MODULE 2: FINC – 102 Share Capital and Their Valuation, and Bonds and Their Valuation

Lesson 1 Nature and Features of Preferred Shares, and Nature and Features of Ordinary Equity Shares
Lesson 2 Market for Stocks, Types of Stock Market Transactions, and Stock Valuation
Lesson 3 Bonds and its Features and Types of Bonds
Lesson 4 Bond Valuation, Bond Yield, and Bond Markets

Lesson 1
Nature and Features of Preferred Shares, and Nature and Features of Ordinary Equity Shares
Nature and Features of Preferred Shares

Preference shares are one of the special types of share capital having fixed rate of dividend and they carry
preferential rights over ordinary equity shares in sharing of profits and also claims over assets of the firm.

Preferred shares (also known as preferred stock or preference shares) are securities that represent ownership in a
corporation, and that have a priority claim over common shares on the company’s assets and earnings. The shares are
more senior than common stock but are more junior relative to bonds in terms of claim on assets. Holders of preferred stock
are also prioritized over holders of common stock in dividend payments.

Characteristics or Features of Preference Shares

1. Dividends for Preference share holders

Preference shareholders enjoy a priority over equity shareholders in payment of dividends. Only after paying
dividend on preference shares, the company shall pay dividend to equity shareholders. Normally, the rate of dividend on
preference shares is fixed by the controller of capital issues.
Preference shares may be:

 Cumulative preference shares. With regard to cumulative preference shares, any dividend not paid by the company
(in those years in which it made no profit) accumulates. The company must pay these unpaid dividends before the
payment of dividends to equity shareholders. These unpaid dividends are called dividends-in-arrears.

 Non-cumulative preference shares. Non-cumulative dividends are in contrast to cumulative dividends. Non-
cumulative dividends do not accumulate if they are not paid when they become due.

2. Voting rights of preference shareholders

As preference shareholders are relatively in a secure position, they have no right to vote except in the special
circumstances. In the event of non-payment of dividend for two years or more, the preference shareholders can vote.

The voting right of each preference shareholder is to be in the proportion which the paid up share capital on his
shares bears to the total equity share capital of the company.

3. Participating preference shares

Participating preference shares mean that the preference shareholder receives stipulated dividend and also
participates in the additional earnings of the company along with the equity shareholders.

Module II
 In practice, most preference shares are non-participating in nature. It means that the preference shareholder
receives only his stated dividend and no more. The basis for this is that the preference shareholders surrender their claim to
extra earnings in lieu of their right to receive the stated dividend.

4. Right on assets

Preference shareholders’ right on the assets of the company is similar to that of bond holders. When the company
is liquidated, preference shareholders are paid and the residue is available to the equity shareholders. So, preference
shareholders have a prior right to that of the equity shareholders.

However, preference shareholders claim their right only after the payment of bondholders.

5. Par value of preference shares

Usually, preference shares have a par value. It is the face value or denomination by which the preference share is
valued. The dividend rate and call money are generally fixed with reference to the par value.

6. Redeemable preference shares

Preference shares have no maturity date. Redeemable preference shares are paid back (retired) to the preference
shareholders by the issuing company. In other words, redeemable preference shares are retired by the company by paying
the special sum as stated in the investment.

The terms of redemption are made known to the preference shareholders at the time of issue of shares. This
arrangement is advantageous to the company. When money rate declines, the company may redeem the shares and
refinance it at a lower dividend rate.

7. Sinking fund retirement

The retirement of preference shares calls for the payment of enormous funds. So, the company creates a special
fund known as the sinking fund for the purpose of retirement.

Every year a stated sum is set apart in this fund and the accumulated sum is used to retire the preference shares
when they become due. Thus, the payment out of sinking fund reduces preference shares outstanding. This will give the
remaining preference shares a strong income position.

In other words, payment of dividend to the remaining preference shares is more certain. Ultimately, creation of
sinking fund improves the investment status of preference shares.

8. Preemptive right of preference shareholders

Preemptive right means the preference shareholders have the right of receiving further issues from the company
before it is offered to the public. This preemptive right is advantageous to the preference shareholders. They can receive
the benefits of growth of the company by owning preference shares in addition to their original holding.

9. Convertibility of preference shares

Convertible preference share means that the owner has the right to exchange a preference share for equity share
of the same company.

For example, a 100 preference share may be convertible into 10 equity shares of 10 pesos each. At the time of
issuing convertible preference shares, factors such as rights, privileges and the convertibility aspect, the rate of conversion
and the number of shares offered at the time of conversion are made clear in a separate clause.

The convertibility clause entitles the preference shareholders to a share in the growth of the company.

10. Hybrid security of preference shares

The preference share is a hybrid stock between a bond and a common stock. A preference share partakes the
characteristics of both the shares and the bonds. Like a bond, it has a claim on the assets of the company. At the time of
liquidation of the company, only after the payment of principal to the preference shareholders, the claims of the equity
shareholders can be satisfied.
 Figure 1. Asset Priority Claim

Types of Preferred Stock

Preferred stock is a very flexible type of security. They can be:

 Convertible preferred stock: The shares can be converted to a predetermined number of common shares.

 Cumulative preferred stock: If an issuer of shares misses a dividend payment, the payment will be added to the
next dividend payment.

 Exchangeable preferred stock: The shares can be exchanged for some other type of security.

 Perpetual preferred stock: There is no fixed date on which the shareholders will receive back the invested capital.

Advantages of Preferred Shares

Preferred shares offer advantages to both issuers and holders of the securities. The issuers may benefit in the following
way:

 No dilution of control: This type of financing allows issuers to avoid or defer the dilution of control, as the shares do
not provide voting rights or limit these rights.

 No obligation for dividends: The shares do not force issuers to pay dividends to shareholders. For example, if the
company does not have enough funds to pay dividends, it may just defer the payment.

 Flexibility of terms: The company’s management enjoys the flexibility to set up almost any terms for the shares.
 

Nature and Features of Ordinary Equity Shares

An equity share, normally known as ordinary share is a part ownership where each member is a fractional owner
and initiates the maximum entrepreneurial liability related with a trading concern. These types of shareholders in any
organization possess the right to vote.

Ordinary Shares carry voting rights. Shareholders have some privileges to get voting rights at the general meeting.
They can appoint or remove the directors and auditors of the company. Each of the shareholders has rights to gain profits
that earned by the company as well as to take the dividend.

Equity shares are the main source of finance of a firm. It is issued to the general public. Equity share holders do not
enjoy any preferential rights with regard to repayment of capital and dividend. They are entitled to residual income of the
company, but they enjoy the right to control the affairs of the business and all the shareholders collectively are the owners
of the company.
Features of Equity Shares

The main features of equity shares are:

1. They are permanent in nature.

2. Equity shareholders are the actual owners of the company and they bear the highest risk.
3. Equity shares are transferable, i.e. ownership of equity shares can be transferred with or without consideration to
other person.
4. Dividend payable to equity shareholders is an appropriation of profit.
5. Equity shareholders do not get fixed rate of dividend.
6. Equity shareholders have the right to control the affairs of the company.
7. The liability of equity shareholders is limited to the extent of their investment.
Advantages of Equity Shares

Equity shares are amongst the most important sources of capital and have certain advantages which are mentioned
below:

Advantages from the Shareholders’ Point of View

a. Equity shares are very liquid and can be easily sold in the capital market.
b. In case of high profit, they get dividend at higher rate.
c. Equity shareholders have the right to control the management of the company.
d. The equity shareholders get benefit in two ways, yearly dividend and appreciation in the value of their investment.

Advantages from the Company’s Point of View:

a. They are a permanent source of capital and as such; do not involve any repayment liability.
b. They do not have any obligation regarding payment of dividend.
c. Larger equity capital base increases the creditworthiness of the company among the creditors and investors.

Disadvantages of Equity Shares:

Despite their many advantages, equity shares suffer from certain limitations. These are:

Disadvantages from the Shareholders’ Point of View:

a. Equity shareholders get dividend only if there remains any profit after paying debenture interest, tax and preference
dividend. Thus, getting dividend on equity shares is uncertain every year.
b. Equity shareholders are scattered and unorganized, and hence they are unable to exercise any effective control
over the affairs of the company.
c. Equity shareholders bear the highest degree of risk of the company.
d. Market price of equity shares fluctuate very widely which, in most occasions, erode the value of investment.
e. Issue of fresh shares reduces the earnings of existing shareholders.

Disadvantage from the Company’s Point of View:

 a. Cost of equity is the highest among all the sources of finance.
b. Payment of dividend on equity shares is not tax deductible expenditure.
c. As compared to other sources of finance, issue of equity shares involves higher floatation expenses of brokerage,
underwriting commission, etc.

