7 Fixed-Income Securities: Characteristics and Valuation ©2006 Thomson/South-Western

2 Introduction This chapter focuses on the characteristics and valuation of fixed- income securities.  Long-term debt  Preferred stock

3 Classification of Long-Term (L-T) Debt Mortgage bonds secured Debenturesunsecured  Subordinated and unsubordinated Claims of subordinated debenture holders are considered only after the claims of unsubordinated debt holders

4 Types of L-T Debt Equipment trust certificates Income bonds Collateral trust bonds Pollution control bonds Industrial revenue bonds

5 Characteristics of L-T Debt Indenture  covenants Trustee  TIA 1939 Call feature Call premium Sinking fund Equity-linked debt  convertible  warrant Coupon rates Size $25–$200 million

6 Corporate bonds Market for corporate bonds  Majority traded in the over-the-counter market  Some larger issues traded on the NY Exchange Quotations percent of par value $1000 DukeEn 6 3 / ¾ – 1 / 4 Meaning a Duke Energy bond with an interest rate (coupon rate) of percent, maturing in 2008, yielding 6.8 percent, $40,000 dollars traded, closing price of $930.75, down $2.50 from the previous day. Current information:

7 U.S. Government Debt Securities U.S. Treasury bills S-T  Maturities of 3, 6, and 12 months  Minimum denominations of $10,000  Sold at a discount from maturity value Treasury notes and bondsL-T  Notes 1–10 year maturity  Bonds 10–30 year maturity

8 Bond Ratings QualityS & P’sMoody’s HighestAAAAaa HighAAAa Upper MediumAA MediumBBBBaa JunkBB,B,CCC,CC, C Ba,B,Caa,Ca,C DefaultD

9 Ratings Higher rated bonds generally carry lower market yields. Interest rate spread between ratings is less during prosperity than during recessions. Junk bonds typically yield 3–6 percent or more.

10 International Bonds Eurobonds  Issued outside of the issuer’s country  Denominated in the home currency  May have less regulatory interference  May have less disclosure requirements Foreign bonds are issued in a single foreign country with interest and principal paid in that foreign currency.

11 Value of an Asset Based on the expected future benefits over the life of the asset Future benefits = cash flows (CFs) Capitalization of cash flow method – PV of the stream of future benefits discounted at an appropriate required rate of return

12 Market Value of an Asset Market price Demand & Supply (D&S) Approximated value Equilibrium D&S Intersection Consensus Judgment

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14 The Value of a Bond is the Present Value of its Cash Flows

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16 Bond Prices and Interest Rates Relationship between P 0 and k d  There is an inverse relationship between a bond’s value, P 0, and its required rate of return, k d. L-T vs. S-T Bonds  A change in k d changes the value of a long-term bond more than the value of a short-term bond.

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18 Yield to maturity of a bond If the price is known, you can solve for the value of k d which is the yield to maturity on the bond (the yield that makes the present value of the promised cash flows equal to the market price of the bond.

19 Perpetual Bond A perpetual bond pays $I forever— the value of a perpetual bond is computed as:

20 Zero Coupon Bonds formula table

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22 Ethical Issue In many leveraged buyouts (LBOs), the buyer of the firm financed the purchase with a large amount of debt. Often, stockholders made a large gain while bond prices plummeted because of the higher leverage the firm has assumed.

23 Preferred Stock (P/S) Is in an intermediate position between C/S and L-T debt Part of equity while increasing financial leverage Dividends on P/S are not tax deductible. Has preference over C/S with regard to earnings and assets Dividends can not be paid on C/S unless the preferred dividend for the period has been paid.

24 Characteristics of P/S Selling price Par value Adjusted rate P/S Cumulative Participation Maturity Call feature Voting rights

25 P/S Advantages and Disadvantages Advantages  Flexible  Can increase financial leverage  Corporate tax advantage Disadvantages  High after-tax cost  Dividends are not tax deductible

26 Value of P/S A share of preferred stock pays $I forever—the value of a preferred share is computed as: