John Joseph Thoppil Roll no:48

 The following applies to any financial asset : V = Current value of the asset C t = Expected future cash flow in period (t) k = Investor’s required rate of return Note : When analyzing various assets (e.g., bonds, stocks), the formula below is simply modified to fit the particular kind of asset being evaluated.

 Determining Intrinsic Value:  The intrinsic value of an asset (the perceived value by an individual investor) is determined by discounting all of the future cash flows back to the present at the investor’s required rate of return (i.e., Given the C t ’s and k, calculate V).  Determining Expected Rate of Return:  Find that rate of discount at which the present value of all future cash flows is exactly equal to the current market value. (i.e., Given the C t ’s and V, calculate k).

 In general, the intrinsic value of an asset = the present value of the stream of expected cash flows discounted at an appropriate required rate of return.

A hybrid security:  It’s like common stock - no fixed maturity.  Technically, it’s part of equity capital.  It’s like debt - preferred dividends are fixed.  Missing a preferred dividend does not constitute default, but preferred dividends are cumulative.

 Dividends are fixed either as a rupee amount or as a percentage of par value.  Example: In 1988, Xerox issued $75 million of 8.25% preferred stock at $50 per share.  $4.125 is the fixed, annual dividend per share. Preferred Stock

 Firms may have multiple classes of preferreds, each with different features.  Priority: lower than debt, higher than common stock.  Cumulative feature: all past unpaid preferred stock dividends must be paid before any common stock dividends are declared. Preferred Stock Features

 Protective provisions are common.  Convertibility: many preferreds are convertible into common shares.  Adjustable rate preferreds have dividends tied to interest rates.  Participation: some (very few) preferreds have dividends tied to the firm’s earnings. Preferred Stock Features

 PIK Preferred: Pay-in-kind preferred stocks pay additional preferred shares to investors rather than cash dividends.  Retirement: Most preferreds are callable, and many include a sinking fund provision to set cash aside for the purpose of retiring preferred shares. Preferred Stock Features

 A preferred stock can usually be valued like a perpetuity: V = D k ps

 Xerox preferred pays an 8.25% dividend on a $50 par value.  Suppose our required rate of return on Xerox preferred is 9.5%. V ps = =

 Xerox preferred pays an 8.25% dividend on a $50 par value.  Suppose our required rate of return on Xerox preferred is 9.5%. V ps = = $43.42

 Just adjust the valuation model: DPoDPo k ps =

 If we know the preferred stock price is $40, and the preferred dividend is $4.125, the expected return is: DPoDPo k ps = = =

P b = Price of the bond I t = Interest payment in period (t) (Coupon interest) P n = Principal payment at maturity (par value) Y = Bondholders’ required rate of return or yield to maturity Annual Discounting:

 Semiannual Discounting:  Divide the annual interest payment by 2  Divide the annual required rate of return by 2  Multiply the number of years by 2

 Determining Intrinsic Value  The investor’s perceived value  Given I t, P n, and Y, solve for P b  Determining Yield to Maturity  Expected rate of return  Given I t, P n, and P b, solve for Y

 Trial and Error : Keep guessing until you find the rate whereby the present value of the interest and principal payments is equal to the current price of the bond. (necessary procedure without a financial calculator or computer).  Easiest Approach : Use a computer or financial calculator. Note, however, that it is extremely important to understand the mechanics that go into the calculations.

 For both bonds shown below, the coupon rate is 10% (i.e., I t = $100 and P n = $1,000). Bond Price Yield to Maturity (Y) - Percent 5 year bond 20 year bond

 1: When Y = coupon rate, P b = P n  2. When Y P n  (Bond sells at a premium)  3. When Y > coupon rate, P b < P n  (Bond sells at a discount) Also Note : If interest rates (Y) go up, bond prices drop, and vice versa. Furthermore, the longer the maturity of the bond, the greater the price change for any given change in interest rates.