(Test Bank) Essentials of Corporate Finance

Ross,Trayler,Hambusch,Koh,Westerfield,Jordan, 10

Business

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10th Edition

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Test Bank for Essentials of Corporate Finance, The downloadable file consists of 689 pages, and the total size of the file is 9.42 MB. Purchase now only for highly discounted price.

Author(s): Ross, Trayler, Hambusch, Koh, Westerfield, Jordan

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Essentials of Corporate Finance ros13952_fm_i-xxxvi.indd 1 1/4/19 12:19 PMThe McGraw-Hill Education Series in Finance, Insurance, and Real Estate FINANCIAL MANAGEMENT Block, Hirt, and Danielsen Foundations of Financial ManagementSeventeenth Edition Brealey, Myers, and Allen Principles of Corporate FinanceThirteenth Edition Brealey, Myers, and Allen Principles of Corporate Finance, ConciseSecond Edition Brealey, Myers, and Marcus Fundamentals of Corporate FinanceTenth Edition Brooks FinGame Online 5.0 Bruner, Eades, and Schill Case Studies in Finance: Managing for Corporate Value CreationEighth Edition Cornett, Adair, and Nofsinger Finance: Applications and TheoryFifth Edition Cornett, Adair, and Nofsinger M: FinanceFourth Edition DeMello Cases in FinanceThird Edition Grinblatt (editor) Stephen A. Ross, Mentor: Influence through Generations Grinblatt and Titman Financial Markets and Corporate StrategySecond Edition Higgins Analysis for Financial ManagementTwelfth Edition Ross, Westerfield, Jaffe, and Jordan Corporate FinanceTwelfth Edition Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and ApplicationsFifth EditionRoss, Westerfield, and JordanEssentials of Corporate FinanceTenth Edition Ross, Westerfield, and Jordan Fundamentals of Corporate FinanceTwelfth Edition Shefrin Behavioral Corporate Finance: Decisions that Create ValueSecond Edition INVESTMENTS Bodie, Kane, and Marcus Essentials of InvestmentsEleventh Edition Bodie, Kane, and Marcus InvestmentsEleventh Edition Hirt and Block Fundamentals of Investment ManagementTenth Edition Jordan, Miller, and Dolvin Fundamentals of Investments: Valuation and ManagementEighth Edition Stewart, Piros, and Heisler Running Money: Professional Portfolio ManagementFirst Edition Sundaram and Das Derivatives: Principles and PracticeSecond Edition FINANCIAL INSTITUTIONS AND MARKETS Rose and Hudgins Bank Management and Financial ServicesNinth Edition Rose and Marquis Financial Institutions and MarketsEleventh Edition Saunders and Cornett Financial Institutions Management: A Risk Management ApproachNinth EditionSaunders and CornettFinancial Markets and InstitutionsSeventh Edition INTERNATIONAL FINANCE Eun and Resnick International Financial ManagementEighth Edition REAL ESTATE Brueggeman and Fisher Real Estate Finance and InvestmentsSixteenth Edition Ling and Archer Real Estate Principles: A Value ApproachFifth Edition FINANCIAL PLANNING AND INSURANCE Allen, Melone, Rosenbloom, and Mahoney Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation ApproachesTwelfth Edition Altfest Personal Financial PlanningSecond Edition Harrington and Niehaus Risk Management and InsuranceSecond Edition Kapoor, Dlabay, Hughes, and Hart Focus on Personal Finance: An Active Approach to Help you Achieve Financial LiteracySixth Edition Kapoor, Dlabay, Hughes, and Hart Personal FinanceThirteenth Edition Walker and Walker Personal Finance: Building Your FutureSecond Edition ros13952_fm_i-xxxvi.indd 2 1/4/19 12:19 PMStephen A. Ross Randolph W. Westerfield University of Southern California Bradford D. Jordan University of KentuckyEssentials of Corporate Finance Tenth Edition ros13952_fm_i-xxxvi.indd 3 1/4/19 12:19 PMESSENTIALS OF CORPORATE FINANCE, TENTH EDITION Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2020 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2017, 2014, and 2011. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper.1 2 3 4 5 6 7 8 9 0 LWI 21 20 19 ISBN 978-1-260-01395-5 MHID 1-260-01395-2 Portfolio Manager: Charles Synovec Product Developers: Michele Janicek, Jennifer UptonMarketing Manager: Trina MaurerContent Project Managers: Daryl Horrocks, Jill Eccher, Jamie KochBuyer: Sandy LudovissyDesign: Matt DiamondContent Licensing Specialist: Melissa HomerCover Image: ©vladitto/ShutterstockCompositor: MPS Limited All credits appearing on page or at the end of the book are considered to be an extension of the copyright page. Library of Congress Cataloging-in-Publication Data Ross, Stephen A., author. | Westerfield, Randolph W., author. |  Jordan, Bradford D., author. Essentials of corporate finance / Stephen A. Ross, Massachusetts  Institute of Technology, Randolph W. Westerfield, University of Southern  California, Bradford D. Jordan, University of Kentucky. Tenth edition. | New York, NY : McGraw-Hill Education, [2020] |  Includes index. LCCN 2018056010 | ISBN 9781260013955 (student edition : alk. paper) LCSH: Corporations—Finance. LCC HG4026 .R676 2020 | DDC 658.15—dc23 LC record available at https://lccn.loc.gov/2018056010 The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites. mheducation.com/highered ros13952_fm_i-xxxvi.indd 4 1/4/19 12:19 PMv About the Authors Stephen A. Ross Stephen A. Ross was the Franco Modigliani Professor of Finance and Economics at the Sloan School of Management, Massachusetts Institute of Technology. One of the most widely published authors in finance and economics, Professor Ross was widely recognized for his work in develop-ing the Arbitrage Pricing Theory and his substantial contributions to the discipline through his research in signaling, agency theory, option pricing, and the theory of the term structure of interest rates, among other topics. A past president of the American Finance Association, he also served as an associate editor of several academic and practitioner journals. He was a trustee of CalTech. He died suddenly in March 2017. Randolph W. Westerfield Marshall School of Business, University of Southern California Randolph W. Westerfield is Dean Emeritus of the University of Southern California’s Marshall School of Business and is the Charles B. Thornton Professor of Finance Emeritus. Professor West-erfield came to USC from the Wharton School, University of Pennsylvania, where he was the chair - man of the finance department and member of the finance faculty for 20 years. He is a member of the Board of Trustees of Oak Tree Capital Mutual Funds. His areas of expertise include corporate financial policy, investment management, and stock market price behavior. Bradford D. Jordan Gatton College of Business and Economics, University of Kentucky Bradford D. Jordan is Professor of Finance and holder of the duPont Endowed Chair in Banking and Financial Services. He has a long-standing interest in both applied and theoretical issues in corporate finance and has extensive experience teaching all levels of corporate finance and finan-cial management policy. Professor Jordan has published numerous articles on issues such as cost of capital, capital structure, and the behavior of security prices. He