Lecture Note Bond & Stock

Debt Valuation
and Interest
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Learning Objectives
1. Identi!y the "ey !eatures o! #onds and
descri#e the di!!erence #et$een private and
pu#lic de#t %ar"ets.
2. Calculate the value o! a #ond and relate it
to the yield to %aturity on the #ond.
&. 'escri#e the !our "ey #ond valuation
relationships.
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Learning Objectives (cont.)
4. Identi!y the %a(or types o! corporate
#onds.
). E*plain the e!!ects o! in!lation on interest
rates and descri#e the term structure of
interest rates.
9.1 OVERVIEW OF
OR!OR"#E DE$#
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or%orate $orro&ings
+ ,here are t$o %ain sources o! #orro$ing !or
a corporation-
1. .oan !ro% a !inancial institution /"no$n as
%rivate debt since it involves only t$o parties0
2. 1onds /"no$n as %ublic debt since they can #e
traded in the pu#lic !inancial %ar"ets0
$orro&ing 'one( in t)e !rivate
Financial 'ar*et
Financial Institutions provide loans to
!inance !ir%3s daytoday operations /&or*ing
ca%ital loans0 or it %ight #e used !or the
purchase o! e4uip%ent or property
/transaction loans0. .oans %ay or %ay not
#e secured #y a collateral.
$orro&ing 'one( in t)e !rivate
Financial 'ar*et (cont.)
+ "dvantages o! Private 'e#t Place%ent
6 7peed
6 8educed costs
6 9inancing !le*i#ility
+ Disadvantages o! Private 'e#t Place%ent
6 Interest costs
6 8estrictive covenants
6 ,he possi#ility o! !uture 7EC registration
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Floating+Rate Loans
In the private !inancial %ar"et, loans are
typically ,loating rate loans i.e. the interest
rate is ad(usted #ased on a speci!ic
#ench%ar" rate. ,he %ost popular #ench%ar"
rate is the London Interban* O,,ered Rate
(LI$OR), rate at $hich #an"s o!!er to lend in
the .ondon $holesale or inter#an" %ar"et
#able 9+1 #(%es o, $an* Debt
$orro&ing 'one( in t)e !ublic
Financial 'ar*et
Corporations engage the services o! an
invest-ent ban*er $hile raising longter%
!unds in the pu#lic !inancial %ar"et. ,he
invest%ent #an"er per!or%s three #asic !unctions-
6 .nder&riting- assu%ing ris" o! selling a
security issued. ,he client is given the %oney
#e!ore the securities are sold to the pu#lic.
6 Distributing
6 "dvising
or%orate $onds
+ or%orate bond is a de#t security issued
#y corporation that has pro%ised !uture
pay%ents and a %aturity date.
+ I! the !ir% !ails to pay the pro%ised !uture
pay%ents o! interest and principal, the #ond
trustee can classi!y the !ir% as insolvent and
!orce the !ir% into #an"ruptcy.
$asic $ond Features
+ ,he #asic !eatures o! a #ond include the
!ollo$ing-
6 1ond indenture
6 Clai%s on assets and inco%e
6 Par or !ace value
6 Coupon interest rate
6 ;aturity and repay%ent o! principal
6 Call provision and conversion !eatures
$ond Ratings and De,ault Ris*
$ond ratings indicate the de!ault ris" i.e. the
pro#a#ility that the !ir% $ill %a"e the #ond3s
pro%ised pay%ents. 8ating agencies use
#orro$er3s !inancial state%ents, !inancing %i*,
pro!ita#ility, varia#ility o! past pro!its, and
%a"e (udg%ents a#out the 4uality o! the
!ir%3s %anage%ent in order to deter%ine
ratings.
#able 9./ Inter%reting $ond Ratings
9.0 V"L.I12 OR!OR"#E
DE$#
Valuing or%orate Debt
,he value o! corporate de#t is e4ual to the
present value o! the contractually pro%ised
principal and interest pay%ents /the cash
!lo$s0 discounted #ac" to the present using
the %ar"et3s re4uired yield to %aturity on
si%ilar ris".
#able 9.0 $ond #er-inolog(
Valuing $onds b( Discounting Future
as) Flo&s
7tep 1- 'eter%ine #ondholder cash !lo$s,
$hich are the the a%ount and ti%ing o! the
#ond3s pro%ised interest and principal
pay%ents to the #ondholders.
+Annual Interest < Par value = coupon rate
+E*a%ple 9.1- ,he annual interest !or a 10year #ond
$ith coupon interest rate o! 5> and a par value o!
?1,000 is e4ual to ?50, /.05 = ?1,000 < ?500. ,his
#ond $ill pay ?50 every year and ?1,000 at the end o!
10years.
Valuing $onds b( Discounting
Future as) Flo&s (cont.)
7tep 2- Esti%ate the appropriate discount rate
on a #ond o! si%ilar ris". 'iscount rate is the
return the #ond $ill yield i! it is held to
%aturity and all #ond pay%ents are %ade.
Valuing $onds b( Discounting
Future as) Flo&s (cont.)
7tep &- Calculate the present value o! the
#ond3s interest and principal pay%ents !ro%
7tep 1 using the discount rate in step 2.
alculating a $ond3s 4ield to
'aturit( (4#')
@e can thin" o! A,; as the discount rate that
%a"es the present value o! the #ond3s
pro%ised interest and principal e4ual to the
#ond3s o#served %ar"et price.
5E6!OI1# 9.07
CHECK YOURSELF
alculating t)e 4ield to 'aturit( on a
or%orate $ond
Calculate the A,; on the 9ord #ond $here the
#ond price rises to ?900 /holding all other things
e4ual0.
8te% 17 !icture t)e !roble-
A,;<B
Aears
Cash !lo$ ?900 ?2) ?2) ?2) ?1,02)
+ Purchase price < ?900
+ Interest pay%ents < ?2) per year !or years 111
+ 9inal pay%ent < ?1,000 in year 11 o! principal.
0 1 2 & C 11
8te% 07 Decide on a 8olution
8trateg(
@e can use e4uation 92a to !ind A,;. A,; is
the rate that %a"es the present value o! all
!uture e*pected cash !lo$s e4ual to the
current %ar"et price. @e can also solve !or
A,; using a calculator and a spreadsheet.
8te% /7 8olve
Dsing a ;athe%atical E4uation
+It is cu%#erso%e to solve !or A,; #y hand
using the e4uation. It is %ore practical to use
the !inancial calculator or the spread sheet.
8te% /7 8olve (cont.)
Dsing a 9inancial
Calculator
E < 11
IFA < 9.:9
PG < 900
P;, < 2)
9G < 1,000
Dsing an E*cel
7preadsheet
< 8A,E/nper,
p%t,pv,!v0
< 8A,E /11,2),
900,10000
< 9.:9;
8te% <7 "nal(=e
,he yield to %aturity on the #ond is 5.:9>.
,he yield is higher than the coupon rate o!
interest o! 2.)>. 7ince the coupon rate is
lo$er than the yield to %aturity, the #ond is
trading at a price #elo$ ?1,000. @e call this a
discount bond.
.sing 'ar*et+4ield+to+'aturit( Data
;ar"etyieldto%aturity data is regularly
reported #y a nu%#er o! investor services and
is 4uoted in ter%s o! credit s%reads or
s%reads to #reasur( bonds. ,a#le 94
contains so%e e*a%ples o! spreads.
#able 9+< or%orate $ond 8%read
#ables
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.sing 'ar*et 4ield to 'aturit( Data
(cont.)
+ ,he spread values reported in ta#le 94
represent #asis points over a D7 ,reasury
security o! the sa%e %aturity as the
corporate #ond.
+ 9or e*a%ple, a &0year 1a1F11H corporate
#ond has a spread o! 25) #asis points over a
si%ilar &0year D7 ,reasury #ond.
+ ,hus this corporate #ond should earn 2.5)>
over the 4.)2> earned on treasury yield or
5.&1>.
!ro-ised versus
E>%ected 4ield to 'aturit(
,he yield to %aturity calculation assumes that
the #ond per!or%s according to the ter%s o!
the #ond contract or indenture. 7ince
corporate #onds are su#(ect to ris" o! de!ault,
the promised yield to %aturity %ay not #e
e4ual to expected yield to %aturity.
!ro-ised versus E>%ected 4ield to
'aturit( (cont.)
+ E*a%ple Consider a oneyear #ond that
pro%ises a coupon rate o! :> and has a
principal /par value0 o! ?1,000. 9urther
assu%e the #ond is currently trading !or
?:)0. @hat is the pro%ised yield to
%aturityB
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'aturit( (cont.)
Pro%ised A,;
< I/Interest
year 1
H Principal0 J /1ond Galue0K 6 1
< I/?:0H?1,0000 J /?:)00K 6 1
< 09.?@;
'aturit( (cont.)
,he yield o! 25.02> is #ased on the
assu%ption o! no de!ault. Assu%e there is a
40> pro#a#ility o! de!ault on this #ond and i!
the #ond de!aults, the #ondholders $ill receive
only 20> o! the principal and interest o$ed.
@hat is the e*pected A,; on this #ondB
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5E6!OI1# 9./7
CHECK YOURSELF
Valuing a $ond Issue
Calculate the present value o! the A,L,
#ond should the yield to %aturity !or
co%para#le ris" #onds rise to 9> /holding
all other things e4ual0.
i< 9>
Aears
Cash !lo$s ?:) ?:) ?:) ?1,0:)
0 1 2 & C 20
PG o! all
Cash !lo$s
<B
?:) annual
interest
?:) interest
H ?1,000
Principal
8trateg(
+ Mere $e "no$ the !ollo$ing-
6 Annual interest pay%ents < ?:)
6 Principal a%ount or par value < ?1,000
6 ,i%e < 20 years
6 A,; or discount rate < 9>
+ @e can use the a#ove in!or%ation to
deter%ine the value o! the #ond #y
discounting !uture interest and principal
pay%ent to the present.
Copyright 2014 Pearson Education, Inc. All rights reserved. 9&:
8te% /7 8olve
Dsing a ;athe%atical 9or%ula
< ? :)IN1/1F/1.090
20
O J /.200K H
?1,000F/1.090
20
< ?:) /9.12:0 H ?15:.4&
< A9B<./@
Dsing a 9inancial
Calculator
6 E < 20
6 1Fy < 9.0
6 P;, < :)
6 9G < 1000
6 PG < 9B<./@
Dsing an E*cel
7preadsheet
< PG /rate, nper, p%t, !v0
< PG /.09,20,:),10000
< A9B<./@
8te% <7 "nal(=e
+ ,he value o! A,L, #ond !alls to ?9)4.&2
$hen the yield to %aturity rises to 9>. ,he
#onds are no$ trading at a discount as the
coupon rate on A,L, #onds is lo$er than the
%ar"et yield.
+ An investor $ho #uys A,L, #onds at its
current discounted price $ill earn a
pro%ised yield to %aturity o! 9>.
8e-iannual Interest !a(-ents
Corporate #onds typically pay interest to
#ondholders se%iannually. @e can adapt
E4uation /92a0 !ro% annual to se%iannual
pay%ents as !ollo$s-
5E6!OI1# 9.<7
CHECK YOURSELF
Valuing a $ond Issue #)at !a(s 8e-iannual
Interest
Calculate the present value o! the A,L, #ond
should the yield to %aturity on co%para#le #onds
rise to 9> /holding all other things e4ual0.
i< 9>
Periods
Cash !lo$
?42.) ?42.) ?42.) ?1,042.)0
0 1 2 & C 40
PG<B
?42.)0
7e%iannual
interest
?42.) interest
H ?1,000
Principal
40
2%onth
periods
8trateg(
+ Mere $e "no$ the !ollo$ing-
6 7e%iannual interest pay%ents < ?42.)0
6 Principal a%ount or par value < ?1,000
6 ,i%e < 20 years or 40 periods
6 A,; or discount rate < 9> or 4.)> !or 2%onths
+ @e can use the a#ove in!or%ation to
deter%ine the value o! the #ond #y
discounting !uture interest and principal
pay%ent to the present.
