Question

1. Short Answers

   1. An equity and a bond have very different risk characteristics. Describe the differences.

   2. A corporation’s stock price falls in the secondary market. Describe the impact of the stock price fall on the balance sheet of the corporation. Is there any impact on the primary market?

   3. Asset values decline and this decline must be reflected in the financial institution’s balance sheet.

      i. Describe the impact on the liabilities and capital when there is a decline in asset values.
      ii. Describe the impact on the leverage ratio, specifically the capital-asset ratio and the liabilities-

      asset ratio. When is the firm insolvent?

   4. Show how to compute the yield to maturity for a coupon bond with the following structure: a 10% coupon bond with face value $1000 maturing in 5 years selling for $1100. You do not need to compute a numerical answer; just provide the formula using the information provided.

Answer 1

While choosing to buy between company's bond or equity an investor will take certain points in her mind.

First of all while buying bond she will have zero control over a corporate's decision making and will not be part of it's profit sharing .

On, the other hand equity ownership provides power over decisions made by a corporate. It depends on the percentage of share holding in the given corporate. Benefit of which is getting return in the form of dividents which are nothing but profits in liue of the share capital invested.

Now, both equity and bonds have their share of pro's and con's which are as follows:

1. Bond's value depends on the future interest rate. If the interest rate rises in future it's value decreases whereas under equity interest rate have nothing to do with it's return over investment.

2.Inflation risk is high in bonds because their value is static and if the inflation rates rises manifolds the value of bond will reduce and it will become a loss making asset. Equity share holders will gain profits which are going to be higher during high inflation rates . Thus, they won't face a loss .

3. Credit/default risk

There's always a risk of default while investing in both bond markets and equity market. If a company is unable to pay it's due then there is no guarantee of return from investment. If company doesn't make any profits then it will not be able to give dividents.

4. Reduction in value-

If a company's stock rates reduces than the value of stock invested will also go down which could result in losses.Bond's value is relatively stable in comparison to stock value.

Fall in price of corporations stock in the secondary market will not impact corporation's balance sheet. A company raises capital when they sell shares through an Initial Public Offering (IPO). Fall of share price in secondary market does not causes any loss to the company directly. Occasional fall of share price along with rebound will have negligible effect on the coroporate's image.

Now, if the share prices has reduced substantially and the cimpaco now wants to raise more capital through share rights issue then they may find difficult to find shareholders who would invest in a company with unsatisfactory performance.

Impact of asset decline are as follows

(I) With decreases asset value it will become difficult to cover existing liabilities of the company. On the other hand raising more capital willnagain be difficult due to reduced value of assets which investors introspect before investing.

(II) Capital Asset ratio sets standards to a company's ability to pay it's liabilities and respond to credit risk. Higher ratio means bank will have enough capital to absorb potential loss thus, investors look for CAR value to ascertain if they will get return's in future and won't undertake any undue loss.

When the capital adequecy ratio is too low to pay back investors their invested amount then the firm is deemed insolvent. Under this the capital availabile with the firm is not enough to pay back it's liabilities.

Yield to maturity formula =[C + FV-PV/t]/FV+PV/2

Here ,

C is interest/coupon payment = 100

FV is face value = $1000

PV is present value $1100

T = time taken to reach maturity