV (coupons) + PV (face value)

= (coupon annuity factor) + (face value discount

factor)

Problem:

Calculate the present value of a 6-year bond with a 9 percent

coupon. The interest rate is 12 percent?

FIGURE

the 6 percent coupon bond

maturing in 2002. The bond

pays semiannual coupons, so

there are two payments of

$30 each year.

the coupon rate. In that case the price of the bond was higher

than its face value i.e. bond is at premium. We then valued it

using an interest rate that is equal to the coupon rate and

found that bond price equaled face value. You have probably

already guessed that when the cash flows are discounted at a

rate that is higher than the bonds coupon rate, the bond is

worth less than its face value.

Investors will pay $1,000 for a 6 percent, 3-year Treasury bond, when

the interest rate is 6 percent. Suppose that the interest rate is higher

than the coupon rate at (say) 15 percent. Now what is the value of

the bond? Simple! We just repeat our initial calculation but with r = .

15:

We conclude that when the market interest rate exceeds the coupon rate,

bonds sell for less than face value. When the market interest rate is below

the

coupon rate, bonds sell for more than face value.

The fundamental principle of valuation is that the value is equal to the present

value of its expected cash flows.The valuation process involves the following

three steps:

1. Estimate the expected cash flows.

2. Determine the appropriate interest rate or interest rates that should be used to

discount the cash flows.

3. Calculate the present value of the expected cash flows found in step one by

using the interest rate or interest rates determined in step two.

Computing a Bonds Value

First of all, we need to find thepresent value (PV) of the future cash flows in

order to value the bond.The present value is the amount that would be needed

to be invested today to generate that future cash flow.PV is dependant on the

timing of the cash flow and the interest rate used to calculate the present

value.To figure out the value the PV of each individual cash flow must be

found.Then, just add the figures together to determine the bonds price.

PV at time T = expected cash flows in period T / (1 + I) to the T power

Value = present value @ T1 + present value @ T2 + present value @Tn

Lets throw some numbers around to further illustrate this concept.

Example: The Value of a Bond

Bond GHJ matures in five years with a coupon rate of 7% and a maturity value of

$1,000. For simplicitys sake, the bond pays annually and the discount rate is 5%.

The cash flow for each of the years is:

Year one = $70 Year Two = $70 Year Three = $70, Year Four is $70 and Year Five

is $1,070.

PV of the cash flows is: Year one = 70 / (1.05) to the 1st power =$66.67

Year two = 70 / (1.05) to the 2nd power = $ 63.49

Year three = 70 / (1.05) to the 3rd power = $ 60.47

Year four = 70 / (1.05) to the 4th power = $ 57.59

Year five = 1070 / (1.05) to the 5th power = $ 838.37

Value = 66.67 + 63.49 + 60.47 + 57.59 + 838.37

Value = 1, 086.59

This may be the easiest of securities to value because there is only

one cash flow the maturity value.

Value of a zero coupon bond that matures N years from now is:

Maturity value / (1 + I) to the power of the number of years * 2

Where I is the semi-annual discount rate.

Example:The Value of a Zero-Coupon Bond

For illustration purposes, lets look at a zero coupon with a maturity of

three years and a maturity value of $1,000 discounted at 7%

Answer:

I = 0.035 (.07 / 2)

N=3

Value of a Zero = 1,000 / (1.035) to the 6th power (3*2)

= 1,000 / 1.229255

= 813.50

YIELD TO MATURITY VERSUS CURRENT YIELD:

Current Yield: annual coupon payments divided by bond price. A bond

that is priced above its face value is said to sell at a premium.

Investors who buy a bond at a premium face a capital loss over the life

of the bond, so the return on these bonds is always less than the

bonds current yield. A bond priced below face value sells at a

discount. Investors in discount bonds face a capital gain over the life

of the bond; the return on these bonds is greater than the current

yield:

Yield to Maturity (YTM): Interest rate for which the present value of the

bonds payment equals the price. The yield to maturity is defined

as the discount rate that makes the present value of the

bonds payments equal to its price. Price The value of the 6

percent bond is lower at higher discount rates. The yield to maturity

is the discount rate at which price equals present value of cash flows.

1) A $ 1000 par value bond, current market price of the bond is $

761, 12 years remaining till maturity, coupon rate is 8%, using

hit and trial method calculate YTM?

2) A 10 year bond, 5years remaining till maturity and the market

price of the bond is $ 650 whose par is at $ 1000. If Coupon

rate is 6%, calculate YTM using interpolation.

Accrued Interest and Price Terminology

Accrued interest - the amount of interest that builds up in between

coupon payments that will be received by the buyer of the bond

when a sale occurs between these coupon payments, even though

the seller of the bonds earned it.

Full Price - is sometimes referred to as a bond's dirty price, which is the

amount the buyer will pay the seller.It equals the negotiated price of

the bond plus the accrued interest.

Clean Price - is simply the price of the bond without the accrued interest

There are three sources of return an investor can expect to receive by

investing

in bonds:

1. Current Yield

Current yield relates the annual dollar coupon interest to the

bond'smarket price:

Current Yield = annual dollar coupon interest / price

Example: Current Yield

IBM ten-year bond with a rate of 5% and market price of 98.

Answer:

Step1 - Figure out the annual dollar coupon interest= .05 * $100 = 5$

Current Yield = $5 / 98 = .05102= 5.1%

Current yield is greater when bond is selling at a discount.The

opposite is true for a premium bond. If a bond is selling at par, the

current yield will equal the coupon rate.

The drawback using current yield is that it only considers the coupon

interest and nothing else.

Yield to maturity is the most popular measure of yield in the

market.It isthe rate that will make the present value of a bond's cash

flows equal toits market price plus accrued interest.To find YTM, one

has to developthe cash flows and then, through trial and error, find

the interest rate thatmakes the present value of cash flow equal to

the market price plus accrued interest.

Bond Price, Coupon Rate, Current Yield and Yield to Maturity

For a bond selling at par:

Coupon Rate = Current Yield = Yield to Maturity

For a bond selling at a discount:

Coupon Rate < Current Yield < Yield to Maturity

For a bond selling at a premium:

Coupon Rate > Current Yield > Yield to Maturity

that the coupon rate will be reinvested at an interest rate equal to

the YTM.Besides that it does take into consideration the coupon

income and capital gains or loss as well as the timing of the cash

flows.

Yield to first call is computed for a callable bond that is not currently

callable.The actual calculation is the same as the Yield to Maturity

withthe only difference being that instead of using a par value and

the stated maturity, the analyst will use the call price and the first

call date in calculating the yield.

4.Yield to First Par Call

Again, yield to first par call is the same procedure as above, with

thedifference being that the maturity date that will be used instead

of the stated maturity date is the first time the issuer can call the

bonds at par value

5.Yield to Put

Yield to put is the yield to the first put date.It is calculated the same

wayas YTM but instead of the stated maturity of the bond, one uses

the first put date.

Options that Benefit the Issuer.

Call options - allows the issuer to call the bonds prior to maturity if

prevailing rates decrease enough to make it economically feasible for

the issuer to replace the existing issue (consisting of higher rate

coupons) with lower coupon bonds.

Options that Benefit the Holder

Puts - This option is the exact opposite of a call.It allows the

bondholder to sell the bond or "put" the bond back to the issuer at a

certain price and date(s) before its maturity.As rates rise, this helps

the bondholders dump their holdings and reinvest their proceeds at a

higher rate.

The provisions for redeeming bonds are found in the indenture.

They can be:

1.Called

2.Refunded

3.Have Prepayment Options and/or

4.Sinking Fund Provisions

1.Call Redemption

By adding a call feature in the indenture, a bond becomes a callable

bond.A callable bond gives the issuer the right to redeem the bonds

on a stated date or a schedule of dates before the stated maturity

date for the bonds arrives.

