chapter 10 bonds and stocks: characteristics and valuation © 2000 john wiley & sons, inc

Chapter 10

Bonds and Stocks:Bonds and Stocks:

Characteristics and ValuationCharacteristics and Valuation

© 2000 John Wiley & Sons, Inc.

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Chapter Outcomes

• Identify the major sources of external long-term financing for corporations.

• Describe major characteristics of corporate bonds.

• Describe major characteristics of common stock.

• Describe major characteristics of preferred stock.

• Explain how financial securities such as stocks and bond, are valued.

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What is a financial asset?

A claim against the income or assets of an individual, business, or government.

Examples:

Shares of stock

Home Mortgage

Car Loan

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Long-term Financing Sources for Business

New security issues 1996 1997

Corp Bonds 82% 85%

Corp Stocks 18 16

Bonds

Public 85% 84%

Private na na

Sold abroad 15% 16%

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In addition to retained earnings, businesses can raise funds by:

Selling shares (external equity)

Issue debt (bonds)

Funds can be raised publicly or privately

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History Shows….

Internal/external financing varies over the business cycle

Common stock is a major source of external equity

Bonds are a major source of long-term external financing–cheaper than equity–bonds mature

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And Overseas Financing is Rising...

More real assets are overseas for U.S.-based firms

At times, financing costs are lower overseas

No costly SEC process Large issue sizes require a global

marketplace

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Debt Capital

A contract between borrower/lender Bankruptcy/reorganization threat if

contract is violated Priority claim on assets, cash flow Less return potential than equity Little/no voice in management

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General Terms Associated with Debt:

Par value or Face Value Coupon Rate Coupon PaymentAnnual coupon = coupon rate x par value Registered versus Bearer bonds

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Bond Covenants

Impose restrictions or extra duties on the firm

Protect bondholder stake in the firm

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Bond Rating ExamplesSTANDARD DUFF &

MOODY’S& POOR’S PHELPS

Aaa AAA 1 Best quality, least credit risk

Aa1 AA+ 2 High quality, slightly more risk

Aa2 AA 3 than a top-rated bond

Aa3 AA– 4

A1 A+ 5 Upper-medium grade, possible future

A2 A 6 credit quality difficulties

A3 A– 7

Baa1 BBB+ 8 Medium quality bonds

Baa2 BBB 9

Baa3 BBB– 10

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Junk Bonds

STANDARD DUFF &

MOODY’S& POOR’S PHELPS

Ba1 BB+ 11 Speculative issues, greater

Ba2 BB 12 credit risk

Ba3 BB– 13

B1 B+ 14 Very speculative, likelihood of

B2 B future default

B3 B–

Caa CCC Highly speculative, either in

Ca CC or high likelihood of going

C C into default

D

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Bond Ratings

Measure likelihood of default; influenced by level of investor protection in the covenants

Acts as a market signal Lower rating==>Higher risk==>

Higher coupon rate

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Security Features

Collateralized Bond (e.g., CMO) Mortgage Bond Equipment Trust Certificate Debentures Subordinated Debentures

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Other Features of Bonds

Convertible bonds Callable bonds Putable bonds Extendable bonds Securitization Inflation protection (U.S. gov’ts)

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Global Bond Market

Eurodollar bonds

Yankee bonds

Global bonds

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Reading Bond Quotes

Cur Net

Bond Yld Vol Close Chg

AT&T 8 1/8 22 7.6 216 1063/4 –3/8

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Corporate Equity Capital

Represents ownership Certificate versus street name

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Common Stock

Owners of the firm Select Directors Dividends: when declared Lowest priority in bankruptcy Par value--meaningless Different classes to protect control

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Preferred Stock

“Preferred” over common stock with a senior claim on earnings, assets

Fixed dividend; par value is important!

Usually non-voting

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Other Features

Cumulative versus non-cumulative

Callable

Convertible

Tax Advantage

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Reading a Stock Quote

52 weeks Yld

Hi Lo Stock Sym Div %

50 1/2 25 1/8 AFLAC AFL 0.26 0.5

Vol Net

PE 100s Hi Lo Close chg

20 7063 49 1/4 47 9/16 47 5/8 -1 3/8

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Valuation Principles

Basic concept:

Price of an asset =

Present value of future expected cash flows

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In equation form:

price =

[(CF1)/(1+r)1] + [(CF2)/(1+r)2] + ... +

[(CFn)/(1+r)n ] (equation 10.1)

or

price = [CFt/(1+r)t ] (equation 10.1a)

t=1,n

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price = [CFt/(1+r)t ] (equation 10.1a)

t=1,n

Inputs: Cash flows CFt

Discount rate r

Number of time periods n These are easier to determine for

bonds than for stocks

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Bond Valuation

price= PV (expected future cash flows)

= PV (coupon payments) + PV (principal) price=[C1/(1+rb)1] + [C2/(1+rb)2] + ... +

[Cn/(1+rb)n] + [Parn/(1+rb)n]

(10.2) = [Ct/(1+rb)t] + [Parn/(1+rb)n ] (10.2a)

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An example $1,000 par value, Coupon rate 9% paid

once per year, 10 years until maturity Investors require 9% return

$90 x 6.418 = $577.62

$1,000 x 0.422 = 422.00

Bond value = $999.62

(not equal to $1000 because of interest factor rounding)

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If required return rises to 10%:

$90 x 6.145 = $553.05

$1,000 x 0.386= 386.00

Bond value = $939.05 If required return falls to 8%:

$90 x 6.710 = $603.90

$1,000 x 0.463 = 463.00

Bond value = $1,066.90

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The Seesaw Effect

Required rate of return (the market interest rate) rises…bond prices fall

Interest rate = 9% price = $1000

Interest rate = 10% price = $939 Required rate of return falls, bond

prices rise

Interest rate = 8% price = $1067

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Finding the required return if we know the price...

Approximate yield to maturity

= Annual interest + (par – price)/n

(par + price/2) (10.3) Spreadsheet functions Financial calculator

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If coupons are paid semi-annually (twice a year):

In this case, r is the semi-annual discount rate, not an annual discount rate

EAR = YTM = (1 + r)2 – 1 Rearranging, we can solve for the

periodic interest rate r:

r = (1 + YTM)1/2 – 1 Approximation: YTM = 2 x r n = # of years until maturity x 2

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A bond will sell for a higher price if:

Higher coupons (higher coupon rates)

More frequent coupon payments lower required rate of return r

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Risks in Bond Investing

Credit risk (default risk) Interest rate risk (seesaw effect) Reinvestment rate risk Special risks for non-domestic

bonds: Political risk Exchange rate risk

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Valuation of Stocks

Same principal:

Price = Present Value of expected future cash flows

But tougher to apply than with bonds: indefinite life cash flows (dividends) uncertain discount rate hard to determine

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We handle these difficulties by making simplifying assumptions

Constant dividends over time (e.g., preferred stock)

P0 = D0/rs

P0 = $2.00/0.10 = $20.00

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Or constant growth in dividends over time:

P0 = D0(1 + g)

rs – g Today’s dividend = $1.89; g = 8.5%;

rs = 12%

P0 = 1.89 (1+0.085) = $58.57

.12 – .085

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Risks in Stock Valuation

Uncertainty over future dividend changes, growth changes

Changing market/investor expectations for firms, the economy

Changing interest rates

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Learning Extension 10ACalculating Rates of Return

Over a Holding Period

Dollar return = Income received + price change

Percent return =

Dollar return/initial price Receive $2 in income, buy for $25, sell

for $30:Dollar return = $2 + ($30-$25) = $7

Percent return = $7/$25 = 0.28 or 28%

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Annualizing a Return

Annualized return =

(1 + percent return)1/n - 1where n is the number of years the

asset was held or owned

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Two examples: you earn 28% over a holding period

If the holding period is 2 years:

Annualized return =

(1 + .28)1/2 - 1 = 13.1 percent If the holding period is 9 months:

Annualized return =

(1 + .28)1/.75 - 1 = (1.28)4/3 - 1 = 0.389 or 38.9 percent