Module IV: Introduction to Bonds and Stocks PDF

MODULE IV Introduction to Bonds and Stocks  Introduction Welcome to Module IV. Hoping you are having a good day. This module will be giving you idea of the debt and capital investing instruments. The fo...

MODULE IV Introduction to Bonds and Stocks  Introduction Welcome to Module IV. Hoping you are having a good day. This module will be giving you idea of the debt and capital investing instruments. The fourth module will cover the introduction topics for bond value and its determinants, valuation process for bonds, features of preferred and common stocks, valuing preferred and common stocks, valuing preference and common stock process and stockholder’s expected rate of return. MODULE IV Specific Learning Outcomes At the end of the module you are expected to: Understand the characteristics and types of bonds Familiarize with bond value and its determinants Understand the valuation process Enumerate the features of stocks Understand the valuation process of stocks Understand the expected rate or return of stockholders MODULE IV Discussion Valuation of Stocks and Bonds Types of Bonds Corporate bonds evidences obligations of the issuing corporation the benefit of which is in terms of interests paid on such bonds Debenture bonds are unsecured bonds backed only by the reputation and financial stability of the issuer Floating-rate bonds are bonds in which the interest rate changes depending on market conditions Junk bonds are bonds that offer high yield of return but are considered as low quality and high-risk bonds Eurobonds are bonds payable or denominated in the issuer’s currency but sold outside of issuer’s country. Most issuers are from countries such as USA, European countries and Japan Serial Bonds are bonds with serial payment provisions and are paid off in instalments over the life of the issue Straight bonds are bonds which mature at one time MODULE IV Convertible bonds are bonds which can be converted to other forms of security such as common shares Redeemable bonds are bonds with provision, allowing the issuer to retire or redeem the bonds before maturity Income bonds are bonds that pay interest only when the interest is earned by the issuing company. Putable bonds are bonds that can be turned in and exchanged for cash at the holder’s option. Put option generally can only be exercised if the issuer takes some specified actions as being acquired by a weaker company or increasing its outstanding debt by a large amount. T-notes and T-bonds--- securities issued by the treasury of the country Municipal bonds---securities issued by municipalities Mortgage-backed bonds--- bonds issued collateralized by mortgages MODULE IV Characteristics of Bonds Claims on Assets and Income Bonds as instruments for indebtedness are entitled for claims of a firm time of solvency. However, they are based on the hierarchy of the claimants/ creditors of the firm as to the claims of firms assets. Bonds may also have first claims on the income of the firm prior to claims of preferred and common stock holders Par Value This refers to the face value of the bond which is returned to the bondholder at maturity. Coupon Interest This indicates the percentage of the par value of the bond that will be paid out annually in the form of interest Maturity It indicates the length of time until the bond issuer returns the par value to the bondholder and terminates or redeems the bonds Indenture It refers to the legal agreement between the firm issuing the bonds and the trustee who represents the bondholders. It provides the specific terms if the loan agreement, including the description of bonds, the rights of the bondholders, the rights of the issuing firm and the responsibilities of the trustee. MODULE IV Current Yield It refers to the ratio of the annual interest payment to the bond’s current market price. Bond Ratings The ratings are relevant to the judgment about the future risk potential of the bond. These are important to Financial manager for they provide an indicator of default risk that in turns affects the rate of return that must be paid on borrowed funds. Definitions of Value Book value It refers to the value of an asset as shown on a firm’s balance sheet. It refers to the historical cost of the asset rather than its current worth. Liquidation value Is the sum of money that could be realized if an asset were sold individually and not as part of a going concern. Market value It refers to the observed value for the asset in the market place Intrinsic or economic value It is also called as fair value which is the present value of the asset’s expected future cash flows. MODULE IV Valuation: The Basic Process It can be described as: a) it is assigning value to an asset by calculating the present value of its expected future cash flows using the investor’s required rate of return as the discount rate. The investor’s required rate of return, k, is determined by the level of the risk-free rate of interest and risk premium that the investor feels is necessary to compensate for the risks assumed in owning the asset. Bond Valuation Valuation of bonds needs to be familiarize with the following elements Amount and timing of the cash flows to be received by the investor Time to maturity of the loan Investor’s required rate of return Three Important Relationships in Bond Valuation The value of the bond is inversely proportional to changes in the investor’s present required rate of return (the current interest rate). “As interest rates increase (decrease), the value of the bond decreases (increases) The market value of a bond will be less than the par value if the investor’s required rate of return is above the coupon interest rate; but it will be valued above par value if the investor’s required rate of return is below the coupon interest rate. Long term bonds have greater interest rate risk than do short term bonds MODULE IV Preferred Stock Is often referred as hybrid security because it has many characteristics of both common stock and bonds. It has the following features: Multiple classes of preferred stock Preferred stock’s claim on assets and stocks Cumulative dividends Protective provisions Convertibility Retirement features The valuing of preferred stock relies on three principles Risk Return Trade off- don’t take additional risk unless the it is to be compensated with additional return Time Value of Money-the value of money today is not equivalent to its value in the future Cash not profits is king MODULE IV Synthesis The bonds and stocks are common instruments for investments used by firms. The key to investing is knowing the basics of these instruments from features to the principles applied to maximize the investment activities