Lecture 4

Lecture 4
Homework 5 Review &

Chapter 7
Homework 5 Review
Question 1
Sustainable Growth
Based on the following information, the
sustainable growth rate for Hendrix
Guitars, Inc., is 13.02%. The ROA is
11.52%.
Profit margin=6.4 %
Total asset turnover=1.80
Total debt ratio=0.60
Payout ratio=60 %
Question 1
We should begin by calculating the D/E ratio. We calculate the D/E
ratio as follows:
Total debt ratio = .60 = TD / TA
Inverting both sides we get:
1 / .60 = TA / TD
Next, we need to recognize that
TA / TD = 1 + TE / TD
Substituting this into the previous equation, we get:
1 / .60 = 1 + TE /TD
Subtract 1 (one) from both sides and inverting again, we get:
D/E = 1 / [(1 / .60) 1]
D/E = 1.5
With the D/E ratio, we can calculate the EM and solve for ROE using
the DuPont identity:
Question 1
ROE = (PM)(TAT)(EM)
ROE = (.064)(1.80)(1 + 1.5)
ROE = .2880 or 28.80%
Now, we use the ROE equation:
ROE = ROA(EM)
.2880 = ROA(2.5)
ROA = .1152 or 11.52%
Now we can calculate the retention ratio as:
b = 1 .60
b = .40
Finally, putting all the numbers we have calculated into the sustainable
growth rate equation, we get:
Sustainable growth rate = (ROE b) / [1 (ROE b)]
Sustainable growth rate = [.2880(.40)] / [1 .2880(.40)]
Sustainable growth rate = .1302 or 13.02%
Question 2
Sustainable Growth Rate
No Return, Inc., had equity of $165,000 at the beginning
of the year. At the end of the year, the company had
total assets of $250,000. During the year the company
sold no new equity. Net income for the year was
$80,000 and dividends were $49,000. (Input answers as
a percent rounded to 2 decimal places, without the
percent sign.)
The sustainable growth rate for the company is ___
percent.
The sustainable growth rate is ____ percent if you use the
formula and beginning of period equity. If you use end of
period equity in this formula, the sustainable growth rate
is ____ percent. Is this number too high or too low?
Why?
Question 2
Since the company issued no new equity,
shareholders equity increased by retained
earnings.
Retained earnings for the year were:
Retained earnings = NI Dividends
Retained earnings = $80,000 49,000
Retained earnings = $31,000
So, the equity at the end of the year was:
Ending equity = $165,000 + 31,000
Ending equity = $196,000
Question 2
The ROE based on the end of period equity is:
ROE = $80,000 / $196,000
ROE = 40.82%
The plowback ratio is:
Plowback ratio = Addition to retained earnings/NI
Plowback ratio = $31,000 / $80,000
Plowback ratio = .3875 or = 38.75%
Using the equation presented in the text for the sustainable growth rate,
we get:
Sustainable growth rate = (ROE b) / [1 (ROE b)]
Sustainable growth rate = [.4082(.3875)] / [1 .4082(.3875)]
The ROE based on the beginning of period equity is
ROE = $80,000 / $165,000
ROE = .4848 or 48.48%
Question 2
Using the shortened equation for the sustainable growth rate and the
beginning of period ROE, we get:
Sustainable growth rate = ROE b
Sustainable growth rate = .4848 .3875
Using the shortened equation for the sustainable growth rate and the
end of period ROE, we get:
Sustainable growth rate = ROE b
Sustainable growth rate = .4082 .3875
Using the end of period ROE in the shortened sustainable growth rate
results in a growth rate that is too low. This will always occur
whenever the equity increases. If equity increases, the ROE based on
end of period equity is lower than the ROE based on the beginning of
period equity. The ROE (and sustainable growth rate) in the
abbreviated equation is based on equity that did not exist when the
net income was earned.
Question 2
Sustainable Growth Rate
No Return, Inc., had equity of $165,000 at the beginning of
the year. At the end of the year, the company had total
assets of $250,000. During the year the company sold
no new equity. Net income for the year was $80,000 and
dividends were $49,000. (Input answers as a percent
rounded to 2 decimal places, without the percent sign.)
The sustainable growth rate for the company is 18.79
percent.
The sustainable growth rate is 18.79% percent if you use
the (ROE x b) formula and beginning of period equity. If
you use end of period equity in this formula, the
sustainable growth rate is 15.82% percent. Is this
number too high or too low? This is too low because
equity has increased (see previous slide) Why?
Question 3
Assets and costs are proportional to
sales. Debt and equity are not. A
dividend of $963.60 was paid, and
McGillicudy wishes to maintain a constant
payout ratio. Next year's sales are
projected to be $23,040. The external
financing needed is $ _____
Balance Sheet
Income Statement
Sales
$ 19,200
Costs
15,550
Assets
Taxes (34 %)
$ 3,650
1,241
========
Net income
$ 2,409
========
Debt
Equity
========
Taxable
income
$ 93,000
========
Total
$ 93,000
========
$ 20,400
72,600
========
Total
$ 93,000
========
Question 3
An increase of sales to $23,040 is an increase of:
Sales increase = ($23,040 19,200) / $19,200
Sales increase = .20 or 20%
Assuming costs and assets increase proportionally, the pro
forma financial statements will look like this:
Pro forma income statement
Sales
$23,040.00
Costs
18,660.00
EBIT
4,380.00
Taxes(34%)1,489.20
Net income$2,890.80
Pro forma balance sheet

