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Table of Contents

SYLLABUS FOR ......................................................................................................................... 4

1. Course Description: ................................................................................................................. 4 2. Course objectives ..................................................................................................................... 4 3. Course content ...................................................................................................................... 4 4. Learning Resources: ............................................................................................................... 5 Additional Reading ...................................................................................................................... 5

6. Evaluation of the student performance .................................................................................. 5 Knowing Our Finance Program ................................................................................................. 5 Internet Web for this Courses: .................................................................................................... 6 7-HOME WORK AND ASSIGNMENT ..................................................................................... 6

Homework and Assignment .................................................................................................. 7 Course Outline for Corporate Finance ................................................................................. 7

Lesson Plan .......................................................................................................................... 8 The road forward to Success in this course ......................................................................... 9

Management and Accountant ........................................................................................ 9

Notes: Financial statements ...................................................................................................... 10

Balance Sheet ............................................................................................................................ 10 Income Statement ...................................................................................................................... 10 Statement of Cash Flows ........................................................................................................... 10

Statement of Owner’s Equity .................................................................................................... 10 Conceptual Framework ...................................................................................................... 11 Review ................................................................................................................................ 12

The Key Attributes of Successful Companies ........................................................................... 13 Chapter 1. Introduction to Corporate Finance ................................................ 14

What is Corporate Finance? ..................................................................................................... 15

Hypothetical Organization Chart ............................................................................................. 16

The Financial Manager ............................................................................................................ 17 The Firm and the Financial Markets ....................................................................................... 17

Debt and Equity as Contingent Claims .................................................................................... 18 The Corporate Firm .................................................................................................................. 19 Goals of the Corporate Firm ..................................................................................................... 19 The Set-of-Contracts Perspective .............................................................................................. 19

Primary Market ............................................................................................................... 20

Secondary Markets .......................................................................................................... 20

Exchange Trading of Listed Stocks .......................................................................................... 20

Chapter Quiz .......................................................................................................................... 21 Chapter 2. Introduction to Valuation: The Time Value of Money ....................................... 23

The One-Period Case: Future Value ........................................................................................ 24 Present Value (PV) and Discounting ....................................................................................... 25 Compounding Periods ............................................................................................................... 26 Simplifications ........................................................................................................................... 26

Annuity ................................................................................................................................... 26 Perpetuity ............................................................................................................................... 27

EARs and APRs ......................................................................................................................... 27 Summary and Conclusions ................................................................................................. 29 Use Ms. Excel 2003, 2007, and 2010 ................................................................................. 29

Chapter Quiz ..................................................................................................................... 35

Chapter 3: Interest Rates and Bond Valuation .......................................................... 39 Valuation of Bonds and Stock ................................................................................................ 40


Bonds and Bond Valuation .................................................................................................... 40 Bond Features and Prices .................................................................................................. 40

Bond Values and Yields ......................................................................................................... 40 3.1 Definition and Example of a Bond .............................................................................. 41

Definition and Example of a Bond ........................................................................................... 41 3.2 How to Value Bonds.................................................................................................... 41 Pure Discount Bonds .............................................................................................................. 42 Level-Coupon Bonds .............................................................................................................. 42 Bond Concepts ....................................................................................................................... 43 Bond Markets ......................................................................................................................... 43

Bond Price Reporting ............................................................................................................. 44 Formulas of the Bonds ....................................................................................................... 44

In Microsoft Excel .................................................................................................................. 45 Problem on Chapter 3: ....................................................................................................... 46

Chapter Quiz ..................................................................................................................... 48

Chapter 04: Stock Valuation ............................................................................................. 50 Common Stock Valuation ......................................................................................................... 51 Cash Flows ................................................................................................................................ 51 The Present Value of Common Stocks ..................................................................................... 52

Case 1: Zero Growth .............................................................................................................. 52

Case 2: Constant Growth ........................................................................................................ 53

Case 3: Differential Growth or Supernormal Growth ............................................................ 54

Components of the Required Return ............................................................................. 54

Stock Market Reporting ............................................................................................................ 55 Solved Problems ................................................................................................................. 56

Chapter Quiz ...................................................................................................................... 58

Capital Budgeting ...................................................................................................................... 61

Chapter 5. Net Present Value and Other Investment Criteria ............................................... 61

What is Capital Budgeting? ...................................................................................................... 62 1. Net present value ................................................................................................................ 62

The Net Present Value (NPV) Rule .................................................................................... 62 Good Attributes of the NPV Rule .......................................................................................... 62

2. Payback .................................................................................................................................. 63 The Profitability Index (PI) Rule ........................................................................................... 65 The Practice of Capital Budgeting ......................................................................................... 65

Net Present Value Profile.......................................................................................................... 65 Accept/Reject Decision ....................................................................................................... 67 Problems on Chapter 5 ...................................................................................................... 69

Glossary ..................................................................................................................................... 75


SYLLABUS FOR

Corporate Finance

By Nut Khorn

(Course Facilitator)

For BBA students

1. Course Description:

This course aims to introduce to the students the modern fundamental theory of finance.

Specifically it refers to the issues faced by the modern day company in the management of its

financial function. This course is designed for both finance and non-finance major student.

At the end of the course, student will be familiar the central concepts of finance which include

net present value, agency theory, risk and return, financial analysis theory and international

financial theory.

2. Course objectives

The objectives of the course are to enable the student to:

1. Apply the financial technique in valuation and capital budgeting

2. Analyze financial statements and planning

3. Understand issues in working capital management

4. Analyze the issues in capital structure and dividend policy decision

5. Understand various sources of long term and short term finance

6. Analyze and evaluate contemporary corporate finance issue

3. Course content

Unit 1. THE WORLD OF FINANCE

Introduction to the corporate finance

Financial market and institution

Unit 2. ESSENTIAL CONCEPT IFN FINANCE

Financial statements, taxes and Cash flow

Analysis of financial statement

The time value of money

Unit 3. CAPITAL BUDGETING

Introduction to risk and return

Capital budgeting method

Unit 4. DIVIDEND POLICY AND CAPITAL STRUCTURE

Cost of Capital

Capital structure

The dividend controversy

Unit 5 WORKING CAPITAL MANAGEMEMT

Working capital policy

Managing Cash


Unit 6. CONTEMPORARY ISSUE IN FINANCE

International finance

Merger and acquisition

4. Learning Resources:

Required textbook

Ross Stephen A., Westerfield Randolph W., Jordon Bradford D. (2006) fundamentals of

coporate finance, McGraw- Hill international edition, Seventh edition.

Stephen A. Ross, Randolph W. Westerfield, and Jeffrey F. Jaffe, (2005), Corporate

Finance, McGraw- Hill international, 6th

Edition

Additional Reading

JOEL LERNER and JAMES A. CASHIN, (1998), ―financial Management” The Second

Edition, McGraw- Hill, (SCHAUM‘S OUTLINES).

Paul G. KEAT and PHILIP K.Y. YOUNG, (2000), ―Managerial Economics” The Third

Edition, Prentice Hall ( USA).

5. Course requirement

Student should have basic knowledge of Business mathematics, statistics, economics,

financial accounting, financial issues, Microsoft Office such MS. Word and Ms. Excel and

Casio.

6. Evaluation of the student performance

Course assessment:

Attendance and participation……………. 10%

Homework……………. 30%

Assignment………………................... 20 %

Mid-term Exam…………… 20%

Final Examination ………….. 20%

Total: ………….. 100%

Knowing Our Finance Program

Four major areas:

1. Corporate Finance (Financial Management): How the corporation raises and uses its

resources, short-term and long-term, capital structure, dividend policy and other

related topics on the financial management of the corporation.

2. Money and Capital Markets (Financial Markets and Institutions): Environment needed

for the development of our financial systems, money and capital markets, banking

system (central and commercial banks), other non-bank financial institutions.

3. Investment Analysis and Portfolio Management: Fundamental analysis for fixed

income securities (bonds) and equity securities (stocks), portfolio theory and

management, derivative securities and other related portfolio topics.

4. International Finance: Financial management in the context of the global financial

markets, foreign exchange principles and applications, international money and capital

markets, international diversification, and related topics.


Work Requirement for a Corporate Finance Major under Mr. Nut Khorn

• I will apply the international standard when I teach all finance courses I will require

that you do all the assigned work before class:

Read your textbook (slide presentation is not complete)

Read the power point materials

Do the assignments

Prepare for all examinations.

Internet research work.

• To perform well in my courses, you need to spend about a minimum of 15 hours per

week for this class. If you do not want to make this commitment, then do not take my

courses.

• You should be present in all my classes. If you do not show up for my lectures, I will

consider you as absent (no need to give excuses).

• If you fail any of my courses (I hope you won‘t), you must retake a new written

examination plus an oral examination to prove that you know the subjects.

Internet Web for this Courses:

www.mhhe.com/rwj (fundamentals of corporate finance) or www.mhhe.com/bmm

When you search the web you will get power point presentation (Slide), quizzes, multiple

choices, excel template, and so on.

Other webs to supporting of your course.

www.mhhe.com (General subjects)

www.mhhe.com/bh (Foundation of Financial Management)

www.mhhe.com/williams_basis14e (Financial & Managerial Accounting)

www.mhhe.com/garrison12e (Managerial Accounting)

www.wiley.com (General Subjects)

www.wiley.com/college/weygandt (Accounting Principles, Financial Accounting,

Hospital Accounting, and Managerial Accounting)

General Research: www.en.wikipedia.org

My Blog: www.nutkhorn.wordpress.com and Videos www.youtube.com/nutkhorn

Note: When you research the entire web above you should

enter the STUDENT CENTER OR STUDENT COMPONION.

7-HOME WORK AND ASSIGNMENT

Students MUST COMPLY STRICTLY with the following instructions in writing their

Home Work, Individual Assignments, Group Case-study and Group Case-Study Presentation.

1. The student(s) is expected to do his/her own research in order to write up individual

assignments and homework.

2. All Individual Assignments/Homework and Group Case-Study MUST be type written on

A-4 sized paper with adequate margins. You should include a TITLE PAGE and a LIST

OF CONTENTS.

3. Use headings and sub-headings to organize your report, including supporting material(s) as

attachments.

http://www.mhhe.com/rwj

http://www.mhhe.com/

http://www.mhhe.com/bh

http://www.mhhe.com/williams_basis14e

http://www.mhhe.com/garrison12e

http://www.wiley.com/

http://www.wiley.com/college/weygandt

http://www.en.wikipedia.org/

http://www.nutkhorn.wordpress.com/

http://www.youtube.com/nutkhorn


4. All reference books/published materials you refer to should be properly referenced (arrange

in this order: name of author(s), year, and title of the book, publisher, and the country the

book was published) and this must be included in a bibliography at the end of the assignment.

5. Use text referencing when you cite somebody else’s work from your references. Citation

may mean direct quoting, or paraphrasing, or summarizing, or simply to make a statement

of that author's view of finding. An example of text referencing: Beamer and Varner (2001),

Suggested that culture is not something we are born with, but rather it is learned.

6. Number all pages sequentially and securely staple and/or bind all sheets together.

Homework and Assignment

Course Outline for Corporate Finance

Teaching

Weeks Chapters Topics Date Time Allowed

Week 1

Week 2

Week 3

Week 4

Week 5

Week6

Week 7

Week8

Week 9

Week 10

Week 11

Week 12

Week 13

Week 14

Week 15

Week 16

Date Chapter Topic Homework & Assignment

dMeNIrkarTIpSarmUlbRt enAkñúgRbeTskm<úCa Assignment

Group = 4 Students

Ch01

Ch02 P2-7,9,30,36,38,50 Home work

Ch03 P3-8,13,18 Home work

Ch04 P4-16,19,27 Home work

Ch05 P5-11,12 Home work


Lesson Plan

Week 01

Date Chapter Main Contents Taught

Hours Others


The road forward to Success in this course

Management and Accountant

1. Actual Objective and Really Practices

2. Terminology

3. Conceptual Frame works

4. Theories

5. Formulas

6. Practices all time


Notes: Financial statements

The same financial statement sometime receives different titles.

Balance Sheet =Statement of Financial Position

=Statement of Financial Condition

Income Statement =Statement of Income

=Operating Statement

=Statement of Operations

=Statement of Operating Activities

=Earnings Statement

=Statement of Earnings

=Profit and Loss (P&L) Statement

Statement of Cash Flows =Statement of Cash Flow

=Cash Flows Statement

=Statement of Changes in Cash Position

=Statement of Changes in Financial Position

Statement of Owner‘s Equity =Statement of Changes in Owner‘s Equity

= Statement of Changes in Owner‘s Capital

=Statement of Shareholders' Equity*

=Statement of Changes in Shareholders' Equity*

= Statement of Changes in Capital Accounts*

* Corporation only.


Conceptual Framework

Objectives

To provide information:

Useful for investor and creditor decisions.

That helps predict cash flows.

About economic resources, claims to resources and changes in resources and

claims.

Qualitative

Characteristics

Elements

Recognition and

Measurement

Concepts

Financial

Statements

Constraints

Figure 1: Conceptual Framework


Review

Finance

Finance is a science. Like other sciences, it has fundamental concepts, principles, and theories.

Nobel Prize Winners Whose Work Has Contributed Significantly to Finance

Jame Tobin, 1981– Liquidity and Behavior under risk.

Franco Modigliani, 1985– Capital Structure and Dividend Policy.

Harry M. Markowitz, 1990– Portfolio theory.

Merton H. Miller, 1990– Capital Structure and Dividend Policy.

William F. Sharp, 1990– Capital Asset Pricing.

John Nash, 1994– Game theory.

James A. Mirrlees, 1996– Asymmetric Information.

William S. Vickrey, 1996- Asymmetric Information.

Robert C. Merton, 1997– Option Pricing

Myron S. Scholes, 1997– Option Pricing.

George A. Ackerloff, 2001– Adverse Selection.

A Michael Spence, 2001– Asymmetric Information.

Joseph E Stiglitz, 2001-- Asymmetric Information.

Danniel Kahmeman, 2002– Behavior al Finance.

Lornon L. Smith, 2002-- Behavior al Finance.

Functions of Financial Systems

Figure 2: Functions of Financial Systems


The Key Attributes of Successful Companies

First, successful companies have skilled people at all levels inside the company, including

leaders, managers, and a capable workforce.

Second, successful companies have strong relationships with groups outside the company.

For example, successful companies develop win–win relationships with suppliers and excel in

customer relationship management.

Third, successful companies have enough funding to execute their plans and support their

operations. Most companies need cash to purchase land, buildings, equipment, and materials.

Companies can reinvest a portion of their earnings, but most growing companies must also

raise additional funds externally by some combination of selling stock and/or borrowing in the

financial markets.

Just as a stool needs all three legs to stand, a successful company must have all three attributes:

skilled people, strong external relationships, and sufficient capital.


Chapter 1. Introduction to Corporate Finance

Chapter Outline

1.1 What is Corporate Finance?

1.2 Corporate Securities as Contingent Claims on Total Firm Value

1.3 The Corporate Firm

1.4 Goals of the Corporate Firm

1.5 Financial Markets

After studying this chapter, you should understand:

LO1 The basic types of financial management decisions and the role of the

financial manager.

LO2 The goal of financial management.

LO3 The financial implications of the different forms of business

organization.

LO4 The conflicts of interest that can arise between managers and owners.


Finance

Noun

1.[U] finance (for sth) money used to run a business, an activity or a project:

2.[U]the activity of managing money, especially by a government or commercial

organization:

3.finances [pl.] the money available to a person, an organization or a country; the way this

money is managed:

Corporate:

adjective

1.connected with a corporation:

2. (technical) forming a corporation:

3. involving or shared by all the members of a group:

Finance is the science of funds management.[1] The general areas of finance are business

finance, personal finance, and public finance.[2] Finance includes saving money and often

includes lending money. The field of finance deals with the concepts of time, money and risk

and how they are interrelated. It also deals with how money is spent and budgeted.

Corporate finance is an area of finance dealing with the financial decisions corporations make

and the tools and analysis used to make these decisions. The primary goal of corporate finance

is to maximize corporate value [1] while managing the firm's financial risks. Although it is in

principle different from managerial finance which studies the financial decisions of all firms,

rather than corporations alone, the main concepts in the study of corporate finance are

applicable to the financial problems of all kinds of firms.

What is Corporate Finance?

Corporate Finance addresses the following three questions:

1. What long-term investments should the firm engage in?

2. How can the firm raise the money for the required investments?

3. How much short-term cash flow does a company need to pay its bills?

The Balance-Sheet Model of the Firm

Total Value of Assets Total Firm Value to Investors:

Current Assets

Fixed Assets

1. Tangible Assets

2. Intangible Assets

Current Liabilities

Long-term Debt

Shareholders’ Equity

=


The Capital Budgeting Decision

The Capital Structure Decision

The Net Working Capital Investment Decision

--------------------------

---------------------

Capital Structure:

The value of the firm can be thought of as a pie.

The goal of the manager is to increase the size of the pie.

The Capital Structure decision can be viewed as how best to slice up the pie.

If how you slice the pie affects the size of the pie, then the capital structure decision

matters.

Hypothetical Organization Chart

Fixed Assets

1. Tangible Assets

2. Intangible Assets

What long-term investments should

the firm engage in?

Current Liabilities

Long-term Debt

Shareholders’ Equity

How can the firm raise the money

for the required investments?

Current Assets

Current Liabilities

How much short-term cash flow does a

company need to pay its bills?

70% Debt 30%

Equity


The Financial Manager

To create value, the financial manager should:

1. Try to make smart investment decisions.

2. Try to make smart financing decisions.

The Firm and the Financial Markets


Corporate Securities as Contingent Claims on Total Firm Value

The basic feature of a debt is that it is a promise by the borrowing firm to repay a fixed

dollar amount of by a certain date.

The shareholder’s claim on firm value is the residual amount that remains after the

debtholders are paid.

If the value of the firm is less than the amount promised to the debtholders, the

Shareholders get nothing

Debt and Equity as Contingent Claims

Combined Payoffs to Debt and Equity


The Corporate Firm

The corporate form of business is the standard method for solving the problems

encountered in raising large amounts of cash.

However, businesses can take other forms.

Forms of Business Organization

The Sole Proprietorship

The Partnership

General Partnership

Limited Partnership

The Corporation

Advantages and Disadvantages

Liquidity and Marketability of Ownership

Control

Liability

Continuity of Existence

Tax Considerations

A Comparison of Partnership and Corporations

Goals of the Corporate Firm

The traditional answer is that the managers of the corporation are obliged to make

efforts to maximize shareholder wealth.

The Set-of-Contracts Perspective

The firm can be viewed as a set of contracts.

One of these contracts is between shareholders and managers.


The managers will usually act in the shareholders‘ interests.

The shareholders can devise contracts that align the incentives of the managers

with the goals of the shareholders.

The shareholders can monitor the managers‘ behavior.

This contracting and monitoring is costly.

Managerial Goals

Managerial goals may be different from shareholder goals

Expensive perquisites

Survival

Independence

Increased growth and size is not necessarily the same thing as increased shareholder

wealth.

Do Shareholders Control Managerial Behavior?

Shareholders vote for the board of directors, who in turn hire the management team.

Contracts can be carefully constructed to be incentive compatible.

There is a market for managerial talent—this may provide market discipline to the

managers—they can be replaced.

If the managers fail to maximize share price, they may be replaced in a hostile

takeover.

Financial Markets

Primary Market

When a corporation issues securities, cash flows from investors to the firm.

Usually an underwriter is involved

Secondary Markets

Involve the sale of ―used‖ securities from one investor to another.

Securities may be exchange traded or trade over-the-counter in a dealer market.

Exchange Trading of Listed Stocks

Auction markets are different from dealer markets in two ways:


Trading in a given auction exchange takes place at a single site on the floor of

the exchange.

Transaction prices of shares are communicated almost immediately to the

public.

Chapter Quiz

1

Determining the mix of debt and equity to be used to finance a firm is which type of a decision?

A) capital budgeting

B) working capital

C) capital structure

2

Which one of the following statements concerning partnerships is correct?

A)

All partners enjoy limited liability if they create a general partnership of equal

shares.

B) A limited partner actively participates in running the partnership on a daily basis.

C) A general partnership terminates whenever one general partner decides to sell her share of the business.

D) A general partnership has an unlimited life while a limited partnership has a limited life.

3

Which one of the following statements concerning corporations is correct?

A) The rules describing how a corporation regulates its own existence are set forth in the bylaws.

B)

The procedures to be followed for electing corporate directors are included in the

articles of incorporation.

C) Corporate income is taxed only when the corporate earnings are distributed to shareholders.

D) A corporation is the easiest form of business entity to create.

4

The goal of financial management is to maximize the current:

A) net income per share.

B) dividends per share.

C) total assets.

D) market value per share.

5

Which one of the following statements concerning the financial markets is correct?

A) Shareholders exchange shares with each other in the primary market.

B) The New York Stock Exchange is an auction market.

C) Dealer markets have a physical trading floor.

D) Stocks traded in auction markets are said to trade over-the-counter.

6

Which one of the following provides limited liability for all of its owners?

A) sole proprietorship

B) partnership with only general partners


C) partnership with both general and limited partners

D) corporation

7

Which one of the following represents a potential agency problem?

A) adherence to the Sarbanes-Oxley Act in 2002

B) hiring a manager and compensating her with shares of company stock

C) paying a management bonus based on the number of employees managed

D) paying all company earnings out to shareholders in the form of dividends

8

Firms that "went dark" following the enactment of the Sarbanes-Oxley Act in 2002:

A) must still comply with all the terms of that act.

B) did not meet the requirements of the act and were involuntarily delisted by the SEC.

C) generally did so to avoid the high cost of compliance.

D) now trade on NASDAQ where previously the firm's shares were traded on the NYSE.

9

Which one of the following is found in the corporate bylaws?

A) intended life of the corporation

B) the state of residence

C) the number of shares that can be issued

D) the procedures for electing the directors

10

Which one of the following statements concerning financial markets is correct?

A) The NYSE is an auction market.

B) All dealer markets require a physical trading floor.

C)

Corporations initially sell shares of stock in the secondary market, which is an auction market.

D) All private sales of stock must first be registered with the SEC.


Chapter 2. Introduction to Valuation: The Time Value of Money

ONE OF THE BASIC problems faced by the financial manager is how to determine the value

today of cash flows expected in the future. For example, the jackpot in a PowerBall™ lottery

drawing was $110 million. Does this mean the winning ticket was worth $110 million? The

answer is no because the jackpot was actually going to pay out over a 20-year period at a rate

of $5.5 million per year. How much was the ticket worth then? The answer depends on the

time value of money, the subject of this chapter.

In the most general sense, the phrase time value of money refers to the fact that a dollar in hand

today is worth more than a dollar promised at some time in the future.

On a practical level, one reason for this is that you could earn interest while you waited; so a

dollar today would grow to more than a dollar later. The trade-off between money now and

money later thus depends on, among other things, the rate you can earn by investing. Our goal

in this chapter is to explicitly evaluate this trade-off between dollars today and dollars at some

future time.

A thorough understanding of the material in this chapter is critical to understanding material in

subsequent chapters, so you should study it with particular care.

We will present a number of examples in this chapter. In many problems, your answer may

differ from ours slightly. This can happen because of rounding and is not a cause for concern.


LO1 How to determine the future value of an investment made today.

LO2 How to determine the present value of cash to be received at a future

date.

LO3 How to find the return on an investment.

LO4 How long it takes for an investment to reach a desired value.


The One-Period Case: Future Value

The first thing we will study is future value. Future value (FV) refers to the amount of money

an investment will grow to over some period of time at some given interest rate. Put another

way, future value is the cash value of an investment at some time in the future. We start out by

considering the simplest case, a single period investment.

Future value (FV) The amount an investment is worth after one or more periods.

If you were to invest $10,000 at 5-percent interest for one year, your investment would

grow to $10,500.

$500 would be interest ($10,000 × .05)

$10,000 is the principal repayment ($10,000 × 1)

$10,500 is the total due. It can be calculated as:

$10,500 = $10,000× (1.05).

The total amount due at the end of the investment is calling the Future Value (FV).

In the one-period case, the formula for FV can be written as:

)1( rt

PVFV

Compounding

The process of accumulating interest on an investment over time to earn more interest.

Interest on interest

Interest earned on the reinvestment of previous interest payments.

Compound interest: Interest earned on both the initial principal and the interest reinvested

from prior periods.

Simple interest: Interest earned only on the original principal amount invested.


Present Value (PV) and Discounting

When we discuss future value, we are thinking of questions like, what my $2,000 investment

will grow to if it earns a 6.5 percent return every year for the next six years? The answer to this

question is what we call the future value of $2,000 invested at 6.5 percent for six years (verify

that the answer is about $2,918).

There is another type of question that comes up even more often in financial management that

is obviously related to future value. Suppose you need to have $10,000 in 10 years, and you

can earn 6.5 percent on your money. How much do you have to invest today to reach your

goal? You can verify that the answer is $5,327.26.

How do we know this? Read on.

Present value (PV) The current value of future cash flows discounted at the appropriate

discount rate.

Discount Calculate the present value of some future amount.

)1( rt

FVPV

Suppose you need $400 to buy textbooks next year. You can earn 7 percent on your money.

How much do you have to put up today?

The quantity in brackets,

)1(

1

rt

, goes by several different names. Because it‘s used to

discount a future cash flow, it is often called a discount factor. With this name, it is not

surprising that the rate used in the calculation is often called the discount rate. We will tend to

call it this in talking about present values. The quantity in brackets is also called the present

value interest factor (or just present value factor) for $1 at r percent for t periods and is

sometimes abbreviated as PVIF(r, t). Finally, calculating the present value of a future cash

flow to determine its worth today is commonly called discounted cash flow (DCF) valuation.


Compounding Periods

Compounding an investment m times a year for t years provides for future value of wealth:

For example, if you invest $50 for 3 years at 12% compounded semi-annually, your investment

will grow to

Simplifications

Annuity

A stream of constant cash flows that lasts for a fixed number of periods.

Perpetuity

A constant stream of cash flows that lasts forever

Annuity

A constant stream of cash flows with a fixed maturity.

The formula for the future value of an annuity is:

]1

[)1(

rCFV

rt

An annuity is set up in which there are yearly payments of $200 for 5 years with interest being

paid at the annual rate of 6% compounded annually. Find the amount of the annuity.

The formula for the present value of an annuity is:

Example: If you can afford a $400 monthly car payment, how much car can you afford if

interest rates are 7% on 36-month loans?

tm

m

rPVFV

1

93.70$)06.1(50$2

12.150$ 6

32

FV

tr

C

r

C

r

C

r

CPV

)1()1()1()1( 32

trr

CPV

)1(

11


Perpetuity A constant stream of cash flows that lasts forever.

The formula for the present value of perpetuity is:

Example : What is the value of a British consol that promises to pay £15 each year, every year

until the sun turns into a red giant and burns the planet to a crisp?

The interest rate is 10-percent.

EARs and APRs Stated interest rate:

The interest rate expressed in terms of the interest payment made each period. Also, quoted

interest rate.

Effective annual rate (EAR):

The interest rate expressed as if it were compounded once per year.

Annual percentage rate (APR)

The interest rate charged per period multiplied by the number of periods per year.

To see why it is important to work only with effective rates, suppose you‘ve shopped around

and come up with the following three rates:

59.954,12$)1207.1(

11

12/07.

400$36

PV

32 )1()1()1( r

C

r

C

r

CPV

r

CPV


Bank A: 15 percent compounded daily

Bank B: 15.5 percent compounded quarterly

Bank C: 16 percent compounded annually

Which of these is the best if you are thinking of opening a savings account? Which of these is

best if they represent loan rates?

1)1(

m

APRm

EAR

mrAPR

For example, suppose you are offered 12 percent compounded monthly. In this case, the

interest is compounded 12 times a year; so m is 12. You can calculate the effective rate as:

Sometimes it‘s not altogether clear whether or not a rate is an effective annual rate.

A case in point concerns what is called the annual percentage rate (APR) on a loan.

Truth-in-lending laws in the United States require that lenders disclose an APR on virtually all

consumer loans. This rate must be displayed on a loan document in a prominent and

unambiguous way.

Given that an APR must be calculated and displayed, an obvious question arises:

Is an APR an effective annual rate? Put another way, if a bank quotes a car loan at 12 percent

APR, is the consumer actually paying 12 percent interest? Surprisingly, the answer is no. There

is some confusion over this point, which we discuss next.

The confusion over APRs arises because lenders are required by law to compute the APR in a

particular way. By law, the APR is simply equal to the interest rate per period multiplied by the

number of periods in a year. For example, if a bank is charging

1.2 percent per month on car loans, then the APR that must be reported is 1.2% x 12 =14.4%.

So, an APR is in fact a quoted, or stated, rate in the sense we‘ve been discussing.

For example, an APR of 12 percent on a loan calling for monthly payments is really 1 percent

per month. The EAR on such a loan is thus:

The difference between an APR and an EAR probably won‘t be all that great, but it is

somewhat ironic that truth-in-lending laws sometimes require lenders to be untruthful about

the actual rate on a loan.

There are also truth-in-saving laws that require banks and other borrowers to quote an ―annual

percentage yield,‖ or APY, on things like savings accounts. To make things a little confusing,

an APY is an EAR. As a result, by law, the rates quoted to borrowers (APRs) and those quoted

to savers (APYs) are not computed the same way.


Summary and Conclusions

Two basic concepts, future value and present value are introduced in this chapter.

Interest rates are commonly expressed on an annual basis, but semi-annual, quarterly,

monthly and even continuously compounded interest rate arrangements exist.

The formula for the net present value of an investment that pays $C for t periods is:

Use Ms. Excel 2003, 2007, and 2010

Using a Spreadsheet for Time Value of Money Calculations

=fv(r,t,,-pv)

=pv(r, t,,-fv)

=rate(t,,-pv,fv)

=nper(r,,-pv,fv) a) Ordinary of FVA

=fv(rate,nper, -pv,0,0)

=fv(r,t,-C,,0)

b) FVA of Annuity Due:

=fv(rate, nper,-pv,0,1)

=fv(r,t,-C,,1)

a) Ordinary of PVA

=pv(rate,nper,-pv,0,0)

=pv(r,t,-C,,0)

b)PVA of Annuity Due:

=pv(rate, nper,-pv,0,1)

=pv(r,t,-C,,1)

APR= nominal(effect_rate, npery)

EAR=effect(nominal_rate,npery) End of Chapter 2

r

CPV :Perpetuity

trr

CPV

)1(

11:Annuity


a) Future Value (FV) FV r tPV 1

P2-1)

If you invest $12,000 today, how much you will have:

a. In 6 years at 7 percent?

b. In 15 years at 12 percent?

c. In 25 years at 10 percent?

P2-2) Assume you deposit $10,000 today in an account that pays 6 percent interest. How much

will you have in five years?

P2-3)

For each of the following, compute the future value:

Present Value Years Interest Rate

$2,250 30 18%

9,310 16 6%

76,355 3 12%

183,796 7 8%

P2-4) . Bottom Line, Inc. has identified an investment project with the following cash flows. If

the discount rate is 8 percent, what is the future value of these cash flows in Year 4? What is

the future value at a discount rate of 11 percent? At 24 percent?

Year Cash Flow

1 $500

2 600

3 700

4 800

P2-5) Kingen Credit Bank is offering 4.5 percent compounded annually on its saving accounts

.If you deposit $5,000 today, how much you will have in the account in 5 years? in 10 years? in

20 years?

P2-6) You have an investment that will pay you 1.5 percent per month. How much will you

have per dollar invested in 1 year? In 2 years?

P2-7) If today is Year 0, what is the future value of these cash flows five years from now? What

is the future value 10 years from now? Assume a discount rate of 14 percent per year.

Year Cash Flow

2 $25,000

3 50,000

5 75,000

P2-8) A investor deposits $1,000 into a bank account that pays interest at the rate of 10% per

year (payable at the end of each year). She leaves the money and all accrued interest the

account for 5 years.

a) How much money does she have after 1 year?

b) How much money does she have at the end of 5 years?

P2-9) You plan to make a series of deposits in an individual retirement accounts. You will

deposit $1,000 today, $2,000 in two years, and $2,000 in five years. If you withdraw $1,500 in

three years and $1,000 in seven years, assuming no withdrawal penalties, how much will you

have after eight years if the interest rate is 7 percent? What is the present value of these cash

flows?


b) Present Value (PV)

)1( rt

FVPV

P2-10) What is the present value of: a. $8,000 in 10 years at 6 percent? b. $16,000 in 5 years at 12 percent? c. $25,000 in 15 years at 8 percent? d. $1,000 in 20 periods at 20 percent?

P2-11) How much would you have to invest today to receive: a. $12,000 in 6 years at 12 percent? b. $15,000 in 15 years at 8 percent? P2-12) John Longwaite will receive $100,000 in 50 years. His friends are very jealous of him. If the funds are discounted back at a rate of 14 percent, what is the present value of his future “pot of gold”? P2-13) Suppose you have just celebrated your 19th birthday. A rich uncle has set up a trust fund for you that will pay you $150,000 when you turn 30. If the relevant discount rate is 9 percent, how much is this fund worth today? P2-14)

For each of the following, compute the present value:

Years Interest Rate Future Value

3 4% $15,451 5 12% 51,557

12 22% 886,073

6 20% 550,164

P2-15) Stellato Shaved Ice Company has identified an investment with the following cash flows. If the discount rate is 10 percent, what is the present value of these cash flows? What is the present value at 18 percent? At 24%?

Year Cash Flow

1 $1,000

2 200

3 800

4 1,500 P2-16) You will receive $1,000 after four years at a discount rate of 10 percent. How much is this worth today? P2-17) Smolinski Company is considering an investment that will return a lump sum (= total) of $500,000 5 years from now.

What amount should Smolinski Company pay for this investment in order to earn a 15% return?

P2-18) Imprudential,Inc., has an unfunded pension liabilities of $425 million that must be paid in 20 years. To assess the value of the firm’s stock, financial analysts want of discount this liabilities back to present. If the relevant discount rate is 8 percent, what is the present value of this liability?


P2-19) Suppose you are still committed to owning a $120,000 Ferrari. If you believe your mutual fund can achieve a 9 percent annual interest rate of return and you want to buy the car in 10 years on the day you turn 30, how much must you to invest today? P2-20) Calculate the present value of the following cash flows discounted at 10 percent. a. $1,000 received seven years from today. b. $2,000 received one year from today. c. $500 received eight years from today.

c) Find r P2-21) You are considering a two-year investment. If you put up $1,250, you will get back $1,350. What rate is this investment paying? P2-22)

Solve for the unknown interest rate in each of the following:

Present Value Years Future Value

$207.22 3 $307 $450.44 9 $761

$37,548.84 15 $136,771 $78,871.00 30 $255,810

P2-23) Assume the total cost of a college education will be $200,000 when your child enters college in 18 years. You presently have $15,000 to invest. What annual rate of interest must you earn on your investment to cover the cost of your child’s college education?

d) Find t P2-24) You’ve been offered an investment that will pay you 9 percent per

year. If you invest $ 15,000, how long until you have $30,000? How long until

you have $45,000?

P2-25)

Solve for the unknown number of years in each of the following:

Present Value Interest Rate Future Value

$542 4% $1,284

$1,834 9% $4,341

$22,196 23% $402,662

$96,591 34% $173,439

P2-26) You’re trying to save to buy a new $120,000 Ferrari. You have $40,000

today that can be invested at your bank. The bank pays 4 percent annual

interest on its accounts. How long will it be before you have enough to buy the

car?

P2-27) You expect to receive $80,000 at graduation in two years. You plant to

investing it at 6 percent until you have $120,000. How long will you wait from

now?


e) Find FV and PV (Interest is often compounded quarterly, semi-annually,

monthly, daily, and continuously in the real world.)

em

r rtmt

PVFVPVFV

,1

P2-28) Determine the amount of money in a saving account at the end of 5 years, given an initial deposit of $3,000 and an 8 percent annual interest rate when interest rate is compounded (a) annually, (b) semi-annually , (c) quarterly, (d) monthly, (e) daily, and (f) continuously. P2-29) Suppose $1,000 is invested at an annual interest rate of 6%. Compute the balance after 10 years if the interest is compounded (a) Quarterly (b) Monthly (c) Daily (d) Continuously P2-30) Suppose $1,000 is invested at an annual interest rate of 7%. Compute the balance after 10 years if the interest is compounded:

(a) Annually (c) Monthly (b)Quarterly (d) Continuously

f) Find PV =

)1(

11

rtr

C

P2-31) How much would you have to invest today to receive:

q. $5,000 each year for 10 years at 8 percent?

b. $40,000 each year for 40 years at 5 percent?

P2-32) Kilary Company is considering investing in an annuity contract that will

return $20,000 annually at the end of each year for 15 years. What amount

should Kilary Company pay for this investment if it ears a 6% return?

P2-33) You will receive $ 1,000 at the end of each period for four years. At

discount rate of 10% percent, what is cash flow currently worth?

P2-34) Zarita Enterprises earns 11% on an investment that pays back $110,000

at the end of each of the next 4 years. What is the amount Zarita Enterprises

invested to earn the 11% rate of return?

P2-35) An investment offers $2,250 per year for five years, with the first payment

occurring one year from now. If the required return is 10 percent, what is the

value of the investment? What would the value be if the payments occurred

for 40 years? For 75 years?

P2-36) Peter Lynchpin wants to sell you an investment contract that pays

equal $10,000 amount at the end of each of the next 20 years. If you require

an effective annual return of 14 percent on this investment, how much will you

pay for the contract to day?

g) Making- decisions P2-37) Plly Graham will receive $ 12,000 a year for the next 15 years as the result of her patent. If a 9 percent rate is applied, should she be willing to sell

out her future rights now for $100,000?


P2-38) Your rich uncle has offered you a choice of one of the three following alternatives: $10,000 now; $2,000 a year for eight years; or $24,000 at the

end of eight years. Assuming you could earn 11 percent annually, which alternative should you choose? If you could earn 12% percent annually, would you still choose the

same alternative?

h) Perpetuity PVr

C

P2-39) Consider a perpetuity paying $100 a year. If the relevant interest rate is 8 percent,

what is the value of consol?

P2-40) The market interest rate is 15 percent. What is the price of a consol bond that pays $120

annually?

P2-41) If the rate of interest is 10 percent and if the aim is to provided $100,000 a year in

perpetuity, What is the amount that must be set aside today?

Future Value of an Annuity (FVA) : ]1

[)1(

rCFV

rt

P2-42) If you deposit $1,000 at the end of each of the next 20 years into an account paying 8.5

percent interest, how much money will you have in the account in 20 years? How much will

you have if you make deposits for 40 years?

P2-43) . Assume an ordinary annuity of $500 at the end of each of the next three years:

What is the future value at 10%?

P2-44). What is the future value at the end of year 6 of a six-year annuity of $1,000 per year if

the expected return is 10%?

P2-45) You want to have $50,000 in your savings account five years from now, and you‘re

prepared to make equal annual deposits into the account at the end of each year. If the account

pays 9.5 percent interest, what amount must you deposit each year?

P2-46) Find the effective annual interest rate for each case:

APR Compounding Period

12% Monthly

8% Quarterly

10% Semiannually P2-47) Find the APR (the stated interest rate) for each case:

EAR Compounding Period

10% Monthly

5% Quarterly

24% Semiannually

P2-48)

The going rate on student loans is quoted as 8 percent APR. The terms of the loans call for

monthly payments. What is the effective annual rate (EAR) on such a student loan?

P2-49) Find the EAR in each of the following cases:


P2-50)

Find the APR, or stated rate, in each of the following cases:

P2-51)

First National Bank charges 7.5 percent compounded quarterly on its business loans. First

United Bank charges 7.5 percent compounded semiannually. As a potential borrower, which

bank would you go to for a new loan?

Chapter Quiz

1

Gloria wants to have $20,000 in her investment account ten years from now. Currently, she has nothing saved. How much would she have to deposit today to reach her goal if

this is the only amount she invests? She expects to earn 8.5 percent, compounded annually. How much must she deposit today?

A) $11,520.74

B) $9,684.28

C) $8,845.71

D) $14,705.88

2

Four years ago, your baseball card collection was worth $1,200. You have not added any cards to the collection over the past four years, but the collection has still increased in value. Today, it is worth $1,500. What rate of return are you earning on this collection?

A) 5.74 percent

B) 6.23 percent

C) 4.98 percent

D) 5.25 percent

3

Amy invested $1,500 in a stock that has returned 12 percent, compounded annually. Today, that investment is worth $3,600. How long has Amy owned this stock?

A) 5.92 years

B) 6.54 years

C) 7.18 years

D) 7.73 years

4

When your parents got married 38 years ago, they purchased a house for $31,900. They have taken good care of the house but have not invested any more money into it. Today, their house is valued at $149,900. What rate of return have your parents earned on their home?

A) 3.92 percent

B) 4.16 percent


C) 4.58 percent

D) 5.39 percent

5

Which one of the following statements is correct, assuming all else is constant?

A) The discount rate increases as the present value increases.

B) The future value decreases as the present value increases.

C) The time period increases as the interest rate increases.

D) The present value increases as the discount rate decreases.

6

You invested $5,000 at 6 percent simple interest for five years. How much total interest will you earn over these five years?

A) $300.00

B) $742.97

C) $1,500.00

D) $1,691.13

7

Scott and Todd are twins. Scott invests $50 a month for ten years starting on his 20th birthday. Todd invests $50 a month for ten years starting on his 25th birthday. Both Scott and Todd earn 7 percent. Which one of the following statements is correct based on this information? Assume they never withdraw any money from their accounts.

A)

Both Scott and Todd will have the same amount saved when they turn 60 if the

7 percent is simple interest.

B) Scott and Todd will earn the same amount of interest during the year of their 40th birthday if the 7 percent is simple interest.

C) Todd will have more money saved than Scott when they are 70 years old if the 7 percent is compounded annually.

D)

Scott and Todd will earn the same amount of interest during the year of their 50th birthday if the 7 percent is compounded annually.

8

Flo deposited $5,000 into her retirement account today. How much money will she have 40 years from now if this is the only deposit she makes and she earns an average of 13

percent, compounded annually?

A) $597,264

B) $648,306

C) $663,908

D) $671,909

9

You have been offered a business opportunity that will pay you $57,000 in six years if you

invest $25,000 today. What is the expected rate of return on this investment?

A) 14.72 percent

B) 15.36 percent

C) 15.78 percent

D) 16.22 percent

10

According to the Rule of 72, how long will it take you to double your money is you can

earn a 6 percent rate of return?

A) 6 years

B) 7.2 years


C) 9 years

D) 12 years

11

What is the interest rate per period multiplied by the number of periods per year called?

A) effective annual yield

B) compounded effective yield

C) periodic rate

D) annual percentage rate

12

Your employer has offered to contribute $50 a week to your retirement savings account.

Assume you work for this employer for another 15 years and earn an average return of 8.5 percent, compounded weekly, on your savings. What is this offer worth to you today?

A) $39,000

B) $42,315

C) $78,764

D) $81,309

13

This morning, you purchased some stereo equipment costing $2,659. You charged this purchase on your credit card. This card charges 16.9 percent interest, compounded monthly. How long will it take you to pay off this purchase if this is the only charge on your credit card and you make monthly payments of $40?

A) 15.13 years

B) 12.95 years

C) 14.82 years

D) 16.40 years

14

Every month for the past eight years you have invested $50 in a mutual fund. Today, your account is valued at $6,419. What rate of return have you been earning on this

investment?

A) 7.03 percent

B) 5.86 percent

C) 6.29 percent

D) 6.54 percent

15

You just purchased a home and agreed to a mortgage payment of $1,264 a month for 30

years at 7.5 percent interest, compounded monthly. How much interest will you pay over the life of this mortgage assuming that you make all payments as agreed?

A) $181,267

B) $274,266

C) $387,280

D) $455,040

16

You are going to receive $6,000 at the end of each quarter for the next five years. What is the net present value of these payments at a discount rate of 7 percent, compounded


quarterly?

A) $63,564

B) $100,517

C) $102,276

D) $103,012

17

What is the effective annual rate of 10.75 percent compounded continuously?

A) 11.04 percent

B) 11.19 percent

C) 11.30 percent

D) 11.35 percent

18

A preferred stock pays annual dividends of $1.80 per share. What is this stock worth to you today if you desire a 14.5 percent return on this investment?

A) $11.87

B) $12.41

C) $25.98

D) $26.10

19

A project will produce cash flows of $2,400, $2,800, and $4,100 a year for the next three years, respectively. What is the net value of these cash flows today if the applicable

discount rate is 12 percent?

A) $7,778.80

B) $8,056.16

C) $7,293.30

D) $8,303.57

20

Sue plans to save $100 at the beginning of each month for the next five years. Scott plans

to save $100 at the end of each month for the next five years. Assume that both Sue and Scott earn 4.5 percent on their savings. Which one of the following statements is correct given this information?

A) Sue will have $6,721.68 at the end of the five years.

B) Sue will have $25.17 more in her account than Scott will have in his account at the end of the five years.

C)

Scott will have $8.67 more in his account than Sue will have in her account after the first three years.

D)

Both Sue and Scott will have the same amount of money in their accounts after

five years.

End of the problem of Chapter 2


Chapter 3: Interest Rates and Bond Valuation After studying this chapter, you should understand:

LO1 Important bond features and types of bonds.

LO2 Bond values and yields and why they fluctuate.

LO3 Bond ratings and what they mean.

LO4 The impact of inflation on interest rates.

LO5 The term structure of interest rates and the determinants of bond

yields.


Valuation of Bonds and Stock

First Principles:

Value of financial securities = PV of expected future cash flows

To value bonds and stocks we need to:

Estimate future cash flows:

Size (how much) and

Timing (when)

Discount future cash flows at an appropriate rate:

The rate should be appropriate to the risk presented by the security.

Bonds and Bond Valuation When a corporation (or government) wishes to borrow money from the public on a long-term

basis, it usually does so by issuing or selling debt securities that are generically called bonds.

In this section, we describe the various features of corporate bonds and some of the

terminology associated with bonds. We then discuss the cash flows associated with a bond and

how bonds can be valued using our discounted cash flow procedure.

Bond Features and Prices

As we mentioned in our previous chapter, a bond is normally an interest-only loan, meaning

that the borrower will pay the interest every period, but none of the principal will be repaid

until the end of the loan. For example, suppose the Beck

Corporation wants to borrow $1,000 for 30 years. The interest rate on similar debt issued by

similar corporations is 12 percent. Beck will thus pay .12 x $1,000 = $120 in interest every

year for 30 years. At the end of 30 years, Beck will repay the $1,000.

As this example suggests, a bond is a fairly simple financing arrangement. There is, however, a

rich jargon associated with bonds, so we will use this example to define some of the more

important terms.

In our example, the $120 regular interest payments that Beck promises to make are called the

bond‘s coupons. Because the coupon is constant and paid every year, the type of bond we are

describing is sometimes called a level coupon bond. The amount that will be repaid at the end

of the loan is called the bond‘s face value, or par value. As in our example, this par value is

usually $1,000 for corporate bonds, and a bond that sells for its par value is called a par value

bond. Government bonds frequently have much larger face, or par, values. Finally, the annual

coupon divided by the face value is called the coupon rate on the bond; in this case, because

$120/1,000 = 12%, the bond has a 12 percent coupon rate.

The number of years until the face value is paid is called the bond‘s time to maturity. A

corporate bond will frequently have a maturity of 30 years when it is originally issued, but this

varies. Once the bond has been issued, the number of years to maturity declines as time goes

by.

Bond Values and Yields As time passes, interest rates change in the marketplace. The cash flows from a bond, however,

stay the same. As a result, the value of the bond will fluctuate. When interest rates rise, the

present value of the bond‘s remaining cash flows declines, and the bond is worth less. When

interest rates fall, the bond is worth more.

To determine the value of a bond at a particular point in time, we need to know the number of

periods remaining until maturity, the face value, the coupon, and the market interest rate for

bonds with similar features. This interest rate required in the market on a bond is called the

bond‘s yield to maturity (YTM). This rate is sometimes called the bond‘s yield for short.

Given all this information, we can calculate the present value of the cash flows as an estimate

of the bond‘s current market value.

For example, suppose the Xanth (pronounced ―zanth‖) Co. were to issue a bond with 10 years

to maturity. The Xanth bond has an annual coupon of $80. Similar bonds have a yield to


maturity of 8 percent. Based on our preceding discussion, the Xanth bond will pay $80 per

year for the next 10 years in coupon interest. In 10 years, Xanth will pay $1,000 to the owner

of the bond. The cash flows from the bond are shown in Figure 3. What would this bond sell

for?

As illustrated in Figure 3 , the Xanth bond‘s cash flows have an annuity component (the

coupons) and a lump sum (the face value paid at maturity). We thus estimate the market value

of the bond by calculating the present value of these two components separately and adding the

results together. First, at the going rate of 8 percent, the present value of the $1,000 paid in 10

years is:

3.1 Definition and Example of a Bond A bond is a legally binding agreement between a borrower and a lender:

Specifies the principal amount of the loan.

Specifies the size and timing of the cash flows:

In dollar terms (fixed-rate borrowing)

As a formula (adjustable-rate borrowing)

Coupon: The stated interest payment made on a bond.

Face value: The principal amount of a bond that is repaid at the end of the term. Also, par

value.

Coupon rate: the annual coupon divided by the face value of a bond.

Maturity: Specified date on which the principal amount of a bond is paid.

Yield to maturity (YTM): the rate required in the market on a bond.

Definition and Example of a Bond

Consider a U.S. government bond listed as 6 3/8 of December 2009.

The Par Value of the bond is $1,000.

Coupon payments are made semi-annually (June 30 and December 31 for this

particular bond).

Since the coupon rate is 6 3/8 the payment is $31.875.

On January 1, 2005 the size and timing of cash flows are:

3.2 How to Value Bonds Identify the size and timing of cash flows.

$31.875 $31.875

$31.875

$31.875

$1,031.875

1/1/05 6/30/05 12/30/05 6/30/09 12/06/09

Figure 3 : Cash flows of Bond


0

0 $

1

0 $

2

0 $

1 -

T

F $

t

Discount at the correct discount rate.

If you know the price of a bond and the size and timing of cash flows, the yield

to maturity is the discount rate.

Pure Discount Bonds Information needed for valuing pure discount bonds:

Time to maturity (T) = Maturity date - today‘s date

Face value (FV)

Yield to Maturity (YTM)

Present value of a pure discount bond at time 0:

Example: Find the value of a 30-year zero-coupon bond with a $1,000 par value and a YTM

of 6%.

11.174$000,1$

)06.01()1(30

YTMt

FVPV

Level-Coupon Bonds Information needed to value level-coupon bonds:

Coupon payment dates and time to maturity (t)

Coupon payment (C) per period and Face value (FV)

Yield to maturity (FV)

Notes: rFVC where r = discount rate

Value of a Level-coupon bond = PV of coupon payment annuity + PV of face value

)1()1(

11

YTMYTMtt

FV

YTM

cPV

Example: Find the present value (as of January 1, 2004), of a 6-3/8 coupon T-bond with semi-

annual payments, and a maturity date of December 2009 if the YTM is 5-percent.

On January 1, 2004 the size and timing of cash flows are:

tYTM

FVPV

)1(

0

0

0$

1

0$

2

0$

29

000,1$

30

0

0$

1

0$

2

0$

29

000,1$

30

0

0

C$

1

C$

2

C$

1T

FC $$

T


52.070,1$000,1$1

12/05.0

875.31$

)025.01()025.01( 1212

PV

Bond Concepts 1. Bond prices and market interest rates move in opposite directions.

2. Putting together our observations about yield measures, we have the following:

a) Premium bonds: Coupon rate > Current yield > Yield to maturity

b) Discount bonds: Coupon rate < Current yield < Yield to maturity

c) Par value bonds: Coupon rate = Current yield = Yield to maturity

3. A bond with longer maturity has higher relative (%) price change than one with shorter

maturity when interest rate (YTM) changes. All other features are identical.

4. A lower coupon bond has a higher relative price change than a higher coupon bond

when YTM changes. All other features are identical.

Bond Markets Bonds are bought and sold in enormous quantities every day. You may be surprised to learn

that the trading volume in bonds on a typical day is many, many times larger than the trading

volume in stocks (by trading volume, we simply mean the amount of money that changes

hands). Here is a finance trivia question: What is the largest securities market in the world?

Most people would guess the New York Stock Exchange. As if! In fact, the largest securities

market in the world in terms of trading volume is the U.S. Treasury market.

How Bonds Are Bought and Sold

As we mentioned all the way back in Chapter 1, most trading in bonds takes place over the

counter, or OTC. Recall that this means that there is no particular places where buying and

selling occur. Instead, dealers around the country (and around the world) stand ready to buy

and sell. The various dealers are connected electronically.

One reason the bond markets are so big is that the number of bond issues far exceeds the

number of stock issues. There are two reasons for this. First, a corporation would typically

have only one common stock issue outstanding (there are exceptions to this that we discuss in

our next chapter). However, a single large corporation could easily have a dozen or more note

and bond issues outstanding. Beyond this, federal, state, and local borrowing is simply

enormous. For example, even a small city would usually have a wide variety of notes and

bonds outstanding, representing money borrowed to pay for things like roads, sewers, and

schools. When you think about how many small cities there are in the United States, you begin

to get the picture!

Because the bond market is almost entirely OTC, it has little or no transparency.

A financial market is transparent if it is possible to easily observe its prices and trading

volume. On the New York Stock Exchange, for example, it is possible to see the price and

……………

1/1/04 6/30/04 12/31/04 6/30/09 12/31/09

$31.875 $31.875

$31.875

$1,031.875


quantity for every single transaction. In contrast, in the bond market, it is usually not possible

to observe either. Transactions are privately negotiated between parties, and there is little or no

centralized reporting of transactions.

Although the total volume of trading in bonds far exceeds that in stocks, only a very small

fraction of the total bond issues that exist actually trade on a given day.

This fact, combined with the lack of transparency in the bond market, means that getting up-to-

date prices on individual bonds is often difficult or impossible, particularly for smaller

corporate or municipal issues. Instead, varieties of sources of estimated prices exist and are

very commonly used.

Bond Price Reporting

Although most bond trading is OTC, there is a corporate bond market associated with the New

York Stock Exchange. If you were to look in The Wall Street Journal (or similar financial

newspaper), you would find price and volume information from this market on a relatively

small number of bonds issued by larger corporations.

This particular market represents only a sliver of the total market, however.

Mostly, it is a ―retail‖ market, meaning that smaller orders from individual investors are

transacted here. Bond quotes are shown in Figure 4

Formulas of the Bonds

1) Zero-coupon Bond:

)1( YTM t

FVPV

2) Level-Coupon Bond

a) Annually:

)1()1(

11

YTMYTM tt

FV

YTM

CPV

rFVC

b) Semi-annually:

)2

1()2

1(22

11

YTMYTM tt

FV

YTM

CPV

3) Find YTM

Figure 4: Bond Quotes


FVPVt

PVFVC

YTM4.06.0

PV

CCouponCYYieldCurrent

AmountBaseAmountCurrentChangeNet

PriceClosing)(

In Microsoft Excel

1) Annually: =pv(YTM,t,r*1,000,1,000)*-1

2) Semi-annually: =pv(YTM/2,t*2,r/2*1,000,1000)*-1


Problem on Chapter 3:

P3-1: What is the present value of a 10-year, pure discount bond that pays $1,000 at maturity

and is price to yield the following rate:

a) 5 percent

b) 10 percent

c) 15 percent

P3-2. The Lone Star Company has $1,000 par value of bonds outstanding at

9 percent interest. The bonds will mature in 20 years. Compute the current price of the bonds if the present yield to maturity is:

a) 6 percent. b) 8 percent.

c) 12 percent. P3-3. Applied Software has $1,000 par value bonds outstanding at 12

percent interest. The bonds will mature in 25 years. Compute the current price of the bonds if the present yield to maturity is:

a) 11 percent. b) 13 percent.

c) 16 percent. P3-4. The Hartford Telephone Company has a $1,000 par value bond

outstanding that pays 11 percent annual interest. The current yield to

maturity on such bonds in the market is 14 percent. Compute the price of bonds for these maturity dates:

a. 30 years. b. 15 years.

C. 1 year. P3-5. Ron Rhodes calls his broker to require about purchasing a bond of

Golden Year Recreation Corporation. His broker quotes a price of $1,170. Ron is concerned that the bond might be overpriced based on the fact

involved. The $1,000 par value of bond pays 13 percent interest, and it has 18 years remaining until maturity. The current yield to maturity on similar

bonds is 11 percent. Do you think the bond is overpriced? Do the necessary calculations.

P3-6. What is the present value of a 20-year pure discount bond paying

$1,000 at maturity if the approximate interest rate is:

a. 3 percent. b. 7 percent.

c. 25 percent. P3-7. Heather Smith is considering a bond investment in Locklear Airlines.

The $1,000 par value bonds have a quoted annual interest rate of 9 percent and interest is paid semiannually. The yield to maturity on the

bonds is 12 percent annual interest rate. There are 15 years to maturity. Compute the price of the bonds based on semiannual analysis.

P3-8. You are called in as a financial analyst to appraise the bonds of Virginia Slim‟s Closing Stores. The $1,000 par value bonds have a quoted

annual interest rate of 13 percent, which is paid semiannually. The yield to


maturity on the bonds is 10 percent annual interest rate. There are 25 years to maturity.

a) Compute the prices of the bonds based on semiannual analysis. b) With 20 years to maturity, if the yield to maturity goes down

substantially to 8 percent, what will be the new price of the bonds? P3-9. Microhard has issued a bond with the following characteristics:

Principal: $1,000 Time to maturity: 20 years

Coupon rate: 8 percent, compounded semiannually

Semiannual payments Calculate the price of this bond if the stated annual interest rate,

compounded semiannually, is: a) 8 percent

b) 10 percent c) 6 percent

P3-10. Consider a bond with a face value of $1,000. The coupon payment is made semiannually and the yield on the bond is 12 percent (effective

annual yield). How much would you pay for the bond if: a) The coupon rate is 8 percent and the remaining time to maturity is 20

years. b) The coupon rate is 10 percent and the remaining time to maturity is 15

years. P3-11. Bonds issued by the Coleman Manufacturing Company have a par

value of $1,000, which, of course, is also the amount of principal to be paid

at maturity. The bonds are currently selling for $850. They have 10 years remaining to maturity. The annual interest payment is 8 percent ($80).

Compute the approximate yield to maturity.

P3-12. Bonds issued by the Tyler Food Corporation have a par value of $1,000, are selling for $1,080, and have 20 years remaining to maturity.

The annual interest payment is 12.5 percent ($125). Compute the approximate yield to maturity.

P3-13 Consider the bond paying an annual coupon of $80 with a face value of $1,000. Calculate the yield to maturity if the bond has:

a) 20 years remaining to maturity and is price at $1,200. b) 10 years remaining to maturity and is price at $950.

Note: Formula in computing the approximate yield to maturity:

YTM= FVPo

T

PoFVCoupon

4.06.0

P3-14) a bond has a 9% coupon rate, matures in 12 years and pays interest semi-annually. The

face value is $1,000.

What is the current price of this bond if the market rate of return is 8.3%?

P3-15) an 8%, semi-annual coupon bond has a $1,000 face value and matures in 8 years.

What is the current yield on this bond if the yield to maturity is 7.8%?

P3-16) Winslow, Inc. issues 20-year zero coupon bonds at a price of $224.73. The face value

is $1,000.What is the amount of the implicit interest for the first year of this bond‘s life?


P3-17) A Microgates Industries bond has a 10 percent coupon rate and a $1,000 face value.

Interest is paid semiannually, and the bond has 20 years to maturity. If investors require a 12

percent yield, what is the bond‘s value?

What is the effective annual yield on the bond?

P3-18) BrainDrain Software has 12 percent coupon bonds on the market with 7 years to

maturity. The bonds make semiannual payments and currently sell for 105 percent of par.

What is the current yield on BrainDrain‘s bonds? The YTM? The effective annual yield?

P3-19 ) Suppose the following bond quote for IOU Corporation appears on the financial page

of today‘s newspaper. If this bond has a face value of $1,000, what closing price appeared in

yesterday‘s newspaper?

Chapter Quiz

1

Christine earned 7.5 percent on her investments last year. Her real rate of return was 4.6 percent. What was the inflation rate for the year?

A) 2.62 percent

B) 2.77 percent

C) 3.06 percent

D) 3.49 percent

2

A zero coupon bond has a yield to maturity of 9.26 percent and 8 years until it fully matures. What is the current price of this bond if the face value is $1,000? Assume semiannual compounding.

A) $458.80

B) $471.20

C) $484.73

D) $503.72

3

Which one of the following bonds has the most interest rate risk?

A) 6%, 20 year

B) 6%, 10 year

C) 0%, 10 year

D) 0%, 20 year

4

Of the following ratings, which one is the lowest investment-quality bond rating by Standard & Poor's?

A) Baa

B) A

C) BBB

D) B


5

A semi-annual coupon bond is currently selling for $747 and has a yield to maturity of 8.13 percent. The bond matures in 7 years. What is the coupon rate of this bond if the face

value is $1,000?

A) 0 percent

B) 3.32 percent

C) 8.47 percent

D) 16.60 percent

6

Miller Stores bonds are currently quoted at 97.54 percent of par and mature in 11 years. The bonds pay a $30 semiannual coupon and have a $1,000 face value. What is the current yield on these bonds?

A) 3.00 percent

B) 3.15 percent

C) 6.15 percent

D) 6.00 percent

7

Which one of the following is the price you will pay if you buy a bond from a dealer?

A) bid

B) yield

C) call

D) asked

8

Which one of the following terms is most associated with the ranking of a debt should a firm declare bankruptcy?

A) seniority

B) indenture

C) sinking fund

D) positive covenant

9

Delta Pipe offers a 6 percent coupon bond with a yield to maturity of 6.5 percent. The bond pays interest annually and matures in 12 years. What is the market price of one of these bonds if the face value is $1,000?

A) $959.21

B) $958.78

C) $947.27

D) $946.39

10

The Kandy Store has 7.5 percent semiannual bonds outstanding with 16 years to maturity. What is the yield to maturity if the bonds are currently selling for $1,012.50 each?

A) 6.98 percent

B) 7.37 percent

C) 7.54 percent

D) 7.67 percent


Chapter 04: Stock Valuation


LO1 How stock prices depend on future dividends and dividend growth.

LO2 The different ways corporate directors are elected to office.

LO3 How the stock markets work.


IN OUR PREVIOUS CHAPTER, we introduced you to bonds and bond valuation. In this

chapter, we turn to the other major source of financing for corporations, common and preferred

stock. We first describe the cash flows associated with a share of stock and then go on to

develop a very famous result, the dividend growth model. From there, we move on to examine

various important features of common and preferred stock, focusing on shareholder rights. We

close out the chapter with a discussion of how shares of stock are traded and how stock prices

and other important information are reported in the financial press.

Common Stock Valuation

A share of common stock is more difficult to value in practice than a bond, for at least three

reasons. First, with common stock, not even the promised cash flows are known in advance.

Second, the life of the investment is essentially forever, since common stock has no maturity.

Third, there is no way to easily observe the rate of return that the market requires. Nonetheless,

as we will see, there are cases in which we can come up with the present value of the future

cash flows for a share of stock and thus determine its value.

Cash Flows

Imagine that you are considering buying a share of stock today. You plan to sell the stock in

one year. You somehow know that the stock will be worth $70 at that time.

You predict that the stock will also pay a $10 per share dividend at the end of the year.

If you require a 25 percent return on your investment, what is the most you would pay for the

stock? In other words, what is the present value of the $10 dividend along with the $70 ending

value at 25 percent?

If you buy the stock today and sell it at the end of the year, you will have a total of $80 in cash.

At 25 percent:

64$1.25

$70)($10 (PV) ValuePresent

Therefore, $64 is the value you would assign to the stock today.

More generally, let P0 be the current price of the stock, and assign P1 to be the price in one

period. If D1 is the cash dividend paid at the end of the period, then:

)1(

)( 110

R

PDP

where R is the required return in the market on this investment.

Notice that we really haven‘t said much so far. If we wanted to determine the value of a share

of stock today (P0), we would first have to come up with the value in one year (P1). This is

even harder to do, so we‘ve only made the problem more complicated.

What is the price in one period, P1? We don‘t know in general. Instead, suppose we somehow

knew the price in two periods, P2. Given a predicted dividend in two periods, D2, the stock

price in one period would be:

)1(

)( 221

R

PDP

If we were to substitute this expression for P1 into our expression for P0, we would have:

)1()1()1(221

221

221

110

11

)1(

)(

RRR

PDD

RR

PDD

R

PDP

Now we need to get a price in two periods. We don‘t know this either, so we can procrastinate

again and write:

)1(

)( 332

R

PDP


If we substitute this back in for P2, we have:

You should start to notice that we can push the problem of coming up with the stock price off

into the future forever. It is important to note that no matter what the stock price is, the present

value is essentially zero if we push the sale of the stock far enough away. What we are

eventually left with is the result that the current price of the stock can be written as the present

value of the dividends beginning in one period and extending out forever:

We have illustrated here that the price of the stock today is equal to the present value of all of

the future dividends. How many future dividends are there? In principle, there can be an

infinite number. This means that we still can‘t compute a value for the stock because we would

have to forecast an infinite number of dividends and then discount them all. In the next section,

we consider some special cases in which we can get around this problem.

General Formulas: R

PDP

ttt

1

11

The Present Value of Common Stocks Dividends versus Capital Gains

Valuation of Different Types of Stocks

Zero Growth

Constant Growth

Differential Growth

Case 1: Zero Growth

Assume that dividends will remain at the same level forever

DivDivDivDiv ....321

Since future cash flows are constant, the value of a zero growth stock is the present

value of perpetuity:

....)1()1()1(3

32

21

1 r

Div

r

Div

r

DivPo


r

Divpo

Example: The preferred stock of Denver Savings and Loan pays an annual

dividend of $5.60. It has a required rate of return of 8 percent. Compute the price of the preferred stock.

r

Divpo = 70$

08.0

60.5$

Case 2: Constant Growth

Assume that dividends will grow at a constant rate, g, forever. i.e.

)1(

.............................

)1)](1([)1(

)1(

1

0

012

1

)1(

)1(2

gDivDiv

DivDiv

DivggDivgDivDiv

gDivDiv

tt

t

o

o

g

g

t

Po = grT

T Div

r

Div

r

Div

r

Div

r

Div

1.........................3

32

21

1

)1()1()1()1(

groDiv

P

1 OR

gr

Div

gr

gDivPt tt

1)1(

Notes: grR

Example: 1) Suppose Do is $ 2.30, r is 13 % and g is 5%. The price per share in this case is:

2) Price of stock as of time. Now we need to compute P5 of stock. First need

the dividend at time 5. The dividend just paid is $ 2.30 and the growth rate is

5% per year, D5 is

53.38$05.13.

05.1935.2$155

gr

gDP

gr

gDivPo

)1(0

19.30$)/(1 grgDoPo

935.2$05.130.2$5 5 D


3 Gordon Growth Company will be $4 per share. Investors require a 16 % return

on companies such as Gordon. Gordon‗s dividend increases by 6% every year.

Base on the dividend growth model, what is the value of Gordon‗s stock

today? What is the value in four years?

40$06.16.

4$1

gr

DPo

P4 ? D4=D1x (1+g)

3

50.50$06.16./06.1764.4$/144 grgDP

Alternative: 50.50$06.140$14 44 gPoP

Case 3: Differential Growth or Supernormal Growth

Assume that dividends will grow at different rates in the foreseeable future and then

will grow at a constant rate thereafter.

To value a Differential Growth Stock, we need to:

Estimate future dividends in the foreseeable future.

Estimate the future stock price when the stock becomes a Constant Growth

Stock (case 2).

Compute the total present value of the estimated future dividends and future

stock price at the appropriate discount rate.

If the dividend grows steadily after t periods, then the price can be written as:

gr

gT

Twhere

TT

TTPo

DivP

r

P

r

Div

r

Div

r

Div

)1(.............

22

11

)1()1()1()1(

Ex- Required return is 10 % per year.

Nonconstant growth Constant growth at 5 %

Time 0 1 2 3 4 5

Dividends $1 $2 $2.5 $2.5 $2.5

5 x 1.052

)/(133 grgDP = $2.50 x 1.05/(.10 - .05 ) = $ 52.50

Components of the Required Return

Dividend yield : A stock‗s expected cash dividend divided by its current price.

Example: Suppose we observe a stock selling for $20 per share. The next dividend will be$1

per share. You think that the dividends will growth by 10 percent per year more or less

indefinitely. What return does this stock offer you if this is correct?

88.43$

10.1

50.52

10.1

50.2

10.1

2

10.1

1$

)1(

3

)1(

3

1

2

)1(

1332332

r

P

r

D

r

D

r

DPo


%15%1020

1$

0

1 gP

rDiv

Stock Market Reporting If you look through the pages of The Wall Street Journal www.wsj.com (or other financial newspaper),

you will find information on a large number of stocks in several different markets. It is shown in

Figure 5: Stock Market Reporting

Web Resources

www.finpipe.com

www.investinginbonds.com

www.bloomberg.com/markets/C13.html

www.bondmarkets.com/publications/IGCORP/what.htm

www.moodys.com

www.standardandpoors.com/ratings

www.ganesha.org/invest/index.html

www.nasdaq.com

www.nyse.com

www.fool.com/School/HowtoValueStocks.htm

www.zacks.com

Investools.com

www.morningstar.net

www.brill.com

End of Chapter 4

gPo

Dr

gr

gDoPo

1)1(

Figure 5: Stock Market Reporting

http://www.wsj.com/

http://www.finpipe.com/

http://www.investinginbonds.com/

http://www.bloomberg.com/markets/C13.html

http://www.bondmarkets.com/publications/IGCORP/what.htm

http://www.moodys.com/

http://www.standardandpoors.com/ratings

http://www.ganesha.org/invest/index.html

http://www.ganesha.org/invest/index.html

http://www.nasdaq.com/

http://www.nyse.com/

http://www.fool.com/School/HowtoValueStocks.htm

http://www.zacks.com/

http://investools.com/

http://www.morningstar.net/

http://www.morningstar.net/

http://www.brill.com/

http://www.brill.com/


Solved Problems

P4-1. The preferred stock of Denver Savings and Loan pays an annual

dividend of $5.60. It has a required rate of return of 8 percent. Compute

the price of the preferred stock. P4-2. X-Tech Company issued preferred stock many years ago. It carries

a fixed dividend of $5.00 per share. With the passage of time, yields have soared from the original 5 percent to 12 percent (yield is the same as

required rate of return). a) What is the original issue price?

b) What is the current value of this preferred stock? P4-3. Grant Hillside Homes, Inc., has preferred stock outstanding that

pays an annual dividend of $9.80. Its price is $110. What is the required rate of return (yield) on the preferred stock? P4-4: Consider the stock of Davidson Company that will pay an annual dividend of $ 2 in the

coming year. The dividend is expected to grow at a constant rate of 5 percent permanently.

The market requires a 12-percent return on the company.

What is the current price of a share of the stock?

P4-5: The Brigapenski Co. has just paid a cash dividend of $2 per share. Investors require a

16 percent return from investments such as this. If the dividend is expected to grow at a steady

8 percent per year, what is the current value of the stock? What will the stock be worth in five

years?

P4-6: In problem P4-5 what would the stock sell for today if the dividend was expected to

grow at 20 percent per year for the next three years and then settle down to 8 percent per year,

indefinitely?

P4-7. Favre, Inc., just paid a dividend of $2 per share on its stock. The dividends are expected

to grow at a constant rate of 5 percent per year, indefinitely. If investors require a 12 percent

return on Favre stock, what is the current price? What will the price be in three years? In 15

years.

P4-8. The next dividend payment by SAF, Inc. will be $3 per share. The dividends are

anticipated to maintain a 6 percent growth rate, forever. If SAF stock currently sells for $48.00

per share, what is the required return?

P4-9. Madonna Corporation will pay a $4.00 per share dividend next year. The company

pledges to increase its dividend by 3 percent per year, indefinitely. If you require a 14 percent

return on your investment, how much will you pay for the company‘s stock today?

P4-10. Chain Reaction, Inc., has been growing at a phenomenal rate of 30 percent per year

because of its rapid expansion and explosive sales. You believe that this growth rate will last

three year more years and that the rate will then drop to 10 percent per year. If the growth rate

then remains at 10 percent indefinitely, what is the total value of the stock? Total dividends

just paid were $5 million, and the required return is 20 percent.

P4-11. Mega Growth Co. is growing quickly. Dividends are expected to grow at a 30 percent

rate for the next three years, with the growth rate falling off to a constant 7 percent, thereafter.

If the required rate of return is 21 percent and the company just paid a $1.50 dividend, what is

the current share price?

P4-12. You have found the following stock quote for RJW Enterprises, Inc., in the financial

pages of today‘s newspaper. What was the closing price for this stock that appeared in

yesterday‘s paper? If the company currently has one million shares of stock outstanding, what

was net income for the most recent four quarters?


P4-131

Rainbow Rentals pays a constant annual dividend of $1.00 per share on their common stock.

How much are you willing to pay for one share of this stock if you want to earn a 9% rate of

return?

P3-14

Bits ‗n Pieces pays a constant annual dividend of $.50 a share. The market price of the stock is

$5.41 today. What is the rate of return on this stock?

P4-15

The common stock of Kathy‘s Antiques, Etc. is priced at $12.50 a share. The stock provides a

10% rate of return. The company pays a constant dividend.

What is the amount of the annual dividend?

P4-16

JLE, Inc. just paid their annual dividend of $1.10 a share. JLE‘s policy is to increase the

dividend by 2% annually.

How much are you willing to pay today for a share of this stock if you require an 11% rate of

return?

P4-17

SLG, Inc. announced today that they will be increasing their annual dividend to $1.60 per

share next year. After that, they expect to increase the dividend by 3% annually. You want to

buy shares of stock in this company but cannot afford to do so for another two years. At that

time, you will buy shares if you can earn a 12% rate of return.

How much will you be willing to pay for one share of this stock two years from today?

P4-18

Alex‘s Ventures, Inc. stock has a 13% rate of return and a current market price of $16.18. The

company pays annual dividends. The last dividend paid was $1.40 per share.

What is the growth rate of this stock?

P4-19

C and F Fabrics is going to pay an annual dividend of $1.36 per share next week. The

dividends have been increasing by 2% annually and this trend is expected to continue. The

stock is selling for $15.11 per share.

What is the market rate of return on this stock?

P4-20

The Thomas Co. is in a declining industry and has just announced that they will be reducing

their annual dividend by 2% annually from now on. The last dividend they paid was $1.60. The

market rate of return on this stock is 6%.

What is the market price of one share of Thomas Co. stock?

P4-21

Isaac‘s Shoes just announced that they will commence paying annual dividends next year. The

plan is to pay $.50, $.75 and $1.00 per share over the next three years, respectively. After that

the company plans on increasing the dividend by 2.5% annually. The market rate of return on

this stock is 12.5%.

What should the market price of this stock be?

P4-22

Nu-Tek, Inc. just paid their annual dividend of $1.20 per share. The company has stated that

dividends will increase by 20% a year for the next two years. After that, the dividends will

increase by 4% annually.

What is one share of this stock worth today if the required return is 14%?

P4-23

RPJ, Inc. is currently reinvesting all of their earnings back into the company. They predict that

they will pay their first annual dividend five years from now in the amount of $1.00 per share.

After that, they will increase the dividends by 2% annually.

1 P4-13 –P4-27 FCF ( Disk 2006) of RWJ


How much are you willing to pay for one share of this stock today if you require a 15% rate of

return?

P4-24

The common stock of Flo‘s Home Furnishings has a 3.5% dividend yield. You expect the

company to grow by 6% annually.

What is the required return on this stock?

P4-24

The common stock of Roy‘s Outdoor Sports Store has a market rate of return of 17.5% and a

market price of $15.00 per share. Roy‘s will pay their annual dividend next week in the

amount of $2.10 per share.

What is the capital gains yield on this stock?

P4-25

The common stock of Viola‘s Flowers, Inc. has a required return of 12.25% and a growth rate

of 8%. The stock has a current market price of $32.94 a share.

What is the amount of the next annual dividend?

P4-26

The 7% preferred stock of Lamey, Inc. is priced to yield a 12.5% rate of return.

What is the market price of this stock?

P4-27

ABC Co. stock closed today at a price of $48.24. The price-earnings (P/E) ratio is 18 and the

dividend yield is 2.1%.

What is the amount of the earnings per share?

What is the amount of the annual dividend?

P4-28

You found the following stock quote for DRK Enterprises, Inc., in the financial pages of

today‘s newspaper. What was the closing price for this stock that appeared in yesterday‘s

paper? How many round lots of stock were traded yesterday?

P4-29

In the P4-28, assume the company has five million shares of stock outstanding. What was the

net income for the most recent four quarters?

Chapter Quiz

1

The common stock of Wells Moving Co. is selling for $28.95 a share and offers a 7.9 percent rate of return. If the dividend growth rate is constant at 2.5 percent, what is the next dividend expected to be?

A) $1.25

B) $1.38

C) $1.43

D) $1.56

2

Concrete Rail Ties recently announced that it will pay its first annual dividend next year in


the amount of $0.45 a share. The dividend will be increased by 4 percent annually thereafter. How much are you willing to pay today for one share of this stock if you require a 10 percent rate of return?

A) $6.50

B) $6.80

C) $7.50

D) $8.65

3

A market maker who operates at a post on the floor of the NYSE is called a:

A) specialist.

B) floor broker.

C) floor trader.

D) commission broker.

4

Dry Goods and More is expected to pay annual dividends of $1.15, $1.20, and $1.35 a share over the next three years, respectively. After that, the dividend is expected to increase by 2.5 percent annually. What is one share of this stock worth today if similar stocks are yielding a 9.5 percent return?

A) $18.14

B) $18.78

C) $19.26

D) $19.73

5

Which one of the following is used to appoint an individual to vote on your behalf at a shareholder's meeting?

A) post

B) proxy

C) DOT

D) yield

6

You own 100 shares of noncumulative, nonvoting, 8 percent preferred stock. Which one of the following statements is correct given this information?

A) The stock pays 8 percent of $1,000 as the annual dividend.

B)

You are guaranteed to receive $800 of dividend income each year that you own these shares.

C) If the issuer skips multiple dividend payments, you may receive voting rights.

D)

If the issuer skips one or more dividend payments, you will receive those payments prior to any common stock dividends being distributed.

7

Dixie South just paid an annual dividend of $1.20 per share. The firm is expected to increase its dividend by 4 percent per year for the next 3 three years. After that, the dividend is expected to increase by 2.5 percent each year indefinitely. What is one share

of this stock worth today at a discount rate of 12 percent?

A) $12.21

B) $12.54

C) $13.01

D) $13.48


8

Bennington Brothers has 175,000 shares of stock outstanding with a market price of $12.70 a share. You currently own 40,000 of these shares. The company has 3 open

positions on its board of directors and uses cumulative voting. You realize that no one else will vote for you but you still want to be elected to the board. How much must you spend to purchase sufficient shares to guarantee your election?

A) $0

B) $47,638

C) $232,846

D) $555,638

9

The Hen's Nest just paid an annual dividend of $0.82 a share. What will the dividend be in year 4 if the dividend growth rate is 3 percent?

A) $0.88

B) $0.92

C) $0.96

D) $1.00

10

Which one of the following statements related to equity securities is correct?

A)

Preferred shareholders generally receive two votes for every one vote granted to

a common shareholder.

B) If a dividend payment is missed on a cumulative preferred stock, the issuer must pay the missed dividend prior to paying any common stock dividends.

C) Dividend income received by an individual is exempt from federal taxation.

D) The dividend growth model can be used to determine the value of any individual stock.

End of the Problems


Capital Budgeting

Chapter 5. Net Present Value and Other Investment Criteria

Chapter Outline

• Net present value

• Payback

• Internal rate of return

• Crossover point

• Profitability index

• Mutually exclusive projects

• Multiple independent projects

After studying this chapter, you should have a good understanding of:

LO1 The reasons why the net present value criterion is the best way to

evaluate proposed investments.

LO2 The payback rule and some of its shortcomings.

LO3 The discounted payback rule and some of its shortcomings.

LO4 Accounting rates of return and some of the problems with them.

LO5 The internal rate of return criterion and its strengths and weaknesses.

LO6 The modified internal rate of return.

LO7 The profitability index and its relation to net present value.


What is Capital Budgeting?

Capital Budgeting: represents a long-term investment decision

for example, buy a new computer system or build a new plant

involves the planning of expenditures for a project with a life of 1 or

more years

emphasizes amounts and timing of cash flows and opportunity costs

and benefits

investment usually requires a large initial cash outflow with

the expectation of future cash inflows

considers only those cash flows that will change as a result of the

investment all cash flows are calculated aftertax

1. Net present value

Why Use Net Present Value? Accepting positive NPV projects benefits shareholders.

NPV uses cash flows

NPV uses all the cash flows of the project

NPV discounts the cash flows properly

The Net Present Value (NPV) Rule

Net Present Value (NPV) =

Total PV of future CF’s + Initial Investment

CoT

ii

iNPVORT

ii

i

r

CC

r

C

1

01 )1()1(

Estimating NPV:

1. Estimate future cash flows: how much? And when?

2. Estimate discount rate

3. Estimate initial costs

Minimum Acceptance Criteria: Accept if NPV > 0

Ranking Criteria: Choose the highest NPV

Good Attributes of the NPV Rule

1. Uses cash flows

2. Uses ALL cash flows of the project

3. Discounts ALL cash flows properly

Reinvestment assumption: the NPV rule assumes that all cash flows can be reinvested

at the discount rate.

Example:

You are considering a project which requires an initial investment of $24,000. The project

will produce cash inflows of $8,000, $9,800, $7,600 and $6,900 over the next four years,

respectively.

What is the net present value of this project if the required rate of return is 12%?


Should this project be accepted?

NPV = $749.96 accept this project.

2. Payback

How long does it take the project to “pay back” its initial investment?

Payback Period = number of years to recover initial costs

Minimum Acceptance Criteria:

set by management

Ranking Criteria:

set by management

Disadvantages:

Ignores the time value of money

Ignores cash flows after the payback period

Biased against long-term projects

Requires an arbitrary acceptance criteria

A project accepted based on the payback criteria may not have a positive NPV

Advantages:

Easy to understand

Biased toward liquidity

Example: A project has an initial cost of $199,000. The project produces cash inflows of

$46,000, $54,000, $57,500, $38,900 and $46,500 over the next five years, respectively.

What is the payback period for this project?

Should the project be accepted if the required payback period is 3 years?

Year Cash flow Cumulative cash flow

1 $46,000 $ 46,000

2 $54,000 $100,000

3 $57,500 $157,500

4 $38,900 $196,400

5 $46,500 $242,900

Accept the project

3. The Internal Rate of Return (IRR) Rule

IRR: the discount that sets NPV to zero


Accept if the IRR exceeds the required return.

Ranking Criteria:

96.749$

07.385,4$53.409,5$50.812,7$86.142,7$000,24$

4)12.1(

900,6$

3)12.1(

600,7$

2)12.1(

800,9$

1)12.1(

000,8$000,24$

NPV

yearsPayback 06.40559.4500,46$

600,2$

500,46$

400,196$000,199$4


Select alternative with the highest IRR

Reinvestment assumption:

All future cash flows assumed reinvested at the IRR.

Disadvantages:

Does not distinguish between investing and borrowing.

IRR may not exist or there may be multiple IRR

Problems with mutually exclusive investments

Advantages:

Easy to understand and communicate

0C0NPVT

1ii

i

IRR)(1

C

Example: Consider the following project:

The internal rate of return for this project is 19.44%

The NPV Payoff Profile for This Example

If we graph NPV versus discount rate, we can see the IRR as the x-axis intercept.

Note: Mutually Exclusive Projects: only ONE of several potential

projects can be chosen, e.g. acquiring an accounting system.

RANK all alternatives and select the best one.

200IRR)(1

$150

IRR)(1

$100

IRR)(1

$500NPV

32

($60.00)

($40.00)

($20.00)

$0.00

$20.00

$40.00

$60.00

$80.00

$100.00

$120.00

-1% 9% 19% 29% 39%

Discount rate

NP

V

Discount Rate NPV

0% $100.00

4% $71.04

8% $47.32

12% $27.79

16% $11.65

20% ($1.74)

24% ($12.88)

28% ($22.17)

32% ($29.93)

36% ($36.43)

40% ($41.86)


Independent Projects: accepting or rejecting one project does not affect

the decision of the other projects.

Must exceed MINIMUM acceptance criteria.

The Profitability Index (PI) Rule


Accept if PI > 1

Ranking Criteria:

Select alternative with highest PI

Disadvantages:

Problems with mutually exclusive investments

Advantages:

May be useful when available investment funds are limited

Easy to understand and communicate

Correct decision when evaluating independent projects

The Practice of Capital Budgeting Varies by industry:

Some firms use payback, others use accounting rate of return.

The most frequently used technique for large corporations is IRR or NPV.

Example of Investment Rules

Compute the IRR, NPV and payback period for the following two projects. Assume the

required return is 10%.

Year Project A Project B

0 -$200 -$150

1 $200 $50

2 $800 $100

3 -$800 $150

Project A Project B

CF0 -$200.00 -$150.00

PV0 of CF1-3 $241.92 $240.80

NPV = $41.92 $90.80

IRR = 0%, 100% 36.19%

PI = 1.2096 1.6053

Net Present Value Profile

Net Present Value Profile:

0C

NPV1

Investent Initial

FlowsCash Future of PV TotalPI


a graph of the NPV of a project at different discount rates shows the NPV

at 3 different points:

a zero discount rate

the normal discount rate (or cost of capital)

the IRR

allows an easy way to visualize whether or not an investment should be

undertaken

Net Cash Inflows

(of a $10,000 investment)

Year Investment A Investment B investment C

1...... $5,000 $1,500 $9,000

2.... 5,000 2,000 3,000

3...... 2,000 2,500 1,200

4................................... 5,000

5.................................. 5,000

Cost of capital r =10%


Accept/Reject Decision Payback Period (PP):

if PP < cutoff period, accept the project

if PP > cutoff period, reject the project

Internal Rate of Return (IRR):

if IRR > cost of capital, accept the project

if IRR < cost of capital, reject the project

Net Present Value (NPV):

if NPV > 0, accept the project

if NPV < 0, reject the project

Compute NPV and IRR in Microsoft Excel

1) Find NPV:

=npv(rate, value1,[value2],...)

=npv(r,C1...Cn)+Co

2) Find IRR:

=irr(values,[guess])

=irr(Co...Cn)

Addition:

Use The MS Excel: FV and PV

FV( rate, nper, pmt,[pv],[type]) where:

-rate: CaGRtakarR)ak;kñúgRKa


Nper: cMnYnRKa

Pmt: CacMnYnTwkR)ak;Edlbg;tamkalnImYy²

PV: CatMélbc©úb,nñ

Type: sMrab;kMNt;ry³eBlCak;EsþgEdleyIgRtUvbg;EdlmanCMerIsBI KW 0 nig 1

Edl 0 eRbIsMrab;krNIbg;cugRKa

1 eRbIsMrab;krNIbg;edImRKa

Single Amount of FV and PV

You should type the formula:

=fv( rate,nper,0, -pv, 0)

=pv(rate, nper,0,-fv,0)

Annuity a) Ordinary of FVA

=fv(rate,nper, -pv,0,0)

b) FVA of Annuity Due:

=fv(rate, nper,-pv,0,1)

a) Ordinary of PVA

=pv(rate,nper,-pv,0,0)

b)PVA of Annuity Due:

=pv(rate, nper,-pv,0,1)

Web Resources

www.nacubo.org/website/members/bomag/cbg396.htmlA good article

showing how capital budgeting is used in decision making

asbdc.ualr.edu/fod/1518.htm

How NPV analysis helps answer business questions

www.eastcentral.ab.ca/Courses/budgeting.html

Putting project cost analysis in perspective

End of Chapter 5

http://www.nacubo.org/website/members/bomag/cbg396.html

http://www.nacubo.org/website/members/bomag/cbg396.html

http://asbdc.ualr.edu/fod/1518.htm#4

http://asbdc.ualr.edu/fod/1518.htm#4

http://www.eastcentral.ab.ca/Courses/budgeting.html

http://www.eastcentral.ab.ca/Courses/budgeting.html


Problems on Chapter 5

P5-1: This problem will give you some practice calculating NPVs and paybacks. A proposed

overseas expansion has the following cash flows:

Year Cash Flow

0 -$200

1 $50

2 $60

3 $70

4 $200

Calculate the payback period IRR, PI, and the NPV at a required return of 10 percent.

P5-2: Fuji Software, Inc. has the following projects.

Year Project A Project B

0 -$7,500 -$5,000

1 $4,000 $2,500

2 $3,500 $1,200

3 $1,500 $3,000

a. Suppose Fuji‘s cutoff payback period is two years. Which of these two projects should

be chosen?

b. Suppose Fuji‘s uses the NPV rule to rank these two projects. If the approximate

discount rate is 15 percent, which the project should be chosen?

c. Computer PIA, and PIB

P5-3: CPC, Inc. has a project with the following cash flows.

Year Cash Flows ($)

0 -8,000

1 4,000

2 3,000

3 2,000 a) Compute the internal rate of return (IRR) on the project.

b) Suppose the approximate discount rate is 8 percent. Should the project be adopted by

CPC?

P5-4: Assume a $40,000 investment and the following cash flows for two alternatives:

Years Investment X Investment Y

1 $6,000 $15,000

2 8,000 20,000

3 9,000 10,000

4 17,000 ____

5 20,000 ____


Which of the alternative would you select under the payback method? If the inflow in the fifth

year for Investment X were $20,000,000 instead of $20,000, would your answer change under

the payback method?

P5-5: Elgin Restaurant Supplies is analyzing the purchase of manufacturing equipment that

will cost $20,000. The annual cash inflows for the next three years will be:

Year Cash Flow

1 $ 10,000

2 9,000

3 6,500

Determine the internal rate of return (IRR) using interpolation.

With a cost of capital of 20 percent, should the machine be purchased?

P5-:6 ) Project M has a cost of $35,000, and its expected net cash inflows are $9,000 per year

for 6 years.

a. What is the project‘s payback (to the closest year)?

b. The cost of capital is 12 percent. What is the project‘ net present value (NPV) ?

c. What is the project‘s internal rate of return (IRR)? (Hint: Recognize that the project

is an annuity.)

P5-7 : The Danforth Tire Company is considering the purchase of a new machine that would

increase the speed of manufacturing and save money. The net cost of this machine is $66, 000.

The annual cash flows have the following projections.

Year Cash Flows

1 $21,000

2 29,000

3 36,000

4 16,000

5 8,000

a) If the cost of capital is 10 percent, what is the net present value (NPV)?

b) What is the internal rate of return ( IRR)

c) Should the project be accepted? Why?

P5-8. What is the payback period for the following set of cash flows?

Year Cash Flow

0 -$2,500

1 $400

2 $1,600

3 $700

4 $300 P5-9. A firm evaluates all of its projects by applying the IRR rule. If the required return is 18

percent, should the firm accept the following project?


Year Cash Flow

0 -$30,000

1 $25,000

2 $0

3 $15,000

P5-10. For cash flows in problem P5-9, suppose the firm uses the NPV decision rule. At a

required return is 9 percent, should the firm accept this project? What if the required return was

19 percent?

P5-11. Generation X, Inc., has identified the following two mutually exclusive projects:

Year Cash Flow (A) Cash Flow (B)

0 -$11,000 -$11,000

1 $4,000 $1,000

2 $5,000 $6,000

3 $6,000 $5,000

4 $1,000 $5,000 a.) What is the IRR for each of these projects? If you apply the IRR decision rule, which project

should the company accept? Is this decision necessarily correct?

b.) If the required is 11 percent, what is the NPV for each of these projects? Which project will

you choose if you apply the NPV decision rule?

P5-12. Consider the following two mutually exclusive projects:

Year Cash Flow (A) Cash Flow (B)

0 -$180,000 -$18,000

1 $10,000 $10,000

2 $25,000 $5,000

3 $25,000 $3,000

4 $380,000 $2,000

Whichever project you choose, if any, you required a 15 percent return on your investment.

a) If you apply the payback criterion, which investment will you choose? Why?

b) If you apply the NPV criterion, which investment will you choose? Why?

c) If you apply the IRR criterion, which investment will you choose? Why?

P5-13.

Consider an investment which has the following cash flows:

Year Cash Flow ($)

0 (31,000)

1 10,000

2 20,000

3 10,000

4 10,000

5 5,000

a) Compute the: (1) payback period ;( 2) net present value (NPV); at 14 percent

cost of capital; and (3) internal rate of return (IRR).

b) Based on (2) and (3) in part (a), make a decision about the investment. Should

it be accepted or not?


P5-14

Consider the following two mutually exclusive projects:

Sketch the NPV profiles for X and Y over a range of discount rates from zero to 25 percent.

What is the crossover rate for these two projects?

P5-15

What is the profitability index for the following set of cash flows if the relevant discount rate is

10 percent? What if the discount rate is 15 percent? If it is 22 percent?

Chapter Quiz

1

Use the following information to answer the question.

You are analyzing a proposed project and have compiled the following information:

What is the net present value of this proposed project?

A) -$1,980

B) -$611

C) $867

D) $2,011

2




Should the proposed project be accepted based on its internal rate of return? Why or why not?

A) yes; IRR = 12.28 percent

B) yes; IRR = 11.79 percent

C) no; IRR = 12.28 percent

D) no; IRR = 11.79 percent

3

Use the following information to answer the question. You are analyzing a proposed project and have compiled the following information:

Should the proposed project be accepted based on its payback period? Why or why not?

A) yes; PB = 2.49 years

B) yes; PB = 2.51 years

C) no; PB = 2.49 years

D) no; PB = 2.51 years

4



What is the profitability index of the proposed project?

A) 0.97

B) 0.99

C) 1.01

D) 1.03

5

The Even Cut Co. is considering opening a new plant to produce lawn mowers. The initial cost of the project is $6 million. This cost will be depreciated straight-line to a zero book value over the 15-year life of the project. The net income of the project is expected to be $137,000 a year for the first four years and $538,000 for years 5 through 15, respectively. What is the average accounting return on this project?

A) 12.47 percent

B) 13.17 percent

C) 14.37 percent

D) 15.87 percent

6

Which one of the following indicates an accept decision for a project?


A) NPV = -$318

B) PI = 0.92

C) IRR = 15.6 percent; Required return = 15 percent

D) Payback = 3.31 years; Required payback = 3 years

7

The point where the net present values of two mutually exclusive projects are equal is

referred to as the:

A) profitability point.

B) crossover point.

C) payback point.

D) internal rate of return.

8

For an independent project, the NPV:

A) is the difference between the project's cost and its market value.

B)

generally indicates an accept/reject decision that conflicts with the internal rate of return accept/reject decision.

C) is the least favored method of project analysis from a finance perspective.

D) indicates an accept decision when it is negative.

9

Which one of the following statements correctly applies to the modified internal rate of return (MIRR)?

A) The MIRR is preferable to the IRR when a project has conventional cash flows.

B) The MIRR is used to evaluate projects that have negative NPVs.

C) The MIRR is another means of computing an accounting rate of return.

D)

The MIRR depends upon an external discount rate, an external compounding rate,

or both.

10

Which one of the following statements related to the profitability index (PI) is correct?

A) PI should be used to determine which one of two mutually exclusive projects should be accepted.

B) PI is the discount rate that makes the net present value equal zero.

C) There can be multiple PIs if the cash flows are unconventional.

D) PI is used to rank positive NPV projects when the available funds are limited.

Figure 1: Conceptual Framework ............................................................................................... 11

Figure 2: Functions of Financial Systems .................................................................................. 12 Figure 3 : Cash flows of Bond ................................................................................................... 41 Figure 4: Bond Quotes ............................................................................................................... 44 Figure 5: Stock Market Reporting .............................................................................................. 55


Glossary

Abnormal return Part of return that is not due to marketwide price movements.

Absolute priority Rule in bankruptcy proceedings whereby senior creditors are required to be paid in full before junior creditors receive any payment.

Accelerated depreciation

Any depreciation method that produces larger deductions for depreciation

in the early years of a project's life.

Accounts payable

(payables, trade debt)

Money owed to suppliers.

Accounts receivable (receivables, trade credit)

Money owed by customers.

Accrued interest Interest that has been earned but not yet paid.

ACH Automated Clearing House.

Acid-test ratio Quick ratio.

Adjusted present value (APV)

Net present value of an asset if financed solely by equity plus the present value of any financing side effects.

ADR American depository receipt.

Adverse selection A situation in which a pricing policy causes only the less desirable

customers to do business, e.g., a rise in insurance prices that leads only the worst risks to buy insurance.

Affirmative covenant Loan covenant specifying certain actions that the borrower must take.

Agency costs Losses that arise when an agent (e.g., a manager) does not act solely in the interests of the principal (e.g., the shareholder).

Agency theory Theory of the relationship between a principal, e.g., a shareholder, and an agent of the principal, e.g., the company's manager.

Aging schedule Summary of age of receivables that are outstanding from each customer.

AIBD Association of International Bond Dealers.

All-or-none

underwriting

An arrangement whereby a security issue is canceled if the underwriter is

unable to resell the entire issue.

Alpha Measure of portfolio return adjusted for effect of market.

Alternative minimum tax (AMT)

A separately calculated minimum amount of tax that must be paid by corporations or individuals.

American depository

receipt (ADR)

A certificate issued in the United States to represent shares of a foreign

company.

American option Option that can be exercised any time before the final exercise date

(cf. European option).

Amex American Stock Exchange.

Amortization (1) Repayment of a loan by installments; (2) allowance for depreciation.

AMT Alternative minimum tax.

Angel investor Wealthy individual who provides capital for small start-up businesses.

Annual percentage rate (APR)

The interest rate per period (e.g., per month) multiplied by the number of periods in a year.

Annuity Investment that produces a level stream of cash flows for a limited


number of periods.

Annuity due Annuity whose payments occur at the start of each period.

Annuity factor Present value of $1 paid for each of t periods.

Anticipation Arrangement whereby customers who pay before the final date may be entitled to deduct a normal rate of interest.

Appraisal rights A right of shareholders in a merger to demand the payment of a fair price

for their shares, as determined independently.

Appropriation request Formal request for funds for a capital investment project.

APR Annual percentage rate.

APT Arbitrage pricing theory.

APV Adjusted present value.

Arbitrage Purchase of one security and simultaneous sale of another to give a risk-free profit.

"Arbitrage" or "risk arbitrage"

Often used loosely to describe the taking of offsetting positions in related securities, e.g., at the time of a takeover bid.

Arbitrage pricing theory (APT)

Model in which expected returns increase linearly with an asset's sensitivity to a small number of pervasive factors.

Arranger Lead underwriter to a syndicated loan.

Articles of incorporation

Legal document establishing a corporation and its structure and purpose.

Asian currency units Dollar deposits held in Singapore or other Asian centers.

Asian option Option based on the average price of the asset during the life of the

option.

Asked price (offered price)

Price at which a dealer is willing to sell (cf. bid price).

Asset-backed securities

Securities issued by a special purpose company that holds a package of assets whose cash flows are sufficient to service the bonds.

Asset stripper Acquirer who takes over firms in order to sell off a large part of their

assets.

Asymmetric information

Difference in information available to two parties, e.g., a manager and investors.

At-the-money option Option whose exercise price equals the current asset price (cf. in-the-

money option, out-of-the-money option).

Auction market Securities exchange in which prices are determined by an auction process, e.g., NYSE (cf. dealer market).

Auction-rate preferred

A variant of floating-rate preferred stock where the dividend is reset every

49 days by auction.

Authorized share capital

Maximum number of shares that a company can issue, as specified in the firm's articles of incorporation.

Automated Clearing House (ACH)

Private electronic system run by banks for high-volume, low-value payments.

Automatic debit Direct payment.

Availability float Checks deposited by a company that have not yet been cleared.

Aval Bank guarantee for debt purchased by forfaiter.

Backwardation Condition in which spot price of commodity exceeds price

of future (cf. contango).


Balloon payment Large final payment (e.g., when a loan is repaid in installments).

Bank discount Interest deducted from the initial amount of a loan.

Banker's acceptance (BA)

Written demand that has been accepted by a bank to pay a given sum at a future date (cf. trade acceptance).

Barrier option Option whose existence depends on asset price hitting some specified

barrier (cf. down-and-out option, down-and-in option).

Basel Accord International agreement on the amount of capital to be maintained by large banks to support their risky loans.

Basis point (bp) .01%.

Basis risk Residual risk that results when the two sides of a hedge do not move exactly together.

Bearer security Security for which primary evidence of ownership is possession of the certificate (cf. registered security).

Bear market Widespread decline in security prices (cf. bull market).

Behavioral finance Branch of finance that stresses aspects of investor irrationality.

Benchmark maturity Maturity of a newly issued Treasury bond.

Benefit–cost ratio One plus profitability index.

Bermuda option Option that is exercisable on discrete dates before maturity.

Best-efforts underwriting

An arrangement whereby underwriters do not commit themselves to

selling a security issue but promise only to use best efforts.

Beta Measure of market risk.

Bid price Price at which a dealer is willing to buy (cf. asked price).

Big Board Colloquial term for the New York Stock Exchange.

Bill of exchange General term for a document demanding payment.

Bill of lading Document establishing ownership of goods in transit.

Binomial method Method for valuing options that assumes there are only two possible

changes in the asset price in any one period.

Blue-chip company Large and creditworthy company.

Blue-sky laws State laws covering the issue and trading of securities.

Boilerplate Standard terms and conditions, e.g., in a debt contract.

Bond Long-term debt.

Bond rating Rating of the likelihood of bond's default.

Bookbuilding The procedure whereby underwriters gather nonbinding indications of

demand for a new issue.

Book entry Registered ownership of stock without issue of stock certificate.

Book runner The managing underwriter for a new issue. The book runner maintains the

book of securities sold.

Bought deal Security issue where one or two underwriters buy the entire issue.

BP Basis point.

Bracket A term signifying the extent of an underwriter's commitment in a new

issue, e.g., major bracket, minor bracket.

Break-even analysis Analysis of the level of sales at which a project would just break even.


Bridge loan Short-term loan to provide temporary financing until more permanent financing is arranged.

Bull–bear bond Bond whose principal repayment is linked to the price of another security. The bonds are issued in two tranches: In the first the repayment increases

with the price of the other security; in the second the repayment decreases with the price of the other security.

Bulldog bond Foreign bond issue made in London.

Bullet payment Single final payment, e.g., of a loan (in contrast to payment in installments).

Bull market Widespread rise in security prices (cf. bear market).

Butterfly spread The purchase of two call options with different exercise prices and

simultaneous sale of two calls exercisable at the average of these two exercise prices. Provides a bet that the share price will stay within a narrow range.

Bund Long-term German government bond.

Buyback Repurchase agreement.

Cable The exchange rate between U.S. dollars and sterling.

Call option Option to buy an asset at a specified exercise price on or before a specified exercise date (cf. put option).

Call premium (1) Difference between the price at which a company can call its bonds and their face value; (2) price of a call option.

Call provision Provision that allows an issuer to buy back the bond issue at a stated

price.

Cap An upper limit on the interest rate on a floating-rate note.

CAPEX Capital expenditure.

Capital asset pricing model (CAPM)

Model in which expected returns increase linearly with an asset's beta.

Capital budget List of planned investment projects, usually prepared annually.

Capitalization Long-term debt plus preferred stock plus net worth.

Capital lease Financial lease.

Capital market Financial market (particularly the market for long-term securities).

Capital market line A plot of the set of portfolios with the highest Sharpe ratio. The line passes

through the riskfree interest rate and the tangent efficient portfolio of risky

assets.

Capital rationing Shortage of funds that forces a company to choose between worthwhile projects.

Capital structure Mix of different securities issued by a firm.

CAPM Capital asset pricing model.

Captive finance

company

Subsidiary whose function is to provide finance for purchases from the

parent company.

Caput option Call option on a put option.

CAR Cumulative abnormal return.

CARDs (Certificates for Amortizing Revolving Debt)

Pass-through securities backed by credit card receivables.

Carried interest A proportion of the profits to which private equity partnerships, etc. are


entitled.

Carry trade Borrowing in country with low interest rate to relend in another country

with a higher rate.

CARs (Certificates of

Automobile Receivables)

Pass-through securities backed by automobile receivables.

Carve-out Public offering of shares in a subsidiary.

Cascade Rational herding in which each individual deduces that previous decisions by others may have been based on extra information.

Cash and carry Purchase of a security and simultaneous sale of a future, with the balance

being financed with a loan or repo.

Cash budget Forecast of sources and uses of cash.

Cash cow Mature company producing a large free cash flow.

Cash cycle The time from a firm's payment for raw materials until the payment for the finished product from the customer.

Cash-deficiency arrangement

Arrangement whereby a project's shareholders agree to provide the operating company with sufficient net working capital.

Catastrophe bond (CAT bond)

Bond whose payoffs are linked to a measure of catastrophe losses such as

insurance claims.

CAT bond Catastrophe bond.

CBD Cash before delivery.

CD Certificate of deposit.

CDS Credit default swap.

CEO Chief executive officer.

Certainty equivalent A certain cash flow that has the same present value as a specified risky cash flow.

Certificate of deposit (CD)

A certificate providing evidence of a bank time deposit.

CFTC Commodity Futures Trading Commission.

CFO Chief financial officer.

Chaebol A Korean conglomerate.

Chapter 7 Bankruptcy procedure whereby a debtor's assets are sold and the proceeds are used to repay creditors.

Chapter 11 Bankruptcy procedure designed to reorganize and rehabilitate defaulting firm.

Check conversion When customer writes a check, information is automatically captured and his bank account immediately debited.

Check 21 Check Clearing for the 21st Century Act allows banks to process checks electronically.

CHIPS Clearinghouse Interbank Payments System.

Chooser option Holder decides whether it is a call option or put option.

Clean price (flat price)

Bond price excluding accrued interest (cf. dirty price).

Clearinghouse Interbank Payments System (CHIPS)

An international wire transfer system operated by a group of major banks for high-value dollar payments.


CLO Collateralized loan obligation. Also CDO (collateralized debt obligation) and

CMO (collateralized mortgage obligation).

Closed-end fund Company whose assets consist of investments in a number of industrial and commercial companies.

Closed-end mortgage Mortgage against which no additional debt may be issued (cf. open-end

mortgage).

CMOs Collateralized mortgage obligations.

COD Cash on delivery.

Collar An upper and lower limit on the interest rate on a floating-rate note.

Collateral Assets that are given as security for a loan.

Collateralized loan

obligation (CLO)

A security backed by a pool of loans and issued in tranches with different

levels of seniority.

Collateralized

mortgage obligations (CMOs)

A variation on the mortgage pass-through security in which the cash flows

from a pool of mortgages are repackaged into several tranches of bonds with different maturities.

Collateral trust bonds Bonds secured by common stocks or other securities that are owned by

the borrower.

Collection float Customer-written checks that have not been received, deposited, and added to the company's available balance (cf. payment float).

Commercial draft (bill of exchange)

Demand for payment.

Commercial paper Unsecured notes issued by companies and maturing within nine months.

Commitment fee Fee charged by bank on an unused line of credit.

Common-size financial

statements

Balance sheet where entries are expressed as proportion of total assets

and income statement where entries are expressed as a proportion of revenues.

Common stock Security representing ownership of a corporation.

Company cost of capital

The expected return on a portfolio of all the firm's securities.

Compensating balance

Non-interest-bearing demand deposits to compensate banks for bank loans or services.

Competitive bidding Means by which public utility holding companies are required to choose

their underwriter (cf.negotiated underwriting).

Completion bonding Insurance that a construction contract will be successfully completed.

Composition Voluntary agreement to reduce payments on a firm's debt.

Compound interest Reinvestment of each interest payment on money invested to earn more interest (cf. simple interest).

Compound option Option on an option.

Concentration banking

System whereby customers make payments to a regional collection center. The collection center pays the funds into a regional bank account and surplus money is transferred to the company's principal bank.

Conditional sale Sale in which ownership does not pass to the buyer until payment is completed.

Conglomerate merger Merger between two companies in unrelated businesses (cf. horizontal

merger, vertical merger).

Consol Name of a perpetual bond issued by the British government. Sometimes


used as a general term for perpetuity.

Contango Condition in which spot price of a commodity is below that of the future (cf. backwardation).

Contingent claim Claim whose value depends on the value of another asset.

Contingent project Project that cannot be undertaken unless another project is also undertaken.

Continuous compounding

Interest compounded continuously rather than at fixed intervals.

Controller Officer responsible for budgeting, accounting, and auditing in a firm (cf. treasurer).

Convenience yield The extra advantage that firms derive from holding the commodity rather than the future.

Conversion price Par value of a convertible bond divided by the number of shares into which

it may be exchanged.

Conversion ratio Number of shares for which a convertible bond may be exchanged.

Convertible bond Bond that may be converted into another security at the holder's option.

Similarly convertiblepreferred stock.

Convexity In a plot of a bond „s price against the interest rate, convexity measures

the curvature of the line.

Corporate venturing Practice by which a large manufacturer provides financial support to new companies.

Corporation A business that is legally separate from its owners.

Correlation coefficient

Measure of the closeness of the relationship between two variables.

Cost company

arrangement

Arrangement whereby the shareholders of a project receive output free of

charge but agree to pay all operating and financing charges of the project.

Cost of (equity)

capital

Opportunity cost of capital.

Counterparty Party on the other side of a derivative contract.

Coupon (1) Specifically, an attachment to the certificate of a bearer security that

must be surrendered to collect interest payment; (2) more generally, interest payment on debt.

Covariance Measure of the co-movement between two variables.

Covenant Clause in a loan agreement.

Covered option Option position with an offsetting position in the underlying asset.

Cramdown Action by a bankruptcy court to enforce a plan of reorganization.

Credit default swap (CDS)

Credit derivative in which one party makes fixed payments while the

payments by the other party depend on the occurrence of a loan default.

Credit derivative Contract for hedging against loan default or changes in credit risk

(e.g., credit default swap).

Credit rating Debt rating assigned by a rating agency such as Moody's or Standard & Poor's.

Credit scoring A procedure for assigning scores to borrowers on the basis of the risk of default.

Cross-default clause Clause in a loan agreement stating that the company is in default if it fails to meet its obligation on any other debt issue.


Cum dividend With dividend.

Cum rights With rights.

Cumulative preferred stock

Stock that takes priority over common stock in regard to dividend

payments. Dividends may not be paid on the common stock until all past dividends on the preferred stock have been paid.

Cumulative voting Voting system under which a stockholder may cast all of his or her votes for one candidate for the board of directors (cf. majority voting).

Current asset Asset that will normally be turned into cash within a year.

Current liability Liability that will normally be repaid within a year.

Current ratio Current assets divided by current liabilities—a measure of liquidity.

Current yield Bond coupon divided by price.

Data mining (data snooping)

Excessive search to find interesting (but probably coincidental) behavior in a body of data.

DCF Discounted cash flow.

DDM Dividend discount model.

Dealer market Securities exchange in which dealers post offers to buy or sell, e.g., Nasdaq (cf. auction market).

Dealer paper Commercial paper sold through a dealer rather than directly by the

company.

Death spiral convertible

Convertible bond exchangeable for shares with a specified market value.

Debenture Unsecured bond.

Debtor-in–possession financing (DIP

financing)

Debt issued by a company in Chapter 11 bankruptcy.

Decision tree Method of representing alternative sequential decisions and the possible outcomes from these decisions.

Defeasance Practice whereby the borrower sets aside cash or bonds sufficient to

service the borrower's debt. Both the borrower's debt and the offsetting

cash or bonds are removed from the balance sheet.

Degree of operating leverage (DOL)

The percentage change in profits for a 1% change in sales.

Delta Hedge ratio.

Depository transfer check (DTC)

Check made out directly by a local bank to a particular company.

Depreciation (1) Reduction in the book or market value of an asset; (2) portion of an

investment that can be deducted from taxable income.

Derivative Asset whose value derives from that of some other asset (e.g., a future or an option).

Designated market maker

Member of NYSE responsible for market in specified securities (formerly

called “specialist”).

Diff Differential swap.

Differential swap (diff, quanto swap)

Swap between two LIBOR rates of interest, e.g., yen LIBOR for dollar

LIBOR. Payments are in one currency.

Digital option Option paying fixed sum if asset price is the right side of exercise

price, otherwise zero.


Dilution Diminution in the proportion of income to which each share is entitled.

DIP financing Debtor-in–possession financing.

Direct deposit The firm authorizes its bank to deposit money in the accounts of its employees or shareholders.

Direct lease Lease in which the lessor purchases new equipment from the manufacturer

and leases it to thelessee (cf. sale and lease-back).

Direct payment (automatic debit, direct debit)

The firm's customers authorize it to debit their bank accounts for the amounts due (cf. direct deposit).

Direct quote For foreign exchange, the number of U.S. dollars needed to buy one unit of a foreign currency (cf. indirect quote).

Dirty price Bond price including accrued interest, i.e., the price paid by the bond

buyer (cf. clean price).

Discount bond Debt sold for less than its principal value. If a discount bond pays no

interest, it is called a “pure” discount, or zero-coupon, bond.

Discounted cash flow (DCF)

Future cash flows multiplied by discount factors to obtain present value.

Discount factor Present value of $1 received at a stated future date.

Discount rate Rate used to calculate the present value of future cash flows.

Discounted payback

rule

Requirement that discounted values of cash flows should be sufficient to

pay back initial investment within a specified time.

Discriminatory price

auction

Auction in which successful bidders pay the price that they bid (cf. uniform

price auction).

Disintermediation Withdrawal of funds from a financial institution in order to invest them directly (cf.intermediation).

Dividend Payment by a company to its stockholders.

Dividend discount

model

Model showing that the value of a share is equal to the discounted value of future dividends.

Dividend reinvestment plan (DRIP)

Plan that allows shareholders to reinvest dividends automatically.

Dividend yield Annual dividend divided by share price.

DOL Degree of operating leverage.

Double-declining-balance depreciation

Method of accelerated depreciation.

Double-tax agreement

Agreement between two countries that taxes paid abroad can be offset against domestic taxes levied on foreign dividends.

Down-and-in option Barrier option that comes into existence if asset price hits a barrier.

Down-and-out option Barrier option that expires if asset price hits a barrier.

DRIP Dividend reinvestment plan.

Drop lock An arrangement whereby the interest rate on a floating-rate

note or preferred stock becomes fixed if it falls to a specified level.

DTC Depository transfer check.

Dual-class equity Shares with different voting rights.

Dual-currency bond Bond with interest paid in one currency and principal paid in another.

DuPont formula Formula expressing relationship between return on assets, sales-to-assets, profit margin, and measures of leverage.


Duration The average number of years to an asset's discounted cash flows.

Dutch auction In a Dutch auction investors submit the prices at which they are prepared

to buy (or sell) the security. The purchase price is the lowest price that allows the firm to sell (or buy) the specified amount of the security.

EBIT Earnings before interest and taxes.

EBITDA Earnings before interest, taxes, depreciation, and amortization.

EBPP Electronic bill presentment and payment.

Economic depreciation

Decline in present value of an asset.

Economic exposure Risk that arises from changes in real exchange rates (cf. transaction

exposure, translation exposure).

Economic income Cash flow plus change in present value.

Economic rents Profits in excess of the competitive level.

Economic value added (EVA)

A measure of residual income implemented by the consulting firm Stern

Stewart.

Efficient market Market in which security prices reflect information instantaneously.

Efficient portfolio Portfolio that offers the lowest risk ( standard deviation) for its expected return and the highest expected return for its level of risk.

EFT Electronic funds transfer.

Electronic bill presentment and

payment (EBPP)

Allows companies to bill customers and receive payments via the Internet.

Electronic funds transfer (EFT)

Transfer of money electronically (e.g., by Fedwire).

Employee stock ownership plan

(ESOP)

A company contributes to a trust fund that buys stock on behalf of employees.

Entrenching investment

An investment that makes particular use of the skills of existing management.

EPS Earnings per share.

Equipment trust certificate

Form of secured debt generally used to finance railroad equipment. The

trustee retains ownership of the equipment until the debt is repaid.

Equity (1) Common stock and preferred stock. Often used to refer to common

stock only. (2) Net worth.

Equity-linked bond Bond whose payments are linked to a stock market index.

Equivalent annual cash

flow (or cost)

Annuity with the same present value as the company's proposed

investment.

ESOP Employee stock ownership plan.

ETF Exchange-traded fund.

Euribor Euro interbank offered rate.

Euro interbank offered rate (Euribor)

The interest rate at which major international banks in Europe lend euros to each other.

Eurobond Bond that is marketed internationally.

Eurocurrency Deposit held outside the currency's issuing country (e.g., euroyen, or eurodollar deposit)


Eurodollar deposit Dollar deposit with a bank outside the United States.

European option Option that can be exercised only on final exercise date (cf. American

option).

EVA Economic value added.

Event risk The risk that an unanticipated event (e.g., a takeover) will lead to a debt default.

Evergreen credit Revolving credit without maturity.

Exchange of assets Acquisition of another company by purchase of its assets in exchange for cash or shares.

Exchange of stock Acquisition of another company by purchase of its stock in exchange for cash or shares.

Exchange-traded fund (ETF)

A stock designed to track a stock market index.

Ex dividend Purchase of shares in which the buyer is not entitled to the forthcoming dividend (cf. with dividend, cum dividend).

Exercise price (strike price)

Price at which a call option or put option may be exercised.

Expectations theory Theory that forward interest rate ( forward exchange rate) equals expected spot rate.

Expected return Average of possible returns weighted by their probabilities.

Ex rights Purchase of shares that do not entitle the owner to buy shares in the company's rights issue (cf.with rights, cum rights, rights on).

Extendable bond Bond whose maturity can be extended at the option of the lender (or

issuer).

External finance Finance that is not generated by the firm: new borrowing or an issue of stock (cf. internal finance).

Extra dividend Dividend that may or may not be repeated (cf. regular dividend).

Face value Par value.

Factoring Arrangement whereby a financial institution buys a company's accounts

receivable and collects the debt.

Fair price provision Appraisal rights.

Fallen angel Junk bond that was formerly investment grade.

FASB Financial Accounting Standards Board.

FCIA Foreign Credit Insurance Association.

FDIC Federal Deposit Insurance Corporation.

Federal funds Non-interest-bearing deposits by banks at the Federal Reserve. Excess

reserves are lent by banks to each other.

Fedwire A wire transfer system for high-value payments operated by the Federal Reserve System (cf.CHIPS).

Field warehouse Warehouse rented by a warehouse company on another firm's premises (cf. public warehouse).

Financial assets Claims on real assets.

Financial engineering Combining or dividing existing instruments to create new financial products.

Financial lease (capital lease, full-payout

Longterm, noncancelable lease (cf. operating lease).


lease)

Financial leverage

(gearing)

Use of debt to increase the expected return on equity. Financial leverage is

measured by the ratio of debt to debt plus equity (cf. operating leverage).

Firm commitment Arrangement whereby the underwriter guarantees to sell the entire issue.

Fiscal agency agreement

An alternative to a bond trust deed. Unlike the trustee, the fiscal agent

acts as an agent of the borrower.

Flat price Clean price.

Flipping Buying shares in an IPO and selling immediately.

Float See availability float, collection float, payment float.

Floating lien General lien against a company's assets or against a particular class of

assets.

Floating-price convertible

Death spiral convertible.

Floating-rate note (FRN)

Note whose interest payment varies with the short-term interest rate.

Floating-rate preferred

Preferred stock paying dividends that vary with short-term interest rates.

Floor planning Arrangement used to finance inventory. A finance company buys the inventory, which is then held in trust by the user.

Flow-to-equity method

Discounted value of cash flows to equityholders.

Foreign bond A bond issued on the domestic capital market of another country.

Forex Foreign exchange.

Forfaiter Purchaser of promises to pay (e.g., bills of exchange or promissory notes)

issued by importers.

Forward cover Purchase or sale of forward foreign currency in order to offset a known future cash flow.

Forward exchange rate

Exchange rate fixed today for exchanging currency at some future date (cf. spot exchange rate).

Forward interest rate Interest rate fixed today on a loan to be made at some future date (cf. spot interest rate).

Forward rate agreement (FRA)

Agreement to borrow or lend at a specified future date at an interest rate that is fixed today.

FRA Forward rate agreement.

Free cash flow Cash not required for operations or for reinvestment.

Free-rider problem The temptation not to incur the costs of participating in a decision when one's influence on that decision is small.

FRN Floating-rate note.

Full-payout lease Financial lease.

Full-service lease (rental lease)

Lease in which the lessor promises to maintain and insure the equipment

(cf. net lease).

Fundamental analysis Security analysis that seeks to detect misvalued securities by an analysis of the firm's business prospects (cf. technical analysis).

Funded debt Debt maturing after more than one year (cf. unfunded debt).

Futures contract A contract to buy a commodity or security on a future date at a price that is fixed today. Unlike forward contracts, futures are traded on organized


exchanges and are marked to market daily.

GAAP Generally accepted accounting principles.

Gamma A measure of how the option delta changes as the asset price changes.

Gearing Financial leverage.

General cash offer Issue of securities offered to all investors (cf. rights issue).

Gilt A British government bond.

Golden parachute A large termination payment due to a company's officers if they lose their jobs as a result of amerger.

Goodwill The difference between the amount paid for a firm in a merger and its

book value.

Governance The oversight of a firm's management.

Gray market Purchases and sales of securities that occur before the issue price is set.

Greenmail Situation in which a large block of stock is held by an unfriendly company, forcing the target company to repurchase the stock at a substantial premium to prevent a takeover.

Greenshoe option Option that allows the underwriter for a new issue to buy and resell

additional shares.

Growth stock Common stock of a company that has an opportunity to invest money to

earn more than theopportunity cost of capital (cf. income stock).

Haircut An additional margin of collateral for a loan.

Hedge fund An investment fund charging a performance fee and open to a limited range of investors. Funds often follow complex strategies including short

sales.

Hedge ratio (delta,

option delta)

The number of shares to buy for each option sold to create a safe position;

more generally, the number of units of an asset that should be bought to hedge one unit of a liability.

Hedging Buying one security and selling another to reduce risk. A perfect hedge

produces a riskless portfolio.

Hell-or-high-water clause

Clause in a lease agreement that obligates the lessee to make payments

regardless of what happens to the lessor or the equipment.

Highly leveraged transaction (HLT)

Bank loan to a highly leveraged firm (formerly needed to be separately reported to the Federal Reserve Board).

High-yield bond Junk bond.

HLT Highly leveraged transaction.

Holding company Company whose sole function is to hold stock in the firm's subsidiaries.

Horizontal merger Merger between two companies that manufacture similar products

(cf. vertical merger, conglomerate merger).

Horizontal spread The simultaneous purchase and sale of two options that differ only in their

exercise date (cf.vertical spread).

Hurdle rate Minimum acceptable rate of return on a project.

IBF International banking facility.

IMM International Monetary Market.

Immunization The construction of an asset and a liability that have offsetting changes in value.

Implied volatility The volatility implied by option prices.


Imputation tax system

Arrangement by which investors who receive a dividend also receive a tax

credit for corporate taxes that the firm has paid.

Income bond Bond on which interest is payable only if earned.

Income stock Common stock with high dividend yield and few profitable investment

opportunities (cf. growth stock).

Indenture Formal agreement, e.g., establishing the terms of a bond issue.

Indexed bond Bond whose payments are linked to an index, e.g., a consumer price index

(see TIPS).

Index fund Investment fund designed to match the returns on a stock market index.

Indirect quote For foreign exchange, the number of units of a foreign currency needed to buy one U.S. dollar (cf. direct quote).

Industrial revenue

bond (IRB)

Bond issued by local government agencies on behalf of corporations.

Initial public offering (IPO)

A company's first public issue of common stock.

Inside director Director who is also employed by the company.

In-substance defeasance

Defeasance whereby debt is removed from the balance sheet but not

canceled (cf. novation).

Intangible asset Nonmaterial asset, such as technical expertise, a trademark, or a patent (cf. tangible asset).

Integer programming Variant of linear programming whereby the solution values must be

integers.

Interest cover Times interest earned.

Interest rate parity Theory that the differential between the forward exchange rate and

the spot exchange rate is equal to the differential between the foreign and

domestic interest rates.

Intermediation Investment through a financial institution (cf. disintermediation).

Internal finance Finance generated within a firm by retained

earnings and depreciation (cf. external finance).

Internal growth rate The maximum rate of firm growth without external finance (cf. sustainable

growth rate).

Internal rate of return (IRR)

Discount rate at which investment has zero net present value.

International banking facility (IBF)

A branch that an American bank establishes in the United States to do eurocurrency business.

International Monetary

Market (IMM)

The financial futures market within the Chicago Mercantile Exchange.

Interval measure The number of days that a firm can finance operations without additional

cash income.

In-the-money option An option that would be worth exercising if it expired immediately (cf. out-

of-the-money option).

Investment-grade bond

Bond rated at least Baa by Moody's or BBB by Standard and Poor's or

Fitch.

IOSCO International Organization of Securities Commissions.

IPO Initial public offering.

IRB Industrial revenue bond.


IRR Internal rate of return.

IRS Internal Revenue Service.

ISDA International Swap and Derivatives Association.

ISMA International Securities Market Association.

Issued share capital Total amount of shares that are in issue (cf. outstanding share capital).

Junior debt Subordinated debt.

Junk bond (high-yield bond)

Debt that is rated below an investment-grade bond.

Just-in-time System of inventory management that requires minimum inventories of materials and very frequent deliveries by suppliers.

Keiretsu A network of Japanese companies organized around a major bank.

LBO Leveraged buyout.

Lease Long-term rental agreement.

Legal capital Value at which a company's shares are recorded in its books.

Legal defeasance Novation.

Lessee User of a leased asset (cf. lessor).

Lessor Owner of a leased asset (cf. lessee).

Letter of credit Letter from a bank stating that it has established a credit in the company's favor.

Letter stock Privately placed common stock, so called because the SEC requires a letter

from the purchaser that the stock is not intended for resale.

Leverage See financial leverage, operating leverage.

Leveraged buyout (LBO)

Acquisition in which (1) a large part of the purchase price is debt-financed and (2) the remainingequity is privately held by a small group of

investors.

Leveraged lease Lease in which the lessor finances part of the cost of the asset by an issue

of debt secured by the asset and the lease payments.

Liabilities, total liabilities

Total value of financial claims on a firm's assets. Equals (1) total assets or (2) total assets minusnet worth.

LIBOR London interbank offered rate.

Lien Lender's claims on specified assets.

Limited liability Limitation of a shareholder's losses to the amount invested.

Limited partnership Partnership in which some partners have limited liability and general

partners have unlimited liability.

Limit order Order to buy (sell) securities within a maximum (minimum) price (cf. market order).

Linear programming (LP)

Technique for finding the maximum value of some objective function subject to stated linear constraints.

Line of credit Agreement by a bank that a company may borrow at any time up to an established limit.

Liquid asset Asset that is easily and cheaply turned into cash—notably cash itself and short-term securities.

Liquidating dividend Dividend that represents a return of capital.

Liquidator Person appointed by unsecured creditors in the United Kingdom to


oversee the sale of an insolvent firm's assets and the repayment of debts.

Liquidity-preference

theory

Theory that investors demand a higher yield to compensate for the extra risk of long-term bonds.

Liquidity premium (1) Additional return for investing in a security that cannot easily be turned into cash; (2) difference between the forward interest rate and the

expected spot interest rate.

Liquid yield option note (LYON)

Zero-coupon, callable, puttable, convertible bond.

Loan origination fee Up-front fee charged by the lending bank.

Lockbox system Form of concentration banking. Customers send payments to a post office

box. A local bank collects and processes the checks and transfers surplus funds to the company's principal bank.

London interbank offered rate (LIBOR)

The interest rate at which major international banks in London lend to each other. (LIBID is London interbank bid rate; LIMEAN is mean of bid and offered rate.)

Long hedge Purchase of a hedging instrument (e.g., a future) to hedge a short position

in the underlying asset (cf. short hedge).

Longevity bonds Bonds that pay a higher rate of interest if a high proportion of the

population survives to a particular age.

Lookback option Option whose payoff depends on the highest asset price recorded over the

life of the option.

LP Linear programming.

LYON Liquid yield option note.

MACRS Modified accelerated cost recovery system.

Maintenance margin Minimum margin that must be maintained on a futures contract.

Majority voting Voting system under which each director is voted upon separately (cf. cumulative voting).

Management buyout (MBO)

Leveraged buyout whereby the acquiring group is led by the firm's

management.

Mandatory convertible

Bond automatically convertible into equity, usually with a limit on the

value of stock received.

Margin Cash or securities set aside by an investor as evidence that he or she can honor a commitment.

Marked to market An arrangement whereby the profits or losses on a futures contract are

settled up each day.

Market capitalization Market value of outstanding share capital.

Market capitalization rate

Expected return on a security.

Market model Model suggesting a linear relationship between actual returns on a stock and on the market portfolio.

Market order Order to buy or sell securities at the prevailing market price (cf. limit

order).

Market risk (systematic risk)

Risk that cannot be diversified away.

Market-to-book ratio Ratio of market value to book value of firm's equity.

Market value added Difference between market value and book value of firm's equity.

Maturity factoring Factoring arrangement that provides collection and insurance of accounts


receivable.

MBO Management buyout.

MDA Multiple-discriminant analysis.

Medium-term note (MTN)

Debt with a typical maturity of 1 to 10 years offered regularly by a company using the same procedure as commercial paper.

Merger (1) Acquisition in which all assets and liabilities are absorbed by the buyer (cf. exchange of assets, exchange of stock); (2) more generally, any

combination of two companies.

MIP (Monthly income preferred security)

Preferred stock issued by a subsidiary located in a tax haven. The

subsidiary relends the money to the parent.

Mismatch bond Floating-rate note whose interest rate is reset at more frequent intervals

than the rollover period (e.g., a note whose payments are set quarterly on the basis of the one-year interest rate).

Modified accelerated

cost recovery system (MACRS)

Schedule of depreciation deductions allowed for tax purposes.

Modified IRR Internal rate of return calculated by first discounting later cash flows back

to earlier periods so that there remains only one change in the sign of the

cash flows.

Momentum Characteristic of stocks showing persistent recent high returns.

Money center bank A major U.S. bank that undertakes a wide range of banking activities.

Money market Market for short-term safe investments.

Money-market deposit account (MMDA)

A bank account paying money-market interest rate.

Money-market fund Mutual fund that invests solely in short-term safe securities.

Monoline Insurance company that insures debtholders against the risk of default.

Monte Carlo

simulation

Method for calculating the probability distribution of possible outcomes,

e.g., from a project.

Moral hazard The risk that the existence of a contract will change the behavior of one or

both parties to the contract; e.g., an insured firm may take fewer fire precautions.

Mortality bonds Bonds that pay a higher rate of interest if there is a sharp rise in the death

rate.

Mortgage bond Bond secured against plant and equipment.

MTN Medium-term note.

Multiple-discriminant

analysis (MDA)

Statistical technique for distinguishing between two groups on the basis of

their observed characteristics.

Mutual fund Managed investment fund whose shares are sold to investors.

Mutually exclusive

projects

Two projects that cannot both be undertaken.

Naked option Option held on its own, i.e., not used for hedging a holding in the asset or

other options.

Nasdaq National Association of Security Dealers Automated Quote System. A U.S. stock exchange whose dealers tend to specialize in high-tech stocks.

Negative pledge clause

Clause under which the borrower agrees not to permit an exclusive lien on

any of its assets.

Negotiated Method of choosing an underwriter. Most firms may choose


underwriting their underwriter by negotiation (cf.competitive bidding).

Net lease Lease in which the lessee promises to maintain and insure the equipment

(cf. full-service lease).

Net present value (NPV)

A project's net contribution to wealth—present value minus initial

investment.

Net working capital Current assets minus current liabilities.

Net worth Book value of a company's common stock, surplus, and retained earnings.

Nominal interest rate Interest rate expressed in money terms (cf. real interest rate).

Nonrefundable debt Debt that may not be called in order to replace it with another issue at a lower interest cost.

NOPAT Net operating profit after tax.

Normal distribution Symmetric bell-shaped distribution that can be completely defined by its mean and standard deviation.

Note Unsecured debt with a maturity of up to 10 years.

Novation (legal defeasance)

Defeasance whereby the firm's debt is canceled (cf. in-substance

defeasance).

NPV Net present value.

NYSE New York Stock Exchange.

OAT (Obligation

assimilable du Trésor)

French government bond.

Odd lot A trade of less than 100 shares (cf. round lot).

Off-balance-sheet financing

Financing that is not shown as a liability in a company's balance sheet.

Offer price Asked price.

OID debt Original issue discount debt.

Old-line factoring Factoring arrangement that provides collection, insurance, and finance

for accounts receivable.

On the run The most recently issued (and, therefore, typically the most liquid) government bond in a particular maturity range.

Open account Arrangement whereby sales are made with no formal debt contract. The

buyer signs a receipt, and the seller records the sale in the sales ledger.

Open-end mortgage Mortgage against which additional debt may be issued (cf. closed-end

mortgage).

Open interest The number of currently outstanding futures contracts.

Operating cycle The time from a firm's initial purchase of raw materials until the payment from the customer for the finished product.

Operating lease Short-term, cancelable lease (cf. financial lease).

Operating leverage Fixed operating costs, so called because they accentuate variations in profits (cf. financial leverage).

Opportunity cost of

capital (hurdle rate, cost of capital)

Expected return that is foregone by investing in a project rather than in

comparable financial securities.

Option See call option, put option.

Option delta Hedge ratio.


Original issue discount debt (OID debt)

Debt that is initially offered at a price below face value.

OTC Over-the-counter.

Out-of-the-money

option

An option that would not be worth exercising if it matured immediately

(cf. in-the-money option).

Outstanding share capital

Issued share capital less the par value of shares that are held in the

company's treasury.

Oversubscription privilege

In a rights issue, arrangement by which shareholders are given the right

to apply for any shares that are not taken up.

Over-the-counter (OTC)

Informal market that does not involve a securities exchange.

Partnership Joint ownership of business whereby general partners have unlimited liability.

Par value (face value) Value of a security shown on the certificate.

Pass-through securities

Notes or bonds backed by a package of assets (e.g., mortgage pass-throughs, CARs, CARDs).

Path-dependent

option

Option whose value depends on the sequence of prices of the underlying

asset rather than just the final price of the asset.

Payables Accounts payable.

Payback rule Requirement that project should recover its initial investment within a specified time.

Pay-in-kind bond

(PIK)

Bond that allows the issuer to choose to make interest payments in the

form of additional bonds.

Payment float Company-written checks that have not yet cleared (cf. availability float).

Payout ratio Dividend as a proportion of earnings per share.

PBGC Pension Benefit Guarantee Corporation.

P/E ratio Share price divided by earnings per share.

PERC (Preferred equity redemption cumulative stock)

Preferred stock that converts automatically into equity at a stated date. A

limit is placed on the value of the shares that the investor receives.

Perpetuity Investment offering a level stream of cash flows in perpetuity (cf. consol).

PIK Pay-in-kind bond.

PN Project note.

Poison pill Includes a variety of takeover defenses, notably the right of existing

shareholders to acquire stock at a discount if a bidder acquires a minimum number of shares.

Poison put A covenant allowing the bond holder to demand repayment in the event of a hostile merger.

Pooling of interest Method of accounting for mergers (no longer available in the USA). The

consolidated balance sheet of the merged firm is obtained by combining the balance sheets of the separate firms (cf.purchase accounting).

Position diagram Diagram showing the possible payoffs from a derivative investment.

Postaudit Evaluation of an investment project after it has been undertaken.

Praecipium Arrangement fee for syndicated loan.

Preemptive right Common stockholder's right to anything of value distributed by the company.


Preferred stock Stock that takes priority over common stock in regard to dividends. Dividends may not be paid on common stock unless the

dividend is paid on all preferred stock (cf. cumulative preferred stock). The

dividend rate on preferred is usually fixed at time of issue.

Prenegotiated bankruptcy

Chapter 11 bankruptcy where only principal creditors have agreed to the

reorganization plan before filing (cf. prepackaged bankruptcy).

Prepack Prepackaged bankruptcy.

Prepackaged

bankruptcy (prepack)

Bankruptcy proceedings intended to confirm a reorganization plan that

has already been agreed to informally.

Present value Discounted value of future cash flows.

Present value of growth opportunities (PVGO)

Net present value of investments the firm is expected to make in the

future.

PRIDE Similar to a PERC except that as the equity price rises beyond a specified

point, the investor shares in the stock appreciation.

Primary issue Issue of new securities by a firm (cf. secondary issue).

Prime rate Benchmark lending rate set by U.S. banks.

Principal Amount of debt that must be repaid.

Principal–agent problem

Problem faced by a principal (e.g., shareholder) in ensuring that an agent (e.g., manager) acts on his or her behalf.

Private equity Equity that is not publicly traded and that is used to finance business

start-ups, leveraged buyouts, etc.

Private placement Issue of bonds or stock that is placed privately with a few investors and is

not then publicly traded.

Privileged subscription

issue

Rights issue.

Production payment Loan in the form of advance payment for future delivery of a product.

Profitability index Ratio of a project's NPV to the initial investment.

Pro forma Projected.

Project finance Debt that is largely a claim against the cash flows from a particular project rather than against the firm as a whole.

Project note (PN) Note issued by public housing or urban renewal agencies.

Promissory note Promise to pay.

Prospect theory A theory of asset pricing suggested by the observation of behavioral psychologists that investors have a particular aversion to losses even if very small.

Prospectus Summary of the registration statement providing information on an issue

of securities.

Protective put Put option that is combined with holding in the underlying asset.

Proxy vote Vote cast by one person on behalf of another.

Public warehouse (terminal warehouse)

Warehouse operated by an independent warehouse company on its own premises (cf. field warehouse).

Purchase accounting Method of accounting for mergers. The assets of the acquired firm are shown at market value on the balance sheet of the acquirer (cf. pooling of

interest).

Purchase fund Resembles a sinking fund except that money is used only to purchase bonds if they are selling below their par value.


Put–call parity The relationship between the prices of European put and call options.

Put option Option to sell an asset at a specified exercise price on or before a specified

exercise date (cf. call option).

PVGO Present value of growth opportunities.

Pyramid Created by forming a holding company whose only asset is a controlling

interest in a second holding company, which in turn has a controlling interest in an operating company.

q Ratio of the market value of an asset to its replacement cost.

QIBs Qualified institutional buyers.

Quadratic programming

Variant of linear programming whereby the equations are quadratic rather

than linear.

Qualified Institutional buyers (QIBs)

Institutions that are allowed to trade unregistered stock among themselves.

Quanto swap Differential swap.

Quick ratio (acid-test ratio)

Measure of liquidity: (cash + marketable securities + receivables) divided

by current liabilities.

R Range forward A forward exchange rate contract that places upper and lower bounds on

the cost of foreign exchange.

Ratchet bonds Floating-rate bonds whose coupon can only be reset downward.

Rate-sensitive bonds Bonds whose coupon rate changes as issuer's credit-rating changes.

Real assets Tangible assets and intangible assets used to carry on business

(cf. financial assets).

Real estate investment trust (REIT)

Trust company formed to invest in real estate.

Real interest rate Interest rate expressed in terms of real goods, i.e., nominal interest rate adjusted for inflation.

Real option The flexibility to modify, postpone, expand, or abandon a project.

Receivables Accounts receivable.

Receiver A bankruptcy practitioner appointed by secured creditors in the United Kingdom to oversee the repayment of debts.

Record date Date set by directors when making dividend payment. Dividends are sent

to stockholders who are registered on the record date.

Recourse Term describing a type of loan. If a loan is with recourse, the lender has a general claim against the parent company if the collateral is insufficient to

repay the debt.

Red herring Preliminary prospectus.

Refunding Replacement of existing debt with a new issue of debt.

Registered security Security whose ownership is recorded by the company's registrar (cf. bearer security).

Registrar Financial institution appointed to record issue and ownership of company securities.

Registration Process of obtaining SEC approval for a public issue of securities.

Regression analysis In statistics, a technique for finding the line of best fit.

Regular dividend Dividend that the company expects to maintain in the future.

Regulation A issue Small security issues that are partially exempt from SEC


registration requirements.

REIT Real estate investment trust.

Rental lease Full-service lease.

Replicating portfolio Package of assets whose returns exactly replicate those of an option.

Repo Repurchase agreement.

Repurchase agreement

(RP, repo, buy-back)

Purchase of Treasury securities from a securities dealer with an

agreement that the dealer will repurchase them at a specified price.

Residual income After-tax profit less the opportunity cost of capital employed by the

business (see also Economic Value Added).

Residual risk Specific risk.

Retained earnings Earnings not paid out as dividends.

Return on equity Usually, equity earnings as a proportion of the book value of equity.

Return on investment (ROI)

Generally, book income as a proportion of net book value.

Revenue bond Municipal bond that is serviced out of the revenues from a particular

project.

Reverse convertible Bond that gives the issuer the right to convert it into common stock.

Reverse FRN (yield curve note)

Floating-rate note whose payments rise as the general level of interest

rates falls and vice versa.

Reverse split Action by the company to reduce the number of outstanding shares by replacing two or more of its shares with a single, more valuable share.

Revolving credit Legally assured line of credit with a bank.

Rights issue

(privileged subscription issue)

Issue of securities offered to current stockholders (cf. general cash offer).

Rights on With rights.

Risk premium Expected additional return for making a risky investment rather than a safe one.

Road show Series of meetings between a company and potential investors before the company decides on the terms of a new issue.

ROI Return on investment.

Roll-over CD A package of successive certificates of deposit.

Round lot A trade of 100 shares (cf. odd lot).

RP Repurchase agreement.

R squared ( R 2) Square of the correlation coefficient—the proportion of the variability in

one series that can be explained by the variability of one or more other series.

Rule 144a SEC rule allowing qualified institutional buyers to buy and trade

unregistered securities.

Sale and lease-back Sale of an existing asset to a financial institution that then leases it back to the user (cf. direct lease).

Salvage value Scrap or resale value of plant and equipment.

Samurai bond A yen bond issued in Tokyo by a non- Japanese borrower (cf. bulldog

bond, Yankee bond).

SBIC Small Business Investment Company.


Scenario analysis Analysis of the profitability of a project under alternative economic scenarios.

Season datings Extended credit for customers who order goods out of the peak season.

Seasoned issue Issue of a security for which there is an existing market (cf. unseasoned

issue).

SEC Securities and Exchange Commission.

Secondary issue (1) Procedure for selling blocks of seasoned issues of stock; (2) more

generally, sale of already issued stock.

Secondary market Market in which one can buy or sell seasoned issues of securities.

Secured debt Debt that, in the event of default, has first claim on specified assets.

Securitization Substitution of tradable securities for privately negotiated instruments.

Security market line Line representing the relationship between expected return and market

risk.

Self-liquidating loan Loan to finance current assets. The sale of the current assets provides the

cash to repay the loan.

Self-selection Consequence of a contract that induces only one group (e.g., low-risk individuals) to participate.

Semistrong-form efficient market

Market in which security prices reflect all publicly available information (cf. weak-form efficient market and strong-form efficient market).

Senior debt Debt that, in the event of bankruptcy, must be repaid before subordinated

debt receives any payment.

Sensitivity analysis Analysis of the effect on project profitability of possible changes in sales, costs, and so on.

Serial bonds Package of bonds that mature in successive years.

Series bond Bond that may be issued in several series under the same indenture.

Shark repellant Amendment to company charter intended to protect against takeover.

Sharpe ratio Ratio of portfolio's risk premium to its risk (standard deviation).

Shelf registration A procedure that allows firms to file one registration statement covering

several issues of the same security.

Shogun bond Dollar bond issued in Japan by a nonresident.

Short hedge Sale of a hedging instrument (e.g., a future) to hedge a long position in the

underlying asset (cf.long hedge).

Short sale Sale of a security the investor does not own.

Sight draft Demand for immediate payment (cf. time draft).

Signal Action that demonstrates an individual's unobservable characteristics (because it would be unduly costly for someone without those

characteristics to take the action).

Simple interest Interest calculated only on the initial investment (cf. compound interest).

Simulation Monte Carlo simulation.

Sinker Sinking fund.

Sinking fund (sinker) Fund established by a company to retire debt before maturity.

SIV (structured investment vehicle)

A fund that typically invested in mortgage-backed securities, which it financed by issuing senior and junior tranches of asset-backed commercial

paper and longer-term notes.

Skewed distribution Probability distribution in which an unequal number of observations lie


below and above the mean.

SPE Special-purpose entity.

Special dividend (extra dividend)

Dividend that is unlikely to be repeated.

Specialist Designated market maker.

Special-purpose entity

Partnerships established by companies to hold certain assets and obtain

funding. May be used to obtain off-balance-sheet debt for the parent.

Specific risk (residual risk, unique risk,

unsystematic risk)

Risk that can be eliminated by diversification.

Spinning The underwriter of an IPO unethically allots a portion of offering to senior

management of a client company.

Spin-off Distribution of shares in a subsidiary to the company's shareholders so that they hold shares separately in the two firms.

Spot exchange rate Exchange rate on currency for immediate delivery (cf. forward exchange

rate).

Spot price Price of asset for immediate delivery (in contrast to forward or futures price).

Spot rate Interest rate fixed today on a loan that is made today (cf. forward interest

rate).

Spread Difference between the price at which an underwriter buys an issue from a

firm and the price at which the underwriter sells it to the public.

Staggered board Board whose directors are elected periodically, instead of at one time.

Standard deviation Square root of the variance—a measure of variability.

Standard error In statistics, a measure of the possible error in an estimate.

Standby agreement In a rights issue, agreement that the underwriter will purchase any stock

not purchased by investors.

Step-up bond Bond whose coupon is stepped up over time (also step-down bond).

Stock dividend Dividend in the form of stock rather than cash.

Stock split “Free” issue of shares to existing shareholders.

Straddle The combination of a put option and a call option with the same exercise

price.

Straight-line depreciation

An equal dollar amount of depreciation in each period.

Strike price Exercise price of an option.

Stripped bond (strip) Bond that is subdivided into a series of zero-coupon bonds.

Strong-form efficient market

Market in which security prices reflect instantaneously all information available to investors (cf.weak-form efficient market and semistrong-form

efficient market).

Structured debt Debt that has been customized for the buyer, often by incorporating unusual options.

Subordinated debt

(junior debt)

Debt over which senior debt takes priority. In the event of bankruptcy,

subordinated debtholders receive payment only after senior debt is paid off in full.

Subprime loans The most risky category of loans.

Sum-of-the-years'- Method of accelerated depreciation.


digits depreciation

Sunk costs Costs that have been incurred and cannot be reversed.

Supermajority Provision in a company's charter requiring a majority of, say, 80% of shareholders to approve certain changes, such as a merger.

Sushi bond A eurobond issued by a Japanese corporation.

Sustainable growth rate

Maximum rate of firm growth without increasing financial leverage (cf. internal growth rate).

Swap An arrangement whereby two companies lend to each other on different terms, e.g., in different currencies, or one at a fixed rate and the other at

a floating rate.

Swaption Option on a swap.

Sweep program Arrangement whereby bank invests a company's available cash at the end

of each day.

Swingline facility Bank borrowing facility to provide finance while the firm replaces U.S. commercial paper with eurocommercial paper.

Syndicated loan A large loan provided by a group of banks.

Systematic risk Market risk.

Take-or-pay In project finance, arrangement where parent company agrees to pay for

output of project even if it chooses not to take delivery.

Take-up fee Fee paid to underwriters of a rights issue on any stock they are obliged to

purchase.

Tangent efficient portfolio

The portfolio of risky assets offering the highest risk premium per unit of risk ( standard deviation).

Tangible asset Physical asset, such as plant, machinery, and offices (cf. intangible asset).

Tax-anticipation bill Short-term bill issued by the U.S. Treasury that can be surrendered at face value in payment of taxes.

T-bill Treasury bill.

Technical analysis Security analysis that seeks to detect and interpret patterns in past security prices (cf.fundamental analysis).

TED spread Difference between LIBOR and U.S. Treasury bill rate.

Tender offer General offer made directly to a firm's shareholders to buy their stock.

10-K Annual financial statements as filed with the SEC.

10-Q Quarterly financial statements as filed with the SEC.

Tenor Maturity of a loan.

Terminal warehouse Public warehouse.

Term loan Medium-term, privately placed loan, usually made by a bank.

Term structure of interest rates

Relationship between interest rates on loans of different maturities (cf. yield curve).

Throughput arrangement

Arrangement by which shareholders of a pipeline company agree to make sufficient use of pipeline to enable the pipeline company to service its debt.

Tick Minimum amount the price of a security may change.

Time draft Demand for payment at a stated future date (cf. sight draft).

Times-interest-earned (interest cover)

Earnings before interest and tax, divided by interest payments.


TIPS (Treasury Inflation Protected

Securities)

U.S. Treasury bonds whose coupon and principal payments are linked to

the Consumer Price Index.

Toehold Small investment by a company in the shares of a potential takeover

target.

Tolling contract In project finance, arrangement whereby parent company promises to

deliver materials to project for processing and then to repurchase them.

Tombstone Advertisement listing the underwriters to a security issue.

Trade acceptance Written demand that has been accepted by an industrial company to pay a given sum at a future date (cf. banker's acceptance).

Trade credit Accounts receivable.

Trade debt Accounts payable.

Tranche Portion of a new issue sold at a point in time different from the remainder or that has different terms.

Transaction exposure Risk to a firm with known future cash flows in a foreign currency that arises from possible changes in the exchange rate (cf. economic exposure,

translation exposure).

Transfer agent Individual or institution appointed by a company to look after the transfer of securities.

Translation exposure Risk of adverse effects on a firm's financial statements that may arise from changes in exchange rates (cf. economic exposure, transaction

exposure).

Treasurer Principal financial manager (cf. controller).

Treasury bill (T-bill) Short-term discount debt maturing in less than one year, issued regularly by the government.

Treasury stock Common stock that has been repurchased by the company and held in the

company's treasury.

Trust deed Agreement between trustee and borrower setting out terms of a bond.

Trust receipt Receipt for goods that are to be held in trust for the lender.

Tunneling Actions by a controlling shareholder to transfer wealth out of the firm (e.g., by supplying goods at an inflated price).

Underpricing Issue of securities below their market value.

Underwriter Firm that buys an issue of securities from a company and resells it to investors.

Unfunded debt Debt maturing within one year (cf. funded debt).

Uniform price auction Auction in which all successful bidders pay the same price (cf. discriminatory price auction).

Unique risk Specific risk.

Unseasoned issue Issue of a security for which there is no existing market (cf. seasoned

issue).

Unsystematic risk Specific risk.

V Value additivity Rule that the value of the whole must equal the sum of the values of the parts.

Value at risk (VAR) The probability of portfolio losses exceeding some specified proportion.

Value stock A stock that is expected to provide steady income but relatively low growth (often refers to stocks with a low ratio of market-to-book value).


Vanilla issue Issue without unusual features.

VAR Value at risk.

Variable-rate demand bond (VRDB)

Floating-rate bond that can be sold back periodically to the issuer.

Variance Mean squared deviation from the expected value; a measure of variability.

Variation margin The daily gains or losses on a futures contract credited to the investor's

margin account.

Vega A measure of how the option price changes as the asset's volatility

changes.

Venture capital Capital to finance a new firm.

Vertical merger Merger between a supplier and its customer (cf. horizontal merger,

conglomerate merger).

Vertical spread Simultaneous purchase and sale of two options that differ only in their exercise price (cf.horizontal spread).

VIX A measure of the implied volatility of stocks in the S&P 500 Index.

VRDB Variable rate demand bond.

WACC Weighted-average cost of capital.

Warehouse receipt Evidence that a firm owns goods stored in a warehouse.

Warrant Long-term call option issued by a company.

Weak-form efficient market

Market in which security prices instantaneously reflect the information in the history of security prices. In such a market security prices follow a random walk (cf. semistrong-form efficient market and strong-form

efficient market).

Weighted-average cost

of capital (WACC)

Expected return on a portfolio of all the firm's securities. Used as hurdle

rate for capital investment.

White knight A friendly potential acquirer sought out by a target company threatened by a less welcome suitor.

Wi. When issued.

Winner's curse Problem faced by uninformed bidders. For example, in an initial public

offering uninformed participants are likely to receive larger allotments of

issues that informed participants know are overpriced.

With dividend (cum dividend)

Purchase of shares in which the buyer is entitled to the forthcoming dividend (cf. ex dividend).

Withholding tax Tax levied on dividends paid abroad.

With rights (cum rights, rights on)

Purchase of shares in which the buyer is entitled to the rights to buy shares in the company'srights issue (cf. ex rights).

Working capital Current assets and current liabilities. The term is commonly used as

synonymous with net working capital.

Workout Informal arrangement between a borrower and creditors.

Writer Option seller.

xd Ex dividend.

xr Ex rights.

Yankee bond A dollar bond issued in the United States by a non-U.S. borrower

(cf. bulldog bond, Samurai bond).

Yield curve Term structure of interest rates.


Yield curve note Reverse FRN.

Yield to maturity Internal rate of return on a bond.

Zero-coupon bond Discount bond making no coupon payments.

Z-score Measure of the likelihood of bankruptcy.

A

Annuity · 2, 26, 29, 34, 71, 80, 98 APRs · 2, 27, 28 auction exchange · 19

B

Balance Sheet · 9 Bond · 3, 40, 41, 42, 43, 44, 45, 46, 78, 80, 84, 85, 87, 89,

91, 93, 95, 97, 98, 99, 100, 105, 106, 107, 110, 113, 116, 122, 125, 127

C

capital budgeting · 4, 20, 71 Capital Markets · 6 capital structure · 4, 6, 15, 20 common · 45, 53, 59, 60, 61, 62, 63, 89, 93, 98, 106, 108,

113, 117, 122 common stock · 53, 93, 117 Compounding · 2, 24, 25 Corporate Finance · 2, 4, 5, 6, 7, 12, 14 Corporate Securities · 2, 12, 16

D

discount rate · 24, 25, 30, 31, 33, 36, 39, 43, 44, 56, 62, 65, 67, 69, 72, 75, 78

dividend policy decision · 4

E

EAR · 27, 28, 29, 34

F

finance · 4, 5, 6, 13, 14, 20, 45, 78, 83, 86, 98, 100, 102, 106, 107, 114, 118, 119, 124, 128, 130, 132

Finance · 2, 6, 11, 13, 100, 106 financial analysis · 4 financial function · 4 financial management · 6, 13, 20, 24 Financial management · 6 financial manager · 13, 16, 22, 131 Financial Markets · 2, 6, 12, 16, 19 financial statement · 5, 9 financial statements · 4, 90, 129, 131

financial technique · 4 Fundamental analysis · 6, 103 fundamental theory of finance · 4 Future value (FV) · 23

I

Income Statement · 9 interest · 13, 22, 23, 24, 25, 26, 27, 28, 30, 31, 32, 33, 34,

36, 37, 38, 40, 41, 42, 44, 47, 48, 49, 50, 51, 79, 80, 81, 86, 87, 89, 90, 91, 92, 95, 96, 97, 99, 100, 101, 102, 105, 106, 109, 110, 112, 114, 115, 116, 117, 119, 120, 122, 125, 126, 129, 130, 134

Interest Rates · 3, 40 Internal rate of return · 64, 106, 107, 112, 134 investors · 19, 45, 49, 58, 82, 97, 103, 104, 105, 108, 109,

113, 118, 119, 123, 127, 131

L

Level-Coupon Bonds · 3, 44

M

Market Reporting · 3, 57, 78 Mutually exclusive projects · 64, 113

N

Net present value · 3, 64, 65, 79, 113, 114, 118

P

Payback · 3, 64, 66, 70, 77, 116 Perpetuity · 2, 26, 34, 117 preferred stock · 39, 53, 55, 58, 60, 62, 63, 82, 86, 93, 96,

98, 117 Present Value (PV) and Discounting · 2, 24 present value factor · 25 Primary Market · 2, 19 principles · 6, 11, 103 Profitability index · 64, 118 Pure Discount Bonds · 3, 43

S

sciences · 11 Secondary Markets · 2, 19 Securities · 19, 82, 93, 107, 124, 130


Statement of Cash Flows · 9 Statement of Owner’s Equity · 9 Stock · 3, 21, 41, 45, 52, 53, 56, 57, 78, 80, 84, 93, 114,

117, 127

T

theories · 11 time value of money · 5, 22, 66

W

working capital management · 4

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