Chapter 9 Debt Valuation and Interest Rates

Chapter 9 Debt Valuation and Interest Rates

Slide Contents Learning Objectives Principles Used in This Chapter 1.Overview of Corporate Debt 2.Valuing Corporate Debt 3.Bond Valuation: Four Key Relationships 4.Types of Bonds 5.Determinants of Interest Rates 9-2

Learning Objectives 1. Identify the key features of bonds and describe the difference between private and public debt markets. 2. Calculate the value of a bond and relate it to the yield to maturity on the bond. 3. Describe the four key bond valuation relationships. 4. Identify the major types of corporate bonds. 5. Explain the effects of inflation on interest rates and describe the term structure of interest rates. 9-3

9.1 Overview of Corporate Debt

Corporate Borrowings There are two main sources of borrowing for a corporation: 1. Loan from a financial institution (known as private debt) 2. Bonds (known as public debt since they can be traded in public financial markets) 9-5

Corporate Borrowings (cont.) Smaller firms choose to raise money from banks in the form of loans because of the high costs associated with issuing bonds. Larger firms generally raise money from banks for short-term needs and depend on the bond market for long-term financing needs. 9-6

Borrowing Money in the Private Financial Market (cont.) In the private financial market, loans are typically floating rate loans i.e. the interest rate is periodically adjusted based on a specific benchmark rate. The most popular benchmark rate is the London Interbank Offered Rate (LIBOR) LIBOR is the daily interest rate that is based on the interest rates at which banks offer to lend in the London wholesale or interbank market. 9-7

Borrowing Money in the Public Financial Market Firms also raise money by selling debt securities to individual investors and financial institutions such as mutual funds. In order to sell debt securities to the public, the issuing firm must meet the legal requirements as specified by the securities laws. 9-8

Borrowing Money in the Public Financial Market Corporate bond is a debt security issued by corporation that has promised future payments and a maturity date. If the firm fails to pay the promised future payments of interest and principal, the bond trustee can classify the firm as insolvent and force the firm into bankruptcy. 9-9

Basic Bond Features The basic features of a bond include the following: Bond Indenture Claims on Assets and Income Par or Face Value Coupon Interest Rate Maturity and Repayment of Principal Call Provision and Conversion Features 9-10

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Bond Ratings and Default Risk Bond ratings indicate the default risk i.e. the probability that the firm will make the promised payments. Bond ratings affect the rate of return that lenders require of the firm and the firm s cost of borrowing. 9-12

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9.2 Valuing Corporate Debt

Valuing Corporate Debt The value of corporate debt is equal to the present value of the contractually promised principal and interest payments (the cash flows), which discounted back to the present using the market s required yield. 9-15

Step-by-Step: Valuing Bonds by Discounting Future Cash Flows Step 1: Determine the amount and timing of bondholder cash flows. The total cash flows equal the promised interest payments and principal payment. Annual Interest = Par value coupon rate Example 9.1: The annual interest for a bond with coupon interest rate of 7% and a par value of $1,000 is equal to $70, (.07 $1,000 = $70). 9-16

Step-by-Step: Valuing Bonds by Discounting Future Cash Flows (cont.) Step 2: Estimate the appropriate discount rate on a similar risk bond. Discount rate is the return the bond will yield if it is held to maturity and all bond payments are made. Discount rate can be either calculated or obtained from various sources (such as Yahoo! Finance). 9-17

Step-by-Step: Valuing Bonds by Discounting Future Cash Flows (cont.) Step 3: Calculate the present value of the bond s interest and principal payments from Step 1 using the discount rate estimated in step 2. 9-18

Calculating a Bond s Yield to Maturity (YTM) We can think of YTM as the discount rate that makes the present value of the bond s promised interest and principal equal to the bond s observed market price. 9-19

Checkpoint 9.3: Check Yourself Consider a $1,000 par value bond issued by AT&T (T) with a maturity date of 2026 and a stated coupon rate of 8.5%. On January 1, 2007, the bond had 20 years left to maturity. If the market s required yield to maturity on a comparable risk bond is 9%, what is the value of the bond? 9-20

Step 1: Picture the Problem Years i= 9% 0 1 2 3 20 Cash flows $85 $85 $85 $1,085 PV of all Cash flows =? $85 annual interest $85 interest + $1,000 Principal 9-21

Step 2: Decide on a Solution Strategy Here we know the following: Annual interest payments = $85 Principal amount or par value = $1,000 Time = 20 years YTM or discount rate = 9% We can use the above information to determine the value of the bond by discounting future interest and principal payment to the present. 9-22

Step 3: Solve Using Mathematical Equation Bond Value = $ 85{[1-(1/(1.09) 20 ] (.09)} + $1,000/(1.09) 20 = $85 (9.128) + $178.43 = $954.36 9-23

Step 4: Analyze The value of AT&T bond is $954.36 when the yield to maturity for comparable risk bond is 9%. The bonds are now trading at a discount as the coupon rate on AT&T bonds is lower than the market yield. 9-24

9.3 Bond Valuation: Four Key Relationships

Bond Valuation: Four Key Relationships First Relationship The value of bond is inversely related to changes in the yield to maturity. YTM = 12% YTM rises to 15% Par value $1,000 $1,000 Coupon rate 12% 12% Maturity date 5 years 5 years Bond Value $1,000 $899.44 Bond Value Drops 9-26

Bond Valuation: Four Key Relationships (cont.) 9-27

Bond Valuation: Four Key Relationships (cont.) Second Relationship: The market value of a bond will be less than its par value if the yield to maturity is above the coupon interest rate and will be valued above par value if the yield to maturity is below the coupon interest rate. 9-28

Bond Valuation: Four Key Relationships (cont.) When a bond can be bought for less than its par value, it is called discount bond. For example, buying a $1,000 par value bond for $950. Bonds will trade at a discount when the yield to maturity on the bond exceeds the coupon rate. 9-29

Bond Valuation: Four Key Relationships (cont.) When a bond can be bought for more than its par value, it is called premium bond. For example, buying a $1,000 par value bond for $1,110. Bonds will trade at a premium when the yield to maturity on the bond is less than the coupon rate. 9-30

Bond Valuation: Four Key Relationships (cont.) Third Relationship As the maturity date approaches, the market value of a bond approaches its par value. Regardless of whether the bond was trading at a discount or at a premium, the price of bond will converge towards par value as the maturity date approaches. 9-31

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Bond Valuation: Four Key Relationships (cont.) Fourth Relationship Long term bonds have greater interest rate risk than short-term bonds. While all bonds are affected by a change in interest rates, long-term bonds are exposed to greater volatility as interest rates change. 9-33

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9.4 Types of Bonds

Types of Bonds The differences among the various types of bond are based on the following bond attributes: 1. Secured versus Unsecured, 2. Priority of claim, 3. Initial offering market, 4. Abnormal risk, 5. Coupon level, 6. Amortizing or non-amortizing, and 7. Convertibility. 9-36

Types of Bonds (cont.) Secured versus Unsecured Secured bonds have specific assets pledged to support repayment of the bond. Bonds secured by lien on real property is called a mortgage bond. Unsecured bond are referred to as debentures. 9-37

Types of Bonds (cont.) Priority of Claim The priority of claim refers to the order of repayment when the firm s assets are distributed, as in the case of liquidation. Secured bonds are paid first followed by debentures; Among debentures, subordinated debentures have lower priority than secured debt and unsubordinated debentures. 9-38

Types of Bonds (cont.) Initial Offering Market Bonds are classified by where they were originally issued (in the domestic bond market or not). For example, Eurobonds are issued in a foreign country but are denominated in domestic currency. For example, a US corporation issuing bonds in Germany in US dollars. 9-39

Types of Bonds (cont.) Abnormal Risk Junk, or high-yield, bonds have a belowinvestment grade bond rating. These bonds have a high risk of default as the firms that issued these bonds are facing severe financial problems. 9-40

Types of Bonds (cont.) Coupon Level Bonds with a zero or very low coupon are called zero coupon bonds. These bonds are issued at substantial discounts from their par value and promise to repay a zero or very low coupon rate each year. The par value is repaid at the maturity of the bond. 9-41

Types of Bonds (cont.) Amortizing or Non-Amortizing The payments from amortizing bonds, like a home mortgage, include both the interest and principal. The payments from a non-amortizing bonds include only interest. At maturity, the bonds repay the par value of bond. 9-42

Types of Bonds (cont.) Convertibility Convertible bonds are debt securities that can be converted into a firm s stock at a prespecified price. 9-43

9.5 Determinants of Interest Rates

Determinants of Interest Rates As we observed earlier, bond prices vary inversely with interest rates. Therefore in order to understand bond pricing we need to know the determinants of interest rates. 9-45

Real Rate of Interest and the Inflation Premium (cont.) The nominal return or interest rate on a note or bond can be thought of including four basic components: 9-46

I. Real Rate of Interest and the Inflation Premium Quotes of interest rates in the financial press are commonly referred to as the nominal (or quoted) interest rates. Real rate of interest adjusts the nominal rate for the expected effects of inflation. 9-47

Fisher Effect The relationship between the nominal rate of interest, r nominal, the anticipated rate of inflation, r inflation, and the real rate of interest is known as the Fisher effect. 9-48

