VALUATION

AND
CHARACTERISTICS
OF
BONDS
CHAPTER 7
 TYPES OF BOND

– A bond is a type of debt or long-term promissory note, issued by the borrower,

promising to pay its holder a predetermined and fixed amount of interest per year.
Just to mention a few, we have:
o Debentures
o Subordinated Debentures
o Mortgage Bonds
o Eurobonds
o Zero and Very Low Coupon Bonds
o Junk Bonds
o Convertible Bonds
 TYPES OF BONDS DEFINITION CHARACTERISTICS
1. DEBENTURES • Applied to any unsecured long-term  Unsecured bonds that only
debt. creditworthy firms can issue.
2. SUBORDINATED • A debenture that is subordinated to  Claims are not satisfied until of
DEBENTURES other debentures in terms of its those of the creditors holding
payments in case of insolvency. certain (senior) debts have been
fully satisfied.
3. MORTGAGE BONDS • Is a bond secured by a lien on real  Secured by real estate or
property. buildings.
4. EUROBONDS • Bonds issued in a country different from  Usually in dollar-denominated
the one in whose currency the bond is bond.
denominated.  The bond is denominated based
on the issuing country’s
currency.
5. ZERO AND VERY LOW • Allow the issuing firm to issue bonds at  Issued with no (zero) or a very
COUPON BONDS a substantial discount from their $1000 low coupon (stated interest) rate
face value with a zero or very low and sold at a large discount from
coupon rate. par.
 TYPES OF BONDS DEFINITION CHARACTERISTICS
6. JUNK BONDS • It is also called high-yield bonds.  Usually yields to three and five
• It is a high-risk debt with ratings of BB or percent interest rate more AAA
below which makes the firms have a rate long term debt.
higher chance of default if they are
issued by it which makes the issuing
firms or the “fallen angles” have a
higher chance of default.
7. CONVERTIBLE BONDS • It is debt security that can be converted  These bond will only realize on
into a firm’s stock at a prespecified the investor’s choice of
price. converting the par value of a
debt security into share of
common stocks.
 TERMINOLOGIES OF
BONDS
Some of the more important terms and characteristics that you might hear about
bonds are as follows:
• CLAIMS ON ASSETS AND INCOME
-Claims of debt including bonds are generally honored before those of
both common stock and preferred stock in case of inventory.

• PAR VALUE
-The face value that is returned to the bondholder at maturity.

• COUPON INTEREST RATE

-The interest rate contractually owed on a bond as a percent of its par
value.
• MATURITY
-It indicate the length of time until the bond issuer returns the par value to
the bondholder and terminates the bond.

• INDENTURES
-The legal agreement between the firm issuing the bonds and the bond
trustee who represents the bondholders providing the specific items of the loan
agreement.

• CALL PROVISION
-It is also called callable or (redeemable bond) an option available to a
company issuing a bond whereby the issuer can call or redeem the bond before
it matures.
- This is usually done if interest rates decline below what the firm is paying
on the bond.
• BOND RATINGS
-Involve a judgment about the future risk potential of
the bond.
-AAA, AA, A, BBB, BB, B, CCC, CC, C, D

 Moody’s and Standard and Poors regularly monitors issuers’

financial conditions and assign a rating to the debt. Bond rating
shows the relative probability of default.
 DEFINITION OF VALUE

• Book value
- It is the value of an asset as shown on a firm’s balance sheet.
- It represents the historical cost of the asset rather that its current market value.
• Liquidation value
- It is the dollar sum that could be realized if an asset were sold.
• Market value
- It is the value observed in the marketplace.
• Intrinsic / Economic value
- It is the present value of the asset’s expected for future cash flows.
- This value is the amount considered by the investor as the fair value given the amount,
timing and riskiness of future cash flows.
• Fair value
-The present value of asset’s expected future cash flows.
 DETERMINANTS OF
VALUE
1. The amount and timing of the asset’s
expected cash flows
2. The riskiness of these cash flows
3. The investor’s required rate of return for
undertaking the investment
A Concept Map of the Determinants
of Value
BOND VALUATION
*Derivation into “Easier”
Bond Valuation Formula
EXAMPLE:
(Bonds with annual coupons)
The WSJ lists a bond as Acme 9s13 and the price as 89.875. If your
required rate of return is 10%, would you buy one of these bonds in 2001?

