Planning

Planning Organizing
Organizing
Critical
CriticalSuccess
SuccessFactors
Factors

Stakeholders
Stakeholders
Economic Marketing
EX Top Management

L
NA
TE
RN Social Vision
Vision Operations Finance

R
Political

TE
AL

IN
Mission
Mission Human
Technological Resources
Strategy
Strategy

Middle Management
First-Line Management
Controlling
Controlling Directing
Directing
 Canadian Financial System
Funds Required

Debt Equity / Stocks

Short term Long term Private Public sale

Bonds placement
Banks OSC
- institutional investors
Money Market Investment Dealers
- t-bills
Agent vs. Principal
- short term gov’t notes
-commercial paper
-Gov’t bonds

Over-the-Counter Market Stock Exchanges

bonds/debentures, unlisted stock, Preferred &Common
mutual funds, shares, Options (derivatives)
Alternate Types of Investments
• Bonds: Definition
A bond is a promise by the issuer or
borrower (government or corporation) to
repay an investor (the lender) a set dollar
amount (the principal), at a set date (the
date of final maturity), and to pay the
investor a fixed rate of interest (the coupon
rate) each year
 Characteristics of All Bonds
• Face Value
– Most bonds are initially sold at a face value
(par value) of $1,000 per bond
• Length of Life/Date of Final Maturity
– Most bonds have a relatively long life from the
time they are initially sold (issued) until the
time that they mature (date of final maturity)
– This is referred to as the bond’s “run to
maturity” or “life expectancy” and is normally
20 years
 – However, some bonds may have a longer run
to maturity (for example 30 years) or a shorter
run to maturity (10 or 15 years)
– For the sake of simplicity, we will always
assume that a bond will have a life
expectancy (or run to maturity) of 20 years

• Date of Final Maturity

– At the end of it’s life, a bond is said to
“mature” and the issuer will repay the principal
($1,000) to the holder of the bond
• Coupon Rate
– Each year the owner of a bond will receive a
fixed rate of interest from the issuer of the
bond
– The amount of interest received annually is
determined by the following formula

Annual Interest = Coupon Rate X Face or Par Value ($1,000)

– An investor will never receive anything more

than this amount of interest, but will also
never receive anything less than this amount
– If the issuer of a bond fails to pay the required
amount of interest to the investor, it is
considered to be an act of bankruptcy
– The bondholders can then take action to force
the company to liquidate its assets and use
the proceeds to pay their outstanding claims
(all interest owed plus full repayment of the
principal loaned)
– How Is This Accomplished?
• The Bond Indenture (Contract)
• The Bond Trustee
• The Order of Liquidation
 Order of Liquidation
(According to Canadian Bankruptcy Law)
• Secured Creditors (Banks, Bondholders)
• Preferred Creditors (Government)
• Unsecured Creditors (Suppliers,
Employees, Debenture Holders)
• Preferred Stockholders
• Common Stockholders
• In view of the foregoing, Bonds are usually
very safe investments
• If the issuer defaults on the terms of the
bond indenture, the trustee can force the
company to sell the assets pledged as
security for the loan (as outlined in the
indenture) and then use the proceeds to
pay the bondholder’s claims
• The types of security pledged as collateral
give rise to different types of bonds
 Different Types of Bonds
Type of Bond Type of Collateral

Mortgage Bonds Real Property (land, buildings)

Collateral Trust Bonds Stocks and Bonds (Securities)

Equipment Trust Bonds Machinery and Equipment

Debentures No Collateral. Bondholders are

unsecured creditors
 Reading Bond Quotations
in the Financial Press
Issuer Coupon Maturity Bid

Canada 5.50 Jun1/09 106.48*

Bell 6.55 May1/29 99.42*

*Actual Selling Price = Bid Price x 10

Government of Canada 5.5 of ’09 = $1,064.80

Bell Canada 6.55 of ’29 = $994.20
The Rough Bond Yield Formula
• The rough bond yield formula assumes that the Investor
holds the bond until the date of final maturity

= Annual Interest + Annual Capital Gain X 100%

Purchase Price of Bond

= (Coupon Rate X Par Value) + (Par Value – P. Price)

# years to Maturity
Purchase Price of Bond
• Example #1:

Calculate the yield on a GM 10 of Oct. 1 ’18 purchased

for $900 on October 1, 2008?

Yield = Annual Interest/Bond + Annual Capital Gain (Loss)

Purchase Price/Bond
= (10% X $1,000) + $1,000 - $900
10 years
$900
= $110 = 12.22%
$900
• Example 2:

Calculate the yield on a GM 10 of Oct 1 ’18 purchased

for $1,100 on October 1, 2008?

