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Chapter Four
Chapter Four
Bonds are “Fixed Income” securities, since the cash flows that the bondholder will receive have
been fixed or pre-specified in the bond contract.
In the case of a firm's insolvency, a bondholder has a priority of claim to the firm’s assets before
the preferred and common stockholders. Also, bond holders must paid interest due them before
dividends can be distributed to the stockholders.
Par or Face Value: The amount of money that is paid to the bondholders at maturity.
For most bonds this amount is birr 1,000. It also generally represents the amount of
money borrowed by the bond issuer.
Coupon Rate: The coupon rate, which is generally fixed, determines the periodic coupon
or interest payments. It is expressed as a percentage of the bond's face value. It also
represents the interest cost of the bond to the issuer.
Coupon Payments: The coupon payments represent the periodic interest payments from
the bond issuer to the bondholder. The annual coupon payment is calculated by
multiplying the coupon rate by the bond's face value. Since most bonds pay interest
semiannually, generally one half of the annual coupon is paid to the bondholders every
six months.
Maturity Date: The maturity date represents the date on which the bond matures, i.e., the
date on which the face value is repaid. The last coupon payment is also paid on the
maturity date.
Call provision- is a provision which gives the issuer the right to pay off the bonds under
specified terms prior to the stated maturity date.
Call Date: For bonds which are callable, i.e., bonds which can be redeemed by the issuer
prior to maturity, the call date represents the earliest date at which the bond can be called.
i. Treasury bonds, sometimes referred to as government bonds, are issued by the federal
government.1 It is reasonable to assume that the federal government will make good on
its promised payments, so these bonds have no default risk. However, Treasury bond
prices decline when interest rates rise, so they are not free of all risks.
ii. Corporate bonds, as the name implies, are issued by corporations. Unlike Treasury
bonds, corporate bonds are exposed to default risk—if the issuing company gets into
trouble, it may be unable to make the promised interest and principal payments. Different
corporate bonds have different levels of default risk, depending on the issuing company’s
characteristics and on the terms of the specific bond.
iii. Municipal bonds, or “munis,” are issued by state and local governments. Like corporate
bonds, munis have default risk. However, munis offer one major advantage over all other
bonds: As we discussed in Chapter 2, the interest earned on most municipal bonds is
exempt from federal taxes and also from state taxes if the holder is a resident of the
issuing state. Consequently, municipal bonds carry interest rates that are considerably
lower than those on corporate bonds with the same default risk.
iv. Foreign bonds are issued by foreign governments or foreign corporations. Foreign
corporate bonds are, of course, exposed to default risk, and so are some foreign
government bonds. An additional risk exists if the bonds are denominated in a currency
other than that of the investor’s home currency. For example, if you purchase corporate
bonds denominated in Japanese yen, you will lose money—even if the company does not
default on its bonds—if the Japanese yen falls relative to the birr.
Other features
Several other types of bonds are used sufficiently often to warrant mention.
First, convertible bonds are bonds that are convertible into shares of common stock, at a fixed
price, at the option of the bondholder. Convertibles have a lower coupon rate than nonconvertible
debt, but they offer investors a chance for capital gains in exchange for the lower coupon rate.
Bonds issued with warrants are similar to convertibles. Warrants are options that permit the
holder to buy stock for a stated price, thereby providing a capital gain if the price of the stock
Valuation: An overview
- Value is a function of three elements:
1. The amount and timing of the asset's expected cash flow
2. The riskiness of these cash flows
3. The investors' required rate of return for undertaking the investment.
Expected cash flows are used in measuring the returns from an investment.
Bond Valuation
The value of a bond is simply the present value of the future interest payments and maturity was
value discounted at the bondholder’s required rate of return.
A. Valuation of bond with finite maturity
1. Non-zero coupon bonds: if the bond has a finite maturity with coupon rate we must
consider the interest stream and the maturity value in valuing the bonds.
VB= I I I MV
(1+Kd) + (1+Kd) +---+ (1+Kd) + (1+Kd) n
1 2 n
= I (1- 1 ) MV
(1+Kd) n
+ (1+Kd) n
or VB = INT(PVIFAkd,n) + M(PVIFkd,n)
Where: VB= bond value
kd= the bond’s market rate of interest
Answer: VB = I (1- 1 ) MV
(1+Kd) n
+ (1+Kd) n
= 100(1- 1 ) 1,000
(1+0.12) 9
+ (1+0.12) 9
= 532.82+360.61
= Birr 893.43
2. Zero- coupon bond: Make no periodic interest payment but, interest sold at a deep
discount from its face value.
VB = MV
(1+Kd) n
Example: Xyz Corporation issues zero coupon bond having 10 year maturity with birr 1,000 face
value. What is the value of the bond, if the required rate of return is 12%?
Answer: VB = MV
(1+Kd) n
= 1,000
(1+0.12)10
= Birr 321.99
B. Valuation of bond with Infinite maturity
Perpetuity Bond: It is an ordinary annuity by which payments or receipts continue
forever.
VB = I
Kd
Example: suppose you could buy a bond issued by government that paid birr 50 a year to recover
your preferred rate of return 12%. What is the value of the bond?
Answer: VB = I
Kd
= 50
0.12
= Birr 416.67
Since the bond's coupon rate, Kc, is fixed for the life of bond, the following \YTM/bond price
relationship is created:
Example: Xyz Corporation is proposing to sell a 5 years bond of birr 1,000 at 10% of coupon
rate per annum. How much is the value of the bond to an investor whose required rate of return is
1- 10%
2- 2- 12%
3- 3- 8%
Answer:
1. Birr 1000
2. Birr 927.91
3. Birr 1079.85
4.1.2. Valuation of stocks
A. Preferred Stock Valuation
Preferred stock represents some degree of ownership in a company but usually doesn't come with
the same voting rights. (This may vary depending on the company.) With preferred shares,
investors are usually guaranteed a fixed dividend forever. This is different than common stock,
which has variable dividends that are never guaranteed. Another advantage is that in the event of
liquidation, preferred shareholders are paid off before the common shareholder (but still after
debt holders). Preferred stock may also be callable, meaning that the company has the option to
purchase the shares from shareholders at anytime for any reason (usually for a premium).
Over the long term, common stock, by means of capital growth, yields higher returns than
almost every other investment. This higher return comes at a cost since common stocks entail the
most risk. If a company goes bankrupt and liquidates, the common shareholders will not receive
money until the creditors, bondholders and preferred shareholders are paid.
The value of a share of common stock is equal to the present value of all future dividends it is
expected to provide over an infinite time horizon. It is assumed that dividends will grow at a
constant rate g, (i.e. growth which is expected to continue into the foreseeable future at about the
same rate as that of the economy as a whole; g = a constant), that is less than the required rate of
return, (the minimum rate of return), on a common stock that stockholders consider acceptable.
The assumption Rc > g is necessary mathematical condition for driving the model.
The Gordon Growth Formula, also known as The Constant Growth Formula assumes that a
company grows at a constant rate forever. This, by the way, is impossible. I mean, it can't grow
forever. You know, if a company doubles in size every 5 years, pretty soon every single person
in the world is their customer and then they can't grow at that rate anymore. (Because the world
population isn't doubling every 5 years)
Where:
Ki = Cost of debt before taxes FV = Face value of the bond
Kd = After taxes cost of debt MV = Maturity value of the bond
I = Interest Payment n = Maturity period of the bond.
Example 1:A corporation sold a Br. 20 million bond that mature in 25 years at par value. Each
bond has a Br.1,000 par value and carries a 12% coupon rate (interest rate). Assume a 45% tax
rate. Compute the specific cost of capital for this bond before and after tax effect.
Given: I = 1,000 X 0.12 = Br.120, FV = 1,000, MV = 1,000, I = 12%, T = 45% and n = 25 yrs
i. The specific cost of bond before tax effect is
1 1
I + ( FV −MV ) B r .120+ (Br .1,000 – Br .1,000)
n 25
Ki = = = Br.120/Br.1,000 = 12%
1 1
(FV + MV ) ( Br .1,000+ Br .1,000)
2 2
Therefore, if a bond is sold at its par value the cost of the bond and its interest rate are equal
before the tax effect.
Example 3:ABC Company sold Br.100 par value bond that mature in 7 years. The rate of
interest is 15% per year, and the bond will be redeemed at 5% premium on maturity. The firm’s
tax rate is 35%.
1
Br .15+ (Br .100 – Br .105)
7 Br .14 .286
Ki = = = 13.94%
1 Br .102 .5
(Br .100+ Br .105)
2
Thus, Kd = 13.94%(1− 0.35) = 9.1%
When a bond is sold at premium, the cost of the bond is less than its interest rate.
Cost of debt is the after tax cost of long-term funds through borrowing. Debt may be issued at
par, at premium or at discount and also it may be perpetual or redeemable.
Debt Issued at Par
Debt issued at par means, debt is issued at the face value of the debt. It may be calculated with
the help of the following formula.
Kd = (1 – t) R
Where,
Kd = Cost of debt capital
t = Tax rate
R = Debenture interest rate
Debt Issued at Premium or Discount
If the debt is issued at premium or discount, the cost of debt is calculated with the help of the
= 90,000 × (1 – 0.5)
1,078,000
= 4.17% = 1,100,000 – 22,000 = Rs. 1,078,000
B. Cost of preferred stock
It is the rate of return that must be earned on the preferred stockholders’ investment to satisfy
their requirement (fixed dividend payment). When a corporation sells preferred stock, it expects
to pay dividends to investors in return for their money capital. The dividend payments are costs
to the firms issuing preferred stock. In order to express this dividend cost as yearly rate, the firm
uses the selling price it receives after deducting flotation costs incurred in issuing the preferred
stocks. The cost of preferred stock can be estimated by dividing the annual preference dividend
by the current market price per share or net proceed; as the dividend can be considered a
continuous (stable) level of payment.
- Preferred stock dividends are either expressed as a stated birr amount or annual percentage.
- Preference capital is never issued with an intention not to pay dividends.
- The cost of preferred stock is not adjusted for taxes, because preference dividend is paid after
corporate tax is paid.
- The cost of preferred stock (Kp) can be estimated through the following formula;
dividendpers h are Dp
Kp = =
netproceed ( NP) NP
Example: A preferred stock selling for Br.500 with an annual stated dividend per share of Br.50
requires a flotation cost of Br.10 per share. Determine the specific cost of the preferred stock if
the corporate tax rate is 40%.
Solution-
Dp = Br.50, NP = market price minus flotation cost = Br.500 – Br.10 = Br.490
Dp Br .50
Thus, Kp = = = 10.2%
NP Br .490
It implies that the firm must earn 10.2% on preferred stock investment to satisfy the preferred
stock holders’ interest.
C. Cost of Common Stock
Cost of common stock is a minimum rate of return that the corporation must earn for its common
stock holders in order to maintain the market value of the firm’s equity. However, cost of equity
Where:
Kc = cost of equity
Rf = Risk free rate
Rm = market return
βj = beta of firm’s share
Example: Assume that the risk free rate is 7%, the expected return in the market is 16% and the beta
for the firm’s common stock is 0.82. Compute the cost of equity using CAPM.
Kc = Rf + (Rm − Rf)βj = 0.07 + (0.16 − 0.07)0.82 = 14.38%
D. Cost of Retained Earnings
Retained Earnings (RE) represents profit available to common stockholders that the corporation
chooses to reinvest. The cost of RE is costly related to the use of equity shares. If earnings were not
retained, they will be paid out to the common stockholders in dividend form. The cost of retained
earnings is the opportunity cost forgone dividends to the existing shareholders. Thus, its cost is the
same as that of equity shares. Since retained earnings represent the internal source of capital, it is not
necessary to adjust the cost of it for flotation costs. So, specific cost of RE (K RE) is equated in the same
way as the cost of equity was equated. That is,
D1
KRE¿ + g , where MP = market price of existing common stock.
MP
Example: a company’s common stock has recent dividend per share of Br.12. It is found that the
company dividend per share should continue to increase at 6% growth rate. What is the cost of
retained earnings if a market price of Br.100 with a flotation cost of per share Br.8 is expected up on
selling the common stocks?
Do(1+ g) Br .12(1+ 0.06)
KRE¿ +g = +0.06 = 18.72%
MP Br .100
4.2.2 Capital structure
4.2.1.1 Capital structures and financial structure;
The term capital structures differ from financial structure. Financial structure refers to the way of firms
assets are financed. In other words, it includes both, long –term as well as short – term source of
funds.
Capital structure is the permanent financing structure of the company represented primarily by long –
term bonds and stockholders’ funds but excluding all short term credit. Thus a company’s capital
structures only a part of its financial structure.
Pattern of capital structure:
In case of a new company the capital structure may be of any of the following three patterns
Capital structure with common stock only.
Capital structure with both common stocks and preference stocks
Capital structure with common stock and long term bonds
Capital structure with common stock , preference stocks and bonds
The capital structure of a given business organization should be at the composition of debt and equity
at which weighed average cost of capital is minimized and the value of the firm is maximized. This
composition of debt and equity is said to be optimal capital structure and this debt-equity composition
should be a target capital structure for an organization. Firms should first analyze a number of factors,
and then establish a target capital structure. This target may change over time as conditions change,
but at any given moment, management should have a specific capital structure in mind. If the actual
debt ratio is below the target level, expansion capital should generally be raised by issuing debt,
whereas if the debt ratio is above the target, equity should generally be issued.
Capital structure policy involves a trade-off between risk and return:
Using more debt raises the risk borne by stockholders.
However, using more debt generally leads to a higher expected rate of return on equity.
Higher risk tends to lower a stock’s price, but a higher expected rate of return raises it. Therefore, the
optimal capital structure must strike a balance between risk and return so as to maximize the firm’s
stock price.
Four primary factors influence capital structure decisions.
1. Business risk or the riskiness inherent in the firm’s operations if it used no debt. The greater the
firm’s business risk, the lower its optimal debt ratio.
2. The firm’s tax position. A major reason for using debt is that interest is deductible, which
lowers the effective cost of debt. However, if most of a firm’s income is already sheltered from
taxes by depreciation tax shields, by interest on currently outstanding debt, or by tax loss carry-
forwards, its tax rate will be low, so additional debt will not be as advantageous as it would be
to a firm with a higher effective tax rate.
3. Financial flexibility or the ability to raise capital on reasonable terms under adverse conditions.
Corporate treasurers know that a steady supply of capital is necessary for stable operations,
Financial Management teaching material Page 17
which is vital for long-run success. They also know that when money is tight in the economy,
or when a firm is experiencing operating difficulties, suppliers of capital prefer to provide
funds to companies with strong balance sheets.
4. Managerial conservatism or aggressiveness. Some managers are more aggressive than others;
hence some firms are more inclined to use debt in an effort to boost profits. This factor does
not affect the true optimal or value-maximizing capital structure, but it does influence the
manager determined target capital structure.
Traditional theory
As per traditional theory percentage change in dividend (D) is greater than percentage change in cost
of stock (Ks) as we increase debt financing. In fact this trend has its own limit; this trend is true until
we reach at some specified debt level which is termed as optimal capital structure. Until we reach at
this level debt financing has positive impact on the value of the firm. On the other hand, percentage
change in dividend (D) is less than percentage change in cost of stock (Ks) after certain financial
leverage level (the optimal capital structure). This change (i.e. D< Ks) is a result of trait of bankruptcy
as debt goes beyond the optimal point; from this point on debt financing has a negative impact on the
firm’s value.
Modigliani and Miller: Proposition I and II; No Taxes
Modern capital structure theory began in 1958, when Professors Franco Modigliani and Merton Miller
(M & M) published what has been called the most influential finance article ever written. M & M’s
study was based on some strong assumptions, which included the following:
1. There are no brokerage costs.
2. There are no taxes.
3. There are no bankruptcy costs.
4. Investors can borrow at the same rate as corporations.
5. All investors have the same information as management about the firm’s future investment
opportunities.
6. EBIT is not affected by the use of debt.
Modigliani and Miller imagined two hypothetical portfolios. The first contains all the equity of an
unlevered firm, so the portfolio’s value is VU, the value of an unlevered firm.
Because the firm has no growth (which means it does not need to invest in any new net assets) and
because it pays no taxes, the firm can pay out all of its EBIT in the form of dividends. Therefore, the
cash flow from owning this first portfolio is equal to EBIT.
Now consider a second firm that is identical to the unlevered firm except that it is partially financed
with debt. The second portfolio contains all of the levered firm’s stock (SL) and debt (D), so the
Jams horns has defined leverage as ‘the employment of an asset or funds for which the firm pays a
fixed cost of fixed return’. Thus, according to him, leverage results as a result of the firm employing
an asset or source of funds which has a fixed cost (or return). The former may be termed as’’ fixed
operating cost ‘, while the later may be termed ‘fixed financial cost’. It should be noted that fixed cost
or return is the fulcrum of leverage. If a firm is not required to pay fixed cost of fixed return, there will
be no leverage.
Since fixed cost or return has to be paid or incurred irrespective of the volume of output or sales, the
size of such cost of return has considerable influence over the amount of profits available for
shareholders. When the volume of sales changes; leverage helps in quantifying such influence. It may,
therefore, be defined as relative change in profit due to change in sales. A high degree of leverage
implies that there will be a large profit due to relatively small change in sales and vice versa. Thus,
higher is the leverage, higher is the risk and higher is the expected return.
Types of leverage
There are three types of leverage
a. Operating leverage
b. Financial leverage
c. Composite leverage / combined leverage.
A. operating leverage
The operating leverage may be defined as the tendency of the operating profit to vary of
disproportionately with sales. It is said to exist when a firm has to pay a fixed cost regardless of
volume of output or sales. The firm is said to have a high degree of Operating leverage if it employees
a greater amount of fixed cost and a small amount of variable cost. On the other hand, a firm will have
low operating leverage when it employees a greater amount of variable cost and a small amount of
fixed costs. Thus the degree of operating leverage depends upon the amount of fixed elements in the
cost structure.
It measures operating risk; the chance of incurring loss and the variability in returns because of change
in production and sales.
% change in operating income (EBIT) = % change in sale x degree of operating leverage (DOL)
% changes in EBIT
DOL = ------------------------------------------
% changes in sales
Notes
Changes in EBIT
1. %changes in EBIT = --------------------------------
Base EBIT
Changes in sales
2. % changes in sales = ----------------------------
Bases sales
B. Financial leverage
The financial leverage may be defined as the tendency of the residual net income to vary
disproportionately with operating profit. It indicates the change that takes place in the taxable income
as result of change in the operating income. It signifies the existence of fixed interest / fixed dividend
bearing securities such as bonds and preferred stock along with the common equity in the total capital
structure of the company, is described as financial leverage where in the capital structure of the
company, the fixed interest/dividend bearing securities are greater as compared to the equity capital
the leverage is said to be larger. In a reverse case the leverage will be said to be smaller.
Financial leverage is also sometimes termed as ‘’trading on equity’’. However, most of the author on
financial management is of the opinion that the term trading on equity should be used for the term
financial leverage only when financial leverage is favorable. The company resorts to trading on equity
with the objective of giving the equity shareholders a high rate of return than the general rate of
earning on capital employed in the company, to compensate them for the risk that they have to bear.
Degree of leverage: - when the relationship between the change in one amount and the corresponding
change in another amount is ‘’quantified’’; it is degree of leverage.
There are two types of income statements:
A) Traditional or functional income statement Accounting based – expenses are classified by
functional area.
B) Contribution or variable costing income statement/ Economic based - cost or expenses are
classified according to cost behaviors as fixed and variable.
Thus the contribution income statement is useful for leverage analysis.
Table 5.1
Financial data for company x
Starting Point (Baseline) 2% Increase Over Starting Point
Solution
a) operating leverage
Or alternatively
= 440, 0000 = 11
40,000
b) financial leverage
Degree of financial leverage (DFL) = %change in EBT
c) Combined leverage
DCL = %change in EBT
% changes in sale
%change in EBT = Change in EBT
Base EBT
%change in EBT = 18,800 – 10,000 = 0.88 = 88%
10,000
% changes in sales = Change in sales
Base sale
= 1,122,000 – 1,100,000 = 0.02 = 2%
1,100,000
Therefore, DCL
= 0.88/0.02 = 44
Or
DCL = DOL X DFL
= 11 X 4 =44
OR
Degree of Composite leverage = %change in EPS
%change in Sales
%change in EPS = Change in EPS
Base EPS
2.63 -1.4 = 0.878 = 88%
1.4
Therefore if sales increased by 2% (i.e. from birr 1,100,000 to birr 1,122, 000; then taxable
income increases by 88% (i.e.; from 410,000 to birr 18,800)
4.2.4. The overall cost of capital
Weighted Average Cost of Capital (WACC)
Every company has a capital structure - a general understanding of what percentage of debt comes
from retained earnings, common stocks, preferred stocks, and bonds.
By taking a weighted average, we can see how much interest the company has to pay for every birr it
borrows. This is the weighted average cost of capital.
Capital Component Cost Times % of capital structure Total
Retained Earnings 10% X 25% 2.50%
Common Stocks 11% X 10% 1.10%
Preferred Stocks 9% X 15% 1.35%
Bonds 6% X 50% 3.00%
TOTAL 7.95%
So the WACC of this company is 7.95%.