You should buy it. 

EXAMPLE:
(Bonds with semiannual
coupons)
CONTINUATION…

TABLE OF DATA:
 THE BOND HOLDER’S
EXPECTED RATE OF RETURN
(YIELD TO MATURITY)
To measure the bondholder's expected rate of return (kb), we would find the
discount rate that equates the present value of the future cash flows. The expected
rate of return for a bond is also the rate of return the investor will earn if the bond
is held to maturity, or the yield to maturity. Thus, when referring to bonds, the
terms expected rate of return and yield to maturity are often used interchangeably.

or,
EXAMPLE:
Finding the Yield to Maturity
(kb or Y)
 5 IMPORTANT
RELATIONSHIPS OF
BOND VALUATION
 1st Relationship:
Inverse Relationship
“As interest rates increase (decrease), the value of
the bond decreases (increases).”
 2nd Relationship
“The market value of a bond will be less than the par value if
the investor's required rate is above the coupon interest rate;
but it will be valued above par value if the investor's required
rate of return is below the coupon interest rate.”
 3rd Relationship:
“Market value approaches par value as maturity date
approaches.”
Bond Values Over Time

$1,200.00
$1,167.68

$1,100.00
Bond Value

k = 10%
$1,000.00 0 k = 8%
1
2
3 k = 6%
4
6 5
$900.00 8 7
$863.73 10 9
$870.10

$800.00
12 11 10 9 8 7 6 5 4 3 2 1 0
Time to Maturity
 4th Relationship:
Interest Rate Risk

“Long-term bonds have greater interest rate risk than

do short-term bonds.”
 5th Relationship
“The sensitivity of a bond's value to changing interest rates
depends not only on the length of time to maturity, but also
on the pattern of cash flows provided by the bond.”
STOCK
VALUATION

CHAPTER 8
 PREFERRED STOCK

– It is often referred to as a hybrid security because it has many characteristics of

both common stocks and bonds.
– Preferred Stock is similar to common stock in that:
1. It has no fixed maturity date. (perpetuity)
2. If the firm fails to pay dividends, it does not bring on bankruptcy.
3. Dividends are not deducted for tax purposes.
- Preferred stock is similar to bonds in that:
1. Dividends are fixed in amount.
 FEATURES AND TYPES
OF PREFERRED STOCK
1. MULTIPLE CLASSES – a company can issue more than one series of preferred
stock, and each series can have different characteristics. These issues can be
differentiated in that some are convertible into common stock and others are
not, and they have varying protective provisions in the event of bankruptcy.
2. CLAIM ON ASSETS AND INCOME
• Claim on Income – Cannot be paid until the claims of all creditors have been
satisfied.
• Claim on Assets – Secondary to the claims of creditors. If the firm fails, its
assets are sold and the proceeds are distributed in a specified order:
employees and customers, the government, creditors, then equity holders.
3. CUMULATIVE DIVIDENDS – Requires all past unpaid preferred stock dividends to be
paid before any common stock dividends are declared.
4. PROTECTIVE PROVISIONS – Generally allow for voting rights in the event of non-
payment of dividends, or they restrict the payment of common stock dividends if sinking-
fund payments are not met or if the firm is in financial difficulty.
5. CONVERTIBILITY – It allows the preferred stockholder to convert the preferred stock
into a predetermined number of shares of common stock, if he/she so chooses.
6. ADJUSTABLE RATE PREFERRED STOCK – It is developed to provide investors with
some protection against wide swings in principal that occur when interest rates move up
and down.
7. PARTICIPATION – It allows the stockholder to participate in earnings beyond
the payment of the stated dividend.
8. PIK PREFERRED – Investors receive no dividends initially, they merely get more
preferred stock, which in turn pays dividends in even more preferred stock.
9. RETIREMENT FEATURES
• Call Provision – Lets the company buy its preferred stock back from the
investors, usually at a premium price above the stock’s par value.
• Sinking Fund – Requires the firm periodically to set aside an amount of money
for the retirement of its preferred stock. This money is the used to purchase the
preferred stock in the open market or through the use of the call provision,
whichever method is cheaper.
 Valuing Preferred Stock

As already explained, the owner of preferred stock generally

receives a constant income from the investment in each period.
However, the return from preferred stock comes in the form of
dividends rather than interest. In addition, whereas bonds generally
have a specific maturity date, most preferred stocks are perpetuities
(non-maturing). In this instance, finding the value (present value) of
preferred stock, Vps, with a level cash flow stream continuing
indefinitely, may best be explained by an example.
Example:

What will be the yield on XYZ’s preferred stock if

the company has promised annual dividend of
$1.20 per share and each share is currently selling
for $32.50?
Example:

Valuing Preferred Stock

Consider Con Edison’s (ED) preferred stock issue, which pays an
annual dividend of $5.00 per share, does not have a maturity date,
and on which the market’s required yield or promised rate of return
(rps) for similar shares of preferred stock is 6.02%. What is the value
of the Con Edison preferred stock?
 COMMON STOCK

- Represents ownership in the corporation.

- A certificate that indicates the ownership in a corporation.
- Common stock does not have a maturity date but exists as long as the firm
does.
 CHARACTERISTICS OF
COMMON STOCK

1. CLAIM ON INCOME – This income may be paid directly to the shareholders in the
form of dividends or retained and reinvested by the firm.
2. CLAIM ON ASSETS – This residual claim on assets adds to the risk of common
stock.
3. VOTING RIGHTS – The common shareholders elect the board of directors and are
in general the only security holders given a vote.
• Proxy – Gives a designated party the temporary power of attorney to vote for the
signee at the corporation’s annual meeting.
• Proxy Fights – When rival groups compete for proxy votes in order to control the
decision made in a stockholders meeting.
4. PREEMPTIVE RIGHTS – The right of a common shareholder to maintain a proportionate
share of ownership in the firm when new shares are issued, common shareholders have
the first right of refusal.
• RIGHTS – Certificate issued to shareholders giving them an option to purchase a stated
number of new shares of stock at a specified price during a 2 to 10 week period.
5. LIMITED KIABILITY - Although the common shareholders are the actual owners of the
corporation, their liability in the case of bankruptcy is limited to the amount of their
investment.
 VALUING COMMON
STOCK
Like both bonds and preferred stock, a common stock's value is equal to the
present value of all future cash flows expected to be received by the stockholder.
However, in contrast to bonds, common stock does not promise its owners interest
income or a maturity payment at some specified time in the future. Nor does
common stock entitle the holder to a predetermined constant dividend, as does
preferred stock. For common stock, the dividend is based on:
1. The profitability of the firm
2. On management's decision to pay dividends or to retain the profits to grow the
firm.
 THE GROWTH FACTOR IN
VALUING COMMON STOCK

A company can grow in a variety of ways. It can become larger

by borrowing money to invest in new projects. Likewise, it can issue
new stock for expansion. Management could also acquire another
company to merge with the existing firm, which would increase the
firm's assets. In all of these cases, the firm is growing through the use
of new financing, by issuing debt or common stock.
Formula:

Vcs = Value of a share of common stock

D0 = Annual cash dividend in the year of valuation (paid already)
g = annual growth rate in the dividend
rcs = the common stockholder’s required rate of return
Example:

Valuing Common Stock

Consider the valuation of a share of common stock that paid a $2
dividend at the end of last year and is expected to pay a cash
dividend every year from now to infinity. Each year, the dividends are
expected to grow at a rate of 10%. Based on an assessment of the
riskiness of the common stock, the investor’s required rate of return
is 15%. What is the value of this common stock?
 STOCKHOLDER’S EXPECTED
RATE OF RETURN

As stated in Chapter 7, the expected rate of return on a bond

is the return the bondholder expects to receive on the investment by
paying the existing market price for the security. This rate of return is
of interest to the financial manager because it tells the manager
about the investor's expectations, which in turn affects the firm's
cost of financing new projects. The same can be said for the financial
manager needing to know the expected rate of return of the firm's
stockholders.
 THE PREFERRED
STOCKHOLDER'S EXPECTED
RATE OF RETURN
FORMULA:
 For example, if the present market price of preferred stock is
$83.06 and it pays a $5.00 annual dividend, the expected rate of
return implicit in the present market price is:

 Therefore, investors at the margin (who pay $83.06 per share for a
preferred security that is paying $5.00 in annual dividends) are expecting
a 6.02 percent rate of return.
 THE COMMON
STOCKHOLDER’S EXPECTED
RATE OF RETURN

FORMULA: