Valuation of equities and bonds

Question 1

Market value

Answer 1

represents the market price at which an asset trades.

Question 2

Intrinsic value

Answer 2

represents the price a security “ought to have” based on all factors bearing on valuation.

Question 3

Equity Finance 6

Answer 3

1. Par value versus market value
2. Ordinary share account and share premium account
3. Authorised versus issued share capital
4. Risk and the creditor hierarchy
5. Shareholder returns not guaranteed
6. Cost of equity is higher than cost of debt or cost of preference shares

Question 4

A shareholder has the right to: 8

Answer 4

1. Attend general meetings of the company.
2. Vote on appointment of directors.
3. Vote on appointment, remuneration and removal of auditors.
4. Receive annual accounts of the company and the report of its auditors.
5. Receive a share of any dividend paid.
6. Vote on important issues such as permitting repurchase of shares, using shares in a takeover bid, or a change in authorised share capital.
7. Receive a share of assets remaining after the company has been liquidated.
8. Participate in a new issue of shares of company (the preemptive right).

Question 5

Common Stock Valuation

Answer 5

represents a residual ownership position in the corporation.

Question 6

What cash flows will a shareholder receive when owning shares of common stock? 2

Answer 6

1. Future dividends
2. Future sale of the common stock shares

Question 7

Dividend Growth Pattern

Answer 7

1. The dividend valuation model requires the forecast of all future dividends.

• Constant Growth
• No Growth
• Growth Phases

Question 8

Constant Growth Model

Answer 8

The constant growth model assumes that dividends will grow forever at the rate g.

Question 9

Zero Growth Model

Answer 9

The zero growth model assumes that dividends will grow forever at the rate g = 0.

Question 10

Growth Phases Model

Answer 10

Note that the second phase of the growth phases model assumes that dividends will grow at a constant rate g2 .

Question 11

Preference shares 5

Answer 11

1. Equity or debt?
2. Preferential right to receive dividend
3. Although permanent capital, do not normally carry voting rights
4. Less risky than ordinary shares, riskier than debt
5. Cumulative and non-cumulative preference shares.

Question 12

Advantages of preference shares: 4

Answer 12

1. No need to pay dividend if profits are poor
2. Do not dilute ownership and control
3. Unsecured, so preserve debt capacity
4. No right to appoint a receiver.

Question 13

Disadvantages of preference shares:

Answer 13

Higher cost compared to debt due to tax inefficiency.

Question 14

Preferred Stock

Answer 14

is a type of stock that promises a (usually) fixed dividend, but at the discretion of the board of directors

Question 15

Long Term Bond

Answer 15

A bond is a long-term debt instrument issued by a corporation or government.

Question 16

Maturity value (MV)

Answer 16

of a bond is the stated value

Question 17

coupon rate

Answer 17

is the stated rate of interest; the annual interest payment divided by the bond’s face value.

Question 18

discount rate

Answer 18

is dependent on the risk of the bond and is composed of the risk-free rate plus a premium for risk.

Question 19

perpetual bond

Answer 19

is a bond that never matures. It has an infinite life.

Question 20

Zero Coupon Bonds

Answer 20

is a bond that pays no interest but sells at a deep discount from its face value; it provides compensation to investors in the form of price appreciation.

Question 21

Non-Zero Coupon Bonds

Answer 21

is a couponpaying bond with a finite life. Most non-zero coupon bonds pay interest twice a year (1/2 of the annual coupon).

Question 22

Debentures and loan stock 5

Answer 22

1. Fixed or floating interest rate
2. Par value of bonds is £100
3. On maturity, bond issue must be redeemed
4. Debentures are secured bonds – fixed charge – floating charge
5. Covenants written to protect investors

Question 23

Other types of debt 5

Answer 23

1. Subordinate debt
2. Junk bonds
3. Deep discount bonds: issued at deep discount to par so lower coupon as revenue return traded for capital gain
4. Zero coupon bonds: pay no interest so return is entirely capital gain
5. Eurobonds.

Question 24

Bank and institutional debt 5

Answer 24

1. Bank loans are not traded so no market value can be placed on the debt
2. Fixed or variable interest rate
3. Secured on assets of the company
4. Repayment schedule means capital owed decreases each year
5. Small businesses may get government assistance when seeking debt finance.

Question 25

Convertible bonds 4

Answer 25

1. Convertible bonds can be converted to ordinary shares at option of the holder. 2. Option to convert leads to interest being lower than on straight debt. 3. Company hopes convertible debt will not need to be redeemed. 4. Conversion terms will be designed to make conversion attractive.

Question 26

Warrants 4

Answer 26

1. Warrants give option to buy shares on a future date at a set price. 2. Warrants are attached to loan stock to make it more attractive to investors. 3. Warrants can be detached and sold on. 4. Exercising warrants has no effect on the loan stock, which continues to trade to redemption.

Question 27

Leases Finance 6

Answer 27

1. Several lessees over useful economic life of asset 2. Maintenance costs borne by lessor 3. Lease payments are tax-allowable 4. Effectively, a rental agreement 5. Accounted for ‘off balance sheet’ 6. Includes cars, computers etc.