is a past president of the Southern Finance Association and is coauthor of Fundamentals of Investments: Valuation and Management, 8th edition, a leading investments text, also published by McGraw-Hill Education. ros13952_fm_i-xxxvi.indd 5 1/4/19 12:19 PMvi From the Authors When we first wrote Essentials of Corporate Finance, we thought there might be a small niche for a briefer book that really focused on what students with widely varying backgrounds and interests needed to carry away from an introductory finance course. We were wrong. There was a huge niche! What we learned is that our text closely matches the needs of instructors and faculty at hundreds of schools across the country. As a result, the growth we have experienced through the first nine editions of Essentials has far exceeded anything we thought possible. With the tenth edition of Essentials of Corporate Finance, we have continued to refine our focus on our target audience, which is the undergraduate student taking a core course in busi - ness or corporate finance. This can be a tough course to teach. One reason is that the class is usually required of all business students, so it is not uncommon for a majority of the students to be nonfinance majors. In fact, this may be the only finance course many of them will ever have. With this in mind, our goal in Essentials is to convey the most important concepts and principles at a level that is approachable for the widest possible audience. To achieve our goal, we have worked to distill the subject down to its bare essentials (hence, the name of this book), while retaining a decidedly modern approach to finance. We always have maintained that the subject of corporate finance can be viewed as the workings of a few very powerful intuitions. We also think that understanding the “why” is just as important, if not more so, than understanding the “how”—especially in an introductory course. Based on the gratifying market feedback we have received from our previous editions, as well as from our other text, Fundamentals of Corporate Finance (now in its twelfth edition), many of you agree. By design, this book is not encyclopedic. As the table of contents indicates, we have a total of 18 chapters. Chapter length is about 30 pages, so the text is aimed squarely at a single-term course, and most of the book can be realistically covered in a typical semester or quarter. Writ - ing a book for a one-term course necessarily means some picking and choosing, with regard to both topics and depth of coverage. Throughout, we strike a balance by introducing and covering the essentials (there’s that word again!) while leaving some more specialized topics to follow-up courses. The other things we always have stressed, and have continued to improve with this edition, are readability and pedagogy. Essentials is written in a relaxed, conversational style that invites the students to join in the learning process rather than being a passive information absorber. We have found that this approach dramatically increases students’ willingness to read and learn on their own. Between larger and larger class sizes and the ever-growing demands on faculty time, we think this is an essential (!) feature for a text in an introductory course. Throughout the development of this book, we have continued to take a hard look at what is truly relevant and useful. In doing so, we have worked to downplay purely theoretical issues and minimize the use of extensive and elaborate calculations to illustrate points that are either intuitively obvious or of limited practical use. As a result of this process, three basic themes emerge as our central focus in writing Essentials of Corporate Finance: ros13952_fm_i-xxxvi.indd 6 1/4/19 12:19 PMvii An Emphasis on Intuition We always try to separate and explain the principles at work on a commonsense, intuitive level before launching into any specifics. The underlying ideas are discussed first in very general terms and then by way of examples that illustrate in more concrete terms how a financial manager might proceed in a given situation. A Unified Valuation Approach We treat net present value (NPV) as the basic concept underlying corporate finance. Many texts stop well short of consistently integrating this important principle. The most basic and important notion, that NPV represents the excess of market value over cost, often is lost in an overly mechanical approach that emphasizes computation at the expense of comprehension. In contrast, every subject we cover is firmly rooted in valuation, and care is taken throughout to explain how particular decisions have valuation effects. A Managerial Focus Students shouldn’t lose sight of the fact that financial management concerns management. We emphasize the role of the financial manager as decision maker, and we stress the need for managerial input and judgment. We consciously avoid “black box” approaches to finance, and, where appropriate, the approximate, pragmatic nature of finan-cial analysis is made explicit, possible pitfalls are described, and limitations are discussed. Today, as we prepare once again to enter the market, our goal is to stick with and build on the principles that have brought us this far. However, based on an enormous amount of feed - back we have received from you and your colleagues, we have made this edition and its package even more flexible than previous editions. We offer flexibility in coverage and pedagogy by pro - viding a wide variety of features in the book to help students learn about corporate finance. We also provide flexibility in package options by offering the most extensive collection of teaching, learning, and technology aids of any corporate finance text. Whether you use just the textbook, or the book in conjunction with other products, we believe you will find a combination with this edition that will meet your needs. Randolph W. Westerfield Bradford D. Jordan ros13952_fm_i-xxxvi.indd 7 1/4/19 12:19 PMviii Organization of the Text We designed Essentials of Corporate Finance to be as flexible and modular as possible. There are a total of nine parts, and, in broad terms, the instructor is free to decide the particular sequence. Further, within each part, the first chapter generally contains an over - view and survey. Thus, when time is limited, subsequent chapters can be omitted. Finally, the sections placed early in each chapter are generally the most important, and later sections frequently can be omitted without loss of continuity. For these reasons, the instructor has great control over the topics covered, the sequence in which they are covered, and the depth of coverage. Just to get an idea of the breadth of coverage in the tenth edition of Essentials, the fol- lowing grid presents for each chapter some of the most significant new features, as well as a few selected chapter highlights. Of course, in every chapter, figures, opening vignettes, boxed features, and in-chapter illustrations and examples using real companies have been thoroughly updated as well. In addition, the end-of-chapter material