P1: a/b fm P2: c/d QC: e/f JWBT310-Fabozzi T1: g July 8, 2010 13:51 vi Printer: Courier Westford, Westford, MA P1: a/b fm P2: c/d QC: e/f JWBT310-Fabozzi T1: g July 8, 2010 13:51 Printer: Courier Westford, Westford, MA The Basics of Finance i P1: a/b fm P2: c/d QC: e/f JWBT310-Fabozzi T1: g July 8, 2010 13:51 Printer: Courier Westford, Westford, MA The Frank J Fabozzi Series Fixed Income Securities, Second Edition by Frank J Fabozzi Focus on Value: A Corporate and Investor Guide to Wealth Creation by James L Grant and James A Abate Handbook of Global Fixed Income Calculations by Dragomir Krgin Managing a Corporate Bond Portfolio by Leland E Crabbe and Frank J Fabozzi Real Options and Option-Embedded Securities by William T Moore Capital Budgeting: Theory and Practice by Pamela P Peterson and Frank J Fabozzi The Exchange-Traded Funds Manual by Gary L Gastineau Professional Perspectives on Fixed Income Portfolio Management, Volume edited by Frank J Fabozzi Investing in Emerging Fixed Income Markets edited by Frank J Fabozzi and Efstathia Pilarinu Handbook of Alternative Assets by Mark J P Anson The Global Money Markets by Frank J Fabozzi, Steven V Mann, and Moorad Choudhry The Handbook of Financial Instruments edited by Frank J Fabozzi Interest Rate, Term Structure, and Valuation Modeling edited by Frank J Fabozzi Investment Performance Measurement by Bruce J Feibel The Handbook of Equity Style Management edited by T Daniel Coggin and Frank J Fabozzi The Theory and Practice of Investment Management edited by Frank J Fabozzi and Harry M Markowitz Foundations of Economic Value Added, Second Edition by James L Grant Financial Management and Analysis, Second Edition by Frank J Fabozzi and Pamela P Peterson Measuring and Controlling Interest Rate and Credit Risk, Second Edition by Frank J Fabozzi, Steven V Mann, and Moorad Choudhry Professional Perspectives on Fixed Income Portfolio Management, Volume edited by Frank J Fabozzi The Handbook of European Fixed Income Securities edited by Frank J Fabozzi and Moorad Choudhry The Handbook of European Structured Financial Products edited by Frank J Fabozzi and Moorad Choudhry The Mathematics of Financial Modeling and Investment Management by Sergio M Focardi and Frank J Fabozzi Short Selling: Strategies, Risks, and Rewards edited by Frank J Fabozzi The Real Estate Investment Handbook by G Timothy Haight and Daniel Singer Market Neutral Strategies edited by Bruce I Jacobs and Kenneth N Levy Securities Finance: Securities Lending and Repurchase Agreements edited by Frank J Fabozzi and Steven V Mann Fat-Tailed and Skewed Asset Return Distributions by Svetlozar T Rachev, Christian Menn, and Frank J Fabozzi Financial Modeling of the Equity Market: From CAPM to Cointegration by Frank J Fabozzi, Sergio M Focardi, and Petter N Kolm Advanced Bond Portfolio Management: Best Practices in Modeling and Strategies edited by Frank J Fabozzi, Lionel Martellini, and Philippe Priaulet Analysis of Financial Statements, Second Edition by Pamela P Peterson and Frank J Fabozzi Collateralized Debt Obligations: Structures and Analysis, Second Edition by Douglas J Lucas, Laurie S Goodman, and Frank J Fabozzi Handbook of Alternative Assets, Second Edition by Mark J P Anson Introduction to Structured Finance by Frank J Fabozzi, Henry A Davis, and Moorad Choudhry Financial Econometrics by Svetlozar T Rachev, Stefan Mittnik, Frank J Fabozzi, Sergio M Focardi, and Teo Jasic Developments in Collateralized Debt Obligations: New Products and Insights by Douglas J Lucas, Laurie S Goodman, Frank J Fabozzi, and Rebecca J Manning Robust Portfolio Optimization and Management by Frank J Fabozzi, Peter N Kolm, Dessislava A Pachamanova, and Sergio M Focardi Advanced Stochastic Models, Risk Assessment, and Portfolio Optimizations by Svetlozar T Rachev, Stogan V Stoyanov, and Frank J Fabozzi How to Select Investment Managers and Evaluate Performance by G Timothy Haight, Stephen O Morrell, and Glenn E Ross Bayesian Methods in Finance by Svetlozar T Rachev, John S J Hsu, Biliana S Bagasheva, and Frank J Fabozzi The Handbook of Commodity Investing by Frank J Fabozzi, Roland Fuss, ă and Dieter G Kaiser The Handbook of Municipal Bonds