Fixed-income Securities Introduction - Financial Management

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.

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