has been completely revised. Chapters Selected Topics Benefits to Users PART ONE Overview of Financial Management Chapter 1 New opener discussing Uber Updated Finance Matters box on corporate ethicsDescribes ethical issues in the context of mortgage fraud, offshoring, and tax havens. Updated information on executive and celebrity compensationHighlights important developments regarding the very current question of appropriate executive compensation. Updated Work the Web box on stock quotes Goal of the firm and agency problems Stresses value creation as the most fundamental aspect of management and describes agency issues that can arise. Ethics, financial management, and executive compensationBrings in real-world issues concerning conflicts of interest and current controversies surrounding ethical conduct and management pay. New proxy fight example involving Trian Partners and Procter & Gamble New takeover battle discussion involving Verizon and Yahoo! PART TWO Understanding Financial Statements and Cash Flow Chapter 2 New opener discussing the Tax Cuts and Jobs Act of 2017 Cash flow vs. earnings Clearly defines cash flow and spells out the differences between cash flow and earnings. Market values vs. book values Emphasizes the relevance of market values over book values. New discussion of corporate taxes in light of the TCJA ros13952_fm_i-xxxvi.indd 8 1/4/19 12:19 PMix Chapters Selected Topics Benefits to Users Chapter 3 Additional explanation of alternative formulas for sustainable and internal growth ratesExpanded explanation of growth rate formulas clears up a common misunderstanding about these formulas and the circumstances under which alternative formulas are correct. Updated opener on PE ratios Updated examples on Amazon vs. AlibabaUpdated Work the Web box on financial ratiosDiscusses how to find and analyze profitability ratios. Updated Finance Matters box on financial ratiosDescribes how to interpret ratios. PART THREE Valuation of Future Cash Flows Chapter 4 First of two chapters on time value of moneyRelatively short chapter introduces just the basic ideas on time value of money to get students started on this traditionally difficult topic. Updated Finance Matters box on collectibles Chapter 5 Second of two chapters on time value of moneyCovers more advanced time value topics with numerous examples, calculator tips, and Excel spreadsheet exhibits. Contains many real-world examples. Updated opener on professional athletes’ salariesProvides a real-world example of why it’s important to properly understand how to value costs incurred today versus future cash inflows. Updated Finance Matters box on lotteries Updated Finance Matters box on student loans PART FOUR Valuing Stocks and Bonds Chapter 6 New opener on negative interest on various sovereign bondsDiscusses the importance of interest rates and how they relate to bonds. Bond valuation Thorough coverage of bond price/yield concepts. Updated bond features example using Sprint issue Interest rates and inflation Highly intuitive discussion of inflation, the Fisher effect, and the term structure of interest rates. Updated “fallen angels” example using Teva Pharmaceuticals issue “Clean” vs. “dirty” bond prices and accrued interestClears up the pricing of bonds between coupon payment dates and also bond market quoting conventions. Updated Treasury quotes exhibit and discussion Updated historic interest rates figureFINRA’s TRACE system and transparency in the corporate bond marketUp-to-date discussion of new developments in fixed income with regard to price, volume, and transactions reporting. “Make-whole” call provisions Up-to-date discussion of relatively new type of call provision that has become very common. ros13952_fm_i-xxxvi.indd 9 1/4/19 12:19 PMx Chapters Selected Topics Benefits to Users Chapter 7 Stock valuation Thorough coverage of constant and nonconstant growth models. Updated opener on difference in dividend payouts Updated discussion of the NYSE, including its acquisition by ICE and rising role of technology of the floorUp-to-date description of major stock market operations. Updated Finance Matters box on the OTCBB and the Pink Sheets markets PART FIVE Capital Budgeting Chapter 8 Updated opener on GE’s “Ecomagination” programIllustrates the growing importance of “green” business. First of two chapters on capital budgeting Relatively short chapter introduces key ideas on an intuitive level to help students with this traditionally difficult topic. NPV, IRR, MIRR, payback, discounted payback, and accounting rate of returnConsistent, balanced examination of advantages and disadvantages of various criteria. Chapter 9 Project cash flow Thorough coverage of project cash flows and the relevant numbers for a project analysis. New opener on project failures and successes Shows the importance of properly evaluating net present value. New discussion of bonus depreciation Scenario and sensitivity “what-if” analyses Illustrates how to actually apply and interpret these tools in a project analysis. PART SIX Risk and Return Chapter 10 Updated opener on stock market performanceDiscusses the relationship between risk and return as it relates to personal investing. Capital market history Extensive coverage of historical returns, volatilities, and risk premiums. Market efficiency Efficient markets hypothesis discussed along with common misconceptions. Geometric vs. arithmetic returns Discusses calculation and interpretation of geometric returns. Clarifies common misconceptions regarding appropriate use of arithmetic vs. geometric average returns. Updated Finance Matters box on professional fund management and performance Chapter 11 Diversification, systematic, and unsystematic riskIllustrates basics of risk and return in a straightforward fashion. Updated opener on stock price reactions to announcements Updated beta coefficients exhibit and associated discussionDevelops the security market line with an intuitive approach that bypasses much of the usual portfolio theory and statistics. New discussion of alpha PART SEVEN Long-Term Financing Chapter 12 Cost of capital estimation Intuitive development of the WACC and a complete, web-based illustration of cost of capital for a real company. Updated WACC calculations for Eastman Geometric vs. arithmetic growth rates Both approaches are used in practice. Clears up issues surrounding growth rate estimates. ros13952_fm_i-xxxvi.indd 10 1/4/19 12:19 PMxi Chapters Selected Topics Benefits to Users Updated section on company valuation with the WACCExplores the difference between valuing a project and valuing a company. Chapter 13 Basics of financial leverage Illustrates effect of leverage on risk and return. Optimal capital structure Describes the basic trade-offs leading to an optimal capital structure. New chapter opener on Tax Cuts and Jobs Act New discussion of the effects of the TCJA on corporate taxes Financial distress and bankruptcy Briefly surveys the bankruptcy process. Chapter 14 Updated opener with Apple dividend announcementRaises questions about why raising dividends and repurchasing stock would please investors. Updated figures on aggregate dividends, stock repurchases, and proportion of firms paying dividendsBrings students the latest thinking and evidence on dividend policy. Dividends and dividend policy Describes dividend payments and the factors favoring higher and lower payout policies. Includes recent survey results on setting dividend policy. Updated examples and Finance Matters box covering buyback activityExplores the reasons that buybacks are gaining in popularity now, following the recent recession. Chapter 15 IPO valuation Extensive, up-to-date discussion of IPOs, including the 1999–2000 period and the recent Alibaba IPO. Dutch auctions Explains uniform price (“Dutch”) auctions using Google IPO as an example. New subsection on crowdfunding Discusses the JOBS Act and crowdfunding. New subsection on initial coin offerings New discussion of direct listingUpdated tables and figures on IPO initial returns and number of offerings PART EIGHT Short-Term Financial Management Chapter 16 Operating and cash cycles Stresses the importance of cash flow timing. Short-term financial planning Illustrates the creation of cash budgets and the potential need for financing. Updated Finance Matters box discussing operating and cash cyclesExplores how comparing the cash cycles of companies can reveal whether a company is performing well. Chapter 17 Cash collection and disbursement Examination of systems used by firms to handle cash inflows and outflows. Credit management Analysis of credit policy and implementation. Inventory management Brief overview of important inventory concepts. PART NINE Topics in Business Finance Chapter 18 New opener on corporate cash held in international accountsRaises questions about how currency appreciation affects the broader economy. Foreign exchange Covers essentials of exchange rates and their determination. International capital budgeting Shows how to adapt the basic DCF approach to handle exchange rates. Updated discussion of exchange rates and political riskDiscusses hedging and issues surrounding sovereign risk. New discussion of the Tax Cuts and Jobs ActDiscusses how U.S. legislation changes the way that corporations manage their profits to minimize taxes. ros13952_fm_i-xxxvi.indd 11 1/4/19 12:19 PMxii Learning Solutions In addition to illustrating relevant concepts and presenting up-to-date coverage, Essentials of Corporate Finance strives to present the material in a way that makes it engaging and easy to understand. To meet the varied needs of the intended audience, Essentials of Corpo - rate Finance is rich in valuable learning tools and support. Each feature can be categorized by the benefit to the student: ■Real financial decisions ■Application tools ■Study aids ▼ CHAPTER-OPENING VIGNETTES Each chapter begins with a contemporary real-world event to introduce students to chapter concepts. ▲ FINANCE MATTERS BOXES Most chapters include at least one Finance Matters box, which takes a chapter issue and shows how it is being used right now in every - day financial decision making. Exotic Bonds Bonds come in many flavors. The unusual types are called “exotics” and can range from the fairly simple to the truly esoteric. Take the case of mortgage-backed securities (MBSs). MBSs are a type of securitized financial instrument. In securitization, cash flows from financial assets are pooled together into securities, and the securities are sold to inves- tors. With an MBS, banks or mortgage brokers who originate mortgages sell the mortgages to a trust. The trust pools the mortgages and sells bonds to investors. Bondholders re - ceive payments based on the mortgage payments made by homeowners. During 2008, problems with MBSs skyrock - eted due to the precipitous drop in real estate values and the sharply increased default rates on the underlying mortgages. The reverse convertible is a relatively new type of structured note. One type generally offers a high coupon rate, but the redemption at maturity can be paid in cash at par value or paid in shares of stock. For example, one recent General Motors (GM) reverse convertible had a coupon rate of 16 percent, which is a very high coupon rate in today’s in- terest rate environment. However, at maturity, if GM’s stock declined sufficiently, bondholders would receive a fixed number of GM shares that were worth less than par value. So, while the income portion of the bond return would be high, the potential loss in par value easily could erode the extra return.CAT bonds are issued to cover insurance companies against natural catastrophes. The type of natural catastro - phe is outlined in the bond. For example, about 30 percent of all CAT bonds protect against a North Atlantic hurricane. The way these issues are structured is that the borrowers can suspend payment temporarily (or even permanently) if they have significant hurricane-related losses. These CAT bonds may seem like pretty risky investments, but, to date, only five have not been paid in full. Because of Hurricane Katrina, CAT bondholders lost $190 million. CAT bondhold - ers also lost $300 million due to the 2011 tsunami in Japan. During 2011, two other CAT bond issues, each worth $100 million, were triggered due to an unusually active tornado season, and a CAT bond was triggered due to the 2017 earthquake in Mexico. This bond was issued on August 4th and the earthquake occurred on September 7th.  Perhaps the most unusual bond (and certainly the most ghoulish) is the “death bond.” Companies such as Stone Street Financial purchase life insurance policies from indi - viduals who are expected to die within the next 10 years. They then sell bonds that are paid off from the life insurance proceeds received when the policyholders die. The return on the bonds to investors depends on how long the policyhold - ers live. A major risk is that if medical treatment advances quickly, it will raise the life expectancy of the policyholders, thereby decreasing the return to the bondholder.FINANCE MATTERS 186BOND MARKETS Bonds are bought and sold in enormous quantities every day. You may be surprised to learn that the trading volume in bonds on a typical day is many, many times larger than the trad- ing volume in stocks (by trading volume, we mean the amount of money that changes hands). Here is a finance trivia question: What is the largest securities market in the world? Most people would guess the New York Stock Exchange. In fact, the largest securities mar- ket in the world in terms of trading volume is the U.S. Treasury market. How Bonds Are Bought and Sold As we mentioned all the way back in Chapter 1, most trading in bonds takes place over the counter, or OTC. Recall that this means that there is no particular place where buying and selling occur. Instead, dealers around the country (and around the world) stand ready to buy and sell. The various dealers are connected electronically. One reason the bond markets are so big is that the number of bond issues far exceeds the number of stock issues. There are two reasons for this. First, a corporation would typi - cally have only one common stock issue outstanding (there are exceptions to this that we discuss in our next chapter). However, a single large corporation could easily have a dozen 6.5 coverage online Excel Master Please visit us at essentialsofcorporatefinance.blogspot.com for the latest developments in the world of corporate finance. 