Unit 2 Tutorials: Time Value of Money

and Financial Securities

INSIDE UNIT 2

Time Value of Cash Flows

Introduction to the Time Value of Money

Future Value, Single Cash Flows
Present Value, Single Cash Flows
Annuities
Valuing Multiple Cash Flows
Additional Detail on Present and Future Values
Yield

Bond Valuation

The Basics of Interest Rates

Understanding Bonds
Key Characteristics of Bonds
Advantages and Disadvantages of Bonds
Types of Bonds
Valuing Bonds
Bond Risk

Stock Valuation

Defining Stock
Types of Stock
Rules and Rights of Common and Preferred Stock
Stock Markets
Stock Valuation
Valuing the Corporation

Introduction to the Time Value of Money

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by Sophia Tutorial

 WHAT'S COVERED

In this lesson, you will learn the basic concepts associated with the time value of money. Specifically,
this lesson will cover:
1. Defining the Time Value of Money
2. The Importance of the Time Value of Money

1. Defining the Time Value of Money

One of the most fundamental concepts in finance is the time value of money. It states that money today is
worth more than money in the future.

Imagine you are lucky enough to have someone come up to you and say, “I want to give you $500. You can
either have $500 right now, or I can give you $500 in a year. What would you prefer?” Presumably, you
would ask to have the $500 right now. If you took the money now, you could use it to buy a TV. If you chose
to take the money in one year, you could still use it to buy the same TV, but there is a cost. The TV might not
be for sale, inflation may mean that the TV now costs $600, or simply, you would have to wait a year to do so
and should be paid for having to wait. Since there’s no cost to taking the money now, you might as well take
it.

There is some value, however, that you could be paid in one year that would be worth the same to you as
$500 today. Suppose it’s $550; you are completely indifferent between taking $500 today and $550 next
year, because even if you had to wait a year to get your money, you think $50 is worth the wait.

In finance, there are special names for each of these numbers to help ensure that everyone is talking about
the same thing.

Present Value (PV) is what the money is worth right now.

Future Value (FV) is what the money today is worth after the time period (t).

In this example, money with a PV of $500 has a FV of $550. The rate that you must be paid per year in order
to not have the money is called an interest rate (i or r).
All four of the variables (PV, FV, r, and t) are tied together in the equation below.

 FORMULA

Simple Interest

 BIG IDEA

Simple interest is when interest is only paid on the amount you originally invested (the principal). You don’t

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earn interest on interest you previously earned. Don’t worry if this seems confusing; the concept will be
explored in more depth later.

 TERMS TO KNOW

Present Value (PV)

The value of the money today.

Future Value (FV)

The value of the money in the future.

Interest Rate
The percentage of an amount of money charged for its use per some period of time. It can also be thought of
as the cost of not having money for one period, or the amount paid on an investment per year.

2. The Importance of the Time Value of Money

The time value of money is integral to making the best use of a financial player’s limited funds.

The time value of money is a concept integral to all parts of business. A business does not want to know just
what an investment is worth today; ​it wants to know the total value of the investment. What is the investment
worth in total?

Let’s take a look at a couple of examples.

IN CONTEXT
Suppose you are one of the lucky people to win the lottery. You are given two options on how to
receive the money.
Option 1: Take $5,000,000 right now.
Option 2: Get paid $600,000 every year for the next 10 years.

In option 1, you get a total of $5,000,000 and in option 2 you get a total of $6,000,000. Option 2
may seem like the better bet because you get an extra $1,000,000, but the time value of money
theory says that since some of the money is paid to you in the future, it is worth less.

By figuring out how much option 2 is worth today (through a process called discounting), you’ll be
able to make an apples-to-apples comparison between the two options. If option 2 turns out to be
worth less than $5,000,000 today, you should choose option 1, or vice versa.

IN CONTEXT
Suppose you go to the bank and deposit $100.

Bank 1 says that if you promise not to withdraw the money for 5 years, they’ll pay you an interest rate
of 5% a year. Before you sign up, consider that there is a cost to you for not having access to your

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 money for 5 years. At the end of 5 years, Bank 1 will give you back $128.

But you also know that you can go to Bank 2 and get a guaranteed 6% interest rate, so your money
is actually worth 6% a year for every year you don’t have it.

Use the following compounding interest formula to convert the present cash worth into future value
using the two different interest rates offered by Banks 1 and 2.

 FORMULA

Compound Interest

Bank 1

Bank 2

We see that putting our money in Bank 1 gives us roughly $128 in 5 years, while Bank 2’s interest
rate gives $134. Between these two options, Bank 2 is the better deal for maximizing future value.

 TERM TO KNOW

Discounting
The process of finding the present value using the discount rate.

 SUMMARY

In this lesson, you learned that the time value of money is a concept in finance which holds that
money today is worth more than money in the future, and vice versa. The present value and future
value of money can be calculated using the interest rate, the period of time under consideration, and
whether the interest is simple or compounding. The importance of the time value of money rests in a
business’s interest in maximizing its investments.

Best of luck in your learning!

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 4
Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Introduction to the Time Value of
Money” TUTORIAL.

 TERMS TO KNOW

Discounting
The process of finding the present value using the discount rate.

Future Value (FV)

The value of the money in the future.

Interest Rate
The percentage of an amount of money charged for its use per some period of time. It can also be thought
of as the cost of not having money for one period, or the amount paid on an investment per year.

Present Value (PV)

The value of the money today.

 FORMULAS TO KNOW

Compound Interest

Simple Interest

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Future Value, Single Cash Flows
by Sophia Tutorial

 WHAT'S COVERED

In this lesson, you will examine how to calculate the future value of a single-period investment and of
a multi-period investment with simple and compound interest rates. Specifically, this lesson will cover:
1. Single-Period Investment
2. Multi-Period Investment
a. Simple Interest
b. Compound Interest
3. Calculating Future Value

1. Single-Period Investment
The amount of time between the present and future is called the number of periods. Aperiod is a general
block of time. Usually, a period is one year. The number of periods can be represented as either t or n.

Suppose you are making an investment, such as depositing your money in a bank. If you plan on leaving the
money there for one year, you’re making a single-period investment.

You can calculate an investment with the following formulas:

 FORMULA

Compound Interest

Simple Interest

In each equation, the variables are defined as:

FV = Future Value
PV = Present Value
i or r = Interest Rate
t or n = Number of Periods

 HINT

For all formulas, express interest in decimal form, not as a whole number. 7% is 0.07, 12% is 0.12, and so on.

We will address these formulas later, but note that for a single period of one year, when t = 1, both formulas

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become FV = PV ⋅ (1+i).

Thus, in a single period, there is only one formula you need to know:

 FORMULA

Single-Period Interest

IN CONTEXT
Suppose you deposit $100 into a bank account that pays 3% interest. What is the balance in your
account after one year?

In this case, your PV is $100 and your interest is 3%. You want to know the value of your investment
in the future, so you’re solving for FV. Since this is a single-period investment, t (or n) is 1.

Plugging the numbers into the formula, you get:

Your balance will be $103 in one year.

 TERMS TO KNOW

Periods (t or n)
The length of time during which interest accrues, usually one year.

Single-Period Investment
An investment that takes place over one period, usually one year.

2. Multi-Period Investment
Multi-period investments take place over more than one period, usually multiple years. They can either
accrue simple or compound interest. There are two primary ways of determining how much an investment will
be worth in the future if the time frame is more than one period.

 TERMS TO KNOW

Multi-Period Investment
An investment that takes place over more than one period.

Accrue
To add or grow

2a. Simple Interest

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The first concept of accruing or earning interest is called simple interest. Simple interest means that you earn
interest only on the amount you originally invested, or the principal. Your total balance will go up each period,
because you earn interest each period, but the interest is paid only on the amount you originally
borrowed/deposited.
Simple interest is expressed through the following formula:

 FORMULA

Simple Interest

IN CONTEXT
Suppose you make a deposit of $100 in the bank and earn 5% interest per year. After one year, you
earn 5% interest, or $5, bringing your total balance to $105. One more year passes, and it’s time to
accrue more interest. Since simple interest is paid only on your principal ($100), you earn 5% of $100,
not 5% of $105. That means you earn another $5 in the second year, and will earn $5 for every year
of the investment.

 BIG IDEA

In simple interest, you earn interest based on the original deposit amount, not the account balance.

 TERM TO KNOW

Principal
The money originally invested or loaned, on which basis interest and returns are calculated.

2b. Compound Interest

The second way of accruing interest is called compound interest. In this case, interest is paid at the end of
each period based on the balance in the account. In simple interest, it is only how much the principal is that
matters. In compound interest, it is what the balance is that matters. Compound interest is named as such
because the interest compounds: interest is paid on interest.
Compound interest is expressed through the following formula:

 FORMULA

Compound Interest

IN CONTEXT
Suppose you make the same $100 deposit into a bank account that pays 5%, but this time, the
interest is compounded. After the first year, you will again have $105. At the end of the second year,
you also earn 5%, but it’s 5% of your balance, or $105. You earn $5.25 in interest in the second year,
bringing your balance to $110.25. In the third year, you earn interest of 5% of your balance, or
$110.25. You earn $5.51 in interest, bringing your total to $115.76.

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  THINK ABOUT IT

Compare compound interest to simple interest. Simple interest earns you 5% of your principal each year, or
$5 a year. Your balance will go up linearly each year. Compound interest earns you $5 in the first year, $5.25
in the second, a little more in the third, and so on. Your balance will go up exponentially.

 HINT

Simple interest is rarely used compared to compound interest, but it’s good to know both types.

3. Calculating Future Value

When calculating a future value (FV), you are calculating how much a given amount of money today will be
worth some time in the future. In order to calculate the FV, the other three variables (present value, interest
rate, and number of periods) must be known.

 HINT

Recall that the interest rate is represented by either r or i, and the number of periods is represented by either t
or n.

It is also important to remember that the interest rate and the periods must be in the same units. That is, if the
interest rate is 5% per year, one period is one year. However, if the interest rate is 5% per month, t or n must
reflect the number of periods in terms of months.

IN CONTEXT
Example 1: Compound, Yearly Loan, Yearly Interest

What is the FV of a $500, 10-year loan with 7% annual interest?

In this case, the PV is $500, t is 10 years, and i is 7% per year. The next step is to plug these
numbers into an equation. But recall that there are two different formulas for the two different types
of interest, simple interest and compound interest. If the problem doesn’t specify how the interest is
accrued, assume it is compound interest, at least for business problems.

So, using the compound interest formula, we see that the future value is equal to $983.58:

In practical terms, you just calculated how much your loan will be in 10 years. This assumes that you
don’t need to make any payments during the 10 years, and that the interest compounds. Unless the

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 problem states otherwise, it is safe to make these assumptions – you will be told if there are
payments during the 10-year period or if it is simple interest.

IN CONTEXT
Example 2: Compound, Yearly Loan, Monthly Interest

Suppose we want to again find the future value of a $800, 10-year loan, but with an interest rate of
1% per month.

Remember that the interest rate and periods must be in the same units. In this case, the loan is in
units of years, but the interest rate is in units of months. In order to get our total number of periods
(t), we would multiply 12 months by 10 years, which equals 120 periods.

Therefore, we can see that the future value is equal to $2,640.31:

IN CONTEXT
Example 3: Simple, Yearly Loan, Yearly Interest

Suppose you take out a $5000, eight-year loan, with this one accruing 5% interest per year. The
loan accrues interest on the principal only. What is the total future value?

Since the loan is accruing interest on just the principal, this means that we will use the simple interest
formula and get a future value of $7,000:

 SUMMARY

In this lesson, you learned that the future value of a single-period investment can be calculated by
knowing the present value and the interest rate. Calculating a multi-period investment involves
knowing the present value, the interest rate, the number of time periods, and whether the interest is
simple or compounding. Calculating future value is useful for knowing what a given amount of money

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 will be worth at a later date.

Best of luck in your learning!

Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Future Value, Single Amount”
TUTORIAL.

 TERMS TO KNOW

Accrue
To add or grow.

Multi-Period Investment
An investment that takes place over more than one periods.

Periods (t or n)
The length of time during which interest accrues, usually one year.

Principal
The money originally invested or loaned, on which basis interest and returns are calculated.

Single-Period Investment
An investment that takes place over one period, usually one year.

 FORMULAS TO KNOW

Compound Interest

Simple Interest

Single-Period Interest

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Present Value, Single Cash Flows
by Sophia Tutorial

 WHAT'S COVERED

In this lesson, you will learn how to calculate the present value of a single-period and multi-period
investment over time. Specifically, this lesson will cover:
1. The Discount Rate
2. Formulas
a. Single-Period Investment
b. Multi-Period Investment
3. Calculating Present Value

1. The Discount Rate

The time value of money framework says that money in the future is not worth as much as money in the
present. Investors would prefer to have the money today because then they are able to spend it, save it, or
invest it right now instead of having to wait to be able to use it.

The difference between what the money is worth today and what it will be worth at a point in the future can
be quantified. The value of the money today is called the present value (PV), and the value of the money in the
future is called the future value (FV).

Another common term for finding present value (PV) is discounting . Discounting is the procedure of finding
what a future sum of money is worth today. As you know from the previous sections, to find the PV of a
payment, you need to know the future value (FV), the number of time periods in question, and the interest
rate. The interest rate, in this context, is more commonly called the discount rate.

The discount rate is the term for the cost of not having the money today.

 EXAMPLE If the interest rate is 3% per year, it means that you would be willing to pay 3% of the money
to have it one year sooner.

It also represents some cost (or group of costs) to the investor or creditor. The sum of these costs amounts to
a percentage which becomes the interest rate (plus a small profit, sometimes).

Here are some of the most significant costs from the investor/creditor’s point of view:

Opportunity Cost: This is the cost of not having the cash on hand at a certain point of time. If the
investor/creditor had the cash, they could spend it. But since it has been invested/loaned out, they incur
the cost of not being able to spend it.
Inflation: The real value of a single dollar decreases over time with inflation. That means that even if

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 everything else is constant, a $100 item will retail for more than $100 in the future. Inflation is generally
positive in most countries at most times (if it’s not, it’s called deflation, but it’s rare).
Risk: There is a chance that you will not get your money back because it is a bad investment, and the
debtor defaults. You require compensation for taking on that risk.
Liquidity: Investing or loaning out cash necessarily reduces your liquidity.

