Question

Define these business finance terms in your own words and then give a real world example of each: Protective Covenant, Sinking Fund, Yield to maturity vs. Coupon rate, Zero Coupon Bond, Capital Gains yield and dividend yield.

Answer 1

Protective covenants - it is a part of a loan agreement that limits certain actions of a comapny during the term of the loan to protect the interest of the lender. These restricts certain actions on the part of the borrower and are not allowed to perform those actions. For example, lender may restrict the amount of dividends to be paid by the company.

Sinking fund - Sinking fund is a type of account where companies put aside a part of the profits for a period of time which can then be used to fund the purchase of certain capital assets, or to repay a loan matured. Creating a sinking fund softens the burden of the company when the maturity of a debt occurs. For example a company may put aside $1 million every year for 10 years to replace an obsolete machine at the end of the period.

Yield to Maturity vs Coupon rate - coupon rate is the annual interest rate to be received by the bond holder, whereas Yield to maturity is the percentage rate of return assuming that the holder holds the bond till maturity. Yield to maturity also takes into account the market price of the bond. For example coupon rate is 5% and the face value is $100 and the market price is $95. The yield to maturity also takes into account the profit of $5 when purchased at 95 and to be matured at $100.

Zero coupon bond - It is a type of debt raised by the companies where the maturity of the bond happens at the face value or par value but is issued at a deep discount. There are no in between payments of interest. The difference between the issue price and the maturity price is the profit over the bond period.

Capital Gains yield - it is defined as the percentage increase in the investments made. It refers to the appreciation of the investments. For example if one purchased a stock worth $100 for investment and later sold it for $150, the capital gains yield is calculated as (150-100)/100 = 50%.

Dividend yield- dividend yield of a company is the dividend received over the year divided by the market price of the share of the comapany. It is expressed in percentage terms. for example a company whose share price is of $200, pays annual dividend of $10, then the dividend yield ratio is 10/200 = 5%.