165Generally, when you make an investment, you expect that you will get back more money in the future than you invested today. But in December 2017, this wasn’t the case for many bond investors. The yield on a 5-year German government bond was about negative .20 percent, and the yields on 2-year and 5-year Japanese govern - ment bonds were negative .14 percent and negative .09 percent, re - spectively. In fact, in 2016, the amount of debt worldwide that had a negative yield reached a record $13.4 trillion! And negative yields were not restricted to government bonds, as at one point the yield on a bond issued by chocolate maker Nestlé was negative as well. So what happened? Central banks were in a race to the bot - tom, lowering interest rates in an attempt to improve their domestic economies. This chapter takes what we have learned about the time value of money and shows how it can be used to value one of the most common of all financial assets, a bond. It then discusses bond fea - tures, bond types, and the operation of the bond market. What we will see is that bond prices depend critically on interest rates, so we will go on to discuss some very fundamental issues regarding interest rates. Clearly, interest rates are important to everybody because they underlie what businesses of all types—small and large—must pay to borrow money.Interest Rates and Bond  Valuation 6 LEARNING OBJECTIVES After studying this chapter, you should be able to: LO 1 Identify important bond features and types of bonds. LO 2 Describe bond values and why they fluctuate. LO 3 Discuss bond ratings and what they mean. LO 4 Evaluate the impact of inflation on interest rates. LO 5 Explain the term structure of interest rates and the determinants of bond yields.PART FOUR Valuing Stocks and Bonds Our goal in this chapter is to introduce you to bonds. We begin by showing how the techniques we developed in Chapters 4 and 5 can be applied to bond valuation. From there, we go on to discuss bond features and how bonds are bought and sold. One important thing we learn is that bond values depend, in large part, on interest rates. Thus, we close out the chapter with an examination of interest rates and their behavior.Please visit us at essentialsofcorporatefinance.blogspot.com for the latest developments in the world of corporate finance.REAL FINANCIAL DECISIONS We have included two key features that help students connect chapter concepts to how decision makers use this material in the real world. ros13952_fm_i-xxxvi.indd 12 1/4/19 12:19 PMxiii ▼ WORK THE WEB These in-chapter boxes show students how to research financial issues using the web and how to use the information they find to make business decisions. All the Work the Web boxes also include interactive follow-up questions and exercises.▼ CHAPTER CASES Located at the end of most chapters, these cases focus on hypothetical company situations that embody corporate finance topics. Each case presents a new scenario, data, and a dilemma. Several questions at the end of each case require students to analyze and focus on all of the material they learned from the chapters in that part. These are great for homework or in-class exercises and discussions! chapter 6 Interest Rates and Bond Valuation 187 or more note and bond issues outstanding. Beyond this, federal, state, and local borrowing is enormous. For example, even a small city would usually have a wide variety of notes and bonds outstanding, representing money borrowed to pay for things like roads, sewers, and schools. When you think about how many small cities there are in the United States, you begin to get the picture! Because the bond market is almost entirely OTC, it has historically had little or no transparency . A financial market is transparent if it is possible to easily observe its prices and trading volume. On the New York Stock Exchange, for example, it is possible to see the price and quantity for every single transaction. In contrast, in the bond market, historically it was not possible to observe either. Transactions are privately negotiated between parties, and there is little or no centralized reporting of transactions. Although the total volume of trading in bonds far exceeds that in stocks, only a very small fraction of the total bond issues that exist actually trade on a given day. This means that getting up-to-date prices on individual bonds is often difficult or impossible, particu - larly for smaller corporate or municipal issues. Instead, a variety of sources of estimated prices exist and are very commonly used. Most of the information is self-explanatory. The Price and Yield columns show the price and yield to maturity of the issues based on their most recent sales. If you need more information about a particular issue, clicking on it will give you more details such as coupon dates and call dates. QUESTIONS 1. Go to this website and find the last bond shown in the accompanying table. When was this bond issued? What was the size of the bond issue? What were the yield to maturity and price when the bond was issued? 2. When you search for Chevron bonds (CVX), you will find bonds for several companies listed. Why do you think Chevron has bonds issued with different corporate names?W RK THE WEB Bond quotes have become more available with the rise of the web. One site where you can find current bond prices (from TRACE) is finra-markets.morningstar.com/BondCenter. We went to the site and entered “AZO” for AutoZone, the well-known auto parts company. We found a total of 10 bond issues outstanding. Here you see the information we pulled up. EXPLANATORY WEB LINKS ► These web links are provided in the margins of the text. They are specifically selected to accompany text material and provide students and instructors with a quick way to check for additional information using the internet.188 part 4 Valuing Stocks and Bonds Bond Price Reporting In 2002, transparency in the corporate bond market began to improve dramatically. Under new regulations, corporate bond dealers are now required to report trade information through what is known as the Trade Reporting and Compliance Engine (TRACE). A nearby Work the Web box shows how to get TRACE prices. As we mentioned before, the U.S. Treasury market is the largest securities market in the world. As with bond markets in general, it is an OTC market, so there is limited transpar - ency. However, unlike the situation with bond markets in general, trading in Treasury issues, particularly recently issued ones, is very heavy. Each day, representative prices for outstand- ing Treasury issues are reported. Figure 6.3 shows a portion of the daily Treasury note and bond listings from The Wall Street Journal online. The only difference between a