Bonds and Stocks: Valuation and Features - Prof. Steven Mckay Price, Study notes of Finance

Download Bonds and Stocks: Valuation and Features - Prof. Steven Mckay Price and more Study notes Finance in PDF only on Docsity! Chapter 7  Definitions o bonds--debt securities issued by corporations or governments o coupon payment--an interest payment o face/par value--the principal amount of a cong that is repaid at the end of the term o coupon rate--the annual coupon divided by the face value of a bond (interest rate) o maturity date--the specified date on which the principal amount of a bond is paid o yield to maturity (YTM)--the rate required in the market on a bond; the market interest rate for bonds with similar features o discount bonds--bonds that sell for less than face value o premium bonds--bonds that sell for greater than face value  Present value of cash flows--used to estimate a bond's current market value (bond price) o calculate the annuity (coupons) and lump sum (principle) portions separately then add the results together  ex. A company issues $1,000 bonds with 10 years to maturity and an annual coupon of $80. Similar bonds have a YTM of 8%. What would this bond sell for?  lump sum: N=10; I/Y=8; FV=1,000; CPT PV= $463.19 annuity: N=10; I/Y=8; PMT=80; CPT PV= $536.81 + $463.19 = $1,000.00 o When interest rates increase, the present value decreases. Therefore, when interest rates increase, bond prices decrease and vice versa  ex. One year goes by (9 years to maturity) and the market interest rate is now 10%. What is the bond worth?  lump sum: N=9; I/Y=10; FV=1000; CPT PV= $424.10 annuity: N=9; I/Y=10; PMT=80; CPT PV= $460.72 + $424.10 = $884.82 o Conclusion:  If YTM = coupon rate, then par value = bond price  If YTM > coupon rate, then par value > bond price  the discount will provide a yield above the coupon rate, giving investors an initiative to buy the bond  If YTM < coupon rate, then par value < bond price  the higher coupon rate causes the value of the bond to be above par  Interest rate risk--the risk that arises for bond owners from fluctuating interest rates  increases at a decreasing rate o Price risk  All other things being equal, the longer the time to maturity, the greater the interest rate risk  relates to the volatility of the present value of the face value  All other things being equal, the lower the coupon rate, the greater the interest rate risk  the smaller coupon rate makes the value of bond (specifically, the face value) more sensitive to interest rates o Reinvestment rate risk--uncertainty concerning rates at which cash flows can be reinvested  All other things being equal, the shorter the time to maturity, the greater the risk  All other things being equal, the higher the coupon rate, the greater the risk  Computing YTM o done by trial and error without a calculator o with a calculator, require N, PV, PMT, and FV (remember sign conventions!) o Ex. A bond with a price of $928.09 has a 10% annual coupon rate, 15 years to maturity, and a $1,000 face value. What is the YTM?  NOTE: the yield will be greater than the coupon rate because this is a discount bond  N=15; PV=-928.09; PMT=100; FV=1,000; CPT I/Y= 11% o Ex. A bond that sells for $1,107.93 has a 10% coupon rate and semiannual coupons. It has a face value of $1,000 and 20 years to maturity. What is the YTM?  NOTE: the yield will be less than the coupon rate because this is a premium bond  N=20; PV=-1,107.93; P/Y=2; PMT=100/2=50; FV=1,000; CPT I/Y= 8%  Current Yield vs. Yield To Maturity  Bond Pricing Theorems o Bonds of similar risk (and maturity) will be priced to yield about the same return, regardless of the coupon rate o If you know the price of one bond, you can estimate its YTM and use that to find the price of the second bond  indenture--the written agreement between the corporation and the lender detailing the terms of the debt issue  basic terms of the bonds  total amount of bonds issued  description of property used as security  collateral--secured by financial securities  mortgage--secured by real property  seniority  debts can be labeled as senior or junior to indicate seniority  in the event of default, holders of subordinated debt must give preference to other specified creditors  debt cannot be subordinated to equity  repayment arrangements  sinking fund provisions  call provisions--"refinancing" for a new interest rate (good for companies, bad for investors)  details of the protective covenants  Bond classifications  registered form--the form of bond issue in which the registrar of the company records ownership of each bond; payment is made directly to the owner of record  bearer form--the form of bond issue in which the bond is issued without the record of the owner's name; payment is made to whomever holds the bond  debenture (unsecured) bond--an unsecured debt, usually with a maturity of 10 years or more  used when the current dividend paid is known  P0=D1/(R-g)  used when the expected, or next, dividend is known  P0=current price  Do=dividend just paid  D1=dividend paid at the end of period 1  R=required return  g=growth rate  ex. A company just paid a dividend of $0.50. It is expected to increases its dividend by 2% per year. If the market requires a return of 15% on assets of this risk, how much should the stock be selling for?  P0=.50(1+.02)/(.15-.02)=.50(1.02)/(.13)=.51/.13= $3.92  ex. A company is expected to pay a $2.00 dividend in 1 year. The dividend is expected to grow 5% per year and the required rate of return is 20%. What is the price?  P0=2/(.20-.05)=2/.15= $13.33  ex. A company is expected to pay a $4 dividend next period, and dividends are expected to grow at 6% each year. The required return is 16%. What is the price?  P0=4/(.16-.06)= $40.00  ex. (continued from above example) What is the expected price in year 4?  Period 4 is now the initial year, so 4 years is added to the subscripts. (1+g) is raised to the fourth to account for the growth of 4 periods  P4=D4(1+g)/(R+g)=D5/(R+g) P4=4(1+.06)4/(.16-.06)=4(1.2635)/.10=5.0499/.10= $50.50  supernormal growth--dividend growth is not consistent initially, but settles down to constant growth at some point in the future  use the dividend growth model in steps  ex. Suppose a firm is expected to increase dividends by 20% in one year and by 15% in two years. After that, dividends will increase at a rate of 5% per year indefinitely. If the last dividend was $1 and the required return is 20%, what is the price of the stock?  Step 1: calculate dividends D1=1(1.2)=$1.20; D2=1.20(1.15)=$1.38; D3=1.38(1.05)=$1.449 Step 2: calculate expected future price P2=D3/(R+g)=1.449/(.20-.05)=$9.66 Step 3: discount all cash flows to present value CF0=0; CF1=1.20; F1=1; CF2=1.38+9.66=11.04; F2=1; I=20; CPT NPV= $8.67  Required return o components: 1. dividend yield--D1/P0; a stock's expected cash dividend by its current price 1. capital gains yield--g; the dividend growth rate, or the rate at which the value of an investment grows  R=dividend yield+capital gains yield R=(D1/P0)+g o ex. A firm's stock is selling for $10.50. It just paid a $1 dividend and dividends are expected to grow at 5% per year. What is the required return?  R=(1(1.05)/10.50)+.05=.1+.05= 15% **$1=D0; Therefore, D1=1(1.05)**  Stock features o Common stock--equity without priority for dividends or in bankruptcy  voting rights--the right to elect the board of directors  proxy voting--a grant of authority by a shareholder allowing another individual to vote his or her shares  classes of stock--generally create unequal voting rights in order for certain share holders to maintain control of a firm  share proportionally in dividends paid  dividend characteristics  not a liability  firms cannot go bankrupt for not declaring a dividend  no a business expense and, therefore, not tax deductable  dividends received by individuals are taxable  share proportionally in assets remaining after liabilities in a liquidation  preemptive right--first shot at new stock issue to maintain proportional ownership if desired o Preferred stock--stock with dividend priority over common stock, normally with a fixed dividend rate, generally without voting rights  rights to a stated dividend that must be paid before dividends can be paid to common stockholders  dividends are not a liability of the firm, and preferred dividends can be deferred indefinitely  most preferred dividends are cumulative--any missed preferred dividends have to be paid before common dividends can be paid  Stock market o primary market--the market in which new securities are originally sold to investors o secondary market--the market in which previously issued securities are traded among investors o dealer--an agent who buys and sells securities from inventory o broker--and agent who arranges security transactions among investors o New York Stock Exchange (NYSE)  largest stock market in the world  1,366 members (owners of trading licenses on the NYSE) o NASDAQ  computer based quotation system  electronic communications network (ECN)--a web site that allows investors to trade directly with each other  large portion of technology stocks **growth rate must be less than the discount rate!** Chapter 9  Capital budgeting decision making o Net present value (NPV)--the difference between an investment's market value and its cost; represents the dollar change in the firm's value resulting from undertaking a project  Steps: 1. estimate future cash flows 1. estimate required return for investments of that risk 1. find the present value of the future cash flows and subtract the initial investment  Decision rule  If NPV < 0, the investment will not reach shareholder expectations and should not be taken on.  If NPV = 0, the investment meets shareholder expectations and should be treated indifferently.  If NPV > 0, the investment exceeds shareholder expectations and should be taken on.  NOTE: NPV account for risk by adjusting the discount rate  high rate=risky investment  low rate=safe investment  ex. A project is estimated to have the following cash flows: CF0= - 165,000; CF1= 63,120; CF2= 70,800; CF3= 91,080. If the required rate of return is 12%, should the investment be taken on?  CF0= -165,000; CF1= 63,120; CF2= 70,800; CF3= 91,080; I/Y=12; CPT NPV= $12,627.41; YES o Payback period--the amount of time required for an investment to generate cash flows sufficient to recover its initial cost  Steps:  estimate cash flows  subtract the future cash flows from the initial cost until the initial investment has been recovered  Decision rule:  If payback is < some preset time, the investment should not be taken on.  If payback is = some preset time, the investment should be treated indifferently  If payback is > some preset time, the investment should be taken on  ex. A project is estimated to have the following cash flows: CF0= - 165,000; CF1= 63,120; CF2= 70,800; CF3= 91,080. If the required payback period is 2 years, should the investment be taken on?  Year 1: 165,000 (initial investment) - 63,120 (CF1)= 101,880 still to recover Year 2: 101,880 - 70,800= 31,080 Year 3; 31,080 - 91,080= -60,000; 31,080/91,080=0.3412 The investment pays off in 2.34 years; NO o Discounted payback period--the length of time required for an investment's discounted cash flows to equal its initial cost  Steps  estimate cash flows  compute the present value of each cash flow  subtract the present value of the future cash flows from the initial cost until the initial investment has been recovered