CHAPTER 6 INTEREST RATE FUNDAMENTALS

The interest rate or

required
return
represents the cost
of money. It is the
compensation that a
supplier of funds
expects
and
a
demander of funds
must pay. Usually
the term interest rate is applied to debt instruments such as bank loans or bonds, and the
term required return is applied to equity investments, such as common stock, that give
the investor an ownership stake in the issuer. In fact, the meaning of these two terms is
quite similar because, in both cases, the supplier is compensated for providing funds to the
demander.
A variety of factors can influence the equilibrium interest rate. One factor is inflation, a
rising trend in the prices of most goods and services. Typically, savers demand higher
returns (that is, higher interest rates) when inflation is high because they want their
investments to more than keep pace with rising prices. A second factor influencing interest
rates is risk. When people perceive that a particular investment is riskier, they will expect a
higher return on that investment as compensation for bearing the risk. A third factor that
can affect the interest rate is a liquidity preference among investors. The term liquidity
preference refers to the general tendency of investors to prefer short-term securities (that
is, securities that are more liquid). If, all other things being equal, investors would prefer to
buy short-term rather than long-term securities, interest rates on short-term instruments
such as Treasury bills will be lower than rates on longer-term securities. Investors will hold
these securities, despite the relatively low return that they offer, because they meet
investors preferences for liquidity.
real rate of interest The rate that creates equilibrium between the supply of savings and
the demand for investment funds in a perfect world, without inflation, where suppliers and
demanders of funds have no liquidity preferences and there is no risk.
nominal rate of interest The actual rate of interest charged by the supplier of funds and
paid by the demander. Investors generally demand higher rates of return on risky
investments as compared to safe ones. Otherwise, there is little incentive for investors to
bear the additional risk. Therefore, investors will demand a higher nominal rate of return on
risky investments.
term structure of interest rates The relationship between the maturity and rate of return
for bonds with similar levels of risk.
yield curve A graphic depiction of the term structure of interest rates.
yield to maturity (YTM) Compound annual rate of return earned on a debt security
purchased on a given day and held to maturity.
inverted yield curve A downward-sloping yield curve indicates that short-term interest
rates are generally higher than long-term interest rates.
normal yield curve An upward-sloping yield curve indicates that long-term interest rates
are generally higher than short-term interest rates.
flat yield curve A yield curve that indicates that interest rates do not vary much at different
maturities.
expectations theory The theory that the yield curve reflects investor expectations about
future interest rates; an expectation of rising interest rates results in an upward sloping
yield curve, and an expectation of declining rates results in a downward-sloping yield
curve.
liquidity preference theory Theory suggesting that longterm rates are generally higher
than short-term rates (hence, the yield curve is upward sloping) because investors
perceive short-term investments to be more liquid and less risky than long-term

investments. Borrowers must offer higher rates on long-term bonds to entice investors
away from their preferred short-term securities.
market segmentation theory Theory suggesting that the market for loans is segmented
on the basis of maturity and that the supply of and demand for loans within each segment
determine its prevailing interest rate; the slope of the yield curve is determined by the
general relationship between the prevailing rates in each market segment.
Corporate bond A long-term debt instrument indicating that a corporation has borrowed a
certain amount of money and promises to repay it in the future under clearly defined terms.
coupon interest rate The percentage of a bonds par value that will be paid annually,
typically in two equal semiannual payments, as interest.
bond indenture A
legal
document that specifies both
rights of the bondholders and
duties of the issuing
corporation.
The
standard debt
provisions in the bond
indenture specify certain
record-keeping and general

the
the

business practices that the

bond
issuer must follow.
Restrictive Provisions Bond
indentures also
normally include certain restrictive covenants, which place operating and financial
constraints on the borrower. These provisions help protect the bondholder against
increases in borrower risk. Without them, the borrower could increase the firms risk but not
have to pay increased interest to compensate for the increased risk.
The most common restrictive covenants do the following:
1. Require a minimum level of liquidity, to ensure against loan default.
2. Prohibit the sale of accounts receivable to generate cash. Selling receivables could
cause a long-run cash shortage if proceeds were used to meet current obligations.
3. Impose fixed-asset restrictions. The borrower must maintain a specified level of fixed
assets to guarantee its ability to repay the bonds.
4. Constrain subsequent borrowing. Additional long-term debt may be prohibited, or
additional borrowing may be subordinated to the original loan.
Subordination means that subsequent creditors agree to wait until all claims of the senior
debt are satisfied.
5. Limit the firms annual cash dividend payments to a specified percentage or amount.
sinking-fund requirement A restrictive provision often included in a bond indenture,
providing for the systematic retirement of bonds prior to their maturity.
Trustee A paid individual, corporation, or commercial bank trust department that acts as
the third party to a bond indenture and can take specified actions on behalf of the
bondholders if the terms of the indenture are violated.
COST OF BONDS TO THE ISSUER

The
cost

of bond financing
is
generally greater
than the issuer
would

have to pay for short-term borrowing. The major factors that

affect the cost, which is the rate of interest paid by the bond
issuer, are the bonds maturity, the size of the offering, the
issuers risk, and the basic cost of money.
Impact of Bond
Maturity Long-

term debt pays higher

interest rates than

short-term debt.
The longer the maturity of a
bond, the less
accuracy there is in predicting
future interest
rates, and therefore the greater the
bondholders risk
of giving up an opportunity to lend money at a
higher rate. In addition, the longer the term, the greater the chance that the issuer might
default.
Impact of Offering Size The size of the bond offering also affects the interest cost of
borrowing but in an inverse manner: Bond flotation and administration costs per dollar
borrowed are likely to decrease with increasing offering size. On the other hand, the risk to
the bondholders may increase, because larger offerings result in greater risk of default.
Impact of Issuers Risk The greater the issuers default risk, the higher the interest rate.
Some of this risk can be reduced through inclusion of appropriate restrictive provisions in
the bond indenture. Bondholders must be compensated with higher returns for taking
greater risk. Bond buyers rely on bond ratings to determine the issuers overall risk.
Impact of the Cost of Money The cost of money in the capital market is the basis for
determining a bonds coupon interest rate. Generally, the rate on U.S. Treasury securities
of equal maturity is used as the lowest-risk cost of money. To that basic rate is added a risk
premium that reflects the factors (maturity, offering size, and issuers risk).
BOND ISSUE FEATURES
conversion feature A feature of convertible bonds that allows bondholders to change
each bond into a stated number of shares of common stock.
call feature A feature included in nearly all corporate bond issues that gives the issuer the
opportunity to repurchase bonds at a stated call price prior to maturity.

call price The stated price at which a bond may be repurchased, by use of a call
feature, prior to maturity. call premium The amount by which a bonds call price exceeds
its par value.
stock purchase warrants Instruments that give their holders the right to
purchase a certain number of shares of the issuers common stock at a specified
price over a certain period of time.
BOND YIELDS
The yield, or rate of return, on a bond is frequently used to assess a bonds
performance over a given period of time, typically 1 year. Because there are a
number of ways to measure a bonds yield, it is important to understand popular yield
measures. The three most widely cited bond yields are (1) current yield, (2) yield to
maturity (YTM), and (3) yield to call (YTC). Each of these yields provides a unique
measure of the return on a bond. High-quality (high-rated) bonds provide lower
returns than lower-quality (low-rated) bonds.
Eurobond A bond issued by an international borrower and sold to investors in
countries with currencies other than the currency in which the bond is
denominated.
CONTEMPORARY BOND TYPES
Zero- (or low-coupon bonds) Issued with no (zero) or a very low coupon (stated
interest) rate and sold at a large discount from par. A significant portion (or all) of the
investors return comes from gain in value (that is, par value minus purchase
price). Generally callable at par value. Because the issuer can annually deduct the
current
years interest accrual without having to pay the interest until the bond matures (or is
called), its cash flow each year is increased by the amount of the tax shield provided by the
interest deduction.
Junk bonds -Debt rated Ba or lower by Moodys or BB or lower by Standard & Poors.
Commonly used by rapidly growing firms to obtain growth capital, most often as a way
to finance mergers and takeovers. High risk bonds with high yieldsoften yielding 2% to
3% more than the best-quality corporate debt.
Floating-rate bonds Stated interest rate is adjusted periodically within stated limits in
response to changes in specified money market or capital market rates. Popular when
future inflation and interest rates are uncertain. Tend to sell at close to par because of the
automatic adjustment to changing market conditions. Some issues provide for annual
redemption at par at the option of the bondholder.
Extendible notes Short maturities, typically 1 to 5 years, that can be renewed for a similar
period at the option of holders. Similar to a floating-rate bond. An issue might be a series of
3-year renewable notes over a period of 15 years; every 3 years, the notes could be
extended for another 3 years, at a new rate competitive with market interest rates at the
time of renewal.
Putable bonds Bonds that can be redeemed at par (typically, $1,000) at the option of their
holder either at specific dates after the date of issue and every 1 to 5 years thereafter or
when and if the firm takes specified actions, such as being acquired, acquiring another
company, or issuing a large amount of additional debt. In return for its conferring the right
to put the bond at specified times or when the firm takes certain actions, the bonds yield
is lower than that of a nonputable bond.
foreign bond A bond that is issued by a foreign corporation or government and is
denominated in the investors home currency and sold in the investors home market.
Valuation The process that links risk and return to determine the worth of an asset.
Cash Flows (Returns) The value of any asset depends on the cash flow(s) it is expected
to provide over the ownership period. To have value, an asset does not have to provide an
annual cash flow; it can provide an intermittent cash flow or even a single cash flow over
the period.

Timing.
Risk and Required Return The level of risk
associated with a given cash flow can
significantly affect its value. In general, the greater the risk of (or the less
certain) a cash flow, the lower its value. Greater risk can be incorporated
into a valuation analysis by using a higher required
return or discount rate. The higher the risk, the
greater the required return, and the lower
the risk, the less the required return.
Discount The amount by which a bond sells
at a value that is less than its par value.
Premium The amount by which a bond sells
at a value that is greater than its par value.
interest rate risk The chance that interest
thereby
change the required return and bond value. Rising
rates, which result in decreasing bond values, are
of greatest concern.

rates will change and

CHAPTER 7 STOCK VALUATION

Debt Includes all borrowing incurred by a firm,
including bonds, and is repaid according to a fixed schedule of payments.
Equity Funds provided by the firms owners (investors or stockholders) that are repaid
subject to the firms performance.
privately owned (stock) The common stock of a firm is owned by private investors; this
stock is not publicly traded.
publicly owned (stock) The common stock of a firm is owned by public investors; this
stock is publicly traded.
closely owned (stock) The common stock of a firm is owned by an individual or a small
group of investors (such as a family); these are usually privately owned companies.
widely owned (stock) The common stock of a firm is owned by many unrelated individual
or institutional investors.
par-value common stock An arbitrary value established for legal purposes in the firms
corporate charter and which can be used to find the total number of shares outstanding
by dividing it into the book value of common stock.
preemptive right Allows common stockholders to maintain their proportionate ownership
in the corporation when new shares are issued, thus protecting them from dilution of their
ownership.
dilution of ownership A reduction in each previous shareholders fractional ownership
resulting from the issuance of additional shares of common stock.
dilution of earnings A reduction in each previous shareholders fractional claim on the
firms earnings resulting from the issuance of additional shares of common stock.
Rights Financial instruments that allow stockholders to purchase additional shares at a
price below the market price, in direct proportion to their number of owned shares
Authorized Shares Shares of common stock that a firms corporate charter allows it to
issue.
Outstanding Shares Issued shares of common stock held by investors, including both
private and public investors.
Treasury stock Issued shares of common stock held by the firm; often these shares have
been repurchased by the firm.
Issued shares Shares of common stock that have been put into circulation; the sum of
outstanding shares and treasury stock.
Proxy statement A statement transferring the votes of a stockholder to another party.