Treasury note and a Treasury bond is that notes have 10 years or less to maturity at the time of issuance. The entry that begins “5/15/2030” is highlighted. Reading from left to right, the “5/15/2030” tells us that the bond’s maturity is May 15, 2030. The 6.250 is the bond’s coupon rate. Treasury bonds all make semiannual payments and have a face value of $1,000, so this bond will pay $31.25 per six months until it matures. The next two pieces of information are the bid and asked prices . In general, in any OTC or dealer market, the bid price represents what a dealer is willing to pay for a security, and the asked price (or “ask” price) is what a dealer is willing to take for it. The difference between the two prices is called the bid-ask spread (or “spread”), and it represents the dealer’s profit. Treasury prices are quoted as a percentage of face value. The bid price, or what a dealer is willing to pay for the bond, on the 5/15/2030 bond is 132.8984. With a $1,000 face value, this quote represents $1,328.984. The asked price, or the price at which the dealer is willing to sell the bond, is 132.9609, or $1,329.609. The next number quoted is the change in the asked price from the previous day, mea - sured as a percentage of face value, so this issue’s asked price rose by .4688 percent, or $4.688, in value from the previous day. Finally, the last number reported is the yield to ma- turity, based on the asked price. Notice that this is a premium bond because it sells for more than its face value. Not surprisingly, its yield to maturity (2.949 percent) is less than its coupon rate (6.25 percent). The very last ordinary bond listed, in this case the 5/15/2048, is often called the “bell- wether” bond. This bond’s yield is the one that is usually reported in the evening news. So, for example, when you hear that long-term interest rates rose, what is really being said is that the yield on this bond went up (and its price went down). If you examine the yields on the various issues in Figure 6.3, you clearly see that they vary by maturity. Why this occurs and what it might mean is one of the things we discuss in our next section.To learn more about TRACE, visit www.finra .org. To purchase newly issued corporate bonds, go to www.incapital.com . To buy Treasury bonds directly from the government, go to www .treasurydirect.gov . bid price The price a dealer is willing to pay for a security. asked price The price a dealer is willing to take for a security. bid-ask spread The difference between the bid price and the asked price.The Federal Reserve Bank of St. Louis maintains dozens of online files containing macroeconomic data as well as rates on U.S. Treasury issues. Go to fred.stlouisfed.org . EXAMPLE 6.5 Treasury Quotes Locate the Treasury issue in Figure 6.3 maturing in February 2024. What is its coupon rate? What is its bid price? What was the previous day’s asked price? The bond listed as 2/29/2024 is the one we seek. Its coupon rate is 2.125 percent of face value. The bid price is 96.1172, or 96.1172 percent of face value. The ask price is 96.1328, which is up by .1484 from the previous day. This means that the ask price on the previous day was equal to 96.1328 − .1484 = 95.9844. A Note on Bond Price Quotes If you buy a bond between coupon payment dates, the price you pay is usually more than the price you are quoted. The reason is that standard convention in the bond market is to quote prices net of “accrued interest,” meaning that 204 part 4 Valuing Stocks and Bonds Although Chris is aware of the bond features, he is uncertain as to the costs and benefits of some features, so he isn’t clear on how each feature would affect the coupon rate of the bond issue. Y ou are Renata’s assis - tant, and she has asked you to prepare a memo to Chris describing the effect of each of the following bond fea - tures on the coupon rate of the bond. She also would like you to list any advantages or disadvantages of each feature.Mark Sexton and Todd Story, the owners of S&S Air, have decided to expand their operations. They in - structed their newly hired financial analyst, Chris Guthrie, to enlist an underwriter to help sell $20 million in new 10-year bonds to finance construction. Chris has entered into discussions with Renata Harper, an underwriter from the firm of Crowe & Mallard, about which bond features S&S Air should consider and what coupon rate the issue will likely have.CHAPTER CASE Financing S&S Air’s Expansion Plans with a Bond Issue 1. The security of the bond—that is, whether the bond has collateral. 2. The seniority of the bond. 3. The presence of a sinking fund. 4. A call provision with specified call dates and call prices. 5. A deferred call accompanying the preceding call provision. 6. A make-whole call provision.7. Any positive covenants. Also, discuss several possible positive covenants S&S Air might consider. 8. Any negative covenants. Also, discuss several possible negative covenants S&S Air might consider. 9. A conversion feature (note that S&S Air is not a publicly traded company). 10. A floating rate coupon.QUESTIONSAPPLICATION TOOLS Because there is more than one way to solve prob - lems in corporate finance, we include many sections that encourage students to learn or brush up on dif - ferent problem-solving methods, including financial calculator and Excel spreadsheet skills. ros13952_fm_i-xxxvi.indd 13 1/4/19 12:19 PMxiv WHAT’S ON THE WEB? ► These end-of-chapter activities show students how to use and learn from the vast amount of financial resources available on the internet. EXCEL MASTER ICONS ► Topics covered in the comprehensive Excel Master supplement (found in Connect) are indicated by an icon in the margin. SPREADSHEET STRATEGIES ► The unique Spreadsheet Strategies feature is also in a self-contained section, showing students how to set up spreadsheets to solve problems—a vital part of every business student’s education. chapter 6 Interest Rates and Bond Valuation 203 EXCEL MASTER IT! PROBLEM In an earlier worksheet, we discussed the difference between yield to maturity and yield to call. There is another yield that is commonly quoted, the yield to worst. The yield to worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting. Yield to worst is calculated on all possible call dates. It is assumed that prepayment occurs if the bond has a call provision. The yield to worst will be the lower of yield to maturity or yield to call. The yield to worst may be the same as yield to maturity but never higher. Of course, with a traditional callable bond that has a call premium, the call premium can decline over time. A company has the following bond outstanding. The bond is callable every year on May 1, the anniversary date of the bond. The bond has a deferred call with three years left. The call premium on the first call date is one year’s interest. The call premium will decline by 10 percent of the original call premium for 10 years. Thirteen years from today, the call pre - mium will be zero. Given the following information, what is the yield to worst for this bond? Current date: 