Chapter 6 Fixed-Income Securities: Characteristics and Valuation © 2001 South-Western College Publishing

Classification of Long-Term Debt  Mortgage bonds secured  Debentures unsecured çSubordinated and Unsubordinated çClaims of subordinated debenture holders are considered only after the claims of unsubordinated debt holders

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

Characteristics of L-T Debt  Indenture äcovenants  Trustee äTIA 1939  Call feature  Call premium  Sinking fund  Equity-linked debt äconvertible äwarrant  Coupon rates  Size $25-$200 million

Debt Information  Corporate bonds Majority traded in the over-the-counter market Some larger issues traded on the NY Exchange  Quotations % of par value $1000 DukeEn 6 3 / ¾ - 1 / 4 Meaning a Duke Energy bond with an interest rate ( coupon rate ) of 6.375%, maturing in 2008, yielding 6.8 %, $40,000 dollars traded, closing price of $9307.5, down $2.50 from the previous day.

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 bonds L-T Notes 1-10 year maturity Bonds year maturity

Bond Ratings QualityS & P’sMoody’s HighestAAAAaa HighAAAa Upper Medium AA MediumBBBBaa JunkBB,B,CCC,CC, C Ba,B,Caa,Ca, C DefaultDD

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 % or more

L-T Debt Advantages and Disadvantages  Advantages Tax deductibility of interest Financial leverage can increase EPS Ownership is not diluted  Disadvantages Increased financial risk Indenture provisions restrict firm’s flexibility

Value of an Asset  Based on the expected future benefits over the life of the asset  Future benefits = cash flows ( CF’s ) u Capitalization of cash flow method u PV of the stream of future benefits discounted at an appropriate required rate of return

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

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

Bond Prices and Interest Rates  Relationship between P 0 & 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

Perpetual Bond

Zero Coupon Bonds  formula u table

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

Characteristics of P/S  Selling price  Par value  Participation  Cumulative  Maturity  Voting rights

P/S Advantages and Disadvantages  Advantages äFlexible äCan increase financial leverage äCorporate tax advantage  Disadvantages äHigh after tax cost äDividends is not tax deductible

Value of P/S