Let's look at callable bonds in a little more detail.First, some

terminology:

Call Price - This is the price that the issuer will pay the bondholder;

also know as the redemption price.

Call Date - This is the date or dates that the issuer can call the bond

from the holders.

have a deferred call of so many years up to the first call date, which

is the first day the bond can be called by the issuer.

Strategic Financial

Management

Stock Valuation

Security Valuation

The Top-Down Approach

The top-down approach is a valuation approach that begins

with first analyzing the overall economy and then

continuing to drill down to the specific analysis.The idea

behind the top-down approach when valuing securities is to

start from a high level analysis: the general economic

conditions. The next step would then be to analyze a

specific industry within the economy.Last, an investor

would compare and analyze specific securities to invest in.

The top-down approach allows an investor to make an

informed investment decision based on a keen

understanding of the economy and industry and how that

relates the stock, versus comparing the stocks

fundamentally against their peers without thinking about

the overall movement in the market.

The top-down approach can be particularly useful when

analyzing the valuation of world stocks.Given the starting

point of understanding the world economies, an investor is

able choose an appropriate stock based on areas of the

world that may be doing better.a

Value of a Preferred Stock

Unlike common equity, preferred stocks pay a fixed dividend.

As such, the value of a preferred stock can be calculated

using the dividend discount model.The value of the

preferred stock is essentially the present value of the

dividend in perpetuity, where k is the required return.

Value of preferred stock

Assume that Newcos preferred stock pays out to an investor

an annual dividend of $8 per share.Given a rate of return of

10%, what is the value of Newcos preferred stock?

Value of Newcos preferred stock = ($5/0.10) = $50

Value of a Common Stock

Much like a preferred stock, holders of common stock can

also receive dividends.However, dividends on common stock

are not guaranteed, nor are they a fixed amount from year-

_____________

P0

Let us now look at how our formula works. Suppose Blue Skies stock

is selling for $75 a share (P0 = $75). Investors expect a $3 cash

dividend over the next year (DIV1 = $3). They also expect the stock to

sell for $81 a year hence (P1 = $81). Then the expected return to

stockholders is 12 percent:

Expected rate of return = expected dividend yield + expected capital gain

Problem: Androscoggin Copper is increasing next years dividend to

$5.00 per share. The forecast stock price next year is $105. Equally

risky stocks of other companies offer expected rates of return of 10

percent. What should Androscoggin common stock sell for?

dividends grow at constant rate.

Suppose forecast dividends grow at a constant rate into

the indefinite future. If dividends grow at a steady rate,

then instead of forecasting an infinite number of

dividends, we need to forecast only the next dividend

and the dividend growth rate.

Recall Blue Skies Inc. It will pay a $3 dividend in 1 year. If the

dividend grows at a constant rate of g = .08 (8 percent)

thereafter, then dividends in future years will be

DIV1 = $3 = $3.00

DIV2 = $3 (1 + g) = $3 1.08 = $3.24

DIV3 = $3 (1 + g)2 = $3 1.082 = $3.50

P0 = DIV1

________

r-g

This equation is called the constant-growth dividend

discount model.

The superior prospects of Blue Skies are reflected

in its price-earnings ratio. With a stock price of

$75.00 and earnings of $5.00, the P/E ratio is

$75/$5 = 15. If Blue Skies had no growth

opportunities, its stock price would be only $41.67

and its P/E would be $41.67/$5 = 8.33. The P/E

ratio, therefore, is an indicator of the prospects of

the firm. To justify a high P/E, one must believe

the firm is endowed with ample growth

opportunities.

stock is simply

divided by the earnings per share of the stock as follows:

Example: Determining a companys price-to-earnings ratio using

the DDM

With Newcos $0.25 dividend payout, an EPS of $1.00,

calculate the stocks P/E ratio assuming 10% required return

and 5% growth.

Answer:

P/E ratio = 0.25/1.00 = 5%

(0.10-0.05)

supernormal growth

An investor plans to hold Newcos stock for 3 years.In that time

period, Newco plans to grow at a rate of 6% in the first two years

and 3% thereafter.Newcos last dividend was $0.25.Given a rate

of return of 10%, what is the value of Newcos common stock at

the end of the three-year time period?

Answer:

To begin, the dividend in each time period must be calculated [D

= D0(1+g)]

D1 = (0.25)(1.06) = 0.265

D2 = (0.265)(1.06) = 0.281

D3 = (0.281)(1.03) = 0.289

Since we expect the dividend to grow indefinitely in year 3 and

on, the present value of the stock price in year 3 is calculated as

follows:

P3 = 0.289 (1+0.03) = 4.252

(0.10-0.03)

The value of Newcos common stock is as follows:

Newcoscs = $0.265+ $0.281 + 0.289 + $4.252 =

****

(1.10)1 (1.10)2 (1.10)3 (1.10)3

is prevalent, but that it is simply generated by the supply

and demand of the markets.

potential inflation that is going to occur in the market.

inherent in the stock, as well as the market.Such risks

include liquidity risk, business risk and general

macroeconomic risk.

The Country Risk Premium

Thecountry risk premium is the general risk of a security

inherent with the foreign country related to the security.

The country risk premium should be added to the general

risks a security faces when estimating the required return

for a foreign security

The Implied Dividend Growth Rate

A companys dividend growth rate can be derived from a

companys ROE and its retention rate.

The retention rate of a company is the amount of earnings a

company retains for its internal growth. A companys ROE is the

return on the funds invested back into the company. Keep in mind

Newcos annual EPS last year was $1.00.The company

maintained its annual dividend payout ratio of 40% and ROE of

16%.Newcos beta is 1.3.Given a risk-free rate of 4% and an

expected return on the market of 18%, determine Newcos

required rate of return, expected growth rate and next years

dividend and price?

Answer:

Required rate of return

RNewco = 4% + 1.3(18% - 4%) = 22.2%

Expected growth rate

Retention rate = (1 payout rate) = (1 0.40) = 0.60

g = (0.60)(0.16) = 0.096 or 9.6%

Dividend

D1 = D0(1+g) = $1.00(1+.096) = $1.096

Future price

P1 = D1/(r g) = $1.096/(22.2% - 9.6%) = $8.70

Growth Company and Growth Stock

projects that will generate growth.A growth stock, however, is a stock

that earns a higher rate of return over stocks with a similar risk

profile.Feasibly, a company could be a growth company, but its stock

could be a value stock if it is trading below its peers of similar risk.

Defensive Company and Defensive Stock

A defensive company is a company whose earnings are relatively

unaffected in a business cycle downturn.A defensive company is

typically reflective of products that we need versus want.A food

company, such as Kellogg, is considered a defensive company.A

defensive stock, however, will hold its value relatively well in a business

cycle downturn.

Cyclical Company and Cyclical Stock

A cyclical company is a company whose earnings are affected relative to

a business cycle.A cyclical company is typically reflects products we

want.A retail store, such as The Gap, is considered a cyclical

company.A cyclical stock, however, will move with the market in relation

to the business cycle.

Speculative Company and Speculative Stock.

A speculative company is a company that invests in a business with an

uncertain outcome.An oil exploration company is an example of a

speculative company.A speculative stock, however, is a stock that has

pricing information. Technical analysis assumes the following:

asset.

Supply and demand are driven by rational factors, such as data and

economic analysis, as well as irrational factors, such as guesses.

Shifts in supply and demand will shift the trends in the market and

can be detected in the market.

Technical vs. Fundamental Analysis

The main difference between technical analysis and fundamental

analysis is the use of financial statements to value equities. Technical

analysis is the practice of valuing stocks on past volume and pricing

information.Technical analysis combines both the use of past

information (how stocks have reacted previously) and feeling (how

the market is moving the name) to value a security.

Fundamental analysis, however, takes a more formal

approach.Fundamental analysts review the financial statements of a

company and generate metrics, such as price-to-book value and

enterprise value-to-EBITDA to value a security.

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