Explain the correlation between returns on a project and returns on the firm’s other assets affect the project’s risk.
Most projects’ risk are positively correlated with returns of the firm’s other assets.
Taking on a project with a high degree of either stand-alone or corporate riskwill not necessarily affect the firm’s beta. However, if the project has highly uncertain returns, and if those returns are highly correlated with returns on the firm’s other assets and with most other assets in the economy, the project will have a high degree of all types of risk. For example, suppose General Motors decides to undertake a major expansion to build commuter airplanes. GM is not sure how its technology will workon a mass production basis, so there are great risks in the venture—its stand-alone risk is high. Management also estimates that the project will do best if the economy is strong, for then people will have more money to spend on the new planes. This means that the project will tend to do well if GM’s other divisions do well and will tend to do badly if other divisions do badly. This being the case, the project will also have high corporate risk. Finally, since GM’s profits are highly correlated with those of most other firms, the project’s beta will also be high. Thus, this project will be risky under all three definitions of risk.
Define floating rate bonds and zero coupon bonds.
Floating rate bond a debt instrument with a variable interest rate. Also known as a “floater” or “FRN. Financial institutions and governments mainly issue floaters, and they typically have a two- to five-year term to maturity. They tend to become more popular when interest rates are expected to increase. Compared to fixed-rate debt instruments, floaters protect investors against a rise in interest rates. Because interest rates have an inverse relationship with bond prices, a fixed-rate note’s market price will drop if interest rates increase. FRNs, however, carry lower yields than fixed notes of the same maturity. They also have unpredictable coupon payments. FRNs may be issued with or without a call option
Zero Coupon Bond a bond that pays no annual interest but is sold at a discount below par, thus providing compensation to investors in the form of capital appreciation. Also known as an "accrual bond." A zero-coupon bond makes no periodic interest payments but instead is sold at a deep discount from its face value. Why buy a bond that pays no interest? The answer lies in the fact that the buyer of such a bond does receive a return. This return consists of the gradual increase (or appreciation) in the value of the security from its original, below-face-value purchase price until it is redeemed at face value on its maturity date.
Define convertible bonds, bonds with warrants, income bonds, and indexed bonds.
Convertible bond a bond that is exchangeable, at the option of the holder, for common stock of the issuing firm. Convertible have a lower coupon rate than nonconvertible debt.
Warrant a long term option to buy a stated number of shares of common stock at a specified price. Bond issued with warrants, similar to convertibles. They carry lower coupon rates than straight bonds and provide a capital gain if the price of the stock rises.
Income bond a bond that pays interest only if the interest is earned. This securities cannot bankrupt a company, but from an investor’s standpoint they are riskier than regular bonds.
Indexed bond a bond that has interest payments based on an inflation index so as to protect the holder from inflation. Also called “Purchasing power bond”. This bond first became popular in Israel and Brazil, and other countries with high inflation. The interest rate paid on this bond is based on an inflation index, so if inflation rises interest paid rises automatically, thus protecting bondholders against inflation.