Fundamentals of Finance Tom C. Nelson, PhD 9/20/2018 CUBIC 2014 Section 2 Fundamentals of Finance Tom C. Nelson, PhD CUBIC Fundamentals of Finance

2-0 Sources of capital funding by companies Topics 2-0 Private sources of funding 2-1 Retained profits 2-2 Bonds and bank loans 2-3 Stock

Sources of Capital 2-0 Private Sources of Funding Private start-ups initially get money from: Self Family and friends Angel capital Venture capital

Sources of Capital 2-1 Retained profits Company profits can be used for: Dividends Retained earnings

Clicker Question (2.1.1) The more a company pays in dividends (all other aspects remaining the same) A. The faster a company can grow B. The slower a company can grow C. Dividends have no effect on growth

Sources of Capital 2-2 Bonds Section Topics: Bond Terminology Bond Ratings Types of Bonds Interest rates and their effect on bond values

Sources of Capital 2-2 Bonds Bond Terminology Par/Face Value: amount paid at maturity Coupon: interest payment (usually fixed) Maturity: date when bond face value paid Yield to maturity (YTM): % return of bond (if held to maturity) Bond covenants: loan agreement, terms

Sources of Capital 2-2 Bonds 9/20/2018 Sources of Capital 2-2 Bonds Rating agencies and sample rating chart QUALITY S&P Moody's Description High Grade AAA Aaa Bonds judged to be of the best quality. They carry the smallest degree of investment risk.    AA Aa Bonds that are judged to be of high quality by all standards. They are rated lower than the best bonds because margins of protection may not be as large.  Medium Grade A Upper-medium grade obligations. Factors giving security to principal and interest are considered adequate. Bottom of Inv. Grade BBB Baa Bonds that are considered as medium-grade obligations -- they are neither highly protected or poorly secured. Speculative Grade BB Ba Bonds that have speculative elements. Protection of principal and interest may be moderate. B Bonds that lack the characteristics of a desirable investment. There may be small assurance of principal and interest payments over any long period. Default CCC Caa Bonds of poor standing. These issues may be in default or there may be elements of danger present with respect to principal and interest. CC Ca Obligations speculative to a high degree. These issues are often in default. C Lowest rated class in Moody's list. Rating given to income bonds on which interest is not being paid. D Issues in arrears in interest and/or principal payments. CUBIC Fundamentals of Finance

Sources of Capital 2-2 Bonds Rating agencies and sample rating chart QUALITY S&P Moody's High Grade AAA Aaa   AA Aa Medium Grade A Bottom of Inv. Grade BBB Baa Speculative Grade BB Ba B Default CCC Caa CC Ca C D

Sources of Capital 2-2 Bonds Bond Ratings Estimates bond quality, probability of default Has major effect on yields and price As ratings fall: Quality of the bonds fall The probability of bond default rises The price of the bond falls The resulting yields rise to compensate for risk

Sources of Capital 2-2 Bonds Types of Bonds Secured versus unsecured bonds Callable bonds Convertible bonds Zero coupon bonds Bond by issuer Corporation Government

Sources of Capital 2-2 Bonds Yield curves (term structure of interest rates) Provides the yields on the same type of bond over different maturity levels

Sources of Capital 2-2 Bonds Interest rates Changes in interest rate have a strong effect on bond prices: As interest rates rise, bond prices fall As interest rates fall, bond prices rise Long term bonds are affected much more than short term bonds On-line resources: http://finance.yahoo.com/bonds http://www.investinginbonds.com/

Sources of Capital 2-2 Bonds Advantages of debt Cheaper than equity Usually a fixed cost Usually a tax deductible interest expense After expenses, interest, and taxes are paid, shareholders keep all profits remaining—no “dilution” of equity. Debt can enhance profitability through financial leverage.

Sources of Capital 2-2 Bonds Disadvantages of debt Interest is a required expense and must be paid. If not, possible bankruptcy Debt usually entails many terms and conditions that can limit flexibility of the company. The more debt used, the higher the probability of financial distress.

Clicker Question (2.2.2) What will likely happen to the price of a bond issued by a company that may be approaching bankruptcy? A. Its price will rise B. Its price will fall C. The price will remain unchanged D. It really depends

Sources of Capital 2-3 Stocks and Stock Valuation Topics Features of equity Stock valuation Stock quotes

Clicker Question (2.3) Typically, which security is riskier to an investor? A. Bonds B. Common stock

Sources of Capital 2-3 Stocks and Stock Valuation Features of equity Common stock Shareholders “own” the company Proportional claim to company and dividends Returns come from dividends and price appreciation Shareholders elect Board of Directors who elect Officers Proxy voting allows shareholders to appoint a representative to vote Dividends paid at discretion of Board of Directors

Sources of Capital 2-3 Stocks and Stock Valuation Stock Quotes On-line resource: http://finance.yahoo.com/

Sources of Capital 2-3 Stocks and Stock Valuation Price Trend On-line resource: http://finance.yahoo.com/

Sources of Capital A comparison between stocks and bonds Item Bonds (debt) Stock (equity) Cost to Company Cheaper More Expensive Risk to company Higher (can cause bankruptcy) Lower (can’t cause bankruptcy) Return to Buyer Risk to Buyer (depends on rating) (price fluctuates more)

9/20/2018 CUBIC Fundamentals of Finance