Download finc 5000 lesson notes -- session 2

BUSN 5200 LESSON NOTES – WEEK 5 CHAPTERS 6 & 7
Overview of Corporate Bonds and Stock
Introduction:
Bonds
- Bonds are essentially IOUs that promise to pay their owners a certain amount of money on
some specified date in the future—and in most cases, interest payments at regular
intervals until maturity. When companies want to borrow money (usually a fairly large
amount for a long period of time), they arrange for their investment bankers to print up
the IOUs and sell them to the public at whatever price they can get. In essence, a firm
that issues a bond is borrowing the amount that the bond sells for on the open market.
Bond Terminology and Types. Although many types of bonds exist, most bonds have three
special features: face value, maturity date, and coupon interest.
- Face value: The amount that the bond promises to pay its owner at some date in the future
is called the bond’s face value, or par value, or principal. Bond face values range in
multiples of $1,000 all the way up to more than $1 million. Unless otherwise noted,
assume that all bonds we discuss in this course have a face value of $1,000.
- Maturity date: The date on which the issuer is obligated to pay the bondholder the bond’s
face value.
- Coupon interest: The interest payments made to the bond owner during the life of the bond.
Some bonds pay coupon interest once a year; many pay it twice a year. Some bonds don’t
pay any interest at all. These bonds are called zero-coupon bonds.
- The percentage of face value that the coupon interest payment represents is called the
coupon interest rate. For example, assuming the face value of the bond was $1,000, a
bond owner who received $80 interest payments each year would own a bond paying an 8
percent coupon interest rate:
$80 / $1,000 = .08, or 8%
- The major types of bonds include Treasury bonds and notes (called T-bonds and T-notes),
issued by the federal government; municipal bonds, issued by state and local governments;
and corporate bonds, issued by corporations. In this course we are interested primarily in
Corporate Bonds
Corporate Bonds:
- Corporate bonds are similar to T-bonds and T-notes except they are issued by corporations.
Like T-bonds and T-notes, they pay their owner interest during the life of the bond and
repay principal at maturity. Unlike T-bonds and T-notes, however, corporate bonds
sometimes carry substantial risk of default. As a last resort, the U.S. government can print
money to pay off its Treasury bill, note, and bond obligations; but when private
corporations run into trouble, they have no such latitude. Corporations’ creditors may get
paid late or not at all.
- Relatively safe bonds are called investment-grade bonds. Many financial institutions and
money management firms are required to invest only in those corporate bonds that are
investment grade. Relatively risky bonds are called junk bonds. Junk bonds are generally
issued by troubled companies, but they may be issued by financially strong companies that
later run into trouble.
Corporate Stock
- Rather than borrowing money by issuing bonds, a corporation may choose to raise money
by selling shares of ownership interest in the company. Those shares of ownership are
called stock. Investors who buy stock are called stockholders.
- As a source of funds, stock has an advantage over bonds: The money raised from the sale
of stock doesn’t ever have to be paid back, and the company doesn’t have to make interest
payments to the stockholders.
- A corporation may issue two types of corporate stock: common stock and preferred stock.
Let’s look at their characteristics.
Common Stock.
- Common stock is so called because there is nothing special about it. The holders of a
company’s common stock are simply the owners of the company. Their ownership entitles
them to the firm’s earnings that remain after all other groups having a claim on the firm
(such as bondholders) have been paid. Those security holders who are paid before
common stockholders almost always have a fixed claim on the issuing firm. If all parties
with a claim on the firm were to line up according to the priority of their claim, common
stockholders would be at the end of that line.
- Common stockholders—as owners—are entitled to all the residual income of the firm, and
there is no upper limit on how great the residual income of the firm might be. Other
claimants (e.g. bondholders, preferred stockholders, etc.) usually have a fixed dollar claim.
Common stockholders are paid last but they are entitled to all the income left over after
those ahead of them have been paid. This residual income can be paid in the form of
dividends to the common stockholders or reinvested in the firm they own.
- Each common stockholder owns a portion of the company represented by the fraction of
the whole that the stockholder’s shares represent. Thus, if a company issued 1 million
shares of common stock, a person who holds one share owns one-millionth of the
company.
- Common stockholders receive a return on their investment in the form of common stock
dividends, distributed from the firm’s profits, and capital gains, realized when they sell the
shares.
Preferred Stock
- Preferred stock is so called because if dividends are declared by the board of directors of a
business, they are paid to preferred stockholders first. If any funds are left over, they may
be paid to the common stockholders. Preferred stockholders are not owners and normally
don’t get to vote on how the firm is run as do common stockholders Also, holders of
preferred stock have a lower expected return than to holders of common stock because
preferred stock is a less risky investment. The party that is paid last, the common
stockholder, is taking a greater risk since funds may run out before getting to the end of the
line.
BOND VALUATION
Introduction:
- Computing the value of a bond is just a present value problem because if you buy a bond,
or any business asset, you're doing so to get a claim on the money it will produce in the
future
-- The question is, what will you pay now to get that future money? That is, what is the
asset's present value? That is what bond valuation is all about.
Bond Valuation:
- Suppose the Microsoft company issues a 7%, 2026 bond
-- This bond promises to pay $1000 (called the Par, or Face Value) in 2026
(which is called the Maturity date)
Remember, all bonds that you will deal with in this course have a par, or face value
at maturity of $1,000. This may or may not be specified in the problems you
encounter. Regardless of whether or not it is specified, assume it is so.
-- The bond also promises to pay 7% of $1000, or $70 a year, for the next 20
years (assuming the time now is during the year 2006)
--- The 7% is called the coupon interest rate and the $70 is called
coupon interest
(Do NOT confuse this with the investment YIELD on the bond)
Aside: In the Wall St Journal, the bond would be listed as follows:
Microsoft 7 26
(Where Microsoft is the issuing company name, 7 is the coupon interest rate--7%, and 26 is when
the bond matures--2026)
- The question: What would you be willing to pay for this bond today; that is, what is its
present value?
- The Answer: it depends on interest rates. Remember you need a Discount rate
to compute present value
Choosing a discount rate for use in valuing bonds:
- The usual practice in bond valuation is to select for a discount rate the market's
Required Rate of Return , or Yield, on bonds of similar risk & maturity
Example: According to some source such as www.bondsonline.com bonds similar to
the Microsoft bond in question are currently yielding 8%
Calculating the Present Value of a Bond:
The present value of Microsoft’s bond, @ 8%, is:
PV = PV of the coupon Interest Pmts + PV of the Principal paid @ Maturity
PVbond =
Pmt(PVIFA i%, n)
+ FV (PVIF i%, n)
PVbond =
70(PVIFA 8%, 20)
+ FV (PVIF 8%, 20)
PVbond =
70(9.818)
PVbond =
687.26
+ 1000(.215)
+
215.00
(Eq 6.3a on pg 253)
PVbond = $902.26
(Note that the PV is below $1000. This results because you're buying 7% payments at a time
when the going interest rate is 8%--therefore you get the bond for a discount. Bonds selling for
more than $1,000 are said to be selling at a premium)
Aside: Most bonds pay interest semiannually.
- When you compute the PV of a semi-annual interest paying bond, just divide the coupon
payment by 2, multiply the years by 2, and divide the yield by 2.
Computing a bond's Yield to Maturity (YTM):
- Suppose you knew the price of a bond and you wanted to compute the yield you'd get (that
is, your rate of return) if you bought it and held it until maturity.
- Example: Suppose you looked in the Wall St Journal and found that the Microsoft bond
we've been discussing was selling for “111.470.” Bond prices are quoted as a percentage
of par ($1,000), so a quote of 111.470 translates into a dollar price of $1,114.70. If you
bought the bond and held it to maturity, what would be your average annual rate of return
for the 20 year investment?
- Answer: According to the Wall St Journal, the PV of the bond is $1,114.70. So, we can
plug that into the bond valuation formula as follows:
1,114.70 = 70(PVIFA i%, 20) + 1,000(PVIF i%, 20)
The only unknown in the equation now is i%, the bond's yield to maturity, which is what
you want to know
-- So, solve the equation for i%
-- To solve this algebraically, you would have to plug in values for i and solve the equation
repeatedly until the right hand side of the equation equaled 1,114.70. Fortunately this is not often
necessary as the values can be entered into a financial calculator and it will calculate i for you.
You can also solve the problem easily in Excel by entering all the variables and then solving with
Excel’s “Rate” function
(The YTM, found using Excel’s’ Rate function, is 6%)
Chapter 7, Stock Valuation
Introduction:
- Computing the value of a stock is just a present value problem because if you buy a stock,
or a company, or any business asset, you're doing so to get a claim on the money it will
produce in the future
-- The question is, what are you willing to pay now to get that future money? That is, what
is the asset's present value? That is what stock valuation is all about.
Stock Valuation Procedure:
- Finding the Present Value of a stock is just like finding the present value of a bond, but
it's tougher, because you don't have any promised amounts due at some time in the future
- So, you must make a "guesstimate" of the firm's future prospects using your expertise as a
financial analyst
-- For example, if you analyzed a company and its situation, you might be able to estimate
the firm's future sales. From there, you could develop future income statements, and
project future cash flow figures. Then you could discount the cash flows to the present at
your required rate of return and you would have the PV of the firm.
-- Problem: The company is presumed to go on forever. It's tough to forecast to
that time.
The Dividend Growth Model:
-- Here is a formula that effectively deals with the forever situation described above:
PV, or P0 = D1 / (ks - g)
where:
(Eq 7.4 on page 292)
P0 is the present value of the stock today
D1 is next year's expected dividend per share
ks is your required rate of return for this stock
g is the annual rate of growth you expect
NOTE: This model assumes a constant growth rate of earnings and dividends forever. If growth
is not expected to be constant the situation is a little more complicated. (ask your instructor if
you are interested or see www.aw-bc.com/gitman)
- This formula is very famous--it's called the Gordon Dividend Growth Model, or the
Dividend Discount Model
- An example for practice:
-- Suppose you are interested in Wendy’s common stock. Wendy’s is expected to pay
$0.25 per share dividends in the coming year, growth is expected to be constant forever at
8% a year, and your required rate of return for this stock is 10%.
-- Given your assumptions, the stock's present value today is:
PV = .25 / (.10 - .08)
= .25 / .02
= $12.50 a share
Issues Associated With The Dividend Growth Model:
1. Estimating the long-term growth rate g:
(1) There is no easy answer or short cut. You must call upon all your powers as a
prognosticator, and your vast knowledge of the industry in which the company operates,
to put forth your estimate of the company’s long-term sustainable growth rate.
(2) Draw upon the following simplified model to at least get you in the ball park:
a. Calculate the company’s latest Return on Equity (ROE)
b. Calculate the company’s Dividend Payout Ratio (POR)
c. Solve the following formula for g:
g = ROE x (1 - POR)
2. Estimating the required rate of return Ks:
- There are a number of approaches, but most of the time we estimate Ks by applying the
Capital Asset Pricing Model (CAPM) (see discussion in the book, pages 212-218)
3. Growth rate higher than the required rate of return:
- The model will not work if the growth rate g is higher than the required rate of return Rs.
If this happens, the resulting stock value will be negative. You cannot use the dividend
growth model in this situation.
Other stock valuation models:
Note: Some of these are not covered in your textbook. However, they are
popular among analysts out in the real world. Therefore we offer them to you for
the enhancement of your knowledge.
1. Book Value (page 296)
- Note: Book Value will not indicate a market value directly. It just tells you how much
the current owners paid for the firm. However, this can serve as a convenient starting
point for a valuation analysis.
Net book value of the firm = Total Assets - Total Liabilities
2. Cash Liquidation Value (page 297)
- This model tells you how much cash you might expect to get assuming a "worst case" in
which the firm's assets have to be sold piecemeal on the open market.
- Estimating Cash Liquidation Value:
Cash……………………………………..____________
+ Accounts Receivable…………………….____________
+ Estimated value of inventory……………____________
+ Estimated value of Net Fixed Assets……____________
+ Estimated value of other assets (specify)..____________
- Total Liabilities…………………………____________
= Cash Liquidation Value ……….………..____________
- You must rely on your experience and judgment to fill in the value estimates above
3. Implied Value of Earnings (not in book)
- This model tells you the present value of a firm's profits if they continue without change
forever, given your required rate of return:
Value of the firm = Net Income / Ks
(Note that this is simply an application of the PV of a perpetuity formula)
4. The PE model (page 297)
- This method calls for estimating what the company’s value “ought” to be, based on
comparisons with the PE ratios of similar firms.
- Example: PE Ratio comparisons for the Tootsie Roll Company:
Company
a.
b.
c.
Hershey
Nestle
M&M Mars
Average:
PE Ratio (from the Internet)
15
18
12
15
Implied “appropriate” PE for Tootsie Roll: 15
Value per share of Tootsie Roll, assuming Tootsie Roll’s EPS = $3.52:
Value per share of Tootsie Roll = Tootsie Roll EPS x Implied PE = $3.52 x 15 = $52.80
Summary:
- In stock valuation it is best to estimate the value of the company using as many models
as possible. Then reconcile the results of the models and decide on one value for the firm
based on your knowledge and experience and any other factors you think should be
considered.)
End of notes