Chapter No.10
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Chapter No.10

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Chapter No.10 Chapter No.10 Presentation Transcript

  • Chapter 10 The Capital Markets
  • Purpose of the Capital Market
    • Original maturity is greater than one year, typically for long-term financing or investments
    • Best known capital market securities:
      • Stocks and bonds
  • Capital Market Participants
    • Primary issuers of securities:
      • Federal and local governments: debt issuers
      • Corporations: equity and debt issuers
    • Largest purchasers of securities:
      • You and me
    View slide
  • Capital Market Trading
    • Primary market for initial sale (IPO)
    • Secondary market
      • Over-the-counter
      • Organized exchanges (i.e., NYSE)
    View slide
  • Types of Bonds
    • Bonds are securities that represent debt owed by the issuer to the investor, and typically have specified payments on specifies dates.
    • Types of bonds we will examine include long-term government bonds (T-bonds), municipal bonds, and corporate bonds.
  • Types of Bonds: Sample Corporate Bond Figure 10.1 Sohio/BP Corporate Bond
  • Treasury Bonds
    • The U.S. Treasury issues notes and bonds to finance its operations.
    • The following table summarizes the maturity differences among the various Treasury securities.
  • Treasury Bonds
  • Treasury Bond Interest Rates
    • No default risk since the Treasury can print money to payoff the debt
    • Very low interest rates, often considered the risk-free rate (although inflation risk is still present)
  • Treasury Bonds: Recent Innovation
    • Treasury Inflation-Indexed Securities: the principal amount is tied to the current rate of inflation to protect investor purchasing power
  • Municipal Bonds
    • Issued by local, county, and state governments
    • Used to finance public interest projects
    • Tax-free municipal interest rate = taxable interest rate  (1  marginal tax rate)
  • Municipal Bonds: Example
    • Suppose the rate on a corporate bond is 9% and the rate on a municipal bond is 6.75%. Which should you choose?
    • Answer: Find the marginal tax rate:
    • 6.75% = 9% x (1 – MTR), or MTR = 25%
    • If you are in a marginal tax rate above 25%, the municipal bond offers a higher after-tax cash flow.
  • Municipal Bonds
    • Two types
      • General obligation bonds
      • Revenue bonds
    • NOT default-free
      • Defaults in 1990 amounted to $1.4 billion in this market
  • Corporate Bonds
    • Typically have a face value of $1,000, although some have a face value of $5,000 or $10,000
    • Pay interest semi-annually
  • Corporate Bonds
    • Cannot be redeemed anytime the issuer wishes, unless a specific clause states this (call option).
    • Degree of risk varies with each bond, and the required interest rate varies with level of risk.
  • Corporate Bonds: Characteristics of Corporate Bonds
    • Registered Bonds
      • Replaced “bearer” bonds
      • IRS can track interest income this way
    • Restrictive Covenants
      • Mitigates conflicts with shareholder interests
      • May limit dividends, new debt, ratios, etc.
  • Corporate Bonds: Characteristics of Corporate Bonds
    • Call Provisions
      • Higher yield
      • Sinking fund
      • Interest of the stockholders
      • Alternative opportunities
    • Conversion
      • Some debt may be converted to equity
  • Corporate Bonds: Characteristics of Corporate Bonds
    • Secured Bonds
      • Mortgage bonds
      • Equipment trust certificates
    • Unsecured Bonds
      • Debentures
      • Subordinated debentures
      • Variable-rate bonds
    • Junk Bonds
      • Debt that is rated below BBB
      • Often, trusts and insurance companies are not permitted to invest in junk debt
    Corporate Bonds: Characteristics of Corporate Bonds
  • Financial Guarantees for Bonds
    • Some debt issuers purchase financial guarantees to lower the risk of their debt.
    • The guarantee provides for timely payment of interest and principal, and are usually backed by large insurance companies.
  • Investing in Stocks
    • Represents ownership in a firm
    • Earn a return in two ways
      • Price of the stock rises over time
      • Dividends are paid to the stockholder
    • Stockholders have claim on all assets
    • Right to vote for directors and on certain issues
    • Two types
      • Common stock
        • Right to vote
        • Receive dividends
      • Preferred stock
        • Receive a fixed dividend
        • Do not usually vote
  • Investing in Stocks: Sample Corporate Stock Certificate Figure 11.1 Wien Consolidated Airlines Stock
  • Investing in Stocks: How Stocks are Sold
    • Organized exchanges
      • Account for over 72% of total dollar volume
      • Larges U.S. Exchange is the NYSE
      • Others include Nikkei, LSE, DAX, etc.
      • Listing requirements exclude small firms
    • Over-the-counter markets
      • Best example is NASDAQ
      • Dealers stand ready to make a market
  • Computing the Price of Common Stock
    • Valuing common stock is, in theory, no different from valuing debt securities: determine the future cash flows and discount them to the present at an appropriate discount rate.
    • We will review four different methods for valuing stock, each with its advantages and drawbacks.
  • Computing the Price of Common Stock: The One-Period Valuation Model
    • Simplest model, just taking using the expected dividend and price over the next year.
    • Price =
  • Computing the Price of Common Stock: The One-Period Valuation Model
    • What is the price for a stock with an expected dividend and price next year of $0.16 and $60, respectively? Use a 12% discount rate
    • Answer:
    • Price =
  • Computing the Price of Common Stock: The Generalized Dividend Valuation Model
    • Most general model, but the infinite sum may not converge.
    • Price =
    • Rather than worry about computational problems, we use a simpler version, known as the Gordon growth model.
  • Computing the Price of Common Stock: The Gordon Growth Model
    • Same as the previous model, but it assumes that dividend grow at a constant rate, g . That is,
        • Div (t+1) = Div t x ( 1 + g )
    • Price =
  • Computing the Price of Common Stock: The Gordon Growth Model
    • The model is useful, with the following assumptions:
    • Dividends do, indeed, grow at a constant rate forever
    • The growth rate of dividends, g , is less than the required return on the equity, k e .
  • Computing the Price of Common Stock: The Generalized Dividend Valuation Model
    • The price earnings ratio (PE) is a widely watched measure of much the market is willing to pay for $1.00 of earnings from the firms.
    • Price =
  • Computing the Price of Common Stock: The Price Earnings Valuation Method
    • If the industry PE ratio for a firm is 16, what is the current stock price for a firm with earnings for $1.13 / share?
    • Answer:
    • Price = 16 x $1.13 = $18.08
  • How the Market Sets Security Prices
    • Generally speaking, prices are set in competitive markets as the price set by the buyer willing to pay the most for an item.
    • The buyer willing to pay the most for an asset is usually the buyer who can make the best use of the asset.
    • Superior information can play an important role.
  • How the Market Sets Security Prices
    • Consider the following three valuations for a stock with certain dividends but different perceived risk:
    • Bud, who perceives the lowest risk, is willing to pay the most and will determine the “market” price.
  • Errors in Valuations
    • Although the pricing models are useful, market participants frequently encounter problems in using them. Any of these can have a significant impact on price in the Gordon model.
    • Problems with Estimating Growth
    • Problems with Estimating Risk
    • Problems with Forecasting Dividends
  • Stock Market Indexes
    • Stock market indexes are frequently used to monitor the behavior of a groups of stocks.
    • Major indexes include the Dow Jones Industrial Average, the S&P 500, and the NASDAQ composite.
    • The securities that make up the (current) DJIA are included on the next slide.
  • Buying Foreign Stocks
    • Buying foreign stocks is useful from a diversification perspective. However, the purchase may be complicated if the shares are not traded in the U.S.
    • American depository receipts (ADRs) allow foreign firms to trade on U.S. exchanges, facilitating their purchase. U.S. banks buy foreign shares and issue receipts against the shares in U.S. markets.