IMC Financial Analysis & Derivatives 4 — Questions and Answers
Question 1: What does 'yield to maturity' (YTM) represent for a bond?
- The bond's coupon rate as a percentage of par value
- The total return anticipated on a bond if held until maturity, assuming all coupons are reinvested at the same rate (Correct answer)
- The bond's current yield based on market price
- The yield on a comparable government bond
Correct answer: The total return anticipated on a bond if held until maturity, assuming all coupons are reinvested at the same rate
YTM is the internal rate of return of a bond — the discount rate that equates the present value of all future coupon payments and principal repayment to the bond's current market price. It reflects the total expected return if the bond is held to maturity and coupons are reinvested at the YTM.
Question 2: What is the 'credit spread' on a corporate bond?
- The difference between the bid and offer price of a bond
- The additional yield a corporate bond pays over a comparable maturity government bond, compensating for credit risk (Correct answer)
- The difference between short-term and long-term corporate bond yields
- The spread between investment grade and high yield bond indices
Correct answer: The additional yield a corporate bond pays over a comparable maturity government bond, compensating for credit risk
The credit spread is the yield difference between a corporate bond and a comparable government bond (e.g., gilt). It compensates investors for the additional credit risk (default risk) of the corporate issuer compared to the government, which is assumed to be risk-free.
Question 3: What is the 'dividend discount model' (DDM) used for?
- Discounting a company's tax liabilities to present value
- Valuing a company's shares based on the present value of expected future dividend payments (Correct answer)
- Calculating the expected dividend growth rate
- Discounting bond coupons to find fair value
Correct answer: Valuing a company's shares based on the present value of expected future dividend payments
The DDM values a share as the present value of all future expected dividends, discounted at the required rate of return. The Gordon Growth Model simplifies this: Price = D1 / (r - g), where D1 is next year's dividend, r is required return, and g is the sustainable dividend growth rate.
Question 4: What is 'price-to-book' (P/B) ratio and when is it most commonly used?
- The ratio of a company's share price to its annual sales
- The ratio of market capitalisation to net asset value (book value), commonly used for financial sector companies and asset-heavy industries (Correct answer)
- The ratio of a company's P/E to its growth rate
- The ratio of market price to operating cash flow
Correct answer: The ratio of market capitalisation to net asset value (book value), commonly used for financial sector companies and asset-heavy industries
P/B ratio = Market Cap / Net Book Value (shareholders' equity). It measures the premium or discount investors pay relative to the accounting value of assets. It is widely used for banks (where assets are largely financial and book value is meaningful) and capital-intensive industries.
Question 5: What is the 'enterprise value' (EV) of a company?
- The market capitalisation of ordinary shares only
- The total value of a company including equity market cap plus net debt (debt minus cash), representing the total cost to an acquirer (Correct answer)
- The book value of a company's total assets
- The present value of a company's future earnings
Correct answer: The total value of a company including equity market cap plus net debt (debt minus cash), representing the total cost to an acquirer
Enterprise Value = Market Cap + Net Debt (total debt minus cash). EV represents the total value of a business to all capital providers (equity and debt holders) and is the theoretical acquisition price. EV-based ratios (EV/EBITDA) enable comparison across companies with different capital structures.
Question 6: What is 'EBITDA' and why is it commonly used in financial analysis?
- Earnings Before Interest, Tax, Depreciation and Amortisation — a proxy for operating cash generation used to compare companies across different capital structures and tax regimes (Correct answer)
- Earnings Before Internal Tax, Depreciation and Administration — used for private company valuation
- Estimated Book Income Tax Deferred Annually — an accounting adjustment
- A regulatory measure of capital adequacy for investment firms
Correct answer: Earnings Before Interest, Tax, Depreciation and Amortisation — a proxy for operating cash generation used to compare companies across different capital structures and tax regimes
EBITDA strips out interest (financing differences), tax (jurisdiction differences), depreciation and amortisation (non-cash charges and accounting policy differences) to provide a cleaner measure of operating profitability. EV/EBITDA is widely used in M&A and company comparisons.
IMC Financial Analysis & Derivatives 4
What does 'yield to maturity' (YTM) represent for a bond?