Studyworth
FINS1613 Quiz 2 review
Lucas 2021-7-18
1
Ethics
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Bonds
Coupon Bonds
u Almost universally in all bond markets, the coupon is paid in 2 equal
instalments per year. The last payment coincides with the repayment of
the principal to investors.
u The annual coupon rate is given as percentage of face value or par value
u Coupon rate=annual coupon/face value
PV of coupon-paying bonds
u We calculate the price (present value) of a corporate bond just after a
coupon payment (i.e. discounting full periods) as follows:
u Notes:
1) As usual, is the per-period rate and t is the # of periods.
2) Translate the coupon rate given as % of face value into a $ amount !
3) There are now two percentage numbers in a bond problem. Take extra
care not to confuse them!
Types of bonds
u Government bonds
-- Issued by the Australian Treasury
-- Assumed to have no default risk
-- Risk-free bond
u Corporate bonds
-- Issued by corporations
-- Have varying levels of default risk
-- The greater the default risk, the higher the coupon payment the
corporation will pay to attract buyers
u Credit risk is a measure of the default risk in bonds
Credit risk
u Credit risk=credit spread=risk premium=default spread=default
risk
u Credit risk=Yield(YTM)-Risk-free rate
YTM
u The unique interest rate that makes the present value of its future
cash flows equal to its price as observed in the market is called the
yield to maturity (YTM).
u YTM is always written as an APR
u YTM=r*m
u If YTM = coupon rate, then par value = bond price
u If YTM > coupon rate, then par value > bond price
-- Selling at a discount, called a discount bond.
u If YTM < coupon rate, then par value < bond price
-- Selling at a premium, called a premium bond.
Loan instalments
u Where:
C= the instalment amount
PV = the loan amount (present value)
r = nominal interest rate per period
t = number of compounding periods
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Equity
Dividend Yields and Capital Gains
u P0=(D1+P1)/(1+re)
u 1+re=(D1+P1)/P0
u re=D1/P0 + P1/P0 – 1
u re=D1/P0 + (P1-P0)/P0
Constant DDM
u Assume D0=D1=D2=…..
u P0=D1/re
u re=D1/P0
Constant dividend growth model
u Assume D1=D0(1+g); D2=D1(1+g); D3=D2(1+g)…
u P0=D1/(re-g)
u re=D1/P0 +g
EPS and Earnings growth rate
u D t=(Total Earnings t/Shares Outstanding t)*Payout Ratio t
u D t=EPS t * Payout Ratio t
u Retention Rate=100%-Payout Ratio= Retained amount per
share/Earnings per share
u g=Earnings growth rate(%)=Retention Rate(%)*RONI(%)
u g t=Retention Rate t-1 * RONI t
u EPS@t+1 =EPS@t *(1+g@t+1)
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Investment
decision rules
Net Present Value
NPV Decision Rules
u Accept projects with NPV > 0
u Reject projects with NPV < 0
u When choosing among several projects, choose the highest NPV.
Internal Rate of Return
u IRR is the discount rate that makes the project’s NPV=0
IRR Decision Rules
u For projects with standard cash flows (i.e. negative cash flows first,
positive cash flows later), the IRR decision rule is:
u Accept the project if IRR > required rate of return.
u Reject the project if IRR < required rate of return.
IRR in Excel
u =IRR(CF0:CFn)
Pros and Cons of IRR Decision Rules
u Pros:
u In standard cases, IRR and NPV rules give the same answer.
u Meaning of IRR(IRR=RONI) intuitively appealing, easy to communicate.
u IRR provides a margin of error: If IRR is high, we do not need to know the
required rate exactly.
u Cons:
u Non-standard cash flows make the IRR rule unusable.
u IRR may not correctly rank competing projects(mutually exclusive projects).
u IRR focuses on return and cannot capture differences in scale of projects.
EAA
u The EAA measure allows projects with different lives to be compared
on an equal basis assuming infinite replacements.
EAA Decision Rule
u Choose the project with the highest EAA when calculated on NPV.
u Or lowest EAA when calculated on PV(costs).
Profitability Index
u PI is used when there are resource constraints and projects need to
be prioritized.
u PI=NPV/Resource consumed
PI Decision Rules
u For independent projects:
u PI>1 means NPV>0
u For mutually exclusive projects:
u Choose the one with the highest PI>0 until resource constraint is
reached.
Payback Period Decision Rule
u A project is accepted if the payback period is less than some
pre-set threshold.
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