Finance Notes Ch. 7-14

CHAPTER 7 7.1 Bonds and Bond Valuation A bond is normally an interest only loan, none of the principal will be repaid until the end of the loan. Coupons: the regular interest payments that are made on a bond Face value (or par value): the amount that will be repaid at the end of the loan Coupon rate: the annual coupon divided by the face value of a bond Maturity: the date the face value is paid Yield to maturity: the rate required in the market on a bond. ** cash flows from a bond stay the same while interest rates change in the marketplace, so the value of the bond will fluctuate. (bond prices and interest rates move in opposite directions) - When interest rates rise, the PV of the bonds remaining cash flows declines, and vice versa. - When a bond sells for less than its face value, it is said to be a discount bond - When it sells for more than its face value it is a premium bond Present value of the 1000 face amount + Annuity present value of the coupons = bond’s value Interest Rate Risk - The risk that arises for bond owners from fluctuations in interest rates - How much interest rate risk a bond has depends on how sensitive the price is to interest rate changes and this depends on two things: time to maturity and coupon rate - It increases at a decreasing rate - All other things = the longer the time to maturity, the greater the interest rate risk - All other things = the lower the coupon rate, the greater the interest rate risk Finding the YTM: Trial and Error - Little r - We cannot solve for r explicitly - the only way is trial and error - Not to be confused with current yield: the bonds annual coupon divided by its price. 7.2 More about Bond Features Main differences between debt and equity: - Debt is not ownership interest, and creditors do not usually have voting rights - The corporations payment of interest on debt is considered a cost of doing business and is fully tax deductible, dividends paid to shareholders are not tax deductible - Unpaid debt is a liability of the firm. If not paid, the creditors can legally claim the assets of the firm. This can result in liquidation or reorganization, two possible consequences of bankruptcy. One of the costs of issuing debt is financial failure, this does not arise when equity is issued. Long-term debt: the basics - Short term: one year or less (sometimes referred to as unfunded debt) - Long term: more than one year - 10 years or less: notes, longer: bonds The indenture: (deed of trust) - The written agreement between the corporation and its creditors - Usually a trustee, is appointed by the corporation to represent the bondholders - Trust company must - Make sure the terms are obeyed - Manage the sinking fund - Represent the bondholders in default Terms of a bond: - Usually have a face value of 1000 but not always - Registered form: the company records ownership of each bond, and payment is made directly to the owner of record - Interest is payable semiannually on July 1 and Jan 1 of each year to the person who is registered, at the close of business on june 15 or december 15 respectively - To obtain an interest payment, the owner of the bond must separate a coupon from the bond certificate and send it to the company registrar - Bearer form: the certificate is the evidence of ownership of the bond. Security: - Collateral: securities that are pledged as security for payment of debt. - Mortgage securities are secured by a mortgage on the real property of the borrower, usually real estate. - described in the mortgage trust indenture or trust deed. - Blanket mortgage: pledges all the real property owned by the borrower company - Debenture: unsecured bond, no specific pledge of property is made - Debenture holders have a claim only on property not otherwise pleldged - the property that remains after mortgages and collateral trusts are taken into account. Seniority: - Preference in position over other lenders; debts are sometimes labeled as senior or junior to indicate seniority. Some debt is subordinated - In the event of default, holders of subordinated debt must give preference to other specified creditors Repayment: - Bonds can be repaid at maturity, or they may be paid in part or in entirety before maturity (more typical) handled through a sinking fund - Sinking fund: an account managed by the bond truste for the purpose of repaying the bonds. The firm makes annual payments to the trustee, who then uses the funds to retire a portion of the debt. By either buying up some of the bonds in the market, or calling in a fraction of the outstanding bonds. The Call Provision: - Allows the company to repurchase or “call” part or all of the bond issue at stated prices over a specific period of time. Corporate bonds are usually callable - Generally the call price is above the bond’s stated value. The difference between the call price and the stated value is the call premium and it may become smaller over time. Often not operable during the first part of the bond’s life. (deferred call provision) “Make whole call” present value of remaining interest and principal payments…. Made whole on their investment. Protective Covenants: - Part of the indenture that limits certain actions a company might wish to take during the term of the loan (positive covenants and negative covenants) - Negative: thou shall not - Positive: thou shall 7.3 Bond Ratings Bond ratings are an assessment of credit worthiness & likelihood of defaulting on a loan - The highest possible rating is AAA or Aaa (lowest degree of risk) 7.4 Different Types of Bonds: Government Bonds: - Treasury notes and bonds - No default risk; exempt from state income taxes - State and local governments also borrow money by selling municipal bonds - Because of the tax break, yields on government bonds are much lower than yields on other types of bonds. Zero coupon bonds: - Pays no coupons at all - Must be offered at a price that is much lower than its stated value. - For tax purposes, the issuer of a zero coupon bond deducts interest every year through no interest is actually paid, the owner must pay taxes on interest accrued every year, even though no interest is actually received. Floating-Rate Bonds: - Coupon payments are adjustable - the adjustments are tied to an interest rate index - Value of a floating-rate bond depends on exactly how the coupon payment adjustments are defined - Majority have these features: - The holder has the right to redeem the note at par on the coupon payment date after some specified amount of time. (put provision) - The coupon rate has a floor and a ceiling - Inflation linked bond: coupons that are adjusted according to the rate of inflation Warrant: gives the buyer of a bond the right to purchase shares of stock in the company at a fixed price. *** more types of bonds on page 216 Sukuk: - Demand for assets that comply with islamic law - does not permit charging interest 7.5 Bond Markets OTC - electronically - Little or no transparency: difficult to observe prices and trading volume - TRACE: Trade Reporting and Compliance Engine (2002) improved transparency Bid price : what a dealer is willing to pay Asked price: what a dealer is willing to accept Bid-ask spread: the difference between ^^ Clean price: the price of a bond net accrued interest; what is typically quoted Dirty price: the price of a bond including accrued interest, also known as the full, or invoice price - the price the buyer actually pays 7.6 Inflation and Interest Rates Real rates: interest rates that have been adjusted for inflation Nominal rates: not adjusted for inflation **The nominal rate on an investment is the percentage changein the number of dollars you have. The real rate on an investment is the percentage change in how much you can buy with your dollars- the percentage change in your buying power. ** The Fisher Effect: the relationship between nominal returns, real returns, and inflation 1 + R = (1+r) x (1+h) R = nominal rate r = real rate h = inflation rate 7.7 Determinants of Bond Yields The term structure on interest rates: the relationship between nominal interest rates on default-free, pure discount securities and time to maturity, the pure time value of money for different lengths of time after adjusting for inflation - Reflects the combined effect of the real rate of interest, the inflation premium, and the interest rate risk premium Interest rate risk premium: extra compensation for bonds with high interest rate risk Treasury Yield Curve: a plot of the yields on Treasury notes and bonds relative to maturity - The shape reflects the term structure of interest rates; the treasury yield curve and the term structure of interest rates are almost the same - term structure is based on pure discound bonds, whereas the yield curve is based on coupon bond yields. - Treasury yields depend on 3 things: the real rate, expected future inflation, and the interest rate risk premium Default risk premium: the portion of a nominal interest rate or bond yield that represents compensation for the possibility of default. Taxability premium: the portion of the nominal rate that represents compensation for unfavorable tax status liquidity premium: portion of the nominal rate that represents compensation for lack of liquidity *** Bond yields represent the combined effect of 6 things: 1. Real rate of interest 2. Expected future inflation premium 3. Interest rate risk premium 4. Default risk premium 5. Taxability premium 6. Lack of liquidity premium CHAPTER 8: Stock Valuation 8.1 Common Stock Valuation Stock is more difficult to value than a bond: - Not even the promised cash flows are known in advance. - The life of the investment is essentially forever because common stock has no maturity - There is no way to easily observe the rate of return that the market requires Present value of a stock - We need the price in one period - very hard to find, we have made the problem more complicated - No matter what the stock price is, the present value is essentially zero if we push the sale of the stock far enough away Some special cases - The dividend has a zero growth rate - The dividend grows at a constant rate - The dividend grows at a constant rate after some length of time Zero growth: - Because the stock can be viewed as an ordinary perpetuity, the per-share value is: - P = D/R (R is required return) Constant Growth: - Growing perpetuity - D(t) = D(o) x (1+g)^t - We have replaced the problem of coming up with future dividends with coming up with a growth rate -a simplification - Dividend growth model: page 243 - Determines the current price of a stocks its dividend next period divided by the discount rate less the dividend growth rate - Can also get the stock price at any point in time. - If the constant growth rate exceeds the discount rate, the stock price is infinitely large. Same is true if the two rates are equal Nonconstant Growth: - Main reason to consider: to allow for “supernormal” growth rates over some finite length of time - Growth rate cannot exceed the required return indefinitely, but it can for a number of years. - Easiest way to compute is to split it up on a timeline, nonconstant growth and constant growth Two-Stage Growth - The idea is that the dividend will grow at a rate of g1 for t years and then grow at a rate of g2 thereafter forever. - First term is the present value of a growing annuity, and in this first stage, g1 can be greater than R. The second part is the present value of the stock price once the second stage begins at time t Components of the required return - R = D1/ P0 + g - D1/P0 is called the dividend yield - Growth rate can be interpreted as capital gains yield: the rate at which the value of an investment grows Stock Valuation using Multiples: - Price at time t = Pt = Benchmark PE ratio x EPS - Benchmark PE can come from several sources - When valuing newer companies that don’t pay dividends and are not yet profitable, use pricesales ratio 8.2 Some Features of Common and Preferred Stocks Common Stock Features: - No special preference either in receiving dividends or in bankruptcy Shareholder Rights: - One share, one vote - Cumulative voting: a shareholder may cast all votes for one member of the board of directors; to permit minority shareholders participation; number of shares multiplied by the number of directors to be elected - Straight voting: directors are elected one at a time; the only way to guarantee a seat is to own 50 percent plus one share; all or nothing - Many companies have staggered elections - Staggering makes it more difficult for a minority to elect a director because there are fewer directors to be elected at one time - Staggering makes takeover attempts less likely to be successful because it makes it more difficult to vote in a majority of new directors - Also provides “institutional memory” continuity on the board of directors - Proxy Voting: - Proxy: the grant of authority by a shareholder to someone else to vote his or her shares; most of the voting in large public companies is done by proxy - Proxy fight: when outside group of shareholders tries to obtain votes via proxy in attempt to replace management by electing enough directors Classes of Stock: - Some firms have more than one class of common stock - unequal voting power - Much to do with control of the firm Other Rights - The right to share proportionally in dividends paid - The right to share proportionally in assets remaining after liabilities have been paid in a liquidation - The right to vote on stockholder matters of great importance, such as a merger - Sometimes: the tight to share proportionally in any new stock sold (preemptive right) - The company that wishes to sell stock must first offer it to the existing shareholders - to allow them to protect their share in the corporation Dividends: represent a return on the capital directly or indirectly contributed to the corporation by the shareholders. Payment of dividends is at the discretion of the BOD - Unless a dividend is declared by the BOD, it is not a liability of the corporation. A corporation cannot default on an undeclared dividend. Corporations cannot become bankrupt because of nonpayment of dividends. The amount of the dividend and even whether it is paid are decisions based on the business judgment of the BOD - The payment of dividends is not a business expense. They are not deductible for corporate tax purposes, they are paid out of aftertax profits - Dividends recieved by individual shareholders are taxable, however corporations that own stock in other corporations are permitted to exclude 70% of the dividend amounts they receive and are only taxed on 30% Preferred stock Features: - Preference over common stock in the payment of dividends and in the distribution of corporation assets in the event of liquidation. - Only the holders of preferred stock must receive a dividend Stated Value - Preferred shares have a stated liquidation value usually $100 per share Cumulative and Noncumulative Dividends - Dividends on preferred stock are either cumulative or noncumulative; if they are cumulative and not paid in a particular year , they will be carried forward as an arrearage. - Unpaid preferred dividends are not debts of the firm 8.3 The Stock Markets Dealer: agent who buys and sells securities from inventory Broker: agent who arranges security transactions among investors NYSE Members: 1,366 members - As of 2006, a member is the owner of a trading license on the NYSE CHAPTER 9 I pretty much get the jist….. CHAPTER 10: Making Capital Investment Decisions 10.1 Project Cash Flows: A First Look 1st step: decide which cash flows are relevant Relevant Cash Flows: - General principle: a relevant cash flow for a project is a change in the firms overall future cah flow that comes as a direct consequence of taking the project - Incremental cash flows: the difference between a firm’s future cash flows with a project and those without the project The Stand-alone principle: the assumption that evaluation of a project may be based on the project’s incremental cash 10.2 Incremental Cash Flows Sunk Costs: a cost that has already been incurred and cannot be removed and therefore should not be considered in an investment decision - Not relevant to the decision at hand - always exclude from analysis Opportunity cost: the most valuable alternative that is given up if a particular investment is undertaken Side Effects: Erosion: the cash flows of a new project that come at the expense of a firm’s existing projects - Erosion is relevant only when the sales would not otherwise be lost Net Working Capital - Normally a project will require that the firm invest in NWC as well as long term assets - As a project winds down, inventories are sold, bills are paid, receivables are collected… these activities free up the net working capital originally invested - NWC closely resembles a loan Financing Costs: - In analyzing a proposed investment, we will not include interest paid or any other financing costs such as dividends because we are interested in the cash flow generated by the assets of the project. - Goal in project evaluation: compare the cash flow from a project to the cost of acquiring that project in order to estimate NPV 10.3 Pro Forma Financial Statements and Project Cash Flows Pro forma: projected financial statements - To prepare, need estimates of quantities such as unit sales, the selling price per unit, the variable cost per unit, and total fixed costs. - Interest expense is NOT deducted Project Cash Flows - Cash flow from assets has 3 components: operating cash flow, capital spending, changes in NWC - To evaluate a project, we must estimate these - Project Cash Flow = project operating cash flow - project change in NWC - project capital spending Project Operating Cash Flow - OCF = EBIT + Depreciation - taxes - Taken from pro forma income statement Project Net working capital and capital spending - Whenever we have an investment in NWC, that same investment has to be recovered, the same number needs to appear at some time in the future with the opposite sign Projected Total Cash Flow and Value - Calculate NPV with values found 10.4 More about Project Cash Flow Net Working Capital - Total cash flow = operating cash flow - change in NWC - capital spending Depreciation - Noncash deduction, but has cash flow consequences only because it affects the tax bill - ACRS accelerated cost recovery system: a depreciation method under US tax law allowing for the accelerated write off of property under various classifications Modified ACRS Depreciation - Every asset is assigned to a particular class. An asset’s class established its life for tax purposes. Once its life is determined, the depreciation for each year is computed by multiplying the cost of the asset by a fixed percentage. Book Value vs. Market Value - Taxes paid on the difference between the sale price and thee book value because the difference is the “excess” depreciation and it must be “recaptured” when the asset is sold 10.5 Alternative Definitions of Operating Cash Flow The Bottom-up approach - Project net income = EBIT - Taxes - Add depreciation to both sides - OCF = Net Income + depreciation - This is only correct if there is no interest expense subtracted from net income The Top-Down Approach - Perhaps the most obvious way to calculate OCF - OCF = Sales - Costs - Taxes - Leave out noncash items such as depreciation The Tax Shield Approach - OCF = (Sales - Costs) x ( 1 - T) + Depreciation x T - T = corporate tax rate - Views OCF has having two components - What the project’s cash flow would be if there were no depreciation expense - The depreciation tax shield - Depreciation tax shield: the tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate