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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