edited by Sylvan G Feldstein and Frank J Fabozzi Subprime Mortgage Credit Derivatives by Laurie S Goodman, Shumin Li, Douglas J Lucas, Thomas A Zimmerman, and Frank J Fabozzi Introduction to Securitization by Frank J Fabozzi and Vinod Kothari Structured Products and Related Credit Derivatives edited by Brian P Lancaster, Glenn M Schultz, and Frank J Fabozzi Handbook of Finance: Volume I: Financial Markets and Instruments edited by Frank J Fabozzi Handbook of Finance: Volume II: Financial Management and Asset Management edited by Frank J Fabozzi Handbook of Finance: Volume III: Valuation, Financial Modeling, and Quantitative Tools edited by Frank J Fabozzi Finance: Capital Markets, Financial Management, and Investment Management by Frank J Fabozzi and Pamela Peterson Drake Active Private Equity Real Estate Strategy edited by David J Lynn Foundations and Applications of the Time Value of Money by Pamela Peterson Drake and Frank J Fabozzi Leveraged Finance: Concepts, Methods, and Trading of High-Yield Bonds, Loans, and Derivatives by Stephen Antczak, Douglas Lucas, and Frank J Fabozzi Modern Financial Systems: Theory and Applications by Edwin Neave Institutional Investment Management: Equity and Bond Portfolio Strategies and Applications by Frank J Fabozzi Quantitative Equity Investing: Techniques and Strategies by Frank J Fabozzi, Sergio M Focardi, Petter N Kolm Basics of Finance: An Introduction to Financial Markets, Business Finance, and Portfolio Management by Frank J Fabozzi and Pamela Peterson Drake Simulation and Optimization in Finance: Modeling with MATLAB, @Risk, or VBA by Dessislava Pachamanova and Frank J Fabozzi ii P1: a/b fm P2: c/d QC: e/f JWBT310-Fabozzi T1: g July 8, 2010 13:51 Printer: Courier Westford, Westford, MA The Basics of Finance An Introduction to Financial Markets, Business Finance, and Portfolio Management PAMELA PETERSON DRAKE FRANK J FABOZZI John Wiley & Sons, Inc iii P1: a/b fm P2: c/d QC: e/f JWBT310-Fabozzi Copyright C T1: g July 8, 2010 13:51 Printer: Courier Westford, Westford, MA 2010 by John Wiley & Sons All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002 Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic books For more information about Wiley products, visit our web site at www.wiley.com Library of Congress Cataloging-in-Publication Data: Fabozzi, Frank J The basics of finance : an introduction to financial markets, business finance, and portfolio management / Frank J Fabozzi, Pamela Peterson Drake p cm – (Frank J Fabozzi series ; 192) Includes index ISBN 978-0-470-60971-2 (cloth); 978-0-470-87743-2 (ebk); 978-0-470-87771-5 (ebk); 978-0-470-87772-2 (ebk) Finance I Peterson Drake, Pamela, 1954- II Title HG173.F25 2010 332–dc22 2010010863 Printed in the United States of America 10 iv P1: a/b fm P2: c/d QC: e/f JWBT310-Fabozzi T1: g July 8, 2010 13:51 Printer: Courier Westford, Westford, MA To my husband, Randy, and my children, Ken and Erica —P.P.D To my wife, Donna, and my children, Francesco, Patricia, and Karly —F.J.F v P1: a/b fm P2: c/d QC: e/f JWBT310-Fabozzi T1: g July 8, 2010 13:51 vi Printer: Courier Westford, Westford, MA P1: a/b fm P2: c/d QC: e/f JWBT310-Fabozzi T1: g July 8, 2010 13:51 Printer: Courier Westford, Westford, MA Contents Preface CHAPTER What Is Finance? Capital Markets and Capital Market Theory Financial Management Investment Management Organization of This Book The Bottom Line Questions xiii 8 PART ONE The Financial System CHAPTER Financial Instruments, Markets, and Intermediaries The Financial System The Role of Financial Markets The Role of Financial Intermediaries Types of Financial Markets The Bottom Line Questions 13 13 17 18 24 33 33 CHAPTER The Financial System’s Cast of Characters 37 Domestic Nonfinancial Sectors Nonfinancial Businesses Domestic Financial Sectors Foreign Investors The Bottom Line Questions 39 42 43 60 60 61 vii P1: a/b fm P2: c/d QC: e/f JWBT310-Fabozzi T1: g July 8, 2010 13:51 Printer: Courier Westford, Westford, MA viii CONTENTS PART TWO Financial Management CHAPTER Financial Statements Accounting Principles: What Are They? The Basic Financial Statements How Are the Statements Related? Why Bother about the Footnotes? Accounting