Finance
required return
usually applied to equity instruments such as common stock; the cost of funds obtained by selling an ownership interest
Interest rate
usually applied to debt instruments such as bank loans or bonds; the compensation paid by the borrower of funds to the lender; from the borrower's point of view the cost of borrowing funds
Chapter 7 PP
- g=0 (preferred stock valuation, *,) - g is a constant - g is non-constant (not a constant, variable growth rate) Differences Between Debt and Equity Debt includes all borrowing incurred by a firm, including bonds, and is repaid according to a fixed schedule of payments. Equity consists of funds provided by the firm's owners (investors or stockholders) that are repaid subject to the firm's performance. Debt financing is obtained from creditors and equity financing is obtained from investors who then become part owners of the firm. Creditors (lenders or debt holders) have a legal right to be repaid, whereas investors only have an expectation of being repaid. Differences Between Debt and Equity: Voice in Management Unlike creditors, holders of equity (stockholders) are owners of the firm. Stockholders generally have voting rights that permit them to select the firm's directors and vote on special issues. In contrast, debtholders do not receive voting privileges but instead rely on the firm's contractual obligations to them to be their voice. Differences Between Debt and Equity: Claims on Income and Assets Equityholders' claims on income and assets are secondary to the claims of creditors. Their claims on income cannot be paid until the claims of all creditors, including both interest and scheduled principal payments, have been satisfied. Because equity holders are the last to receive distributions, they expect greater returns to compensate them for the additional risk they bear. Matter of Fact How Are Assets Divided in Bankruptcy? According to the U.S. Securities and Exchange Commission, in bankruptcy assets are divided up as follows: Secured Creditors - secured bank loans or secured bonds, are paid first. Unsecured Creditors - unsecured bank loans or unsecured bonds, suppliers, or customers, have the next claim. Equityholders - equityholders or the owners of the company have the last claim on assets, and they may not receive anything if the Secured and Unsecured Creditors' claims are not fully repaid. Differences Between Debt and Equity: Maturity Unlike debt, equity capital is a permanent form of financing. Equity has no maturity date and never has to be repaid by the firm. Differences Between Debt and Equity: Tax Treatment Interest payments to debtholders are treated as tax-deductible expenses by the issuing firm. Dividend payments to a firm's stockholders are not tax-deductible. The tax deductibility of interest lowers the corporation's cost of debt financing, further causing it to be lower than the cost of equity financing. Common and Preferred Stock: Common Stock Common stockholders, who are sometimes referred to as residual owners or residual claimants, are the true owners of the firm. As residual owners, common stockholders receive what is left—the residual—after all other claims on the firms income and assets have been satisfied. They are assured of only one thing: that they cannot lose any more than they have invested in the firm. Because of this uncertain position, common stockholders expect to be compensated with adequate dividends and ultimately, capital gains. Common Stock Valuation: Basic Common Stock Valuation Equation The value of a share of common stock is equal to the present value of all future cash flows (dividends) that it is expected to provide. where Common Stock Valuation: The Zero Growth Model The zero dividend growth model assumes that the stock will pay the same dividend each year, year after year. The equation shows that with zero growth, the value of a share of stock would equal the present value of a perpetuity of D1 dollars discounted at a rate rs. Personal Finance Example Chuck Swimmer estimates that the dividend of Denham Company, an established textile producer, is expected to remain constant at $3 per share indefinitely. If his required return on its stock is 15%, the stock's value is: $20 = $3 ÷ 0.15 per share Common Stock Valuation: Constant-Growth Model The constant-growth model is a widely cited dividend valuation approach that assumes that dividends will grow at a constant rate, but a rate that is less than the required return. The Gordon model is a common name for the constant-growth model that is widely cited in dividend valuation. Common Stock Valuation: Constant-Growth Model (cont.) Lamar Company, a small cosmetics company, paid the following per share dividends: Common Stock Valuation: Constant-Growth Model (cont.) Using a financial calculator or a spreadsheet, we find that the historical annual growth rate of Lamar Company dividends equals 7%, given the required return is 15%. D1= D0 (1+g) = 1.4 (1+.07) = 1.50 Common Stock Valuation: Constant-Growth Model (cont.) Using a financial calculator or a spreadsheet, we find that the historical annual growth rate of Lamar Company dividends equals 7%, given the required return is 15%. D1= D0 (1+g) = 1.4 (1+.07) = 1.50 Common Stock Valuation: Variable-Growth Model The zero- and constant-growth common stock models do not allow for any shift in expected growth rates. The variable-growth model is a dividend valuation approach that allows for a change in the dividend growth rate. To determine the value of a share of stock in the case of variable growth, we use a four-step procedure. Common Stock Valuation: Variable-Growth Model (cont.) Step 1. Find the value of the cash dividends at the end of each year, Dt, during the initial growth period, years 1 though N. Dt = D0 × (1 + g1)t Common Stock Valuation: Variable-Growth Model (cont.) Step 2. Find the present value of the dividends expected during the initial growth period. Common Stock Valuation: Variable-Growth Model (cont.) Step 3. Find the value of the stock at the end of the initial growth period, PN = (DN+1)/(rs - g2), which is the present value of all dividends expected from year N + 1 to infinity, assuming a constant dividend growth rate, g2. Common Stock Valuation: Variable-Growth Model (cont.) Step 4. Add the present value components found in Steps 2 and 3 to find the value of the stock, P0. Common Stock Valuation: Variable-Growth Model (cont.) The most recent annual (2012) dividend payment of Warren Industries, a rapidly growing boat manufacturer, was $1.50 per share. The firm's financial