3
LONG-TERM FINANCING
SHARES & BONDS VALUATION
Learning Outcomes
At the end of this chapter, you should be able
to:
Explain bonds and calculate the value of bonds
Explain shares and calculate the value of
shares
Definition of Preference Share
The capital stock of the owners of the firm
whose claim on assets and income is
secondary to that of bondholders but preferred
as to that of the common stockholders
Definition of Preference Share
Often referred to as a hybrid security because it
has many characteristics of both common stock
and bonds. Similar to common stock in that it
has no fixed maturity period, the non-payment
of dividend does not bring on bankruptcy, and
dividend are not deductible for tax purpose.
Similar to bonds in that dividends are limited in
amount.
3.2.1 Types of Preference Shares
• The issuing company has the right to buy back
Callable these shares at a certain price on a certain date
• The owner of these preference shares has the option,
Convertible but not the obligation, to convert the shares to a
company's common stock
• If a company does not have the financial resources to
pay a dividend to the owners of its preference shares,
Cumulativ then it still has the payment liability, and cannot pay
e dividends to its common shareholders for as long as
that liability remains unpaid
3.2.1 Types of Preference Shares
Non- • If a company does not pay a scheduled dividend,
cumulativ it does not have the obligation to pay the dividend
e at a later date
• The issuing company must pay an increased
dividend to the owners of preference shares if there
is a participation clause in the share agreement. This
Participatin clause states that a certain portion of earnings (or of
the dividends issued to the owners of common
g stock) will be distributed to the owners of
preferences shares in the form of dividends. These
shares also have a fixed dividend rate
3.2.1 Features of Preference
Share
Multiple series/classes
• There are various classes o PS produces by a
company. Each class has different characteristics. For
example, PS can be converted into common shares,
and some have different priorities associated with the
assets in the event of bankruptcy.
Claim on assets and income
• In the event of bankruptcy claims, PS hold priority
compared to common stocks. This means that firms
must pay preferred share dividends before commons
stocks dividends
3.2.1 Features of Preference
Share
Cumulative provision
• Most PS require a cumulative dividend payable prior to
be settled before the common stock share dividends
may be declared. The aim is to provide a level of
protection for preferred stockholders.
Convertibles
• Which carry the right to exchange to common stock
3.2.1 Features of Preference
Share
Protective provision
• This allows voting rights to preferred shareholders in
the event of stopped no dividend payments. The right
to vote is granted after the PS dividend is not paid for
several times
3.2.2 Calculate Price of Shares
The purpose of valuation is to find the fair value (price)
of the securities
When the market price above the fair value or intrinsic
value, the securities is said to be overvalued
When the market price below than its fair value, the
securities is undervalued
The securities is recommended buy when undervalued
and sell when overvalued.
3.2.2 Calculate Price of Shares
Valuing Preferred Stock
the value of a preferred stock is the present
value of all future dividends.
But because most preferred stocks are
nonmaturing—the dividends continue to infinity
3.2.2 Calculate Price of Shares
PG&E’s preferred stock pays an annual
dividend of $1.25. The shares do not have a
maturity date; that is, they are a perpetuity. The
investor’s required rate of return is assumed to
equal 5 percent for the preferred stock.
3.2.2 Calculate Price of Shares
Example 3.2-1
3.2.2 Calculate Price of Shares
3.2.2 Calculate Price of Shares
When the Deutsche Bank preferred stock was sold at
the $25 par value, the investors’ required rate of return
was equal to the coupon dividend rate of 7.35 percent.
As an investor’s required rate of return increases
(decreases), the security value decreases (increases)
The firm will recall the stock only if it is in its best
interest. For instance, if with time the firm could issue
preferred stock with a lower dividend rate, it would be
inclined to do so
Thus, an investor should require a slightly higher
required rate of return if a stock is redeemable.
3.2.2 Calculate Price of Shares
Exercise
If a preferred stock pays 4 percent on its par, or
stated, value of $100, and your required rate of
return is 7 percent, what is the stock worth to
you?
3.3.3 Calculate Expected Rate of Return
is the rate of return the investor can expect to earn from
the investment if it is bought at the current market price.
To compute the expected rate of return of preferred
stockholders, we use the valuation equation for
preferred stock. Earlier, equation specified the value of
a preferred stock, Vps, as
Solving equation for rps, we have
3.3.3 Calculate Expected Rate of
Return
Thus, the required rate of return of preferred
stockholders simply equals the stock’s annual
dividend divided by the stock’s intrinsic value.
We can also use this equation to solve for a
preferred stock’s expected rate of return, rps, as
follows:
3.3.3 Calculate Expected Rate of
Return
For example, if the present market price of the
preferred stock is $50 and it pays a $3.64
annual dividend, the expected rate of return
implicit in the present market price is
Therefore, investors who pay $50 per share for
a preferred security that is paying $3.64 in
annual dividends are expecting a 7.28 percent
rate of return
3.3.3 Calculate Expected Rate of
Return
In Example 3.2-1, we calculated the value of
Deutsche Bank’s preferred stock, where the
stock had a par value of $25 and a coupon
dividend rate of 7.35 percent, which resulted in
a $1.84 [Link] computed the value of the
stock given different required rates of return. At
the time, the stock was actually selling for $26
in the market. What is the expected rate
ofreturn if you purchased the stock at the
current market price?
3.3.3 Calculate Expected Rate of
Return