Immaculate Conception - I College of Arts and Technology

FINANCIAL MANAGEMENT

LESSON 8 Week 11

Topic: Financial Assets: Bonds and Stocks

At the end of the lesson, the students are expected to:

1. Enumerate and discuss the determinants of interest rate.
2. Explain what is bond and stock.
3. Discuss the valuation of bonds and stocks
4. Solve problems related to bonds and stocks and its decision to invest.

DETERMINANTS OF INTEREST RATE

Interest rate is the rate at which the lender charges the borrower. This is calculated as a percentage of
the principal balance taken by the lender of the money. Interest rates tends to fluctuate/change which is
dependent locally or internationally on the following factors/variables;
1. Demand and supply of money
If the demand for money is higher than the supply, interest rate will increase and opposite occur if the
demand for money is lower than the supply, that is interest rate decreases,
2. Rate of inflation – if inflation is high the government increases interest rate for borrowing in order to
contain the inflation and reverse happen, when the rate of inflation decreases.
3. Growth rate of the economy - if the economy of a country is strong, the government tend to keep
interest high while if the economy is weak or in recession, interest rate is kept low in order for the
economy to recover.
4. Global interest rate and foreign exchange rates - The interest rates in the economy must be set in
line with global trends in interest rate.
5. Monetary policy of the central bank – the country’s monetary policy is dependent upon the various
objectives, if it focuses on the containment of inflation, there is a need to increase interest rates in order
to curtail consumption and investments driven by borrowed money. On the other hand, during
recession, the central bank does otherwise, that is to induce growth by incentivizing consumptions and
investments, interest rates are reduced.
6. Fiscal deficit and government borrowing - Deficit is the result where government spending
exceeded government revenues. To fund this deficit, the government resort to borrowing and being the
largest borrower, the quantum of government borrowing influences the demand for money and in turn
sways interest rates. The higher the fiscal deficit, higher government borrowing, higher interest rates
occur. Bond markets respond to higher fiscal deficits.

TERM STRUCTURE OF INTEREST RATE

This relates to the rate of return to the time of maturity of an investment. There are three (3) theories
considered to explain the shape of yield curve. These are

1. Expectation Theory
This theory suggest that the yield curve reflects investor’s expectation about future interest rates and
inflation. An increasing inflation expectation results in an upward -sloping yield curve whereas a
decreasing inflation expectation results in a downward yield curve.

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2. Liquidity Preference Theory

This theory suggests that for any given issuer long term investment rates tend to be higher than short
term rates. This is to be accounted for on the following factors:
2.1. Investors perceive less risk in short-term securities than in longer securities and are therefore
willing to accept lower yield on them. (short-term securities are more liquid and less responsive
to general interest rate movements)
2.2. Borrowers are more willing to pay a higher rate for long-term than short-term financing. This is
accountable on locking funds in longer period of time. They can eliminate the potential adverse
consequence of having funds roll over short-term debt at unknown costs to obtain long-term
borrowing.
3. Market Segmentation Theory. This theory suggests that the market for loans is segmented on the
basis of maturity and that the supply of and demand for loans which each segment determine its
prevailing interest rate. This means that the equilibrium between the suppliers and demanders of short-
term funds (e.g. seasonal business loans) would determine current short-term interest rates and the
equilibrium between suppliers and demanders of long-term funds (e.g. real estate) would determine
prevailing long-term interest rates.

CONCEPT OF BONDS
Bond Indebture is a legal document that specifies both the right of the bondholders and the duties of
the issuing corporation. This include among other things descriptions of the amount and the timing of all
interest and principal payment, various standards and restrictive provisions, sinking -fund requirements and
security interest provisions.

