Financial Institutions and Markets FIN 304 Dr. Andrew L. H. Parkes Day 9 “How do financial markets work?” 卜安吉

Financial Institutions & Markets, Day 92 Chapter 10: Bonds and Stocks What is Yield to a Call?  Remember what Call means?  Higher yield – potential early maturity date  Only if favorable to the issuer!  Only done in Excel and with a FINANCIAL calculator => The U.S. Budget

Financial Institutions & Markets, Day 93 Callable Bond

Financial Institutions & Markets, Day N I/YR PV PMT FV x 2 = 7.53% A 10-year, 10% semiannual coupon, $1,000 par value bond is selling for $1, with an 8% yield to maturity. It can be called after 5 years at $1,050. What’s the bond’s nominal yield to call (YTC)? INPUTS OUTPUT Callable Bond

Financial Institutions & Markets, Day 95 r Nom = 7.53% is the rate brokers would quote. Could also calculate EAR (Equivalent Annual Rate) to call: EAR = ( ) = 7.672%. This rate could be compared to monthly mortgages, and so on. Callable Bond Continued - EAR

Financial Institutions & Markets, Day 96 If you bought bonds, would you be more likely to earn YTM or YTC? The Coupon rate = 10%  YTC = r d = 7.53%. The Coupon rate = 10%  YTC = r d = 7.53%. Could raise money by selling new bonds which pay 7.53%. Could raise money by selling new bonds which pay 7.53%. Then replace bonds which pay $100/year with bonds that pay only $75.30/year. Then replace bonds which pay $100/year with bonds that pay only $75.30/year. Investors will expect a call, hence YTC = 7.5%, not YTM = 8% will be the return for investors. Investors will expect a call, hence YTC = 7.5%, not YTM = 8% will be the return for investors.

Financial Institutions & Markets, Day 97 If a bond sells at a premium, then (1) coupon > r d, so (2) a call is likely. If a bond sells at a premium, then (1) coupon > r d, so (2) a call is likely. So, expect to earn: So, expect to earn: –YTC on premium bonds. –YTM on par & discount bonds. In General:

Financial Institutions & Markets, Day 98 Disney recently issued 100-year bonds with a YTM of 7.5%--this represents the promised return. The expected return was less than 7.5% when the bonds were issued. Disney recently issued 100-year bonds with a YTM of 7.5%--this represents the promised return. The expected return was less than 7.5% when the bonds were issued. If issuer defaults, investors receive less than the promised return. Therefore, the expected return on corporate and municipal bonds is less than the promised return. If issuer defaults, investors receive less than the promised return. Therefore, the expected return on corporate and municipal bonds is less than the promised return. Disney Bonds

Financial Institutions & Markets, Day 99 Bond Ratings Provide One Measure of Default Risk Investment GradeJunk Bonds Moody’s AaaAaABaaBaBCaaC S&P AAAAAABBBBBBCCCD

Financial Institutions & Markets, Day 910 What factors affect default risk and bond ratings? Financial performance Financial performance –Debt ratio –Coverage ratios, such as interest coverage ratio or EBITDA coverage ratio –Current ratios (More…)

Financial Institutions & Markets, Day 911 Bankruptcy Two main chapters of Federal Bankruptcy Act: Two main chapters of Federal Bankruptcy Act: –Chapter 11, Reorganization –Chapter 7, Liquidation Typically, company wants Chapter 11, creditors may prefer Chapter 7. Typically, company wants Chapter 11, creditors may prefer Chapter 7.

Financial Institutions & Markets, Day 912 If company can’t meet its obligations, it files under Chapter 11. That stops creditors from foreclosing, taking assets, and shutting down the business. If company can’t meet its obligations, it files under Chapter 11. That stops creditors from foreclosing, taking assets, and shutting down the business. Company has 120 days to file a reorganization plan. Company has 120 days to file a reorganization plan. –Court appoints a “trustee” to supervise reorganization. –Management usually stays in control. Bankruptcy continued

Financial Institutions & Markets, Day 913 Very Simply: Very Simply: A company must demonstrate in its reorganization plan that it is “worth more alive than dead.” Otherwise, judge will order liquidation under Chapter 7. Bankruptcy continued

Financial Institutions & Markets, Day 914 If the company is liquidated, here’s the payment priority: If the company is liquidated, here’s the payment priority: 1.Secured creditors from sales of secured assets. 2.Trustee’s costs 3.Wages, subject to limits 4.Taxes 5.Unfunded pension liabilities 6.Unsecured creditors 7.Preferred stock 8.Common stock Bankruptcy continued

Financial Institutions & Markets, Day 915 In a liquidation, unsecured creditors generally get zero. This makes them more willing to participate in reorganization even though their claims are greatly scaled back. In a liquidation, unsecured creditors generally get zero. This makes them more willing to participate in reorganization even though their claims are greatly scaled back. Various groups of creditors vote on the reorganization plan. If both the majority of the creditors and the judge approve, company “emerges” from bankruptcy with lower debts, reduced interest charges, and a chance for success. Various groups of creditors vote on the reorganization plan. If both the majority of the creditors and the judge approve, company “emerges” from bankruptcy with lower debts, reduced interest charges, and a chance for success. Bankruptcy continued

Financial Institutions & Markets, Day 916 Dividend growth model Dividend growth model Using the multiples of comparable firms Using the multiples of comparable firms Free cash flow method (covered in Fin 102) Free cash flow method (covered in Fin 102) Approaches for Valuing Common Stock

Financial Institutions & Markets, Day 917 One whose dividends are expected to grow forever at a constant rate, g. Stock Value = PV of Dividends What is a constant growth stock? Dividend growth model

Financial Institutions & Markets, Day 918 As you know: for a constant growth stock, If g is constant, then:

Financial Institutions & Markets, Day 919 $ 0.25 Years (t) 0

Financial Institutions & Markets, Day 920 What happens if g > r s (k e )? If r s < g, get negative stock price, which is nonsense. If r s < g, get negative stock price, which is nonsense. We can’t use model unless (1) g  r s and (2) g is expected to be constant forever. Because g must be a long-term growth rate, it cannot be  r s.

Financial Institutions & Markets, Day 921 Assume beta = 1.2, r RF = 7%, and RP M = 5%. What is the required rate of return on the firm’s stock? r s = r RF + (RP M )b Firm = 7% + (5%) (1.2) = 13%. (k e ) Use the SML to calculate r s (k e ) :

Financial Institutions & Markets, Day 922 D 0 was $2.00 and g is a constant 6%. Find the expected dividends for the next 3 years, and their PVs. r s = 13% g=6% D 0 = % 2.12

Financial Institutions & Markets, Day 923 What’s the stock’s market value? D 0 = 2.00, r s = 13%, g = 6%. Constant growth model: = = $ $

Financial Institutions & Markets, Day 924 What is the stock’s market value one year from now, P 1 ? D 1 will have been paid, so expected dividends are D 2, D 3, D 4 and so on. Thus, D 1 will have been paid, so expected dividends are D 2, D 3, D 4 and so on. Thus, ^

Financial Institutions & Markets, Day 925 Find the expected dividend yield and capital gains yield during the first year. Dividend yield = = = 7.0%. $2.12 $30.29 D1D1 P0P0 CG Yield = = P 1 - P 0 ^ P0P0 $ $30.29 $30.29 = 6.0%.

Financial Institutions & Markets, Day 926 Total return = Dividend yield + Capital gains yield. Total return = Dividend yield + Capital gains yield. Total return = 7% + 6% = 13%. Total return = 7% + 6% = 13%. Total return = 13% = r s. Total return = 13% = r s. For constant growth stock: For constant growth stock: Capital gains yield = 6% = g. Capital gains yield = 6% = g. Find the total return during the first year.

Financial Institutions & Markets, Day 927 Rearrange model to rate of return form: Then, r s = $2.12/$ = = 13%. ^

Financial Institutions & Markets, Day 928 What would P 0 be if g = 0? The dividend stream would be a perpetuity r s =13% P 0 = = = $ PMT r $ ^

Financial Institutions & Markets, Day 929 If we have supernormal growth of 30% for 3 years, then a long-run constant g = 6%, what is P 0 ? r is still 13%. Can no longer use constant growth model. Can no longer use constant growth model. However, growth becomes constant after 3 years. However, growth becomes constant after 3 years. ^

Financial Institutions & Markets, Day 930 Nonconstant growth followed by constant growth: r s =13% = P 0 g = 30% g = 6% D 0 = ^

Financial Institutions & Markets, Day 931 What is the expected dividend yield and capital gains yield at t = 0? At t = 4? Dividend yield = = = 4.8%. $2.60 $54.11 D1D1 P0P0 CG Yield = 13.0% - 4.8% = 8.2%. At t = 0: (More…)

Financial Institutions & Markets, Day 932 During nonconstant growth, dividend yield and capital gains yield are not constant. During nonconstant growth, dividend yield and capital gains yield are not constant. If current growth is greater than g, current capital gains yield is greater than g. If current growth is greater than g, current capital gains yield is greater than g. After t = 3, g = constant = 6%, so the t = 4 capital gains gains yield = 6%. After t = 3, g = constant = 6%, so the t = 4 capital gains gains yield = 6%. Because r s = 13%, the t = 4 dividend yield = 13% - 6% = 7%. Because r s = 13%, the t = 4 dividend yield = 13% - 6% = 7%.

Financial Institutions & Markets, Day 933 The current stock price is $ The current stock price is $ The PV of dividends beyond year 3 is $46.11 (P 3 discounted back to t = 0). The PV of dividends beyond year 3 is $46.11 (P 3 discounted back to t = 0). The percentage of stock price due to “long-term” dividends is: The percentage of stock price due to “long-term” dividends is: ^ = 85.2%. $46.11 $54.11 Is the stock price based on short-term growth?

Financial Institutions & Markets, Day 934 Sometimes changes in quarterly earnings are a signal of future changes in cash flows. This would affect the current stock price. Sometimes changes in quarterly earnings are a signal of future changes in cash flows. This would affect the current stock price. Sometimes managers have bonuses tied to quarterly earnings. Sometimes managers have bonuses tied to quarterly earnings. If most of a stock’s value is due to long- term cash flows, why do so many managers focus on quarterly earnings?

Financial Institutions & Markets, Day 935 Suppose g = 0 for t = 1 to 3, and then g is a constant 6%. What is P 0 ? r s =13% g = 0% g = 6%  P  ^...

Financial Institutions & Markets, Day 936 What is dividend yield and capital gains yield at t = 0 and at t = 3? t = 0: D1D1 P0P0 CGY = 13.0% - 7.8% = 5.2%.  2.00 $ %. t = 3: Now have constant growth with g = capital gains yield = 6% and dividend yield = 7%.

Financial Institutions & Markets, Day 937 If g = -6%, would anyone buy the stock? If so, at what price? Firm still has earnings and still pays dividends, so P 0 > 0: ^ = = = $9.89. $2.00(0.94) (-0.06) $

Financial Institutions & Markets, Day 938 What are the annual dividend and capital gains yield? Capital gains yield = g = -6.0%. Dividend yield= 13.0% - (-6.0%) = 19.0%. Both yields are constant over time, with the high dividend yield (19%) offsetting the negative capital gains yield.

Financial Institutions & Markets, Day 939 Analysts often use the P/E multiple (the price per share divided by the earnings per share) or the P/CF multiple (price per share divided by cash flow per share, which is the earnings per share plus the dividends per share) to value stocks. Analysts often use the P/E multiple (the price per share divided by the earnings per share) or the P/CF multiple (price per share divided by cash flow per share, which is the earnings per share plus the dividends per share) to value stocks. Example: Example: –Estimate the average P/E ratio of comparable firms. This is the P/E multiple. –Multiply this average P/E ratio by the expected earnings of the company to estimate its stock price. Using the Stock Price Multiples to Estimate Stock Price

Financial Institutions & Markets, Day 940 The entity value (V) is: The entity value (V) is: –the market value of equity (# shares of stock multiplied by the price per share) –plus the value of debt. Pick a measure, such as EBITDA, Sales, Customers, Eyeballs, etc. Pick a measure, such as EBITDA, Sales, Customers, Eyeballs, etc. Calculate the average entity ratio for a sample of comparable firms. For example, Calculate the average entity ratio for a sample of comparable firms. For example, –V/EBITDA –V/Customers Using Entity Multiples

Financial Institutions & Markets, Day 941 Find the entity value of the firm in question. For example, Find the entity value of the firm in question. For example, –Multiply the firm’s sales by the V/Sales multiple. –Multiply the firm’s # of customers by the V/Customers ratio The result is the total value of the firm. The result is the total value of the firm. Subtract the firm’s debt to get the total value of equity. Subtract the firm’s debt to get the total value of equity. Divide by the number of shares to get the price per share. Divide by the number of shares to get the price per share. Using Entity Multiples (Continued)

Financial Institutions & Markets, Day 942 It is often hard to find comparable firms. It is often hard to find comparable firms. The average ratio for the sample of comparable firms often has a wide range. The average ratio for the sample of comparable firms often has a wide range. –For example, the average P/E ratio might be 20, but the range could be from 10 to 50. How do you know whether your firm should be compared to the low, average, or high performers? Problems with Market Multiple Methods

Financial Institutions & Markets, Day 943 Why are stock prices volatile? r s = r RF + (RP M )b i could change. Inflation expectations Risk aversion Company risk g could change. ^

Financial Institutions & Markets, Day 944 What is market equilibrium? ^ In equilibrium, stock prices are stable. There is no general tendency for people to buy versus to sell. The expected price, P, must equal the actual price, P. In other words, the fundamental value must be the same as the price. (More…)

Financial Institutions & Markets, Day 945 In equilibrium, expected returns must equal required returns: r s = D 1 /P 0 + g = r s = r RF + (r M - r RF )b. ^

Financial Institutions & Markets, Day 946 How is equilibrium established? If r s = + g > r s, then P 0 is “too low.” If the price is lower than the fundamental value, then the stock is a “bargain.” Buy orders will exceed sell orders, the price will be bid up, and D 1 /P 0 falls until D 1 /P 0 + g = r s = r s. ^ ^ D1P0D1P0 ^

Financial Institutions & Markets, Day 947 Now take a look at YOURS! You will want to begin looking for a Chinese company to value as well! I want you to look at the Chinese company as you would the U.S. company. What problems do you have now?