II. Default Premium In addition to accounting for the time value of money and inflation, the interest rate that a firm s bonds pay must also offer a default premium i.e. risk that the issuer will fail to repay interest and principal in a timely manner. 9-49

III. Maturity Premium The Term Structure of Interest Rates Long-term bonds are more sensitive to interest rate changes. Maturity premium is the compensation that investors demand for bearing interest rate risk on long-term bonds. 9-50

Chapter 10 Stock Valuation

Slide Contents Learning Objectives Principles Used in This Chapter 1.Common Stock characteristics 2.The Approach to Valuing Common Stock 3.Preferred Stock 4.The Stock Market Key Terms 9-52

Learning Objectives 1. Identify the basic characteristics and features of common stock and use the discounted cash flow model to value common shares. 2. Use the price to earnings (P/E) ratio to value common stock. 3. Identify the basic characteristics and features of preferred stock and value preferred shares. 4. Use the secondary market for common stock. 9-53

10.1 Common Stock Characteristics

Common Stock Common stockholders are the owners of the firm. They elect the firm s board of directors who in turn appoint the firm s top management team. 9-55

Common Stock Characteristics Claim on Income Common stockholders have the right to the firm s income that remains after bondholders and preferred stockholders have been paid. The common stockholders either receive cash payments in the form of dividends or the firm s management reinvests the earnings in the firm. 9-56

Common Stock Characteristics (cont.) Claim on Assets In case of liquidation, common stockholders have residual claim on assets. However, bankrupt firms rarely have enough assets to satisfy the claims of stockholders. 9-57

Common Stock Characteristics (cont.) Voting Rights In general, common shareholders are the only security holders given the right to vote. Common shareholders have the right to elect the board of directors and approve any changes in the corporate charter. Some firms have multiple classes of stock with different voting rights. 9-58

Common Stock Characteristics (cont.) Agency Costs and Common Stock In theory, common stockholders elect the board and effectively control the firm through their representatives on the board. In reality, stockholders are given a slate of nominees (list of candidates) for the board selected by the management. As a result, management effectively elects the board and thus the board may have more allegiance (trust) to the managers than to the shareholders. This may lead to agency problems. 9-59

10.2 Valuing Common Stock

Valuing Common Stock Using the Discounted Dividend Model Like bonds, common stock s value is equal to the present value of all future cash flows that the stockholder expects to receive from owning the shares of stock. However, unlike bonds, the future cash flows in the form of dividends are not fixed. Thus the value of common stock is derived from discounting expected dividend. 9-61

Basic Concept of the Stock Valuation Model Example 10.1 Consider a situation in which we are valuing a share of common stock that we plan to hold for only one year. What will be the value of the stock today if it pays a dividend of $2.00, is expected to have a price of $75 and the investor s required rate of return is 12%? 9-62

Basic Concept of the Stock Valuation Model (cont.) Value of Common stock = Present Value of future cash flows = Present Value of (dividend + expected price) = ($2+$75) (1.12) 1 = $68.75 9-63

Basic Concept of the Stock Valuation Model (cont.) Example 10.2 Continue example 10.1. What will be the value of common stock if you hold the stock for two years and sell it for $82? 9-64

Basic Concept of the Stock Valuation Model (cont.) Value of Common stock = Present Value of future cash flows = Present Value of (dividends + expected price) = {($2) (1.12) 1 } + {($2+$82) (1.12) 2 } = $68.75 9-65

Basic Concept of the Stock Valuation Model (cont.) Since stocks do not have a maturity period, we can consider the value of stock to be equal to the present value of future expected dividends. Valuing common stocks using general discounted cash flow model is made difficult as analyst has to forecast each of the future dividends. This problem is greatly simplified if we assume that dividends grow at a fixed or constant rate. 9-66

The Constant Dividend Growth Rate Model If the firm s cash dividend grow by a constant rate each year, then the common stock can be valued as follows: 9-67

The Constant Dividend Growth Rate Model (cont.) V cs = Value of a share of common stock D 0 = Annual cash dividend in the year of valuation g = annual growth rate in the dividend D 1 = expected dividend for the end of year 1 r cs = the common stockholder s required rate of return 9-68

Checkpoint 10.1: Check Yourself What is the value of a share of common stock that paid $6 dividend at the end of last year and is expected to pay a cash dividend every year from now to infinity, with that dividend growing at a rate of 5 percent per year, if the investor s required rate of return is 12% on that stock? 9-69

Solve (cont.) V cs = $6*(1+0,05) (0.12-0.05) = $6.30 (0.12-0.05) = $6.30 0.07 = $90 Thus the value of common stock is $90. 9-70

The Comparable Approach to Valuing Common Stock This method estimates the value of the firm s stock as a multiple of some measure of firm s performance, such as the firm s earnings per share, book value per share, sales per share, cash flow per share, where the multiple is determined by the multiples observed from comparable companies. The most common metric (ratio) is earnings per share (EPS Earnings for end of year per share). 9-71

Define the P/E Ratio Valuation Model Price/Earnings ratio (P/E ratio) is a popular measure of stock valuation. P/E ratio (Current Price/ Earnings) is a relative value model because it tells the investor how many dollars investors are willing to pay for each dollar of the company s earnings. 9-72

Define the P/E Ratio Valuation Model (cont.) V cs = the value of common stock of the firm. P/E 1 = the price earnings ratio for the firm based on the current price per share divided by earnings for end of year 1. E 1 = estimated earnings per share of common stock for the end of year 1. 9-73

Checkpoint 10.2: Check Yourself After some careful analysis and reflection on the valuation of the Heals shares the company CFO suggested that the earnings projection are too conservative and earnings for the coming year could easily jump to $2.00. What does this do for your estimate of the value of Heals shares if P/E ratio equal ith 22,61? 9-74

Solve What does this do for your estimate of the value of Heals shares if P/E ratio equal ith 22,61 and earnings for the coming year could easily jump to $2.00? V cs = 22.61 $2 = $45.22 9-75

10.3 Preferred Stock

Features of Preferred Stock Dividend: In general, size of preferred stock dividend is fixed, and it is either stated as a dollar amount or as a percentage of the preferred stock s par value. Unlike common stockholders, preferred stockholders receive the same fixed dividend regardless of how well the firm does. 9-77

Features of Preferred Stock (cont.) Multiple Classes: If a company chooses, it can issue more than one class of preferred stock, and each class can have different characteristics. For example, Public Storage (PSA) has 16 different issues of preferred stock outstanding that vary in terms of dividend, convertibility, seniority. 9-78

Features of Preferred Stock (cont.) Claims on Assets and Income: In the event of bankruptcy, preferred stockholders have priority over common stock. However, they have lower priority than the firm s debt holders. Firm must pay dividends on preferred stock prior to paying dividend on common stock. 9-79

Features of Preferred Stock (cont.) Claims on Assets and Income (cont.) Most preferred stock carry a cumulative feature. Cumulative feature requires that all past unpaid dividends to be paid before any common stock dividends can be declared. Thus preferred stocks are less risky than common stocks but more risky than bonds. 9-80

Features of Preferred Stock (cont.) Preferred Stock as a Hybrid Security Like common stocks, preferred stocks do not have a fixed maturity date. Also, like common stocks, nonpayment of dividends does not lead to bankruptcy of the firm. Like debt, preferred stocks have a fixed dividend. Also, most preferred stocks are periodically retired even though there is no stated maturity date. 9-81

Valuing Preferred Stock Since preferred stockholders generally receive a fixed dividend and the stocks are perpetuities (non-maturing), it can be valued using the present value of perpetuity equation introduced as in chapter 6. 9-82

Valuing Preferred Stock (cont.) Since preferred stockholders generally receive a fixed dividend and the stocks are perpetuities (non-maturing), V ps = the value of a share of preferred stock D ps = the annual preferred stock dividend r ps = the market yield or the rate of return on the preferred stock s promised dividend 9-83

Checkpoint 10.3: Check Yourself What is the present value of a share of preferred stock that pays a dividend of $12 per share if the market s yield on similar issues of preferred stock is 8%? 9-84

Solve V ps = $12.08 = $150 Thus the present value of this preferred stock is $150. 9-85

10.4 The Stock Market

The Stock Market New securities trade in the primary market while currently outstanding securities trade in the secondary market. The corporation receives money from sale of its securities only in the primary market. 9-87

The Stock Market (cont.) There are two types of secondary markets: Organized exchanges where trading occurs at a physical location; and Over-the-counter market where trading occurs over the telephone or through computer networks. 9-88

Organized Exchanges The New York Stock Exchange (NYSE), also called the Big Board, is the oldest of all organized exchanges and the largest organized exchange in the world. While the NYSE is considered an organized exchange because of its physical location, the majority of its trades are done electronically without a face-to-face meeting of traders. 9-89

Organized Exchanges (cont.) The American Stock Exchange (AMEX) is the nation s second largest, floor-based exchange. However, in terms of volume, the AMEX is a distant number two with less than 5% of that on the NYSE. AMEX merged with NASDAQ in 1998 but continues to operate as a separate entity. 9-90

Over-the-Counter (OTC) Market The over-the-counter market is a network of dealers that has no listing or membership requirements. Today, the OTC market is electronic with Nasdaq leading the way. OTC listings generally include companies too new or too small to be eligible for listing on a major exchange. 9-91