manager expects that these dividends will increase at a 10% annual rate, g1, over the next three years. At the end of three years (the end of 2015), the firm's mature product line is expected to result in a slowing of the dividend growth rate to 5% per year, g2, for the foreseeable future. The firm's required return, rs, is 15%. Steps 1 and 2 are detailed in Table 7.3 on the following slide. Common Stock Valuation: Variable-Growth Model (cont.) Step 3. The value of the stock at the end of the initial growth period (N = 2015) can be found by first calculating DN+1 = D2016. D2016 = D2015 (1 + 0.05) = $2.00 (1.05) = $2.10 By using D2016 = $2.10, a 15% required return, and a 5% dividend growth rate, we can calculate the value of the stock at the end of 2015 as follows: P2015 = D2016 / (rs - g2) = $2.10 / (.15 - .05) = $21.00 Common Stock Valuation: Variable-Growth Model (cont.) Step 3 (cont.) Finally, the share value of $21 at the end of 2015 must be converted into a present (end of 2012) value. P2015 / (1 + rs)3 = $21 / (1 + 0.15)3 = $13.81 Step 4. Adding the PV of the initial dividend stream (found in Step 2) to the PV of the stock at the end of the initial growth period (found in Step 3), we get: P2012 = $4.14 + $13.82 = $17.93 per share Common Stock Valuation: Free Cash Flow Valuation Model A free cash flow valuation model determines the value of an entire company as the present value of its expected free cash flows discounted at the firm's weighted average cost of capital, which is its expected average future cost of funds over the long run. where Common Stock Valuation: Free Cash Flow Valuation Model (cont.) Because the value of the entire company, VC, is the market value of the entire enterprise (that is, of all assets), to find common stock value, VS, we must subtract the market value of all of the firm's debt, VD, and the market value of preferred stock, VP, from VC. VS = VC - VD - VP Common Stock Valuation: Free Cash Flow Valuation Model Common Stock Valuation: Free Cash Flow Valuation Model (cont.) Step 1. Calculate the present value of the free cash flow occurring from the end of 2021 to infinity, measured at the beginning of 2021. Common Stock Valuation: Free Cash Flow Valuation Model (cont.) Step 2. Add the present value of the FCF from 2021 to infinity, which is measured at the end of 2020, to the 2020 FCF value to get the total FCF in 2020. Total FCF2020 = $600,000 + $10,300,000 = $10,900,000 Step 3. Find the sum of the present values of the FCFs for 2016 through 2020 to determine the value of the entire company, VC. This step is detailed in Table 7.5 on the following slide. Table 7.5 Calculation of the Value of the Entire Company for Dewhurst, Inc. Common Stock Valuation: Free Cash Flow Valuation Model (cont.) Step 4. Calculate the value of the common stock. VS = $8,626,426 - $3,100,000 - $800,000 = $4,726,426 The value of Dewhurst's common stock is therefore estimated to be $4,726,426. By dividing this total by the 300,000 shares of common stock that the firm has outstanding, we get a common stock value of $15.76 per share ($4,726,426 ÷ 300,000). Common Stock Valuation: Other Approaches to Stock Valuation The price/earnings (P/E) ratio reflects the amount investors are willing to pay for each dollar of earnings. The price/earnings multiple approach is a popular technique used to estimate the firm's share value; calculated by multiplying the firm's expected earnings per share (EPS) by the average price/earnings (P/E) ratio for the industry. Common Stock Valuation: Other Approaches to Stock Valuation (cont.) Lamar Company is expected to earn $2.60 per share next year (2016). Assuming a industry average P/E ratio of 7, the firms per share value would be $2.60 7 = $18.20 per share Common Stock: Ownership The common stock of a firm can be privately owned by an private investors, closely owned by an individual investor or a small group of investors, or publicly owned by a broad group of investors. The shares of privately owned firms, which are typically small corporations, are generally not traded; if the shares are traded, the transactions are among private investors and often require the firm's consent. Large corporations are publicly owned, and their shares are generally actively traded in the broker or dealer markets . Matter of Fact Problems with P/E Valuation The P/E multiple approach is a fast and easy way to estimate a stock's value. However, P/E ratios vary widely over time. Therefore, analysts using the P/E approach in the 1980s would have come up with much lower estimates of value than analysts using the model 20 years later. By 2012, the average stock had a P/E ratio of about 20, which is close to the long-run average. In other words, when using this approach to estimate stock values, the estimate will depend more on whether stock market valuations are high or low rather than on whether the particular company is doing well or not. Common Stock: Par Value The par value of common stock is an arbitrary value established for legal purposes in the firm's corporate charter, and can be used to find the total number of shares outstanding by dividing it into the book value of common stock. When a firm sells news shares of common stock, the par value of the shares sold is recorded in the capital section of the balance sheet as part of common stock. At any time the total number of shares of common stock outstanding can be found by dividing the book value of common stock by the par value. Common Stock: Preemptive Rights A preemptive right allows common stockholders to maintain their proportionate ownership in the corporation when new shares are issued, thus protecting them from dilution of their ownership. Dilution of ownership is a reduction in each previous shareholder's fractional ownership resulting from the issuance of additional shares of common stock. Dilution of earnings is a reduction in each previous shareholder's fractional claim on the firm's earnings resulting from the issuance of additional shares of common stock. Common Stock: Preemptive Rights (cont.) Rights are financial instruments that allow stockholders to purchase additional shares at a price below the market price, in direct proportion to their number of owned shares. Rights are an important financing tool without which shareholders would run the risk of losing their proportionate control of the corporation. From the firm's viewpoint, the use of rights offerings to raise new equity capital may be less costly than a public offering of stock. Common Stock: Voting Rights Generally, each share of common stock entitles its holder to one vote in the election of directors and on special issues. Votes are generally assignable and may be cast at the annual stockholders' meeting. A proxy statement is a statement transferring the votes of a stockholder to another party. Because most small stockholders do not attend the annual meeting to vote, they may sign a proxy statement transferring their votes to another party. Existing management generally receives the stockholders' proxies, because it is able to solicit them at company expense. Common Stock: Voting Rights (cont.) A proxy battle is an attempt by a nonmanagement group to gain control of the management of a firm by soliciting a sufficient number of proxy votes. Supervoting shares is stock that carries with it multiple votes per share rather than the single vote per share typically given on regular shares of common stock. Nonvoting common stock is common stock that carries no voting rights; issued when the firm wishes to raise capital through the sale of common stock but does not want to give up its voting control. Common Stock: Dividends The payment of dividends to the firm's shareholders is at the discretion of the company's board of directors. Dividends may be paid in cash, stock, or merchandise. Common stockholders are not promised a dividend, but they come to expect certain payments on the basis of the historical dividend pattern of the firm. Before dividends are paid to common stockholders any past due dividends owed to preferred stockholders must be paid. Common Stock: International Stock Issues The international market for common stock is not as large as that for international debt. However, cross-border issuance and trading of common stock have increased dramatically during the past 30 years. Stock Issued in Foreign Markets A growing number of firms are beginning to list their stocks on foreign markets. Issuing stock internationally both broadens the company's ownership base and helps it to integrate itself in the local business environment. Locally traded stock can facilitate corporate acquisitions, because shares can be used as an acceptable method of payment. Common Stock: International Stock Issues (cont.) Foreign Stocks in U.S. Markets American depositary receipts (ADRs) are dollar-denominated receipts for the stocks of foreign companies that are held by a U.S. financial institution overseas. American depositary shares (ADSs) are securities, backed by American depositary receipts (ADRs), that permit U.S. investors to hold shares of non-U.S. companies and trade them in U.S. markets. ADSs are issued in dollars to U.S. investors and are subject to U.S. securities laws. ADSs give investors the opportunity to diversify their portfolios internationally. Issuing Common Stock Initial financing for most firms typically comes from a firm's original founders in the form of a common stock investment. Early stage debt or equity investors are unlikely to make an investment in a firm unless the founders also have a personal stake in the business. Initial non-founder financing usually comes first from private equity investors. After establishing itself, a firm will often "go public" by issuing shares of stock to a much broader group. Issuing Common Stock: Venture Capital Venture capital is privately raised external equity capital used to fund early-stage firms with attractive growth prospects. Venture capitalists (VCs) are providers of venture capital; typically, formal businesses that maintain strong oversight over the firms they invest in and that have clearly defined exit strategies. Angel capitalists (angels) are wealthy individual investors who do not operate as a business but invest in promising early-stage companies in exchange for a portion of the firm's equity. Venture Capital: Deal Structure and Pricing Venture capital investments are made under legal contracts that clearly allocate responsibilities and ownership interests between existing owners (founders) and the VC fund or limited partnership Terms depend on factors related to the (a) original founders, (b) business structure, (c) stage of development, and (d) other market and timing issues. Specific financial terms depend upon (a) the value of the enterprise, (b) the amount of funding required, and (c) the perceived risk of the investment. Venture Capital: Deal Structure and Pricing (cont.) To control the VC's risk, various covenants are included in agreements and the actual funding provided may be staggered based on the achievement of measurable milestones. The contract will also have a defined exit strategy. The amount of equity to which the VC is entitled depends on (a) the value of the firm, (b) the terms of the contract, (c) the exit terms, and (d) minimum compound annual rate of return required by the VC on its investment. Going Public When a firm wishes to sell its stock in the primary market, it has three alternatives. A public offering, in which it offers its shares for sale to the general public. A rights offering, in which new shares are sold to existing shareholders. A private placement, in which the firm sells new securities directly to an investor or a group of investors. Here we focus on the initial public offering (IPO), which is the first public sale of a firm's stock. Going Public (cont.) IPOs are typically made by small, fast-growing companies that either: require additional capital to continue expanding, or have met a milestone for going public that was established in a contract to obtain VC funding. The firm must obtain approval of current shareholders, and hire an investment bank to underwrite the offering. The investment banker is responsible for promoting the stock and facilitating the sale of the company's IPO shares. Going Public (cont.) The company must file a registration statement with the SEC. The prospectus is a portion of a security registration statement that describes the key aspects of the issue, the issuer, and its management and financial position. A red herring is a preliminary prospectus made available to prospective investors during the waiting period between the registration statement's filing with the SEC and its approval. Going Public (cont.) Investment bankers and company officials promote the company through a road show, a series of presentations to potential investors around the country and sometimes overseas. This helps investment bankers gauge the demand for the offering which helps them to set the initial offer price. After the underwriter sets the terms, the SEC must approve the offering. Going Public: The Investment Banker's Role An investment banker is a financial intermediary that specializes in selling new security issues and advising firms with regard to major financial transactions. Underwriting is the role of the investment banker in bearing the risk of reselling, at a profit, the securities purchased from an issuing corporation at an agreed-on price. This process involves purchasing the security issue from the issuing corporation at an agreed-on price and bearing the risk of reselling it to the public at a profit. The investment banker also provides the issuer with advice about pricing and other important aspects of the issue. Going Public: The Investment Banker's Role (cont.) An underwriting syndicate is a group of other bankers formed by an investment banker to share the financial risk associated with underwriting new securities. The syndicate shares the financial risk associated with buying the entire issue from the issuer and reselling the new securities to the public. The selling group is a large number of brokerage firms that join the originating investment banker(s); each accepts responsibility for selling a certain portion of a new security issue on a commission basis. Compensation for underwriting and selling services typically comes in the form of a discount on the sale price of the securities. For example, an investment banker may pay the issuing firm $24 per share for stock that will be sold for $26 per share. The investment banker may then sell the shares to members of the selling group for $25.25 per share. In this case, the original investment banker earns $1.25 per share ($25.25 sale price - $24 purchase price). The members of the selling group earn 75 cents for each share they sell ($26 sale price - $25.25 purchase price). Common Stock Valuation Common stockholders expect to be rewarded through periodic cash dividends and an increasing share value. Some of these investors decide which stocks to buy and sell based on a plan to maintain a broadly diversified portfolio. Other investors have a more speculative motive for trading. They try to spot companies whose shares are undervalued—meaning that the true value of the shares is greater than the current market price. These investors buy shares that they believe to be undervalued and sell shares that they think are overvalued (i.e., the market price is greater than the true value). Common Stock Valuation: Market Efficiency Economically rational buyers and sellers use their assessment of an asset's risk and return to determine its value. In competitive markets with many active participants, the interactions of many buyers and sellers result in an equilibrium price—the market value—for each security. Because the flow of new information is almost constant, stock prices fluctuate, continuously moving toward a new equilibrium that reflects the most recent information available. This general concept is known as market efficiency. Common Stock Valuation: Market Efficiency The efficient-market hypothesis (EMH) is a theory describing the behavior of an assumed "perfect" market in which: securities are in equilibrium, security prices fully reflect all available information and react swiftly to new information, and because stocks are fully and fairly priced, investors need not waste time looking for mispriced securities. Common Stock Valuation: Market Efficiency Although considerable evidence supports the concept of market efficiency, a growing body of academic evidence has begun to cast doubt on the validity of this notion. Behavioral finance is a growing body of research that focuses on investor behavior and its impact on investment decisions and stock prices. Advocates are commonly referred to as "behaviorists." Focus on Practice Understanding Human Behavior Helps Us Understand Investor Behavior Regret theory deals with the emotional reaction people experience after realizing they have made an error in judgment. Some investors rationalize their decision to buy certain stocks with "everyone else is doing it." (Herding) People have a tendency to place particular events into mental compartments, and the difference between these compartments sometimes impacts behavior more than the events themselves. Prospect theory suggests that people express a different degree of emotion toward gains than losses. Anchoring is the tendency of investors to place more value on recent information. Preferred Stock Preferred stock gives its holders certain privileges that make them senior to common stockholders. Preferred stockholders are promised a fixed periodic dividend, which is stated either as a percentage or as a dollar amount. Par-value preferred stock is preferred stock with a stated face value that is used with the specified dividend percentage to determine the annual dollar dividend. No-par preferred stock is preferred stock with no stated face value but with a stated annual dollar dividend. Preferred Stock Valuation Preferred stock is valued as a perpetuity. P = C / R Suppose a preferred stock has a face value of 100, and 5% dividends, how much should it be traded given a 8% required return. P = 5/.08 = $62.5 Preferred Stock: Basic Rights of Preferred Stockholders Preferred stock is often considered quasi-debt because, much like interest on debt, it specifies a fixed periodic payment (dividend). Preferred stock is unlike debt in that it has no maturity date. Because they have a fixed claim on the firm's income that takes precedence over the claim of common stockholders, preferred stockholders are exposed to less risk. Preferred stockholders are not normally given a voting right, although preferred stockholders are sometimes allowed to elect one member of the board of directors. Preferred Stock: Features of Preferred Stock Restrictive covenants including provisions about passing dividends, the sale of senior securities, mergers, sales of assets, minimum liquidity requirements, and repurchases of common stock. Cumulative preferred stock is preferred stock for which all passed (unpaid) dividends in arrears, along with the current dividend, must be paid before dividends can be paid to common stockholders. Noncumulative preferred stock is preferred stock for which passed (unpaid) dividends do not accumulate. Preferred Stock: Features of Preferred Stock (cont.) A callable feature is a feature of callable preferred stock that allows the issuer to retire the shares within a certain period time and at a specified price. A conversion feature is a feature of convertible preferred stock that allows holders to change each share into a stated number of shares of common stock.
Chapter 6 PP
Corporate Bonds A bond is a long-term debt instrument indicating that a corporation has borrowed a certain amount of money and promises to repay it in the future under clearly defined terms. The bond's coupon interest rate is the percentage of a bond's par value that will be paid annually, typically in two equal semiannual payments, as interest. The bond's par value, or face value the amount borrowed by the company and the amount owed to the bond holder on the maturity date. The bond's maturity date the time at which a bond becomes due and the principal must be repaid. Corporate Bonds: Legal Aspects of Corporate Bonds The bond indenture is a legal document that specifies both the rights of the bondholders and the duties of the issuing corporation. Standard debt provisions are provisions in a bond indenture specifying certain record-keeping and general business practices that the bond issuer must follow; normally, they do not place a burden on a financially sound business. Restrictive covenants are provisions in a bond indenture that place operating and financial constraints on the borrower. Corporate Bonds: Legal Aspects of Corporate Bonds (cont.) The most common restrictive covenants do the following: Require a minimum level of liquidity, to ensure against loan default. Prohibit the sale of accounts receivable to generate cash. Selling receivables could cause a long-run cash shortage if proceeds were used to meet current obligations. Impose fixed-asset restrictions. The borrower must maintain a specified level of fixed assets to guarantee its ability to repay the bonds. Constrain subsequent borrowing. Additional long-term debt may be prohibited, or additional borrowing may be subordinated to the original loan. Subordination means that subsequent creditors agree to wait until all claims of the senior debt are satisfied. Limit the firm's annual cash dividend payments to a specified percentage or amount. Corporate Bonds: Legal Aspects of Corporate Bonds (cont.) Subordination in a bond indenture is the stipulation that subsequent creditors agree to wait until all claims of the senior debt are satisfied. Sinking fund requirements are a restrictive provision often included in a bond indenture, providing for the systematic retirement of bonds prior to their maturity. A trustee is a paid individual, corporation, or commercial bank trust department that acts as the third party to a bond indenture and can take specified actions on behalf of the bondholders if the terms of the indenture are violated. Corporate Bonds: Cost of Bonds to the Issuer In general, the longer the bond's maturity, the higher the interest rate (or cost) to the firm. In addition, the larger the size of the offering, the lower will be the cost (in % terms) of the bond (Flotation Costs). Also, the greater the default risk of the issuing firm, the higher the cost of the issue. Finally, the cost of money in the capital market is the basis form determining a bond's coupon interest rate. Corporate Bonds: General Features of a Bond Issue A call feature, which is included in nearly all corporate bond issues, gives the issuer the opportunity to repurchase bonds at a stated call price prior to maturity. The call price is the stated price at which a bond may be repurchased, by use of a call feature, prior to maturity. The call premium is the amount by which a bond's call price exceeds its par value. Corporate Bonds: General Features of a Bond Issue (cont.) In general, the call premium is equal to one year of coupon interest and compensates the holder for having it called prior to maturity. Furthermore, issuers will exercise the call feature when interest rates fall and the issuer can refund the issue at a lower cost. Issuers typically must pay a higher rate to investors for the call feature compared to issues without the feature. Corporate Bonds: General Features of a Bond Issue (cont.) The conversion feature of convertible bonds allows bondholders to change each bond into a stated number of shares of common stock. Bondholders will exercise this option only when the market price of the stock is greater than the conversion price. Bonds also are occasionally issued with stock purchase warrants, which are instruments that give their holders the right to purchase a certain number of shares of the issuer's common stock at a specified price over a certain period of time. Occasionally attached to bonds as "sweeteners." Including warrants typically allows the firm to raise debt capital at a lower cost than would be possible in their absence. Focus on Ethics Can We Trust the Bond Raters? Credit-rating agencies evaluate and attach ratings to credit instruments (e.g, bonds). Historically, bonds that received higher ratings were almost always repaid, while lower rated more speculative "junk" bonds experienced much higher default rates. Recently, the credit-rating agencies have been criticized for their role in the subprime crisis. The agencies attached ratings to complex securities that did not reflect the true risk of the underlying investments. What effect will the new legislation likely have on the market share of the largest rating agencies? How will the new legislation affect the process of finding ratings information for investors? Corporate Bonds: International Bond Issues Companies and governments borrow internationally by issuing bonds in two principal financial markets: A Eurobond is a bond issued by an international borrower and sold to investors in countries with currencies other than the currency in which the bond is denominated. In contrast, a foreign bond is a bond issued in a host country's financial market, in the host country's currency, by a foreign borrower. Both markets give borrowers the opportunity to obtain large amounts of long-term debt financing quickly, in the currency of their choice and with flexible repayment terms. Valuation Fundamentals Valuation is the process that links risk and return to determine the worth of an asset. There are three key inputs to the valuation process: Cash flows (returns) Timing A measure of risk, which determines the required return Starting from here, you will need to understand and get yourself familiar about all the following calculations Basic Valuation Model The value of any asset is the present value of all future cash flows it is expected to provide over the relevant time period. The value of any asset at time zero, V0, can be expressed as where Bond Valuation: Bond Fundamentals As noted earlier, bonds are long-term debt instruments used by businesses and government to raise large sums of money, typically from a diverse group of lenders. Most bonds pay interest semiannually at a stated coupon interest rate, have an initial maturity of 10 to 30 years, and have a par value of $1,000 that must be repaid at maturity. Bond Valuation: Basic Bond Valuation The basic model for the value, B0, of a bond is given by the following equation: Where Bond Valuation: Basic Bond Valuation (cont.) Mills Company, a large defense contractor, on January 1, 2016, issued a 10% coupon interest rate, 10-year bond with a $1,000 par value that pays interest annually. Investors who buy this bond receive the contractual right to two cash flows: (1) $100 annual interest (10% coupon interest rate $1,000 par value) at the end of each year, and (2) the $1,000 par value at the end of the tenth year. Assuming that interest on the Mills Company bond issue is paid annually and that the required return is equal to the bond's coupon interest rate, I = $100, rd = 10%, M = $1,000, and n = 10 years. Bond Valuation: Basic Bond Valuation (cont.) Bond Valuation: Basic Bond Valuation (cont.) Bond Valuation: Bond Value Behavior In practice, the value of a bond in the marketplace is rarely equal to its par value. Whenever the required return on a bond differs from the bond's coupon interest rate, the bond's value will differ from its par value. The required return is likely to differ from the coupon interest rate because either (1) economic conditions have changed, causing a shift in the basic cost of long-term funds, or (2) the firm's risk has changed. Increases in the basic cost of long-term funds or in risk will raise the required return; decreases in the cost of funds or in risk will lower the required return. Bond Valuation: Bond Value Behavior (cont.) Bond Valuation: Bond Value Behavior (cont.) Bond Valuation: Bond Value Behavior (cont.) Bond Valuation: Bond Value Behavior (cont.) Bond Concepts Bond prices and market interest rates move in opposite directions. When coupon rate = YTM, price = par value When coupon rate > YTM, price > par value (premium bond) When coupon rate < YTM, price < par value (discount bond) Figure 6.4 Bond Values and Required Returns Yield to Maturity (YTM) The yield to maturity (YTM) is the rate of return that investors earn if they buy a bond at a specific price and hold it until maturity. (Assumes that the issuer makes all scheduled interest and principal payments as promised.) The yield to maturity on a bond with a current price equal to its par value will always equal the coupon interest rate. When the bond value differs from par, the yield to maturity will differ from the coupon interest rate. Personal Finance Example The Mills Company bond, which currently sells for $1,080, has a 10% coupon interest rate and $1,000 par value, pays interest annually, and has 10 years to maturity. What is the bond's YTM? Personal Finance Example (cont.) Personal Finance Example (cont.) Yield to Maturity (YTM): Semiannual Interest and Bond Values The procedure used to value bonds paying interest semiannually is similar to that shown in Chapter 5 for compounding interest more frequently than annually, except that here we need to find present value instead of future value. It involves Converting annual interest, I, to semiannual interest by dividing I by 2. Converting the number of years to maturity, n, to the number of 6-month periods to maturity by multiplying n by 2. Converting the required stated (rather than effective) annual return for similar-risk bonds that also pay semiannual interest from an annual rate, rd, to a semiannual rate by dividing rd by 2. Yield to Maturity (YTM): Semiannual Interest and Bond Values (cont.) Assuming that the Mills Company bond pays interest semiannually and that the required stated annual return, rd is 12% for similar risk bonds that also pay semiannual interest, substituting these values into the previous equation yields Yield to Maturity (YTM): Semiannual Interest and Bond Values (cont.) Assuming that the Mills Company bond pays interest semiannually and that the required stated annual return, rd is 12% for similar risk bonds that also pay semiannual interest, substituting these values into the previous equation yields Yield to Maturity (YTM): Semiannual Interest and Bond Values (cont.) Bond Valuation: Bond Value Behavior (cont.) Interest rate risk is the chance that interest rates will change and thereby change the required return and bond value. Rising rates, which result in decreasing bond values, are of greatest concern. The shorter the amount of time until a bond's maturity, the less responsive is its market value to a given change in the required return. Interest Rates and Required Returns: Interest Rate Fundamentals The interest rate is usually applied to debt instruments such as bank loans or bonds; the compensation paid by the borrower of funds to the lender; from the borrower's point of view, the cost of borrowing funds. The required return is usually applied to equity instruments such as common stock; the cost of funds obtained by selling an ownership interest. Interest Rates and Required Returns: Interest Rate Fundamentals Several factors can influence the equilibrium interest rate: Inflation, which is a rising trend in the prices of most goods and services. Risk, which leads investors to expect a higher return on their investment Liquidity preference, which refers to the general tendency of investors to prefer short-term securities Interest Rates and Required Returns: Nominal or Actual Rate of Interest (Return) The nominal rate of interest is the actual rate of interest charged by the supplier of funds and paid by the demander. The nominal rate differs from the real rate of interest, r* as a result of one factor: Inflationary expectations reflected in an inflation premium (IP) (1 + R) = (1 + r ) (1 + h) R is nominal interest rate r is real interest rate h is inflation rate Term Structure of Interest Rates The term structure of interest rates is the relationship between the maturity and rate of return for bonds with similar levels of risk. A graphic depiction of the term structure of interest rates is called the yield curve. The yield to maturity is the compound annual rate of return earned on a debt security purchased on a given day and held to maturity. Term Structure of Interest Rates: Yield Curves (cont.) A normal yield curve is an upward-sloping yield curve indicates that long-term interest rates are generally higher than short-term interest rates. An inverted yield curve is a downward-sloping yield curve indicates that short-term interest rates are generally higher than long-term interest rates. A flat yield curve is a yield curve that indicates that interest rates do not vary much at different maturities. Matter of Fact Bond Yield Hits Record Lows On July 25, 2012, the 10-year Treasury note and 30-year Treasury bond yields reached all-time lows of 1.43% and 2.46%. That was good news for the housing market. Many mortgage rates are linked to rates on Treasury securities. For example, the traditional 30-year mortgage rate is typically linked to the yield on 10-year Treasury notes. With mortgage rates reaching new lows, potential buyers found that they could afford more expensive homes, and existing homeowners were able to refinance their existing loans, lowering their monthly mortgage payments and leaving them with money to spend on other things. This kind of activity is precisely what the Federal Reserve hoped to stimulate by keeping interest rates low during the economic recovery. Term Structure of Interest Rates: Theories of Term Structure Expectations Theory Expectations theory is the theory that the yield curve reflects investor expectations about future interest rates; an expectation of rising interest rates results in an upward-sloping yield curve, and an expectation of declining rates results in a downward-sloping yield curve. Term Structure of Interest Rates: Theories of Term Structure (cont.) Liquidity Preference Theory Liquidity preference theory suggests that long-term rates are generally higher than short-term rates (hence, the yield curve is upward sloping) because investors perceive short-term investments to be more liquid and less risky than long-term investments. Borrowers must offer higher rates on long-term bonds to entice investors away from their preferred short-term securities. Term Structure of Interest Rates: Theories of Term Structure (cont.) Market Segmentation Theory Market segmentation theory suggests that the market for loans is segmented on the basis of maturity and that the supply of and demand for loans within each segment determine its prevailing interest rate; the slope of the yield curve is determined by the general relationship between the prevailing rates in each market segment. Risk Premiums: Issue and Issuer Characteristics
Equity
Funds provided by the firm's owners (investors or stockholders) that are repaid subject to the firm's performance Firm can obtain equity either internally, by retaining earnings rather than paying them out as dividends to its stockholders Externally by selling common or preferred stock Voice in management - yes Claims on income and assets - subordinate to debt Maturity - none tax treatment - no deduction
Bond features
Purpose of a bond indenture - the contract between a bond holer and the issuer Basic features maturity, pav value, co
Debt
all borrowing incurred by a firm, including bonds, and is repaid according to a fixed schedule of payments. Voice in management - no Claims on income and assets - senior to equity Maturity - stated tax treatment - interest deduction Debt holders do not have voting rights but instead they rely on the firm's contractual obligations to them to by their voice.
Theories on term structure
3 theories Expectations theory - yield curve reflects investor expectations about future interest rates, an expectation of rising interest rates results in an upward sloping yield curve, and an expectation of declining rates results in a downward sloping yield curve. When investors expect short term interest rates to rise in the figure (because investors believe that inflation will rise in the future) today's long term rates will be higher than current short term rates and the yield curve will be upward sloping. The opposite is true when investors expect declining short term rates. Today's short term rates will be higher than current long term rates and the yield curve will be inverted. (page 218) Liquidity preference theory - theory suggesting that long term rates are generally higher than short term rates *yield curve is upward sloping) because investors perceive short term investments to be more liquid and less risky than long term investments. Borrowers must offer higher rates on long term bonds to entice investors away from their preferred short term securities. For investors short term securities are attractive because they are highly liquid and their prices are not particularly volatile. Investors will accept somewhat lower rates on short-term bonds because they are less risky than long term bonds. When firms or governments want to lock in their borrowing costs for a long period of time by selling long term bonds, those bonds have to offer higher rates to entice investors away from the short term securities that they prefer. Borrowers are willing to pay somewhat higher rates because long term debt allows them to eliminate or reduce the risk of not being able to refinance short term debts when they come due. Borrowing on a long term basis also reduces uncertainty about future borrowing costs. Market segmentation theory - the market for loans is totally segmented on the basis of maturity and that the supply of and demand for loans within each segment determine its prevailing interest rate. The equilibrium between suppliers and demanders of short term funds such as seasonal business loans would determine prevailing short term interest rates and the equilibrium between suppliers and demanders of long term funds such as real estate loans would determine prevailing long term interest rates. The slope of the yield curve would be determined by the general relationship between the prevailing rates in each market segment. An upward sloping yield curve indicates greater borrowing demand relative to the supply of funds in the long term segment of the debt market relative to the short term segment. All three theories have merit. We can conclude that at any time the slope of the yield curve is affected by interest rate expectations, liquidity preferences, and the comparative equilibrium of supply and demand in the short term and long term market segments. Upward sloping yield curves
Homework ch 7
The maximum number of new shares of common stock that a firm can sell without receiving further authorization is equal to the number of shares authorized by the charter minus the number of shares currently outstanding. -To be able to find out if the firm is able to riase the needed funds without receiving further authorization, you first need to compute the total number of shares needed using the formula; total number of shares needed = total amount of funds need / price per share. If the total number of shares needed is greater than the maximum number of new shares, then the firm requires an additional authorization of shares to raise the necessary funds at the current stock price. *The firm must amend its corporate charter to authorize the issuance of additional shares. Preferred stockholders have preference over common stockholders in the distribution of earnings. Most preferred stock is cumulative with respect to any dividends passed. All dividends in arrears, along with the current dividends, must be paid before dividends can be paid to common stockholders. Dcumulative = number to pay * dividend OR Dcumulaive = number to pay * rate * par You should buy the stock if the value is greater than the offering price otherwise the stock is overpriced and you should not buy it. TH\he offering price is higher than estimated value, the stock is overvalued and you should not buy it. Price is a function of the current dividend, expected dividend growth rate, and the risk-free rate, and the company specific risk premium. Craft lowering of the dividend growth rate reduced future cash flows resulting in a reduction in share price. The decrease in risk premium reflected a reduction in risk leading to an increase in share price.
Homework things
The term structure of interest rates is the relationship between the maturity and rate of return for bonds with similar levels of risk. A graph of this relationship is called the yield curve. A quick glance at the yield curve tells analysts how rates vary between short medium and long term bonds but it may also provide information on thwere interest rates and the economy in general are headed in the future. A downward sloping yield curve indicates that short term interest rates are generally higher than long term interest rates an upward sloping yield curve indicates that long term interest rates are generally higher than short term interest rates and a flat yield curve indicates that interest rates do not vary much at different maturities. The yield curve is slightly downward sloping reflecting lower expected future interest rates. THe curve may reflect a general expectation for an economic recovery due to inflation coming under control and a stimulating impact on the economy from the lower rates. A slowing economy may diminish the perceived need for funds and the resulting interest rate being paid for cash. The fact that the yield curve might indicate more than one possibles scenario highlights the challenge of forecasting the future based on the term structure of interest rates. *yield curve is downward sloping indicating that the interest rates are expected to be lower in the long term. Dollar amount of interest per bond is the annual interest payment; annual interest payment = (annual coupon rate * par value of the bond) -A coupon bond sells at discount to its par value when the coupon rate is less than the required rate of return -A coupon bond sells its par value when the coupon rate equals the required rate of return. -A coupon bond sells at a premium to its par value when the coupon rate is greater than the required rate of return. The market value of the bond approaches its par value as the time to maturity declines. THe yield to maturity approaches the coupon interest rate as the time to maturity declines. The greater the length of time to maturity the more responsive the market value of the bond is to returns and vice versa. Minimize interest rate risk in the future, choose shorter maturity. Any change in interest rates will impact the market value of bond a than bond b.
nominal rate of interest
the actual rate of interest charged by the supplier of funds and paid by the demander. When people save money and invest it, they are sacrificing consumption today (spending less than they could) in return for higher future consumption. When investors expect inflation to occur, the believe that the price of consuming goods and services will be higher in the future than in the present. They will be reluctant to sacrifice today's consumption unless the return they can earn on on the money they save or invest will be high enough to allow them to purchase the goods and services they desire at a higher future price. Investors demand a higher nominal rate of return if they expect inflation. The additional return that investors require to compensate them for inflation is called the expected inflation premium (IP) Investors generally demand higher rates of return on risky investments as compared to safe ones, little incentive for investors to bear the risk. Investors will demand a higher nominal rate of return on risky investments. The more they expect, the higher will be the inflation premium, and the higher will be the nominal interest rate. Three month treasury bills (t-bills) are short-term IOUs are widely regarded as the safest investment in the world. They are as close as we can get in the real world to a risk-free investment. To estimate real rate of interest, analysts typically try to determine what rate of inflation investors expect over the coming 3 months. The subtract the expected inflation rate from the nominal rate on the 3 month t-bill to arrive at the underlying real rate of interest. the expected inflation represents the average rate of inflation over the life of an investment it is not the rate of inflation experienced over the immediate past, although investors inflation expectations are undoubtedly influenced by the rate of inflation that has occurred in the recent past.
Yield curves
yield curve - graphic depiction of the term structure of interest rates yield to maturity (YTM) the compound annual rate of return earned on a debt security purchased on a given day and held to maturity. Yield curve - yield to maturity is plotted on the vertical axis and time to maturity is plotted on the horizontal axis. Inverted yield curve - downward sloping yield curve indicates that short term interest rates are generally short term interest rates are generally higher than long term interest rates Normal yield curve - upward sloping yield curve indicates that long term interest rates are generally higher than short term interest rates flat yield curve - indicates that interest rates do not vary much at different maturities.