All of these costs combine to determine the interest rate on an account, and that interest rate, in turn, is the
rate at which the sum is discounted.
 TERMS TO KNOW

Discounting
The process of finding the present value using the discount rate.

Discount Rate
The interest rate used to discount future cash flows of a financial instrument; the annual interest rate used to
decrease the amounts of future cash flow to yield their present value.

2. Formulas
The PV and the discount rate are related through the same formula we have been using for a future value of a
single payment. The equation can be rearranged to solve for PV of a single amount of money. That is, it tells
you what a single payment is worth today, but not what a series of payments is worth today (that will come
later). In order to find the PV, you must know the FV, i, and n.

 BIG IDEA

If FV and n are held as constants, then as the discount rate (i) increases, PV decreases. PV and the discount
rate, therefore, vary inversely, a fundamental relationship in finance.

2a. Single-Period Investment

With single-period investments, the concept of the time value of money is relatively straightforward. The future
value is simply the present value applied to the interest rate compounded one time. So, by definition, the
variable for time, n, is equal to one. If we update the formula with this information, and rearrange it so we are
solving for PV, this simply means that the PV is FV divided by 1+i.
 FORMULA

Single-Period Interest

There is a cost to not having the money for one year, which is what the interest rate represents. Therefore, the
PV is i% less than the FV.

2b. Multi-Period Investment

When investing, the time value of money is a core concept investors simply cannot ignore. A dollar today is

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valued higher than a dollar tomorrow, and when utilizing the capital, it is important to recognize the
opportunity cost involved in what it could have been invested in instead.
With multi-periods in mind, interest begins to compound. Compound interest simply means that the interest
from the first period is added to the future present value, and the interest rate the next time around is now
being applied to a larger amount. This turns into an exponential calculation of interest, calculated as follows:

 FORMULA

Compound Interest

This means that the interest rate of a given period may not be the same percentage as the interest rate over
multiple periods (in most situations). A useful tool at this point is a way to create an average rate of return over
the life of the investment, which can be derived with the following:
 FORMULA

Average Rate of Return

 BIG IDEA

All and all, the difference from a time value of money perspective between single- and multiple-period
investments is relatively straightforward. Normalizing expected returns in present value terms (or projecting
future returns over multiple time periods of compounding interest) paints a clearer and more accurate picture
of the actual worth of a given investment opportunity.

 TERM TO KNOW

Compound Interest
An interest rate applied to multiple applications of interest during the lifetime of the investment.

3. Calculating Present Value

Finding the present value (PV) of an amount of money is finding the amount of money today that is worth the
same as an amount of money in the future, given a certain interest rate.

Calculating the present value (PV) of a single amount is a matter of combining all of the different parts we
have already discussed. But first, you must determine whether the type of interest is simple or compound
interest. If the interest is simple interest, you plug the numbers into the simple interest formula. If it is
compound interest, you can rearrange the compound interest formula to calculate the present value.

Once you know these three variables, you can plug them into the appropriate equation. If the problem doesn’t
say otherwise, it’s safe to assume the interest compounds. If you happen to be using a program like Excel, the
interest is compounded in the PV formula. Simple interest is fairly rare.

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 IN CONTEXT
Suppose you would like to have $1,000 dollars in an account after three year’s time. If the account
earns 5% compounded interest yearly, how much would you have to deposit today?

Deciding how much to deposit today is the same as the present value. Since we know the future
value ($1,000), the timing (3 years), and the interest rate (5%), we can find the present value using the
following formula:

 HINT

One area where there is often a mistake is in defining the number of periods and the interest rate. They have
to have consistent units, which may require some work. For example, interest is often listed as X% per year.
The problem may talk about finding the PV 24 months before the FV, but the number of periods must be in
years since the interest rate is listed per year. Therefore, n is 2. As long as the units are consistent, however,
finding the PV is done by plug-and-chug.

 TERM TO KNOW

Simple Interest
Interest paid only on the principal.

 SUMMARY

In this lesson, you learned that the discount rate can be applied to the future value of an investment
to determine the investment’s present value. Similar to an interest rate, it represents the cost of not
having the money today. Like with future value, there are formulas for determining the current value
of a single-period investment and a multi-period investment that utilize the discount rate. Calculating
present value is useful for knowing what a future amount of money is equivalent to today.

Best of luck in your learning!

Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Present Value, Single Amount”
TUTORIAL.

 TERMS TO KNOW

Compound Interest
An interest rate applied to multiple applications of interest during the lifetime of the investment.

Discount Rate
The interest rate used to discount future cash flows of a financial instrument; the annual interest rate used

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 to decrease the amounts of future cash flow to yield their present value.

Discounting
The process of finding the present value using the discount rate.

Simple Interest
Interest paid only on the principal.

 FORMULAS TO KNOW

Average Rate of Return

Compound Interest

Single-Period Interest

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Annuities
by Sophia Tutorial

 WHAT'S COVERED

In this lesson, you will learn about the advantages of annuities and their different types. Specifically,
this lesson will cover:
1. Annuities
2. Future Value of Annuity
3. Present Value of Annuity
4. Calculating Annuities

1. Annuities
An annuity is a type of multi-period investment where there is a certain principal deposited and then regular
payments made over the course of the investment. The payments are all a fixed size.

 EXAMPLE A car loan may be an annuity. In order to get the car, you are given a loan to buy the car. In
return, you make an initial payment (down payment), and then payments each month of a fixed amount.

There is still an interest rate implicitly charged in the loan. The sum of all the payments will be greater than the
loan amount, just as with a regular loan, but the payment schedule is spread out over time.

As a bank, there are three advantages to making the loan an annuity:

1. There is a regular, known cash flow. You know how much money you’ll be getting from the loan and when
you’ll be getting them.
2. It should be easier for the person you are loaning to to repay, because they are not expected to pay one
large amount at once.
3. It helps them monitor the financial health of the debtor. If the debtor starts missing payments, the bank
knows right away that there is a problem, and they could potentially amend the loan to make it better for
both parties.

Similar advantages apply to the debtor. There are predictable payments, and paying smaller amounts over
multiple periods may be advantageous over paying the whole loan plus interest and fees back at once.
Since annuities, by definition, extend over multiple periods, there are different types of annuities based on
when in the period the payments are made:

Ordinary Annuity: Payments are made at the end of the period. If a period is one month, this means that
payments are made on the 28th/30th/31st of each month. Mortgage payments are usually ordinary
annuities.
Annuity-Due: Payments are made at the beginning of the period. For example, if a period is one month,

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 payments are made on the first of each month.
Perpetuities: Payments continue forever. This is much rarer than the first two types.

 TERMS TO KNOW

Annuity
An investment in which regular payments are made over the course of multiple periods.

Ordinary Annuity
An investment with fixed payments that occur at regular intervals, paid at the end of each period.

Annuity-Due
An investment with fixed payments that occur at regular intervals, paid at the beginning of each period.

Perpetuity
An investment in which the periodic payments begin on a fixed date and continue indefinitely.

2. Future Value of Annuity

The future value of an annuity is the sum of the future values of all of the payments in the annuity. It is possible
to take the FV of all cash flows and add them together, but this isn’t really pragmatic if there are more than a
couple of payments. If you were to manually find the FV of all the payments, it would be important to be
explicit about when the inception and termination of the annuity is.

For an annuity-due, the payments occur at the beginning of each period, so the first payment is at the
inception of the annuity, and the last one occurs one period before the termination.

For an ordinary annuity, however, the payments occur at the end of the period. This means the first payment is
one period after the start of the annuity, and the last one occurs right at the end. There are different FV
calculations for annuities-due and ordinary annuities because of when the first and last payments occur.

There are some formulas to make calculating the FV of an annuity easier. For both of the formulas we will
discuss, you need to know the payment amount (m, though can be written as pmt or p), the interest rate of the
account the payments are deposited in (r, though sometimes i), the number of periods per year (n), and the
time frame in years (t).

The formula for an ordinary annuity is as follows:

 FORMULA

FV of Ordinary Annuity

In contrast, the formula for an annuity-due is as follows:

 FORMULA

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FV of Annuity-Due

 HINT

Provided you know m, r, n, and t, therefore, you can find the future value (FV) of an annuity.

3. Present Value of Annuity

The Present Value (PV) of an annuity can be found by calculating the PV of each individual payment and then
summing them up. As in the case of finding the Future Value (FV) of an annuity, it is important to note when
each payment occurs.

Annuities-due have payments at the beginning of each period, and ordinary annuities have them at the end.
Recall that the first payment of an annuity-due occurs at the start of the annuity, and the final payment occurs
one period before the end. The PV of an annuity-due can be calculated as follows:

 FORMULA

PV of Annuity-Due

An ordinary annuity has annuity payments at the end of each period, so the formula is slightly different than
for an annuity-due. An ordinary annuity has one full period before the first payment (so it must be discounted)
and the last payment occurs at the termination of the annuity (so it must be discounted for one period more
than the last period in an annuity-due). The formula is:
 FORMULA

PV of Ordinary Annuity

 BIG IDEA

In both formulas, P is the size of the payment (sometimes A or pmt), i is the interest rate, and n is the number
of periods.

Both annuities-due and ordinary annuities have a finite number of payments, so it is possible, though
cumbersome, to find the PV for each period. For perpetuities, however, there are an infinite number of
periods, so we need a formula to find the PV. The formula for calculating the PV is the size of each payment
divided by the interest rate.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 19
4. Calculating Annuities
Suppose you have won a lottery that pays $1,000 per month for the next 20 years. But, you prefer to have the
entire amount now. If the interest rate is 8%, how much will you accept?

Consider for argument purposes that two people, Mr. Cash and Mr. Credit, have won the same lottery of
$1,000 per month for the next 20 years. Now, Mr. Credit is happy with his $1,000 monthly payment, but Mr.
Cash wants to have the entire amount now. Our job is to determine how much Mr. Cash should get. We
reason as follows: if Mr. Cash accepts x dollars, then the x dollars deposited at 8% for 20 years should yield
the same amount as the $1,000 monthly payments for 20 years. In other words, we are comparing the future
values for both Mr. Cash and Mr. Credit, and we would like the future values to be equal.

Since Mr. Cash is receiving a lump sum of x dollars, its future value is given by the lump sum formula:

Since Mr. Credit is receiving a sequence of payments, or an annuity, of $1,000 per month, its future value is
given by the annuity formula:

The only way Mr. Cash will agree to the amount he receives is if these two future values are equal. So we set
them equal and solve for the unknown:

So, if Mr. Cash takes his lump sum of $119,554.29 and invests it at 8% compounded monthly, he will have
$589,020.45 in 20 years.

 SUMMARY

In this lesson, you learned that annuities are multi-period investments that pay out a regular fixed
sum. They can be categorized as ordinary annuities, annuity-due, or perpetuities. The future value of
an annuity can be determined by knowing the payment amount, the interest rate where the money is

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 20
 held, the number of annual payments, and the number of years that payments will occur. The present
value of an annuity can also be calculated using the same variables. Calculating annuities is useful
for making investment choices that maximize returns.

Best of luck in your learning!

Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “ Annuities” TUTORIAL.

 TERMS TO KNOW

Annuity
An investment in which regular payments are made over the course of multiple periods.

Annuity-Due
An investment with fixed-payments that occur at regular intervals, paid at the beginning of each period.

Ordinary Annuity
An investment with fixed-payments that occur at regular intervals, paid at the end of each period.

Perpetuity
An investment in which the periodic payments begin on a fixed date and continue indefinitely.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 21
Valuing Multiple Cash Flows
by Sophia Tutorial

 WHAT'S COVERED

In this lesson, you will learn how to calculate the future and present value of multiple cash flows.
Specifically, this lesson will cover:
1. Future Value, Multiple Flows
2. Present Value, Multiple Flows
3. Calculating Present Value from Future Value

1. Future Value, Multiple Flows

Finding the future value (FV) of multiple cash flows means that there are more than one payment/investment,
and a business wants to find the total FV at a certain point in time. These payments can have varying sizes,
occur at varying times, and earn varying interest rates, but they all have a certain value at a specific time in the
future.

The first step in finding the FV of multiple cash flows is to define when the future is. Once that is done, you
can determine the FV of each cash flow using the formula below. Then, simply add all of the future values
together.

 FORMULA

FV of Multiple Cash Flows

Manually calculating the FV of each cash flow and then summing them together can be a tedious process. If
the cash flows are irregular, don’t happen at regular intervals, or earn different interest rates, there isn’t a
special way to find the total FV.
However, if the cash flows do happen at regular intervals, are a fixed size, and earn a uniform interest rate,
there is an easier way to find the total FV. Investments that have these three traits are called annuities.

There are formulas to find the FV of an annuity depending on some characteristics, such as whether the
payments occur at the beginning or end of each period. There is another module that goes through exactly
how to calculate the FV of annuities.

If the multiple cash flows are a part of an annuity, you’re in luck; there is a simple way to find the FV. If the
cash flows aren’t uniform, don’t occur at fixed intervals, or earn different interest rates, the only way to find the
FV is to find the FV of each cash flow and then add them together.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 22
2. Present Value, Multiple Flows
The PV of multiple cash flows follows the same logic as the FV of multiple cash flows. The PV of multiple cash
flows is simply the sum of the present values of each individual cash flow. We can use the following formula to
find the PV:

 FORMULA

PV of Multiple Cash Flows

Each cash flow must be discounted to the same point in time.

 EXAMPLE You cannot sum the PV of two loans at the beginning of the loans if one starts in 2012 and
one starts in 2014. If you want to find the PV in 2012, you need to discount the second loan an additional
two years, even though it doesn’t start until 2014.

The calculations get markedly simpler if the cash flows make up an annuity. In order to be an annuity, the cash
flows need to have three traits:

Constant payment size

Payments occur at fixed intervals
A constant interest rate

Things may get slightly messy if there are multiple annuities, and you need to discount them to a date before
the beginning of the payments.

IN CONTEXT
Suppose there are two sets of cash flows which you determine are both annuities. The first extends
from 1/1/14 to 1/1/16, and the second extends from 1/1/15 to 1/1/17. You want to find the total PV of all
the cash flows on 1/1/13.

The annuity formulas are good for determining the PV at the date of the inception of the annuity.
That means that it’s not enough to simply plug in the payment size, interest rate, and number of
periods between 1/1/13 and the end of the annuities. If you do, that supposes that both annuities
begin on 1/1/13, but neither do. Instead, you have to first find the PV of the first annuity on 1/1/14 and
the second on 1/1/15 because that’s when the annuities begin.

You now have two present values, but both are still in the future. You then can discount those
present values as if they were single sums, to 1/1/13.

Unfortunately, if the cash flows do not fit the characteristics of an annuity, there isn’t a simple way to
find the PV of multiple cash flows; each cash flow must be discounted and then all of the PVs must
be summed together.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 23
  TERM TO KNOW

Discounting
The process of finding the present value using the discount rate.

3. Calculating Present Value from Future Value

A corporation must decide whether to introduce a new product line. The new product will have start-up
expenditures, operational expenditures, and then it will have associated incoming cash receipts (sales) and
disbursements (cash paid for materials, supplies, direct labor, maintenance, repairs, and direct overhead) over
12 years.

This project will have an immediate (t=0) cash outflow of $100,000, which might include all cash paid for the
machinery, transportation-in and set-up expenditures, and initial employee training disbursements.

The annual net cash flow (receipts less disbursements) from this new line for years 1-12 is forecast as follows:

Year 1: -$54,672

Year 2: -$39,161

Year 3: $3,054

Year 4: $7,128

Year 5: $25,927

Year 6: $28,838

Year 7: $46,088

Year 8: $77,076

Year 9: $46,726

Year 10: $76,852

Year 11: $132,332

Year 12: $166,047

This is reflecting two years of running deficits as experience and sales are built up, with net cash receipts
forecast positive after that.
At the end of the 12 years, it’s estimated that the entire line becomes obsolete and its scrap value just covers
all the removal and disposal expenditures. All values are after-tax, and the required rate of return is given to
be 10%. (This also makes the simplifying assumption that the net cash received or paid is lumped into a single
transaction occurring on the last day of each year.)

The present value (PV) can be calculated for each year:

Time PV

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 T=0

T=1

T=2

T=3

T=4

T=5

T=6

T=7

T=8

T=9

T=10

T=11

T=12

SUM
The sum of all these present values is the net present value, which equals $65,816.04. Since the NPV is
greater than zero, it would be better to invest in the project than to do nothing, and the corporation should
invest in this project if there is no alternative with a higher NPV.

 TERM TO KNOW

Net Present Value

The present value of a project or an investment decision determined by summing the discounted incoming
and outgoing future cash flows resulting from the decision.

 SUMMARY

In this lesson, you learned that you can calculate the future value of multiple flows by applying the

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 25
 formula for future value to each investment and adding the results together. Similarly, you can find the
present value of multiple flows by summing up the present value of each cash flow. Calculating
present value from future value allows companies to make decisions about long-term investments,
such as new product lines.

Best of luck in your learning!

Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Valuing Multiple Cash Flows”
TUTORIAL.

 TERMS TO KNOW

Discounting
The process of finding the present value using the discount rate.

Net Present Value

The present value of a project or an investment decision determined by summing the discounted incoming
and outgoing future cash flows resulting from the decision.

 FORMULAS TO KNOW

FV of Multiple Cash Flows

PV of Multiple Cash Flows

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 26
Additional Detail on Present and Future Values
by Sophia Tutorial

 WHAT'S COVERED

In this lesson, you will learn about the effect of interest rates on present and future values.
Specifically, this lesson will cover:
1. The Relationship Between Present and Future Value
2. Calculating Perpetuities

1. The Relationship Between Present and Future

Value
The future value determines what a sum of money will be worth at a period in the future, given various rates of
interest, compounding periods, and time. The FV is calculated by multiplying the present value by the
accumulation function. The value does not include corrections for inflation or other factors that affect the true
value of money in the future. The process of finding the FV is often called capitalization.

On the other hand, the present value (PV) is the value on a given date of a payment or series of payments
made at other times. The process of finding the PV from the FV is called discounting.

PV and FV are related, as reflected in the following compounding interest formula.

 FORMULA

Compound Interest

 HINT

Simple interest has n multiplied by i, instead of as the exponent. However, since it is rather rare to use simple
interest, the compounding interest formula is the important one.

PV and FV vary directly; when one increases, the other increases, assuming that the interest rate and number
of periods remain constant.

The interest rate (or discount rate) and the number of periods are the two other variables that affect the FV
and PV. The higher the interest rate, the lower the PV and the higher the FV. The same relationships apply for
the number of periods. The more time that passes, or the more interest accrued per period, the higher the FV
will be if the PV is constant, and vice versa.

The formula implicitly assumes that there is only a single payment. If there are multiple payments, the PV is

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 27
the sum of the present values of each payment and the FV is the sum of the future values of each payment.

 TERM TO KNOW

Capitalization
The process of finding the future value of a sum by evaluating the present value.

Discounting
The process of finding the present value using the discount rate.

2. Calculating Perpetuities
A perpetuity is a unique type of annuity. Whereas an annuity has a specified end, a perpetuity is a stream of
cash flow payments that has no end – it continues forever. Essentially, they are ordinary annuities, but have
no end date. There aren’t many actual perpetuities, but the United Kingdom has issued them in the past.

Since there is no end date, the annuity formulas we have explored don’t apply here. There is no end date, so
there is no future value formula. To find the FV of a perpetuity would require setting a number of periods
which would mean that the perpetuity up to that point can be treated as an ordinary annuity.

There is, however, a PV formula for perpetuities. The PV is simply the payment size (A) divided by the interest
rate (r). Notice that there is no n, or number of periods. More accurately, it is what results when you take the
limit of the ordinary annuity PV formula as n → ∞.

It is also possible that an annuity has payments that grow at a certain rate per period. The rate at which the
payments change is fittingly called the growth rate (g). The PV of a growing perpetuity is represented with the
following formula:

 FORMULA

PV of a Growing Perpetuity

It is essentially the same except that the growth rate is subtracted from the interest rate. Another way to think
about it is that for a normal perpetuity, the growth rate is just 0, so the formula boils down to the payment size
divided by r.
 TERM TO KNOW

Growth Rate
The percentage by which the payments grow each period.

 SUMMARY

In this lesson, you learned more about the relationship between present value and future value,
which are directly related. However, the difference between the two is affected by the interest rate
and the number of periods. Calculating perpetuities, or payment streams that continue indefinitely, is
different from other annuities. This involves knowing the payment size, the interest rate, and the

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 28
 growth rate (in the case of growing perpetuities).

Best of luck in your learning!

Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Additional Detail on Present and
Future Values” TUTORIAL.

 TERMS TO KNOW

Capitalization
The process of finding the future value of a sum by evaluating the present value.

Discounting
The process of finding the present value using the discount rate.

Growth Rate
The percentage by which the payments grow each period.

 FORMULAS TO KNOW

Compound Interest

PV of a Growing Perpetuity

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 29
Yield
by Sophia Tutorial

 WHAT'S COVERED

In this lesson, you will differentiate between the methods of calculating yield of a single-period
investment and an annuity. Specifically, this lesson will cover:
1. Calculating the Yield of a Single-Period Investment
a. Change-In-Value
b. Annual Percentage Rate
c. Effective Annual Rate
2. Calculating the Yield of an Annuity

1. Calculating the Yield of a Single-Period

Investment
The yield on an investment is the amount of money that is returned to the owner at the end of the term. In
short, it’s how much you get back on your investment.

Naturally, this is a number that people care a lot about. The whole point of making an investment is to get a
yield. There are a number of different ways to calculate an investment’s yield, though. You may get slightly
different numbers using different methods, so it’s important to make sure that you use the same method when
you are comparing yields. This section will address the yield calculation methods you are most likely to
encounter, though there are many more.

 TERM TO KNOW

Yield
The amount in cash that returns to the owners of a security.

1a. Change-In-Value

The most basic type of yield calculation is the change-in-value calculation. This is simply the change in value
(FV minus PV) divided by the PV times 100%. This calculation measures how different the FV is from the PV as
a percentage of PV.
 FORMULA

Change-in-Value

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1b. Annual Percentage Rate

Another common way of calculating yield is to determine the Annual Percentage Rate, or APR. You may have
heard of APR from ads for car loans or credit cards. These generally have monthly loans or fees, but if you
want to get an idea of how much you will accrue in interest per year, you need to calculate an APR. Nominal
APR is simply the interest rate multiplied by the number of payment periods per year.
 FORMULA

Nominal Annual Percentage Rate (APR)

However, since interest compounds, nominal APR is not a very accurate measure of the amount of interest
you actually accrue.

1c. Effective Annual Rate

The Effective Annual Rate is the amount of interest actually accrued per year based on the APR. The following
formula can be used, where n is the number of compounding periods of APR per year:
 FORMULA

Effective Annual Rate (EAR)

IN CONTEXT
You may see an ad that says you can get a car loan at an APR of 10% compounded monthly. That
means that the APR is 0.10 and n is 12, since the APR compounds 12 times per year. The effective
APR would then be:

That means the EAR is 10.47%.

The EAR is a form of the Annual Percentage Yield (APY). APY may also be calculated using interest rates other
than APR, so the following is a more general formula:

 FORMULA

Annual Percentage Yield (APY)

The logic behind calculating APY is the same as that used when calculating EAR: you want to know how much
you actually accrue in interest per year. Interest usually compounds, so there is a difference between the
nominal interest rate (e.g., monthly interest times 12) and the effective interest rate.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 31
  BIG IDEA

The Annual Percentage Yield is a way of normalizing the nominal interest rate. Basically, it is a way to account
for the time factor in order to get a more accurate number for the actual interest rate In the formula, inom is the
nominal interest rate and N is the number of compounding periods per year.

2. Calculating the Yield of an Annuity

The yield of an annuity can be calculated in similar ways to the yield for a single payment, but two methods
are most common.

Percentage-Change: Just as for a single payment, this method calculates the percentage difference
between the FV and the PV. Since annuities include multiple payments over the lifetime of the investment,
the PV is the present value of the entire investment, not just the first payment.
Internal rate of return (IRR): This method is the interest rate (or discount rate) that causes the Net Present
Value (NPV) of the annuity to equal 0. That means that the PV of the cash outflows equals the PV of the
cash inflows. The higher the IRR, the more desirable is the investment. In theory, you should make
investments with an IRR greater than the cost of capital.

IN CONTEXT
Suppose you have a potential investment that would require you to make a $4,000 investment
today, but would return cash flows of $1,200, $1,410, $1,875, and $1,050 in the four successive years.
This investment has an implicit rate of return, but you don’t know what it is. You plug the numbers
into the NPV formula and set NPV equal to 0.

You then solve for r, which is your IRR. It is not easy to solve this problem by hand. You will likely
need to use a business calculator or Excel. When r = 14.3%, NPV = 0, so therefore the IRR of the
investment is 14.3%.

 HINT

This above example is not technically an annuity because the payments vary, but it still is a good example for
how to find IRR.

 SUMMARY

In this lesson, you learned that there are different methods of calculating the yield of a single-period
investment, such as determining the change-in-value, the annual percentage rate, or the effective
annual rate. Similarly, calculating the yield of an annuity can be done in different ways, most
commonly by determining the percentage-change or the internal rate of return.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 32
 Best of luck in your learning!

Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Yield” TUTORIAL.

 TERMS TO KNOW

Yield
The amount in cash that returns to the owners of a security.

 FORMULAS TO KNOW

Annual Percentage Yield (APY)

Change-in-Value

Effective Annual Rate (EAR)

Nominal Annual Percentage Rate (APR)

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 33
The Basics of Interest Rates
by Sophia Tutorial

 WHAT'S COVERED

In this lesson, you will learn about different yield curves and their meanings. Specifically, this lesson
will cover:
1. Understanding the Cost of Money
2. Interest Rate Levels
3. Drivers of Market Interest Rates
4. The Term Structure
a. Shapes of Curve
b. Theories
5. Using the Yield Curve to Estimate Interest Rates in the Future

1. Understanding the Cost of Money

The concept of the cost of money, as does the subject of finance in general, has its basis in the time value of
money. The time value of money is the value of money, taking into consideration the interest earned over a
given amount of time. If offered a choice between $100 today or $100 in a year’s time – and there is a positive
real interest rate throughout the year – a rational person will choose $100 today. This is described by
economists as time preference. The time preference can be thought of as a US Treasury bill.

 EXAMPLE Consider a $100 Treasury bill that currently sells for $80. The present value of the bill is
$80 whereas the future value of the bill would be $100 in one year.

This fee paid as compensation for the current use of assets is known as interest. In other words, the concept
of interest describes the cost of having funds tied up in investments or savings.

Furthermore, the time value of money is related to the concept of opportunity cost. The cost of any decision
includes the cost of the most forgone alternative. The cost of money is the opportunity cost of holding money
in hand instead of investing it. The trade-off between money now (holding money) and money later (investing)
depends on, among other things, the rate of interest that can be earned by investing. An investor with money
has two options:

Spend the money right now

Save the money

The financial compensation for saving it versus spending it is that the money value will accrue through the
compound interest that he will receive from a borrower (the bank account or investment in which he has the
money).

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 34
  TERM TO KNOW

Opportunity Cost
The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity);
the most valuable forgone alternative.

2. Interest Rate Levels

An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a
lender. Changes in interest rate levels signal the status of the economy. As a vital tool of monetary policy,
interest rates are kept at target levels – taking into account variables like investment, inflation, and
unemployment – for the purpose of promoting economic growth and stability. In the US, the Federal Reserve,
often referred to as "The Fed," implements monetary policies largely by targeting the federal funds rate. This
is the rate that banks charge each other for overnight loans of federal funds, which are the reserves held by
banks at the Fed.

Monetary policy can be classified as being either expansionary or contractionary.

Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering

interest rates in the hope that easy credit will entice businesses into expanding. An expansionary policy
increases the total supply of money in the economy more rapidly than usual.
Contractionary policy is intended to slow inflation in hopes of avoiding the resulting distortions and
deterioration of asset values. Contractionary policy increases interest rate levels by expanding the money
supply more slowly than usual or even shrinking it.

Most central banks around the world assume and expect that lowering interest rates (expansionary monetary
policies) would produce the effect of increasing investments and consumptions. However, lowering interest
rates can sometimes lead to the creation of massive economic bubbles, when a large amount of investments
are poured into the real estate market and stock market.
Crowding out is a phenomenon occurring when expansionary fiscal policy causes interest rates to rise,
thereby reducing investment spending. That means an increase in government spending crowds out
investment spending. This change in fiscal policy shifts equilibrium in the goods market. A fiscal expansion
increases equilibrium income. If interest rates are unchanged, an increase in the level of aggregate demand
will follow. This increase in demand must be met by a rise in output.

With this increase in equilibrium income, the quantity of money demanded is higher. Because there is an
excessive demand for real balances, the interest rate rises. Firms' planned spending declines at higher
interest rates, thus the aggregate demand falls. The adjustment of interest rates and their impact on
aggregate demand dampens the expansionary effect of the increased government spending.

 TERMS TO KNOW

Interest Rate
The percentage of an amount of money charged for its use per some period of time. It can also be thought of
as the cost of not having money for one period, or the amount paid on an investment per year.

Monetary Policy

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 35
The process by which the monetary authority of a country controls the supply of money, often targeting a rate
of interest for the purpose of promoting economic growth and stability.

3. Drivers of Market Interest Rates

Market interest rates are mostly driven by deferred consumption, inflationary expectations, alternative
investments, risk of investment, and liquidity preference.

Factor Description

Deferred consumption When money is loaned, the lender delays spending the money on
consumption goods. According to time preference theory, people prefer
goods now to goods later. In a free market, there will be a positive
interest rate.

Inflationary expectations Most economies generally exhibit inflation, meaning a given amount of
money buys fewer goods in the future than it will now. The borrower
needs to compensate the lender for this. If the inflationary expectation
goes up, then so does the market interest rate and vice versa.

Alternative investments The lender has a choice between using his money in different
investments. If he chooses one, he forgoes the returns from all the
others. Different investments effectively compete for funds, boosting the
market interest rate up.

Risks of investment The chance of an investment defaulting is always prevalent. Because of

this, lenders will assess a risk premium, to account for this risk and
compensate the lender for taking on additional units of risk. The greater
the risk is, the higher the market interest rate will get.

Liquidity preference This describes the fact that investors prefer to be able to easily convert
their investments to cash. If people are willing to hold more money in
hand for convenience, the money supply will contract, increasing the
market interest rate.
There is a market for investments that ultimately includes the money market, bond market, stock market, and
currency market as well as retail financial institutions like banks. Exactly how these markets function is
sometimes complicated. However, economists generally agree that the interest rates yielded by any
investment take into account:

Risk-free cost of capital

Inflationary expectations
Level of risk in the investment
Costs of the transaction

This rate incorporates the deferred consumption and alternative investment elements of interest.

4. The Term Structure

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 36
Term structure is a phrase used to describe how a given quantity or variable changes with time. In the case of
bonds, time to maturity, or terms, vary from short-term (usually less than a year) to long-term (10, 20, 30, 50
years, etc.). Term structure of interest rates is often referred to as the yield curve. Ayield curve indicates
various interest rates across various contract lengths. The curve illustrates the relationship between the time
of maturity and the interest rate.

The curve allows an interest rate pattern to be determined, which can then be used to discount cash flows
appropriately. Unfortunately, most bonds carry coupons, so the term structure must be determined using the
prices of these securities.

 TERMS TO KNOW

Term Structure of Interest Rates

The relationship between the interest on a debt contract and the maturity of the contract.

Yield Curve
The graph of the relationship between the interest on a debt contract and the maturity of the contract.

4a. Shapes of Curve

Based on the shape of the yield curve, we have normal yield curves, steep yield curves, flat or humped yield
curves, and inverted yield curves.

Shape Description

Normal The yield curve is normal, meaning that yields rise as maturity lengthens (i.e., the
slope of the yield curve is positive). This positive slope reflects investor
expectations for the economy to grow in the future and, importantly, for this growth
to be associated with a greater expectation that inflation will rise in the future rather
than fall. This expectation of higher inflation leads to expectations that the central
bank will tighten monetary policy by raising short-term interest rates in the future to
slow economic growth and dampen inflationary pressure.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 37
 Steep Sometimes, Treasury bond yield averages higher than that of Treasury bills (e.g.,
20-year Treasury yield rises higher than the three-month Treasury yield). In
situations when this gap increases, the economy is expected to improve quickly in
the future. This type of steep yield curve can be seen at the beginning of an
economic expansion (or after the end of a recession). Here, economic stagnation
will have depressed short-term interest rates. However, rates begin to rise once the
demand for capital is re-established by growing economic activity.

Flat A flat yield curve is observed when all maturities have similar yields, whereas a
humped curve results when short-term and long-term yields are equal and medium-
term yields are higher than those of the short-term and long-term. A flat curve
sends signals of uncertainty in the economy.

Inverted An inverted yield curve occurs when long-term yields fall below short-term yields.
This would occur when lenders are seeking long-term debt contracts more
aggressively than short-term debt contracts. The yield curve “inverts,” with interest
rates (yields) being lower and lower for each longer periods of repayment so that
lenders can attract long-term borrowing.

4b. Theories

There are three main economic theories attempting to explain different term structures of interest rates. Two
of the theories are extreme positions, while the third attempts to find a middle ground between two extremes.

Expectation hypothesis: This theory of the term structure of interest rates is the proposition that the long-
term rate is determined by the market’s expectation for the short-term rate plus a constant risk premium.
A shortcoming of the expectation theory is that it neglects the risks inherent in investing in bonds, namely
interest rate risk and reinvestment rate risk.
Liquidity premium theory: This theory asserts that long-term interest rates not only reflect investors’
assumptions about future interest rates, but also include a premium for holding long-term bonds
(investors prefer short-term bonds to long-term bonds), called the term premium or the liquidity premium.
This premium compensates investors for the added risk of having their money tied up for a longer period,
including the greater price uncertainty. Because of the term premium, long-term bond yields tend to be
higher than short-term yields, and the yield curve slopes upward. Long-term yields are also higher, not
just because of the liquidity premium, but also because of the risk premium added by the risk of default
from holding a security over the long term.
Segmented market hypothesis: With this theory, financial instruments of different terms are not
substitutable. As a result, the supply and demand in the markets for short-term and long-term instruments
is determined largely independently. Prospective investors decide in advance whether they need short-
term or long-term instruments. If investors prefer their portfolio to be liquid, they will prefer short-term
instruments to long-term instruments. Therefore, the market for short-term instruments will receive a
higher demand. Higher demand for the instrument implies higher prices and lower yield. This explains the
stylized fact that short-term yields are usually lower than long-term yields. This theory explains the
predominance of the normal yield curve shape. However, because the supply and demand of the two
markets are independent, this theory fails to explain the observed fact that yields tend to move together
(i.e., upward and downward shifts in the curve).

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 38
5. Using the Yield Curve to Estimate Interest
Rates in the Future
For debt contracts, the overall duration of time of the debt security coupled with the interest rate compounded
over that time frame will illustrate the overall yield of the security during its lifetime, also referred to as a yield
curve. When this is applied to US Treasury securities in respect to interest rates, useful information regarding
projected interest rates in the future over time can be estimated. This is carefully monitored by many traders,
and utilized as a point of comparison or benchmark for other investments (particularly valuation of bonds).

Projections Description

Relationship Through assessing the slope of a yield curve on debt instruments such as governmental
to the Treasury bonds, investors can estimate the overall health of the economy in the future (i.e.,
Business inflation, interest rates, recessions, growth). Inverted yield curves are typically predictors of
Cycle recession, while positively sloped yield curves indicate inflationary growth.

The Financial Defined as the rate of difference between a 10-year Treasury bond rate and a 3-month
Stress Index Treasury bond rate, the Financial Stress Index is a useful tool in projecting future economic
well-being. In fact, each of the recessionary periods since 1970 have demonstrated an
inverted yield curve when subjected to a Financial Stress Test just prior to that recessionary
period.

Market When it comes to interest rates specifically, yield curves are useful constructs in projecting
Expectations future behavior. The market expectations theory assumes that various maturities are perfect
(i.e., Pure substitutes, and as a result the shape of the yield curve represents market expectations over
Expectations) time in relation to interest rates. In short, through investor expectations of what the 1-year
interest rates will be next year, the current 2-year interest rate can be calculated as the
compounding of this year’s 1-year interest rate by next year’s expected 1-year interest rate.

Heath- When it comes to predicting future interest rates, the Heath-Jarrow-Morton framework is
Jarrow- considered a standard approach. It focuses on modeling the evolution of the interest rate
Morton curve (instantaneous forward rate curve in particular). The equation itself is a rather evolved
Framework derivation, incorporating bond prices, forward rates, risk free rates, the Wiener process,
Leibniz’s rule, and Fubini’s Theorem.

 SUMMARY

In this lesson, you developed your understanding of the cost of money, which is quantified by the
interest rate. Interest rate levels rise and fall according to economic conditions. They are a key tool of
monetary policy, but they also respond to other drivers of market interest rates that impact supply
and demand. Yield curves reflect the term structure of interest rates for various contract lengths.
These curves can be used by traders and other parties to evaluate the state of the economy and to
estimate interest rates in the future.

Best of luck in your learning!

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 39
Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “The Basics of Interest Rates” and
"Additional Detail on Interest Rates" TUTORIALs.

ATTRIBUTIONS


Yield Curve | Author: Wikipedia | License: Creative Commons

 TERMS TO KNOW

Interest Rate
The percentage of an amount of money charged for its use per some period of time. It can also be thought
of as the cost of not having money for one period, or the amount paid on an investment per year.

Monetary Policy
The process by which the monetary authority of a country controls the supply of money, often targeting a
rate of interest for the purpose of promoting economic growth and stability.

Opportunity Cost
The cost of an opportunity forgone (and the loss of the benefits that could be received from that
opportunity); the most valuable forgone alternative.

Term Structure of Interest Rates

The relationship between the interest on a debt contract and the maturity of the contract.

Yield Curve
The graph of the relationship between the interest on a debt contract and the maturity of the contract.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 40
Understanding Bonds
by Sophia Tutorial

 WHAT'S COVERED

In this lesson, you will learn about the basic characteristics of bonds. Specifically, this lesson will
cover:
1. Understanding Bonds
2. Types of Bonds
3. Contract for the Bond
4. Bond Ratings

1. Understanding Bonds
A bond is an instrument of debt; it is a debt security. Bonds provide a way for government and businesses to
borrow money in large amounts for a longer period of time.

When an entity issues bonds, it is borrowing money. In the primary market, when an investor buys a bond, it is
lending money. The terms of the bond require that the borrower pay the bondholder interest, which is also
called the coupon rate. It also requires that they repay the principal at a later date. This is the par value, or
face value, that is paid at maturity. The coupon interest is usually paid semi-annually, or every six months.

Bonds can be issued by:

Public authorities
The federal government
State governments
City and county governments
Municipalities
Credit institutions
Companies themselves
Multinational institutions

Companies and individuals themselves can purchase bonds. Because these bonds are negotiable, ownership
of them can be transferred in the secondary market, as if you or I were to invest in bonds. We are not lending
money to the entity that issued them, but we are paying for the current bondholder to transfer that security to
us.
A bond is a form of a loan. The holder of the bond is the lender; the creditor and the issuer of the bond is the
borrower, or the debtor. The interest rate is the coupon. These bonds provide the buyer with external funds to
finance long-term investments, and in the case of government bonds, they finance current expenditures.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 41
Certificates of deposit (CDs) or short-term commercial paper are not considered to be bonds. They are
considered to be money market instruments because the length of term is much shorter than the term for
bonds.

2. Types of Bonds
There are different categories of bonds. There are corporate bonds that are issued by companies. Municipal
bonds are issued by state, county, and local governments. Also, the United States Department of Treasury
issues Treasury bonds, notes, and bills, which altogether are referred to as treasuries.

There are two features of a bond that are the main determinants of a bond's coupon rate:

Credit quality
Time to maturity

 HINT

Maturities range from a one-year Treasury bill to a 30-year government bond. Corporate and municipal bonds
are often in the 3 to 10-year range, but can be longer.

 TERMS TO KNOW

Corporate Bond
A bond issued by a corporation to raise money effectively in order to expand its business.

Municipal Bond
A bond issued by an American city or other local government, or their agencies.

Treasury Bond
A government debt issued by the United States Department of the Treasury through the Bureau of the Public
Debt, with a maturity of 20 years to 30 years.

3. Contract for the Bonds

The bond indenture is the legal contract issued to the lenders that states all of these terms. The specifications
given defines the responsibilities and commitments of the issuer, as well as those of the borrower, and
describes all the key terms including the interest rate, the maturity date, and the repayment dates. If it is
convertible, any representations, covenants, or other terms of the bond offering are stated. If the borrower
fails to meet any of those payment requirements, the results can be drastic, including bankruptcy and
liquidation.

Because it would be impractical for corporations or any other issuer to enter into an agreement with each
individual bondholder, the bond indenture is held by a trustee. This is usually a commercial bank or some
other financial institution. They are appointed to represent the rights of the bondholders.

When the bonds are originally issued in the primary market, there is an offering memorandum that is prepared
in advance of the marketing of the bond, and the indenture is summarized in a section called the description

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 42
of notes. This offering memorandum, usually called a prospectus, is the document that describes the bond for
potential buyers. The prospectus also provides information about the company's business, financial
statements, its executives, information about their compensation, and any litigation that might be taking place,
along with any other material information.

 TERMS TO KNOW

Bond Indenture
A legal contract issued to lenders.

Convertibility
Quality of a bond that allows the holder to convert into shares of common stock in the issuing company or
cash of equal value, at an agreed-upon price.

4. Bond Ratings
In finance, the bond's credit rating reflects the creditworthiness of the corporation or the government's debt
issuer. It's similar to an individual's credit rating. The quality of the bond refers to the probability that the
bondholders will receive the coupon payments and the maturity payments on their due dates. The higher the
credit rating, the lower the interest cost is to the issuer.

Bond ratings are created by credit rating agencies. These include Moody's, Standard and Poor's, and others.
Ratings are usually given in letter designations starting with AAA and going down through BBB, CCC, and
lower. A bond is considered to be investment grade if its credit rating is BBB or higher in the Standard and
Poor's rating. A bond rate lower than this is not considered to represent investment grade bonds. Those that
are very low are usually called junk bonds, or high-yield bonds. These bonds are rated much lower than
investment grade bonds and offer a higher yield because the investor has to take on more risk to earn a
higher coupon rate.

Credit rating agencies are paid for their work largely by investors who want impartial information. Later,
though, they began to be paid by entities issuing the securities, and this led to charges that they could not be
as impartial as they had in the past. Still today, rating agencies' work is thought to be highly respected and, for
the most part, very impartial.

 TERM TO KNOW

Credit Rating Agency

A company that assigns credit ratings to issuers of certain types of debt obligations, as well as to the debt
instruments themselves.

 SUMMARY

To understand bonds, the first thing to note is that a bond is a debt instrument, where the issuer is the
borrower, and the investor is the lender. Different types of bonds can be issued by corporations, state
and local governments, and the federal government. The bond is a loan that makes interest payments
to the bondholder, usually every six months until maturity. At maturity, the face value is repaid.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 43
 All of the details of the bond offering are included in a legal contract called the bond indenture. This
indenture is held by the trustee, which is usually a financial institution.

Finally, the credit ratings of a bond reflect the creditworthiness of the corporation or government
bond issuer. Similar to a credit rating, the rating of the bond impacts the interest rate the issuer has to
pay as well as the risk assumed by the borrower.

Best of luck in your learning!

Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Understanding Bonds”
TUTORIAL.

 TERMS TO KNOW

Bond Indenture
A legal contract issued to lenders.

Convertibility
Quality of a bond that allows the holder to convert into shares of common stock in the issuing company or
cash of equal value, at an agreed-upon price.

Corporate Bond
A bond issued by a corporation to raise money effectively in order to expand its business.

Credit Rating Agency

A company that assigns credit ratings to issuers of certain types of debt obligations, as well as to the debt
instruments themselves.

Municipal Bond
A bond issued by an American city or other local government, or their agencies.

Treasury Bond
A government debt issued by the United States Department of the Treasury through the Bureau of the
Public Debt, with a maturity of 20 years to 30 years.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 44
Key Characteristics of Bonds
by Sophia Tutorial

 WHAT'S COVERED

In this lesson, you will learn about key terms associated with bonds. Specifically, this lesson will cover:
1. Par Value
2. Coupon Rate
3. Maturity Date
4. Call Provision
5. Sinking Fund

1. Par Value
One term that we hear regarding bonds is the par value, which is the face value. This is the amount of money
that a bondholder will be paid at the date of maturity.

 HINT

This is usually $1000, but it can be higher.

 TERM TO KNOW

Par Value
The amount of money a holder will get back once a bond matures.

2. Coupon Rate
The coupon rate is the amount of interest the bondholder will receive per payment. It is expressed as a
percentage of the par value. Most often, it is fixed for the life of the bond; it never changes. Coupon payments
can be paid at any period, but the most common payment is semi-annually.

 DID YOU KNOW

The coupon got its name from the fact that in the past, paper certificates were issued that had coupons
attached to them that the bondholder had to actually cut and deposit in order to receive that interest payment.
Today, coupon payments are made in an automated manner without paper.

 TERM TO KNOW

Coupon Rate
Amount of interest that the bondholder will receive per payment, expressed as a percentage of the par value.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 45
3. Maturity Date
The maturity date is the date on which the bond will be redeemed; it is the payment date for the loan. It is the
date when the principal and any remaining interest is repaid to the bondholder. Most often, the maturity date
is fixed, and the term is 30 years. Some bonds can have a longer maturity.

Treasury securities of the federal government have their own terms.

Short-term bills have maturities between one and five years.

Medium-term maturities, called notes, have maturities between six and 12 years.
Long-term bonds have maturities that are greater than 12 years.

 TERM TO KNOW

Maturity Date
The final payment date of a loan or other financial instrument.

4. Call Provision
An indenture for a bond issuance can also have provisions for callability. A call provision allows the issuer to
redeem the bond at some point in time before the maturity date. This date is called the call date. The call date
is the date on which callable bonds can be redeemed early.

 TERM TO KNOW

Callable Bond
A bond that allows the issuer of the bond to retain the privilege of redeeming the bond at some point before
the bond reaches its date of maturity.

5. Sinking Fund
There can also be provisions in an indenture for a payment to a sinking fund. Asinking fund is a way for an
issuer to set aside money over time to retire the bond. It requires funds to be set aside periodically. For
bondholders, this reduces the risk that the issuer will default when paying the face value at maturity.

 TERM TO KNOW

Sinking Fund
A method by which an organization sets aside money to retire debts.

 SUMMARY

In this lesson, we learned that the par value is the face value of a bond and is the amount the
bondholder will receive at maturity, which is usually $1000. The coupon rate is the amount of interest

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 46
 that a bondholder will receive, expressed as a percentage of the face value. These interest payments
are most often made semi-annually. The maturity date is the date on which the bond will be
redeemed. This is the date that the principal is paid to the bondholder. Maturity is usually 30 years,
and it is a fixed date that is not changed.

There are two provisions that may be found in a bond indenture. One is a call provision that allows an
issuer to redeem their bond prior to maturity. The other is a sinking fund which is a provision that calls
for the issuer to set aside payments periodically that will be used to retire the principal at maturity.

Best of luck in your learning!

Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Key Characteristics of Bonds”
TUTORIAL.

 TERMS TO KNOW

Callable Bond
A bond that allows the issuer of the bond to retain the privilege of redeeming the bond at some point before
the bond reaches its date of maturity.

Coupon Rate
Amount of interest that the bondholder will receive per payment, expressed as a percentage of the par
value.

Maturity Date
The final payment date of a loan or other financial instrument.

Par Value
The amount of money a holder will get back once a bond matures.

Sinking Fund
A method by which an organization sets aside money to retire debts.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 47
Advantages and Disadvantages of Bonds
by Sophia Tutorial

 WHAT'S COVERED

In this lesson, you will learn about the advantages and disadvantages of bond ownership. Specifically,
this lesson will cover:
1. Advantages of Bonds
a. Price Movement
b. Legal Protection
c. Liquidity
d. Variety
2. Disadvantages of Bonds
a. Interest Rate Risk
b. Repayment Risk
c. Credit Rating Risk

1. Advantages of Bonds
Recall that a bond is an instrument of debt, with the issuer being the borrower and the holder being the
lender.

1a. Price Movement

One advantage that bonds have over stocks is that they have relatively low volatility in terms of price. This
means that the shift in price changes for bonds is usually smaller than that of stocks. Due to this, they seem to
be a safer, more conservative investment. Also, because there is some relative certainty that the fixed interest
payment twice a year will happen along with the fixed interest payment at maturity, bonds can be very
attractive.

1b. Legal Protection

This attraction is also related to the fact that there is an element of legal protection that is present with bonds.
If the bond issuer goes bankrupt, bondholders usually receive some money back during the recovery process.
The company's stockholders end up with nothing.

 HINT

The bond indenture outlines these terms.

1c. Liquidity

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 48
The third advantage is that bonds are usually very liquid. It's easy for a financial institution that has invested
heavily in bonds to sell a substantial quantity of them without moving the price. This is much more difficult to
do with stocks.

1d. Variety

Finally, because finance is an area in which new products are created to fulfill almost every need, there is
usually a type of bond available to meet the different needs of investors, including zero-coupon bonds,
convertible bonds, and floating-rate bonds, to name a few.

2. Disadvantages of Bonds
Bonds are subject to various types of risk.

2a. Interest Rate Risk

One type of risk is interest rate risk. Bonds that have fixed coupon rates – and this is most of them – are
subject to interest rate risk. Since the coupon payments are fixed, when market interest rates rise, the price of
the bond will fall. This tells us that investors will be able to get a higher interest rate on their money
somewhere else in the market. Perhaps they will invest in a newly issued bond that reflects the higher interest
rate.

2b. Repayment Risk

Bonds are also subject to repayment risk. This is for bonds that are callable. There's the risk that a
bondholder's specific bond will be called for early repayment by the issuer.

2c. Credit Rating Risk

There is also credit rating risk on the part of the issuer. If a credit rating agency downgrades its rating of the
issuer, the market price of the bond will fall. And just as we saw with interest rate risk, it doesn't affect the
interest payments, but it does affect the price. This would affect the holders of these bonds who may be
seeking to sell them.

 SUMMARY

In this lesson, we learned that the advantages of bonds include the relative lower volatility of bond
prices when compared to stocks. This means prices change in smaller amounts because they are
seen as less risky and more conservative. There is also an amount of legal protection for
bondholders through the bond indenture. If the issuer declares bankruptcy, the bondholder will
receive some payment on the bonds they hold. Bonds are also very liquid, and this is important
because it ensures bondholders can trade large quantities of bonds without significantly impacting
prices. There are also a variety of bonds to meet the needs of different investors.

The disadvantages of bonds include several types of risk that can impact bondholders. Interest rate
risk stems from the fact that fixed coupon payments do not change when overall market interest rates
increase. There is also repayment risk for bonds that are callable. A bondholder may be unwilling to

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 49
 surrender a bond in their portfolio if it is attractively priced at the time it is called. There is also credit
rating risk. If a credit rating agency changes the credit rating for an issuer and lowers it, then the price
for the bond will fall in the market.

Best of luck in your learning!

Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Advantages and Disadvantages
of Bonds” TUTORIAL.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 50
Types of Bonds
by Sophia Tutorial

 WHAT'S COVERED

In this lesson, you will learn about different types of bonds. Specifically, this lesson will cover:
1. Government Bonds
2. Zero-Coupon Bonds
3. Floating-Rate Bonds
4. Other Types of Bonds

1. Government Bonds
Very frequently, products find their way to the market when there is a vacuum; the bond market is no
exception.

One type of bond is the government bond. We consider a government bond to be issued by the US
government, but they actually can be issued by any national government.

 DID YOU KNOW

Outside of the United States, they are called sovereign bonds.

In the US, government bonds are usually referred to as risk-free bonds because the government can raise
taxes or create additional currency in order to redeem the bond at maturity.

 TERM TO KNOW

Government Bond
A bond issued by a national government denominated in the country’s domestic currency.

2. Zero-Coupon Bonds
Zero-coupon bonds are an instrument that was first introduced in the 1960s and became popular in the 1980s.

Zero-coupon bonds are also called discount bonds, and the reason it's called a discount bond is that it does
not make periodic interest payments; the coupon rate is zero.

With a zero-coupon bond, the investor does not receive coupon payments, but does receive the face value at
maturity.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 51
  HINT

Because zero-coupon bonds pay zero interest, they are issued at a substantial discount to face value so that
the interest is effectively included in what gets paid at maturity.

 TERM TO KNOW

Zero-Coupon Bond
A bond with no coupon payments, bought at a price lower than its face value, with the face value repaid at the
time of maturity.

3. Floating-Rate Bonds
While coupon rates are most often fixed, there are bonds that have variable coupon rates. These are called
floating-rate bonds, or FRBs. The spread is the rate that is tied to an index like the federal funds rate, and they
have quarterly coupons.

In the US, issuers of floating-rate bonds are government-sponsored enterprises, such as:

Federal Home Loan Bank

Federal National Mortgage Association (also called Fannie Mae)
Federal Home Loan Mortgage Corporation (also called Freddie Mac)

Floating rate bonds have very little interest rate risk when the market rates are the actual expected coupon
rates of the floating rate bonds. This is different than fixed-rate bonds, whose prices decline when markets
rate rise. For this reason, there is almost no interest rate risk with floating-rate bonds.
 TERM TO KNOW

Floating-Rate Bond
A bond that has a variable coupon equal to a money market reference rate (e.g., LIBOR), plus a quoted
spread.

4. Other Types of Bonds

There are other several types of bonds as well.

Other Types of Bonds Description

Inflation-linked bonds Floating rate bonds with an index that is tied to the inflation rate.

Convertible bonds Bonds that let the bondholder trade the bond for a number of shares of
common stock.

Asset-backed securities Bonds whose cash flows are backed by the output of other assets, like
mortgage-backed securities.

Subordinated bonds Bonds that have a lower priority than other bonds in the case of
liquidation. These bonds would typically have a slightly higher return to

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 52
 compensate for the increased default risk.
 TERMS TO KNOW

Inflation-Linked Bond
A floating-rate bond with an index that is tied to the inflation rate.

Convertible Bond
A bond that lets the bondholder trade the bond for a number of shares of common stock.

Asset-Backed Security
A bond whose cash flows are backed by the output of other assets, like mortgage-backed securities.

Subordinated Bond
A bond that has a lower priority than other bonds in the case of liquidation.

 SUMMARY

In this lesson, we learned that we have government bonds issued by national governments. These
are also called sovereign bonds. We have zero-coupon bonds that have no coupon payment and
therefore sell at a deep discount below face value. There are also floating-rate bonds that are fixed
to an index. Issuers of these bonds include Fannie Mae and Freddie Mac. Other types of bonds are
inflation-linked bonds, convertible bonds, asset-backed securities, and subordinated bonds.

Best of luck in your learning!

Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Types of Bonds” TUTORIAL.

 TERMS TO KNOW

Asset-Backed Security
A bond whose cash flows are backed by the output of other assets, like mortgage-backed securities.

Convertible Bond
A bond that lets the bondholder trade the bond for a number of shares of common stock.

Floating-Rate Bond
A bond that has a variable coupon equal to a money market reference rate (e.g., LIBOR), plus a quoted
spread.

Government Bond
A bond issued by a national government denominated in the country’s domestic currency.

Inflation-Linked Bond
A floating-rate bond with an index that is tied to the inflation rate.

Subordinated Bond
A bond that has a lower priority than other bonds in the case of liquidation.

Zero-Coupon Bond

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 53
 A bond with no coupon payments, bought at a price lower than its face value, with the face value repaid at
the time of maturity.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 54
Valuing Bonds
by Sophia Tutorial

 WHAT'S COVERED

In this lesson, you will learn about the market value of a bond based on its yield to maturity.
Specifically, this lesson will cover:
1. Valuing Bonds
a. At Par
b. At a Discount
c. At a Premium

1. Valuing Bonds
As with all financial securities, the true value of a bond can be calculated from the net present value of all the
expected cash flows. If a bondholder holds a bond to maturity, they will receive interim interest payments at
the coupon rate and the face value at maturity.

 BIG IDEA

The value of a bond is the present value of each of these cash flows added together.

Consider the cash flows on a timeline. If we are going to receive these coupon payments and the face value at
maturity, what is the interest rate at which the present value equals the price of the bond today?

 HINT

Price can be quoted in dollars, but it is often quoted as a percent of face value. For example, if a bond with a
$1000 face value is selling for $980, it can be said that the bond is selling at 98%. If it was selling at $1050, it
would be said that the bond is selling at 105%.

We can determine this by directly solving the following equation:

 FORMULA

Yield to Maturity of a Coupon Bond

In this formula, the variables are equivalent to:

P: price today
CPN: coupon payment
FV: face value at maturity

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 55
 y: interest rate

Solving for the interest rate can prove quite complicated, but it is important, because this rate is called the
yield to maturity. It is like the internal rate of return for the bond cash flows over the market price. Fortunately,
there are tools for this, including spreadsheet software like Excel and other web applications. Let's take a
look.

2a. At Par

Suppose a bond has a face value of $1,000, with a coupon rate of 8%, and five years left to maturity. The
coupon payments are semi-annual and the bond is currently trading at $1,000, meaning it is trading at par.
What is the yield of maturity?

Face Value: $1,000

Annual Coupon Rate: 8%

Years to Maturity: 5

Coupon Payments per Year: 2

Current Bond Price: $1,000

Yield to Maturity: 8.00%

The yield to maturity, or the internal rate of return, would be 8%, which is the same as the coupon rate. This is
due to the fact that the bond is currently selling at par.

 TERM TO KNOW

Selling At Par
A bond’s coupon rate is equal to its yield to maturity (YTM).

2b. At a Discount

Suppose a bond has the same information as above, but now the bond is currently selling at $940. What is the
yield of maturity? Do you think it will be 8%, higher than 8%, or lower than 8%?

Face Value: $1,000

Annual Coupon Rate: 8%

Years to Maturity: 5

Coupon Payments per Year: 2

Current Bond Price: $940

Yield to Maturity: 9.54%

The yield to maturity would actually be 9.54%. It is higher than the coupon rate because the current price is
low at $940. If we are going to still get the face value at maturity in the same coupon payments, the net
present value of this bond is worth more to us. We can say that this bond is selling at a discount.

 TERM TO KNOW

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 56
Selling at a Discount
A bond’s coupon rate is less than its yield to maturity (YTM).

2c. At a Premium

Suppose we have the same bond as above, but the price today is $1,090. The bond is selling at a premium.
What is the yield of maturity?

Face Value: $1,000

Annual Coupon Rate: 8%

Years to Maturity: 5

Coupon Payments per Year: 2

Current Bond Price: $1,090

Yield to Maturity: 5.90%

The yield to maturity would actually be 5.90%. It is lower than the coupon rate because the the bond is selling
at a premium. Since we have to pay so much for it, the yield of maturity will be less.

 TERM TO KNOW

Selling at a Premium
A bond’s coupon rate is more than its yield to maturity (YTM).

 SUMMARY

In this lesson, we learned about valuing bonds. Bonds pay a coupon payment periodically throughout
their life to maturity and most often this interest rate is fixed. At maturity, the holder receives the face
value, which is also fixed. With these two components being fixed, what changes in the market is the
price. The interest rate at which the discounted cash flows of the coupon and maturity payments
equal the price is the yield to maturity.

We also learned how to compare the yield of maturity for bonds that are currently at par, at a
discount, and at a premium.

Best of luck in your learning!

Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Valuing Bonds” TUTORIAL.

 TERMS TO KNOW

Selling At Par
A bond’s coupon rate is equal to its yield to maturity (YTM).

Selling at a Discount
A bond’s coupon rate is less than its yield to maturity (YTM).

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 57
 Selling at a Premium
A bond’s coupon rate is more than its yield to maturity (YTM).

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 58
Bond Risk
by Sophia Tutorial

 WHAT'S COVERED

In this lesson, you will learn about the characteristics of various types of bond risks. Specifically, this
lesson will cover:
1. Interest Rate Risk
2. Reinvestment Risk
3. Default Risk

1. Interest Rate Risk

Interest rate risk is the uncertainty associated with changes in the price of a bond caused by changes in the
general interest rate levels in the economy. Since coupon payments are fixed, if general interest rates fall,
bond prices increase. If interest rates rise, bond prices fall. However, if the bondholder is holding the bond to
maturity, he is insulated from this interest rate risk.

 EXAMPLE If a bondholder is holding a bond paying a 6% coupon and general interest rates fall, he will
continue to receive 6% coupon payments.

If interest rates rise, the bondholder may have opportunities to invest at a higher rate, but as long as he
holds the bond at 6%, that is the return he'll receive.

 TERM TO KNOW

Interest Rate Risk

The risk associated with changes in the price of a bond caused by changes in the general interest rate levels
in the economy.

2. Reinvestment Risk
The other side of the coin is reinvestment risk. Reinvestment risk is the uncertainty that the holder will be able
to reinvest his funds at the same rate, or better rate, at maturity.

If a bond is callable and interest rates fall, it is more likely that the issuer will call the bond while the holder is
enjoying the higher fixed coupon payment. This shows that reinvestment risk and interest rate risk are
inversely related. An investor could moderate one or the other, but they cannot eliminate both.

 TERM TO KNOW

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 59
Reinvestment Risk
The risk that a bond is repaid early, and an investor has to find a new place to invest with the risk of lower
returns.

3. Default Risk
The default risk is the risk that the bond issuer will not make payments as scheduled. If payments are missed
and it goes bankrupt, investors may lose much, if not all, of their money.

In bankruptcy, bank lenders are very high in the precedence of being paid back from liquidation. Bondholders
have precedence over equity holders and have a certain amount of legal protection. If a company goes
bankrupt, its bondholders will often receive some money back. The company's common stockholders usually
end up with nothing.

When a company can't pay its obligations, it enters bankruptcy court. There are two types of bankruptcy for
which a corporation can file:

Chapter 11: With this bankruptcy code, the business remains intact and in control of management but it is
subject to the oversight of the court.
Chapter 7: With this bankruptcy code, the company stops operating, the trustee of the court sells all the
assets, and then distributes the proceeds to the creditors.

 TERM TO KNOW

Default Risk
The risk that a bond issuer will default on any type of debt by failing to make payments which it is obligated to
make.

 SUMMARY

In this lesson, we learned that interest rate risk is the uncertainty of the impact of general economic
rate changes on the price of a bond. If rates fall, the bondholder can still enjoy the higher coupon
payment rate.

Reinvestment risk is the uncertainty that the bondholder won't be able to reinvest funds at the same
rate. This could be encountered when rates fall or conditions when callable bonds are likely to be
redeemed.

And finally, default risk reflects the possibility that the issuer will not make a coupon or maturity
payment as scheduled.

Best of luck in your learning!

Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Bond Risk” TUTORIAL.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 60
  TERMS TO KNOW

Default Risk
The risk that a bond issuer will default on any type of debt by failing to make payments which it is obligated
to make.

Interest Rate Risk

The risk associated with changes in the price of a bond caused by changes in the general interest rate
levels in the economy.

Reinvestment Risk
The risk that a bond is repaid early, and an investor has to find a new place to invest with the risk of lower
returns.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 61
Defining Stock
by Sophia Tutorial

 WHAT'S COVERED

In this lesson, you will learn about the nature of stock and the implications of ownership. Specifically,
this lesson will cover:
1. The Ownership Nature of Stock
2. Control and Preemption

1. The Ownership Nature of Stock

The capital stock, or stock, of a business entity represents the original capital paid into or invested in the
business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to
the detriment of the creditors.

Stock is different from the property and assets of a business, both of which may fluctuate in quantity and
value. Stock of a company is valued according to market demand and overall business health and this value
will fluctuate over time.

Ownership of stock represents a stake of ownership in the business entity. The stock is a security that
represents the equity in the company.

Owners of shares of stock are documented by the issuance of a stock certificate. This certificate is a legally
binding document that indicates the amount of shares possessed by the shareholder. It also informs of other
aspects of the shares such as share classification and its par value. Other documents will specify what rights
come with ownership of certain classes of stock.

Shareholders, otherwise thought of as stockholders, include both individuals and corporations that own
shares in a private or public corporation. Some consider stockholders to be a subclassification of
stakeholders, as stakeholders include anyone that possesses a direct or indirect interest in the corporation.

 TERMS TO KNOW

Stock
The original capital paid into the business by its founders and serves as a security for investors.

Shareholder
An individual who legally owns at least one share of stock in a company and has rights with regards to the
company because of this.

2. Control and Preemption

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 62
The stockholders, whether an individual or a corporation that possesses legal ownership of a corporation, are
granted certain rights. These rights and privileges vary depending on the classification of the stock. These
privileges can include:

The right to sell shares

The right to vote on directors nominated by the board
The right to nominate directors (although this is very difficult in practice because of minority protections)
and propose shareholder resolutions
The right to dividends if they are declared
The right to purchase new shares issued by the company
The right to what assets remain after a liquidation

Owners of common and preferred stock generally have to wait until debt-holders receive assets after
bankruptcy to see any assets after liquidation.
Control and preemption are particular stockholder rights. The right of preemption is a right granted to certain
stockholders granting the ability to acquire specified property before it can be made available to any other
entity or person.

This right is frequently applied for shareholders of a business entity as they are usually offered the first chance
to buy newly issued shares of stock before it becomes available to the general public. While shareholders are
offered the option of early purchase, they do not necessarily have to take it. The incentive to exercise this
option is based on the desire to protect individual ownership or stake in a company from dilution. The
conditions of preemptive rights will vary from company to company and share type to share type.

 TERM TO KNOW

Preemption
The right of a shareholder to purchase newly issued shares of a business entity before they are available to
the general public so as to protect individual ownership from dilution.

 SUMMARY

In this lesson, you learned that the ownership nature of stock means that when an investor buys
stock, he or she purchases a stake of ownership in the business. With stock ownership comes certain
rights and privileges related to control and preemption, which are determined by the class of stock
that was purchased. The former can include the right to vote on directors, while the latter refers to a
stockholder’s right to purchase newly issued shares of stock before they are marketed more broadly.

Best of luck in your learning!

Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Defining Stock” TUTORIAL.

 TERMS TO KNOW

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 63
 Preemption
The right of a shareholder to purchase newly issued shares of a business entity before they are available to
the general public so as to protect individual ownership from dilution.

Shareholder
An individual who legally owns at least one share of stock in a company and has rights with regards to the
company because of this.

Stock
The original capital paid into the business by its founders and serves as a security for investors.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 64
Types of Stock
by Sophia Tutorial

 WHAT'S COVERED

In this lesson, you will learn about common stock and preferred stock. Specifically, this lesson will
cover:
1. Common Stock
2. Preferred Stock

1. Common Stock
Common stock, a term used primarily in the United States, is a security that represents ownership, or equity,
in a corporation. In other parts of the world, the terms “voting share” or “ordinary share” are used to represent
this same concept.

Now, common stock is called “common” in order to distinguish it from another type of stock known as
preferred stock. In the case that a corporation has issued both common and preferred stock, holders of
common stock must wait to be paid dividends until after preferred stock shareholders receive all dividends,
including payments in arrears.

In the event that a corporation goes bankrupt, those shareholders with common stock will only receive the
funds that remain after preferred stockholders, bondholders, and creditors - including employees - receive
their funds. Therefore, when a company liquidation occurs, common stock shareholders typically receive
nothing.

While common stockholders are generally last in line among other creditors to receive assets should the
business in question go bankrupt, common shares do tend to perform better than preferred shares over time.
Also, common stock usually carries the right to vote on certain matters. These matters include, but are not
limited to, deciding who gets to sit on the board of directors of the company. However, a company can have
both a “voting” and “non-voting” class of common stock.

Common shareholders do not get guaranteed dividends, so their returns can be uncertain. It must be
remembered that preferred stock generally does not carry voting rights. As common stockholders, these
shareholders have the ability to influence the corporation, as they are entitled to vote on corporate matters
such as creating corporate objectives and policy, stock splits, and the election of the corporation’s board of
directors.

Common stock also bestows preemptive rights upon those shareholders, which means that common
stockholders can retain their proportional ownership in a company, having a right of first refusal on buying any
new stock that the company might attempt to issue.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 65
  TERMS TO KNOW

Common Stock
A form of equity and type of security; also known as a voting share or an ordinary share.

Dividends
Payments made by a corporation to its shareholder members.

2. Preferred Stock
Another type of stock, mentioned above, is preferred stock, a term used interchangeably with preferred
shares, preference shares, or preferred.

Preferred stock is a hybrid between common stock and bonds, as an equity security retaining properties of
both an equity and debt agent. It is considered to be less risky than common stock but more risky than bonds
in terms of a shareholder’s claim or rights to their share of a corporation’s assets. In other words, in the case
of liquidation or bankruptcy, preferred stock will have claim to assets before common stock, but after
corporate bonds or other debt instruments.

There is a unique set of features and rights associated with preferred stock, such as the lack of voting rights,
although it may carry a dividend and as discussed above, will have a prioritized claim to dividends as well as
assets in the event of a company’s liquidation. The specific terms of owning preferred stock are specified in a
certificate of designation.

In addition to the lack of voting rights and preference in dividends and liquidation assets, preferred stock is
convertible to common stock, and it has a callability feature that can be used at the discretion of the issuer.
Preferred stocks are rated by the major credit rating companies, just like bonds, although their rating is
typically lower than bonds because preferred dividends do not carry the same guarantees as interest
payments from bonds, and they are junior to all creditors.

Details with regards to the rights associated with preferred stock will vary with the business entity that issues
the shares, and preferred stock can come in a number of different classes.

Some examples are:

Prior preferred stock (highest priority)

Preference preferred stock
Convertible preferred stock (exchangeable for common stock)
Cumulative preferred stock
Exchangeable preferred stock
Participating preferred stock
Putable preferred stock
Monthly income preferred stock
Non-cumulative preferred stock

 TERM TO KNOW

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 66
Preferred Stock
An equity security that has the properties of both an equity and debt instrument and is higher ranking than
common stock.

 SUMMARY

In this lesson, you learned that common stock is a type of stock that typically carries voting rights
within a company. However, common stock extends fewer financial benefits than other classes of
stock. In particular, common stockholders are not guaranteed to receive dividends, and in the case of
company bankruptcy, they must wait behind creditors and other classes of stockholders to receive
assets. Preferred stock, on the other hand, does not carry voting rights, but it does claim priority over
common stock when it comes to dividends or asset recovery in the case of company liquidation.

Best of luck in your learning!

Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Types of Stock” TUTORIAL.

 TERMS TO KNOW

Common Stock
A form of equity and type of security; also known as a voting share or an ordinary share.

Dividends
Payments made by a corporation to its shareholder members.

Preferred Stock
An equity security that has the properties of both an equity and debt instrument and is higher ranking than
common stock.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 67
Rules and Rights of Common and Preferred
Stock
by Sophia Tutorial

 WHAT'S COVERED

In this lesson, you will learn how to compare the ownership of common and preferred stock.
Specifically, this lesson will cover:
1. Claim to Income
2. Voting Rights
3. Purchasing New Shares
4. Preferred Stock Rules and Rights
5. Provisions of Preferred Stock
6. Comparing Common Stock, Preferred Stock, and Debt
a. Equity
b. Debt

1. Claim to Income
Preferred and common stock have varying claims to income which will change from one equity issuer to
another. In general, preferred stock will be given some preference in assets to common assets in the case of
company liquidation, but both will fall behind bondholders when asset distribution takes place.

In the event of bankruptcy, common stock investors receive any remaining funds after bondholders, creditors
(including employees), and preferred stockholders are paid. As such, these investors often receive nothing
after a bankruptcy.

Preferred stock also has the first right to receive dividends. In general, common stock shareholders will not
receive dividends until they are paid out to preferred shareholders. Access to dividends and other rights vary
from firm to firm.

In the event of a company’s liquidation, preferred stock may or may not have a fixed liquidation value, or par
value, assigned to it. This face value comprises the amount of capital contributed to the company at the time
of the shares’ issuance. Upon a corporation’s liquidation, preferred stock can claim proceeds equal to its par
(or liquidation) value, except if this was negotiated in a different manner. This claim takes precedence over
the claim of common stock, which only has a residual claim.

Both types of stock can have a claim to income in the form of capital appreciation as well. As company value
increases based on market determinants, the value of equity held in this company also will increase. This
translates to a return on investment to shareholders. This will be different for common stock shareholders and

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 68
preferred stock shareholders because of the different prices and rewards based on holding these different
kinds of shares. In turn, should market forces decrease, the value of equity held will decrease as well,
reflecting a loss on investment and, therefore, a decrease in the value of any claims to income for
shareholders.

2. Voting Rights
Common stock can also be referred to as a “voting share.” Common stock usually carries with it voting rights
on business entity matters, such as electing the board of directors, establishing corporate objectives and
policy, and stock splits. However, common stock can be broken into voting and non-voting classes. While
having superior rights to dividends and assets over common stock, generally preferred stock does not carry
voting rights.

The matters that a stockholder gets to vote on vary from company to company. In many cases, the
shareholder will be able to vote for members of a company board of directors and, in general, each share
gets a vote as opposed to each shareholder.

 EXAMPLE A single investor who owns 300 shares will have more say in a voting matter than a single
shareholder that owns 30.

Every year, official bodies and associations involving the general public, such as companies with
shareholders, hold a mandatory meeting known as an annual general meeting, or AGM. These meetings,
which are often required by law, are held annually to elect the board of directors and update their members of
all activities, past and future.

An AGM also provides a forum for a shareholder to exercise many of his or her voting rights, as well as an
opportunity for shareholders and partners to review copies of the company’s accounts and fiscal information
for the previous year, and to get answers to any questions they may have regarding the future trajectory of
the business. If shareholders are unable to attend the AGM, they can opt to mail in their votes. To this end, in
2007, the Securities and Exchange Commission voted to mandate all public companies to provide access to
their annual meeting materials online, so that shareholders would have multiple ways to exercise their voting
rights if they were so inclined.

 TERM TO KNOW

Voting Rights
Rights that are generally associated with common stock shareholders in regards to business entity matters
(such as electing the board of directors or establishing corporate policy).

3. Purchasing New Shares

New share purchases are an important action by shareholders, since it requires a further investment in a
business entity and is a reflection of a shareholder’s decision to maintain an ownership position in a company
or a potential investor's belief that purchasing equity in a company will be an investment that grows in value.

In the case of new stock issuances by a company, current shareholders may have the right ofpreemption, the

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 69
most common form in practice being the right to obtain new shares issued by a company in a rights issue,
which is typically - but not always - a public offering. In this circumstance, the preemptive right is also known
as “subscription right” or “subscription privilege,” which is a right, but not a requirement, of current
shareholders to purchase the new shares before they are offered to the public. In this manner, current
shareholders are able to preserve their proportional ownership of the company, while preventing dilution of
the stock.

If shareholders decide to purchase the new stock, the transaction is performed over the same exchange
mechanism as the purchase of the previous stock, known as a stock exchange. This form of exchange is often
the most important element of a stock market, and it provides services whereby traders and stockbrokers can
trade stocks, bonds, and other securities. Stock exchanges also provide places for the issuance and
redemption of securities and other financial contracts, as well as capital events like the payment of income
and dividends. As a matter of course, the initial offering of stocks and bonds to investors is accomplished in
the primary market, while successive trading occurs in the secondary market. Within stock markets, supply
and demand are steered by the variety of factors that affect the price of stocks in all free markets.

 TERMS TO KNOW

Preemption
The right of a shareholder to purchase newly issued shares of a business entity before they are available to
the general public so as to protect individual ownership from dilution.

Stock Exchange
A form of exchange that provides services for stockbrokers and traders to trade stocks, bonds, and other
securities.

4. Preferred Stock Rules and Rights

Preferred stock usually carries no voting rights, but may carry a dividend and may have priority over common
stock in the payment of dividends and upon liquidation. Terms of the preferred stock are stated in a
"Certificate of Designation."

Preferred stock is a special class of shares with a unique set of features distinct from common stock,
including:

Preference in dividends and liquidation assets

Convertibility to common stock
Callability feature at the discretion of the issuer
No voting rights (though some preferred shares have special voting rights in the case of an election of
directors or extraordinary events like the issuance of new shares or approval of the acquisition of a
company)

 HINT

It should be noted, however, that in a case in which preferred dividends are in arrears for a considerable time,
preferred shares may be able to gain voting rights.

As mentioned previously, in the event of a company’s liquidation, preferred stock may or may not have a fixed

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 70
liquidation value, or par value, assigned to it. This face value comprises the amount of capital contributed to
the company at the time of the shares’ issuance. Upon a corporation’s liquidation, preferred stock can claim
proceeds equal to its par (or liquidation) value, except if this was negotiated in a different manner. This claim
takes precedence over the claim of common stock, which only has a residual claim. Virtually all preferred
shares have a negotiated, fixed dividend amount, which is stated as a percentage of the par value, or as a
fixed amount; however, occasionally dividends on preferred shares are negotiated as floating, meaning they
may vary based upon a benchmark interest rate index.

 TERM TO KNOW

Liquidation
The process by which a company (or part of a company) is brought to an end, and the assets and property of
the company redistributed.

5. Provisions of Preferred Stock

Preferred stock may be entitled to numerous rights, depending on what is designated by the issuer. One of
these rights may be the right to cumulative dividends. Preferred stock shareholders already have rights to
dividends before common stock shareholders, but cumulative preferred shares contain the provision that
should a company fail to pay out dividends at any time at the stated rate, then the issuer will have to make up
for it as time goes on.

Convertible preferred stock can be exchanged for a predetermined number of company common stock
shares. Generally, this can occur at the discretion of the investor, and he or she may pick any time to do so
and, therefore, take advantage of fluctuations in the price of common stock. Once converted, the common
stock cannot be converted back to preferred status. Oftentimes, companies will keep the right to call or buy
back preferred shares at a predetermined price. These shares are callable shares.

Participating preferred stock is a class of preferred shares that provide shareholders the chance to receive
extra dividends, contingent upon the company reaching predetermined financial goals. Investors who buy
these stocks receive their regular dividends even if the company does not reach those predetermined goals,
as long as the company succeeds enough to make its annual dividend payments; however, if the company
does reach those sales, earnings or profitability goals, the investors receive a bonus dividend.

Virtually all preferred shares have a negotiated, fixed dividend amount, which is stated as a percentage of the
par value, or as a fixed amount; however, occasionally dividends on preferred shares are negotiated as
floating, meaning they may vary based upon a benchmark interest rate index or floating rate (e.g., linking the
dividend rate to LIBOR).

 TERMS TO KNOW

Convertible Preferred Stock

Stock that can be exchanged for a predetermined number of company common stock shares.

Participating Preferred Stock

Stock that provides shareholders the chance to receive extra dividends, contingent upon the company
reaching predetermined financial goals.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 71
6. Comparing Common Stock, Preferred Stock,
and Debt
6a. Equity

Common stock and preferred stock are both methods of purchasing equity in a business entity.
Common stock generally carries voting rights along with it, while preferred shares generally do not.

Preferred shares act like a hybrid security, in between common stock and holding debt. Preferred stock can
(depending on the issue) be converted to common stock and have access to accumulated dividends and
multiple other rights. Preferred stock also has access to dividends and assets in the case of liquidation before
common stock does.

However, both common and preferred stock fall behind debt holders when it comes to claims to assets of a
business entity should bankruptcy occur. Common shareholders often do not receive any assets after
bankruptcy as a result of this principle. However, common stock shareholders can theoretically use their votes
to affect company decision making and direction in a way they believe will help the company avoid liquidation
in the first place.

6b. Debt

Debt can be "purchased" from a company in the form of a bond. In the context of finance, a bond is a contract
of indebtedness, issued by the bond issuers to the bondholders. It is a debt security with a framework outlined
as follows: the bond issuer owes the bondholder a debt, and contingent on the bond terms, is required to pay
them interest and/or repay the principal at a later time, known as the maturity date. Put another way, a bond is
simply a form of loan or IOU, in which the issuer of the bond is the borrower or debtor, the holder of the bond
is the lender or creditor, and the coupon represents the interest.
Bonds are a source of external funds to finance long-term investments or can be used to finance current
expenditures, as in the case of government bonds. Even though bonds and stocks are both securities, there
are several major differences between them:

Capital stockholders have an equity stake in the company, meaning they are owners, while bondholders
have a creditor stake in the company, meaning they are lenders.
Bonds generally have a defined term (maturity), at which point the bond is redeemed, while stocks may be
outstanding forever.

 SUMMARY

In this lesson, you learned in greater detail about the ownership rights associated with common stock
and preferred stock. Both have a claim to income from dividends and capital appreciation, but the
claims of preferred stock take precedence over those of common stock. In exchange, common stock
owners have voting rights that exceed those of preferred stockholders. Stock ownership usually also
comes with rights regarding the purchase of new shares. Preferred stock has different rules and
rights than common stock when it comes to voting, dividends, and valuation, and it may have a
number of additional provisions regarding cumulative or extra dividends and convertibility. When

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 72
 comparing common stock, preferred stock, and debt, however, it is important to note that both types
of stock represent equity or ownership in the company, whereas debt is a long-term loan with a fixed
maturity date.

Best of luck in your learning!

Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Rules and Rights of Common and
Preferred Stock” TUTORIAL.

 TERMS TO KNOW

Convertible Preferred Stock

Stock that can be exchanged for a predetermined number of company common stock shares.

Liquidation
The process by which a company (or part of a company) is brought to an end, and the assets and property of
the company redistributed.

Participating Preferred Stock

Stock that provides shareholders the chance to receive extra dividends, contingent upon the company
reaching predetermined financial goals.

Preemption
The right of a shareholder to purchase newly issued shares of a business entity before they are available to
the general public so as to protect individual ownership from dilution.

Stock Exchange
A form of exchange that provides services for stockbrokers and traders to trade stocks, bonds, and other
securities.

Voting Rights
Rights that are generally associated with common stock shareholders in regards to business entity matters
(such as electing the board of directors or establishing corporate policy).

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Stock Markets
by Sophia Tutorial

 WHAT'S COVERED

In this lesson, you will learn how financial forecasting influences a company's strategic planning.
Specifically, this lesson will cover:
1. Market Actors
2. NYSE
3. NASDAQ
4. Market Reporting

1. Market Actors
The individual actors in the financial markets can be broken down into three main categories:

Investors: Investors can take on many forms. Essentially, an investor is someone that provides capital with
the assumption of a financial return on that capital. There are many different types of investments that
can be made. In the sections to come, we will discuss various roles that are necessitated by the practice
of investing.
Issuers: An issuer is a legal entity that registers and creates securities so that they can be sold. The issuer
can also sell these instruments as well. Common examples of an issuer include investment trusts, foreign
governments, and corporations.
Intermediaries: Financial institutions (intermediaries) perform the vital role of bringing together those
economic agents with surplus funds who want to lend, with those with a shortage of funds who want to
borrow. The classic example of a financial intermediary is a bank that consolidates bank deposits and
uses the funds to transform them into bank loans. Other classes of intermediaries include credit unions,
financial advisers or brokers, collective investment schemes, and pension funds.

Specifically, market actors include individual retail investors, institutional investors such as mutual funds,
banks, insurance companies and hedge funds, and also publicly traded corporations trading in their own
shares.

Funds Description

Pension A pension fund, as the name implies, is any financial plan whose purpose is to provide some
funds type of retirement income. In this type of investment, large institutional investors make up the
majority of the market. It is commonly one of the largest categories of investments.

Mutual A mutual fund is a collection of diversified investments that are professionally managed.
funds Typically these investments seek to pool funds from a variety of investors with the purpose to
purchase additional securities. While there is no legal definition of mutual fund, the term is most

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 commonly applied only to those collective investment vehicles that are regulated, available to
the general public, and open-ended in nature. Hedge funds are not considered a type of mutual
fund.

There are three types of US mutual funds: open-end, unit investment trust, and closed-end. The
most common type, the open-end mutual fund, must be willing to buy back its shares from its
investors at the end of every business day.

Index An index fund or index tracker is a collective investment scheme (usually a mutual fund or
fund exchange-traded fund) that aims to replicate the movements of an index of a specific financial
market, or a set of rules of ownership that are held constant, regardless of market conditions. As
of 2007, index funds made up over 11% of equity mutual fund assets in the United States.

Exchange- An exchange-traded fund, commonly referred to as an ETF, is composed of a mixture of stocks,

traded bonds, and other commodities. The majority of ETFs track an existing stock index such as the
fund (ETF) S&P 500. These are desirable for many investors, as they offer a low cost, tax-efficient option
that is easy to acquire.

Hedge A hedge fund is a fund that can undertake a wider range of investment and trading activities
fund than other funds. It is generally only open to certain types of investors specified by regulators.
These investors are typically institutions, such as pension funds, university endowments and
foundations, or high-net-worth individuals, who are considered to have the knowledge or
resources to understand the nature of the funds. As a class, hedge funds invest in a diverse
range of assets, but they most commonly trade liquid securities on public markets. They also
employ a wide variety of investment strategies and make use of techniques such as short selling
and leverage.

 HINT

Exchange-traded funds are open-end funds or unit investment trusts that trade on an exchange. Open-end
funds are most common, but exchange-traded funds have been gaining in popularity.

 BIG IDEA

The value of a stock is derived from buying and selling decisions of these actors. Some studies have
suggested that institutional investors and corporations trading in their own shares generally receive higher
risk-adjusted returns than retail investors.

2. NYSE
The New York Stock Exchange, commonly referred to as the NYSE, is a stock exchange, or a secondary
market. With primary issuances of securities or financial instruments, or the primary market, investors
purchase these securities directly from issuers such as corporations issuing shares in an IPO or private
placement, or directly from the federal government in the case of treasuries.

After the initial issuance, investors can purchase from other investors in secondary markets like the NYSE. If
an investor wished to buy a stock from Apple, for example, the actual company is not directly involved.
Secondary markets can be further subdivided into auction or dealer markets, typified by the mode of

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transactions. The NYSE is an auction market. Buyers and sellers meet at a physical location (in this case, Wall
Street) and announce their bid or ask prices.

At the NYSE, traders gather around a specialist broker, who acts as an auctioneer in an open outcry auction
market environment to bring buyers and sellers together and to manage the actual auction. The auction
market format aims to bring together the parties with mutually agreeing prices in an efficient manner. The
auction process moved toward automation in 1995 through the use of wireless handheld computers (HHC).
The system enabled traders to receive and execute orders electronically via wireless transmission.

The NYSE represents the largest stock exchange in the world in terms of companies listed andmarket
capitalization. Most of the largest US companies are listed on the NYSE. The NYSE’s biggest competitor is
NASDAQ; both are major secondary markets vying for large and profitable companies to list on their
exchange.

Secondary markets like the NYSE serve a vital function as a setting where companies can raise capital for
expansion through selling shares to the investing public. They also gain advertising and a boost in prestige,
which likely increases their stock value. To be able to trade a security on the NYSE, it must be listed. To be
listed on the New York Stock Exchange, a company must have issued at least a million shares of stock worth
$100 million and must have earned more than $10 million over the last three years. They must also disclose
certain information to the exchange, providing a measure of transparency that prevents insider manipulation
of the stock prices.

 TERM TO KNOW

Market Capitalization
The total market value of the equity in a publicly-traded entity.

3. NASDAQ
The NASDAQ stock market, also known simply as the NASDAQ, is an American stock exchange. “NASDAQ”
originally stood for “National Association of Securities Dealers Automated Quotations.” It is one of the largest
stock exchanges in the world, along with the New York Stock Exchange. The NASDAQ is a dealer-based
market in which stock dealers sell directly to investors or firms electronically via phone or Internet. The New
York Stock Exchange conducts its trading in person.

NASDAQ was founded in 1971 by the National Association of Securities Dealers (NASD), who divested
themselves of it in a series of sales in 2000 and 2001. It is owned and operated by the NASDAQ OMX Group
and regulated by the Financial Industry Regulatory Authority (FINRA), the successor to the NASD.

When the NASDAQ stock exchange began trading on February 8, 1971, it was the world’s first electronic stock
market. At first, it was merely a computer bulletin board system and did not actually connect buyers and
sellers. The NASDAQ helped lower the spread (the difference between the bid price and the ask price of the
stock), but paradoxically was unpopular among brokerages because they made much of their money on the
spread.

Firms including Microsoft began doing business through NASDAQ early in their history, and remained with
this exchange as the technology industry boomed. NASDAQ became known for its concentration of tech and

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high-growth firms, making it the primary tech market and an indicator for industry trends.

A stock index or stock market index is a method of measuring the value of a section of the stock market. It is
computed from the prices of selected stocks, which vary depending on the index. Investors and financial
managers can use it as a “snapshot” to describe the market conditions, and also as a tool to compare the
return on specific investments.

NASDAQ’s major indices include:

NASDAQ-100
NASDAQ Bank
NASDAQ Biotechnology Index
NASDAQ Transportation Index
NASDAQ Composite

 HINT

The NASDAQ Composite is often referred to as the NASDAQ. It is calculated from weighting common stocks
and similar securities listed on the NASDAQ stock market. Thus “NASDAQ” can mean two things: either the
stock exchange itself, or the index.

4. Market Reporting
A stock index provides the ability to measure a particular value of a stock or set of stocks. It is assembled by
combining prices of existing stocks and determining a weighted average. It offers investors and fund
managers the ability to evaluate the market and make comparisons on the current return on certain
investments.

An index is a mathematical construct, so it may not be invested indirectly. Many mutual funds and exchange-
traded funds attempt to “track” an index. The funds that do may not be judged against those that do not.

Stock market indices may be classed in many ways. A ‘world’ or ‘global’ stock market index includes (typically
large) companies without regard for where they are domiciled or traded. Two examples are MSCI World and
S&P Global 100.

By contrast, a national stock index provides details regarding the stock market performance of an entire
nation. This is often used to assess investors’ perception of the current state of that nation’s economy.

 EXAMPLE The most commonly referenced national indices include the U.S. S&P 500, Japan’s Nikkei
225, Britain’s FTSE 100, and India’s SENSEX.

Stock market indices provide invaluable information for investors and accountants. For instance, the current
market price per share, market capitalization, and trading volume are all readily available. With this
information, along with a company’s consolidated financial statements, the following ratios and calculations
can be performed:

Dividend yield on common stock ratio = Dividend per share of common stock

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 Payout ratio on common stock = Dividend per share of common stock
Earnings per share (EPS)

By comparing the above ratios with those of other companies, investors, accountants, and forecasters can
determine the position and health of their respective company’s stock.

 SUMMARY

In this lesson, you learned about the different individual and institutional market actors who engage in
the stock market. You also learned about the two major stock exchanges in the United States, the
NYSE (New York Stock Exchange) and the NASDAQ. Finally, you learned that market reporting is
often done through market indices, which provide investors with information about stock valuation
and individual sectors of the stock market.

Best of luck in your learning!

Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Stock Markets” TUTORIAL.

 TERMS TO KNOW

Market Capitalization
The total market value of the equity in a publicly-traded entity.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 78
Stock Valuation
by Sophia Tutorial

 WHAT'S COVERED

In this lesson, you will learn about the value of stock and use the Constant Growth Model. Specifically,
this lesson will cover:
1. Stock Valuation
2. Constant Growth Model
3. Relationship Between Dividend Payments and the Growth Rate

1. Stock Valuation
Just as we found the value of bonds by calculating the yield to maturity, the present value of future coupons,
and maturity payments, the value of a stock is also found by examining the present value of expected future
cash flows.

Stocks vary in attractiveness to different investors. This is called the clientele effect. At the end of an
accounting period, a business can do one of two things with its net income:

It can pay out dividends to the shareholders.

It can reinvest it in the business.

Growth companies, often younger organizations, generally do not pay out dividends, but rather reinvest all of
their profits into future growth. More mature companies will pay dividends because they are no longer
growing at the same earlier rate.

 BIG IDEA

In either case, we still can project the value of a stock based on our expectation of future dividends even if
they are not being paid now.

2. Constant Growth Model

One familiar model that shows stock valuation is the Constant Growth Model. Here is the formula for the
present value of a stock today that is a long series of the present value of expected future dividends:

This calculation could be quite tedious depending on how far into the future we are expecting to receive the

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dividends. This calculation has been simplified into something called the constant growth model. The constant
growth model allows us to value the price of a stock today on the basis of its next dividend divided by its
required return minus its growth rate. Let's take a look at the simplified formula.

 FORMULA

Constant Growth Model

In this formula:
D0 is the last dividend that was paid
r is the required return on a stock with the same level of risk as this company
g is the expected growth rate that we expect to be constant in the future

 HINT

If we multiply D0 times 1 plus g, we have the next dividend, or D;1 it is compounded by the growth rate.

IN CONTEXT
Suppose we know the current annual dividend is $0.50 a share, the required rate of return is 6%,
and the growth rate is 5%. What current price should we expect?

Current Annual Dividend 0.50

r (required return rate) 6.00%

g (constant growth rate) 5.00%

We can use the formula, a web app, or a spreadsheet tool like Excel, to calculate this.

Using this constant growth model, we get an expected price of $52.50. So, if we are investing in the
market, we may be looking at stocks with the same growth and required rate of return in dividends,
as they might be undervalued and a better bargain for us.

IN CONTEXT
What happens in the constant growth model for different situations? Suppose the board of directors
votes to pay a $0.55 annual dividend, rather than $0.50. The required return rate and growth rate
stay the same at 6% and 5%, respectively.

Current Annual Dividend 0.55

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 r (required return rate) 6.00%

g (constant growth rate) 5.00%

Let's use the constant growth model to calculate:

Now the current price is $57.75. Why is the price of the stock higher now? It is because the annual
dividend is greater, so it is worth more to us.

IN CONTEXT
Suppose the economy goes into a recession and the required return for the stock jumps to 8%
because rates can increase in times of uncertainty. The currents annual dividend is still $0.55 and
the growth rate is 5%.

Current Annual Dividend 0.55

r (required return rate) 8.00%

g (constant growth rate) 5.00%

Again, we can use the constant growth model.

Now the price falls; it plummets to $19.25. Even though the dividend and constant growth rate did
not change, the required return rate is much higher so the project value for that stock is only $19.25.

3. Relationship Between Dividend Payments and

the Growth Rate
Let's consider how this model works for companies that aren't paying dividends. Their price is still dependent
upon the expectation of future dividends. Remember, a company can do one of two things with its net
income:

It can pay out dividends to the shareholders.

It can reinvest it in the business.

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Companies that are new or in a very high growth cycle will invest all of their net income back into the
business. To keep the stock attractive when their future growth is not so rapid, they have to pay a dividend.
Therefore, when a company runs through all of its growth opportunities, it will start paying dividends. The
future value of those dividends is upon which the stock value is based.
What about companies that are not growing at a constant rate? Over the long-term life of a company, this is
frequently the case. But we can use the model to estimate a value for a particular cycle.

 EXAMPLE If the company starts off with a period of high growth of 10%, we can use that growth rate
for the early period. Later, if it flattens out for several years at 5%, use this rate as the growth rate for that
period. After that, in maturity, if it only grows at 3%, use that as the rate, then combine the valuations of
these three periods together.

 SUMMARY

In this lesson, we learned the value of a share of stock is based on our expectations of future
dividend payments in the present value of that cash flow. We can use the constant growth model to
value the price of a stock today on the basis of its next dividend divided by its required return minus
its growth rate. The relationship between dividend payments and the growth rate considers
companies that are not paying dividends and companies that are not growing at a constant rate.

Best of luck in your learning!

Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Stock Valuation” TUTORIAL.

 FORMULAS TO KNOW

Constant Growth Model

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Valuing the Corporation
by Sophia Tutorial

 WHAT'S COVERED

In this lesson, you will learn about the different approaches for valuing a corporation. Specifically, this
lesson will cover:
1. Business Valuation Approaches
a. Income Approach
b. Asset-Based Approach
c. Market Approach

1. Business Valuation Approaches

There are several approaches used in business valuation:

Income approach
Asset-based approach
Market approach

1a. Income Approach

One income approach is calculating the weighted average cost of capital, or WACC. It is the average cost of a
unit of income for the company. It is calculated by using a weighted average of the cost of bonds, the after-tax
yield to maturity, the required return on common stock, and preferred stock, if there is any.
The income approach also includes the capital asset pricing model, or CAPM. This expresses a required
return on a company as a function of risk and a comparison of how risky the stock is compared to the risk of
the market as a whole.

1b. Asset-Based Approach

The asset-based approach is a method based on assets to determine the value of a business. This approach
estimates the cost of replacing the total assets of the business with the same economic utility.

1c. Market Approach

The truest way is the market approach, which tells us that the true value of a firm is what the market says it is.
It is the current price of a share of common stock times the number of shares outstanding. The shares of
common stock represent ownership, and in the market, price represents the true value of what each of the
shares are worth.

 BIG IDEA

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For that reason, the product of these two is the fairest of estimates of the true value of the firm.

 SUMMARY

In this lesson, we learned about income approaches. The weighted average cost of capital (WACC) is
the average of after-tax costs of bonds and the required return of common stock. We can also use the
capital asset pricing model (CAPM), which is based on the risk of the company compared to the risk
for the market overall.

There is also the asset-based approach, which estimates the cost of replacing all assets of the
company with those of the same utility.

Finally, there is the market approach. The market price represents the true value. It is what the market
says the shares of common stock ownership are worth.

Best of luck in your learning!

Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Valuing the Corporation”
TUTORIAL.

© 2020 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC. Page 84