Chapter 10 The Capital Markets
Purpose of the Capital Market <ul><li>Original maturity is  greater  than  one year, typically for long-term financing or ...
Capital Market Participants <ul><li>Primary issuers of securities: </li></ul><ul><ul><li>Federal and local governments: de...
Capital Market Trading <ul><li>Primary market for initial sale (IPO) </li></ul><ul><li>Secondary market </li></ul><ul><ul>...
Types of Bonds <ul><li>Bonds  are securities that represent debt owed by the issuer to the investor, and typically have sp...
Types of Bonds:  Sample Corporate Bond Figure 10.1  Sohio/BP Corporate Bond
Treasury Bonds <ul><li>The U.S. Treasury issues notes and bonds to finance its operations. </li></ul><ul><li>The following...
Treasury Bonds
Treasury Bond Interest Rates <ul><li>No default risk since the Treasury can print money to payoff the debt </li></ul><ul><...
Treasury Bonds:  Recent Innovation <ul><li>Treasury Inflation-Indexed Securities:  the principal amount is tied to the cur...
Municipal Bonds <ul><li>Issued by local, county, and  state governments </li></ul><ul><li>Used to finance public interest ...
Municipal Bonds: Example <ul><li>Suppose the rate on a corporate bond is 9% and the rate on a municipal bond is 6.75%.  Wh...
Municipal Bonds <ul><li>Two types </li></ul><ul><ul><li>General obligation bonds </li></ul></ul><ul><ul><li>Revenue bonds ...
Corporate Bonds <ul><li>Typically have a face value of $1,000, although some have a face value of $5,000 or $10,000 </li><...
Corporate Bonds <ul><li>Cannot be redeemed anytime the issuer wishes, unless a specific clause states this (call option). ...
Corporate Bonds:  Characteristics of Corporate Bonds <ul><li>Registered Bonds </li></ul><ul><ul><li>Replaced “bearer” bond...
Corporate Bonds:  Characteristics of Corporate Bonds <ul><li>Call Provisions  </li></ul><ul><ul><li>Higher yield </li></ul...
Corporate Bonds:  Characteristics of Corporate Bonds <ul><li>Secured Bonds </li></ul><ul><ul><li>Mortgage bonds </li></ul>...
<ul><li>Junk Bonds </li></ul><ul><ul><li>Debt that is rated below BBB </li></ul></ul><ul><ul><li>Often, trusts and insuran...
Financial Guarantees for Bonds <ul><li>Some debt issuers purchase  financial guarantees  to lower the risk of their debt. ...
Investing in Stocks <ul><li>Represents ownership  in a firm  </li></ul><ul><li>Earn a return in  two ways </li></ul><ul><u...
Investing in Stocks:  Sample Corporate Stock Certificate Figure 11.1  Wien Consolidated Airlines Stock
Investing in Stocks:  How Stocks are Sold <ul><li>Organized exchanges  </li></ul><ul><ul><li>Account for over 72% of total...
Computing the Price  of Common Stock <ul><li>Valuing common stock is, in theory, no different from valuing debt securities...
Computing the Price of Common Stock: The One-Period Valuation Model <ul><li>Simplest model, just taking using the expected...
Computing the Price of Common Stock: The One-Period Valuation Model <ul><li>What is the price for a stock with an expected...
Computing the Price of Common Stock: The Generalized Dividend Valuation Model <ul><li>Most general model, but the infinite...
Computing the Price of Common Stock: The Gordon Growth Model <ul><li>Same as the previous model, but it assumes that divid...
Computing the Price of Common Stock: The Gordon Growth Model <ul><li>The model is useful, with the  following assumptions:...
Computing the Price of Common Stock: The Generalized Dividend Valuation Model <ul><li>The  price earnings ratio (PE)  is a...
Computing the Price of Common Stock: The Price Earnings Valuation Method <ul><li>If the industry PE ratio for a firm is 16...
How the Market Sets Security Prices <ul><li>Generally speaking, prices are set in competitive markets as the price set by ...
How the Market Sets Security Prices <ul><li>Consider the following three valuations for a stock with certain dividends but...
Errors in Valuations <ul><li>Although the pricing models are useful, market participants frequently encounter problems in ...
Stock Market Indexes <ul><li>Stock market indexes are frequently used to monitor the behavior of a groups  of stocks. </li...
Buying Foreign Stocks <ul><li>Buying foreign stocks is useful from a diversification perspective.  However, the purchase m...
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Chapter No.10

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Chapter No.10

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

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