Proxy battle The attempt by a nonmanagement group to gain control of the management
of a firm by soliciting a sufficient number of proxy votes.
Supervoting shares Stock that carries with it multiple votes per share rather than the
single vote per share typically given on regular shares of common stock.
Nonvoting common stock Common stock that carries no voting rights; issued when the
firm wishes to raise capital through the sale of common stock but does not want to give
up its voting control.
American depositary shares (ADSs) Dollar-denominated receipts for the stocks of
foreign companies that are held by a U.S. financial institution overseas.
American depositary receipts (ADRs) Securities, backed by American depositary shares
(ADSs), that permit U.S. investors to hold shares of non- U.S. companies and trade them
in U.S. markets.
Par-value Preferred Stock Preferred stock with a stated face value that is used with the
specified dividend percentage to determine the annual dollar dividend.
No-par Preferred Stock Preferred stock with no stated face value but with a stated annual
dollar dividend.
cumulative (preferred stock) Preferred stock for which all passed (unpaid) dividends in
arrears, along with the current dividend, must be paid before dividends can be paid to
common stockholders.
Noncumulative (preferred stock) Preferred stock for which passed (unpaid) dividends do
not accumulate.
Callable Feature (preferred stock) A feature of callable preferred stock that allows the
issuer to retire the shares within a certain period of time and at a specified price.
conversion feature (preferred stock) A feature of convertible preferred stock that allows
holders to change each share into a stated number of shares of common stock.
venture capital Privately raised external equity capital used to fund early stage firms with
attractive growth prospects.
Venture Capitalists (VCs) Providers of venture capital; typically, formal businesses that
maintain strong oversight over the firms they invest in and that have clearly defined exit
strategies.
Angel Capitalists (angels) Wealthy individual investors who do not operate as a
business but invest in promising early-stage companies in exchange for a portion of the
firms equity.
When a firm wishes to sell its stock in the primary market, it has three alternatives. It can
make (1) a public offering, in which it offers its shares for sale to the general public; (2) a
rights offering, in which new shares are sold to existing stockholders; or (3) a private
placement, in which the firm sells new securities directly to an investor or group of
investors. Here we focus on public offerings, particularly the initial public offering (IPO),
which is the first public sale of a firms stock. IPOs are typically made by small, rapidly
growing companies that either require additional capital to continue expanding or have met
a milestone for going public that was established in a contract signed earlier in order to
obtain VC funding.
Investment banker Financial intermediary that specializes in selling new security issues
and advising firms with regard to major financial transactions.
Underwriting The role of the investment banker in bearing the risk of reselling, at a profit,
the securities purchased from an issuing corporation at an agreed-on price.
Underwriting syndicate A group of other bankers formed by an investment banker to
share the financial risk associated with underwriting new securities.
Selling group A large number of brokerage firms that join the originating investment
banker(s); each accepts responsibility for selling a certain portion of a new security issue
on a commission basis.
Efficient-market hypothesis (EMH) Theory describing the behavior of an assumed
perfect market in which (1) securities are in equilibrium, (2) security prices fully reflect all
available information and react swiftly to new information, and (3), because stocks are fully
and fairly priced, investors need not waste time looking for mispriced securities.

Behavioral finance A growing body of research that focuses on investor behavior and its
impact on investment decisions and stock prices. Advocates are commonly referred to as
behaviorists.
zero-growth model An approach to dividend valuation that assumes a
constant, nongrowing dividend stream.
Gordon growth
model A
common name for the
constant growth model that is
widely cited in dividend
valuation.
Variable-growth
model A dividend
valuation approach that
allows for a change in the
dividend growth rate.

free cash flow valuation model A

model that determines the value of an
entire company as the present value
of its expected free cash flows
discounted at the firms weighted
average cost of capital, which is its
expected average future cost of funds

total rate of return

The total gain or loss
experienced on an
investment over a
given period of time;
calculated by dividing
the assets cash
distributions during the
period, plus change in
value, by its beginningrisk averse The attitude toward risk in which investors would require an
increased return as compensation for an increase in risk.
risk neutral The attitude toward risk in which investors choose the investment
with the higher return regardless of its risk.
risk seeking The attitude toward risk in which investors prefer investments
with greater risk even if they have lower expected returns.
scenario analysis An approach for assessing risk that uses several possible
alternative outcomes (scenarios) to obtain a sense of the variability among
returns.
Range A measure of an assets risk, which is found by subtracting the return
associated with the pessimistic (worst) outcome from the return associated
with the optimistic (best) outcome.
Probability The chance that a given outcome will occur.
probability distribution A model that relates probabilities to the associated
outcomes.
bar chart The simplest type of probability distribution; shows only a limited
number of outcomes and associated probabilities for a given event.
continuous probability distribution A probability distrib ution showing all
the possible
outcomes and associated probabilities for a given event.

standard deviation (delta r)

book value per share The amount per share of common stock that would be
received if all of the firms assets were sold for their exact book (accounting)
value and the proceeds remaining after paying all liabilities (including preferred
stock) were divided among the common stockholders.
liquidation value per share The actual amount per share of common stock
that would be received if all of the firms assets were sold for their market
value, liabilities (including preferred stock) were paid, and any remaining
money were divided among the common stockholders.
price/earnings multiple approach A popular technique used to estimate the
firms share value; calculated by multiplying the firms expected earnings per
share (EPS) by the average price/earnings (P/E) ratio for the industry.
CHAPTER 8 RISK AND REQUIRED RATE OF RETURN
Portfolio A collection, or group, of assets.
Risk A measure of the uncertainty surrounding the return that an investment
will earn or, more formally, the variability of returns associated with a given
asset.

The most common statistical

indicator of an assets risk; it
measures the dispersion around the
expected value.

expected value of a return (r

bar) The average return that an

investment is expected to produce

over time.
normal probability distribution A symmetrical probability distribution whose
shape resembles a bell-shaped curve.
coefficient of variation (CV) A measure of relative
dispersion that is useful in comparing the risks of assets with
differing expected returns.
efficient portfolio A portfolio that maximizes return for a given level of risk.
correlation

A statistical
measure of
the
relationship
between any
two series of
numbers.
positively
correlated
Describes two
series that
move
in the same direction.
negatively correlated Describes two series that move in opposite directions.
correlation coefficient A measure of the degree of correlation between two
series.
perfectly positively correlated Describes two positively correlated series
that have a
correlation coefficient of +1.
perfectly negatively correlated Describes two negatively correlated series
that have a
correlation coefficient of -1.
Uncorrelated Describes two series that lack any interaction and therefore
have a correlation coefficient close to zero.
political risk Risk that arises from the possibility that a host government will
take actions
harmful to foreign investors or that political turmoil will endanger investments.
capital asset pricing model (CAPM) The basic theory that links risk and
return for all assets.
total risk The combination of a securitys nondiversifiable risk and
diversifiable risk.
diversifiable risk The portion of an assets risk that is attributable to
firmspecific, random causes; can be eliminated through diversification. Also
called unsystematic risk.
nondiversifiable risk The relevant portion of an assets risk attributable to
market factors that affect all firms; cannot be eliminated through
diversification. Also calledsystematic risk.
beta coefficient (b) A relative measure of nondiversifiable risk. An index of
the degree of movement of an assets return in response to a change in the
market return.
market return The return on the market portfolio of all traded securities.

risk-free rate of return, (RF ) The required return on a riskfree asset,

typically a 3-month

U.S. Treasury bill. U.S. Treasury bills (T-bills) Short-term IOUs issued by the
U.S. Treasury; considered the risk-free asset.
security market line (SML) The depiction of the capital asset pricing model
(CAPM) as
a graph that reflects the required return in the marketplace for each level of
nondiversifiable risk (beta).

CHAPTER 14 Payout Policy

payout policy Decisions that a firm makes regarding whether to distribute
cash to shareholders, how much cash to distribute, and the means by which
cash should be distributed.
date of record (dividends)Set by the firms directors, the date on which all
persons
whose names are recorded as stockholders receive a declared dividend at a
specified future time.
ex dividend A period beginning 2 business days prior to the date of record,
during which a stock is sold without the right to receive the current dividend.
payment date Set by the firms directors, the actual date on which the firm
mails the dividend payment to the holders of record.
open-market share repurchase A share repurchase program in which firms
simply buy back some of their outstanding shares on the open market.
tender offer repurchase A repurchase program in which a firm offers to
repurchase a fixed number of shares, usually at a premium relative to the
market value, and shareholders decide whether or not they want to sell back
their shares at that price.
Dutch auction repurchase A repurchase method in which the firm specifies
how many
shares it wants to buy back and a range of prices at which it is willing to
repurchase shares. Investors specify how many shares they will sell at each
price in the range, and
the firm determines the minimum price required to repurchase its target
number of shares. All investors who tender receive the same price.
dividend reinvestment plans(DRIPs) Plans that enable stockholders to use
dividends received on the firms stock to acquire additional shareseven
fractional sharesat little or no transaction cost.
residual theory of dividends A school of thought that suggests that the
dividend paid
by a firm should be viewed as a residualthe amount left over after all
acceptable investment opportunities have been undertaken.

dividend irrelevance theory Miller and Modiglianis theory that in a perfect

world, the
firms value is determined solely by the earning power and risk of its assets
(investments) and that the manner in which it splits its earnings stream
between dividends and internally
retained (and reinvested) funds does not affect this value.
clientele effect The argument that different payout policies attract different
types of investors but still do not change the value of the firm.
dividend relevance theory The theory, advanced by Gordon and Lintner,
that there
is a direct relationship between a firms dividend policy and its market value.
bird-in-the-hand argument The belief, in support of dividend relevance
theory, that investors see current dividends as less risky than future dividends
or capital gains.
informational content The information provided by the dividends of a firm
with
respect to future earnings, which causes owners to bid up or down the price of
the firms
stock.
dividend policy The firms plan of action to be followed whenever it makes a
dividend decision.
excess earnings accumulation tax The tax the IRS levies on retained
earnings above
$250,000 for most businesses when it determines that the firm has
accumulated an excess of earnings to allow owners to delay paying ordinary
income taxes on dividends received.
catering theory A theory that says firms cater to the preferences of investors,
initiating or increasing dividend payments during periods in which highdividend stocks are particularly

appealing to investors.
dividend payout ratio Indicates the percentage of each dollar earned that a
firm distributes to the owners in the form of cash. It is calculated by dividing
the firms cash
dividend per share by its earnings per share.
constant-payout-ratio dividend policy A dividend policy based on the
payment of a certain percentage of earnings to owners in each dividend period.
regular dividend policy A dividend policy based on the payment of a fixeddollar dividend in each period.
target dividend-payout ratio A dividend policy under which the firm
attempts to pay out a certain percentage of earnings as a stated dollar
dividend and adjusts that dividend toward a target payout as proven earnings
increases occur.
low-regular-and-extra dividend policy A dividend policy based on paying
a low regular dividend, supplemented by an additional (extra) dividend when
earnings are higher than normal in a given period.
extra dividend An additional dividend optionally paid by the firm when
earnings are higher than normal in a given period.
stock dividend The payment, to existing owners, of a dividend in the form of
stock.
small (ordinary) stock dividend A stock dividend representing less than
20 percent to
25 percent of the common stock outstanding when the dividend is declared.
stock split A method commonly used to lower the market price of a firms
stock by increasing the number of shares belonging to each shareholder.
reverse stock split A method used to raise the market price of a firms stock
by exchanging a certain number of outstanding shares for one new share.