1. Bonds and Stocks: Characteristics and Valuation
Chapter 10
Bonds and Stocks:
Characteristics and Valuation
© 2000 John Wiley & Sons, Inc.

2. 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.

3. 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

4. Long-term Financing Sources for Business
New security issues
Corp Bonds 82% 85%
Corp Stocks
Bonds
Public 85% 84%
Private na na
Sold abroad 15% 16%

5. In addition to retained earnings, businesses can raise funds by:
Selling shares (external equity)
Issue debt (bonds)
Funds can be raised publicly or privately

6. 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

7. 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

8. 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

9. General Terms Associated with Debt:
Par value or Face Value
Coupon Rate
Coupon Payment
Annual coupon = coupon rate x par value
Registered versus Bearer bonds

10. Bond Covenants Protect bondholder stake in the firm
Impose restrictions or extra duties on the firm
Protect bondholder stake in the firm

11. Bond Rating Examples STANDARD 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

12. 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 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

13. 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

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

15. Other Features of Bonds
Convertible bonds
Callable bonds
Putable bonds
Extendable bonds
Securitization
Inflation protection (U.S. gov’ts)

16. Global Bond Market
Eurodollar bonds
Yankee bonds
Global bonds

17. Reading Bond Quotes Cur Net Bond Yld Vol Close Chg
AT&T 8 1/ /4 –3/8

18. Corporate Equity Capital
Represents ownership
Certificate versus street name

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

20. Preferred Stock
“Preferred” over common stock with a senior claim on earnings, assets
Fixed dividend; par value is important!
Usually non-voting

21. Other Features Cumulative versus non-cumulative Callable Convertible
Tax Advantage

22. Reading a Stock Quote 52 weeks Yld Hi Lo Stock Sym Div %
50 1/ /8 AFLAC AFL
Vol Net
PE 100s Hi Lo Close chg
/ / /8 -1 3/8

23. Valuation Principles Basic concept: Price of an asset =
Present value of future expected cash flows

24. 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

25. 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

26. 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)

27. An example
$1,000 par value, Coupon rate 9% paid once per year, 10 years until maturity
Investors require 9% return
$ x = $577.62
$1,000 x =
Bond value = $999.62
(not equal to $1000 because of interest factor rounding)

28. If required return rises to 10%:
$90 x = $553.05
$1,000 x =
Bond value = $939.05
If required return falls to 8%:
$90 x = $603.90
$1,000 x =
Bond value = $1,066.90

29. 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

30. 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

31. 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

32. A bond will sell for a higher price if:
Higher coupons (higher coupon rates)
More frequent coupon payments
lower required rate of return r

33. 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

34. 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

35. 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

36. Or constant growth in dividends over time:
P0 = D0(1 + g)
rs – g
Today’s dividend = $1.89; g = 8.5%;
rs = 12%
P0 = ( ) = $58.57
.12 – .085

37. Risks in Stock Valuation
Uncertainty over future dividend changes, growth changes
Changing market/investor expectations for firms, the economy
Changing interest rates

38. Dollar return = Income received + price change Percent return =
Learning Extension 10A Calculating 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%

39. Annualizing a Return Annualized return = (1 + percent return)1/n - 1
where n is the number of years the asset was held or owned

40. Two examples: you earn 28% over a holding period
If the holding period is 2 years:
Annualized return =
( )1/2 - 1 = 13.1 percent
If the holding period is 9 months:
( )1/ = (1.28)4/3 - 1
= or 38.9 percent