5/1/2019 Maturity date: 5/1/2039 Price (percent of par): 98.5% Coupon rate: 10.00% Par value (percent of par): 100% Coupons per year: 2 Call date Call premium 5/1/2022 $100 5/1/2023         90 5/1/2024         80 5/1/2025         70 5/1/2026         60 5/1/2027         50 5/1/2028         40 5/1/2029         30 5/1/2030         20 5/1/2031     106.1 Bond Quotes You can find current bond prices at finra-markets.morningstar.com/ BondCenter. You want to find the bond prices and yields for bonds issued by Pfizer. Enter the ticker symbol “PFE” to do a search. What is the shortest-maturity bond issued by Pfizer that is outstanding? What is the longest-maturity bond? What is the credit rating for Pfizer’s bonds? Do all of the bonds have the same credit rating? Why do you think this is? 6.2 Yield Curves You can find information regarding the most current bond yields at money.cnn.com. Go there and graph the yield curve for U.S. Treasury bonds. What is the general shape of the yield curve? What does this imply about expected future inflation? Now graph the yield curve for AAA-, AA-, and A-rated corporate bonds. Is the corporate yield curve the same shape as the Treasury yield curve? Why or why not? 6.3 Default Premiums The Federal Reserve Bank of St. Louis has files listing historical interest rates on its website www.stlouisfed.org. Find your way to the “FRED” data, then “Interest Rates.” You will find listings for Moody’s Seasoned Aaa Corporate Bond Yield and Moody’s Seasoned Baa Corporate Bond Yield. A default premium can be calculated as the difference between the Aaa bond yield and the Baa bond yield. Calculate the default premium using these two bond indexes for the most recent 36 months. Is the default premium the same for every month? Why do you think this is?WHAT’S ON THE WEB? 166 part 4 Valuing Stocks and Bonds BONDS AND BOND VALUATION When a corporation (or government) wishes to borrow money from the public on a long- term basis, it usually does so by issuing, or selling, debt securities that are generically called bonds. In this section, we describe the various features of corporate bonds and some of the terminology associated with bonds. We then discuss the cash flows associated with a bond and how bonds can be valued using our discounted cash flow procedure. Bond Features and Prices As we mentioned in our previous chapter, a bond is normally an interest-only loan, meaning that the borrower will pay the interest every period, but none of the principal will be repaid until the end of the loan. Suppose the Beck Corporation wants to borrow $1,000 for 30 years. The interest rate on similar debt issued by similar corporations is 12 percent. Beck will thus pay .12 × $1,000 = $120 in interest every year for 30 years. At the end of 30 years, Beck will repay the $1,000. As this example suggests, a bond is a fairly simple financing ar-rangement. There is, however, a rich jargon associated with bonds, so we will use this exam-ple to define some of the more important terms. In our example, the $120 regular interest payments that Beck promises to make are called the bond’s coupons . Because the coupon is constant and paid every year, the type of bond we are describing is sometimes called a level coupon bond . The amount that will be re - paid at the end of the loan is called the bond’s face value or par value . As in our example, this par value is usually $1,000 for corporate bonds, and a bond that sells for its par value is called a par value bond . Government bonds frequently have much larger face, or par, values. Finally, the annual coupon divided by the face value is called the coupon rate on the bond; in this case, because $120/$1,000 = .12, or 12 percent, the bond has a 12 percent coupon rate. The number of years until the face value is paid is called the bond’s time to maturity . A corporate bond will frequently have a maturity of 30 years when it is originally issued, but this varies. Once the bond has been issued, the number of years to maturity declines as time goes by. Bond Values and Yields As time passes, interest rates change in the marketplace. The cash flows from a bond, how-ever, stay the same. As a result, the value of the bond will fluctuate. When interest rates rise, the present value of the bond’s remaining cash flows declines, and the bond is worth less. When interest rates fall, the bond is worth more. To determine the value of a bond at a particular point in time, we need to know the number of periods remaining until maturity, the face value, the coupon, and the market in-terest rate for bonds with similar features. This interest rate required in the market on a bond is called the bond’s yield to maturity (YTM) . This rate is sometimes called the bond’s yield for short. Given all this information, we can calculate the present value of the cash flows as an estimate of the bond’s current market value. For example, suppose the Xanth (pronounced “zanth”) Co. were to issue a bond with 10 years to maturity. The Xanth bond has an annual coupon of $80. Similar bonds have a yield to maturity of 8 percent. Based on our preceding discussion, the Xanth bond will pay $80 per year for the next 10 years in coupon interest. In 10 years, Xanth will pay $1,000 to the owner of the bond. The cash flows from the bond are shown in Figure 6.1. What would this bond sell for? As illustrated in Figure 6.1, the Xanth bond’s cash flows have an annuity component (the coupons) and a lump sum (the face value paid at maturity). We thus estimate the mar-ket value of the bond by calculating the present value of these two components separately 6.1 coverage online Excel Master coupon The stated interest payment made on a bond. face value The principal amount of a bond that is repaid at the end of the term. Also par value. par value The principal amount of a bond that is repaid at the end of the term. Also face value. coupon rate The annual coupon divided by the face value of a bond. maturity Specified date on which the principal amount of a bond is paid. yield to maturity (YTM) The rate required in the market on a bond.174 part 4 Valuing Stocks and Bonds There is an important detail that comes up here. Suppose we have a bond with a price of $902.29, 10 years to maturity, and a coupon rate of 6 percent. As we mentioned earlier, most bonds actually make semiannual payments. Assuming that this is the case for the bond here, what’s the bond’s yield to matu-rity? To answer, we need to enter the relevant numbers like this: Enter 20 30 −902.29 1,000 I/ Y Solve for 3.7 Notice that we entered $30 as the payment because the bond actually makes payments of $30 every six months. Similarly, we entered 20 for N because there are actually 20 six-month periods. When we solve for the yield, we get 3.7 percent, but the tricky thing to remember is that this is the yield per six months , so we have to double it to get the right answer: 2 × 3.7% = 7.4 percent, which would be the bond’s reported yield. HOW TO CALCULATE BOND PRICES AND YIELDS USING A SPREADSHEET Like financial calculators, most spreadsheets have fairly elaborate routines available for calculating bond values and yields; many of these routines involve details that we have not discussed. However, setting up a simple spreadsheet to calculate prices or yields is straightforward, as our next two spreadsheets show:SPREADSHEET STRATEGIES AB CD EF GH 1 2 Using a spreadsheet to calculate bond yields 3 4 Suppose we have a bond with 22 years to maturity, a coupon rate of 8 percent, and a price of 5 $960 .17. If the bond makes semiannual payments, what is its yield to maturity? 6 7 Settlement date: 1/1/00 8 Maturity date: 1/1/22 9 Annual coupon rate: .08 10 Bond price (% of par): 96.017 11 Face value (% of par): 100 12 Coupons per year: 2 13 Yield to maturity: .084 14 15 The formula entered in cell B13 is = YIELD(B7, B8, B9, B10, B11, B12); notice that face value and bond 16 price are entered as a percentage of face value. 17 (continued)◄ CALCULATOR HINTS Calculator Hints is a self-contained section occurring in various chapters that first introduces students to calculator basics and then illustrates how to solve problems with the calculator. Appendix D goes into more detailed instructions by solving problems with two specific calculators. ◄ EXCEL SIMULATIONS Indicated by an Excel icon next to applicable end-of-chapter ques-tions and problems, Excel simulation exercises are available for selected problems in Connect. For even more spreadsheet practice , check out Excel Master, also available in Connect. chapter 6 Interest Rates and Bond Valuation 173 EXAMPLE 6.3 Bond Yields Y ou’re looking at two bonds identical in every way except for their coupons and, of course, their prices. Both have 12 years to maturity. The first bond has a 10 percent coupon rate and sells for $935.08. The second has a 12 percent coupon rate. What do you think it would sell for? Because the two bonds are very similar, they will be priced to yield about the same rate. We first need to calculate the yield on the 10 percent coupon bond. Proceeding as before, we know that the yield must be greater than 10 percent because the bond is selling at a discount. The bond has a fairly long maturity of 12 years. We’ve seen that long-term bond prices are relatively sensitive to interest rate changes, so the yield is probably close to 10 percent. A little trial and error reveals that the yield is actually 11 percent: Bond value = $100 × (1 − 1/1.11 12)/.11 + 1,000/1.1112 = $100 × 6.4924 + 1,000/3.4985 = $649.24 + 285.84 = $935.08 With an 11 percent yield, the second bond will sell at a premium because of its $120 coupon. Its value is Bond value = $120 × (1 − 1/1.11 12)/.11 + 1,000/1.1112 = $120 × 6.4924 + 1,000/3.4985 = $779.08 + 285.84 = $1,064.92 HOW TO CALCULATE BOND PRICES AND YIELDS USING A FINANCIAL CALCULATOR Many financial calculators have fairly sophisticated built-in bond valuation routines. However, these vary quite a lot in implementation, and not all financial calculators have them. As a result, we will illustrate a simple way to handle bond problems that will work on just about any financial calculator. To begin, of course, we first remember to clear out the calculator! Next, for Example 6.3, we have two bonds to consider, both with 12 years to maturity. The first one sells for $935.08 and has a 10 per - cent coupon rate. To find its yield, we can do the following: Enter 12 100 −935.08 1,000 I/ Y Solve for 11 Notice that here we have entered both a future value of $1,000, representing the bond’s face value, and a payment of 10 percent of $1,000, or $100, per year, representing the bond’s annual coupon. Also notice that we have a negative sign on the bond’s price, which we have entered as the present value. For the second bond, we now know that the relevant yield is 11 percent. It has a 12 percent coupon and 12 years to maturity, so what’s the price? To answer, we enter the relevant values and solve for the present value of the bond’s cash flows: Enter 12 11 120 1,000 PV Solve for −1,064.92CALCULATOR HINTS (continued) 200 part 4 Valuing Stocks and Bonds 13. Using Treasury Quotes. Locate the Treasury issue in Figure 6.3 maturing in February 2029. What is its coupon rate? What is the dollar bid price for a $1,000 par value bond? What was the previous day’s asked price for a $1,000 par value bond? 14. Using Treasury Quotes. Locate the Treasury bond in Figure 6.3 maturing in May 2037. Is this a premium or a discount bond? What is its current yield? What is its yield to maturity? What is the bid-ask spread for a $1,000 par value bond? 15. Zero Coupon Bonds. You find a zero coupon bond with a par value of $10,000 and 13 years to maturity. If the yield to maturity on this bond is 4.7 percent, what is the price of the bond? Assume semiannual compounding periods. 16. Valuing Bonds. Lion Corp. has a $2,000 par value bond outstanding with a coupon rate of 3.8 percent paid semiannually and 13 years to maturity. The yield to maturity of the bond is 4.9 percent. What is the dollar price of the bond? 17. Valuing Bonds. Union Local School District has bonds outstanding with a coupon rate of 3.2 percent paid semiannually and 16 years to maturity. The yield to maturity on these bonds is 3.7 percent and the bonds have a par value of $5,000. What is the dollar price of the bonds? INTERMEDIATE (Questions 18–33) 18. Bond Price Movements. Bond X is a premium bond making semiannual payments. The bond has a coupon rate of 7.5 percent, a YTM of 6 percent, and 13 years to maturity. Bond Y is a discount bond making semiannual payments. This bond has a coupon rate of 6 percent, a YTM of 7.5 percent, and also 13 years to maturity. What are the prices of these bonds today assuming both bonds have a $1,000 par value? If interest rates remain unchanged, what do you expect the prices of these bonds to be in one year? In three years? In eight years? In 12 years? In 13 years? What’s going on here? Illustrate your answers by graphing bond prices versus time to maturity. 19. Interest Rate Risk. Both Bond Bill and Bond Ted have 5.8 percent coupons, make semiannual payments, and are priced at par value. Bond Bill has 5 years to maturity, whereas Bond Ted has 25 years to maturity. If interest rates suddenly rise by 2 percent, what is the percentage change in the price of Bond Bill? Of Bond Ted? Both bonds have a par value of $1,000. If rates were to suddenly fall by 2 percent instead, what would the percentage change in the price of Bond Bill be then? Of Bond Ted? Illustrate your answers by graphing bond prices versus YTM. What does this problem tell you about the interest rate risk of longer-term bonds? 20. Interest Rate Risk. Bond J has a coupon rate of 4 percent. Bond K has a coupon rate of 14 percent. Both bonds have 17 years to maturity, a par value of $1,000, and a YTM of 8 percent, and both make semiannual payments. If interest rates suddenly rise by 2 percent, what is the percentage price change of these bonds? What if rates suddenly fall by 2 percent instead? What does this problem tell you about the interest rate risk of lower-coupon bonds?LO 2 LO 2 LO 2 LO 2 LO 2 LO 2 LO 2 LO 2 ros13952_fm_i-xxxvi.indd 14 1/4/19 12:19 PM