Assets
$ 111,600
Total
111,600
Debt
Equity
Total
$20,400.00
74,334.48
$ 94,734.48
Question 3
The payout ratio is constant, so the dividends paid this year is the
payout ratio from last year times net income, or:
Dividends = ($963.60 / $2,409)($2,890.80)
Dividends = $1,156.32
The addition to retained earnings is:
Addition to retained earnings = $2,890.80 1,156.32
Addition to retained earnings = $1,734.48
And the new equity balance is:
Equity = $72,600 + 1,734.48
Equity = $74,334.48
So the EFN is:
EFN = Total assets Total liabilities and equity
EFN = $111,600 94,734.48
EFN = $16,865.52
Question 4
A 20 percent growth rate in sales is
projected. Prepare a pro forma income
statement assuming costs vary with
sales and the dividend payout ratio is
constant.
HEIR JORDAN CORPORATION

Income Statement
--------------------------------------------------------------------------------------------------------------------------Sales
$ 29,000
Costs
11,200
========
Taxable Income
$ 17,800
Taxes (34%)
6,052
========
Net income
$ 11,748
========
Dividends
Addition to retained earnings
$ 4,935
6,813

Pro Forma Income Statement
--------------------------------------------------------------------------------------------------------------------------Sales
=$29,000*1.2=$34,800
Costs
=$11,200*1.2=$13,440
========
Taxable Income
$21,360
Taxes (34%)
$7,262.40
========
Net income
$14,097.60
========
Dividends (Ratio = 4,935/11,748 = .42)
$ 5921.68
$ 8175.92

Balance Sheet
Assets
Liabilities and Owners' Equity

Percentage
Percentage
of Sales
Current assets
Cash
Current liabilities
$ 3,525
Accounts receivable
7,500
Inventory
6,000
========
========
$ 17,025
========
========
Total
Accounts
payable
Notes payable
Total
Long-term debt
Fixed assets
Net plant and
equipment
of Sales
$ 30,000
========
========
$ 3,000
7,500
========
========
$ 10,500
========
========
$ 19,500
========
========
$ 15,000
2,025
========
========
$ 17,025
========
========
$ 47,025
========
========
Owners' equity
Common stock
and paid-in surplus
Retained
earnings
Total
Total liabilities and

Total assets
$ 47,025
========
========
owners' equity
Question 5: Supply the missing information using the percentage of sales approach. Assume that
accounts payable vary with sales, whereas notes payable do not. (Input answers as a percent
rounded to 2 decimal places, without the percent sign.)(Enter "n/a" where needed.)
Balance Sheet
($)
(%)
Assets
Current assets
Cash
$3,525
A/R
7,500
Inventory 6,000
Total
$17,025
Fixed assets
Net P&E 30,000
($)
12.16
25.86
20.69
58.71
103.45
Total assets $47,025 162.16

Total liabilities and owners equity $47,025
n/a
(%)
Liabilities and Owners Equity

Current liabilities
A/P
$3,000
Notes payable
7,500
Total
$10,500
Long-term debt
19,500
10.34
n/a
n/a
n/a
Owners equity
CS & Paid surplus
Retained earnings
$15,000
2,025
n/a
n/a
Total
$17,025
n/a
Question 6: Prepare a pro forma balance sheet showing EFN, assuming a 15

percent increase in sales, no new external debt or equity financing, and a
constant payout ratio.
Assuming costs vary with sales and a 15 percent increase in sales, the pro forma income statement will
look like this:
Sales
$33,350.00
Costs
12,880.00
Taxable income
$20,470.00
Taxes (34%)
6,959.80
Net income
$ 13,510.20
The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times net
income, or:
Dividends = ($4,935/$11,748)($13,510.20)
Dividends = $5,674.94
And the addition to retained earnings will be:
Addition to retained earnings = $13,240.20 5,674.94
Addition to retained earnings = $7,835.26
The new total addition to retained earnings on the pro forma balance sheet will be:
New total addition to retained earnings = $2,025 + 7,835.26
New total addition to retained earnings = $9,860.26
The pro forma balance sheet will look like this:

Pro Forma Balance Sheet
Assets
Current assets
Cash
$
Accounts receivable
Inventory
Total
$
4,053.75
8,625.00
6,900.00
19,578.75

Current liabilities
Accounts payable
$
Notes payable
Total
$
3,450.00
7,500.00
10,950.00
Long-term debt
19,500.00
Owners equity
Common stock and
paid-in surplus
Retained earnings
Total
$
Total liabilities and owners equity $
$15,000.00
9,860.26
24,860.26
55,310.26
Fixed assets
Net plant and
equipment
Total assets
34,500.00
54,078.75
So the EFN is:

EFN = $54,078.75 55,310.26
EFN = $1,231.51
Question 7
Find the following financial ratios for Smolira

Golf Corp. (use year-end figures rather than
average values where appropriate):
For solvency and utilization ratios: (Round

answers to 2 decimal places.)
For profitability ratios: (Input answers as a

percent rounded to 2 decimal places, without a
percent sign.)
SMOLIRA GOLF CORP.

2004 and 2005 Balance Sheets
Assets
Liabilities and Owners'

Equity
2004
2005
2004
2005
$ 983
$ 1,292
Current
liabilities
Current assets
Cash
$ 815
$ 906
Accounts
payable
Accounts
receivable
2,405
2,510
Notes payable
720
840
Inventory
4,608
4,906
Other
105
188
$ 7,828
$ 8,322
Total
$ 1,808
$ 2,320
Long-term debt
$ 4,817
$ 4,960
$ 10,000
$ 10,000
6,367
10,209
Total
$ 16,367
$ 20,209
Total liabilities
and owners'
equity
$ 22,992
$ 27,489
Total
Fixed assets
Net plant and
equipment
Total assets
$ 15,164
$ 19,167
Owners' equity
========
========
Common
stock and paidin surplus
$ 22,992
$ 27,489
Retained
earnings
SMOLIRA GOLF CORP.

2005 Income Statement
Sales
$ 33,500
Costs of goods sold
18,970
Depreciation
1,980
========
Earnings before interest and taxes
$ 12,550
Interest paid
486
========
Taxable Income
$ 12,064
Taxes (35%)
4,222
========
Net income
$ 7,842
========
Dividends
$ 4,000
3,842
Short-term solvency ratios:
Current ratio = Current assets / Current liabilities

Current ratio 2004 = $7,828 / $1,808 = 4.33 times
Current ratio 2005 = $8,322 / $2,320 = 3.59 times
Quick ratio = (Current assets Inventory) / Current liabilities
Quick ratio 2004 = ($7,828 4,608) / $1,808 = 1.78 times
Quick ratio 2005 = ($8,322 4,906) / $2,320 = 1.47 times
Cash ratio = Cash / Current liabilities
Cash ratio 2004
= $815 / $1,808 = 0.45 times
Cash ratio 2005 = $906 / $2,320 = 0.39 times
Asset utilization ratios:

Total asset turnover = Sales / Total assets
Total asset turnover
= $33,500 / $27,489 = 1.22 times
Inventory turnover
= Cost of goods sold / Inventory
Inventory turnover
= $18,970 / $4,906 = 3.87 times
Receivables turnover
= Sales / Accounts receivable
Receivables turnover
= $33,500 / $2,510 = 13.35 times
Long-term solvency ratios:
Total debt ratio
= (Total assets Total equity) / Total assets
Total debt ratio 2004
= ($22,992 16,367) / $22,992 = 0.29
Total debt ratio 2005
= ($27,489 20,209) / $27,489 = 0.26
Debt-equity ratio
= Total debt / Total equity
Debt-equity ratio 2004
= ($1,808 + 4,817) / $16,367 = 0.40
Debt-equity ratio 2005
= ($2,320 + 4,960) / $20,209 = 0.36
Equity multiplier
= 1 + D/E
Equity multiplier 2004
= 1 + 0.40 = 1.40
Equity multiplier 2005
= 1 + 0.36 = 1.36
Times interest earned
= EBIT / Interest
Times interest earned
= $12,550 / $486 = 25.82 times
Cash coverage ratio= (EBIT + Depreciation) / Interest
Cash coverage ratio
= ($12,550 + 1,980) / $486 = 29.90 times
Profitability ratios:
Profit margin
Profit margin
Return on assets
Return on assets
Return on equity
Return on equity
= Net income / Sales

= $7,842 / $33,500 = 23.41%
= Net income / Total assets
= $7,842 / $27,489 = 28.53%
= Net income / Total equity
= $7,842 / $20,209 = 38.80%
Question 8
The most recent financial statements for Moose

Tours, Inc., follow. Sales for 2005 are projected to
grow by 20 percent. Interest expense will remain
constant; the tax rate and the dividend payout
rate will also remain constant. Costs, other
expenses, current assets, and accounts
payable increase spontaneously with sales. If
the firm is operating at full capacity and no new
debt or equity is issued, external financing in
the amount of $_____ is needed to support the
20 percent growth rate in sales.
MOOSE TOURS, INC.

------------------------------------------------------------------------------------------------Sales
$ 905,000
Costs
710,000
Other expenses
12,000
========
$ 183,000
Interest paid
19,700
========
Taxable Income
$ 163,300
Taxes (35%)
57,155
========
Net income
$ 106,145
========
Dividends
$ 42,458
63,687
MOOSE TOURS, INC.

Balance Sheet as of December 31, 2004
Assets
Current assets
Cash
Current liabilities
$ 25,000
Accounts
receivable
43,000
Inventory
76,000
Total
$ 144,000
Accounts payable
Notes payable
$ 65,000
9,000
Total
$ 74,000
Long-term debt
$ 156,000
Owners' equity
Common stock
and
Fixed assets
Net plant and
equipment
$ 364,000
Total assets
$ 508,000
paid-in surplus
Retained
earnings
Total
$ 21,000
257,000
$ 278,000

owners' equity
$ 508,000
Assuming costs vary with sales and a 20 percent increase in sales, the pro forma income
statement will look like this:
MOOSE TOURS INC.
Sales $
1,086,000
Costs 852,000
Other expenses 14,400
EBIT $
219,600
Interest
19,700
Taxable income $199,900
Taxes(35%)
69,965
Net income
$129,935
The payout ratio is constant, so the dividends paid this year is the payout ratio from last
year times net income, or:
Dividends = ($42,458/$106,145)($129,935)
Dividends = $51,974
Addition to retained earnings = $129,935 51,974
Addition to retained earnings = $77,961
The new addition to retained earnings on the pro forma balance sheet will be:
New addition to retained earnings = $257,000 + 77,961
New addition to retained earnings = $334,961
The pro forma balance sheet will look like this:
MOOSE TOURS INC.
Pro Forma Balance Sheet
Assets
Current assets
Current liabilities
Cash
$30,000 Accounts payable
$78,000
Accounts receivable 51,600
Notes payable
Inventory 91,200
Total
$87,000
Total
$
172,800 Long-term debt
9,000
156,000
Fixed assets
Net plant and equipment 436,800 Owners equity
Common stock and
paid-in surplus
$21,000
Retained earnings 334,961
Total $355,961
Total liabilities and owners
Total assets
$609,600 equity
$598,961
Question 8

expenses, current assets, and accounts
payable increase spontaneously with sales. If
the firm is operating at full capacity and no new
debt or equity is issued, external financing in
the amount of $_____ is needed to support the
20 percent growth rate in sales.
Question 8
So the EFN is:
EFN = Total assets Total liabilities and
equity
EFN = $609,600 598,961
EFN = $10,639
Question 9

expenses, current assets, and accounts payable
increase spontaneously with sales. If the firm is
operating at full capacity and wishes to keep its
debt-equity ratio constant, external financing in
the amount of $ is needed to support the 20
percent growth rate in sales.
Question 9
The D/E ratio of the company is:
D/E = ($156,000 + 74,000) / $278,000
D/E = .82734
So the new total debt amount will be:
New total debt = .82734($355,961)
New total debt = $294,500.11
So the EFN is:
EFN = $609,600 ($294,500.11 + 355,961) = $40,861.11
An interpretation of the answer is not that the company has a negative EFN. Looking
back at Question 8, we see that for the same sales growth, the EFN is $10,639. The
negative number in this case means the company has too much capital. There are
two possible solutions. First, the company can put the excess funds in cash, which
has the effect of changing the current asset growth rate. Second, the company can
use the excess funds to repurchase debt and equity. To maintain the current capital
structure, the repurchase must be in the same proportion as the current capital
structure.
At a 20 percent growth rate, and assuming the payout ratio is constant, the
dividends paid will be:
Dividends = ($42,458/$106,145)($129,935)
Dividends = $51,974
Addition to retained earnings = $129,935 51,974
Addition to retained earnings = $77,961
New addition to retained earnings = $257,000 + 77,961
New addition to retained earnings = $334,961
The new total debt will be:
New total debt = .82734($334,961)
New total debt = $294,500
So, the new long-term debt will be the new total debt minus the new shortterm debt, or:
New long-term debt = $294,500 87,000
New long-term debt = $207,500
So the EFN is:

EFN = $609,600 650,461
EFN = $40,861
Question 10
EFN and Sustainable Growth
The most recent financial statements for Moose Tours, Inc., follow. Sales for
2005 are projected to grow by 30 percent. Interest expense will remain
constant; the tax rate and the dividend payout rate will also remain constant.
Costs, other expenses, current assets, and accounts payable increase
spontaneously with sales. If the firm is operating at full capacity and wishes
to keep its debt-equity ratio constant, external financing in the amount of
$_____ is needed to support the 30 percent growth rate in sales. (Round
answers to nearest whole dollar.)
If the projected sales growth rate for 2005 is 35 percent instead of 30 percent,
the amount of external financing needed is $_____.
At a sales growth rate of _____% percent, the EFN is equal to zero.
Note: This last question cannot be answered if you do not allow debt to
change to meet the debt-equity ratio at the beginning of the question.
MOOSE TOURS, INC.

------------------------------------------------------------------------------------------------Sales
$ 905,000
Costs
710,000
Other expenses
12,000
========
$ 183,000
Interest paid
19,700
========
Taxable Income
$ 163,300
Taxes (35%)
57,155
========
Net income
$ 106,145
========
Dividends
$ 42,458
63,687
MOOSE TOURS, INC.

Balance Sheet as of December 31, 2004
Assets
Current assets
Cash
Current liabilities
$ 25,000
Accounts
receivable
43,000
Inventory
76,000
Total
$ 144,000
Accounts payable
Notes payable
$ 65,000
9,000
Total
$ 74,000
Long-term debt
$ 156,000
Owners' equity
Common stock
and
Fixed assets
Net plant and
equipment
$ 364,000
Total assets
$ 508,000
paid-in surplus
Retained
earnings
Total
$ 21,000
257,000
$ 278,000

owners' equity
$ 508,000
20% Sales
Growth
30% Sales
Growth
35% Sales
Growth
Sales
$1,086,000
$1,176,500
$1,221,750
Costs
852,000
923,000
958,500
14,400
15,600
16,200
$ 219,600
$ 237,900
$ 247,050
19,700
19,700
19,700
$ 199,900
$ 218,200
$ 227,350
69,965
76,370
79,573
$ 129,935
$ 141,830
$ 147,778
51,974
$ 56,732
77,961
85,098
Other expenses
EBIT
Interest
Taxable income
Taxes (35%)
Net income
Dividends
Add to RE
59,111
88,667
Under the sustainable growth rate assumption, the company maintains a constant debtequity ratio. The D/E ratio of the company is:
D/E = ($156,000 + 74,000) / $278,000
D/E = .82734
At a 30 percent growth rate, and assuming the payout ratio is constant, the dividends paid
will be:
Dividends = ($42,458/$106,145)($141,830) = $56,732
Addition to retained earnings = $141,830 56,732 = $85,098
New addition to retained earnings = $257,000 + 85,098 = $342,098
New total debt = .82734($342,098) = $300,405
So, the new long-term debt will be the new total debt minus the new short-term debt, or:
New long-term debt = $300,405 93,500 = $206,905
So the EFN is:

EFN = $660,400 663,503
EFN = $3,103
At a 35 percent growth rate, and assuming the payout ratio is constant,

the dividends paid will be:
Dividends = ($42,458/$106,145)($147,778) = $59,111
Addition to retained earnings = $147,778 59,111 = $88,667
The new addition to retained earnings on the pro forma balance sheet
will be:
New addition to retained earnings = $257,000 + 88,667 = $345,667
New total debt = .82734($366,667) = $303,357
So, the new long-term debt will be the new total debt minus the new
short-term debt, or:
New long-term debt = $303,357 96,750 = $206,607
So the EFN is:

EFN = $685,800 670,024
EFN = $15,776
Question 10
EFN and Sustainable Growth
Note: At 30% growth, there is a paydown in
external financing, while at 35% growth there is
a positive need for external financing
At a sales growth rate of 30.82%, the EFN is equal
to zero.
Why is this internal growth rate different from that
found by using the equation in the text?
Chapter 7
Interest Rates and Bond
Valuation
Key Concepts and Skills
Know the important bond features and bond types

Understand bond values and why they fluctuate
Understand bond ratings and what they mean
Understand the impact of inflation on interest
rates
Understand the term structure of interest rates
and the determinants of bond yields
Bond Definitions
Bond
Par value (face value)
Coupon rate
Coupon payment
Maturity date
Yield or Yield to maturity
Present Value of Cash Flows as

Rates Change
Bond Value = PV of coupons + PV of par
Bond Value = PV annuity + PV of lump
sum
Remember, as interest rates increase
present values decrease
So, as interest rates increase, bond prices
decrease and vice versa
Coupon BondYield to
Maturity
Using the same strategy used for the fixed-payment loan:
P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity date
C
C
C
C
F
P=
. . . +
2
3
n
1+i (1+i )
(1+i )
(1+i)
(1+i ) n
When the coupon bond is priced at its face value, the

yield to maturity equals the coupon rate
The price of a coupon bond and the yield to maturity
are negatively related
The yield to maturity is greater than the coupon rate
when the bond price is below its face value
Valuing a Discount Bond with

Annual
Coupons
Consider a bond with a coupon rate of 10% and annual coupons.
The par value is $1000 and the bond has 5 years to maturity. The
yield to maturity is 11%. What is the value of the bond?
Using
the formula:
= PV of annuity + PV of lump sum

B = 100[1 1/(1.11)5] / .11 + 1000 / (1.11) 5
B = 369.59 + 593.45 = 963.04
Using
N
the calculator:
= 5; I/Y = 11; PMT = 100; FV = 1000

CPT PV = -963.04
Valuing a Premium Bond with

Annual
Coupons
Suppose you are looking at a bond that has a 10% annual coupon
and a face value of $1000. There are 20 years to maturity and the
yield to maturity is 8%. What is the price of this bond?
Using
the formula:
B = PV of annuity + PV of lump sum

B = 100[1 1/(1.08)20] / .08 + 1000 / (1.08)20
B = 981.81 + 214.55 = 1196.36
Using
the calculator:
N = 20; I/Y = 8; PMT = 100; FV = 1000

CPT PV = -1196.36
Bond Price
Graphical Relationship Between

Price and Yield-to-maturity
Yield-to-maturity
Bond Prices: Relationship

Between Coupon and Yield
If YTM = coupon rate, then par value = bond price
If YTM > coupon rate, then par value > bond price
Why?
Selling
at a discount, called a discount bond
If YTM < coupon rate, then par value < bond price
Why?
Selling
at a premium, called a premium bond
The Bond-Pricing Equation
1
1
t
(1 r)
Bond Value C
r
F

t
(1 r)
Example 7.1
Find present values based on the payment

period
How
many coupon payments are there?

What is the semiannual coupon payment?
What is the semiannual yield?
B = 70[1 1/(1.08)14] / .08 + 1000 / (1.08)14 = 917.56
Or PMT = 70; N = 14; I/Y = 8; FV = 1000; CPT PV =
-917.56
Interest Rate Risk
Price Risk
Change
in price due to changes in interest rates

Long-term bonds have more price risk than short-term bonds
Low coupon rate bonds have more price risk than high coupon
rate bonds
Reinvestment Rate Risk
Uncertainty concerning rates at which cash flows can be reinvested

Short-term bonds have more reinvestment rate risk than long-term
bonds
High coupon rate bonds have more reinvestment rate risk than low
coupon rate bonds
Interest-Rate Risk
Prices and returns for long-term

bonds are more volatile than those for
shorter-term bonds
There is no interest-rate risk for any bond

whose time to maturity matches the
holding period
Figure 7.2
Computing Yield-to-maturity
Yield-to-maturity is the rate implied by the
current bond price
Finding the YTM requires trial and error if you
do not have a financial calculator and is similar
to the process for finding r with an annuity
If you have a financial calculator, enter N, PV,
PMT, and FV, remembering the sign convention
(PMT and FV need to have the same sign, PV
the opposite sign)
YTM with Annual Coupons
Consider a bond with a 10% annual

coupon rate, 15 years to maturity and a
par value of $1000. The current price is
$928.09.
Will
the yield be more or less than 10%?

N = 15; PV = -928.09; FV = 1000; PMT = 100
CPT I/Y = 11%
YTM with Semiannual Coupons
Suppose a bond with a 10% coupon rate and

semiannual coupons, has a face value of $1000,
20 years to maturity and is selling for $1197.93.
Is
the YTM more or less than 10%?

What is the semiannual coupon payment?
How many periods are there?
N = 40; PV = -1197.93; PMT = 50; FV = 1000; CPT
I/Y = 4% (Is this the YTM?)
YTM = 4%*2 = 8%
Table 7.1
Current Yield vs. Yield to Maturity
Current Yield = annual coupon / price

Yield to maturity = current yield + capital gains yield
Example: 10% coupon bond, with semiannual
coupons, face value of 1000, 20 years to maturity,
$1197.93 price
Current
yield = 100 / 1197.93 = .0835 = 8.35%

Price in one year, assuming no change in YTM = 1193.68
Capital gain yield = (1193.68 1197.93) / 1197.93 =
-.0035 = -.35%
YTM = 8.35 - .35 = 8%, which the same YTM computed
earlier
Bond Pricing Theorems

Bonds of similar risk (and maturity) will be
priced to yield about the same return,
regardless of the coupon rate
If you know the price of one bond, you can
estimate its YTM and use that to find the price
of the second bond
This is a useful concept that can be transferred
to valuing assets other than bonds
Bond Prices with a Spreadsheet
There is a specific formula for finding bond

prices on a spreadsheet
PRICE(Settlement,Maturity,Rate,Yld,Redemption,
Frequency,Basis)
YIELD(Settlement,Maturity,Rate,Pr,Redemption,
Frequency,Basis)
Settlement and maturity need to be actual dates
The redemption and Pr need to given as % of par value
Click on the Excel icon for an example
Differences Between Debt and

Equity
Debt
Not an ownership interest

Creditors do not have
voting rights
Interest is considered a
cost of doing business and
is tax deductible
Creditors have legal
recourse if interest or
principal payments are
missed
Excess debt can lead to
financial distress and
bankruptcy
Equity
Ownership interest
Common stockholders vote
for the board of directors
and other issues
Dividends are not
considered a cost of doing
business and are not tax
deductible
Dividends are not a liability
of the firm and stockholders
have no legal recourse if
dividends are not paid
An all equity firm can not go
bankrupt
The Bond Indenture
Contract between the company and the

bondholders and includes
The
basic terms of the bonds

The total amount of bonds issued
A description of property used as security, if applicable
Sinking fund provisions
Call provisions
Details of protective covenants
Bond Classifications
Registered vs. Bearer Forms
Security
Collateral
secured by financial securities

Mortgage secured by real property, normally land or
buildings
Debentures unsecured
Notes unsecured debt with original maturity less than
10 years
Seniority
Bond Characteristics and

Required Returns
The coupon rate depends on the risk
characteristics of the bond when issued
Which bonds will have the higher coupon, all
else equal?
Secured
debt versus a debenture

Subordinated debenture versus senior debt
A bond with a sinking fund versus one without
A callable bond versus a non-callable bond
Bond Ratings Investment

Quality
High Grade
Moodys Aaa and S&P AAA capacity to pay is extremely strong

Moodys Aa and S&P AA capacity to pay is very strong
Medium Grade
Moodys A and S&P A capacity to pay is strong, but more

susceptible to changes in circumstances
Moodys Baa and S&P BBB capacity to pay is adequate,
adverse conditions will have more impact on the firms ability to
pay
Bond Ratings - Speculative
Low Grade
Moodys
Ba, B, Caa and Ca

S&P BB, B, CCC, CC
Considered speculative with respect to capacity to pay. The B
ratings are the lowest degree of speculation.
Very Low Grade

Moodys
C and S&P C income bonds with no interest being paid

Moodys D and S&P D in default with principal and interest in
arrears
Government Bonds
Treasury Securities
Federal
government debt
T-bills pure discount bonds with original maturity of
one year or less
T-notes coupon debt with original maturity between
one and ten years
T-bonds coupon debt with original maturity greater
than ten years
Municipal Securities
Debt
of state and local governments

Varying degrees of default risk, rated similar to
corporate debt
Interest received is tax-exempt at the federal level
Example 7.4
A taxable bond has a yield of 8% and a municipal

bond has a yield of 6%
If
you are in a 40% tax bracket, which bond do you

prefer?
8%(1 - .4) = 4.8%
The after-tax return on the corporate bond is 4.8%, compared
to a 6% return on the municipal
At
what tax rate would you be indifferent between the two

bonds?
8%(1 T) = 6%
T = 25%
Zero-Coupon Bonds
Make no periodic interest payments (coupon rate =

0%)
The entire yield-to-maturity comes from the difference
between the purchase price and the par value
Cannot sell for more than par value
Sometimes called zeroes, deep discount bonds, or
original issue discount bonds (OIDs)
Treasury Bills and principal-only Treasury strips are
good examples of zeroes
Floating Rate Bonds
Coupon rate floats depending on some index value

Examples adjustable rate mortgages and inflationlinked Treasuries
There is less price risk with floating rate bonds
The
coupon floats, so it is less likely to differ

substantially from the yield-to-maturity
Coupons may have a collar the rate cannot go

above a specified ceiling or below a specified floor
Other Bond Types

Disaster bonds
Income bonds
Convertible bonds
Put bonds
There are many other types of provisions that can be
added to a bond and many bonds have several provisions
it is important to recognize how these provisions affect
required returns
Bond Markets
Primarily over-the-counter transactions with
dealers connected electronically
Extremely large number of bond issues, but
generally low daily volume in single issues
Makes getting up-to-date prices difficult,
particularly on small company or municipal issues
Treasury securities are an exception
Work the Web Example

Bond quotes are available online
One good site is Bonds Online
Click on the web surfer to go to the site
Follow
the bond search, corporate links

Choose a company, enter it under Express
Search Issue and see what you can find!
Treasury Quotations
Highlighted quote in Figure 7.4

8
Nov 21
132:23
132:24
-12 5.14
What is the coupon rate on the bond?
When does the bond mature?
What is the bid price? What does this mean?
What is the ask price? What does this mean?
How much did the price change from the previous day?
What is the yield based on the ask price?
Clean vs. Dirty Prices
Clean price: quoted price

Dirty price: price actually paid = quoted price plus accrued
interest
Example: Consider T-bond in previous slide, assume today is
July 15, 2005
Prices (based on ask):
Number of days since last coupon = 61

Number of days in the coupon period = 184
Accrued interest = (61/184)(.04*100,000) = 1326.09
Clean price = 132,750
Dirty price = 132,750 + 1,326.09 = 134,076.09
So, you would actually pay $134,076.09 for the bond
Inflation and Interest Rates

Real rate of interest change in purchasing
power
Nominal rate of interest quoted rate of
interest, change in purchasing power and
inflation
The ex ante nominal rate of interest includes
our desired real rate of return plus an
adjustment for expected inflation
The Fisher Effect

The Fisher Effect defines the relationship
between real rates, nominal rates and inflation
(1 + R) = (1 + r)(1 + h), where
= nominal rate
r = real rate
h = expected inflation rate
Approximation
R
=r+h
Fisher Equation
i ir e
i = nominal interest rate
ir = real interest rate
e = expected inflation rate

When the real interest rate is low,
there are greater incentives to borrow and fewer incentives to lend.
The real interest rate is a better indicator of the incentives to
borrow and lend.
Example 7.6
If we require a 10% real return and we expect
inflation to be 8%, what is the nominal rate?
R = (1.1)(1.08) 1 = .188 = 18.8%
Approximation: R = 10% + 8% = 18%
Because the real return and expected inflation
are relatively high, there is significant difference
between the actual Fisher Effect and the
approximation.
Term Structure of Interest

Rates
Bonds with identical risk, liquidity, and tax characteristics

may have different interest rates because the time
remaining to maturity is different
Yield curvea plot of the yield on bonds with differing terms

to maturity but the same risk, liquidity and tax considerations
Upward-sloping long-term rates are above

short-term rates
Flat short- and long-term rates are the same
Inverted long-term rates are below short-term rates
Interpreting the Yield Curve
Figure 7.7
Figure 7.6 Upward-Sloping

Yield Curve
Figure 7.6 Downward-Sloping

Yield Curve
Factors Affecting Required

Return
Default risk premium remember bond ratings
Taxability premium remember municipal versus
taxable
Liquidity premium bonds that have more
frequent trading will generally have lower
required returns
Anything else that affects the risk of the cash
flows to the bondholders will affect the required
returns
Quick Quiz
How do you find the value of a bond and why do bond

prices change?
What is a bond indenture and what are some of the
important features?
What are bond ratings and why are they important?
How does inflation affect interest rates?
What is the term structure of interest rates?
What factors determine the required return on bonds?

Lecture 4

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Lecture 4

Homework 5 Review &

Pro forma balance sheet

HEIR JORDAN CORPORATION

HEIR JORDAN CORPORATION

Dividends (Ratio = 4,935/11,748 = .42)

Addition to retained earnings

HEIR JORDAN CORPORATION

Liabilities and Owners' Equity

Total liabilities and

Total assets $47,025 162.16

Liabilities and Owners Equity

Question 6: Prepare a pro forma balance sheet showing EFN, assuming a 15

The pro forma balance sheet will look like this:

Liabilities and Owners Equity

So the EFN is:

Find the following financial ratios for Smolira

For solvency and utilization ratios: (Round

For profitability ratios: (Input answers as a

SMOLIRA GOLF CORP.

Liabilities and Owners'

SMOLIRA GOLF CORP.

Costs of goods sold

Earnings before interest and taxes

Short-term solvency ratios:

Current ratio = Current assets / Current liabilities

Asset utilization ratios:

= Net income / Sales

The most recent financial statements for Moose

MOOSE TOURS, INC.

Earnings before interest and taxes

MOOSE TOURS, INC.

Liabilities and Owners' Equity

Total liabilities and

The most recent financial statements for Moose

The most recent financial statements for Moose

So the EFN is:

MOOSE TOURS, INC.

Earnings before interest and taxes

MOOSE TOURS, INC.

Liabilities and Owners' Equity

Total liabilities and

So the EFN is:

At a 35 percent growth rate, and assuming the payout ratio is constant,

So the EFN is:

Key Concepts and Skills

Know the important bond features and bond types

Present Value of Cash Flows as

When the coupon bond is priced at its face value, the

Valuing a Discount Bond with

= PV of annuity + PV of lump sum

= 5; I/Y = 11; PMT = 100; FV = 1000

Valuing a Premium Bond with

B = PV of annuity + PV of lump sum

N = 20; I/Y = 8; PMT = 100; FV = 1000

Graphical Relationship Between

Bond Prices: Relationship

at a discount, called a discount bond

at a premium, called a premium bond

The Bond-Pricing Equation

Find present values based on the payment

many coupon payments are there?

Interest Rate Risk

in price due to changes in interest rates