Flexibility U.S Accounting vs Outside of the U.S The Bottom Line Solutions to Try It! Problems Questions CHAPTER Business Finance Forms of Business Enterprise The Objective of Financial Management The Bottom Line Solutions to Try It! Problems Questions 65 66 67 81 82 83 83 84 85 86 89 90 97 104 105 105 CHAPTER Financial Strategy and Financial Planning 109 Strategy and Value The Budgeting Process Budgeting Performance Evaluation Strategy and Value Creation The Bottom Line Questions 110 115 119 120 124 128 129 CHAPTER Dividend and Dividend Policies Dividends Stock Distributions Dividend Policies Stock Repurchases The Bottom Line Solutions to Try It! Problems Questions 133 134 137 141 147 150 151 151 APPENDIX: SOLUTIONS TO END OF CHAPTER QUESTIONS be the buyer, with a commitment to take delivery of the lumber at a future point at time at a specified price 13 a Forward contracts have the advantage that they can be customized, but unlike futures contracts, there is counterparty risk—the risk that the other party to the transaction does not carry out their obligations under the contract b A factor to consider is that by tailoring it to the corporation’s needs, there must be another party willing to take the other side of the transaction, as tailored as it is 14 A put option is an option to sell the underlying A call option is an option to buy the underlying 15 An American option may be exercised at any time prior to the expiration date A European option may be exercised only at the expiration date 16 Disagree In the case of an option, the buyer of the option has a choice whether to exercise the option In the case of futures, the buyer is committed to a transaction unless an offsetting transaction is made 17 a A call option: an option to buy the underlying at a specified price b A put option: an option to sell the underlying at a specified price 18 The payoff (that is, profit) for a call option is the price of the underlying − exercise price − option premium; the greater the option premium, the more that the underlying’s price must exceed the exercise price for a profit The payoff (that is, profit) for a put option is the price exercise price − price of the underlying − option premium; the greater the option premium, the more that the price of the underlying must be less than the price of the underlying to be profitable 19 a intrinsic value = $42 − 40 = $2; time value = $5 − = $3 b intrinsic value = $40 − 50 = −$10 → $0; time value = $5 − = $5 20 a Interest rate swap b Orono pays 7% × $75 million = $5,250,000; Portland pays 4% × $75 million = $3,000,000 The net payment (Orono to Portland) is $2,250,000, or 3% of $75 million The Basics of Finance by Pamela Peterson Drake and Frank J Fabozzi APPENDIX Solutions to End of Chapter Questions CHAPTER 15 Equity; Bonds; Real estate; cash equivalents Policy asset allocation focuses on the long-term objective, seeking the greatest return for the level of risk consistent with the investment objective The dynamic asset allocation is the adjustment of the asset mix of a portfolio in response to anticipated market conditions Market cap is market capitalization, the market value of equity outstanding of a corporation Some advocate that the returns to stocks of companies with small versus large capitalization are different, and select common stocks appropriate with this belief An active portfolio strategy involves changing the investments in the portfolio to seek better portfolio returns A passive portfolio strategy focuses on the initial construction of the portfolio, rather than altering investments A passive portfolio is consistent with the belief that the markets are efficient, whereas an active portfolio strategy seeks abnormal returns that arise from pricing inefficiencies A price-efficient market is one in which the current prices of assets reflect all publicly available information The arithmetic average return ignores compounding of returns from one subperiod to the next The time-weighted return is better for evaluating a portfolio manager because it is not affected by the contributions and withdrawals of the fund RTW = (0.95 × 1.1 × 1.1) 1/3 − = 4.754% PV = $1; FV = $1 × 0.95 × 1.1 × 1.1 = $1.1495; N = 3; IRR = 4.754% 10 The purpose of performance attribution models is to assess the performance of an investment or fund associated with the selection of investments and the allocation among investments The Basics of Finance by Pamela Peterson Drake and Frank J Fabozzi APPENDIX: SOLUTIONS TO END OF CHAPTER QUESTIONS 11 a Structured insurance is a form of risk transfer that combines traditional insurance with securities, in which investors in the securities bear some of the risk b Another name for structured insurance is “insurance-linked securities” c An example of structured insurance is the catastrophe-linked bond (or “cat bond”) The Basics of Finance by Pamela Peterson Drake and Frank J Fabozzi APPENDIX Solutions to End of Chapter Questions CHAPTER 16 A utility function is a theoretical description of the tradeoff an individual economic agent has between return and risk If the correlation is positive, the covariance between the two assets’ returns is also positive Diversification is achieved by combining investments whose returns are not perfectly positively correlated Greater diversification is achieved the lower the correlation The efficient portfolio is one of the feasible portfolios It is the feasible portfolio with the highest return for a given level of risk The semivariance provides information on the dispersion below the mean or expected value, whereas the variance provides information on the dispersion above and below the mean A safety-first rule is a decision rule that minimizes the probability of falling below a specified value Prospect theory is a theory of individuals’ behavior such that decisionmaking depends on how a problem is framed, that the focus is on how values change, rather than the values themselves, and that the decision weight given to gains is different than that given to losses Framing is the situation Some behavioral theories argue that investors are influenced by the situation or how an investment is presented, rather than simply on an investment’s expected return and variance Classical safety-first, value at risk, conditional value at risk, lower partial moment 10 A cognitive bias is a bias in decision-making that results from errors in judgment These errors include framing and overconfidence The Basics of Finance by Pamela Peterson Drake and Frank J Fabozzi APPENDIX: SOLUTIONS TO END OF CHAPTER QUESTIONS 11 a If the covariance is negative, the correlation is negative b The portfolio’s risk will be less than the weighted average of the risks of Asset A and Asset B 12 a B: same return, lower risk b C: same return, lower risk c C: higher return, lower risk 13 a Expected return is 5% b Standard deviation is 12.247% Calculations Scenario Possible Probability outcome Recovers 40% Does not 60% recover Probability weighted outcome Deviation from the expected value 0.20000 0.08000 0.15000 −0.05000 −0.03000 −0.10000 Expected value = 0.05000 0.05000 Probability weighted Squared squared deviation deviation 0.02250 0.01000 0.00900 0.00600 Variance = 0.01500 Standard deviation = 0.12247 14 a Expected value = 0% b Standard deviation = 15% Calculations Possible Scenario Probability outcome Recovers 50% Does 50% not recover Expected value = Probability weighted outcome Deviation from the expected value 0.15000 0.07500 0.15000 −0.15000 −0.07500 −0.15000 0.00000 Probability weighted Squared squared deviation deviation 0.02250 0.02250 0.01125 0.01125 Variance = 0.02250 Standard deviation = 0.15000 15 Altering the weights of the securities will change the portfolio risk, similar to Exhibit 16.5, because the weights of the two securities are used in calculation of the variance of the portfolio [see Equation 16.6] The Basics of Finance by Pamela Peterson Drake and Frank J Fabozzi APPENDIX Solutions to End of Chapter Questions CHAPTER 17 Diversifiable risk is the risk that an investor can reduce or eliminate by combining assets in a portfolio such that these assets’ returns are not perfectly positively correlated among themselves In the CAPM, we assume that investors will seek the most return for these least amount of risk A large component of this is holding a welldiversified portfolio Therefore, proponents of the CAPM model argue that assets are priced such that investors are only compensated for the risk that they cannot diversify away This choice cannot be determined without addressing the individual investor’s utility function because neither stock dominates the other in terms of risk and return In pricing assets, only the nondiversifiable risk is compensated This is the market risk premium This is the expected risk premium for the market as a whole Beta is the sensitivity (a.k.a elasticity) of a stock’s return to changes in the return on the market It means that Asset A has more systematic risk than Asset B However, it does not mean that Asset A necessarily has more risk (systematic plus unsystematic) than Asset B The capital market line is the relation between expected return and risk, as measured by variance The security market line is the relation between expected return and systematic risk, as represented by beta Plotting above the security market line means that the stock is undervalued: bidding up the stock’s price will reduce its return, forcing it on the SML 10 Expected return = 0.02 + 1.2(0.10 − 0.02) = 0.02 + 0.096 = 11.6% The Basics of Finance by Pamela Peterson Drake and Frank J Fabozzi APPENDIX: SOLUTIONS TO END OF CHAPTER QUESTIONS 11 An efficient portfolio in the presence of a risk free asset is formed by combining an investment in the market portfolio with either an investment in the risk-free asset or borrowing at the risk-free rate 12 The CAPM cannot be tested unless we specify the correct market portfolio, which is the value-weighted portfolio of all risky assets 13 The assumption regarding borrowing and lending at the risk-free rate of interest is questionable because investors cannot borrow at the risk free rate 14 The homogeneous assumption in the CAPM is the assumption that all investors perceive the same expected return and risk associated with the assets 15 The law of one price implies that assets that have similar payoffs, both in terms of expected returns and risk, should be priced the same; if they are not priced the same, there is an arbitrage opportunity 16 The fundamental principles of the APT model are that asset prices are determined by one or more factors and that returns on assets are driven by unanticipated changes in these factors 17 The APT is more general because it allows for the possibility of more than one factor to affect asset prices (that is, it is a multifactor model), and the APT does not require specifying a market portfolio 18 The APT factors are unknown, and therefore cannot be adequately tested 19 a Disagree: Unsystematic risk is nearly eliminated in a diversified portfolio, whereas the unsystematic risk of an individual asset in the portfolio may be significant b Disagree: Investors are compensated only for the risk that they cannot get rid of; investors are not compensated for diversifiable (that is, unsystematic) risk because they could reduce it if they wished to by diversifying 20 Disagree As with the CAPM, investors are not compensated for risk that they could remove but choose not to The Basics of Finance by Pamela Peterson Drake and Frank J Fabozzi APPENDIX Solutions to End of Chapter Questions CHAPTER 18 The sum of the real interest rate and the expected rate of inflation The yield spread is 170 basis points This spread is the additional premium for bearing credit risk The investor has the option to exchange the debt for another security at a specified exchange rate The muni-Treasury yield ratio = 0.025 − 0.03 = 0.83 The rate on a taxable security that is equivalent, on an after-tax basis, to that of a non-taxable security The difference in yields, expressed in basis points, between Treasury securities of different maturities (1 + 0.05)3 = (1 + 0.045)2 (1 + f ); 1.157625 = 1.092025 (1 + f ); f = 6.01% The normal yield curve is upward sloping Expectations regarding future interest rates; liquidity premiums for longer maturities; preferred habitat among investors; market segmentation 10 Used as a set of benchmark interest rates for loans and bonds 11 Market participants generally gauge the credit risk of a bond issue by relying on the credit ratings by the rating agencies 12 The greater the credit risk of a bond, the greater the risk premium on the bond (and, hence, the greater the bond’s yield) 13 Solve for r in the following: (1 + 0.046)2 = (1 + 0.041) × (1 + r) 1.094116 = 1.041 × (1 + r) (1+r) = 1.094116 ÷ 1.041 r = 5.1024% The Basics of Finance by Pamela Peterson Drake and Frank J Fabozzi APPENDIX: SOLUTIONS TO END OF CHAPTER QUESTIONS 14 2-year spot rate 1-year spot rate 1-year forward rate 5% 4% 3.5% 4% 3.8% 3.25% (1.1025 ÷ 1.04) − (1.0816 ÷ 1.038) − (1.071225 ÷ 1.0325) − = 6.0096% = 4.2% = 3.7506% 15 Forward rates are not a perfect predictor of future rates because if they were, then we would know what bond prices would be in the future Further, empirical evidence indicates that forward rates are not good predictors 16 Forward rates are referred to as hedgeable rates because they indicate how an investor’s expectations must differ from the market consensus to make a correct decision The forward rates are a hedgeable measure of future rates 17 This is an upward-sloping yield curve 18 By calculating the forward rates, based on today’s rates for various maturities, he/she can derive the slope of the yield curve, which suggests the expectations for interest rates in the future 19 The “bias” in biased expectations theories is the belief that interest rates include premiums for liquidity preference (that is, risk) and to induce investors from their preferred habitat The Basics of Finance by Pamela Peterson Drake and Frank J Fabozzi Appendix: Solutions to End of Chapter Questions 20 What is described in the quote is a humped yield curve A humped yield curve is not consistent with the liquidity preference theory and the market segmentation theory However, a humped yield curve may be consistent with the preferred habitat theory, in which interest rates are determined by the supply and demand for securities at the different maturities The Basics of Finance by Pamela Peterson Drake and Frank J Fabozzi APPENDIX Solutions to End of Chapter Questions CHAPTER 19 If earnings grow at a rate similar to the dividends, the dividend payout will remain constant However, if earnings fluctuate, this will have the effect of a varying dividend payout ratio The greater the discount rate, the lower the present value of the stock The discount rate should reflect the uncertainty associated with the amount and timing of dividends The value of the stock will be based on a perpetual stream of cash flows Using the dividend discount model, this means that the growth rate, g, will be zero The average annual growth is g = ( $3 $2 ) − = 14.47% The required rate of return must be greater than the expected growth rate; otherwise, the result does not make sense (that is, a negative value for the stock) Yes A negative growth rate still works in the dividend discount model The expected return on the stock is the sum of the expected dividend yield and the expected capital yield of the stock a Assuming a constant growth rate ad infinitum may not be appropriate Companies tend to experience growth phases throughout their life cycles, and the expected growth rates should change accordingly b Growth, transition, and maturity The estimate is $2 × 15 = $30 per share 10 Earnings captures the results of both operations and financing decisions, whereas sales does not reflect operating efficiency or financial leverage The Basics of Finance by Pamela Peterson Drake and Frank J Fabozzi APPENDIX: SOLUTIONS TO END OF CHAPTER QUESTIONS 11 Value of the stock = $39.7162 Year Expected Dividend Expected Terminal Value Total Cash Flow Present Value (Cash flow discounted at 8%) $2.50 $3.00 $3.25 $40.6250 $2.5000 $43.6250 $2.3148 $37.4014 Value = $39.7162 12 13 14 15 Note: Terminal value (end of Year 2) = $3.25 ÷ 0.08 = $40.6250 [valued as a perpetuity] Required rate of return = dividend yield + growth rate 12% = 4% + growth rate Therefore, the growth rate is 8% Agree Relative valuation focuses more on the fundamental factors behind the growth, rather than strictly dealing with dividends and expected growth in dividends Disagree: The dividend discount model can be evaluated in terms of fundamental factors by restated dividends in terms of dividend payouts and retention rate, multiples, etc Both the dividend discount models and the relative valuation models use proxies for the market’s expectations (dividends and growth with the dividend discount models; comparable companies’ multiples for the relative valuation models) If you are too stringent, you will have a limited number of observations/estimations of the market’s valuation The Basics of Finance by Pamela Peterson Drake and Frank J Fabozzi APPENDIX Solutions to End of Chapter Questions CHAPTER 20 Maturity value (FV), yield to maturity (r × 2), number of periods to maturity (n), periodic cash flow (the interest, or PMT) The use of semiannual periods is to put the zero-coupon bond valuation on the same basis as the typical semiannual coupon bond There is a negative relation between the yield on a bond and the bond’s value: the greater the yield to maturity, the lower the value of the bond When the yield to maturity is higher than the coupon rate, the bond will sell at a discount from its face value This is because the market is demanding the higher yield than what the bond produces through the coupon; the remainder of the yield is from the appreciation in the bond from its discounted value to its face value If the bond is selling at a discount from its face value, the bond’s value will rise until it reaches its face value If the bond is selling at a premium to its face value, the bond’s value will decline until it reaches its face value The current yield is a rough approximation of the bond’s true return, ignoring the time value of money The yield to maturity considers the time value of money, and assumes that any coupons on the bond are reinvested in a similar yielding investment The yield to worst is the lower of the yield to maturity and the yield to call for a callable bond a We are assuming that each cash from is reinvested immediately in a similar yield investment b Coupon rate and maturity The investor has an option to sell the bond back to the issuer if the bond is putable The Basics of Finance by Pamela Peterson Drake and Frank J Fabozzi APPENDIX: SOLUTIONS TO END OF CHAPTER QUESTIONS 10 The coupon rate is less than the yield to maturity because the bond is selling at a discount from its face value 11 Market Price Dollar Price 94.0 102.0 75.0 86.4 $940.00 $102,000 $7,500 $864,000 12 PMT = 3.5; FV = 100; i = 4% a Not PV = 120 →N would be negative (using a calculator)—in other words, it does not make sense Therefore, the bond will not trade for 120 if its maturity is more than one year based on the given yield b Not PV = 100 → N would be 0, which is not plausible if the maturity is actually more than one year c Possible PV = 90 → N is 41.035, which is slightly more than twenty years 13 As a premium the bond approaches maturity, its value converges toward the bond’s maturity value 14 The 10-year coupon bond has more reinvestment rate risk because (1) it has a coupon, which requires reinvestment each period, and (2) it matures sooner than the zero-coupon bond 15 A callable bond is difficult to value because it is not possible to specify precisely if and when the bonds will be called from the investors The issuer’s decision is based on both interest rates on any refunding and the costs of issuing new bonds 16 The convertible bond will trade at the greater of its value as a straight bond and its conversion value, and therefore will trade at $1,100 The Basics of Finance by Pamela Peterson Drake and Frank J Fabozzi OF FINANCE + Web Site Written by the experienced author team of Pamela Peterson Drake and Frank Fabozzi, The Basics of Finance puts the essential elements of this discipline in perspective and will allow you to gain a better understanding of today’s dynamic world of finance Divided into four comprehensive parts, this reliable resource will help you to see how all the pieces of finance fit together Page by informative page, The Basics of Finance: • Provides the basic framework of the financial system and the players in this system • Discusses financial management and topics such as financial statement analysis and financial decision-making within a business enterprise • Examines the analytical part of finance, which involves valuing assets and analyzing performance • Covers the essentials of investment management, which includes portfolio theory and asset pricing Along the way, sample problems with detailed solutions are provided in many chapters, allowing you to practice any math demonstrated in those specific sections End-of-chapter questions are also included for each chapter, along with select solutions easily accessible on the companion Web site, so you can test your knowledge of the basic terms and concepts discussed in each chapter If you’re looking to gain an understanding of what finance is really about at the fundamental level, look no further than this book Jacket Image : © Jupiter Images THE BASICS OF FINANCE + Web Site FRANK J FABOZZI, PHD, CFA, CPA, is Professor in the Practice of Finance and Becton Fellow at the Yale School of Management and Editor of the Journal of Portfolio Management Fabozzi earned a doctorate in economics from the City University of New York He is an Affiliated Professor at the University of Karlsruhe’s Institute of Statistics, Econometrics, and Mathematical Finance and is on the Advisory Council for the Department of Operations Research and Financial Engineering at Princeton University THE BASICS An Introduction to Financial Markets, Business Finance, and Portfolio Management PAMELA PETERSON DRAKE, PHD, CFA, is the J Gray Ferguson Professor of Finance and Department Head of Finance and Business Law at James Madison University She received her PhD in finance from the University of North Carolina at Chapel Hill and her BS in accountancy from Miami University Professor Drake previously taught at Florida State University and Florida Atlantic University Peterson Drake Fabozzi $100.00 USA / $120.00 CAN THE FRANK J FABOZZI SERIES T he Basics of Finance is an accessible book for those who want to gain a better understanding of finance, but lack a strong business background Divided into four parts, it skillfully covers the essential concepts, tools, methods, and strategies in finance without delving too deep into theory or jargon Written by expert authors Pamela Peterson Drake and Frank Fabozzi, this reliable resource addresses everything from financial instruments and markets to portfolio management techniques, understanding and analyzing financial statements, and the different types of corporate financial strategy, planning, and policy Engaging and accessible, this practical guide: THE BASICS OF FINANCE + Web Site An Introduction to Financial Markets, Business Finance, and Portfolio Management PAMELA PETERSON DRAKE • FRANK J FABOZZI • Covers the three main areas of finance— capital market theory, financial management, and investment management—and discusses what each one encompasses • Provides a solid foundation in the field of finance, which you can quickly build upon • Explores in an introductory way important topics such as cash flow analysis, asset valuation, capital budgeting, and derivatives • Includes access to a companion Web site with an appendix of solutions for a selection of the sample problems In addition, each chapter includes valuable sample problems and end-of-chapter questions so readers can measure their progress The Basics of Finance offers finance practitioners and students alike a wealth of essential guidance on the most fundamental and rudimentary topics in finance including an introduction to everything from financial markets and institutions, business finance, portfolio management, and risk management If you’re looking to learn about finance, this is the best place to start ... CAPITAL MARKET THEORY The field of capital markets and capital market theory focuses on the study of the financial system, the structure of interest rates, and the pricing of risky assets The financial... there is not only the awkwardness of dealing directly with the other party or parties, but there is the problem that one party has a different information set than the other In other words, there... CHAPTER 10 The Math of Finance Why the Time Value of Money? Calculating the Future Value Calculating a Present Value Determining the Unknown Interest Rate The Time Value of a Series of Cash Flows