###What is bond?

A bond is a long-term contract under which a borrower agrees to make payments

of interest and principal on specific dates to the holders of the bond. Bonds are
issued by corporations and government agencies that are looking for long-term
debt capital.
Treasury bonds, generally called Treasuries and sometimes referred to as
government bonds, are issued by the federal government.
Corporate bonds are issued by business firms. Unlike Treasuries, corporates are
exposed to default risk—if the issuing company gets into trouble, it may be unable
to make the promised interest and principal payments and bondholders may suffer
losses.
Municipal bonds, or munis, are bonds issued by state and local governments. Like
corporates, munis are exposed to some default risk, but they have one major
advantage over all other bonds: the market interest rate on a muni is considerably
lower than on a corporate bond of equivalent risk.
Foreign bonds are issued by a foreign government or a foreign corporation. All
foreign corporate bonds are exposed to default risk, as are some foreign
government bonds.

###Key Characteristics of Bonds

Par Value The face value of a bond. Coupon Payment The specified number of
dollars of interest paid each year. Coupon Interest Rate The stated annual interest
rate on a bond. Fixed-Rate Bonds: Bonds whose interest rate is fixed for their
entire life. Floating-Rate Bonds Bonds whose interest rate fluctuates with shifts in
the general level of interest rates. Zero Coupon Bonds Bonds that pay no annual
interest but are sold at a discount below par, thus compensating investors in the
form of capital appreciation. Original Issue Discount (OID) Bond Any bond
originally offered at a price below its par value. Maturity Date A specified date on
which the par value of a bond must be repaid. Original Maturity The number of
years to maturity at the time a bond is issued. Call Provision A provision in a bond
contract that gives the issuer the right to redeem the bonds under specified terms
prior to the normal maturity date. Sinking Fund Provision A provision in a bond
contract that requires the issuer to retire a portion of the bond issue each year.
###Mortgage vs Debenture
Feature Mortgage Debenture
A loan secured against a specific A long-term debt instrument issued
Definition
asset (usually real estate). by a company to raise funds.
Security Backed by a tangible asset (e.g., property). May be secured or unsecured.
Issuer Individuals, businesses, or institutions. Only companies and corporations.
Repaid in installments over Repaid at maturity, with periodic interest
Repayment
time. payments.
The lender has a claim over the Debenture holders are creditors
Ownership
mortgaged asset until repayment. but do not own assets.
Interest Usually lower due to Can be higher, especially if
Rate collateral. unsecured.
Risk Lower risk due to security. Higher risk, especially for unsecured debentures.

Risk Aversion Risk-averse investors dislike risk and require higher rates of return
as an inducement to buy riskier securities.
Risk Premium (RP) The difference between the expected rate of return on a given
risky asset and that on a less risky asset.
Chapter-Risk and return
###The Risk-Return Trade-Off

Expected Rate of Return, r ⁄ The rate of return expected to be realized

from an investment; the weighted average of the probability distribution
of possible results.
Risk The chance that some unfavorable event will occur.
Stand-Alone Risk The risk an investor would face if he or she held only
one asset.
###Risk in a Portfolio Context: The Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is a fundamental financial model that
describes the relationship between systematic risk and expected return for assets,
particularly stocks. It is widely used to estimate the required return on an investment
given its risk relative to the market.

1. Understanding Risk in a Portfolio Context

In finance, risk is classified into two main types:

1. Systematic Risk (Market Risk):

o This is the risk inherent to the entire market, such as economic recessions,
interest rate changes, or political instability.
o It cannot be eliminated through diversification.
2. Unsystematic Risk (Firm-Specific Risk):
o This is the risk related to individual securities, such as company
management decisions, financial performance, or product failures.
o It can be reduced through diversification (holding a well-diversified
portfolio).