8te% /7 8olve
Dsing a ;athe%atical 9or%ula
< ? 42.)IN1/1F/1.04)0
40
O J /.200K H
?1,000F/1.04)0
40
< ?42.) /1:.400 H ?151.9&
< A9B<
Dsing a 9inancial
Calculator
6 E < 40
6 1Fy < 4.)0
6 P;, < 42.)0
6 9G < 1000
6 PG < 9B<
Dsing an E*cel
7preadsheet
< PG /rate, nper, p%t, !v0
< PG /.04),40,42.),10000
< A9B<
8te% <7 "nal(=e
Dsing se%iannual co%pounding $e get a
value o! ?9)4 !or A,L, #onds. ,his is very
close to the value o! ?9)4.22 !ound using
annual co%pounding.
9./ $O1D V"L."#IO17
FO.R 6E4 REL"#IO185I!8
$ond Valuation7
Four 6e( Relations)i%s
+ 9irst 8elationship ,he value o! #ond is
inversely related to changes in the yield to
%aturity.
4#' C 10; 4#' rises to
1B;
!ar value A1D??? A1D???
ou%on rate 10; 10;
'aturit( date B (ears B (ears
$ond Value A1D??? A:99.<<
1ond
Galue
'rops
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Figure 9+1 $ond Value and t)e 'ar*et3s ReEuired
4ield to 'aturit( (B+4ear $ondD 10; ou%on
Rate)
$ond Valuation7 Four 6e(
Relations)i%s (cont.)
+ 7econd 8elationship- ,he %ar"et value o! a
#ond $ill #e less than the par value
/discount bond0 i! the %ar"et3s re4uired
yield to %aturity is a#ove the coupon
interest rate and $ill #e valued a#ove par
value /%re-iu- bond0 i! the %ar"et3s
re4uired yield to %aturity is #elo$ the
coupon interest rate.
+ ,hird 8elationship As the %aturity date
approaches, the %ar"et value o! a #ond
approaches its par value. ,hat3s #ecause at
%aturity the #ond $ill #e ta"en a$ay and the
investor $ill receive the par value o! the
#ond.
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#able 9+B $ond !rices Relative to
'aturit( Date
Figure 9+0 Value o, a 10; ou%on
$ond during t)e Li,e o, t)e $ond
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9ourth 8elationship .ong ter% #onds have
greater interestrate ris" than shortter%
#onds.
+@hile all #onds are a!!ected #y a change in
interest rates, the prices o! longerter% #onds
!luctuate %ore $hen interest rates change
than do the prices o! shorterter% #onds /see
,a#le 9.20
9.< #4!E8 OF $O1D8
#able 9+9 #(%es o, or%orate $onds
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9.B DE#ER'I1"1#8 OF
I1#ERE8# R"#E8
Deter-inants o, Interest Rates
As $e o#served earlier, #ond prices vary
inversely $ith interest rates. ,here!ore in
order to understand ho$ #ond prices
!luctuate, $e need to "no$ the deter%inants
o! interest rates.
In,lation and Real versus 1o-inal
Interest Rates
+ Puotes o! interest rates in the !inancial press
are co%%only re!erred to as the no-inal
(or Euoted) interest rates. Real rate o,
interest ad(usts !or the e!!ects o! in!lation.
+ 8eal 8ate o! Interest /appro*i%ation0
Q Eo%inal interest rate 6 In!lation pre%iu%
Fis)er E,,ect7 #)e 1o-inal and Real
Rate o, Interest
+ ,he relationship #et$een the no%inal rate o!
interest, r
no%inal
, the anticipated rate o!
in!lation, r
in!lation
, and the real rate o! interest
is "no$n as the Fis)er e,,ect.
8toc*
Valuation
Learning Objectives
1. Identi!y the #asic characteristics and !eatures
o! co%%on stoc" and use the discounted cash
!lo$ %odel to value co%%on shares.
2. Dse the pricetoearnings /PFE0 ratio to value
co%%on stoc".
&. Identi!y the #asic characteristics and !eatures
o! pre!erred stoc" and value pre!erred shares.
4. Dse the secondary %ar"ets !or co%%on stoc".
1?.1 O''O1 8#O6
o--on 8toc*
Co%%on stoc"holders are the o$ners o! the
!ir%. ,hey elect the !ir%3s #oard o! directors
$ho in turn appoint the !ir%3s top
%anage%ent tea%. ,he !ir%3s %anage%ent
tea% then carries out the daytoday
%anage%ent o! the !ir%.
o--on 8toc* )aracteristics
Clai% on Inco%e Co%%on stoc"holders have
the right to the !ir%3s inco%e a!ter
#ondholders and pre!erred stoc"holders have
#een paid. ,he co%%on stoc"holders either
receive dividends or any increase in value that
results !ro% the reinvested earnings.
(cont.)
+ Clai% on Assets In case o! li4uidation,
co%%on stoc"holders have residual clai% on
assets.
+ Goting 8ights In general, co%%on
shareholders are the only security holders
given the right to vote. ;ost shareholders
vote #y %ro>(.
(cont.)
Agency Costs and Co%%on 7toc"
7hareholders elect the #oard. In reality,
#oard %e%#ers are no%inated #y the
%anage%ent. As a result, %anage%ent
e!!ectively elects the #oard. ,his %ay
lead to agency pro#le%s.
Valuing o--on 8toc* .sing t)e
Discounted Dividend 'odel
.i"e #onds, co%%on stoc"3s value is e4ual to
the present value o! all !uture cash !lo$s that
the stoc"holder e*pects to receive !ro%
o$ning the shares o! stoc". Mo$ever, unli"e
#onds, the !uture cash !lo$s in the !or% o!
dividends are not !i*ed and there is no
%aturity date.
#)ree 8te% !rocedure ,or Valuing
o--on 8toc*
7tep 1- Esti%ate the a%ount and ti%ing o! the
receipt o! the !uture cash !lo$s the co%%on
stoc" is expected to provide.
7tep 2- Evaluate the ris"iness o! the co%%on
stoc"3s !uture dividends to deter%ine the
stoc"3s re4uired rate o! return.
#)ree 8te% !rocedure ,or Valuing
o--on 8toc* (cont.)
7tep &- Calculate the present value o! the
e*pected dividends #y discounting the% #ac"
to the present at the stoc"3s re4uired rate o!
return.
+,he three steps sho$ that the value o! a
co%%on stoc" is e4ual to the present value o!
all !uture dividends.
#)e onstant Dividend 2ro&t) Rate
'odel
I! a !ir%3s cash dividend gro$ #y a constant
rate, then the co%%on stoc" can #e valued as
!ollo$s-
5E6!OI1# 1?.17
CHECK YOURSELF
Valuing o--on 8toc*
#)e !roble-
@hat is the value o! a share o! co%%on stoc"
that paid ?2 dividend at the end o! last year
and is e*pected to pay a cash dividend every
year !ro% no$ to in!inity, $ith that dividend
gro$ing at a rate o! ) percent per year, i! the
investor3s re4uired rate o! return is 12> on
that stoc"B
@ith a perpetuity, a ti%eline goes on !or
ever $ith the gro$ing cash !lo$ occurring
every period.
i<12>
Aears

Cash !lo$s ?2 ?2/1.0)0?2/1.0)0
2

0 1 2 C
Galue o! co%%on
stoc" < Present
Galue o! E*pected
'ividends.
,he gro$ing
dividends go on
!orever
C
8trateg(
+ ,he value o! a share o! stoc" can #e vie$ed
as a the present value o! a gro$ing
perpetuity.
+ Mere $e "no$ the e*pected dividends, the
gro$th rate, and investor3s re4uired rate o!
return.
+ @e can use e4uation 102 to deter%ine the
value o! a share o! co%%on stoc".
8te% /7 8olve
+ @e need to !irst deter%ine '
1,
the dividend
ne*t period.
+ 7ince dividends at the end o! last year $as
?2 and dividends are e*pected to gro$ at a
rate o! )>, dividends !or ne*t period $ill #e-
+ '
1
< '
0
/1Hg0 < ?2 /1.0)0 < ?2.&0
+
G
cs
< ?2.&0 J /0.120.0)0 < ?2.&0 J 0.05
< A9?
8te% <7 "nal(=e
E4uation 102 is #ased on the assu%ption
that dividends $ill gro$ at a constant rate !or
ever. @hile not a realistic assu%ption, it
ena#les us to deter%ine the value o! co%%on
stoc" easily and also helps us to identi!y the
!actors that %ove the stoc" prices.
Copyright 2014 Pearson Education, Inc. All rights reserved. 9:0
W)at auses 8toc* !rices to 2o .%
and Do&nF
E4uation 102 indicates that there are three
varia#les that drive share value-
6 ,he %ost recent dividend /'
0
0,
6 Investor3s re4uired rate o! return /r
cs
0, and
6 E*pected rate o! gro$th in !uture dividends /g0.
W)at auses 8toc* !rices to 2o .%
and Do&nF (cont.)
7ince %ost recent dividend /'
0
0 has already
#een paid, it cannot a!!ect price. ,hus the
other t$o varia#les, r
cs
and g, can vary and
lead to changes in stoc" prices.
Deter-inants o, t)e Investor3s
ReEuired Rate o, Return
,he investor3s re4uired rate o! return is
deter%ined #y t$o "ey !actors-
1.,he level o! interest rates in the econo%yR
2.,he ris" o! the !ir%3s stoc".
Copyright 2014 Pearson Education, Inc. All rights reserved. 9:&
Deter-inants o, t)e Investor3s
ReEuired Rate o, Return (cont.)
CAP; suggests that i! ris"!ree rate andFor
syste%atic ris" /#eta0 rises, the investor3s
re4uired rate o! return $ill rise and the stoc"
price $ill !all.
Deter-inants o, t)e 2ro&t) Rate o,
Future Dividends
,he gro$th rate o! !uture dividends /g0 can
also change and lead to a change in the stoc"
price. ,he t$o "ey deter%inants o! a !ir%3s
gro$th opportunities relate to-
6 the return on e4uity /8SE0, and
6 the retention ratio /#0
Copyright 2014 Pearson Education, Inc. All rights reserved. 9:)
Deter-inants o, 2ro&t) Rate o,
Future Dividends (cont.)
,he gro$th rate is !or%ally e*pressed as
!ollo$s-
+g < the e*pected rate o! gro$th o! dividends
+'
1
FE
1
< the dividend payout ratio
+# < the proportion o! !ir%3s earnings that are
retained and reinvested in the !ir%.
+8SE < the return on e4uity earned $hen the !ir%
reinvests a portion o! its earning #ac" into the !ir%.
1?.0 #5E O'!"R"$LE8
"!!RO"5 #O V"L.I12
O''O1 8#O6
#)e o-%arables "%%roac) to
Valuing o--on 8toc*
,his %ethod esti%ates the value o! the !ir%3s
stoc" as a %ultiple o! so%e %easure o! !ir%3s
per!or%ance. ,he %ost co%%on %etric is
earnings per share. ,hus values are
deter%ined !ro% the %rice+to+earnings ratio
o! co%para#le !ir%s.
Copyright 2014 Pearson Education, Inc. All rights reserved. 9::
De,ining t)e !GE Ratio Valuation
'odel
+G
cs
< the value o! co%%on stoc" o! the !ir%.
+PFE
1
< the price earnings ratio !or the !ir%
#ased on the current price per share divided
#y earnings !or end o! year 1.
+E
1
< esti%ated earnings per share o!
co%%on stoc" !or the end o! year 1.
5E6!OI1# 1?.07
CHECK YOURSELF
Valuing o--on 8toc*
.sing t)e !GE Ratio
#)e !roble-
A!ter so%e care!ul analysis and re!lection on
the valuation o! the Meals3 shares the
co%pany C9S suggested that the earnings
pro(ection are too conservative and earnings
!or the co%ing year could easily (u%p to
?2.00. @hat does this do !or your esti%ate o!
the value o! Meals3 sharesB
EP7
< ?2.00
PFE
;ultiple
7toc" Price
8trateg(
+ ,he co%%on stoc" value can #e co%puted
#y %ultiplying the !ir%3s esti%ated earnings
per share !or the co%ing year #y $hat the
analyst esti%ates to #e an appropriate PFE
ratio.
+ @e can use e4uation 104 to esti%ate the
value o! co%%on stoc".
8te% /7 8olve
G
cs
< 1:.20 = ?2
< A/@.<?
8te% <7 "nal(=e
+ @e esti%ated the value o! Meales3 shares
#ased on the PFE ratios o! three co%para#le
!ir%s. Mo$ever, this esti%ate is contingent
on the appropriateness o! the co%para#le
set o! co%panies to the Meals 7hoe
Co%pany.
+ 9urther%ore, i! the %ar"et conditions
change #y the ti%e the shares are sold in
the %ar"et, the price esti%ate $ill not #e
appropriate.
W)at Deter-ines t)e !GE Ratio ,or a
8toc*F
Dsing E4uation 10)a and 10)#, there are
t$o !unda%ental deter%inants o! a !ir%3s PFE
ratio-
1. 2ro&t) Rate in Dividends /higher the
gro$th rate, higher the PFE ratio0, and
0. Investor+ReEuired Rates o, Return
/higher the re4uired rate, lo$er the PFE
ratio0
1?./ !REFERRED 8#O6
Features o, !re,erred 8toc*
+ Dividend- In general, siTe o! pre!erred
stoc" dividend is fixed, and it is either stated
as a dollar a%ount or as a percentage o! the
pre!erred stoc"3s par value.
+ 'ulti%le lasses- A co%pany can issue
%ore than one class o! pre!erred stoc", and
each class can have di!!erent characteristics.
Features o, !re,erred 8toc* (cont.)
+ lai-s on "ssets and Inco-e7 Pre!erred
stoc"holders have priority over those o!
co%%on stoc"holders !or pay%ent o!
dividends and in settle%ent o! clai%s at
#an"ruptcy. ;ost pre!erred stoc" carry a
cu-ulative ,eature i.e. all past unpaid
dividends %ust #e paid #e!ore any co%%on
stoc" dividends can #e declared.
Features o, !re,erred 8toc* (cont.)
!re,erred 8toc* as a 5(brid 8ecurit(7
6 .i"e co%%on stoc"s, pre!erred stoc"s do not
have a !i*ed %aturity date. Also, li"e co%%on
stoc"s, nonpay%ent o! dividends does not #ring
on #an"ruptcy, and dividends are not deducti#le
!or ta* purposes.
6 .i"e de#t, pre!erred stoc"s have a !i*ed dividend.
Also, %ost pre!erred stoc"s are periodically
retired even though there is no stated %aturity
date.
Valuing !re,erred 8toc*
1ecause pre!erred stoc"s are perpetuities
/non%aturing0, and #ecause the cash
dividend is the sa%e every period, they can
#e valued using the present value o!
perpetuity e4uation introduced in chapter 2
/e4uation 2)0.
Valuing !re,erred 8toc* (cont.)
+G
ps
< the value o! a share o! pre!erred stoc"
+'
ps
< the annual pre!erred stoc" dividend
+r
ps
< the %ar"et yield or the rate o! return on
the pre!erred stoc"3s pro%ised dividend
Esti-ating t)e 'ar*et3s ReEuired
4ield
Esti%ating the 'ar*et 4ield- @e can use
e4uation 102 to solve !or the %ar"et3s
re4uired yield.
r
ps <
'
ps J
G
ps
5E6!OI1# 1?./7
CHECK YOURSELF
Valuing !re,erred 8toc*
@hat is the present value o! a share o!
pre!erred stoc" that pays a dividend o!
?12 per share i! the %ar"et3s yield on
si%ilar issues o! pre!erred stoc" is :>B
Pre!erred stoc"s are constant !or all years
and !or% a level perpetuity.
r
ps
<:>
Aears

'ividends ?12 ?12 ?12 ?12

0 1 2 & C
Galue o! Pre!erred
7toc" < Present
Galue o! pro%ised
dividends.
,he annual
?12 dividends
go on
!orever.
C
8trateg(
8te% /7 8olve
@e can deter%ine the present value o! share
o! pre!erred stoc" using e4uation 102.
G
ps
< ?12 J 0.0: < A1B?
8te% <7 "nal(=e
7ince pre!erred stoc" is a level perpetuity, its
value on any !uture date $ill #e the sa%e as
its present value today as long as the
pro%ised rate o! return on the share re%ains
the sa%e.
1?.< #5E 8#O6 '"R6E#
#)e 8toc* 'ar*et
As discussed in chapter 2, ne$ securities trade
in the %ri-ar( -ar*et $hile currently
outstanding securities trade in the secondar(
-ar*et. ,here are t$o types o! secondary
%ar"ets- organiTed e*changes and overthe
counter %ar"ets.
Organi=ed E>c)anges
#)e 1e& 4or* 8toc* E>c)ange (148E),
also called the U1ig 1oard,V is the oldest o! all
organiTed e*changes. @hile the EA7E is
considered an organiTed e*change #ecause o!
its physical location, the %a(ority o! its trades
are done electronically $ithout a !aceto!ace
%eeting o! traders.
Organi=ed E>c)anges (cont.)
+ ,o #e listed on the EA7E, a !ir% %ust %eet
strict re4uire%ents dealing $ith pro!ita#ility
and %ar"et value, and #e $idely o$ned.
+ ;uch o! the trading on the EA7E is %ade up
o! bloc* trades i.e. transactions involving
10,000 shares or %ore #y a single individual
or institution.
Organi=ed E>c)anges (cont.)
+ ,he "-erican 8toc* E>c)ange /A;EW0 is
the nation3s second largest, !loor#ased
e*change. Mo$ever, in ter%s o! trading
volu%e, the A;EW is a distant nu%#er t$o
$ith less than &> o! that on the EA7E.
+ Although A;EW %erged $ith EA7'AP in
199: it continues to operate as a separate
entity.
Over+t)e+ounter (O#) 'ar*et
,he over+t)e+counter -ar*et is a net$or"
o! dealers that has no listing or %e%#ership
re4uire%ents. ,oday, the S,C %ar"et is
electronic rather than personal, $ith Easda4
leading the $ay. It is also the pri%ary %ar"et
!or #onds.
(cont.)
+ 1asdaE de#uted in 1951 and $as the
$orld3s !irst electronic stoc" %ar"et. @hile
Easda4 lists %ore co%panies than the
EA7E, they are relatively s%aller co%panies
/$ith a !e$ e*ceptions0
+ ,here are a#out 1,000 %ar"et participants,
in general trading !ir%s that are lin"ed
electronically, $ith price and trading
in!or%ation #roadcast to over &)0,000
ter%inals $orld$ide.
(cont.)
,he Easda4 stoc" %ar"et has t$o tiers o!
listed co%panies-
6 Easda4 Eational ;ar"ets, %ade up o! around
4,000 co%panies li"e 'ell /'0, Intel /IE,C0R and
6 Easda4 7%allcap ;ar"et, $hich includes over
1,000 s%aller e%erging gro$th co%panies.

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