Interest rates are inversely related to present (i.e., bond) values.

T
T
r) (1
F
r
r) (1
1
- 1
C Value Bond
+
+
(
(
(
(

+
=

PV of the coupons= C* [1-1/ (1+ r)
T
]/r PV of the Face amount= F/ (1+ r)
T

Interest Rate Risk: 1. the longer the time to maturity. 2. The lower the coupon rate.
To find YTM we use trial and error
Current Yield= Bonds Annual Coupon/ Bonds Price Yield to maturity = current yield + capital gains yield
In a discount bond the Current Yield is lower than the YTM because the Current Yield considers only the coupon portion of your return; it doesnt consider the built in gain from the price
discount. The reverse is true for a premium bond, current yield will be higher because it ignores the built in loss.
The yield to maturity is: 1. the rate that equates the price of the bond with the discounted cash flows. 2. The expected rate to be earned if held to maturity. 3. The rate that is used to determine
the market price of the bond. 4. Equal to the current yield for bonds priced at par.
PV of a Zero coupon bond =
T
r
F
PV
) 1 ( +
=
if not mentioned otherwise - one year and not semiannual, T= number of periods
After Tax Yields: X % * (1 T) = Y% X=Taxable Bond Y=Non Taxable Bond (Munis, T-bonds)
The promised yield (YTM) may be higher than the expected return due to this added default risk on a corporate bond.
Treasury prices are quoted on 32nds. The decimal divided by 32. Bellwether is the last bond in the list, the bond that makes the news.
Dirty price: price actually paid = quoted price (clean price) + accrued interest (fraction of the coupon period that has passed)
1 + R = (1 + r)(1 + h), where R = nominal rate, r = real rate, h = expected inflation rate, R= r + h + r * h
TIPS (Treasury Inflation-Protected Securities), eliminate risk by providing promised payments specified in real terms rather than nominal terms. Fischer Effect = A rise in the rate of inflation
causes the nominal rate to rise just enough so the real rate of interest is unaffected, the real rate of invariant to the rate of inflation.
Term structure is the relationship between time to maturity and yields, all else equal (pure discount bonds). Yield curve graphical representation of the term structure (coupon bonds). Normal
upward-sloping, long-term yields are higher than short-term yields. Inverted downward-sloping, long-term yields are lower than short-term yields. 1. Real rate of interest. 2. Expected future
inflation. 3. Interest rate risk. 4. Default risk. 5. Taxability. 6. Lack of liquidity.
Zero Growth
R
P
Div
0
=
Constant Growth
g R
P

=
1
0
Div
Differential Growth
Earnings next year = Earnings this year + RE this year X Return on RE g = Retention ratio Return on retained earnings (ROE)
RE to Earnings is Retention Ration, Dividends to Earnings is the Payout Ratio, Payout + Retention = 1
R = Dividend Yield + Capital Gains Yield R = Div/P0 + g = (.381(1.056))/11.625) + .056 = (.40/11.625) + .056 = .0346 + .056 = .0906 = 9%
9.3 Growth Opportunities Cash Cow EPS = Div Value of a Share of a Stock EPS/ R = Div/ R
P = EPS/ R + NPVGO NPVGO = Net Present Value (per share) of the Growth Opportunity
A Cash Cow is a 0 Growth firm because Retention Rate is 0.
The difference between the market price and the per share value is the NPVGO, NPVGO / Market Price
Selecting projects with rates of return below the discount rate will grow in terms of earnings and dividends but will destroy firm value. If ROE>R, then increased retention increases firm value
since reinvested capital earns more than the cost of capital.
) * (
EPS * RR) - (1
ROE RR R
P

=

EPS
share per Price
ratio P/E =

EPS
NPVGO
R
PE + =
1

A firms PE ratio is positively related to growth opportunities and negatively related to risk (R), conservative accounting (LIFO) practices have higher PE ratios.
10.2 Holding Period Return (1 + R1) * (1 + R2) * (1 + R3) * (1 + R4) - 1
T
R R
R
T
) (
1
+ +
=


1
) ( ) ( ) (
2 2
2
2
1

+ +
= =
T
R R R R R R
VAR SD
T

Growth Arithmetic Geometric SD Risk Premium
Large Company Stocks $2,049.45 11.7% 9.6% 20.6% 7.9%
Small Company Stocks $9,548.94 16.4% 11.7% 33.0% 12.6%
Long-Term Corporate Bonds 6.2% 5.9% 8.4% 2.4%
Long-Term Government Bonds $99.16 6.1% 5.7% 9.4% 2.3%
Intermediate-term Gov. Bonds 5.6% 5.4% 5.7% 1.8%
U.S. Treasury Bills $20.53 3.8% 3.7% 3.1% Risk Free Rate 0%
Inflation $11.73 3.1% 3.0% 4.2% -0.7%
Sharpe Ratio = Risk Premium / SD
1 SD = 68.26% 2 SD = 95.44% 3 SD = 99.74%
Arithmetic average is the return earned in an average period over multiple periods, overly optimistic for long horizons.
Geometric average is the average compound return per period over multiple periods, overly pessimistic for short horizons.
The geometric average is very useful in describing the actual historical investment experience. The Arithmetic average is useful in making estimates of the future.
Rg = [(1 + R1) * (1 + R2) * (1 + R3) * (1 + RT)]
1/T
- 1
Geometric average Arithmetic Var/ 2
SE (Standard Error) =
ns Observatio
R SD* (

Financial distress is a situation where a firms operating cash flows are not sufficient to satisfy current obligations, and the firm is forced to take corrective action. Financial distress may lead a
firm to default on a contract, and it may involve financial restructuring between the firm, its creditors, and its equity investors.
1. Stock-base insolvency: the value of the firms assets is less than the value of the debt. 2. Flow-base insolvency occurs when the firms cash flows are insufficient to cover contractually
required payments.
Firms deal with distress by: 1. selling major assets. 2. Merging with another firm. 3. Reducing capital spending and research and development. 4. Issuing new securities. 5. Negotiating with
banks and other creditors. 6. Exchanging debt for equity. 7. Filing for bankruptcy. 1-3 is Firm Assets Restructuring; 4-7 is the Firm Financial Restructuring (Debt and Equity).
30.3 Bankruptcy Liquidation and Reorganization
Liquidation (Chapter 7) means termination of the firm as a going concern. It involves selling the assets of the firm for salvage value. The proceeds, net of transactions costs, are distributed to
creditors in order of priority.
Reorganization (Chapter 11) is the option of keeping the firm a going concern. Reorganization sometimes involves issuing new securities to replace old ones.
Straight liquidation under Chapter 7: 1. A petition is filed in a federal court. The debtor firm could file a voluntary petition or the creditors could file an involuntary petition against the firm. 2.
A trustee-in-bankruptcy is elected by the creditors to take over the assets of the debtor firm. The trustee will attempt to liquidate the firms assets. 3. After the assets are sold, after payment of
the costs of administration, money is distributed to the creditors. 4. If any money is left over, the shareholders get it.
Conditions for involuntary bankruptcy: 1. The corporation is not paying pat due debts. 2. More than 12 creditors, at least 3 with claims totaling at least $13,475, less than 12 creditors, one with
a claim of at least $13,475.
Priority of Claims: 1. Administration expenses associated with liquidation. 2. Unsecured claims arising after the filing of an involuntary bankruptcy petition. 3. Wages earned within 90 days
before the filing date, not to exceed $2,000 per claimant. 4. Contributions to employee benefit plans arising with 180 days before the filing date. 5. Consumer claims, not exceeding $900. 6.
Tax claims. 7. Secured and unsecured creditors claims. 8. Preferred stockholders claims. 9. Common stockholders claims. Administrative expenses, wages claims, government tax claims,
debt holder and then equity holder claims
Reorganization: 1. A voluntary petition or an involuntary petition is filed. 2. A federal judge either approves or denies the petition. 3. In most cases the debtor continues to run the business. 4.
The firm is given 120 days to submit a reorganization plan. 5. Creditors and shareholders are divided into classes. Requires only approval by 1/2 of creditors owning 2/3 of outstanding debt. 6.
After acceptance by the creditors, the plan is confirmed by the court. 7. Payments in cash, property, and securities are made to creditors and shareholders.
Private Workout or Bankruptcy:
Both formal bankruptcy and private workouts involve exchanging new financial claims for old financial claims. Usually, senior debt is replaced with junior debt, and debt is replaced with
equity. When they work, private workouts are better than a formal bankruptcy. Complex capital structures and lack of information make private workouts less likely.
Advantages of Bankruptcy: 1. New credit is available - "debtor in possession" debt. 2. Discontinued accrual of interest on pre-bankruptcy unsecured debt. 3. An automatic stay provision. 4.
Tax advantages. 5. Requires only approval by 1/2 of creditors owning 2/3 of outstanding debt
Disadvantages of Bankruptcy: 1. A long and expensive process. 2. Judges are required to approve major business decisions. 3. Distraction to management. 4. Hold out by stockholders.
Prepackaged Bankruptcy is a combination of a private workout and legal bankruptcy. In a prepackaged bankruptcy the firm: 1. and creditors agree to a private reorganization outside formal
bankruptcy. 2. Must reach agreement privately with most of the creditors. 3. Will have difficulty when there are thousands of reluctant trade creditors. The firm and most of its creditors agree
to private reorganization outside the formal bankruptcy. The main benefit is that it forces holdouts to accept bankruptcy reorganization. Offers many of the advantages of a formal bankruptcy,
but is more efficient.
The Z-Score Model: Public, Manufacturers
Z = 3.3*(EBIT/Total Assets) + 1.2*(NWC/Total Assets) + 1.0*(Sales/Total Assets) + .6*(MV Equity / BV Debt) + 1.4* (Accumulated RE / Total Assets)
Z < 1.81 high probability of bankruptcy 1.81 < Z < 2.99 is a grey area Z > 2.99 a low probability of bankruptcy
The Z-Score Model: Private, Non-Manufacturers
Z = 6.56*(NWC/Total Assets) + 3.26*(Accumulated RE / Total Assets) + 1.05* (EBIT/Total Assets) + 6.72* (BV Equity / Total Liabilities)
Z < 1.23 high probability of bankruptcy 1.23 < Z < 2.90 is a grey area Z > 2.90 a low probability of bankruptcy

Div8 = $.4*(1 + .07)6 (1.04)2 = $0.65
If you expect the market rate of return to increase across the board on all equity securities, then you should also expect the market values of all stocks to decrease, all else constant.
The total interest paid on a zero-coupon bond is equal to: the face value minus the issue price.

E(r) = (.20 * -.04) + (.55 * .06) + (.25 * .14) = -.008 + .033 + .035 = .06 = 6.0%
r = 3.125%; PV = = $477.82; Implicit interest = $477.82 - $463.34 = $14.48
If its yield to maturity is less than its coupon rate, a bond will sell at a premium, and increases in market interest rates will decrease this premium.
Altman's Z-score predicts the: Likelihood of bankruptcy of a firm within one year
A bond with semi-annual interest payments, all else equal, would be priced lower than one with annual interest payments.

The "EST SPREAD" shown in The Wall Street Journal listing of corporate bonds represents the estimated: Difference between the bond's yield and the yield of a particular Treasury issue.


Value = $55(PVIFA5%,6) + $1,000(PVIF5%,6) = $279.16 + $746.22 = $1,025.38
Capital gains = ($45.13 - $43.89) * 100 = $124
Geometric average = (1.06 * 1.13 * .89 * 1.17) ^0.25 - 1 = 5.7%
$63.75 in July and January
Assume that you are using the dividend growth model to value stocks. If you expect the market rate of return to increase across the board on all equity securities, then you should also expect
the: market values of all stocks to decrease, all else constant.
Firms deal with financial distress by: A. selling major assets. B. merging with another firm. C. issuing new securities. D. exchanging debt for equity.