Moyer:

Administration
Contemporary
Financial 9th Edition
CHAPTER 6 AND 7
MEMBERS
Inca Vilcapoma, Frank Edward
Mujica Guerrero, Rodrigo Gianfranco
Espinoza Santiago, Junior Pablo
FIXED INCOME SECURITIES
:CHARACTERISTICS AND VALUATION
This chapter focuses on the characteristics and valuation of fixed income securities, namely: long-term debt
and preferred shares. The next chapter contains a similar analysis of equity securities, that is, common
stocks.

• Characteristics of long-term debt:

Long-term debts are those credits, financing or loans whose period extends more than one year .
Frequently, these types of tools are for high amounts, which implies a great responsibility.
Most debts have a par value of $1,000 and are often priced as a percentage of that value. For example, a
market price record of "87" indicates that a bond with a par value of $1,000 can be purchased at $870.
• Long-term debt has several unique characteristics:

Fiduciary Contract

Option
Sinking fund buy and
refunds
bonus

Dimensions
common of Debt
linked with
the the
emissions participation
debt

Coupon Expiration
Rates
• Types of long-term debt
Long-term debts are generally classified according to whether or not they are secured by specific fixed assets of the
issuing company. Typically, secured debt issues are called mortgage bonds, and issues not secured by an asset are
called debentures or sometimes unsecured bonds. The yield spread between mortgage bond and obligation options is
another example of the risk-return trade-off that occurs in finance.

Debt issues are also classified according to their hierarchy as major and minor. Senior debt has a higher priority over
a company's income or assets than junior debt. Sometimes, the true name of the debt issue will have a "minor"
(junior) or "major" (senior) qualifier. The "major" (senior) and "minor" (junior) classification scheme is also used in
relation to common and preferred shares. Preferred stock is lower
relative to long-term debt and higher relative to common stock.
 -The relatively low cost after
tax due to deduction
interest tax

-The increase in earnings per share that

is possible to obtain through financial
leverage -The increase in risk
company financial
as a result of the use of
-The capacity of the owners of the Debt
company to maintain a greater
control over your company

-The restrictions that

long-term debt the lenders
impose on the
financing company
• International aspects in the international bond market
• In addition to raising capital in the United States financial markets, many American companies go to other
countries for capital. There are two main types of long-term instruments in the international bond market:
Eurobonds and foreign bonds.

-The Eurobond market has been used because
there is less regulatory interference than in the
issuing country and, in some cases, less strict
disclosure requirements. For example,
Eurobonds are bonds issued by a US company
denominated in dollars, but sold to investors
residing outside the United States, such as in
Europe and Japan.
-Foreign bonds are subscribed by a group of
investment banks from a single country. They are
usually denominated in the currency of the selling
country. However, the issuer of the bond is from a
country other than the one in which they are
issued. For example, Crowrt Cork & Seal
Company Inc., with plants in 65 countries outside
the United States, could enter the foreign bond
market to raise capital to build a new plant in
France.
Valuation
of Assets
The value of any asset is based on the expected
future benefits, or cash flows, that the owner will
receive over the life of the asset.

These cash flows are

derive from the increase in
profits and/or reduction
of costs, in addition to
any surrender value
received from the sale of
asset.
Bonds that have defined maturity dates

• Bonds that mature within defined periods pay the investor two types of returns: interest
payments (I,, I 2 , ..., I n ) during each of the next n periods and a principal payment (M) in
period no. Period n is defined as the maturity date of the bond, or the time at which the
principal must be settled and the bond issue withdrawn. The value of a bond can be calculated
by applying the cash flow capitalization method to the series of cash flows:

I1 +
I
2 + + In
1 + I
n +M
Po = 2 n-1
(1 + K d ) (1 + K d ) (1 + K d ) (1 + Kd ) n
1 where P 0 is the present value of the bond at time zero, or its
purchase date, and kd is the rate of return required by the
investor on this particular bond issue.
 perpetual bonds

• A perpetual bond, or perpetuity, is a bond that is issued without a defined maturity date.
Perpetual bonds promise to pay interest indefinitely, and there is no contractual
obligation to pay off the principal; that is, M = 0.The valuation of a perpetual bond is
simpler than that of a bond with a defined maturity date. Assuming that the bond pays a
fixed amount of interest, I, per period permanently, the value is as follows:

00

Po = 2 Yo
T=1 (1 + Kd ) t
where kd is the required rate of return.
• Example of perpetual bond:
For example, consider the 4% perpetual obligations of Canadian Pacific Limited Rail-road. What is the value
of a $1,000 bond to an investor who demands an 8% rate of return on these Canadian Pacific bonds? Because
I = 0.04
po
$40 = $
0.08
Therefore, the investor would be willing to pay up to $500 for this bond.
 CHARACTERISTICS OF THE ACTIONS
PREFERRED
• Preferred stock is so named because it generally has preference, or priority, over common stock
with respect to dividends and company assets.

Actions preferential rate

Sale price and par value: very popular in the early 1980s . With
The sale price, or issue price, is the these issues, dividends were reset
unit price at which preferred shares periodically and offered returns that
are sold to the public . varied with interest rates.

adjustable:
This type of preferred stock became
 CHARACTERISTICS OF THE ACTIONS
PREFERRED
Cumulative characteristic: Almost all meaning the preferred dividend
preferred shares are cumulative . This remains constant even when the
means that if for some reason a company's income increases .
company is unable to pay a preferred
dividend, it will not be able to pay a
preferred dividend on common stock
until it has paid all or a pre-specified
amount of preferred dividends in
arrears.
Participation: Shares are said to be
participating if the holders share in any
increase in profits that the company
might experience . However, almost all
preferred shares are non-participating,
 CHARACTERISTICS OF THE ACTIONS
PREFERRED
Maturity: Technically, preferred stock without
is part of a company's capital stock . Call Feature: Like long-term debt,
As such, some companies issue preferred stock can be redeemed, or
preferred stock with the intention that purchased, at the option of the issuing
it be perpetual, that is, a permanent company, at a specified price .
part of the shareholders' interest,
specific expiration date .
 CHARACTERISTICS OF THE ACTIONS
PREFERRED

Voting rights: As a general rule, Preferred stock trading:

holders of preferred shares do not After the initial sale of a company's
have the right to vote on the preferred stock, investors who
appointment of members of the purchase the shares may decide to
company's board of directors. sell them in secondary markets.
However, special voting procedures
often come into effect when the
company omits payment of preferred
dividends or incurs losses during a
certain period or period.
 ADVANTAGES AND
DISADVANTAGES OF
PREFERRED STOCK
From the perspective of the preferred stock financing,
ADVANTA

issuing company, skipping the compared to long-term debt, is

payment of a preferred its high after-tax cost because
dividend in difficult times has dividends cannot be deducted

DISADVANTA
less serious consequences than for income tax purposes.
skipping the payment of
interest on long-term debt.
The main disadvantage of
COMMON
ACTIONS
CHARACTERISTICS, VALUATION AND
ISSUE
 DEFINITION
•Common stock is a non-maturity negotiable financial asset that represents a
residual portion of a company's ownership.

CHARACTERISTICS
Common stock is a residual form of ownership in that the rights of the holders of
common stock over the profits and assets of the company are considered only
after satisfying the rights of governments, creditors and security holders.
preferred stock. Common stock is considered a permanent form of long-term
financing because, unlike debt and some preferred stock, common stock has no
maturity date.
 ACTION CHARACTERISTICS
COMMON
• Voting rights of shareholders. The shareholders of a company elect their board of
directors through a majority or cumulative voting procedure . The ritual vote is similar
to the vote that is carried out in political elections ; If there are two candidates for a
position on the council , the winner will be the one who receives more than 50% of the
votes . s. It is possible to use the following formula to determine the amount of actions
needed forTo elect a certain number of directors :

.. NNUETOdesired readersxNuerOceactionisuseincirculation,
Mmre Ce (CCjoniScIS — ------ +1
i\number ofmr^ct^res chosen # 1
 ACTION CHARACTERISTICS
COMMON
Example: Consider the following example. Markham Company has eleven members
of the board of directors and one million shares of unliquidated common stock. If in a
given year seven members were proposed for re-election and all shares were voting,
the number of shares needed to elect a director would be:

1X
■1000000+1=125001
7+1

In addition to electing the board of directors, a company's shareholders can vote regularly on
various issues, such as retaining a specific audit firm or increasing the number of authorized
shares.
 ACTION CHARACTERISTICS
COMMON
Common Share Classes: that the company's common stock
Sometimes; It is possible that a should be sold at a lower price to
company decides to create more d) . , attract more buyers, it can effect a
class of common stock . The reason stock split . Some members of the
for this may be that the company financial community apparently
wishes to raise additional capital by believe that the optimal common stock
selling some of the owners' existing price range should be between $15
equity without losing control of the and $60 .
company . This is achieved by creating
a separate class of non-voting shares .
Typically, so-called class A common
shares do not have voting rights, while
class B common shares do; Generally,
both classes are otherwise equal .
Stock split . If management believes
 ACTION CHARACTERISTICS
COMMON
Reverse stock split. Reverse stock this type of dividend is in the range of
splits are splits in which the number of 2 to 10%, meaning the number of
shares is reduced . They are used to shares outstanding increases by 2 to
drive low-priced stocks to better 10 percent. From an accounting (but
trading levels . For example, in mid- not cash flow) point of view, stock
1996, troubled utility Tucson Electric dividends involve a transfer from the
Power (now Unisource Energy) retained earnings account to the
declared a one-for-five reverse split . common stock and additional capital
After this split, Tucson shares were payment accounts.
trading in the range of $16 per share .
Dividends on shares . A stock
dividend is a dividend given to
shareholders in the form of additional
shares, rather than in cash. Typically,
 ADVANTAGES AND
ACTION CHARACTERISTICS
DISADVANTAGES OF
COMMON
COMMON ACTIONS
One of the main advantages of investors in common stocks
common stock financing is that require relatively high rates of
ADVANTA

there is no fixed obligation for return.

dividends, at least in principle.

DISADVANTA
From the investor's point of
view, common stocks constitute
an investment that represents
greater risk than debt securities
or preferred stocks. Therefore,
Rights Offerings and Reserve
Subscriptions . Companies can sell
their common shares directly to
existing shareholders through rights
issues, which allow holders to acquire
new shares of the company at a
subscription price, below the market
price .
Direct issuance costs . An investment
banker who agrees to underwrite an
issue of shares assumes a certain
amount of risk and, in return, requires
compensation in the form of a
discount on subscription or extension
of subscription.
 ACTION CHARACTERISTICS
INTERNATIONAL
COMMON ASPECTS
•GLOBAL STOCK MARKETS
• Nowadays, many transnational companies seek to negotiate in global markets since this allows them
to reach more potential investors by taking advantage of the institutional differences between various
countries, also achieving name and product recognition abroad.
• Characteristics:

• Companies are expected to sell their shares in the most in-demand markets.
• Because annuity and perpetuity formulas for bonds and preferred shares are not applicable, more
complex models are used.
• The expected cash flows from common stocks are more uncertain than the flows from bonds and
preferred stocks.
• To better understand the application of the cash flow capitalization valuation method to common
stock, it is best to first consider a one-period dividend valuation model and then consider multi-period
valuation models.
One-period dividend valuation model
• Suppose an investor plans to purchase a common stock and hold it for a period. At the end of this,
the investor expects to receive a cash dividend, D 1 , and sell the stock at a price, p 1 .

• What is the value of the stock to the investor today (time O), given a required rate of return on the
investment, k e ?

• In the cash flow capitalization valuation method, the discounted present value of the security's
expected cash flows is calculated as follows:

Po = ___Gave_+ ___P1_
1 + Ke 1+Ke
One-period dividend valuation model
• If the common stock of Ohio Engineering Company is expected to pay a dividend of one dollar and
at the end of a period sells for $27.50, what is the value of this stock to an investor who requires a
rate of return of 14 percent? ?
• The answer is calculated as follows:

Po = $ 1 00 + $ 27.50
(1+0.14) .1+0.14)
= $1.00 (PVFo.14 1)+$ 27.50 (PVIFo.14. 1)
= $ 1.00 (0.877) + $ 27.50 (0.877)
= $ 24.99 (or $25).

• Thus, the investor who acquires a share for 25 dollars receives the dividend of one dollar and sells
the share for 27.50 dollars; At the end of a period you will earn the required rate of return of 14
percent
• SOLUTION: 25.00
 Dividend valuation model
multiple periods
• The dividend valuation process just described can be generalized to a multi-period case. The
expected cash flows of an investor who purchases a common stock and holds it for n periods consist
of dividend payments during each of the next n periods (D 1 , D 2 , D n ) plus an amount, P n , product
of the sale of the stock at the end of the nth period. The present value of these expected cash flows at
the investor's required rate of return, k e , generates the following valuation equation:

__D1_+ _D2____ + ... + _ dr__ + ___Pn_

(1+Ke1(1+Ke)2 (1+Kejn (1+Kejn
 Dividend valuation model
multiple periods
• Consider again the common stock of Ohio Engineering Company. Suppose the investor considers
purchasing a stock and holding it for five years. Assume that the investor's required rate of return is
still 14 percent. The stock's dividends are expected to be $1 in the first year, $1 in the second year,
$1 in the third year, $1.25 in the fourth year, and $1.25 in the fifth year. The expected sales price of
the stock at the end of five years is $41.
• Using the above equation and the appropriate present value interest factors, the value of the stock to
the investor is calculated as follows:
 Dividend valuation model
multiple periods
Po= $1 .00 (PVIF0.14 1) + $1.00 (PVIF0.14, 1)
+ $1 00(PVIF0.14, 1) + $1.25 (PVIFO.14, I)
+ $1.25(PVIFo.i4,s) + $41.00 (PVIFo.14,5)
= $1.00(0.877) + $1.00(0.769) + $1.00(0.675)
+ $1.25(0.592) + $1.25(0.519) + $41.00(0.519)
= $24.99 (or $25)

Note that the current value of a share of Ohio Engineering Company is the same (i.e., P 0 = $25)
regardless of whether the investor plans to hold it for one, five, or any number of years.
The value of a stock at any time is simply the present value of all dividends expected to be paid from
that point forward. Therefore, the price P 5 of $41 reflects the present value of the dividends expected
in 6 years to infinity.
 General valuation model
dividends
• In the previous models, the current value of the share, P 0, depends on the expected price of the
share at the end of the retention period.

• A final generalization allows us to eliminate P n from the model and thus demonstrate that the
dividend valuation models are consistent with each other.

• First: we redefine the value of the shares at the end of period n, P n.

• With the help of the cash flow capitalization method it is possible to show that P n is a function of
all the expected future dividends that the investor will receive in periods n + 1, n + 2, etc.
Discounting the dividend series at the required rate of return, k e , yields the value of the stock at
the end of period n.

99
Pn = 2D :
ten+1 (1 + Ke)tn
 General valuation model
dividends
Pg.us _____Dl_+______D2_+ ...+ Dn + Pn_
(1+^m+Ke) 3 (1+Kejn
99 (1+Kejn
•When Pn=2 D:

replacing ten+1 (1 + Ke)tn

and simplify, we arrive at the following general

dividend valuation model

00

• Thus, the value of a company's common stock to the investor is equal to the present discounted
value of the expected future dividend series.
 General valuation model
dividends
• How is it possible to apply the general dividend valuation model to the common stock of a
company that reinvests all of its cash and pays no cash dividends?
 General valuation model
dividends
• As stated in chapter one, the primary goal of companies is to maximize the wealth of shareholders.
• In the general dividend valuation model, this wealth is measured by the value of the company's
common shares, which is a function of the series of expected future dividend payments and the rate
of return required by investors.
• Thus, when financial decisions are made with the aim of maximizing the wealth of shareholders,
these factors already mentioned must be taken into account.
• So a fundamental aspect of the role of financial management is to try to define and measure this
relationship.
Applications of the general dividend valuation model
• It is possible to simplify the model if a company's dividend payments follow the following patterns:
• Zero growth
• Constant growth
• Non-constant growth
Applications of the general
dividend valuation model
• DIVIDEND VALUATION MODEL WITH ZERO GROWTH

• If a firm's future dividend payments are expected to remain constant forever then D t in
the general equation

00
00
Pn=2 D
with a constant value D Pn=2__________[ This equation
Ie41(1*Ke)t ten+1(1 + Ke)t
• It represents the value of a perpetuity and is analogous to those we use to evaluate the
perpetual bond and preferred shares, so it can also be simplified.
Applications of the general dividend
valuation model
• Example:

• Assume that Mountaineer Railroad common stock pays a dividend of $1.50 per share annually,
which is expected to remain constant for the foreseeable future. What is the value of the stock to an
investor who requires a 12 percent rate of return? Substituting $1.50 for D and 12% (0.12) for k e in
Equation 7.9 produces the following:
Dividend valuation model with constant growth
• DIVIDEND VALUATION MODEL WITH CONSTANT GROWTH
• If a company's future dividend payments per share are expected to grow at a constant rate, g, then
it is possible to forecast the dividend in any future period t: where D o is the dividend in the
1
• current period (t = 0). The expected dividend in period 1 is D 1 =Do (1+ g) , the expected
dividend in the second period is D 2 = D o (1 + g) 2 , and so on.
• By substituting the equation for D, in the general dividend valuation model
have:
 Dividend valuation model with
•
non-constant
Assuming growth
that the required rate of return, . the rate of
k is greater than
e

dividend growth g, the equation

• This model assumes that a company's 00
Pn=2 D or Í1 + pue
earnings, dividends, and stock price grow at
t=1 |(1 + Ke)'

turn
a constant rate, g, in the future.
• A considerable number of studies indicate that:
• 1) The most accurate estimates of future growth are those provided by securities analysts.
• 2) the forecasts of analysts who estimate growth are an excellent approximation to investors'
growth expectations.
 Business finance aspects
• VALUATION OF CLOSED PROPERTY COMPANIES
• There is typically no active market for closely held company shares. For this reason, business
owners ask independent evaluators to calculate the value of their companies, such as:
• Valuing these types of companies poses unique challenges. When valuing the shares of a closely
held company, several factors are considered:
• Nature and history of the company.
• General economic prospects and conditions.
• Perspectives and economic conditions in the sector that participates.
• Ability to generate income and pay dividends.
• Book value and financial condition.
• Know whether the shares represent a majority or minority interest and whether they have voting
rights or not.
 Business finance aspects
• DETERMINATION OF NORMAL PROFITS
• Generally, determining an average, or "normal," profit figure involves a simple average or some
type of weighted average that considers approximately the last five years of operations.
• But in certain cases the income reported by a company is not the appropriate figures for valuation
purposes in order to avoid paying taxes.
• In this situation, it is advisable to adjust reported earnings to account for these dividends.
Business finance aspects
• DETERMINING AN APPROPRIATE PRICE TO EARNINGS MULTIPLE
• The next step in the valuation process is to determine the appropriate rate at which normal levels
of profits can be capitalized.
• This is equivalent to multiplying earnings by a price-to-earnings multiple.
• Analysts should examine the price-to-earnings multiple of publicly held companies in the same
industry as the company being evaluated, in an effort to find companies similar to the one being
observed.
• The price-to-earnings multiple for these comparable companies is used to capitalize normal
earnings levels.
Business finance aspects
• MINORITY INTEREST DISCOUNT
• Owners of a minority interest in a closely held company have an investment that lacks control,
and often lacks marketability.
• Typically, there is no market for the shares or the buyer is another owner of the same company.
• The usual procedure for evaluating minority shares is to value the company as a whole; Then
you have to divide this value by the number of shares in circulation to obtain the value per share.
Finally, a discount is applied to this value per share to obtain the value of the minority shares.
Dividend valuation model with non-constant growth .
• A wide variety of companies present growth rates in their sales, profits and dividends that are
generally not constant and also go through a period of higher than normal growth when exploiting
new technologies, new markets or both.

• Non-constant growth models can be applied to the valuation of companies that experience
temporary periods of poor performance, after which a normal pattern of growth can be expected
to emerge.

present value of present value of price

Po = expected + expected dividends of the shares During a period of at the
end of the period of
Non-constant growth non- constant growth
Dividend valuation model with
non-constant growth .
• There are several ways to calculate the price of shares at the end of a period of non-growth rates.
constant:
• Securities analysts, such as Value Line, provide a range of estimated future prices (five years out)
for the stocks they track.
• Estimates of future earnings growth rates, up to five years, are provided by Value Line, l/B/E/S,
Zacks and Thomson Financial/First Call. These forecasts can be multiplied by the expected price-
to-earnings (P/E) multiple, which is calculated by looking at the current P/E multiples of similar
companies, to obtain an expected price five years from now.
• At the end of the non-constant growth period it is possible to deduce an estimate of the value of
the shares by simply applying the constant growth rate valuation model.
Dividend valuation model with
non-constant growth .
• To demonstrate how the model works, assume that an investor expects earnings and dividends on
HILO Electronics common stock to grow at an annual rate of 12% over the next five years.
Following the period of above-normal growth, dividends are expected to grow at a lower rate of
6% for the foreseeable future. The company currently pays a dividend, Do, of $2 per share. What
is the value of HILO common stock to an investor requiring a 15 percent rate of return?
Dividend valuation model with
non-constant growth .
Dividend valuation model with
non-constant growth .