Fixed-Income Securities: Characteristics and Valuation
The characteristics of fixed-income (debt and preferred stock) securities are examined, including
Types of each form of security
Advantages and disadvantages
Reading and interpreting financial market data, including stock and bond price quotations, is an essential skill for an effective financial manager.
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.
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.
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.
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.
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.
Preferred stocks are often treated as perpetuities with a value equal to the annual dividend divided by the required rate of return.
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.
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.
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.
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.
Characteristics of Long-Term Debt
When a company borrows money in the capital markets, it issues long -term debt securities to investors. These bonds are usually sold in denominations of $1,000 and constitute a promise by the issuing company to repay a certain amount of money (the $1,000 principal) on a particular date (the maturity date) and to pay a specified amount of interest at fixed intervals (usually twice a year).Most debt has a par value of $1,000, and debt prices are often expressed as a percentage of that value. For example, a market price listing of “87” indicates that a $1,000 par value bond may be purchased for $870.
There are many different types of long-term debt. The type or types a company chooses to use will depend on its own particular financial situation and the characteristics of the industry as a whole.
Types of Long-Term Debt
Long-term debt is generally classified according to whether it is secured by specific physical assets of the issuing company. Secured debt issues are usually called mortgage bonds, and issues not secured by specific assets are called debentures or, occasionally, debenture bonds. The term bond is often used to denote any type of long -term debt security.
Utility companies have been the largest users of mortgage bonds. In recent years, the use of mortgage bonds relative to other forms of long -term debt has declined, whereas the use of debentures has increased. Because debentures are unsecured, their quality depends on the general credit worthiness of the issuing company. As a result, they are usually issued by large, financially strong firms.
The yield differential between the mortgage bond and debenture alternatives is another example of the risk–return trade -off that occurs throughout finance. For example, suppose Midstates Oil Company could issue either mortgage bonds or debentures. If the mortgage bonds could be sold with a 7 percent interest rate, the debentures would have to be sold at a higher rate —for example, 71⁄4 percent—to attract investors. This is due to the fact that investors require a higher return on debentures, which are backed only by the unmortgaged assets of the company and the company’s earning power, than they do on mortgage bonds, which are secured by specific physical assets as well as the company’s earning power.
Debt issues are also classified according to whether they are senior or junior.Senior debt has a higher priority claim to a firm’s earnings and/or assets than junior debt. Occasionally, the actual name of the debt issue will contain a “junior” or “senior” qualifier. In most instances, however, identification of how a particular company’s debt issues are ranked requires an analysis of the restrictions placed on the company by the purchasers of the issue. Unsecured debt may also be classified according to whether it is subordinated to other types of debt. In the event of a liquidation or reorganization, the claims of subordinated debenture holders are considered only after the claims of unsubordinated debenture holders. In general, subordinated debentures are junior to other types of debt, including bank loans, and may even be junior to all of a firm’s other debt. Equipment trust certificates are used largely by railroad and trucking companies.
The proceeds from these certificates are used to purchase specific assets, such as railroad rolling stock. The certificate holders own the equipment and lease it to the company. Technically, equipment trust certificates are not true bonds, even though they are guaranteed by the issuing company, because the interest and principal are paid by the trustee (the financial institution responsible for looking after the investors’ interests). Even so, they are classified as debt because they have all of the characteristics of debt.
Collateral trust bonds are backed by stocks or bonds of other corporations. This type of financing is principally of historic interest; it is used today primarily by holding companies. A holding company, for example, may raise needed funds by pledging the stocks and/or bonds of its subsidiaries as collateral. In this arrangement, the holding company serves as the parent company. The subsidiary borrows from the parent, and the parent borrows from the capital markets. This makes good sense because the parent company can generally get more favorable terms for its debt in the capital markets than the subsidiary.
Income bonds are also largely of historic interest, although they are still used occasionally today. Income bonds promise to pay interest only if the issuing firm earns sufficient income; if it does not, no interest obligation exists. These securities are rarely issued directly. Instead, they are often created in reorganizations following bankruptcy and are normally issued in exchange for junior or subordinated issues. Thus, unsecured income bonds are generally considered to be “weak” securities.
Banks and finance companies often issue bonds backed by a stream of payments from consumer and commercial obligations, known as receivables. Credit card and automobile loan payments are the two primary types of receivables used in the market for asset-backed securities.
Pollution control bonds and industrial revenue bonds are issued by local governments rather than corporations. The interest paid to purchasers of municipal bonds is tax-exempt, and the interest rate is typically less than what a corporation would have to pay. The interest payments are guaranteed by the corporation for whose benefit the bonds are issued.
Features of Long -Term Debt
Long -term debt has a number of unique features. Several of these are discussed in the following paragraphs.
Indenture An indenture is a contract between a firm that issues long-term debt securities and the lenders. In general, an indenture does the following:
It thoroughly details the nature of the debt issue.
It carefully specifies the manner in which the principal must be repaid.
It lists any restrictions placed on the firm by the lenders. These restrictions are called covenants, and the firm must satisfy them to keep from defaulting on its obligations.
Typical restrictive covenants include the following:
A minimum coverage, or times interest earned, ratio the firm must maintain
A minimum level of working capital6 the firm must maintain
A maximum amount of dividends the firm can pay on its preferred and common stock
other restrictions that effectively limit how much leasing and issuing of additional debt the firm may do
Debt covenants are used to resolve agency problems among debtholders, stockholders, and managers. Restrictive covenants, such as those listed, can be used to protect debtholders by prohibiting certain actions by shareholders or managers that might be detrimental to the market value of the debt securities and the ability of the firm to repay the debt at maturity. Debt covenants can also be used to alter the terms of a debt issue if a future significant corporate event should lower the market value of the debt issue.
One such example of “event risk language” is a “poison put” covenant, which allows bondholders to sell their debt back to the company at par value in the event of a leveraged buyout (LBO) transaction and a downgrade in the credit rating of the debt issue to below investment grade.International Paper’s 1992 issue of 75⁄8 percent notes, due 2007, contains an option allowing holders to redeem the bonds at par (plus accrued interest) in the event of a ratings decline to less than investment grade.
Strong debt covenants can reduce managerial flexibility and thus impose opportunity costs on the firm. At the same time, strong covenants can result in higher credit ratings and lower borrowing costs to the firm by limiting transfers of wealth from bondholders to stockholders and placing limits on the bargaining power of management in any future debt renegotiations. The optimal package of covenants minimizes the sum of these costs.
