Chapter 5 - Bonds and Stocks-1

27/04/2022
CHAPTER 5
BONDS AND STOCKS

 I. Opening Prayer
 II. Announcements
 III. Overview of the topic
 IV. Discussion and Recitation
BONDS AND STOCKS

Learning Objectives :
After studying this module, you should be able to :
1) Identify the two types of capital (Debt-Bonds & Equity-Stocks)
2) Determine the valuation of bonds and stocks
3) Identify two types of stocks (Common & Preference Stocks)
4) State the advantages and disadvantages of the different sources of long-term
financing
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BONDS AND STOCKS
TYPES OF CAPITAL
LT –DEBT FINANCING EQUITY FINANCING
Bonds Preference Share Common Share
BONDS AND STOCKS

BONDS
- a bond is an investment product that is issued by corporations (corporate
bonds) and governments (government bonds) to raise funds to finance projects
and fund operations and is evidenced by a bond certificate.
- bonds are the most prevalent example of the interest only loan with investors
receiving exactly the same 2 sets of cash flows ;
1) Periodic interest payments
2) Principal (par value or face value) returned at maturity/before maturity.
- corporate and government bonds trade on major exchanges and usually are
listed with P1,000 face values, also known as the par value.
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BONDS
Trading Process for Bonds
Sells Bonds Sells Bonds
UNDERWRITER INVESTORS
CORPORATION
(INVESTMENT BANK)
Pay Bid Price Pay Offer Price
Firm Commitment Underwriting

- corporate bonds are offered publicly through investment banking firms (underwriters).
* the investment bank guarantees the firm a price for newly issued bonds by buying the
whole issue at a fixed price (bid price) from bond-issuing firm at a discount from par.
* the investment bank then seeks to resell these securities at investor at a higher price
(offer price).
- the bond issuer is protected to sell the whole issue while the investment bank takes the
risk that it may not be able to resell the securities to investors at a higher price.
BONDS
Types and Characteristics of Corporate Bonds
1) Debenture – unsecured bond and backed only by the reputation and financial
stability of the corporation.
2) Subordinated Debenture – claims are honored after the claims of secured

debt and unsubordinated debentures have been satisfied.
3) Zero Coupon Bonds - do not pay any interest over the life of the bond (sold
at a deep discount).
4) Junk Bonds – low-rated bonds, high risk, high yield bonds. The major
participants of this market are new firms that do not have an established record
of performance.
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BONDS
5) Floating Rate Bonds – interest payment changes with market conditions. But
the market price remains relatively stable even though interest rates vary. In
periods of unstable interest rates, this type of bonds is appealing to the investors.
6) Mortgage Bonds – secured by real property. Should the issuing firm fail to pay
the bonds at maturity, the trustees can foreclose or sell the property and used the
proceeds to pay the bondholders.
7) Sinking Fund - typically, a requirement to retire a portion of the bond issue

each year. Outstanding bonds may be purchased in the open market, or they may
be called in by lottery if necessary. (may or may not include a call premium).
BONDS
8) Convertible Bond – provides for conversion into common stock at a fixed
price.
9) Callable Bond - issuer has the right to call in the bonds prior to maturity.
Usually, a premium that declines over time (e.g., one year’s interest initially) must
be paid to bondholders.
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BONDS
Bond Valuation
- is a technique for determining the theoretical fair value of a particular bond.
- bond valuation includes calculating the present value of a bond's future interest
payments, also known as its cash flow, and the bond's value upon maturity, also
known as its face value or par value.
BONDS
Characteristics of a Regular Bond
1) Coupon rate - some bonds have an interest rate, also known as the coupon rate,
which is paid to bondholders semi-annually. The coupon rate is the fixed return that
an investor earns periodically until it matures.
2) Maturity date - all bonds have maturity dates, some short-term, others long-
term. When a bond matures, the bond issuer repays the investor the full par value of
the bond-usually P1,000.
3) Current price - Depending on the level of interest rate in the environment, the
investor may purchase a bond at par, below par, or above par.
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BONDS
Coupon (Interest) Bond Valuation
The present value of expected cash flows is added to the present value of the face value
of the bond as seen in the following formula :
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BONDS
Coupon (Interest) Bond Valuation
Illustration : Solution :
Find the value of a corporate bond
with an annual interest rate of 5%,
making semi-annual interest
payments for 2 years, after which
the bond matures, and the principal
must be repaid. Assume a YTM or
effective rate of 6% and face value
of the bond is P1,000.
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BONDS
Zero Coupon (No-Interest) Bond Valuation
- A zero-coupon bond makes no annual or semi-annual coupon payments for the
duration of the bond. Instead, it is sold at a deep discount to par when issued.
- The difference between the purchase price and par value is the investor’s interest
earned on the bond.
- To calculate the value of a zero-coupon bond, we only need to find the present
value of the face value.
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BONDS
Zero Coupon (No-Interest) Bond Valuation
If an investor wishes to make a 6%
return on a bond, with $25,000 par
value, that's due to mature in three
years.
Compute for the value of the bond.
The bond can be sold at $20,991/$25,000 = 84%

The investor gains $4,009 which translates as 6% interest
per year.
25,000 - 20,991 =4,009
4,009/3 years = 1,366/21,991 = 6%
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BONDS
Methods of Retiring Bonds
1) Serial Payments (Serial Bonds)
- bonds with serial payment provisions are paid off in installment over the life of
the issue.
- each bond has its own predetermined date of maturity and receives interest
to that point.
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BONDS - Serial Payments

As a serial bond, Smith is required to pay $250,000 to reduce the face value each year. In
addition, the unpaid face value for Year One is $1 million so the 5 percent stated rate
necessitates a $50,000 year-end interest payment. Based on the contract, the cash flows
required by this bond are as follows. The effective interest rate is 6%.
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Present value of cash flows (bond valuation)
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Present value of cash flows (bond valuation)
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Amortization Table & Journal Entries
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BONDS
2) Call Provision (Callable Bonds)
- a call provision allows the corporation to retire or force in the debt issue
before maturity.
- this features provides the firm with the flexibility to recall its debt and replace it
with lower-cost debt if interest rates fall.
- the difference between the call price and the par value is referred to as call
premium.
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BONDS - Call Provision

Backstreet Corp. issues callable bonds with a par value of $100,000. The call option
requires the issuer to pay a call premium of $4,000 to bondholders plus the par value if
it chooses to retire the bonds earlier than their maturity date. After the 2nd quarter of the
year on June 30th, 2009, the bonds have a carrying value of $105,500. On the next day,
July 1st, 2009, the issuer calls these bonds and pays $104,000 to the bondholders (par
value $100,000 + call premium $4,000).
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BONDS
3) Conversion (Convertible Bonds)
- a more subtle method of reducing debt outstanding is to provide for debt
conversion into ordinary equity share.
(Debt to Ordinary Share)
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BONDS - Conversion
Backstreet Corp. issues $100,000 par value convertible bonds with a carrying value of
$100,000. The bondholders choose to convert these bonds to shares, at 20,000 common
shares.
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BONDS
Advantages & Disadvantages of Long-term Debt Financing
(Bonds)
ADVANTAGES :
1) Interest payments are tax deductible.
2) The financial obligation is clearly specified and fixed in nature (with exception
of floating rate bonds)
3) In an inflationary economy, debt may be paid back with “cheaper pesos.”
4) The use of debt may lower the cost of capital to the firm.
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BONDS
Advantages & Disadvantages of Long-term Debt Financing
(Bonds)
DISADVANTAGES :
1) Interest and principal payment obligations are set by contract and must be
met, regardless of the economic position of the firm.
2) Indenture agreements may place burdensome restrictions to the firm.
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STOCKS
PREFERRED SHARE
- is a class of equity shares which has preference over ordinary (common) equity
shares in :
1) payment of dividends
2) distribution of corporation assets in the event of liquidation
- has no voting rights/privileges but it is a form of equity from a legal and tax
standpoint.
- the preferred shares has higher risk, investors normally require a higher rate of
return because creditors have priority over preferred share holders in the claims
to both income and assets.
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STOCKS
Preferred Shares Features
1) Par value
- is the face value that appears on the stock certificate.
2) Dividends
- are stated as a percentage of the par value (% x PV).
- usually paid annually or semiannually but are not guaranteed by the issuing
firm. (return on investment)
3) Cumulative and Noncumulative

- cumulative means if dividend are not paid in a particular year, they will be
carried forward as an arrearage. On the other hand, noncumulative means,
dividends not declared in any particular year are lost forever.
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STOCKS
4) No definite maturity date
- preferred share is usually intended to be part of a firm’s equity and has no
definite maturity date.
- however, sometimes preference shares have call provision/feature that gives
the issuing firm the option of purchasing the share directly to the owners,
usually at premium above par value.
- some preferred shares have sinking fund provision that requires the issuer to
repurchase and retire the share on a scheduled basis.
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STOCKS
5) Convertible preferred share
- owners of convertible preferred share have the option of exchanging their
preferred share for ordinary (common) equity share based on specified terms
and conditions.
6) Voting rights
- preferred shares does not carry voting rights.
- special voting procedures may take effect if the issuing firms omits its
preferred dividends, preference shareholders are then permitted to elect
certain number of members to the board of directors in order to represent the
preferred shareholders’ interests.
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STOCKS
7) Participating features
- participating preferred shares entitles its holders to share profits above and
beyond the dividend declared, along with ordinary shareholders.
8) Protective features
- preferred share issues often contain covenants to assure the regular payment
of preferred share dividends and to improve the quality of preferred share.
- preferred shareholders have priority over ordinary (common) equity
shareholders with regards to earnings and assets.
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STOCKS
Categories :
1) Cumulative Preferred Shares
2) Non-cumulative Preferred Shares
3) Participating Preferred Shares
4) Convertible Preferred Shares
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STOCKS
PS Valuation :
Federal Electric and Power Company has an
issue of preferred share outstanding that
pays a yearly dividend of P10.80. Investors
required a 12% return on this preferred
share.
Determine the intrinsic value of the
preferred share.
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STOCKS
Advantages & Disadvantages of Equity Financing
(Preferred Shares)
ADVANTAGES :
1) Financing flexibility – a firm can fix its financial cost.
2) Favorable Financial leverage – This enhance the common shareholders’ return if the
firm earns a rate of return on its preferred share higher than its cost of capital.
3) No dilution of control – no voting rights
4) No maturity – preferred shares does not have to be paid.
5) Asset preservation – does not have to pledge assets as collateral when issuing
preferred shares.
6) No equal participation in earnings - nonparticipating preferred share is limited to
stipulated dividend only.
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STOCKS
(Preferred Shares)
DISADVANTAGES :
1) High cost
– has higher after-tax cost of capital because dividends are not tax deductible.
2) Seniority of the holder’s claim
– preferred shares has preference over ordinary equity share in the payment of
dividends and the liquidation may jeopardize the ordinary equity shareholders’
return.
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STOCKS
ORDINARY (COMMON) SHARE
- is a form of long-term equity that represents ownership interest of the firm.
- ordinary equity holders are called residual owners because their claim to
earnings and assets is what remains satisfying the prior claims of various
creditors and preferred shareholders.
- are the true owners of the corporation and consequently bear the ultimate risk
and rewards of ownership.
- this form of equity ownership typically yields higher rates of return long term.
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STOCKS
Ordinary Shares Features
1) Par value / No par value
- ordinary shares maybe sold with or without par value (sold at stated value).
- ordinary shares are usually sold for more than its par value, the issue price in
excess of par value is recorded as additional-paid-in-capital (APIC), capital surplus,
share premium or capital in excess of par.
Dr: Cash xx
Cr: Share Capital - Preferred Shares xx
Cr: Share Premium xx
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STOCKS
2) Authorized, issued and outstanding
Authorized shares – the maximum number of shares that a corporation may issue.
Issued shares – is the number of authorized shares that have been sold.
Outstanding shares – are those shares held by the public. (net of treasury shares)
* dividends per share and earnings per share are based on the outstanding
shares.
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STOCKS
3) No maturity
- ordinary equity share has no maturity and is a permanent form of long-term
financing.
4) Voting rights
- entitled to vote on the selection of directors and in other matters.
5) Book value per share
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STOCKS
6) Numerous rights of stockholders
a) Right to vote on specific issues such as election of BOD, selecting the firm’s
independent auditors, amending the articles of incorporation and bylaws,
increasing the amount of authorized stock and so forth.
b) Right to receive dividends if declared by the firm’s board of directors.
c) Right to share in the residual interests in the event of liquidation.
d) Right to examine the corporate banks.
e) Right to share proportionally in the purchase of any new issuance of equity
shares (pre-emptive right).
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STOCKS
OS Valuation (based on holding periods) :
1) Finite Period Dividend Valuation
2) Infinite Period Dividend Valuation
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STOCKS
Finite Period Dividend Valuation
- this model is one in which investor plans to purchase an ordinary equity share
and hold it for a specific length of time.
- during the holding period, the investor expects to receive cash dividends and to
sell the stock for a price at the end of the holding period.
Dividend + Stock Price
Po = Price of share
Dp = Cash dividend per share
Pn = Price of share in nth period
Ks = Required rate of return
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STOCKS
Finite Period Dividend Valuation
An investor plans to buy common
share of CS Company and sell it at the Po
end of one year. ^1
The investor expects CS Company to
pay P5.20 dividends and sell for P50
at the end of the year. If the investor’s
required rate of return is 15%.
Compute for the value of share.
This indicates that the investor should pay no more
than P48/share of CS Company.
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STOCKS
Infinite Period Dividend Valuation
- this model assumes that an investor plans to purchase an ordinary share
and hold it indefinitely.
- hence, returns are only in the form of dividends over multiple periods.
Dividend only
Po = Price of share
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STOCKS
Infinite Period Dividend Valuation
An investor plans to buy common
share of CS Company and hold it Po
indefinitely.
The investor expects CS Company to
pay P5.20 dividends.
If the investor’s required rate of return This indicates that the investor should pay no more
than P34.67/share of CS Company.
is 15%.
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STOCKS
OS Valuation (based on dividend growth rates) :
1) Zero Growth Dividend Model
2) Gordon Constant Growth Dividend Model
3) Supernormal Growth Dividend Model
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STOCKS
Zero Growth Dividend Model
- this model assumes dividends remain a fixed amount over time.
Po = Price of share
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STOCKS
Zero Growth Dividend Model
XYZ Company expects to pay P3 cash
dividend at the end of the year Po
indefinitely into the future.
If investors in this stock required 15%
return.
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STOCKS
Gordon Constant Growth Dividend Model
- this model assumes dividends grow at a constant rate each period.
Po = Price of share
D1 = Expected dividend D x (1 + g) ^ 1
g = constant growth rate
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STOCKS
Gordon Constant Growth Dividend Model
RST Corporation currently pays P2 per
share in ordinary equity share D1 = D (1 + g) ^ 1
dividends. = 2 (1 + .05) ^ 1
The firm’s dividends are expected to = 2.1
grow at a constant rate of 5% per
year. Po
Investors require a 15% return on
RST’s ordinary equity share.
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STOCKS
Supernormal Growth Dividend Rate
- this model assumes dividends grow at an above normal rate over some time period and
the grow at a normal rate thereafter.
- this two-staged model is more flexible than a zero or constant growth rate models and
can be adjusted to allow for any number of different expected growth rates.
- PV of expected dividend during above normal growth rates + PV of the sale price at
the end of the above normal growth rate.
PV Expected Dividend + PV Stock Price
Po = Price of share
Do = Dividend
gs = Supernormal growth rate
m = Period of supernormal growth
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STOCKS
QC Company expects dividends to grow at Step 1 : Compute for the present value of dividend
a rate of 10% a year for the next five (5) during above normal growth period.
years and 6% a year thereafter.
The firms current dividend is P2 per share.
The investor requires a 16% rate of return.
Compute for the value of the share.
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STOCKS
QC Company expects dividends to grow at Step 2 : Find the present value of the sale price at the
a rate of 10% a year for the next five (5) end of the above normal growth rate (year 5)
D (1 + g)
Ps
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STOCKS
QC Company expects dividends to grow at Step 3 : Discount the share value at the end of year 5
a rate of 10% a year for the next five (5) to the present at the 16% required rate of return.
The firm's current dividend is P2 per share.
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STOCKS
QC Company expects dividends to grow at Step 4 : PV of expected dividend during above normal
a rate of 10% a year for the next five (5) growth rates + PV of the sale price at the end of the
years and 6% a year thereafter. above normal growth rate.
The investor requires a 16% rate of return. Po
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STOCKS
(Ordinary Shares)
ADVANTAGES :
1) No mandatory fixed charges – no mandatory obligation to pay dividends
2) No definite maturity date
3) Potential greater ease of sale – easier to sell than bonds & preferred shares
4) Increased creditworthiness
5) Avoidance of restrictive provisions
6) More desirable form of financing from a social viewpoint
- ordinary share is less vulnerable to the consequences of decline in sales and
earnings since there is no fixed charge of payments.
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STOCKS
(Ordinary Shares)
DISADVANTAGES :
1) Dilution of control and earnings – newly issued ordinary share may result in the
dilution of existing ownership and control and it may also result to temporary
reduction in earnings per share.
2) Higher issue costs – higher than bonds and preferred shares.
3) Causes increase in component of cost of capital - dividends are not tax
deductible and is a riskier security than bonds & preferred shares.
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27/04/2022

BONDS AND STOCKS

BONDS AND STOCKS

BONDS AND STOCKS

LT –DEBT FINANCING EQUITY FINANCING

Bonds Preference Share Common Share

BONDS AND STOCKS

Pay Bid Price Pay Offer Price

Firm Commitment Underwriting

2) Subordinated Debenture – claims are honored after the claims of secured

7) Sinking Fund - typically, a requirement to retire a portion of the bond issue

The bond can be sold at $20,991/$25,000 = 84%

BONDS - Serial Payments

BONDS - Serial Payments

BONDS - Serial Payments

BONDS - Serial Payments

BONDS - Call Provision

3) Cumulative and Noncumulative

5) Book value per share

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