Interview Questions

Fixed-Income Securities: Characteristics and Valuation

  1. The characteristics of fixed-income (debt and preferred stock) securities are examined, including
    1. Types of each form of security
    2. Features
    3. Users
    4. Advantages and disadvantages
  2. Reading and interpreting financial market data, including stock and bond price quotations, is an essential skill for an effective financial manager.
  3. In the capitalization of cash flow method, the value of an asset is equal to the present value of the expected future cash flows discounted at the appropriate required rate of return.
  4. The required rate of return is a function of the risk or uncertainty associated with the cash flows from the asset, as well as the risk -free rate.
  5. The value of a bond with a finite maturity date is equal to the present value of the interest payments and principal payment (at maturity) discounted at the investor’s required rate of return.
  6. The yield to maturity of a bond is equal to the rate of return that equates the price of the bond to the present value of the interest and principal payments.
  7. The value of a perpetual bond, or perpetuity, is determined by dividing the fixed interest rate per period by the required rate of return, since no calculation for payback of principal is needed in the valuation.
  8. Preferred stocks are often treated as perpetuities with a value equal to the annual dividend divided by the required rate of return.
  9. The market value or market price of an asset is the value placed on the asset by the marginally satisfied buyer and seller, who exchange assets in the marketplace.
  10. Market equilibrium occurs when the price of an asset is such that the expected rate of return is equal to the required rate of return.
  11. Bond refunding involves the replacement of a called bond issue with a lower interest cost issue.

The Bondholders of MCI Worldcomn

At the height of the Internet/technology stock market boom, WorldCom acquired telecom giant MCI for $40 billion. This merger was touted as a path -breaking merger that created the prototypical technology/ telecom firm of the future.Through early 2002, this company was one of the darlings of the stock and bond market.At its peak in 1999, the company was worth $194 billion. In June 2002,MCI WorldCom announced an $11 billion accounting scandal. This revelation led quickly to a Chapter 11 bankruptcy filing in July of 2002.

Stockholders of the company lost virtually all of their investment as the company emerged from bankruptcy proceedings. The estimated value of the newly reconstituted MCI (the new name for the company) was about $13 billion, a far cry from its peak value of $194 billion. Of the $13 billion, about $8 billion was to be in the form of stock when the company emerged from bankruptcy proceedings.This stock went to bondholders of the old firm. Approximately $5.5 billion was to be in the form of debt that was to be awarded to other creditors.These payouts to debtholders are a small fraction of the $41 billion owed to them when the company declared bankruptcy in 2002.

The MCI WorldCom case illustrates some of the relative risks assumed by stockholders and bondholders. Bondholders received only a fraction of what was owed to them by the company. Stockholders, however, fared much worse, losing the value of their entire investment.This chapter discusses the characteristics of long-term debt, reviews the bond quality ratings that are available from various bond rating companies, and develops the techniques of bond valuation.

Introduction

Companies issue various types of long -term securities to help meet their needs for funds. These include long-term debt (bonds),1 preferred stock, and common stock. Long-term debt and preferred stock are sometimes referred to as fixed -income securities. Holders of these types of securities receive relatively constant distributions of interest or dividend payments over time and have a fixed claim on the assets of the firm in the event of bankruptcy. For example, Ford Motor Company sold $250 million of bonds in 1992, at which time it agreed to pay its lenders an interest rate of 87⁄8 percent or $88.75 per year until 2022 for each $1,000 of debt outstanding.

Since then, the company has continued to pay this interest rate, even though market interest rates have fluctuated. Similarly, DuPont issued $70 million of preferred stock in 1947. Investors paid $102 per share, and the company agreed to pay an annual dividend of $3.50 per share. Since then DuPont has continued to pay this amount, even though common stock dividends have been increased numerous times. Common stock, on the other hand, is a variabl e-income security. Common stockholders are said to participate in a firm’s earnings because they may receive a larger dividend if earnings increase in the future, r their dividend may be cut if earnings drop. For example, in 1998 Ford Motor paid an annual dividend per share of $1.72. After a number of disappointing years of earnings, the annual dividend rate was reduced to $0.40 per share in 2004.

Investors in common stock have a residual claim on the earnings (and assets) of the firm since they receive dividends only after the claims of bondholders and other creditors, as well as preferred stockholders, have been met.

Fixed-income securities —long -term debt and preferred stock —differ from each other in several ways. For example, the interest paid to bondholders is a tax -deductible expense for the borrowing company, whereas dividends paid to preferred stockholders are not. Legally, longterm debt holders are considered creditors, whereas preferred stockholders are considered owners. Thus, a firm is not legally required to pay dividends to its preferred stockholders, and the failure to do so has less serious consequences than the failure to meet interest payment and principal repayment obligations on long-term debt. In addition, long-term debt normally has a specific maturity, whereas preferred stock is often perpetual.

A knowledge of the characteristics of the various types of long -term securities is necessary in developing valuation models for these securities. The valuation of long -term securities is important to a firm’s financial managers, as well as to current owners, prospective investors, and security analysts. For example, financial managers should understand how the price or value of the firm’s securities (particularly common stock) is affected by its investment, financing, and dividend decisions. Similarly, both current owners and prospective investors should be able to compare their own valuations of the firm’s securities with actual market prices to make rational security purchase and sale decisions. Likewise, security analysts use valuation techniques in evaluating long-term corporate securities when making investment recommendations.

This chapter focuses on the characteristics and valuation of fixed -income securities, namely, long-term debt and preferred stock. The next chapter contains a similar discussion of variable-income securities, namely, common stock.


Pragna Meter
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