Week 10 Flashcards
Sources of finance
Equity financing
Debt financing
Equity financing
Equity holders have a residual claim to the cashflows
generated by the assets of the company.
e.g. ordinary shares; preference shares
DEBT FINANCING:
Debt providers have a contractual right to the cashflows
generated by the assets of the company.
e.g. term loans (long-term bank loans); debentures;
bonds (government bonds and/or corporate bonds)
CHARACTERISTICS OF Debt vERSUs Equity
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Intrinsic value of an asset
The present value of the stream of expected cash flows discounted at an appropriate required rate of return
The value (or price) is determined by three elements:
- The required rate of return by investor
- The riskiness or uncertainty of expected cash flows
- The amount and timing of expected cash flows
A bond
A bond refers to a contract that is issued by either a government or a corporation (the issuer) promising to pay the holder:
(1)A pre-determined amount of interest payments;
and
(2) The face value at maturity.
A bond represents
A bond represents a form of interest-only direct
finance loan.
A bond pays
A bond pays fixed coupon payments at fixed intervals and pays the par value at maturity
Bond terminology
Par value (or face value)
Maturity date
Coupon rate
Coupon payments
Par value (or face value)
- The principal amount to be repaid on the maturity date.
Maturity date
The date at which the principal amount is payable.
Coupon rate
The annual coupon payments divided by the face value.
Coupon payments
- The fixed interest payments that are payable at fixed intervals
until the maturity date.
Valuation of Bonds
The value (or price) of a bond is determined by the present value of all the cash flows that the bond is expected to produce in the future up to and including the maturity date.
The expected cash flows for a bond consist of:
(1) All coupon payments (paid at fixed intervals until the maturity date);
and
(2) The principal amount or Face Value (paid at the maturity date).
Valuation of Bonds photo
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Time Path of the Value of a 10% coupon, $1,000 Par Value Bond When Interest Rates are 8%, 10% and 12%
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VALUATION OF BONDS
General Rule:
If the Coupon rate = Interest rate:
The bond will sell for its par value (i.e. par bond).
If the Coupon rate > Interest rate:
The bond will sell for a premium (i.e. premium bond).
If the Coupon rate < Interest rate:
The bond will sell for a discount (i.e. discount bond).
VALUATION OF BONDS CONCLUSION
Bond prices are inversely related to interest rate movements:
- If interest rates increase, bond prices will fall and thus sell at a discount; and - If interest rates decrease, bond prices will rise and thus sell at a premium.
The Relationship between Bond prices and interest rates
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SHARES
The main types of equity securities are ordinary shares
and preference shares.
Preference shares are:
A form of hybrid security;
Similar to bonds in that fixed dividends that must be paid to preference shareholders before dividends can be paid to ordinary shareholders;
Similar to ordinary shares in that preference shares have no fixed maturity date and there is no obligation for companies to pay dividends to preference shareholders:
Similar to ordinary shares in that preference shares have no fixed maturity date and there is no obligation for companies to pay dividends to preference shareholders:
- Companies can omit dividend payments to preference shareholders without fear of defaulting and pushing the company into bankruptcy.