1

Chapter-7 BOND
Bond. Who Issues Bonds
A long-term debt instrument.
Treasury Bonds: Bonds issued by the federal government, sometimes referred to as
government bonds.
Corporate Bonds: Bonds issued by corporations.
Municipal Bonds: Bonds issued by state and local governments.
Foreign Bonds: Bonds issued by foreign governments or by foreign corporations.
Key Characteristics of Bonds
1. Par Value: The face value of a bond.
2. Coupon Payment: The specified number of dollars of interest paid each year.
3. Coupon Interest Rate: The stated annual interest rate on a bond.
4. Fixed-Rate Bonds: Bonds whose interest rate is fixed for their entire life.
5. Floating-Rate Bonds: Bonds whose interest rate fluctuates with shifts in the general
level of interest rates.
6. Zero Coupon Bonds: Bonds that pay no annual interest but are sold at a discount
below par, thus compensating investors in the form of capital appreciation.
7. Original Issue Discount (OID) Bond: Any bond originally offered at a price below
its par value.
8. Maturity Date: A specified date on which the par value of a bond must be repaid.
9. Original Maturity: The number of years to maturity at the time a bond is issued.
[Link] Provision: A provision in a bond contract that gives the issuer the right to
redeem the bonds under specified terms prior to the normal maturity date.
[Link] Fund Provision: A provision in a bond contract that requires the issuer to
retire a portion of the bond issue each year.
[Link] Bonds: Bonds that are exchangeable at the option of the holder for
the issuing firm’s common stock.
[Link]: Long-term options to buy a stated number of shares of common stock
at a specified price.
[Link] Bonds: Bonds with a provision that allows investors to sell them back to
the company prior to maturity at a prearranged price.
[Link] Bond: A bond that pays interest only if it is earned.
[Link] (Purchasing Power) Bond: A bond that has interest payments based on
an inflation index so as to protect the holder from inflation.
 2

Bond Valuation
Bond valuation is the process of determining the fair price of a bond based on the
present value of its future cash flows, which include periodic coupon payments and the
principal repayment at maturity. The valuation considers factors such as interest rates,
time to maturity, and risk to estimate the bond’s worth in the market.
Key Bond Concepts
Discount Bond: A bond that sells below its par value; occurs whenever the going rate
of interest is above the coupon rate.
Premium Bond: A bond that sells above its par value; occurs whenever the going rate
of interest is below the coupon rate
Yield to Maturity - YTM: The rate required by investors for holding the bond.
Yield to Call (YTC): The rate of return earned on a bond when it is called before its
maturity date
Bonds with Semiannual Coupons
When a bond pays twice a year, the valuation process requires adjustments to reflect
the more frequent payments.
To properly calculate the bond price, we make the following adjustments:
1. Divide the annual coupon interest payment by 2 to determine the dollars of interest
paid each 6 months.
2. Multiply the years to maturity, N, by 2 to determine the number of semiannual
periods.
3. Divide the nominal interest rate, rd, by 2 to determine the periodic interest rate.
Key Assumptions
1. Constant Market Interest Rate: Assumes YTM remains stable.
2. Efficient Market Pricing: Bond prices reflect all available information.
3. No Default Risk: The issuer will make all payments on time.
4. Fixed Coupon Payments: Coupons remain unchanged throughout the bond's life.
 3

Mortgage versus debenture

 4

Chapter:8 risk and rates of returns

Points of risk and returns
[Link] Risk and Cash Flows – All business assets generate cash flows, and their
riskiness depends on how uncertain these cash flows are. Higher uncertainty means
higher risk.
[Link] of Assets – Assets are divided into:
[Link] assets (stocks, bonds)
[Link] assets (machines, trucks, businesses)
Although risk analysis follows similar principles, different data availability leads to varied
approaches for each type.
[Link] Risk Analysis – A stock’s risk can be viewed in two ways:
[Link]-alone risk (when analyzed individually)
[Link] risk (when combined with other stocks in a portfolio)
A risky stock alone may become less risky when part of a diversified portfolio.
[Link] of Stock Risk – Stock risk consists of:
[Link] risk – Can be reduced through diversification, so it’s less concerning.
[Link] risk – Comes from overall market fluctuations and cannot be diversified away,
making it more relevant to investors.
[Link] vs. Return – Investors demand higher expected returns for riskier stocks. If a
stock’s return is too low for its risk, investors sell it, lowering the price and increasing
expected returns. If it’s too high, buying pressure raises the price and lowers returns
until equilibrium is reached.
[Link]-alone vs. Portfolio Risk – Stand-alone risk is mainly important for analyzing
real assets (e.g., capital investments), whereas portfolio risk is key in stock investing.
Stand-Alone Risk
Risk: Chance of an unfavorable event occurring, leading to loss or injury.
Types of Risk Analysis:
Stand-Alone Risk: The risk an investor would face if he or she held only one asset.
Stand-alone risk is crucial for understanding portfolio risk and is particularly relevant for
small business owners and capital budgeting.
Exp: Investing in a speculative oil exploration stock: High risk with returns ranging
from -100% to 1,000%, and an expected return of 20%.
Portfolio Risk: Risk of an asset when held as part of a diversified portfolio. Stand-
alone risk is important but portfolio risk is more critical for stocks and financial assets.
 5

The risk return trade-off

Panel a: The Individual Investor’s Perspective
Investment Return: The return should compensate for the perceived risk.
Risk-Return Trade-Off:
[Link] investments: The return is sufficient to compensate for the perceived risk.
[Link] investments: The return is insufficient to compensate for the perceived risk.
Investment Risk: The slope of the risk-return line depends on the individual investor’s
willingness to take on risk. A steeper line indicates a more risk-averse investor.
Panel b: Perspective of a Company Raising Money to Invest in Risky Projects
Project Return: The project’s return should exceed the cost of capital.
Cost of Capital: The slope of the cost of capital line depends on the willingness of the
average investor in the market to take on risk. A steeper line indicates that the average
investor is more risk-averse.
Statistical measures of stand-alone risk
Stand-alone risk refers to the risk associated with holding a single asset or investment
without considering its impact on a diversified portfolio. To evaluate this risk, several
statistical measures are used:
1. Probability distributions: A probability distribution shows all possible outcomes of an
investment and their associated probabilities.
It helps investors assess risk by understanding the likelihood of various return scenarios.
2. Expected rates of return, r ⁄ (“r hat”): it represents the average return an investor
expects based on possible outcomes.
3. Historical, or past realized, rates of return, r (“r bar”): it is the average return observed
over past periods.
4. Standard deviation, s (sigma): Measures the dispersion of returns around the expected
return.
5. Coefficient of variation (CV): Standardized risk measure that allows comparison across
different investments.
6. Sharpe ratio: Measures return per unit of risk, considering a risk-free benchmark.
Risk Aversion and required returns
Risk-averse investors dislike risk and require higher rates of return as an inducement
to buy riskier securities.
The required return is the minimum return an investor expects to justify taking on risk.
 6

Capital Asset Pricing Model (CAPM)

A model based on the proposition that any stock’s required rate of return is equal to
the risk-free rate of return plus a risk premium that reflects only the risk remaining
after diversification. CAPM helps estimate required returns based on market risk.
Expected Return on a Portfolio
The weighted average of the expected returns on the assets held in the portfolio.
The Realized Rates of Return,
Returns that were actually earned during some past period. Actual returns (r) usually
turn out to be different from expected returns (r ⁄) except for riskless assets.
Correlation
The tendency of two variables to move together.
Correlation Coefficient
A measure of the degree of relationship between two variables.
Portfolio Risk
Portfolio risk refers to the total risk associated with holding a combination of assets
rather than a single asset. Unlike stand-alone risk, portfolio risk considers how different
assets interact and how diversification affects overall risk exposure.
The portfolio’s total risk can be divided into two parts
Diversifiable Risk
That part of a security’s risk associated with random events; it can be eliminated by
proper diversification. This risk is also known as company specific, or unsystematic,
risk.
Market Risk
The risk that remains in a portfolio after diversification has eliminated all company-
specific risk. This risk is also known as non-diversifiable or systematic or beta risk.
Market Portfolio
The market portfolio is a theoretical portfolio that includes all investable assets in the
market, weighted by their market values. Key Characteristics:
Fully diversified – No unsystematic (company-specific) risk.
Optimal portfolio – It lies on the Efficient Frontier in MPT.
Benchmark for performance – Used in CAPM and other financial models.
Only affected by systematic risk – Inflation, interest rates, and economic downturns.
Beta Coefficient, A metric that shows the extent to which a given stock’s returns move
up and down with the stock market. Beta measures market risk.
 7

