Question

1. Why does money have a time value? Why is it important?

2. Discuss whether the standard deviation of a portfolio is, or is not, a weighted average of the standard deviations of the assets in the portfolio. Fully explain your answer.

3. You want to invest in bonds. Explain whether or not each provision listed will make the bonds more or less desirable as an investment: call provision, convertible bond provision, and subordinated debt.

4. What is the difference between common stock and preferred stock? Is one better than the other?

5. Discuss the pros and cons of stock buyback.

Answer 1

(1): Money has a time value due to the fact that money that is available to you today is worth more than the same amount of money that will be made available to you at some future point of time say tomorrow or after a year or after a decade. The concept of time value of money helps us in determining the value of different cash flows that stands today (i.e. present value). This concept is used in capital budgeting (NPV, IRR, discounted payback etc), in bond valuation (by computing the present value of coupons and maturity amount) and stock valuation (dividend discount mode, DCF model).

(2): No the standard deviation of a portfolio is not the weighted average of the standard deviations of the assets in the portfolio. This is because the risk of a portfolio (as determined by its standard deviation) will always be smaller. Also covariance between assets is also considered when determining the standard deviation of a portfolio.

(3): Call provisions make a bond less desirable as it protects the issuer of the bond when the interest rate declines. Convertible bind provisions make a bond more desirable as it gives the holder the option to convert the bonds held by him if the conversion is financially attractive. Subordinated debt make a bond less desirable as it subordinated debt gets a preference over bonds in case of liquidation of the company.

(4): The primary difference between common stock and preferred stock is in terms of voting rights. Common stock holders have voting rights while preferred stock holders enjoy no voting rights. Secondly preferred stock holders get a greater claim on the assets as well as on the earnings of a company than the common stockholders. In my opinion preferred stocks are better than common stock (despite the absence of voting rights). This is because of two reasons. Firstly preferred stocks are less volatile than common stock. Secondly in case a company is liquidated preferred shareholders will be paid first and then the common stock holders.

(5): In terms of pros the first main advantage is that there is a boost in share prices as fewer shares will now be trading in the secondary markets. Secondly EPS (earnings per share) will receive a boost and thirdly the excess cash of the company will be utilized. Lastly a stock buyback will develop a positive psychology in the minds of investors.

In terms of cons stock buyouts can lead to sinking dividends. Companies often spend a significant amount of money on buying up shares and hence cut their dividends as a result. Secondly the stock buyouts tend to benefit only the big shareholders and minority owners are not so positively affected.