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:
Typical restrictive covenants include the following:
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:
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:V0 = $1,000 (PVIFA0.08, 6) = $1,000(4.623) = $4,623
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.
Financial Management Related Interview Questions
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Financial Management Tutorial
The Role And Objective Of Financial Management
The Domestic And International Financial Marketplace
Evaluation Of Financial Performance
Financial Planning And Forecasting
The Time Value Of Money
Risk And Return On At&t Common Stock
Fixed-income Securities: Characteristics And Valuation
Common Stock: Characteristics,valuation, And Issuance
Capital Budgeting And Cash Flow Analysis
Capital Budgeting: Decision Criteria And Real Option Considerations
Capital Budgeting And Risk
The Cost Of Capital
Capital Structure Concepts
Capital Structure Management In Practice
Working Capital Management
The Management Of Cash And Marketable Securities
Management Of Accounts Receivable And Inventories
Lease And Intermediate-term Financing
Financing With Derivatives
Internationan Financial Management
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