Trustee Because the holders of a large firm’s long -term debt issue are likely to be widely scattered geographically, the Trust Indenture Act of 1939 requires that a trustee represent the debtholders in dealings with the issuing company. A trustee is usually a commercial bank or trust company that is responsible for ensuring that all the terms and covenants set forth in the indenture agreement are adhered to by the issuing company. The issuing company must pay the trustee’s expenses.
Call Feature and Bond Refunding A call feature is an optional retirement provision that permits the issuing company to redeem, or call, a debt issue prior to its maturity date at a specified price termed the redemption, or call, price. Many firms use the call feature because it provides them with the potential flexibility to retire debt prior to maturity if, for example, interest rates decline.
The call price is greater than the par value of the debt, and the difference between the two is the call premium. During the early years of an issue, the call premium is usually equal to about one year’s interest. Some debt issues specify fixed call premiums, whereas others specify declining call premiums. For example, consider the Ford Motor Company $250 million of 87⁄8 percent, 30-year sinking fund debentures discussed earlier. Beginning on November 15, 2002, the company could retire all or part of this issue at 104.153 percent of par value, and the following year the redemption price was scheduled to drop to 103.737 percent of par.
Similar reductions in the redemption price are scheduled for each year up to the year 2012. Thereafter, the bonds can be redeemed by the company at 100 percent of par value. Many bonds are not callable at all for several years after the initial date. For example, the Ford debentures were not callable until 2002—10 years after the issue date. This situation is referred to as a deferred call.
Details of the call feature are worked out in the negotiations between the underwriters and the issuing company before the debt is sold. Because a call feature gives the company significant flexibility in its financing plans, while at the same time potentially depriving the lenders of the advantages they would gain from holding the debt until maturity, the issuing company has to offer the investors compensation in the form of the call premium in exchange for the call privilege.
In addition, the interest rate on a callable debt issue is usually slightly higher than the interest rate on a similar noncallable issue. Because of the interest savings that can be achieved, a firm is most likely to call a debt issue when prevailing interest rates are appreciably lower than those that existed at the time of the original issue.When a company calls a relatively high interest rate issue and replaces it with a lower interest rate issue, the procedure is called bond refunding.
Sinking Fund Lenders often require that a borrowing company gradually reduce the outstanding balance of a debt issue over its life instead of having the entire principal amount come due on a particular date 20 or 30 years into the future. The usual method of providing for a gradual retirement is a sinking fund, so called because a certain amount of money is put aside annually, or “sunk,” into a sinking fund account. For example, with the Ingersoll-Rand 7.20 percent 30-year debentures issued in 1995, the company is required to redeem $7.5 million of the bonds annually between 2006 and 2025, thus retiring 95 percent of the debt issue prior to maturity.
In practice, however, a company can satisfy its sinking fund requirements either by purchasing a portion of the debt each year in the open market or, if the debt is callable, by using a lottery technique to determine which actual numbered certificates will be called and retired within a given year. The alternative chosen depends on the current market price of the debt issue. In general, if current interest rates are above the issue’s coupon rate, the current market price of the debt will be less than $1,000, and the company should meet its sinking fund obligation by purchasing the debt in the open market. If, on the other hand, market interest rates are lower than the issue’s coupon rate, and if the market price of the debt is above the call price, the company should use the call procedure.
Equity -Linked Debt Some debt issues (and some preferred stock issues) are linked to the equity (common stock) of the firm through a conversion feature that allows the holder to exchange the security for the company’s common stock at the option of the holder. Interest costs of a convertible debt issue are usually less than a similar debt issue without the conversion option, because investors are willing to accept the value of the conversion privilege as part of their overall return. Another form of equity -linked debt is the issuance of warrants with debt securities. A warrant is an option to purchase shares of a company’s common stock at a specified price during a given time period.
Typical Sizes of Debt Issues Debt issues sold to the public through underwriters are usually in the 25 million to several hundred million -dollar range. During the past several years, some very large companies, such as Ford and AT&T, have sold multibillion-dollar bond issues to investors. Because the use of an underwriting group in a public offering involves considerable expense, it is usually uneconomical for a company to make a public offering of this nature for debt issues less than about $25 million. Private placements, however, frequently involve lesser amounts of money —for example, $5 to $10 million —because the entire debt issue is purchased by a single investor, such as an insurance company.
Coupon Rates The coupon rates on new bonds are normally fixed and set equal to market interest rates on bonds of comparable quality and maturity so that the bonds sell at or near par value. However, during the inflationary period of the early 1980s, when interest rates reached record levels and bond prices were quite volatile, highly rated companies began issuing bonds with floating coupon rates.
At the end of December 2003, Duke Energy had $2.7 billion of floating rate debt outstanding with an average interest rate of 1.8 percent. The interest rate on this debt is based on commercial paper rates and a spread relative to the U.S. dollar London Interbank Offer Rate (LIBOR). Such a floating rate debt protects investors against a rise in interest rates because the market price of the debt does not fluctuate as much as for fixed interest rate debt. Original issue deep discount (OID) bonds have coupon rates below prevailing market interest rates at the time of issue and hence sell at a discount from par value.
Some OID bond issues pay no interest and are known as zero coupon bonds. The Time Warner zero coupon discounted debenture issue of November 30, 1995, maturing on January 15, 2036, is one such example. One of the advantages to the issuing firm of these types of bonds is the reduction in (or elimination of) interest payments (a cash outflow) during the life of the bonds. Another advantage is the slightly lower cost (yield to maturity) of these issues compared with bonds that are issued at or near par value. The primary disadvantage of these types of bonds is the large cash outflow required by the firm at maturity. OID bonds have decreased in popularity due to changes in the tax laws, which eliminated the tax advantages to companies of these issues over debt issued at par, and the issuance by several brokerage firms of lower-risk substitutes.
One such substitute is Merrill Lynch’s TIGRs —Treasury Investment Growth Receipts —which are backed by U.S. Treasury bonds. The U.S. Treasury has also issued its own zero coupon bonds. These securities, which pay no interest, are purchased at a discount from face value and can then be redeemed for the full face value at maturity.
Maturity The typical maturity on long -term debt is about 20 to 30 years. Occasionally, companies borrow money for as long as 40 years. (In 1993,Walt Disney and Coca-Cola sold 100- year bonds, the first such bond issues since 1954.) On the other end of the scale, companies in need of financing are often willing to borrow for as few as 10 years, especially if they feel that interest rates are temporarily high, as was true in the environment of the early 1980s—an environment characterized by high rates of inflation and historically high interest rates.
But during the late 1990s and early 2000s, a period of generally low inflation and moderate interest rates, many large companies were issuing fixed-rate debt securities with 25- and 30-year maturities. Like the floating rate bonds described earlier, which protect investors against interest rate risk, firms have also been issuing bonds that are redeemable at par at the option of the holder. These are known as extendable notes or put bonds. If interest rates rise and the market price of the bond falls, the holder can redeem them at par and reinvest the proceeds in higher-yielding securities.
An example of a put bond is Ingersoll -Rand’s 6.443 percent debenture issue of 1997 that matures in 2027. The debentures are redeemable for the full principal amount plus interest at the option of the holder on November 15, 2007, and each November 15 thereafter.
When performing bond valuation and yield -to-maturity calculations, bond investors should keep in mind that the realized maturity of a debt issue may differ from its stated maturity. This can occur for a variety of reasons. The bond indenture may include early repayment provisions through the exercise of a call option, required sinking fund payments, open market purchases, or tender offers. Also, maturity extensions or contractions may occur as the result of reorganization, merger, leveraged buyout (LBO), default, or liquidation.
Information on Debt Financing Activities
Every business day, financial newspapers contain information on debt financing activities. For example, The Wall Street Journal devotes at least one page to financing activities in the bond market. This page contains announcements by underwriters concerning the characteristics of the new issues presently being offered. The Wall Street Journal also contains information on the secondary debt markets, including price quotations for the widely traded corporate debt issues listed on the New York and American Exchanges and U.S. government debt securities.
In this section, we illustrate the information that can be obtained from corporate and government bond quotations. Corporate Bonds The majority of existing debt issues (bonds) of U.S. corporations are traded in the over-the-counter market. The OTC market is a network of security dealers who buy and sell bonds and stock from each other, either for their own account or for their retail clients.
Corporate Bond Quotations
The Wall Street Journal (WSJ) publishes trading information on the 40 most actively traded bonds. it shows this trading information for Thursday,May 13, 2004. The first bond listed in that table was issued by General Motors (GM). Note that unlike common stocks, a firm may have several bonds outstanding.shows five other bonds issue by General Motors or its subsidiary General Motors Acceptance Corporation. In addition to these bonds, GM has many other bonds that are not as actively traded or may be privately held and hence are not listed in the WSJ tables. The first GM bond has a coupon rate of 8.375 percent and matures on July 15, 2033. The coupon rate is the interest rate paid on the bond.
The interest is typically paid semiannually, but the rate is quoted as an annual rate. The dollar amount of interest to be received by the bondholder is equal to the coupon rate times the principal (or face) amount of the bond. Unless otherwise stated, the face amount of corporate bonds is $1,000. The 8.375 percent coupon rate on the GM bond means that an investor will receive $83.75 in interest every year (0.08375*$1,000). The maturity date shows the length of life of the debt obligation. In this case, the bond matures on July 15, 2033. On the maturity date, GM will have to pay back the principal or face amount in addition to the final interest payment due. Following the maturity date is the last price, at which the bond traded on the trading date in question. The last price is reported as a percent of the face value following the convention used by brokers to quote bond prices. The closing price on the GM bond is 100.921.
If you had actually bought a bond at this price, you would have paid $1,009.21 (100.921 _10). The next column shows the yield -to -maturity (YTM) of the bond. The YTM tells an investor what rate of return (annual) he or she can expect to receive if the bond is purchased at the last price indicated and is held to maturity. The calculation of the YTM is illustrated later in the chapter. In this case, an investor buying the GM bond at the quoted last price of 100.921 can expect to earn a rate of return of 8.289 percent if the bond is held to maturity.
The next column shows the estimated spread between the YTM of the bond in question and a U.S. Treasury bond with a similar time remaining to maturity. In other words, the spread is calculated as the TYM of the corporate bond minus the YTM of the Treasury bond. This difference or spread is also known as the default risk spread. The default risk spread tells the investor how much additional yield can be expected because of the assumption of default risk. Default risk is the risk that the issuer will be unable to pay its debt obligations (principal and interest) on this bond. All corporate bonds are subject to some default risk while Treasury bonds, because they are issued by the U.S. government, are assumed to have no risk of default. Thus, default risk spreads increase as the risk of default of an issue increases. Default risk spreads may change over time with spreads increasing when the economy is more uncertain. For the GM bond we are examining, the spread is 273 basis points, or 2.73 percentage points (100 basis points equal 1 percentage point).
The next column shows the length of maturity of the U.S. Treasury bond used to compute the default risk spread. In this case, the 30-year Treasury bond was used. The final column shows the estimated volume of trading (in thousands of dollars of face amount of debt). A total of $265,917,000 face amount of GM bonds were traded on May 13, 2004. In general, the trading volume for bonds is considerably less than the volume of trading in the common shares of the same company.
Government Debt Securities The U.S. government raises funds by selling debt securities. These securities take the form of short -term Treasury bills, intermediate-term Treasury notes, and long-term Treasury bonds. U.S. Treasury bills have an initial maturity of 13, 26, or 52 weeks and pay $10,000 per bill to the holder at maturity. Treasury bills pay no explicit interest; rather, they are sold at a discount from maturity value. An investor who buys a bill at a discount and holds it to maturity will receive as interest the difference between the price paid and $10,000. The quote for a typical Treasury bill on May 13, 2004, follows:
The bill shown here matures in 182 days. The “bid” and “asked” prices indicate the annualized percentage discount from maturity value.11 An asked discount of 1.30 percent translates into a cash discount from $10,000 of approximately $64.82 [= (1.30 ÷ 100) ÷ (365/182)*$10,000], or an asked price of $10,000 - $64.82 = $9,935.18. The ask yld. is the annualized yield an investor will receive by purchasing this bill and holding it to maturity. Longer -term government debt is issued in the form of Treasury notes and bonds. Treasury notes typically have an initial maturity ranging from one to 10 years.
Treasury bonds typically have initial maturities ranging from 10 to 30 years. Like corporate bonds, Treasury notes and bonds pay a stated coupon rate of interest semiannually. They are issued in denominations of multiples of $1,000. Treasury note and bond prices vary in units of 1⁄32 of 1 percent of par value. Thus, a price quote of 94:17 means that the bond will sell for 9417⁄32 percent of par, or $945.31.
Moody’s and Standard and Poor’s
Debt issues are rated according to their relative degree of risk by various financial companies, including Moody’s Investors Services and Standard & Poor’s (S&P) Corporation. These agencies consider a variety of factors when rating a firm’s securities, including earnings stability, coverage ratios, the relative amount of debt in the firm’s capital structure, and the degree of subordination, as well as past experience. According to Moody’s rating scale, the highestquality, lowest-risk issues are rated Aaa, and the scale continues down through Aa, A, Baa, Ba, B, Caa, Ca, and C. On the Standard & Poor’s ratings scale, AAA denotes the highest-quality issues, and this rating is followed by AA, A, BBB, BB, B, and so on. S&P also has various C and D classifications for high-risk issues; the majority of debt issues, however, fall into one of the A or B categories. Figure shows Moody’s and S&P’s bond-rating definitions.
Table shows the median profitability and leverage ratios in Standard & Poor’s debt -rating categories for U.S. industrial companies. In general, firms with the most favorable profitability and leverage ratios tend to have the highest credit ratings. Table shows the relationship between Standard & Poor’s bond ratings and bond yields. For comparison, U.S. Treasury bond yields are also shown. Note that for any maturity, the lower a bond’s credit rating, the higher the yield—reflecting an increasing risk of default. Also note that the maturity risk premium is larger for industrial bonds (e.g., as measured by the difference between the yield on a 5-year bond and a 20-year bond) than it is for Treasury bonds.
As a risky bond’s maturity increases, the chance for default also increases because there is more time for something to go wrong at a firm. Companies with weak financial positions (e.g., highly leveraged balance sheets or low earnings) often issue high-yield debt securities to obtain capital needed for internal expansion or for corporate acquisitions and buyouts. Such debt, also known as junk bonds, or speculative debt, is rated Ba or lower by Moody’s (or BB or lower by Standard & Poor’s) and typically yields three percentage points or more over the highest quality corporate debt. For example, Campeau Corporation had to pay over 17 percent in November 1988 to obtain some of the funds it needed to pay for the acquisition of Federated Department Stores. These bonds were rated CCC+ by Standard & Poor’s. At the time, the highest -quality (AAA-rated) corporate debt was yielding less than 10 percent. Two years later, Federated filed for bankruptcy when it was unable to meet the required debt payments.
Junk bonds constitute an important segment of all corporate debt outstanding. The high yield sector averaged approximately 30 percent of the total value of all new corporate bond issues over the five years from 1997 to 2001.12
Users of Long-Term Debt
Most large and medium-size companies finance some portion of their fixed assets with long-term debt. This debt may be in the form of either secured bonds or unsecured debentures. Utilities rely on debt capital to a large degree and, as a group, are the largest users of secured bonds; the first mortgage bonds of a utility are typically a safe, low-risk investment. Manufacturing companies, in contrast, rely on debt capital to varying degrees and generally use unsecured debt more often than secured debt.
Median Profitability and Leverage Ratios for U.S. Industrial Companies
Many large companies have virtually continuous capital expenditure programs. Usually, a company will plan to finance any new assets at least partially with long-term debt. Because it is generally uneconomical to borrow small amounts of long-term capital, however, companies that have ongoing construction programs often gradually “draw down” on their short-term revolving credit agreements. Then, once every couple of years or so, a firm of this type will enter the capital markets and sell long-term debt. At that time, a portion of the proceeds is used to repay the short-term borrowings, and the cycle begins again. This procedure is called funding short -term debt; as a result, long-term debt is sometimes referred to as funded debt.
Most established companies attempt to maintain reasonably constant proportions of long -term debt and common equity in their capital structures. During the course of a company’s normal profitable operations, though, long-term debt is gradually retired as it matures, and the retained earnings portion of common equity is increased. This in turn decreases the debt -to -equity ratio. Thus, to maintain their desired capital structures, companies have to raise long -term debt capital periodically. This gradual refunding of debt, along with the tax deductibility of interest, accounts for the fact that about 85 to 90 percent of the external long-term capital raised in the United States is in the form of debt.
Advantages and Disadvantages of Long -Term Debt Financing
From the issuing firm’s perspective, the major advantages of long-term debt include the following:
Its relatively low after-tax cost due to the tax deductibility of interest
The increased earnings per share possible through financial leverage
The ability of the firm’s owners to maintain greater control over the firm The following are the major disadvantages of long -term debt financing, from the firm’s perspective:
The increased financial risk of the firm resulting from the use of debt
The restrictions placed on the firm by the lenders
From the investors’ viewpoint, in general, debt securities offer stable returns and therefore are considered relatively low -risk investments compared with common stock investments. Because debtholders are creditors, however, they do not participate in any increased earnings the firm may experience. In fact, during periods of relatively high inflation, holders of existing debt find that their real interest payments decrease because the nominal interest payments remain constant.
The value of any asset is based on the expected future benefits , or cash flows, the owner will receive over the life of the asset. For example, the value of a physical asset, such as a new piece of equipment or production plant, is based on the expected cash flows the asset will generate for the firm over its useful life. These cash flows are derived from increased revenues and/or reduced costs plus any salvage value received from the sale of the asset.Similarly, the value of a financial asset, such as a stock or bond, is based on the expected cash flows the asset will generate for the owner during the holding period.
These cash flows take the form of interest or dividend payments over the holding period plus the amount the owner receives when the security is sold. It is assumed throughout this and the following chapter that the firms under discussion are going concerns, that is, that their organization and assets will remain intact and be used to generate future cash flows. Techniques other than the ones described here must be used to value long -term securities of firms faced with the possibility of bankruptcy. In such cases, the liquidation value of the firm’s assets is the primary determinant of the value of the various types of long-term securities.
The International Bond Marketa
In addition to raising capital in the U.S. financial markets, many U.S. firms go to other countries to raise capital. International bonds are sold initially to investors outside the home country of the borrower.There are two major types of long -term instruments in the international bond market —Eurobonds and foreign bonds. Eurobonds are bonds issued by a U.S. corporation, for example, denominated in U.S. dollars but sold to investors outside the United States, such as in Europe and Japan.The bond offering is often underwritten by an international syndicate of investment bankers.For example, IBM could sell dollar -denominated bonds to investors in Europe or Japan.
The Eurobond market has been used because there is less regulatory interference than in the issuing country and, in some cases, less stringent disclosure requirements. Eurobonds are also bearer bonds (the name and country of the bond owner is not on the bond), providing the bondholder with tax anonymity and an opportunity, perhaps, to avoid the payment of taxes. For these reasons, the cost of Eurobond financing may be below that of domestic financing. Foreign bonds, in contrast, are underwritten by an investment banking syndicate from a single country. Foreign bonds are normally denominated in the currency of the country of sale. The bond issuer, however, is from a country other than the country in which the bonds are being issued.
For example, Crown Cork & Seal Company, Inc., with 65 plants outside the United States, might enter the foreign bond market to raise capital for a new plant to be built in France.These bonds could be sold in France and be denominated in euros, or they could be sold in another country and denominated in that country’s currency.
The international bond market has grown rapidly, and it continues to provide firms with additional alternative sources of funds that are, in some cases, lower in cost than purely domestic financing.
Capitalization of Cash Flow Method
One way of determining the value of an asset is to calculate the present value of the stream of expected future cash flows discounted at an appropriate required rate of return. This is known as the capitalization of cash flow method of valuation and is represented algebraically as follows:
where V0 is the value of the asset at time zero, CFt the expected cash flow in period t, i the required rate of return or discount rate, and n the length of the holding period. For example, assume that the cash flows, CFt, of an investment are expected to be an annuity of $1,000 per year for n = 6 years, and the required rate of return, i, is 8 percent. Using the capitalization of cash flow method, the value of this investment is 6 $1,000
Recognizing this expression as the present value of an annuity (PVAN0), the value of the investment is computed using Equation:
The required rate of return, i, on an asset is a function of the uncertainty, or risk, associated with the returns from the asset as well as the risk-free interest rate. As indicated in the discussion of the determinants of discount rates in the previous chapter, this function is upward sloping, indicating that the higher the risk, the greater the investor’s required rate of return.
Market Value of Assets and Market Equilibrium
From Equation, it can be seen that the value of an asset depends on both the expected cash flows, CFt, and the owner’s (or prospective buyer’s) required rate of return, i. However, potential buyers and sellers can have different opinions of an asset’s value based on their individual assessments of the potential cash flows from the asset and individual required rates of return.
The market price, or market value, of an asset (such as shares of common stock) is determined in much the same way as the price of most goods and services in a market -oriented economy, namely, by the interaction of supply and demand. This interaction is shown in Figure. Potential buyers are represented by a demand schedule showing the maximum prices they are willing to pay for given quantities of an asset, and potential sellers are represented by a supply schedule showing the minimum prices at which they are willing to sell given quantities of the asset. The transaction price, the price at which an asset is sold, occurs at the intersection of the demand and supply schedules. The intersection represents the market value, or market price, of the asset, Pm, in
The 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. A marginally satisfied buyer is one who paid his or her maximum acceptable price for the asset, and a marginally satisfied seller is one who received his or her minimum acceptable price for the asset. Clearly, many owners (potential sellers) will place a higher value on the asset than the current market price; likewise, many investors (potential buyers) will place a lower value on the asset than the current market price.
Market equilibrium exists whenever there is no tendency for the price of the asset to move higher or lower. At this point, the expected rate of return on the asset is equal to the marginal investor’s required rate of return. Market disequilibrium occurs when investors’ required rates of return, i, and/or the expected cash flows, CFt, from the asset change. The market price adjusts over time —that is, it moves upward or downward —to reflect changing conditions, and a new market equilibrium is established.
Most financial assets are bought and sold in organized markets. The bonds, preferred stock, and common stock of many small, as well as most medium and large, firms are traded in one or more national or regional exchanges or in the over -the-counter market. Because large numbers of competing buyers and sellers operate in the markets, the market price of a security represents a consensus judgment as to the security’s value or worth. Although no such market -determined measure of value exists for securities of firms that are not publicly traded, their market values can be approximated using the market price of publicly traded securities of firms having similar operating and financial characteristics.
Market Price of an Asset
Book Value of an Asset
The book value of an asset represents the accounting value, or the historic acquisition cost minus any accumulated depreciation or other write -offs. Because market value is normally related to expected future cash flows and book value is based on historic cost, the market value of an asset does not necessarily bear any relationship to the book value. In fact, the market value may be either greater or less than the book value, depending on the changes over time in the market capitalization rate and the asset’s expected future cash flows.
For example, prior to the leveraged buyout of RJR Nabisco in 1988 by the investment firm Kohlberg Kravis Roberts & Co., RJR Nabisco common stock was selling for about $56 per share —more than twice its book value of $24 per share. After a bidding war among potential buyers, Kohlberg Kravis Roberts & Co. agreed to purchase RJR Nabisco for $109 per share, which was over four times its book value per share and almost twice its pre-takeover stock price.
The valuation of bonds is a relatively straightforward process because future cash flows to the bondholder are always specified ahead of time in a contract. The firm issuing the bonds must meet the interest and principal payments as they come due or the bonds will go into default. Defaulting on bond payments can have disastrous consequences for the firm and its stockholders, such as possible bankruptcy, reorganization, or both.
Due to default risk, investors normally require a higher rate of return than the risk -free rate before agreeing to hold a firm’s bonds. The required rate of return varies among bond issues of different firms, depending on their relative risks of default. All other things being equal, the greater the default risk on a given bond issue, the higher the required rate of return.
Bonds Having Finite Maturity Dates
Bonds that mature within finite periods of time pay the investor two types of returns: interest payments (I1, I2,..., In) during each of the next n periods and a principal payment (M) in period n. Period n is defined as the bond’s maturity date, or the time at which the principal must be repaid and the bond issue retired.
The value of a bond can be computed by applying the capitalization of cash flow method to the series of cash flows:
where P0 is the present value of the bond at time zero, or its purchase date, and kd is the investor’s required rate of return on this particular bond issue.
Because all of the interest payments on a bond are normally equal (that is I1 = I2 = . . . = In – 1 = In = I ), Equation can be simplified as follows:
The first term in Equation represents the present value of an annuity of I per period for n periods; the second term represents the present value of a single payment of M in period n. Equation can be further simplified as follows:
P0 = I(PVIFAkd, n) + M(PVIFkd, n)
To illustrate the use of Equation, consider the following example. AT&T issued $3 billion of 6 percent bonds maturing on March 15, 2012. The bonds were issued in $1,000 denominations (par value). For purposes of simplifying this example, assume that the bonds pay interest on March 15 each year.
An investor who wishes to purchase one of these AT&T bonds on March 15, 2005, and requires an 8 percent rate of return on this particular bond issue would compute the value of the bond as follows. These calculations assume that the investor will hold the bond until maturity and receive seven annual (n = 7) interest payments of $60 each(I = $1,000*0.06) plus a principal payment, M, of $1,000 at the end of the seventh year, March 15, 2012. The expected cash flows from this bond are shown in Figure. Substituting these values along with kd = 8 percent (0.08) into Equation gives the following value for the bond:
In other words, an investor requiring an 8 percent return on this AT&T bond would be willing to pay approximately $896 for it on March 15, 2005. A question often arises as to why investors would require an 8 percent rate of return on bonds that pay only 6 percent interest. The answer is that the required rate of return has increased since the bonds were originally issued. At the time of issue, the prevailing rate of interest (that is, the required rate of return) on bonds of this maturity and quality was approximately 6 percent.
Hence, the coupon rate was set at 6 percent. Because of such factors as tight credit market conditions, higher inflation, increased firm risk, and so on, investors now require a higher rate of return to induce them to purchase these bonds. An investor who desires more than an 8 percent rate of return on the AT&T bond would value it at a price less than $896. Similarly, an investor who requires less than an 8 percent rate of return would value it at a price greater than $896. This inverse relationship between the required rate of return and the corresponding value of a bond to the investor is illustrated for bonds with 3-year and 15-year maturities in Table.
In other words, as the required rate of return increases, the value of the bond decreases, and vice versa. The relationship between a bond’s value and the investor’s required rate of return depends on the time remaining before maturity. All other things being equal, the value of a longer-term bond is affected more by changes in required rates of return than the value of a shorter -term bond. As Table shows, the variation in the value of the 15 -year bond is considerably greater than the variation of the 3-year bond over the given range of required rates of return (2 to 10 percent).
Also, as can be seen in Table, when the required rate of return (prevailing market interest rate) is less than the coupon rate, the bond is valued at a premium over its par value of $1,000. Conversely, when the required rate of return is greater than the coupon rate, the bond is valued at a discount under its par value. Investors who purchase a bond at the price determined by Equation and hold it until maturity will realize their required rate of return, regardless of any changes in the market price of the bond.
However, if the market price of the bond declines due to a rise in prevailing interest rates and if the bond is sold prior to maturity, the investors will earn less than their required rate of return and may even incur a loss on the bond. This variation in the market price (and hence in the realized rate of return) of a bond (or any fixed income security) is known as interest rate risk.
Cash Flows from an AT&T Bond
Value of 6 Percent Coupon Rate Bonds at Various Required Rates of Return
Relationship Between the Value of a Bond and the Required Rate of Return
In addition to interest rate risk, bond investors are subject to reinvestment rate risk.
Reinvestment rate risk occurs when a bond issue matures (or is called) and, because of a decline in interest rates, the investor has to reinvest the principal at a lower coupon rate. For example, the owner of the Ford 30-year, 87⁄8 percent debentures, purchased at the time of issue in 1992, is receiving $88.75 annual interest per bond.However, as noted earlier, this bond issue was callable beginning in 2002. If Ford decided to call the bonds because of a decline in interest rates since the time of issue, the bondholder would probably be unable to reinvest the principal in another bond, of comparable risk, that yielded a 87⁄8 percent (or higher) rate of return.
Reinvestment rate risk also refers to the rate at which interest cash flows can be reinvested over the life of the bond. When the reinvestment rate of interest cash flows is different from the yield to maturity on the bond, the return actually realized by a bond investor will be greater than (less than) the yield to maturity if the reinvestment rate is greater than (less than) the promised yield to maturity.
Semiannual Interest Payments Most bonds, such as the AT&T bonds, pay interest semiannually. Recall from the discussion of “Effect of Compounding Periods on Present and Future Values” in PREVIOUS Chapter, the required rate of return (kd) is divided by 2 and the number of periods (n) is multiplied by 2. Therefore, with semiannual interest payments and compounding, the bond valuation formula becomes:
With semiannual interest and compounding, the value for the AT&T bond is calculated as follows:
In this problem, the annual required rate of return (kd = .08) is divided by 2(.08/2 = .04) and the number of periods (n = 7) is multiplied by 2 (7*2 = 14).18 These bond values differ only slightly from the solutions obtained for annual interest payments and compounding.
A perpetual bond, or perpetuity, is a bond issued without a finite maturity date.Perpetual bonds promise to pay interest indefinitely, and there is no contractual obligation to repay the principal, that is, M = 0.
The valuation of a perpetual bond is simpler than the valuation of a bond having a finite maturity date. Assuming that the bond pays a fixed amount of interest, I, per period forever, the value is as follows:
where kd is the required rate of return. Equation can be simplified to obtain the following expression:
Consider, for example, the Canadian Pacific Limited Railroad’s perpetual 4 percent debentures. What is the value of a $1,000 bond to an investor who requires an 8 percent rate of return on these Canadian Pacific bonds? Because I = 0.04 *$1,000, or $40, and kd = 8 percent, Equation can be used to compute the answer as follows:
Thus, the investor would be willing to pay up to $500 for this bond.
Yield to Maturity of a Bond
The yield -to-maturity of a bond is the discount rate that equates the present value of all expected interest payments and the repayment of principal from a bond with the present bond price.(In contrast, the current yield, which is equal to the annual interest payment divided by the current price, ignores the repayment of the principal.) If the current price of a bond, P0, the uniform annual interest payments, I, and the maturity value, or principal, M, are known, the yield to maturity of a bond having a finite maturity date can be calculated by solving Equation presented earlier for kd:
Given values for any three of the four variables in this equation, one can solve for the value of the fourth variable. In the bond valuation calculation illustrated earlier in this section, this equation was used to determine the value of a bond (P0) when the value of kd is known (along with the values of I and M). In the yield -to-maturity calculation that follows, the equation is used to determine kd when the value of P0 is known (along with the values of I and M).
For bonds with a call feature, the expected yield to call can also be computed. This is done by replacing the maturity value (M) by the call price and the number of years until maturity (n) by the number of years until the company can call the bond. If present interest rates are significantly below the coupon rate on the (callable) bond, then it is likely that the bond will be called in the future. In such a case, the relevant expected rate of return on the bond is the yield to call rather than the yield to maturity.
There are a number of ways to compute the yield to maturity of a bond.Most financial calculators are programmed to compute the yield to maturity, given P0, I, n, and M. Also, special bond tables can be used to identify the yield to maturity for any particular bond. Consider again the AT&T 6 percent bonds discussed earlier. Again, assume that interest is paid annually on March 15 each year. Suppose that the bonds are selling for $987.50 on March 15, 2002 (seven years prior to maturity). Determine the bond’s exact yield to maturity. Given n = 7, I = $60, P0 = $987.50, and M = $1,000, we can compute kd.
Therefore, the yield to maturity is 6.23 percent. (See Calculator Solution.) The yield to maturity (or yield to call) can be used to compare the risk of two or more bonds that are similar in all other respects, including time to maturity. The bond with the higher yield to maturity is the one perceived to be the riskier by investors. Also, the yield to maturity on existing bonds can be used as an estimate of the required returns of investors on any new (and similar) bonds the firm may issue.
Zero Coupon Bonds For zero coupon bonds that pay no interest over their life, the only payment to holders is the principal payment at maturity. To illustrate the calculation of the yield-to-maturity for such a bond, consider the Honeywell International zero coupon money multiplier notes that mature on April 21, 2012. Suppose these bonds (having a par value of $1,000) were purchased for $600 on April 21, 2004 (eight years prior to maturity). Determine the yield to maturity on these bonds.
shows cash flows from the purchase of a Honeywell International zero coupon bond. Because there are no interest payments, the yield -to-maturity equation can be simplified to
P0 = M(PVIFkd,n)
Substituting n = 8, P0 = $600, and M = $1,000 into this expression yields
$600 = $1,000(PVIFkd,8)
(PVIFkd,8) = 0.600
From Table at the back of the book, we find this present value interest factor in the 8- year row between the 6 percent (0.627) and 7 percent (0.582) interest rate columns.Hence, by interpolation, the yield to maturity ( k d) on this zero coupon bond is approximately
Leveraged Buyouts and Bond Values
During the 1980s and early 1990s, many firms were acquired or financially restructured in a transaction called a leveraged buyout (LBO). In a typical LBO, the buyer of the firm borrows a large amount of the purchase price, using the purchased assets as collateral for a large portion of the borrowings. Debt ratios (debt to total capital) of 90 percent or more have not been uncommon in early LBOs.
LBOs have led to enormous wealth increases for the common stockholders of the acquired firm. For example, RJR Nabisco (RJR) shareholders saw the value of their common stock increase from the mid-50s price range to over $100 when the firm was acquired by Kohlberg Kravis Roberts in an LBO. Bondholders generally have not fared quite so well.The impact of most LBOs has been a decline in the bond ratings of the acquired or restructured firm because of the substantial increase in perceived risk. Declines in the market value of bonds for firms acquired in LBO transactions have averaged about 7 percent. In the case of the RJR transaction, these bondholder losses initially exceeded 20 percent.
In the RJR case, several large bondholders, notably Metropolitan Life Insurance and Hartford Insurance, sued RJR, claiming among other things that RJR management had the duty to disclose that it was considering the possibility of an LBO at the time it issued bonds six months prior to the announcement of the LBO. Metropolitan Life sought compensation for its bond losses not just on the recent bond issue but also on earlier bond issues of RJR that it held. Do you think that RJR bondholders and the bondholders in many other firms that were restructured with LBOs have a right to compensation from the firm’s owners to offset bondholder losses in these transactions?
What role do you think bond covenants should play in an analysis of the rights of bondholders and the obligations of management? How can bond holders protect themselves from losses arising out of LBOs?
Cash Flows from the Purchase of a Honeywell International Zero
Perpetual Bonds The rate of return, or yield to maturity, on a perpetual bond can be found by solving the perpetual bond valuation equation presented earlier for kd:
For example, recall the 4 percent Canadian Pacific Limited Railroad debentures described earlier. If the current price of a bond is $640, what is the yield on the bond? Substituting P0 = $640 and I = $40 (or 4 percent of $1,000) into Equation gives the following:
kd = ——
= 0.0625 (or 6.25 percent)
Characteristics of Preferred Stock
As a source of capital for a firm, preferred stock occupies an intermediate position between long-term debt and common stock. Like common stock, preferred stock is part of the stockholders’ equity. Like long-term debt, it is considered a fixed-income security, although preferred stockholders receive dividends instead of interest payments. Because the issuing firm often does not promise repayment at a specific date, preferred stock tends to be a more permanent form of financing than long -term debt. Dividends on preferred stock, like interest payments on long -term debt, normally remain constant over time.
The popularity of preferred stock financing has declined in recent decades. Dividends cannot be deducted from income for corporate income tax purposes, whereas interest payments are tax deductible. This means that for a company paying more than one -third of its income in taxes, the after-tax cost of preferred stock is greater than that of long -term debt, assuming that the pretax preferred stock and long-term debt rates are about the same and that the company makes no change in its capital structure. Preferred stock bears its name because it usually has preference, or priority, over common stock with regard to the company’s dividends and assets.
For example, if a company’s earnings in a given year are insufficient to pay dividends on preferred stock, the company is not permitted to pay dividends on its common stock. In the event of a liquidation following bankruptcy, the claims on the firm’s assets by preferred stockholders are subordinate to those of creditors but have priority over those of common stockholders.
Features of Preferred Stock
Like long -term debt, preferred stock has its own unique distinguishing characteristics. A number are discussed here.
Selling Price and Par Value The selling price, or issue price, is the per-share price at which preferred stock shares are sold to the public. Preferred stocks are typically issued at prices of $25, $50, or $100 per share.
The par value is the value assigned to the stock by the issuing company and is frequently the same as the initial selling price. No relationship necessarily exists between the two, however. A preferred stock sold at $25 per share may have a $25 par value, $1 par value, or no par value at all. Regardless of what a preferred stock’s actual par value is, however, in the event of liquidation, preferred stockholders are entitled to the issue price plus dividends, after the claims of creditors have been paid in full. Preferred stock is usually designated by its dividend amount rather than its dividend percentage. For example, suppose Intermountain Power Company has a series of preferred stock that pays an annual dividend of $2.20, has a $1 par value, and was initially sold to the public at $25 per share. An investor would most likely refer to the stock as “Intermountain Power’s $2.20 preferred.”
Adjustable Rate Preferred Stock This type of preferred stock became popular in the early 1980s. With these issues, dividends are reset periodically and offer returns that vary with interest rates. For example, Chase Manhattan (now JP Morgan Chase) issued 9.1 million (series N) shares of adjustable rate preferred stock on April 29, 1994. The annual dividend rate was to be set quarterly at 85 percent of the highest of (1) the 3 -month U.S. Treasury Bill Rate,(2) the U.S. Treasury 10-year Constant Maturity Rate, and (3) the U.S. Treasury 30-year Constant Maturity Rate prior to each quarterly dividend period, with upper and lower limits of 10.50 percent and 4.50 percent, respectively.
Cumulative Feature Most preferred stock is cumulative. This means that if, for some reason, a firm fails to pay its preferred dividend, it cannot pay dividends on its common stock until it has satisfied all or a prespecified amount of preferred dividends in arrears. The principal reason for this feature is that investors are generally unwilling to purchase preferred stock that is not cumulative.
Participation Stock is said to be participating if the holders share in any increased earnings the company might experience.Virtually all preferred stock, however, is nonparticipating; that is, the preferred dividend remains constant, even if the company’s earnings increase.Any dividend increases resulting from higher earnings accrue directly to the common stockholders.
Maturity Preferred stock is technically part of a firm’s equity capital. As such, some firms issue preferred stock that is intended to be perpetual, that is, a permanent portion of the stockholders’ equity having no specific maturity date.Many preferred stock investors, however, desire sinking fund provisions, which guarantee that the issue will be retired over a specified time period.
Call Feature Like long-term debt, preferred stock can sometimes be redeemed, or called, at the issuing firm’s option at some specified price. For example, Citigroup’s 1997 (series R) adjustable rate preferred stock issue was callable (deferred call) on or after May 31, 1999, at a redemption price of $250 per share plus dividends accrued and unpaid to the redemption date.
Whereas the call feature allows the issuing company a measure of flexibility in its financing plans, the call feature is generally not attractive to investors. Thus, a firm usually must also provide investors with a call premium, or the difference between the call price and the original selling price, should it decide to attach a call feature to its preferred stock. The probability that a firm will exercise the call privilege is likely to increase during times when market interest rates have decreased below those that existed at the time of issue. After calling the original issue, the firm can replace it with a lower-cost issue.
Voting Rights As a general rule, preferred stockholders are not entitled to vote for the company’s board of directors. However, special voting procedures frequently take effect if the company omits its preferred dividends or incurs losses for a period of time. In such a case, the preferred stockholders often vote as a separate group to elect one or more members of the company’s board of directors. This ensures that the preferred holders will have direct representation on the board.
Trading of Preferred Shares
Following the initial sale of preferred stock by a firm, investors who purchase the shares may decide to sell them in the secondary markets. Large issues of actively traded preferred stock are listed on the major stock exchanges, such as the New York and the American stock exchanges. However, a majority of preferred stock issues are traded rather thinly, and these are traded over -the -counter.
Users of Preferred Stock
Utility companies have been the most frequent users of preferred stock financing, largely because of the regulatory treatment of preferred stock dividend payments.Utilities are permitted by their regulatory agencies to consider preferred dividends as an expense for ratemaking purposes, thus reducing the after-tax cost disadvantage of preferred stock that deters nonutility firms from making extensive use of this form of financing.
With deregulation, utility company use of preferred stock financing has been greatly reduced. Preferred stock (usually convertible) has also been used extensively in mergers and acquisitions. Frequently, acquiring companies issue preferred stock in exchange for the common stock of acquired companies. For example, Chrysler issued (convertible) preferred stock when it acquired American Motors. This, in effect, is another example of financial leverage, and it can cause an increase in the earnings per common share of the acquiring company.
Other occasional users of preferred stock financing are capital-intensive companies undertaking expansion programs. These companies may choose preferred stock as a means of securing long-term financing for the following reasons:
Their capital structures and various other restrictions prevent the judicious use of additional long-term debt.
Depressed common stock prices and the potential dilution of per-share earnings may cause them to decide against external common equity financing.
Often these same companies have relatively low marginal tax rates (because of losses and accelerated depreciation) that make the after-tax cost of preferred stock not appreciably different from that of long-term debt. For example, USX (formerly U.S. Steel) has issued preferred stock under these circumstances.
Large commercial banks are another group of preferred stock users. These banks, including Bank of America, Citigroup, and JP Morgan Chase, have issued variable -rate preferred stock, partly to get additional equity into their capital structures.
Advantages and Disadvantages of Preferred Stock Financing
From the issuing company’s perspective, the principal advantage of preferred stock is that preferred dividend payments are potentially flexible. Omitting a preferred dividend in difficult times usually results in less severe consequences than omitting an interest payment on long -term debt.
In addition, preferred stock financing can increase a firm’s degree of financial leverage. However, financial analysts may regard the issuance of preferred stock as equivalent to debt. In this case, the company is viewed as having used up a portion of its “debt capacity.” Or, in effect, the company has leveraged with preferred stock rather than long -term debt— at a greater after-tax cost.
From the investors’ perspective, companies who purchase the preferred stock of other companies accrue certain tax advantages resulting from the 70 percent exclusion of intercompany dividends from federal income taxes. For example, an insurance company in the 35 percent tax bracket can invest in the preferred stock of another company and pay taxes equal to only about 10.5 percent of the preferred dividend income. In contrast, the same insurance company would be required to include all the interest received in its taxable income.
The principal disadvantage of preferred stock financing is its high after -tax cost as compared with long-term debt because dividends cannot be deducted for income tax purposes. Thus the after-tax cost to the firm for preferred stock is generally greater than the after -tax cost of long -term debt, assuming that the firm’s capital structure remains constant. As a result, most companies considering long -term financing with fixed -income securities choose long-term debt over preferred stock.
Valuation of Preferred Stock
Most preferred stock pays regular, fixed dividends. Preferred dividends per share are normally not increased when the earnings of a firm increase, nor are they cut or suspended unless the firm faces serious financial problems. If preferred stock dividends are cut or suspended for a period of time for whatever reason, the firm is usually required to make up the past-due payments before paying any common stock dividends. Thus, the investor’s expected cash return from holding most preferred stocks can be treated as a fixed, constant amount per period.
The investor’s required rate of return on a preferred stock issue is a function of the risk that the firm will be unable to meet its dividend payments. The higher the risk, the higher the required rate of return. Because bondholders have a prior claim over preferred stockholders on the income and assets of a firm, it is more risky to hold a firm’s preferred stock than to hold its bonds.As a result, investors normally require a higher rate of return on preferred stock than on bonds.
Because many preferred stock issues do not have maturity dates, the cash flows from holding no -maturity preferred stock can be treated as a perpetual stream of payments, or a perpetuity. Capitalizing the perpetual stream of dividend payments gives the following valuation expression:
where Dp is the dividend per period, and kp is the investor’s required rate of return. Like the perpetual bond valuation model, this equation can be simplified into the following valuation model:
To illustrate the use of Equation , assume that DuPont pays annual end -of -year dividends on its $4.50 series B cumulative preferred stock issue (issue price $100, par value of $0).What is the value of this stock to an investor who requires an 8 percent annual rate of return on the investment? Assume that the issue will not be called for the foreseeable future. Substituting $4.50 (0.045*$100) for Dp and 0.08 for kp yields the following: