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### Week 3: Bonds, Equity and Basic Valuation

February 22, 2012

For today…

- Basic Investment Types
- Bonds
- Equity
- Basic Research and Valuation Techniques

Asset Class: Bonds

- Bonds are a type of debt security.
- Bondholders receive (usually semi-annual) payments called coupons.
- At the bond’s maturity, bondholders receive the Par or Face Value of the debt.

Primary Asset Types: Bond

- A bond typically has a payment schedule that looks like this:

Things to Note about Bonds

- Relatively predictable cash inflows (easier to value).
- Cash flows are legally guaranteed
- Bond-holders fare better in the event of bankruptcy (more on that later)

Bond Characteristics

- Secured/Unsecured: whether payment is backed by assets
- Tax status: some government bonds are tax exempt
- Callability: Whether or not a bond can be called early by the issuing company

Bond Ratings

- Bongs are rated by three credit rating agencies
- Moody’s, S&P and Fitch
- The lower a bond rating is, the higher the yield will be
- Investors want to be compensated for higher risk, as defined by a lower rating
- Countries can also be rated (see US downgrade)

Time Value of Money

- If I have $100 today and can invest it at 5% interest (compounded annually), how much will I have after 1 year? 2 years? 10 years?
- $100 * (1 + .05) = $105 (1 year)
- $105 * (1 + .05) = $110.25 (2 years)
- $100 * (1 + .05)10 = $162.89 (10 years)
- n years?
- $100 * (1 + .05) n

Time Value of Money

- Problems like this are known as future value problems. They answer the question “If I have PV dollars today, how much will I have if I invest at interest rate r for n periods.
- FV = PV * (1 + r)n

Time Value of Money

- Present Value problems do the opposite: They answer the question “How much money do I need to put away today to have FV dollars in n periods if I can invest at rate r?
- PV = FV/(1+ r)n
- For a series of cash flows, the formula is:
- Σ(CF/(1+ r)t) = CF1/(1 + r) + … + CFT/(1 + r)T

What does this mean for us?

- Using our P = $100, r = 0.05, n = 1 example from earlier, the present value formula tells us that we should be indifferent between receiving $100 today and receiving $105 in one year.
- Consequently, the value of a financial asset is the present value of its expected cash flows.

Example

- Suppose I offered you a slip of paper that entitles you to $100 in 1 year, $150 in 2 years, and $50 in 3 years. How much would you be willing to pay for this paper (the interest rate is 5%)?
- PV = CF1/(1 + r) + CF2/(1 + r)2 + CF3/(1 +r)3
- = 100/(1.05) + 150/(1.05)2 + 50/(1.05)3
- $274.48

Valuation Example

- Use the present value of money
- Sum of future cash flows, discounted to today
- 5 year bond, $50 coupon, interest rate is 5%

Valuation Example

- What happens if the market interest rate rises to 6%?
- 5 year bond, $50 coupon, interest rate is 5%

Asset Class: Equity Common Stock

- Common stock represents a claim on the profits of the company.
- Think of stock as partial ownership in a business
- When investing, ask whether you would want to be an owner of the company?
- Stock owners assume the risk of the company
- If it goes under, they probably won’t get paid

Asset Class: Equity Common Stock

- Common stockholders get paid only if all other claimants are paid first.
- Common stockholders are paid in the form of dividends, payments made at the discretion of management.
- So the value of a share of common stock is the present value of its expected future dividends.
- Some companies prefer return money through stock repurchases.

Aside on Valuation

- The present value of a perpetual (never ending) cash flow is (CF)/r.
- The present value of a perpetual cash flow that grows at a rate g every year is (CF)/(r – g).
- To value a stock using DCF, we estimate its dividends for five years, then assume a constant growth rate thereafter.

Profitability Ratios

- Helps ensure that a company can clear its expenses
- One ratio is profit margin: Net Income/Revenue
- Always compare to other similar companies
- Watch out for continuous year over year margin declines
- May indicate disappearing competitive advantage

Liquidity Ratios

- How quickly a company can turn its assets into cash
- Current Ratio: Current Assets/Current Liabilities
- Measure of companies ability to pay off liabilities coming due soon
- Under 1 may signal trouble in the near future

Solvency Ratios

- How well the company can deal with long term obligations
- Total Debt to Total Assets
- Short + Long Term Debt/Total Assets
- Shows how assets were financed
- Through debt or equity
- Usually lower is better, but could mean company is passing up growth opportunities

Valuation Ratios

- Attempts to measure how good an investment would be
- Price to Earnings (P/E) Ratio
- Market Value/Earnings Per Share
- How much investors are willing to pay for $1 of current earnings
- Higher P/E means higher expected future growth
- Best used to compare against other companies

Valuing Common Stock

- PV = D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3 + D4/(1 + r)4 + (D5 + P5)/(1 + r)5, where P5 = D5/(r – g)

Example

- We expect dividends to be $3, $5, $10, $12, and $13 in years 1 through 5, with 3% growth thereafter. The interest rate is 8%. After 5 years, we sell. Note: P5 = 13/(.05) = 260

Preferred Stock

- A special type of equity
- Preferred stock carries a fixed interest rate, but the company can choose to not pay it.
- However, before common stockholders can receive dividends, preferred stockholders must receive all of their back-dividends.
- Preferred stockholders rank above common stockholders in the capital structure.

The Capital Structure

- A company is in default if it has failed to pay its debt obligations on time.
- In the event of default and bankruptcy, a company’s assets are liquidated, and entities that have a claim on its assets are paid in this order:
- Government
- Debt-holders
- Equity-holders
- Note: within each class there are more layers (Senior debt, junior debt, etc.)

Questions for Discussion

- Question 1:
- Which is more expensive debt or equity?
- Question 2:
- As an investor, in the case of bankruptcy would you rather own debt or equity?

Research for Next Week

- Utilize Johnson School databases to conduct basic research of your company
- Search for an read relevant news articles in regards to your company and industry

Answers

- Answer 1: Equity
- Giving up ownership of the company
- Debt acts as a tax shield
- Answer 2: Debt
- Debt holders have a stake in the remaining assets of a company and are therefore one of the first parties to receive compensation

Macroeconomic Presentation

- Government Bonds that have been downgraded:
- United States: AA+/Aaa
- Italy: BBB+/Aa2
- France: AA+/Aaa
- Greece: CCC/Caa1
- Spain: A-/A-1
- Netherlands: AA/Aa1
- Germany: AA+/Aa1
- European Debt Crisis

Next Week

- Macroeconomics and Research Reports
- Basics of macroeconomics
- Industry overviews in reports

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