Yield = Annual Interest/Bond + Annual Capital Gain (Loss)

Purchase Price/Bond
= (10% X $1,000) + $1,000 - $1,100
10 years
$1,100
= $ 90 = 8.18 %
$1,100
 Summary: Bond Yields
• If a Bond sells at a discount (less than $1,000)

The Yield is greater than the Coupon Rate

• If a Bond sells at a premium (greater than $1,000)

The Yield is less than the Coupon Rate

• If a Bond sells at Par or Face Value ($1,000)

The Yield is equal to the Coupon Rate

 Other Characteristics of Bonds
• When you purchase a bond you are a
creditor of the company (not an owner)
• Therefore, you have no voting rights or
say in how the company will be run

• Bond prices vary inversely with interest

rate movements in the economy
– If interest rates increase…bond prices fall
– If interest rates fall…bond prices increase
 Announcements
• New Venture Concept Statements are due
this Friday, October 10 at 12:00 Noon in
drop boxes outside TA Office P1002
• Hard copy turned in to drop boxes by
12:00 Noon…no exceptions
• Electronic copy to Turnitin.com by 12:00
Midnight…no exceptions
• Turnitin Instructions posted on Course
Website under “Assignments” Folder
Why Do Bond Prices Vary Inversely
With Interest Rates?
• Once a bond has been sold, the coupon rate on
that bond is fixed for the entire life of the bond
• If new bonds of similar risk are sold bearing a
higher coupon rate (due to the fact that interest
rates have risen in the economy)
• Then rational investors will prefer to purchase
these new bonds (with higher coupon rates)
rather than the old bonds (with lower coupon
rates) in order to obtain the higher rates of
interest
Why Do Bond Prices Vary Inversely
With Interest Rates?
• Rational investors will only be willing to
own the old (lower coupon rate) bond if
that bond’s yield is equal to that of the
new bonds
• The only way for this to happen is if the
price of the old bond falls (sells at a
discount)
• Summary: Interest rates have gone up
and bond prices have fallen
The Rough Bond Yield Formula
• The rough bond yield formula assumes that the Investor
holds the bond until the date of final maturity

= Annual Interest + Annual Capital Gain X 100%

Purchase Price of Bond

= (Coupon Rate X Par Value) + (Par Value – P. Price)

# years to Maturity
Purchase Price of Bond
 Determining Bond Prices
• Example: What would you pay for a Bell
8 of Oct 1 2018, if similar risk bonds
issued today have coupon rates of 10%?

1998 2008 2018

Bell 8 of Oct 1 2018 New bond sells at 10% coupon = $100/yr
issued at par = $80/yr Will you pay $1,000 for Bell 8 of ‘18?

• pay what will what will yield the same

as the new bonds or 10%
•will pay less than $1,000
• Sample Examination Problem #1: Interest Rates
Rise in the Economy

How much would a rational investor pay for a

Bell Canada 8 of Oct 1 ’18 if bonds of similar risk
were issued today at a coupon rate of 10%?

• Solution:
 The investor is indifferent as to whether he or she
owns the Bell 8 of ’18 or the new bond with a coupon
rate of 10% when the yields on the two bonds are
equal
 Yield on Bell 10 of ’28 = Yield on Bell 8 of ‘18
• Therefore, let the purchase price that a rational
investor will pay today for a Bell 8 of ’18 be X

10% = (8% X $1,000) + ($1,000 – X)

10 years
X

.1X = $80 + ($1,000 – X)

10 yrs
X = $800 + $1,000 – X
2X = $1,800
X = $ 900
Summary:
Interest rates in the economy have risen
from 8% (when the Bell 8 of ’18 was first
Issued in 1998) to their current level of 10%
(the coupon rate on the newly issued bonds)

The effect on the market price of a Bell 8 of ’18 is

an decrease from $1,000 in 1998 to a price of
$900 on October 1, 2008.
Why Do Bond Prices Vary Inversely
With Interest Rates?
• Once a bond has been sold, the coupon rate on
that bond is fixed for the entire life of the bond
• If new bonds of similar risk are sold bearing a
lower coupon rate (due to the fact that interest
rates have fallen in the economy)
• Then rational investors will prefer to purchase
the old bonds (with higher coupon rates) rather
than the new bonds (with lower coupon rates) in
order to obtain the higher rates of interest
Why Do Bond Prices Vary Inversely
With Interest Rates?
• Rational investors will only be willing to
own the new (lower coupon rate) bond if
that bond’s yield is equal to that of the old
bonds
• The only way for this to happen is if the
price of the old bond rises (sells at a
premium)
• Investors will bid up the price of the old
bond until its yield is equal to that of the
new bond

• Summary: Interest rates have gone down

and bond prices have risen
• Sample Examination Problem #2: Interest Rates
Fall in the Economy

How much would a rational investor pay for a

Bell Canada 8 of October 1 ’18 if bonds of
similar risk were issued today at a coupon rate
of 5%?

• Solution:
 The investor is indifferent as to whether he or she
owns the Bell 8 of ’18 or the new bond with a coupon
rate of 5% when the yields on the two bonds are
equal
 Yield on Bell 5 of ’28 = Yield on Bell 8 of ‘18
 Therefore, let the purchase price that a
rational investor will pay today for a Bell 8 of
’18 be X

5% = (8% X $1,000) + ($1,000 – X)

10 years
X

.05X = $80 + ($1,000 – X)

10 yrs
.5X = $800 + $1,000 – X
1.5X = $1,800
X = $1,200
Summary:
Interest rates in the economy have fallen
from 8% (when the Bell 8 of ’18 was first
Issued in 1998) to their current level of 5%
(the coupon rate on the newly issued bonds)

The effect on the market price of a Bell 8 of ’18 is

an increase from $1,000 in 1998 to a price of
$1,200 on September 26, 2008.
 Other Features Possessed By
Some Bonds
• The Call or Redemption Feature (Callable
or Redeemable Bonds)
– Allows the issuer to repurchase the bond for a
predetermined fixed price at the issuer’s
discretion prior to the date of final maturity
– This fixed price is determined by the Call
Schedule printed on the Bond certificate
• Why is a call feature attached to a bond?
• Allows the issuer the flexibility to buy back
the outstanding bonds if interest rates fall
substantially in the future
• Disadvantageous to the investor…why?
• Callables usually pay a higher coupon
than non-callables
• The Conversion Feature (Convertible
Bonds)
– Allows the investor the right to convert the
bond into a prescribed number of common
shares in the same company
– May allow the investor to realize a capital gain
at some time in the future if the firm’s common
stock appreciates substantially in value
– Favourable to the investor
– Convertibles often sell at lower coupon rates
than non-convertibles
• Extendible/Retractable Feature
– Allows the investor the option to extend the
life of the bond beyond it’s maturity date
(extendible) or have the bond refunded before
its date of final maturity (retractable)
– Favourable to the investor
– Can see which way interest rates have moved
(and are likely to move) and make the
decision to extend (if interest rates have fallen
below the coupon rate of the bond) or to
retract (if interest rates have risen above the
coupon rate of the bond)
 Canadian Financial System
Funds Required

Debt Equity / Stocks

Short term Long term Private Public sale

Bonds placement
Banks OSC
- institutional investors
Money Market Investment Dealers
- t-bills
Agent vs. Principal
- short term gov’t notes
-commercial paper
-Gov’t bonds

Over-the-Counter Market Stock Exchanges

bonds/debentures, unlisted stock, Preferred &Common
mutual funds, shares, Options (derivatives)
 Preferred Shares
• Hybrid Financing
• Preferred stock has some features that
make it very similar to a bond and some
features that make it very similar to
common stock
Characteristics of Preferred Shares
• The characteristics of preferred shares will
be discussed in lectures on the
whiteboards.
• No power point slides will be posted on
this topic, with the exception of the
following example of a participating feature
Participating Preferred Example
•• Example:
Example:
•• -- $1,000,000
$1,000,000 netnet profit
profit
•• -- 50%
50% dividend
dividend rate
rate
•• -- 50,000
50,000shares
sharesof of 10%
10% cumulative
cumulativeparticipating
participating
preferreds
preferredswith
with$10
$10 par
parvalue
value
•• -- dividends
dividendsin in arrears
arrears 11yr.
yr.
•• -- participation
participationcommences
commences when whencommon
commondividends
dividends
reach
reach$3/share
$3/share
•• -- 100,000
100,000shares
sharescommon
commonstock stock
•• What
Whatisis the
theamount
amount ofofdividends
dividendsper
pershare
shareforforboth
both
common
commonand andpreferred?
preferred?
Example:
$500,000 total dividend ($1,000,000 x 50%)
- $100,000 preferred dividend
(10% x $10 par x 2 years = $2/share x 50,000 shares)

$400,000
- $300,000 common dividend (100,000 shares x $3)

$100,000 for participation

/ 150,000 shares (50,000 pref. + 100,000 common)

~ $.67 per share

Therefore… preferred dividend = $2.67/share

common dividend = $3.67/share
 Calculating Stock Yield
Stock/Dividend Yield...

= dividends/share/year
price/share

For Example: What is the yield on a stock which is

selling for $20/share, and has an expected dividend of $2?

Dividend Yield = $2 / $20 = 10%