Standards provisions consist of:

1. Maintain satisfactory standards based on GAAP
2. Periodically supply audited financial statements
3. Pay tax and other liabilities when due
4. Maintain all facilities in good working order

Restrictive covenants are:

1. Require minimum level of liquidity
2. Prohibit the sale of accounts receivable to generate cash
3. Imposed fixed -asset restrictions
4. Constraint subsequent borrowing
5. Limit the firm’s annual cash dividend payments to a specific percentage or amount
6. Other restrictive covenants may be included such as:
6.1. Sinking- fund requirements. This has the objective of providing for a systematic retirement of
bond prior to their maturity. That is the corporation makes semi-annual or annual payments that
are used to retire bonds by purchasing them in the market place.
6.2. Security interest. The bond indebture identifies any collateral pledged against the bond and
specifies how it is maintained. That is the protection of the bondholder is secured.
6.3. Trustee. A third party may be present in the bond indebture. It may be an individual or another
corporation (e.g. bank) appointed as a “watchdog” on behalf of the bondholders and can take
special action in case the terms of indebtedness is/are violated.

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Bonds are a source of financing in the form of debt or borrowing. They may be issued by government
or private corporations in order to raise funds/capital. On the part of the government, they resort to this
form of financing in order to finance the building of various infrastructure projects like roads, bridges,
schools, dams, etc. Whereas private corporations would be using bonds as a form of financing to
expand their business or raise capital to undertake profitable venture.

GENERAL FEATURES OF A BOND ISSUE

There are generally three features included in a corporation’s bond issue.
1. Conversion – a feature which allow the bondholders to change each bond into a stated number of
shares of common stock. This normally occur when the market price of the stock is such that their
conversion will provide a profit for the bondholder.
2. Call feature – in most cases, it gives the issuers the opportunity to repurchase bonds prior to maturity.
The call price is the stated price at which the bond may be repurchased only during call/stated period.
As a rule, the call price exceeds the par value of the bond by an amount equal to 1 year’s interest (call
premium).
3. Stock purchase warrant – instruments that give the bondholders the right to purchase certain number of
shares of the issuer’s common stock at a specified price over a certain period of time. (sweeteners)

DISTINCTIONS BETWEEN STOCKS AND BONDS

Basis of Comparison Stocks Bond
These are instruments which Financial instruments which
highlight the interest of ownership highlights the debt takers of the
Definition issued by the firm in exchange for issuing corporation toward the
funds. holders with a promise to pay
back at later period with interest
Issuers Private corporations Government entities, financial
institutions, companies, etc
Status Holders are part owners of the Lenders /creditors of the firm
entity
Risk level High since it is dependent on the Relatively low since holders are
performance of the issuer priority in terms of repayment
Form of return Dividend Interest (fixed payment)
Additional benefit Holders get the right to vote Preference in terms of repayment
(common stock) and liquidation
* Market Stock market (if listed) Over- the-counter (OTC)
Over-the-counter (unlisted)

ADVANTAGES/DISADVANTAGES OF STOCKS AND BONDS

STOCK BOND
Advantages Disadvantages Advantages Disadvantages
Contribution to the Investment risk – this Investor receives regular Since it normally covers
economic growth occur when company income in the form of long duration, the interest
performs poorly (stock interest received may not be
price decrease), investor enough to cover inflation
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is at risk of losing on the

investment
Beats inflation- the rate Stockholders are not Full amount of The risk that companies
of stock is normally priority in terms of investment is returned at not being able to return
higher than that of payment when the firm the maturity date of the the money to the
inflationary rate goes bankrupt. bond investors
Accessibility – it can be Time requirement – there Profit can be generated
bought in capital market is a need to research, from the bond if it can be
thru: broker, financial read financial sold at a higher price
planner or on- line statements/ annual compared to the amount
reports to follow when it is purchased
company’s development
and monitor the stock
market
Return on investment – Stock price volatility –
investors normally depend on the individual
acquire them when intention which could
prices are low and later result to some emotional
sell them when the strain for stock prices
prices are high have tendency to go high
or low
Liquidity and conversion You compete with
to cash - it may be sold professionals.
or acquired any time Institutional investors and
traders have more time
and knowledge to invest.

VALUATION OF BOND AND STOCK

 Bonds. This is affected by three primary factors:
1. Coupon interest rate – this is the percentage amount the bond pays in interest.
2. Time of maturity – bond with long term maturities will not pay back the original investment for a long
period of time, whereas those with short term (5 years) offer the investor his original investment back
in a relatively short period of time
3. Fluctuation in interest rate

Bond valuation is the process used to calculate the theoretical fair value of a particular bond. This
normally involve calculation of the present value of the bond ‘s future interest payments and the bond value
when it reaches the maturity period which is known as the par/face value. This is needed to determine the rate
of return and make’s decision if the investment would be advisable.

A bond’s price equals the present value of its expected future cash flows. The rate of interest used to
discount the bond’s cash flow is known as yield to maturity (YTM)

Yield Measures: There are different types of yield measures that may be use to represent the approximate
return on bonds.
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1) Yield to Maturity (YTM) - The discount rate is used in the bond pricing formula. This is equal to the rate
of return earned by a bondholder (holding period) if:
- The bond is held to maturity
- The coupon payments are reinvested at the YTM*
Note: * trial and error is used in the computation

2) Yield to Call (YTC)

3) Current Yield (CY) – this is measured as a ratio of the bond’s coupon annual payment to the bond’s
market price.

FORMULA:
a) Pricing the Bond - Price = CP [(1+i)-n – 1] + P/FV (1+i)-n
i
b) Current Yield - CY = CP/MP where CP is the coupon payment and MP is the price

ILLUSTRATIVE PROBLEMS
1. The bond has a face value of P1,000, an interest rate of 4% (coupon) is paid yearly and will mature in 4
years. Determine the price of the bond if:
1.1. 4% yield to maturity 1.2. 5% yield to maturity 1.3. 3% yield to maturity

2. A bond is currently selling for P1,080, has coupon payment of 10% and P1,000 face value and has 10
years to mature. Determine the YTM.

3. The bond has a face value of P1,000; coupon payment= 8%; bond’s current market price = P900.
Determine the current yield (CY).

SOLUTION

1. Given: FV – P1,000 CP - 4% x P1,000 = P40 T = 4 yrs.

1.1. Yield rate – 4%
(1.04)-4 -1
Price = P40 ---------------- + P1,000 (1.04)-4 = P40 (3.629895224) + P1,000 (0.8545….)
0.04
= P145.20 + P854.80 = P1,000

1.2. Yield rate - 5%

(1.05)-4 -1
2. Price = P40 ---------------- + P1,000 (1.05)-4 = P40 (3.545950504) + P1,000 (0.8227024748.)
0.05
= P141.84 + P822.70 = P964.54 diff- 35.46
1.3. Yield rate – 3%
(1.03)-4 -1
Price = P40 ---------------- + P1,000 (1.03)-4 = P40 (3.717098403) + P1,000 (0.8884870479)
0.04=3
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= P148.68 + P888.49 = P1,037.17 diff- 37.17

2. Yield to Maturity (YTM)

Given : SP = P1,080 CP = 10% x P1,000 = P100 FV = P1,000 T = 10 yrs.

Trial and Error Method

Trial 1 - @ 9% Trial 2 - @ 8%
(1.09)-10 – 1 + P1000 (1.09) -10 P100 (1.08)-10 – 1 + P1000 (1.08) -10
Price = P100 0.09 0.08

= P100 (6.417657701) +P1,000 (0.42241…) P100 (6.710081398) + P1,000 (0.463193..)

= P641.77 + P422.41 = P1,064.18 P P671.01 + P463.19 = P1,134.18

@ 9% - P1,080 – P1,064.14 = - P15.82 @ 8% = P1,134.18- P1,080 = P54.18

Difference in rate is 1% (9% -8%) and sum in peso of two rates difference is P 70.00
( P15.82 + P54,20)
0.0077….
YTM = 8% + 1% (54.18/70) = 8.77% or 9% - 1% (15.82/70) = 8.77%

3. CY = P80 / P900 = 8.89%

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STOCK
Common stock. Common stockholders are normally called residual owners since they receive what is left
after all other claims on the firm’s income and assets have been satisfied. They are assured of only one thing
that they cannot lose any more than what they have invested.
Preferred stock gives holders certain privileges that makes them senior than that of the common holders.
That is they are entitled to a fixed percentage base on their par or stated value per share or peso amount on
the earnings and is dependent also on the type of preferred they purchased. Features of preferred are of three
types as to dividend:
a) Cumulative – holders of this type are entitled to back dividends or dividend in arrears. That any
unpaid dividends plus the current period of declaration, they are received ahead of the common
holders.
b) Non-cumulative – holders are entitled only during the period wherein there is declaration and
payment of dividend income.
c) Participating – holders of this type are entitled to basic preferential right plus a share in the
remaining income to be distributed after the common have received its basic right.

VALUATION OF STOCK
Common Stock Expected benefit during each period where k =expected return
k= --------------------------------------------------
current price of stock/asset

or

where P0= value of common stock

D1 D2 Dn Dn= per share div. expected at the end
P0 = ----------- + -------------- + …. ----------- k s = required return on common stock
(1+k s )1 (1+ks )2 (1+ks )n
Preferred Stock
D1 D2 D3 Dn (1+i) -n -1
V = ---------- + ---------- + --------- + ……--------- or V = D --------------
(1+i) (1+i) 2 (1+i)3 (1+i)n i

ILLUSTRATIVE PROBLEM 2
1. If Adi Company pays P0.25 dividend per share of preferred every month with a required rate of return
of 6% per annum, calculate the expected value of the stock?

2. Roman Corporation has the following information pertinent to their stockholdings. There are 1,000, 8%
preferred outstanding, P100 par value per share. Common stocks, 5000 outstanding, stated value per
share P100. During the year, the corporation decided to declare and pay P80,000 as dividend to their
stockholders. There were no dividends declared for the last two years. Determine the amount to be
received per category of stock using the assumptions below:
2.1. Preferred is cumulative 2.3. preferred is non-cumulative
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2.2. Preferred is participating up to 12% 2.4. preferred is fully participating & cumulative

SOLUTION:
P0.25 P0.25 P0.25 P0.25
1. V = ------------- + ------------- + ---------- + …… ------------ = P2.91
(1.005) (1.005) 2 (1.005)3 (1.005)12

(1.005) -12 - 1
Or V = P0.25 ---------------------- = 0.25 (11.61893) or P2.91
0.005

2.1. Preferred Common 2.3. Preferred Common

Dividend in arrears Current year
1,000 x P100 x 2 yrs. 1,000 x P100x 8% P 8,000
X 8% P16,000 Remainder P 72,000
Current year’s div. ------------- ------------
1,000 x P100 x 8% 8,000 P 8,000 P 72,000
Remainder _______ P56,000 ======== =======
P24,000 P 56,000
====== ======= 2.4.
2.2. Back dividends
Basic right of P 1,000 x P100 x 2x8% P16,000
1,000 x P100 x 8% P 8,000 Current year
Additional 4% to P 1,000 x P100 x 8% 8,000
1,000x P100 x 4% 4,000 Basic to common
Balance to common --------- P68,000 5,000 x P100x 8% P40,000
12,000 68,000 Remainder – P16,000
P 1/6 2,667
C 5/6 _____ 13,333
P26,667 P54,333
======= ======

Gitman, L. (2015)Managerial Finance. 14th ed. Pearson – Addison.

Gitman, L. ,Joehnk, M. & Smart, S. (2015) Fundamentals of Investing. Pearson Educ.
Pineda, A. (2019). Basic Financial Management. Mindshapes Co., Inc.
Ross, S., Westerfield, R. & Jaffe, J. (2014) Corporate Finance . McG