Topic 10: Equity and Bonds

TOPIC 10
EQUITY AND
BONDS
STOCKHOLDERS' EQUITY
 Stockholders'equity includes common stock,
preferred stock, paid-in capital in excess of
par and retained earnings.
 There has also been a countless stock option

and compensation plans that have an impact
on the stockholders' equity.
COMMON AND PREFERRED
STOCKS
 Shareholders
can own two types of stock –
COMMON and PREFERRED.
COMMON STOCK:
 Basic type of stock
 Generally have voting, dividend and liquidation

payment right
STOCKS
PREFERRED STOCK:
 Preferred as to dividends
 Cumulative dividend rights
 In the event of bankruptcy, first claim to company
assets (following creditors)
 No voting power
 Could be callable/redeemable
 Some preferred stock have a convertible feature
 Allowing them to convert to common stock
STOCKS
Preferred stock offers investors certain advantages
over common stock.
Preferred stock represents ownership units in a
company, but unlike common stock most
preferred stock does not carry voting rights.
However, preferred shareholders have priority
over owners of common shares regarding
payment of dividends. This means that they get
paid their dividends, even if the common stock
holders get none.
Also, if the company goes bankrupt, preferred
stockholders have priority over common
stockholders in the distribution of corporate
assets. The bond investors, though, have
priority over the preferred stockholders.
STOCKS
Preferred stock features:
 The market price of most preferred stock is not as

volatile as common stock, which means the prices of
preferred stocks do not move up or down as quickly as
common stock prices.
 Like bonds, preferred stock prices are interest-rate

sensitive - when interest rates go up, the price of
preferred stocks generally go down; when interest
rates go down, the price of the preferred stocks
generally go up.
TYPES OF PREFERRED
STOCK
 Cumulative preferred stock: arrearage plus current
dividends must be paid before any payment made to
common stockholders.
 Noncumulative preferred stock: make no provision

for the accumulation of unpaid dividends.
 Callable preferred stock: give the corporation the

right to retire the preferred stock at its option.
 Convertible preferred stock: has a special provision

that makes it possible to convert it to common stock of
the corporation, generally at the stockholder’s option.
 Participating preferred stock: allow preferred

shareholders to participate with common shareholders
when larger dividend payouts are available.
VALUATION OF
STOCKS
Valuing Stocks With Constant Dividends
 Constant dividends over time (e.g., preferred
stock)
P0 = D0/rs
P0 = $2.00/0.10 = $20.00
Valuing Stocks With Constant Dividends
Growth Rates
P0 = D0(1 + g)
rs – g
Today’s dividend = $1.89; g = 8.5%;

rs = 12%
P0 = 1.89 (1+0.085) = $58.59
.12 – .085
OTHER USES OF THE
DIVIDEND GROWTH MODEL
P0 = D0(1 + g)
rs – g
Estimate required return:

rs = [D0(1 + g) / P0 ] + g = D1/P0
+g
Estimate g:
g= P0 ∙ r - D0 /(P0 +D0 )
TWO-STAGE GROWTH MODEL
 High-growth period followed by lower,
constant growth
 Estimate dividends during super-normal
growth period, years 1-n
 As constant growth begins in year n+1,
find stock price in year n using the Gordon
model
 Sum present values of dividends and
price
TWO-STAGE GROWTH
MODEL
EXAMPLE
 Recent dividend=$0.50
 Expected to grow 20% each year for three years
 After year 3, “normal” growth of 7% annually is
expected
 Required return = 10%
Estimate dividends in the high-growth period

Year Dividend
1 (0.50)(1+0.20) = $0.60
2 (0.60)(1+0.20) = $0.72
3 (0.72)(1+0.20) = $0.86
Estimate price in year 3:
P3= D4/(r-g) = $0.86(1+.07)/(0.10-0.07)
= $30.67
TWO-STAGE GROWTH
MODEL
Find the present values of the year 1-3 dividends
and
year 3 price:
P0 = $0.60/(1.10) + $0.72/(1.10)2 +
$0.86/(1.10)3
+ $30.67/(1.10)3
= $24.83
WHAT ARE BONDS?
 Bonds are fixed income investments, so called because
the issuer of the bonds pays a regular fixed interest or
coupon to the investor who buys the bonds until the
bonds mature at a specified date.
 Upon maturity, the issuer returns the agreed principal

sum of money to the investor.
 Basic characteristics of a bond:

- A maturity date
- A fixed rate of interest payment or coupon
- A fixed face or par value (principal sum) redeemable
upon maturity
TYPES OF LONG-TERM DEBT
 Common types of long-term debt financing
include notes, bonds, and mortgages,
collateralized mortgage obligations, repurchase
and reverse repurchase agreements, interest
rate swaps, financial futures, derivatives, and
myriad financial instruments.
 Capitalizedlease obligations also represent a

form of long-term debt.
ISSUER AND BUYER OF THE BONDS?
 Issuer:government and corporation is borrowing a
specified amount of money from the investor for a
specified period of time in order to raise capital.
Thus, they issue bonds.
 Buyer: financial institutions, other private companies

or managed funds (e.g. pension, insurance or unit
trust funds) through over-the counter - an average
investment being about RM5 million.
 But in general, investors purchasing bonds are

looking for investments that will give them a stable
fixed income and which are less risk than the stock
market.
HOW ARE BONDS TRADED?
 When the issuer (government or corporations or
institutions) first offers new issues, that first
trading is done at the primary market.
 Subsequently, the bonds bought from the issuer

can be bought and sold among other investors,
and this is referred to as the secondary market.
 The secondary market provides liquidity to the

individuals or institutions that have acquired the
bonds, which are now able to sell off the bonds
before the maturity date, should they wish to do
so.
BOND PRICING: PRINCIPLES
 Ifmarket rate equals coupon rate, bond trades

at par.
 If coupon rate exceeds market rate, the bond

trades above par—at a premium.
 If market rate exceeds coupon rate, bond

trades below par—at a discount.
18
BOND VALUATION
 If coupons are paid semi-annually (twice a year).

 In this case, r is the semi-annual discount rate, not an annual
discount rate
 EAR = YTM = (1 + r)2 – 1
 Rearranging, we can solve for the periodic interest rate r:
r = (1 + YTM)1/2 – 1
 n = # of years until maturity x 2
AN EXAMPLE
$1,000 par value, Coupon rate 8% paid once per year, 5
years until maturity
Investors require 8% return.
1) Using formula
Price=[C1/(1+rb)1] + [C2/(1+rb)2] + ... + [Cn+ Parn/(1+rb)n]
2) Using financial calculator
FV = 1000, PMT=80, N=5, I/Y=8

PV = $1000 (par bond)
EFFECT OF REQUIRED RETURN
TO BOND VALUE
If required return rises to 10.25%:
1) Using formula
Price=[C1/(1+rb)1] + [C2/(1+rb)2] + ... + [Cn+ Parn/(1+rb)n]
2) Using financial calculator

FV = 1000, PMT=80, N=5, I/Y=10.25
PV = $915.25 (discount bond)
If required return falls to 6.09%:

Bond value = $1080.26 (premium bond)
THE SEESAW EFFECT
 Required rate of return (the market interest
rate) rises…bond prices fall
Interest rate = 8% price = $1000

Interest rate = 10.25% price = $915.25
 Required rate of return falls, bond prices rise
Interest rate = 6.09% price = $1080.26

WHAT IS THE DIFFERENCE BETWEEN
INVESTING IN BONDS AND INVESTING IN
SHARES?
 Bonds are medium to long-term debt

instruments, which have the following
advantages and disadvantages when
compared to buying shares.
Advantages Disadvantages
Investor receives periodic fixed As the income (coupons)

interest income, irrespective of derived from bonds is fixed, the
whether the company issuing the investor does not get paid more
even if business is booming as
bonds is doing well or not. in the case of ordinary
shareholders who may be given
higher dividends.
Bondholders have a prior right Bondholders have no voting

over ordinary shareholders on rights and are not owners of the
distribution of earnings and on company while shareholders
claims in the event of have a right to vote at general
bankruptcy. meetings.

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TOPIC 10

 There has also been a countless stock option

 Generally have voting, dividend and liquidation

 The market price of most preferred stock is not as

 Like bonds, preferred stock prices are interest-rate

 Noncumulative preferred stock: make no provision

 Callable preferred stock: give the corporation the

 Convertible preferred stock: has a special provision

 Participating preferred stock: allow preferred

Today’s dividend = $1.89; g = 8.5%;

Estimate required return:

Estimate dividends in the high-growth period

 Upon maturity, the issuer returns the agreed principal

 Basic characteristics of a bond:

 Capitalizedlease obligations also represent a

 Buyer: financial institutions, other private companies

 But in general, investors purchasing bonds are

 Subsequently, the bonds bought from the issuer

 The secondary market provides liquidity to the

 Ifmarket rate equals coupon rate, bond trades

 If coupon rate exceeds market rate, the bond

 If market rate exceeds coupon rate, bond

 If coupons are paid semi-annually (twice a year).

Price=[C1/(1+rb)1] + [C2/(1+rb)2] + ... + [Cn+ Parn/(1+rb)n]

2) Using financial calculator

FV = 1000, PMT=80, N=5, I/Y=8

2) Using financial calculator

If required return falls to 6.09%:

Interest rate = 8% price = $1000

 Required rate of return falls, bond prices rise

Interest rate = 6.09% price = $1080.26

 Bonds are medium to long-term debt

Investor receives periodic fixed As the income (coupons)

Bondholders have a prior right Bondholders have no voting

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