The CAPM equation is:

E(Ri)=Rf+βi×(E(Rm)−Rf)

 E(Ri) = Expected return of the asset

 Rf = Risk-free rate (e.g., government bonds)
 βi = Beta of the asset (measuring its sensitivity to market movements)
 E(Rm) = Expected return of the market
 E(Rm)−Rf = Market risk premium (extra return for taking market risk)

3. Understanding Beta (β)

 If β = 1 → The asset moves exactly with the market.

 If β > 1 → The asset is more volatile than the market (high-risk, high-return
potential).
 If β < 1 → The asset is less volatile than the market (low-risk, low-return
potential).
 If β = 0 → The asset has no correlation with the market (e.g., risk-free assets).

For example, if a stock has β = 1.5, it is 50% more volatile than the market. If the
market increases by 10%, the stock is expected to rise by 15%.
Capital Asset Pricing Model (CAPM) A model based on the proposition that any
stock’s required rate of return is equal to the risk-free rate of return plus a risk
premium that reflects only the risk remaining after diversification.

Expected Return on a Portfolio, r ⁄ p The weighted average of the expected

returns on the assets held in the portfolio.

Realized Rates of Return, r Returns that were actually earned during some past
period. Actual returns (r) usually turn out to be different from expected returns (r ⁄ )
except for riskless assets.

Correlation The tendency of two variables to move together.

Correlation Coefficient, r A measure of the degree of relationship between two

variables.

Diversifiable Risk That part of a security’s risk associated with random events; it
can be eliminated by proper diversification. This risk is also known as company-
specific, or unsystematic, risk.

Market Risk The risk that remains in a portfolio after diversification has
eliminated all company-specific risk. This risk is also known as non-diversifiable
or systematic or beta risk.

Beta Coefficient, b A metric that shows the extent to which a given stock’s returns
move up and down with the stock market. Beta measures market risk.

Market Risk Premium, RPM The additional return over the risk-free rate needed
to compensate investors for assuming an average amount of risk.
###Effects of Portfolio Size on Risk for a Portfolio of Randomly Selected Stocks
### Figure 8.6, which shows that a portfolio’s risk declines as stocks
are added. Here are some points to keep in mind about the figure:
The portfolio’s risk declines as stocks are added, but at a decreasing rate;
once 40 to 50 stocks are in the portfolio, additional stocks do little to
reduce risk.
2. The portfolio’s total risk can be divided into two parts, diversifiable
risk and market risk. Diversifiable risk is the risk that is eliminated by
adding stocks. Market risk is the risk that remains even if the portfolio
holds every stock in the market.
3. Diversifiable risk is caused by such random, unsystematic events as
lawsuits, strikes, successful and unsuccessful marketing and R&D
programs, the winning or losing of a major contract, and other events
that are unique to the particular firm.
4. If we carefully selected the stocks included in the portfolio rather than
adding them randomly, the graph would change. In particular, if we
chose stocks with low correlations with one another and with low stand-
alone risk, the portfolio’s risk would decline faster than if random stocks
were added.
5. Most investors are rational in the sense that they dislike risk, other
things held constant. Consequently, for many investors an ideal strategy
is to hold a large diversified market portfolio that has low transactions
costs and fees.
6. One key question remains: How should the risk of an individual stock
be measured? The standard deviation of expected returns, s, is not
appropriate because it includes risk that can be eliminated by holding the
stock in a portfolio.
###The Relationship between Risk and Rates of Return.
In finance, there is a direct relationship between risk and expected return—higher risk
is associated with the potential for higher returns, while lower risk leads to lower
expected returns. This relationship is fundamental to investment decision-making.

1. Risk and Return Trade-Off

 Low Risk → Low Expected Return (e.g., government bonds, savings accounts).
 High Risk → High Expected Return (e.g., stocks, venture capital,
cryptocurrencies).

2. Types of Risk Affecting Returns

1. Systematic Risk (Market Risk):

o Affects the entire market (e.g., inflation, interest rates, recessions).
o Cannot be diversified away.
o Measured by Beta (β) in the CAPM model.
2. Unsystematic Risk (Firm-Specific Risk):
o Affects individual companies or industries (e.g., management failure,
lawsuits).
o Can be reduced through portfolio diversification.

3. The CAPM

E(Ri)=Rf+βi×(E(Rm)−Rf)

 E(Ri) = Expected return of the asset

 Rf = Risk-free rate (e.g., government bonds)
 βi = Beta of the asset (measuring its sensitivity to market movements)
 E(Rm) = Expected return of the market
 E(Rm)−Rf = Market risk premium (extra return for taking market risk)

4. The Risk-Return Relationship in Practice

 Treasury Bonds (Risk-Free Rate) → Low risk, low return (~3-4%).

 Blue-Chip Stocks → Moderate risk, moderate return (~8-10%).
 Small-Cap Stocks & Emerging Markets → High risk, high return (~12-20%).
 Cryptocurrencies & Startups → Very high risk, very high return (or loss).
Chapter-9
###Common stock versus preferred stock
Feature Common Stock Preferred Stock
Represents equity ownership with Equity ownership but usually no
Ownership
voting rights voting rights
Paid after preferred stock, may Fixed dividends, paid before
Dividends
fluctuate or not be paid common stock
Risk Higher risk, but higher potential returns Lower risk, but limited returns
Priority in Last to receive assets after debt Paid before common stock
Liquidation and preferred stock but after debt holders
Voting Rights Usually has voting rights Usually no voting rights

Proxy A document giving one person the authority to act for another,
typically the power to vote shares of common stock.
Proxy Fight An attempt by a person or group to gain control of a firm
by getting its stockholders to grant that person or group the authority to
vote its shares to replace the current management.
Takeover An action whereby a person or group succeeds in ousting a
firm’s management and taking control of the company
THE PREEMPTIVE RIGHT A provision in the corporate charter or
bylaws that gives common stockholders the right to purchase on a pro
rata basis new issues of common stock (or convertible securities).
###Types of Common Stock
*Classified Stock Common stock that is given a special designation
such as Class A or Class B to meet special needs of the company.
*Founders’ Shares Stock owned by the firm’s founders that enables
them to maintain control over the company without having to own a
majority of stock.
###Stock Price versus Intrinsic Value
Feature Stock Price Intrinsic Value
The market price at which a stock The true or fair value based on
Definition
is currently trading fundamental analysis
Determined Supply and demand, market Company’s financials, earnings,
By sentiment, news, speculation growth potential, and fundamentals
Highly volatile, changes More stable, based on long-term
Volatility
frequently factors
Affected by investor emotions, Determined by fundamental
Influence
trends, and external events analysis and valuation models
Can be overvalued or Helps investors determine if a
Investment
undervalued compared to stock is worth buying or
Perspective
intrinsic value selling
###Why do investors and companies care about intrinsic value?

For Investors:

1. Identifying Undervalued Stocks – If the intrinsic value is higher than the

stock price, investors see a buying opportunity.
2. Avoiding Overpriced Stocks – If the stock price is higher than intrinsic
value, it may be overvalued, signaling a sell or avoid decision.
3. Long-Term Investment Decisions – Intrinsic value focuses on
fundamentals rather than short-term market fluctuations, helping value
investors like Warren Buffett.
4. Risk Management – By comparing stock price with intrinsic value,
investors can reduce risk and avoid speculative bubbles.

For Companies:

1. Attracting Investors – If a company’s stock is trading below its intrinsic

value, it may try to highlight its growth potential to attract investors.
2. Capital Raising Decisions – Companies may issue new shares if their
stock price is higher than intrinsic value to raise capital efficiently.
3. Stock Buybacks – If a company believes its stock is undervalued, it might
repurchase shares to increase shareholder value.
4. Strategic Planning – Understanding intrinsic value helps in making better
financial and investment decisions for long-term growth.
###The Discounted Dividend Model

The Discounted Dividend Model (DDM) is a valuation method used to determine

the intrinsic value of a stock based on the present value of its expected future
dividends. It is useful for valuing companies that consistently pay dividends.

Key Assumptions:

1. The company pays dividends consistently.

2. Dividends grow at a constant rate ggg.
3. The required rate of return rrr is greater than the growth rate ggg (r>gr >
gr>g).

Advantages:

✅ Simple and widely used for dividend-paying stocks.

✅ Focuses on long-term value based on cash returns to investors.
Marginal Investor A representative investor whose actions reflect the
beliefs of those people who are currently trading a stock. It is the
marginal investor who determines a stock’s price.

Market Price, P0 = The price at which a stock sells in the market.

Growth Rate, g The expected rate of growth in dividends per share.

Required Rate of Return, rs The minimum rate of return on a common

stock that a stockholder considers acceptable.

Expected Rate of Return, r ⁄ s The rate of return on a common stock

that a stockholder expects to receive in the future.

Actual (Realized) Rate of Return, rs The rate of return on a common

stock actually received by stockholders in some past period; r s may be
greater or less than r ⁄ s and/or rs .

Dividend Yield The expected dividend divided by the current price of a

share of stock.

Capital Gains Yield The capital gain during a given year divided by the
beginning price.

Expected Total Return The sum of the expected dividend yield and the
expected capital gains yield.

Supernormal (Nonconstant) Growth The part of the firm’s life cycle

in which it grows much faster than the economy as a whole.

Horizon (Terminal) Date The date when the growth rate becomes
constant. At this date, it is no longer necessary to forecast the individual
dividends.
Horizon (Continuing) Value The value at the horizon date of all
dividends expected thereafter.
### Corporate valuation model
A valuation model used as an alternative to the discounted dividend model to
determine a firm’s value, especially one with no history of dividends, or the value
of a division of a larger firm. The corporate model first calculates the firm’s free
cash flows, then finds their present values to determine the firm’s value.
### Preferred Stock
Preferred stock is a hybrid—it is similar to a bond in some respects and
to common stock in others. This hybrid nature becomes apparent when
we try to classify preferred stock in relation to bonds and common stock.
Like bonds, preferred stock has a par value and a fixed dividend that
must be paid before dividends can be paid on the common stock.
Vp=Dp/rp
Positive Alpha (α > 0)

🔹 Definition: Positive alpha means that an investment or portfolio has

outperformed its expected return based on its risk level (beta).

🔹 Formula:

α=Actual Return−Expected Return (CAPM)

If α > 0, the investment beat the market.

🔹 Example:
If a stock was expected to return 8% based on the market and its risk
(beta), but it actually returned 12%, its alpha = +4%, meaning it
outperformed expectations.

📌 Key Takeaway: Positive alpha is a sign of superior investment

performance!

Negative Alpha (α < 0)

🔹 Definition: Negative alpha means an investment or portfolio has

underperformed compared to its expected return based on its risk level
(beta).

🔹 Formula:

α=Actual Return−Expected Return (CAPM)α = \text{Actual Return} -

\text{Expected Return
(CAPM)}α=Actual Return−Expected Return (CAPM)

If α < 0, the investment failed to meet expectations.

🔹 Example:
If a stock was expected to return 10% based on its beta, but it only
returned 6%, then alpha = -4%, meaning it underperformed by 4%.
### Stock Price versus Intrinsic Value.
Stock Price fluctuates due to market sentiment, news, and speculation.
Intrinsic Value is stable, based on a company's fundamentals.
When Stock Price < Intrinsic Value, the stock is undervalued (buy signal).
When Stock Price > Intrinsic Value, the stock is overvalued (sell signal).
Chapter-14
Capital Investor-supplied funds such as long- and short-term loans from
individuals and institutions, preferred stock, common stock, and retained earnings.
Capital Structure The mix of debt, preferred stock, and common equity that is
used to finance the firm’s assets.
Optimal Capital Structure The capital structure that maximizes a stock’s
intrinsic value.

Business Risk:

Business risk refers to the uncertainty a company faces in generating sufficient

revenue and profit due to factors such as market conditions, competition,
operational inefficiencies, and economic fluctuations. It affects both leveraged
and unleveraged companies.

Financial Risk:

Financial risk refers to the possibility of a company failing to meet its financial
obligations due to high debt levels (leverage), interest rate changes, or cash flow
shortages. It primarily affects leveraged companies (those that rely on borrowed
funds).

Operating leverage measures how a company’s fixed costs impact its

profitability. A company with high operating leverage has a high proportion of
fixed costs relative to variable costs, meaning small changes in sales can lead to
significant changes in operating profit.

DOL= Contribution Margin /Operating Profit

Financial leverage refers to the use of debt (borrowed funds) to finance a

company’s operations and investments. It measures how much a company relies on
debt to boost returns for shareholders.

DFL= EBIT / EBIT - Interest Expense

### FACTORS THAT AFFECT BUSINESS RISK
Competition. If a firm has a monopoly on a necessary product, it will
have little risk from competition and thus have stable sales and sales
prices.
Demand variability. The more stable the demand for a firm’s products,
other things held constant, the lower its business risk.
Sales price variability. Firms whose products are sold in volatile
markets are exposed to more business risk than firms whose output
prices are stable, other things held constant.
Input cost variability. Firms whose input costs are uncertain have
higher business risk.
Product obsolescence. Firms in high-tech industries like
pharmaceuticals and computers depend on a constant stream of new
products. The faster its products become obsolete, the greater a firm’s
business risk.
Foreign risk exposure. Firms that generate a high percentage of their
earnings overseas are subject to earnings declines due to exchange rate
fluctuations.
Regulatory risk and legal exposure. Firms that operate in highly
regulated industries such as financial services and utilities are subject to
changes in the regulatory environment that may have a profound effect
on the company’s current and future profitability.
The extent to which costs are fixed: operating leverage. If a high
percentage of its costs are fixed and thus do not decline when demand
falls, this increases the firm’s business risk.
###MM model
Modern capital structure theory began in 1958 when Professors Franco Modigliani
and Merton Miller (hereafter, MM) published what has been called the most
influential finance article ever written.19 MM proved, under a restrictive set of
assumptions, that a firm’s value should be unaffected by its capital structure. Put
another way, MM’s results suggest that it does not matter how a firm finances its
operations—hence, that capital structure is irrelevant. However, the assumptions
upon which MM’s study was based are not realistic, so their results are
questionable.
Here is a partial listing of their assumptions:
1. There are no brokerage costs.
2. There are no taxes.
3. There are no bankruptcy costs.
4. Investors can borrow at the same rate as corporations.
5. All investors have the same information as management about the firm’s future
investment opportunities.
6. EBIT is not affected by the use of debt.

###The effect of taxes

Because of the tax situation, Miller argued that investors are willing to
accept relatively low before-tax returns on stocks as compared to the
before-tax returns on bonds. For example, an investor in the 39.6% tax
bracket might require a 10% pretax return on Bigbee’s bonds, which
would result in a 10%(1 2 T) 5 10%(0.604) 5 6.04% after-tax return.
As Miller pointed out, (1) the deductibility of interest favors the use of
debt financing. (2) The more favorable tax treatment of income from
stocks lowers the required rates of return on stocks and thus favors the
use of equity. It is difficult to specify the net effect of these two factors.
### Trade-off theory
The capital structure theory that states that firms trade off the tax
benefits of debt financing against problems caused by potential
bankruptcy.

Tax Benefits of Debt (Interest Tax Shield)

 Interest on debt is tax-deductible, reducing taxable income.

 More debt → Lower taxes → Higher firm value.
 This is based on Modigliani & Miller’s revised model (1963).

Financial Distress Costs

 Too much debt increases the risk of bankruptcy.

 Costs include legal fees, loss of reputation, employee layoffs,
and higher borrowing costs.
 These costs offset the benefits of debt if leverage is too high.

Optimal Capital Structure

 Firms should balance tax savings from debt with the risk of
financial distress.
 The optimal debt-to-equity ratio is where the marginal benefit
of debt equals the marginal cost.