chapter 14
[Link] is capital?
Answer: Investor-supplied funds such as long- and short-term loans from individuals
and institutions, preferred stock, common stock, and retained earnings.
[Link] is Capital Structure?
Answer: The mix of debt, preferred stock, and common equity that is used to finance
the firm’s assets.
[Link] the capital structure.
Answer: Measuring the capital structure involves analyzing the mix of a company's
financing sources, which typically include debt and equity. This assessment helps
determine how a firm funds its overall operations and growth. Key metrics and ratios
used to measure capital structure include.
Debt-to-Equity Ratio (D/E): Formula: Total Debt / Total Equity
Indicates the relative proportion of shareholders' equity and debt used to finance assets.
A higher ratio suggests more debt financing, which may increase financial risk.
Equity Ratio: Formula: Total Equity / Total Assets
Measures the proportion of a company's assets financed by shareholders' equity. A
higher ratio indicates less reliance on debt.
Debt Ratio: Formula: Total Debt / Total Assets
Shows the percentage of a company's assets financed by debt. A higher ratio implies
greater financial leverage and potential risk.
Interest Coverage Ratio: Earnings Before Interest and Taxes (EBIT) / Interest Expense
Assesses a company's ability to meet interest payments on its debt. A higher ratio
indicates better financial health.
Capitalization Ratio: Long-Term Debt / (Long-Term Debt + Shareholders' Equity)
Focuses on the proportion of long-term debt in the capital structure.
Financial Leverage Ratio: Formula: Total Assets / Total Equity
Measures the extent to which a company uses debt to finance its assets. A higher
ratio indicates more leverage.
Weighted Average Cost of Capital (WACC):
(Cost of Equity * Equity Proportion) + (Cost of Debt * Debt Proportion * (1 -
Tax Rate))
Represents the average cost of financing, considering both debt and equity. It reflects
the overall cost of capital.
 8

[Link]-Value Capital Structure?

This refers to the mix of debt and equity as recorded on the company's balance sheet.
It is based on the historical costs of the assets and liabilities, reflecting the values at
which they were originally acquired or issued.
[Link]-Value Capital Structure?
This represents the mix of debt and equity based on their current market values. It
reflects the prices at which the company's securities (stocks and bonds) are currently
trading in the financial markets.
[Link] Capital Structure?
This is the ideal mix of debt and equity that a company aims to maintain over the
long term. It is based on the company's strategic financial planning and is designed to
optimize the cost of capital and maximize shareholder value.
Difference between these three.
Book-value is based on historical costs and accounting records, which may not reflect
current market conditions.
Market-value is based on current market prices, which fluctuate with market conditions,
investor sentiment, and company performance.
Target Capital Structure: This is a forward-looking, strategic goal that may differ from
both book-value and market-value structures. It represents what the company aims to
achieve rather than its current state.
[Link] the market-value debt ratio tend to be higher than the book-value debt ratio during
a stock market boom or a recession? Explain.
The market-value debt ratio tends to be higher than the book-value debt ratio during
a recession and lower during a stock market boom. Here's why:
During a Stock Market Boom:
Stock prices increase, leading to a higher market value of [Link] the market-
value debt ratio is calculated as:

The denominator (total market value of capital) rises significantly due to an increase
in equity value, reducing the debt ratio.
During a Recession: Stock prices decline, lowering the market value of equity. The
book value of debt remains relatively stable, while the market value of equity shrinks.
Since the denominator decreases, the market-value debt ratio rises.
 9

9. Why would the WACC based on market values tend to be higher than the one based on
book values if the stock price exceeded its book value?
The Weighted Average Cost of Capital (WACC) based on market values tends to be
higher than the WACC based on book values if the stock price exceeds its book value
because of the following reasons:
• Higher Market Value of Equity Increases the Weight of Equity in WACC
• Book Values Understate Equity in Comparison to Market Values Book values are
historical and do not adjust for changing market conditions. If the stock price is
high relative to book value, the market-value-based WACC assigns more weight
to equity, leading to a higher overall WACC than if book values were used.
• Equity is More Expensive Than Debt
• The cost of equity is higher than the cost of debt because:
• Equity investors demand higher returns due to greater risk.
• Interest payments on debt are tax-deductible, reducing the effective cost of debt.
• If market values increase, the weight of equity in WACC rises, making WACC
higher than when book values (which assign a lower proportion to equity) are
used.
When stock prices exceed book value, market-value equity becomes significantly larger
than book-value equity. Since equity is more expensive than debt, the WACC calculated
using market values will be higher than the WACC based on book values.
 10

[Link] would you expect to be more stable over time, a firm’s book-value or market
value capital structure? Explain.
A firm's book-value capital structure is generally more stable over time compared to
its market-value capital structure. Here's why:
* Book Values Change Slowly
The book value of equity is based on historical accounting records and retained earnings,
which do not fluctuate frequently.
The book value of debt remains stable unless the firm issues new debt or repays
existing obligations.
Since these values are recorded at cost and do not adjust for market fluctuations, they
remain relatively steady over time.
* Market Values Fluctuate with Stock Prices
The market value of equity depends on the firm’s stock price, which is highly volatile
and influenced by market conditions, investor sentiment, and economic trends.
The market value of debt can also change based on interest rates and credit risk,
though it tends to be less volatile than equity.
As a result, a firm’s market-value capital structure (i.e., the proportion of debt vs.
equity based on market prices) can change significantly over short periods, especially
during market booms or downturns.
* Economic Cycles Affect Market Values More Than Book Values
During a bull market, stock prices rise, increasing the market value of equity and
making the market-value debt ratio lower.
During a recession, stock prices fall, reducing the market value of equity and making
the market-value debt ratio higher.
However, book values remain largely unchanged, making the book-value capital structure
more stable.
[Link] risk and financial risk?
1. Business risk, which is the riskiness of the firm’s assets if no debt is used.
2. Financial risk, which is the additional risk placed on the common stockholders as a
result of using debt.
[Link] is Business risk?
Answer: The riskiness inherent in the firm’s operations if it uses no debt.
 11

[Link] that affect business risk?

Business risk depends on a number of factors, including the following:
*Competition. If a firm has a monopoly on a necessary product, it will have little risk
from competition and thus have stable sales and sales prices.
* Demand variability. The more stable the demand for a firm’s products, other things
held constant, the lower its business risk.
* Sales price variability. Firms whose products are sold in volatile markets are exposed
to more business risk than firms whose output prices are stable, other things held
constant.
* Input cost variability. Firms whose input costs are uncertain have higher business risk.
*Product obsolescence. Firms in high-tech industries like pharmaceuticals and computers
depend on a constant stream of new products. The faster its products become obsolete,
the greater a firm’s business risk.
* Foreign risk exposure. Firms that generate a high percentage of their earnings overseas
are subject to earnings declines due to exchange rate fluctuations. They are also
exposed to political risk.
* Regulatory risk and legal exposure. Firms that operate in highly regulated industries
such as financial services and utilities are subject to changes in the regulatory
environment that may have a profound effect on the company’s current and future
profitability
*The extent to which costs are fixed: operating leverage. If a high percentage of its
costs are fixed and thus do not decline when demand falls, this increases the firm’s
business risk. This factor is called operating leverage, and it is discussed in the next
section.
14. What is operating leverage?
The extent to which fixed costs are used in a firm’s operations. When a high percentage
of total costs are fixed, the firm is said to have a high degree of operating leverage.
In physics, leverage implies the use of a lever to raise a heavy object with a small
force. In politics, if people have leverage, their
smallest word or action can accomplish a great deal. In business terminology, a high
degree of operating leverage, other factors held constant, implies that a relatively small
change in sales results in a large change in ROIC.
 12

15. Capital structure theory.

Business risk is an important determinant of the optimal capital structure. Moreover,
firms in different industries have different business risks. So we would expect capital
structures to vary considerably across industries, and this is the case. For example,
biotechnology companies generally have very different capital
structures than food processors. In addition, capital structures vary among firms within
a given industry, which is a bit harder to explain. In an attempt to answer that
question, academics and practitioners have developed a number of theories and capital
structure theory is one of them.
[Link] model and assumption of MM model.
Modern capital structure theory began in 1958 when Professors Franco Modigliani and
Merton Miller (hereafter, MM) published what has been called the most influential
finance article ever written.19 MM proved, under a restrictive set of assumptions, that
a firm’s value should be unaffected by its capital structure.
Put another way, MM’s results suggest that it does not matter how a firm finances its
operations—hence, that capital structure is irrelevant. However, the assumptions upon
which MM’s study was based are not realistic, so their results are questionable.
Here is a partial listing of their assumptions:
1. There are no brokerage costs.
2. There are no taxes.
3. There are no bankruptcy costs.
4. Investors can borrow at the same rate as corporations.
5. All investors have the same information as management about the firm’s future
investment opportunities.
6. EBIT is not affected by the use of debt.
 13

17. The effect of taxes.

*Debt is Cheaper Because of Taxes
-Interest on debt is tax-deductible, which reduces the amount of taxes a company
pays.
-This makes debt financing cheaper than equity financing.
*Higher Taxes → More Debt
-When corporate tax rates are high, companies borrow more to take advantage of tax
savings.
-When tax rates are low, the benefit of debt is smaller, so companies might use more
equity instead.
*Book Value vs. Market Value
-Book-value capital structure is more stable and changes slowly, so tax effects are
more predictable.
-Market-value capital structure changes with stock prices, so tax effects vary depending
on market conditions.
*Too Much Debt is Risky
-If a company borrows too much, it may struggle to repay its debt, leading to financial
trouble.
-If a company doesn’t make much profit, the tax savings from debt don’t help much.
Taxes make debt cheaper because of interest deductions. Companies with higher taxes
tend to use more debt. But too much debt can be risky, so companies balance their
financing choices.
18. Trade off theory
Answer: The capital structure
theory that states that firms
trade off the tax benefits of
debt financing against
problems caused by potential
bankruptcy.
 14

Chapter:9 stocks and their valuation

Legal rights and privileges of Common stockholders
Common stockholders have several legal rights and privileges that protect their interests
and ensure their participation in corporate governance. These include:
Voting Rights
• Stockholders can vote to elect the board of directors.
• They may also vote on major corporate decisions
• Voting is often done in person or through a proxy
Right to Dividends
• Stockholders are entitled to dividends when declared by the company.
• However, dividends are not guaranteed and are paid only after preferred
stockholders receive their share.
Ownership & Transferability
• Common stock represents ownership in a company.
• Stockholders can freely buy, sell, or transfer their shares.
Limited Liability
• Stockholders are only liable for the amount they invested in the stock.
• They are not responsible for company debts or legal issues.
Preemptive Rights (in some cases)
• Some companies grant stockholders the right to maintain their proportional
ownership in the firm.
• This means they get the first opportunity to buy new shares before they are
offered to the public.
Right to Information & Inspection
• Stockholders can access financial reports, earnings statements, and other corporate
records.
• They may also attend annual shareholder meetings.
Residual Claim on Assets
• If a company liquidates, common stockholders have the right to receive remaining
assets after debts and preferred stockholders are paid.
• However, they are the last to be compensated, making this a higher-risk
investment.
Legal Action Rights
• Stockholders can sue the company or its executives for mismanagement or fraud.
 15

Common stock versus preferred stock

Control of the FIRM

Control of a firm is determined by who holds the majority of voting power, typically
common stockholders, the board of directors, and executives. Here’s how control is
structured:
Election of Directors: Common stockholders elect the board of directors.
Directors then appoint the officers who manage the company.
Ownership Structure: In small firms, the major stockholder often serves as the president
and board chair. In large public firms, managers usually own some stock but lack
voting control.
Voting Rights & Proxies: Stockholders can vote in person at the annual meeting or
transfer their voting rights via a proxy.
Proxy Fights: If stockholders are dissatisfied with management, outside groups may
solicit proxies to replace leadership.
Takeovers: A corporation may attempt to gain control by purchasing a majority of the
firm’s outstanding stock.
Proxy, proxy fight, takeover
Proxy: A document giving one person the authority to act for another, typically the
power to vote shares of common stock.
Proxy Fight: An attempt by a person or group to gain control of a firm by getting its
stockholders to grant that person or group the authority to vote its shares to replace
the current management.
Takeover: An action whereby a person or group succeeds in ousting a firm’s management
and taking control of the company.
 16

The preemptive right

Preemptive Right: A provision in the corporate charter or bylaws that gives common
stockholders the right to purchase on a pro rata basis new issues of common stock
(or convertible securities).
Types of Common Stock
Common stock can be classified into different types based on voting rights, dividend
policies, and ownership privileges. Here are the main types of common stock:
1. Class A & Class B Shares
Class A Shares: Usually have more voting rights per share.
Class B Shares: Typically have fewer voting rights but may have other benefits, such
as lower prices or special dividend policies.
2. Voting & Non-Voting Common Stock
Voting Stock: Allows shareholders to vote on company matters, such as electing the
board of directors.
Non-Voting Stock: Does not grant voting rights but still allows shareholders to receive
dividends and benefit from stock appreciation.
3. Growth Stocks
Issued by companies with high potential for revenue and earnings growth.
Typically reinvest profits instead of paying high dividends.
4. Income Stocks
Offer regular dividends and stable earnings.
Preferred by investors looking for consistent income.
5. Blue-Chip Stocks
Shares of large, well-established, and financially stable companies.
Known for consistent performance and reliability.
6. Penny Stocks
Low-priced stocks (usually under $5 per share) of small or struggling companies.
High-risk but can offer high rewards.
7. Cyclical & Defensive Stocks
Cyclical Stocks: Perform well during economic booms and poorly during downturns
(e.g., automotive, luxury goods).
Defensive Stocks: Maintain stable performance regardless of economic conditions (e.g.,
utilities, healthcare).
 17

Classified stock
Common stock that is given a special designation such as Class A or Class B to
meet special needs of the company.
Founders’ shares
Stock owned by the firm’s founders that enables them to maintain control over the
company without having to own a majority of stock.
Stock price versus intrinsic value

Determinants of Intrinsic Values and Stock

 18

Determinants of Intrinsic Values and Stock Prices

Why do investors and companies care about intrinsic value?

Importance of Understanding Intrinsic Value
• Investors aim to buy undervalued stocks (market price < intrinsic value) and
avoid overvalued stocks (market price > intrinsic value).
• Wall Street analysts, institutional investors, and individual investors use models to
estimate intrinsic value.
Why Managers Care About Intrinsic Value
• Helps managers understand how their decisions impact stock prices.
• Before issuing new shares, companies should determine whether their stock is
undervalued or overvalued.
• Intrinsic value estimation assists in making strategic financial decisions.
Two Primary Models for Estimating Intrinsic Value
• Discounted Dividend Model (DDM): Focuses on dividends as a measure of
value.
• Corporate Valuation Model: Looks at broader financial aspects like sales, costs,
and free cash flows.
Marginal Investor
A representative investor whose actions reflect the beliefs of those people who are
currently trading a stock. It is the marginal investor who determines a stock’s price.
 19

Market Price, P0 The price at which a stock sells in the market.

Growth Rate, g The expected rate of growth in dividends per share.
Required Rate of Return, rs
The minimum rate of return on a common stock that a stockholder considers acceptable.
Expected Rate of Return, r ⁄s
The rate of return on a common stock that a stockholder expects to receive in the
future.
Actual (Realized) Rate of Return, rs
The rate of return on a common stock actually received by stockholders in some past
period; rs may be greater or less than r ⁄ s and/or rs.
Dividend Yield The expected dividend divided by the current price of a share of stock.
Capital Gains Yield The capital gain during a given year divided by the beginning price.
Expected Total Return
The sum of the expected dividend yield and the expected capital gains yield.
Constant Growth (Gordon) Model
Used to find the value of a constant growth stock.

Valuing Nonconstant Growth Stocks

Supernormal (Nonconstant) Growth: The part of the firm’s life cycle in which it grows
much faster than the economy as a whole.
Horizon (Terminal) Date
The date when the growth rate becomes constant. At this date, it is no longer
necessary to forecast the individual dividends.
Horizon (Continuing) Value
The value at the horizon date of all dividends expected thereafter.
Corporate Valuation Model
A valuation model used as an alternative to the discounted dividend model to determine
a firm’s value, especially one with no history of dividends, or the value of
a division of a larger firm.
The corporate model first calculates the firm’s free cash flows, then finds their present
values to determine the firm’s value.