CONTEMPORARY FINANCIAL MANAGEMENT

Chapter 5:

Fixed-Income Securities: Characteristics and Valuation

INTRODUCTION

This chapter focuses on the valuation and characteristics

of fixed-income securities, including:

Long-term debt

Preferred shares

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CLASSIFICATION OF LONG-TERM DEBT Secured: backed by company assets

Example – mortgage bonds Caveat – not all securities referred to as “bonds” are secured

Unsecured: not backed by company assets Example - debentures

May be subordinated and unsubordinated Claims of subordinated debenture holders are considered only after the

claims of unsubordinated debt holders are satisfied

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OTHER TYPES OF LONG TERM DEBT Equipment trust certificates: used mainly by the

transportation industry to acquire fixed assets, which are leased from the note holder

Income bonds: bonds which pay interest only if the issuer earns sufficient income (rarely used today)

Collateral trust bonds: bonds backed by the shares or bonds of other corporations (used primarily by holding companies pledging shares of their subsidiaries)

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CHARACTERISTICS OF LONG-TERM DEBT

Maturity of greater than one year

Often issued in large amounts

Coupon payment made regularly during the lifetime of the bond (unless a zero coupon bond)

Principal amount repaid to the bond holder on the maturity date of the bond (unless the bond has a sinking fund or call feature)

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SPECIAL LONG-TERM DEBT FEATURES Protective Covenants: contained in the Bond Indenture

(contract between Issuer & Investors)

Call Feature: issuer can redeem bond prior to its stated maturity date

Convertible Feature: investor can convert the bond to common stock

Warrants: a sweetener that allows investors to buy other securities for a fixed period of time.

Sinking Fund: process used to retire the debt over time rather than at maturity

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TRADED DEBT Bonds usually trade in the over-the-counter (OTC) market

Typical Quote:

Issuer is Duke Energy Bond has a coupon rate of 6.375% (6 3/8 %) Bond matures in 2008 Current yield is 6.8% $40,000 dollars traded yesterday Closing price was $937.50 per $1,000 of face value Closing price was down $2.50 from the previous day

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DukeEn 63/8 08 6.8 40 93¾ –1/4

GOVERNMENT DEBT SECURITIES

Treasury bills Issued by both federal & provincial governments Maturities of 3, 6, and 12 months Minimum denominations of $1,000 Sold at a discount from face value Mature at face value The difference between the purchase price and face value is

treated as interest income

8

GOVERNMENT DEBT SECURITIES Government of Canada Fixed-Coupon bonds

Maturity at issue from 2 to 30 years Sold in denominations of $1,000 to $1,000,000 Issued in only in fully registered form Are non-callable Pay interest semi-annually

9

GOVERNMENT DEBT SECURITIES Real Return Bonds

Pay a real rate of interest on the face value Face value is adjusted for changes in the CPI

Canada Premium Bonds Issued since 1998 Similar to Canada Savings Bonds but pay a higher rate of interest Redeemable once a year (on the anniversary date) without penalty Available in denominations as low as $100

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BOND RATINGS

11

DDefault

Ba,B,Caa,Ca,CBB,B,CCC,CC,CJunk

BaaBBBMedium

AAUpper Medium

AaAAHigh

AaaAAAHighest

Moody’sS & P’sQuality

RATINGS Higher rated bonds generally carry lower market yields.

Interest rate spread between each bond rating is less during market expansions than during market contractions

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Yie

ld

Yield Spread

LONG-TERM DEBT

Advantages Tax deductibility of interest Financial leverage can increase Earning Per Share (EPS) Ownership is not diluted

Disadvantages Increased financial risk Indenture provisions restrict firms’ flexibility

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INTERNATIONAL BONDS Eurobonds

Issued outside of the issuer’s country Denominated in a currency other than the currency of the country

where the bond is issued May have less regulatory interference May have less disclosure requirements

Foreign bonds Issued in a single foreign country with interest and principal paid in

the currency of the country where the bond is issued

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VALUE OF AN ASSET Based on the expected future cash flow over the life of the

asset.

• Capitalization of cash flow methodPV of the stream of future cash flows discounted at an appropriate

required rate of return (i)

15

( )+=

= ∑n

tt0

1 it 1

CFV

VALUE OF AN ASSET: EXAMPLE

A asset is expected to generate a free cash flow of $10,000 per year for five years. If the required discount rate is 15%, what is the asset worth in the market?

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VALUE OF AN ASSET: SOLUTION

( )

( ) ( ) ( ) ( ) ( )( )

+=

−

=

= + + + +

− ÷= = ÷

∑n

tt0

1 it 1

1 2 3 4 5

5

CFV

10,000 10,000 10,000 10,000 10,000

1.15 1.15 1.15 1.15 1.15

1 1.1510,000 $33,521.55

0.15

17

0 1 2 3 4 5

$10K $10K $10K $10K $10K

MARKET VALUE OF AN ASSET

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Price $

Quantity

Supply curve

Demand curve

Market Price

Equilibrium Quantity

BOND VALUATION (USING ALGEBRA)

The market value of a bond is equal to the present value of its future cash flows.

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( ) ( )∑n

0 t nt=1 d d

Coupon Face ValueP = +

1+k 1+k

Coupon = $ value of the coupon paymentFace Value = Face amount or principal repaymentk = Required rate of returnn = Maturity (years)t = Coupon Dates (years)

BOND VALUATION: EXAMPLE

You are analyzing a corporate bond with the following characteristics. It has a $10,000 face value, five years to maturity, carries a 6% coupon (paid annually) and has a yield to maturity of 7%. What is the market price of the bond?

20

BOND VALUATION: SOLUTION

21

0 1 2 3 4 5

$600 $600 $600 $600 $10.6K

( ) ( )

( ) ( ) ( ) ( ) ( )( )

+ +=

−

= +

= + + + +

− ÷= + = ÷

∑n

tt n0

1 k 1 kt 1 d d

1 2 3 4 5

5

5

Coupon FaceValueV

600 600 600 600 10,600

1.07 1.07 1.07 1.07 1.07

1 1.07 10,000600 $9,589.98

0.07 1.07

BOND PRICES AND INTEREST RATES

Relationship between P0 and kd

Inverse relationship between a bond’s market value, P0, and its required rate of return, kd

Long-Term Bonds vs. Short-Term Bonds

A change in kd changes the value of a

long-term bond more than the value of a short-term bond

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PERPETUAL BONDS

Bond issued without a finite maturity date (also known as a Consol Bond).

23

0d

IP =

k

I = Coupon Paymentk = Required Rate of Return

PERPETUAL BONDS: EXAMPLE

In the 1930s, the Government of Canada issued $55 Million of Consol Bonds carrying a 3% coupon. If you held $1,000 (face value) of these bonds when interest rates rose to 5%, what would they have been worth in the market?

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( ) ( )=

=

0d

0.03 1,000IP =

k 0.05

$600

ZERO COUPON BONDS Bond that pays no annual interest

Sells at a discount to par or face value to provide a capital gain (treated as interest) on the maturity date.

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0 nd

Face ValueP =

(1 + k )

k = Required rate of returnn = Maturity date (years)

ETHICAL ISSUE

In many leveraged buyouts (LBOs), the buyer of the firm financed the purchase with a large amount of debt.

Shareholders made a large gain while bond prices plummeted because of the higher leverage the firm has assumed.

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PREFERRED SHARES

Intermediate position between common shares and long-term debt

Form of equity financing

Dividends payments are not tax deductible

Have preference over common shares with regard to earnings and assets

No common share dividends paid until all preferred dividends paid. 27

PREFERRED SHARE CHARACTERISTICS

Selling price

Par value

Adjusted rate

Cumulative

Participation

Maturity

Call feature

Voting rights 28

PREFERRED SHARE CHARACTERISTICS

Advantages Flexible Can increase financial leverage

Disadvantages High after-tax cost Dividends are not tax deductible

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PREFERRED SHARE VALUATION

The value of a preferred share is the present value of all its future expected dividends.

Preferred shares are valued as if they are a perpetuity.

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p0

p

DP =

k

D = Dividendk = Required Rate of Return

PREFERRED SHARE VALUATION: EXAMPLE

A preferred share has a par or face value of $25 and a dividend rate of 6%. If investors require an 8% return to hold the preferred shares, what price will they trade at in the market?

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( ) ( )=

=

p0

p

0.06 25DP =

k 0.08

$18.75

MAJOR POINTS

Bonds and debentures are popular debt issues used to finance a firm.

The present value of a bond is equal to its future cash flows (coupons and principal repayment).

Bonds are often issued with special features like protective covenants, warrants and calls.

Preferred shares are ownership securities with fixed income properties.

The value of a preferred share is the present value of its future cash flows. 32