Different Types of Equity Issues:

Equity shares are the main source of long-term finance of a joint stock company. It is issued by the company to the
general public. Equity shares may be issued by a company in different ways but in all cases the actual cash inflow may not
arise (like bonus issue).

The different types of equity issues have been discussed below:

1. New Issue

A company issues a prospectus inviting the general public to subscribe its shares. Generally, in case of new issues,
money is collected by the company in more than one installment— known as allotment and calls. The prospectus contains
details regarding the date of payment and amount of money payable on such allotment and calls. A company can offer to
the public up to its authorized capital. Right issue requires the filing of prospectus with the Registrar of Companies and with
the Securities and Exchange Board of India (SEBI) through eligible registered merchant bankers.

2. Bonus Issue

Bonus in the general sense means getting something extra in addition to normal. In business, bonus shares are the
shares issued free of cost, by a company to its existing shareholders. As per SEBI guidelines, if a company has sufficient
profits/reserves it can issue bonus shares to its existing shareholders in proportion to the number of equity shares held out
of accumulated profits/ reserves in order to capitalize the profit/reserves. Bonus shares can be issued only if the Articles of
Association of the company permits it to do so.

Advantage of Bonus Issues

From the company’s point of view, as bonus issues do not involve any outflow of cash, it will not affect the liquidity
position of the company. Shareholders, on the other hand, get bonus shares free of cost; their stake in the company
increases.

Disadvantages of Bonus Issues

Issue of bonus shares decreases the existing rate of return and thereby reduces the market price of shares of the
company. The issue of bonus shares decreases the earnings per share.

Types of Equity Share

 Authorized Share Capital- This amount is the highest amount an organization can issue. This amount can be
changed time as per the companies’ recommendation and with the help of few formalities.

 Issued Share Capital- This is the approved capital which an organization gives to the investors.

 Subscribed Share Capital- This is a portion of the issued capital which an investor accepts and agrees upon.

 Paid up Capital- this is a section of the subscribed capital that the investors give. Paid-up capital is the money that
an organization really invests in the company’s operation.

 Right Share- These are those type of share that an organization issue to their existing stockholders. This type of
share is issued by the company to preserve the proprietary rights of old investors.

 Bonus Share- When a business split the stock to its stockholders in the dividend form, we call it a bonus share.

 Sweat Equity Share- This type of share is allocated only to the outstanding workers or executives of an organization
for their excellent work on providing intellectual property rights to an organization.

Difference between Equity Shares and Preference Shares

Equity share and Preference share are the two types of share that a company issues.

Equity share is an ordinary share.

 Preference share experience the perquisites of the dividend distribution first.

The equity stockholders get the opportunity to cast their vote in major business decisions.

The company preference share receives the dividend at a fixed rate.

Whenever there is an issue with the company the preference share gets the right to return of the capital before the
equity share.

Basis Preference Share Equity Share

Dividend Rate Has a fixed rate Fluctuates
Vote Rights No voting rights Have voting rights
Participation in Has no right to participate in Has the right to participate in
Management management decision management decision
Preferences Get the first preference, before Gets second preference, after
equity share preference share
LEARNING ACTIVITY
Identify the word or group of words that is being
referred to in the sentence.
1. These are the special
types of share capital having fixed rate of dividend and
they carry preferential rights over ordinary equity shares
in sharing of profits and also claims over assets of the
firm.
2. These are securities
that represent ownership in a corporation, and that have
a priority claim over common shares on the company’s
assets and earnings.
3. It means the
preference shareholders have the right of receiving
further issues from the company before it is offered to the
public.
4. The shares can be
converted to a predetermined number of common shares.
member is a fractional owner and initiates the maximum
entrepreneurial liability related with a trading concern.
12. A company issues a
prospectus inviting the general public to subscribe
its shares.
13. In the general sense
it means getting something extra in addition to normal
and issued free of cost by a company to its existing
shareholders.
14. This amount is the
highest amount an organization can issue and this
amount can be changed time as per the companies’
recommendation and with the help of few formalities.
15. This is the approved
capital which an organization gives to the investors.
16. This is a portion of
the issued capital which an investor accepts and agrees
upon.

5. If an issuer of shares 17. This is a section of

misses a dividend payment, the payment will be added to
the next dividend payment.
6. The shares can be
exchanged for some other type of security.
7. There is no fixed date
on which the shareholders will receive back the invested
capital.
8. This type of financing
allows issuers to avoid or defer the dilution of control, as
the shares do not provide voting rights or limit these
rights.
9. The shares do not
force issuers to pay dividends to shareholders. For
example, if the company does not have enough funds to
pay dividends, it may just defer the payment.
the subscribed capital that the investors give and it is the
money that an organization really invests in the
company’s operation.
18. These are type of
share that an organization issue to their existing
stockholders and it is issued by the company to preserve
the proprietary rights of old investors.
19. When a business
split the stock to its stockholders in the dividend form.
20. This type of share is
allocated only to the outstanding workers or executives of
an organization for their excellent work on providing
intellectual property rights to an organization.
Answer the following:

10. The company’s 1. Differentiate cumulative preference shares from

management enjoys the flexibility to set up almost any non-cumulative preference shares.
terms for the shares.
2. Discuss the preemptive right of preference
11. Normally, it is known shareholders.
as ordinary share and it is a part ownership where each
3. Equity shares are transferable. Explain.
Lesson 2
Market for Stocks, Types of Stock Market Transactions, and Stock Valuation
Market for Stocks

The stock market refers to public markets that exist for issuing, buying, and selling stocks that trade on a stock
exchange or over-the-counter.

Stocks, also known as equities, represent fractional ownership in a company, and the stock market is a place
where investors can buy and sell ownership of such investible assets. An efficiently functioning stock market is considered
critical to economic development, as it gives companies the ability to quickly access capital from the public.

The stock market refers to the collection of markets and exchanges where regular activities of buying, selling, and
issuance of shares of publicly-held companies take place. Such financial activities are conducted through institutionalized
formal exchanges or over-the-counter (OTC) marketplaces which operate under a defined set of regulations. There can be
multiple stock trading venues in a country or a region which allow transactions in stocks and other forms of securities.

While both terms - stock market and stock exchange - are used interchangeably, the latter term is generally a
subset of the former.

If one says that she trades in the stock market, it means that she buys and sells shares/equities on one (or more) of
the stock exchange(s) that are part of the overall stock market. The leading stock exchanges in the U.S. include the New
York Stock Exchange (NYSE), NASDAQ, and the Chicago Board Options Exchange (CBOE). These leading national
exchanges, along with several other exchanges operating in the country, form the stock market of the U.S.

Though it is called a stock market or equity market and is primarily known for trading stocks/equities, other financial
securities - like exchange traded funds (ETF), corporate bonds and derivatives based on stocks, commodities, currencies,
and bonds - are also traded in the stock markets.

Purposes of the Stock Market – Capital and Investment Income

The stock market serves two very important purposes.

The first is to provide capital to companies that they can use to fund and expand their businesses .

If a company issues one million shares of stock that initially sell for Php 10 a share, then that provides the company
with Php 10 million of capital that it can use to grow its business (minus whatever fees the company pays for an investment
bank to manage the stock offering). By offering stock shares instead of borrowing the capital needed for expansion, the
company avoids incurring debt and paying interest charges on that debt.

The secondary purpose the stock market serves is to give investors – those who purchase stocks – the opportunity
to share in the profits of publicly-traded companies .

Investors can profit from stock buying in one of two ways. Some stocks pay regular dividends (a given amount of
money per share of stock someone owns). The other way investors can profit from buying stocks is by selling their stock for
a profit if the stock price increases from their purchase price.

For example, if an investor buys shares of a company’s stock at Php 10 a share and the price of the stock
subsequently rises to Php 15 a share, the investor can then realize a 50% profit on their investment by selling their shares.

Understanding the Stock Market

While today it is possible to purchase almost everything online, there is usually a designated market for every
commodity. For instance, people drive to city outskirts and farmlands to purchase Christmas trees, visit the local timber
market to buy wood and other necessary material for home furniture and renovations, and go to stores like Walmart for their
regular grocery supplies.

Such dedicated markets serve as a platform where numerous buyers and sellers meet, interact and transact. Since
the number of market participants is huge, one is assured of a fair price. For example, if there is only one seller of Christmas
trees in the entire city, he will have the liberty to charge any price he pleases as the buyers won’t have anywhere else to go.
If the number of tree sellers is large in a common marketplace, they will have to compete against each other to attract
buyers. The buyers will be spoiled for choice with low- or optimum-pricing making it a fair market with price transparency.
Even while shopping online, buyers compare prices offered by different sellers on the same shopping portal or across
different portals to get the best deals, forcing the various online sellers to offer the best price.

A stock market is a similar designated market for trading various kinds of securities in a controlled, secured and
managed environment. Since the stock market brings together hundreds of thousands of market participants who wish to
buy and sell shares, it ensures fair pricing practices and transparency in transactions. While earlier stock markets used to
issue and deal in paper-based physical share certificates, the modern day computer-aided stock markets operate
electronically.

How the Stock Market Works

In a nutshell, stock markets provide a secure and regulated environment where market participants can transact in
shares and other eligible financial instruments with confidence with zero- to low-operational risk. Operating under the
defined rules as stated by the regulator, the stock markets act as primary markets and as secondary markets.

As a primary market, the stock market allows companies to issue and sell their shares to the common public for the
first time through the process of initial public offerings (IPO). This activity helps companies raise necessary capital from
investors. It essentially means that a company divides itself into a number of shares (say, 20 million shares) and sells a part
of those shares (say, 5 million shares) to common public at a price (say, $10 per share).

To facilitate this process, a company needs a marketplace where these shares can be sold. This marketplace is
provided by the stock market. If everything goes as per the plans, the company will successfully sell the 5 million shares at a
price of $10 per share and collect $50 million worth of funds. Investors will get the company shares which they can expect to
hold for their preferred duration, in anticipation of rising in share price and any potential income in the form of dividend
payments. The stock exchange acts as a facilitator for this capital raising process and receives a fee for its services from
the company and its financial partners.

Following the first-time share issuance IPO exercise called the listing process, the stock exchange also serves as
the trading platform that facilitates regular buying and selling of the listed shares. This constitutes the secondary market.
The stock exchange earns a fee for every trade that occurs on its platform during the secondary market activity.

The stock exchange shoulders the responsibility of ensuring price transparency, liquidity, price discovery and fair
dealings in such trading activities. As almost all major stock markets across the globe now operate electronically, the
exchange maintains trading systems that efficiently manage the buy and sell orders from various market participants. They
perform the price matching function to facilitate trade execution at a price fair to both buyers and sellers.

A listed company may also offer new, additional shares through other offerings at a later stage, like through rights
issue or through follow-on offers. They may even buyback or delist their shares. The stock exchange facilitates such
transactions.

The stock exchange often creates and maintains various market-level and sector-specific indicators, like the S&P
500 index or Nasdaq 100 index, which provide a measure to track the movement of the overall market. Other methods
include the Stochastic Oscillator and Stochastic Momentum Index.

The stock exchanges also maintain all company news, announcements, and financial reporting, which can be
usually accessed on their official websites. A stock exchange also supports various other corporate-level, transaction-
related activities. For instance, profitable companies may reward investors by paying dividends which usually comes from a
part of the company’s earnings. The exchange maintains all such information and may support its processing to a certain
extent.

Functions of a Stock Market

A stock market primarily serves the following functions:

1. Fair Dealing in Securities Transactions

Depending on the standard rules of demand and supply, the stock exchange needs to ensure that all interested
market participants have instant access to data for all buy and sell orders thereby helping in the fair and transparent pricing
of securities. Additionally, it should also perform efficient matching of appropriate buy and sell orders.

For example, there may be three buyers who have placed orders for buying Microsoft shares at $100, $105 and
$110, and there may be four sellers who are willing to sell Microsoft shares at $110, $112, $115 and $120. The exchange
(through their computer operated automated trading systems) needs to ensure that the best buy and best sell are matched,
which in this case is at $110 for the given quantity of trade.

2. Efficient Price Discovery

 Stock markets need to support an efficient mechanism for price discovery, which refers to the act of deciding the
proper price of a security and is usually performed by assessing market supply and demand and other factors associated
with the transactions.

Say, a U.S.-based software company is trading at a price of $100 and has a market capitalization of $5 billion. A
news item comes in that the EU regulator has imposed a fine of $2 billion on the company which essentially means that 40
percent of the company’s value may be wiped out. While the stock market may have imposed a trading price range of $90
and $110 on the company’s share price, it should efficiently change the permissible trading price limit to accommodate for
the possible changes in the share price, else shareholders may struggle to trade at a fair price.

3. Liquidity Maintenance

While getting the number of buyers and sellers for a particular financial security are out of control for the stock
market, it needs to ensure that whosoever is qualified and willing to trade gets instant access to place orders which should
get executed at the fair price.

4. Security and Validity of Transactions

While more participants are important for efficient working of a market, the same market needs to ensure that all
participants are verified and remain compliant with the necessary rules and regulations, leaving no room for default by any
of the parties. Additionally, it should ensure that all associated entities operating in the market must also adhere to the rules,
and work within the legal framework given by the regulator.

5. Support All Eligible Types of Participants

A marketplace is made by a variety of participants, which include market makers, investors, traders, speculators,
and hedgers. All these participants operate in the stock market with different roles and functions. For instance, an investor
may buy stocks and hold them for long term spanning many years, while a trader may enter and exit a position within
seconds. A market maker provides necessary liquidity in the market, while a hedger may like to trade in derivatives for
mitigating the risk involved in investments. The stock market should ensure that all such participants are able to operate
seamlessly fulfilling their desired roles to ensure the market continues to operate efficiently.

6. Investor Protection

Along with wealthy and institutional investors, a very large number of small investors are also served by the stock
market for their small amount of investments. These investors may have limited financial knowledge, and may not be fully
aware of the pitfalls of investing in stocks and other listed instruments. The stock exchange must implement necessary
measures to offer the necessary protection to such investors to shield them from financial loss and ensure customer trust.

For instance, a stock exchange may categorize stocks in various segments depending on their risk profiles and
allow limited or no trading by common investors in high-risk stocks. Exchanges often impose restrictions to prevent
individuals with limited income and knowledge from getting into risky bets of derivatives.

Balanced Regulation

Listed companies are largely regulated and their dealings are monitored by market regulators, like the Securities
and Exchange Commission (SEC) of the U.S. Additionally, exchanges also mandate certain requirements – like, timely filing
of quarterly financial reports and instant reporting of any relevant developments - to ensure all market participants become
aware of corporate happenings. Failure to adhere to the regulations can lead to suspension of trading by the exchanges
and other disciplinary measures.

Regulating the Stock Market

A local financial regulator or competent monetary authority or institute is assigned the task of regulating the stock
market of a country. The Securities and Exchange Commission (SEC) is the regulatory body charged with overseeing the
U.S. stock markets. The SEC is a federal agency that works independently of the government and political pressure. The
mission of the SEC is stated as: "to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital
formation."

Stock Market Participants

Along with long-term investors and short term traders, there are many different types of players associated with the
stock market. Each has a unique role, but many of the roles are intertwined and depend on each other to make the market
run effectively.

 Stockbrokers, also known as registered representatives in the U.S., are the licensed professionals who buy and sell
securities on behalf of investors. The brokers act as intermediaries between the stock exchanges and the investors
 by buying and selling stocks on the investors' behalf. An account with a retail broker is needed to gain access to the
markets.

 Portfolio managers are professionals who invest portfolios, or collections of securities, for clients. These managers
get recommendations from analysts and make the buy or sell decisions for the portfolio. Mutual fund companies,
hedge funds, and pension plans use portfolio managers to make decisions and set the investment strategies for the
money they hold.

 Investment bankers represent companies in various capacities, such as private companies that want to go public
via an IPO or companies that are involved in pending mergers and acquisitions. They take care of the listing
process in compliance with the regulatory requirements of the stock market.

 Custodian and depot service providers, which are institution holding customers' securities for safekeeping so as to
minimize the risk of their theft or loss, also operate in sync with the exchange to transfer shares to/from the
respective accounts of transacting parties based on trading on the stock market.

 Market maker. A market maker is a broker-dealer who facilitates the trading of shares by posting bid and ask prices
along with maintaining an inventory of shares. He ensures sufficient liquidity in the market for a particular (set of)
share(s), and profits from the difference between the bid and the ask price he quotes.

How Stock Exchanges Make Money

Stock exchanges operate as for-profit institutes and charge a fee for their services. The primary source of income
for these stock exchanges are the revenues from the transaction fees that are charged for each trade carried out on its
platform. Additionally, exchanges earn revenue from the listing fee charged to companies during the IPO process and other
follow-on offerings.

The exchange also earns from selling market data generated on its platform - like real-time data, historical data,
summary data, and reference data – which is vital for equity research and other uses. Many exchanges will also sell
technology products, like a trading terminal and dedicated network connection to the exchange, to the interested parties for
a suitable fee.

The exchange may offer privileged services like high-frequency trading to larger clients like mutual funds and asset
management companies (AMC), and earn money accordingly. There are provisions for regulatory fee and registration fee
for different profiles of market participants, like the market maker and broker, which form other sources of income for the
stock exchanges.

The exchange also makes profits by licensing their indexes (and their methodology) which are commonly used as a
benchmark for launching various products like mutual funds and ETFs by AMCs.

Many exchanges also provide courses and certification on various financial topics to industry participants and earn
revenues from such subscriptions.

Significance of the Stock Market

The stock market is one of the most vital components of a free-market economy.

It allows companies to raise money by offering stock shares and corporate bonds. It lets common investors
participate in the financial achievements of the companies, make profits through capital gains, and earn money
through dividends, although losses are also possible. While institutional investors and professional money managers do
enjoy some privileges owing to their deep pockets, better knowledge and higher risk taking abilities, the stock market
attempts to offer a level playing field to common individuals.

The stock market works as a platform through which savings and investments of individuals are channelized into
the productive investment proposals. In the long term, it helps in capital formation & economic growth for the country.

Two Basic Approaches to Stock Market Investing – Value Investing and Growth Investing

There are countless methods of stock picking that analysts and investors employ, but virtually all of them are one
form or another of the two basic stock buying strategies of value investing or growth investing.

Value investors typically invest in well-established companies that have shown steady profitability over a long
period of time and may offer regular dividend income. Value investing is more focused on avoiding risk than growth
investing is, although value investors do seek to buy stocks when they consider the stock price to be an undervalued
bargain.

Growth investors seek out companies with exceptionally high growth potential, hoping to realize maximum
appreciation in share price. They are usually less concerned with dividend income and are more willing to risk investing in
relatively young companies. Technology stocks, because of their high growth potential, are often favored by growth
investors.

Types of Stock Market Transactions

We are going to learn about stock transactions in this lesson. If you are planning on investing in the stock market,
then this information will be very useful as it informs you about the various ways you can buy and sell stocks.

A stock transaction is the process that occurs when stocks change ownership.

Simple Market Order

The most common stock transaction is the simple market order.

When you give a market order, you're ordering your brokerage firm to buy or sell a specified number of stocks in a
certain company at the current market price. This is a simple buy and sell order and is executed right away. Most times,
these orders go through as there is someone willing to sell you stock at market price or buy your stock at market price. But
sometimes, there won't be anybody and your order will not go through. With each market order, you select how many
shares you want to buy or sell.

For the purpose of this lesson, the ABC stock is fictional stock in a fictional company with a current market price of
Php 36.51. If you give a buy order, then you are saying that you want to buy the ABC stock for Php 36.51 per share. If you
want to buy 10 shares, then your cost for the shares is Php 36.51 x 10 = Php 365.10, plus any fees your brokerage firm
charges. If you give a sell order, then you are saying you want to sell your ABC stock for Php 36.51 per share. If you want to
sell 5 shares, then you will earn Php 36.51 x 5 = Php 182.55 minus any fees from your brokerage firm.

Limit Order

Another type of order you can give is called the limit order. This order gives you more control over how you want to
buy or sell your stocks.

When you place a limit order, you are asking your brokerage firm to buy stock at or below your desired price called
the limit price, or sell stock at or above your desired price. If the price of a certain stock doesn't reach your desired limit price
by the limit order's expiration, then your limit order will not be executed. Each brokerage firm has its own expiration for its
limit orders. Some set a 60-day expiration on their limit orders while others set a 90-day expiration.

For example, going back to your ABC stock, say your ABC stock is currently at Php 28.51. You have 200 shares of
this stock and you want to sell. But you want to sell only if the stock reaches Php 30.00. To do this, you place a limit order to
buy when the stock price reaches Php 30.00. If the ABC stock price reaches Php 30.00 before your limit order expires, then
your 200 ABC shares will sell at Php 30.00 each. But if the ABC stock price only reaches Php 29.95, then your limit order
won't be executed.

A stock transaction is what happens to a stock when it changes ownership. ... When you give a market order,
you're ordering your brokerage firm to buy or sell a specified number of stocks in a certain company at the current market
price.
Types of Stock Market Transactions

Types of stock market transactions include IPO, secondary market offerings, secondary markets, private placement, and
stock repurchase.

o An initial public offering (IPO), or stock market launch, is a type of public offering where shares of stock in a
company are sold to the general public, on a securities exchange, for the first time.

o A secondary market offering is a registered offering of a large block of a security that has been previously
issued to the public.

In the secondary market, securities are sold by and transferred from one investor or speculator to another.
It is therefore important that the secondary market remain highly liquid.

o Private placement (or non-public offering) is a funding round of securities which are sold not through a
public offering, but rather through a private offering, mostly to a small number of chosen investors.

o Stock repurchase (or share buyback) is the reacquisition by a company of its own stock.

Types of Stock Market Transactions

 1. Initial Public Offering (IPO)

An initial public offering (IPO), or stock market launch, is a type of public offering where shares of stock in a
company are sold to the general public, on a securities exchange, for the first time. Through this process, a private company
transforms into a public company. Initial public offerings are used by companies to raise expansion capital, monetize the
investments of early private investors, and become publicly traded enterprises.

A company selling shares is never required to repay the capital to its public investors. After the IPO, when shares
are traded freely in the open market, money passes between public investors.

When a company lists its securities on a public exchange, the money paid by the investing public for the newly
issued shares goes directly to the company (primary offering) as well as to any early private investors who opt to sell all or a
portion of their holdings (secondary offering) as part of the larger IPO. An IPO, therefore, allows a company to tap into a
wide pool of potential investors to provide itself with capital for future growth, repayment of debt, or working capital.

Although an IPO offers many advantages, there are also significant disadvantages. Chief among these are the
costs associated with the process, and the requirement to disclose certain information that could prove helpful to
competitors, or create difficulties with vendors. Details of the proposed offering are disclosed to potential purchasers in the
form of a lengthy document known as a prospectus.

Most companies undertaking an IPO do so with the assistance of an investment banking firm acting in the capacity
of an underwriter. Underwriters provide a valuable service, which includes help with correctly assessing the value of shares
(share price), and establishing a public market for shares (initial sale).

2. Secondary market offering

A secondary market offering, according to the U.S. Financial Industry Regulatory Authority (FINRA), is a registered
offering of a large block of a security that has been previously issued to the public. The blocks being offered may have been
held by large investors or institutions, and proceeds of the sale go to those holders, not the issuing company. This is also
sometimes called secondary distribution.

A secondary offering is not dilutive to existing shareholders, since no new shares are created. The proceeds from
the sale of the securities do not benefit the issuing company in any way. The offered shares are privately held by
shareholders of the issuing company, which may be directors or other insiders (such as venture capitalists) who may be
looking to diversify their holdings. Usually, however, the increase in available shares allows more institutions to take non-
trivial positions in the issuing company which may benefit the trading liquidity of the issuing company's shares.

Transactions on Secondary Market

After the initial issuance, investors can purchase from other investors in the secondary market. In the secondary
market, securities are sold by and transferred from one investor or speculator to another. It is therefore important that the
secondary market be highly liquid. As a general rule, the greater the number of investors that participate in a given
marketplace, and the greater the centralization of that marketplace, the more liquid the market.

3. Private placement

Private placement (or non-public offering) is a funding round of securities which are sold not through a public
offering, but rather through a private offering, mostly to a small number of chosen investors. "Private placement" usually
refers to the non-public offering of shares in a public company (since, of course, any offering of shares in a private company
is and can only be a private offering).

4. Stock repurchase

Stock repurchase (or share buyback) is the reacquisition by a company of its own stock. In some countries,
including the U.S. and the UK, a corporation can repurchase its own stock by distributing cash to existing shareholders in
exchange for a fraction of the company's outstanding equity; that is, cash is exchanged for a reduction in the number of
shares outstanding. The company either retires the repurchased shares or keeps them as treasury stock, available for re-
issuance.

Companies making profits typically have two uses for those profits. Firstly, some part of profits can be distributed to
shareholders in the form of dividends or stock repurchases. The remainder, termed stockholder's equity, are kept inside the
company and used for investing in the future of the company. If companies can reinvest most of their retained earnings
profitably, then they may do so. However, sometimes companies may find that some or all of their retained earnings cannot
be reinvested to produce acceptable returns.

Stock Valuation
 Every investor who wants to beat the market must master the skill of stock valuation. Essentially, stock valuation is
a method of determining the intrinsic value (or theoretical value) of a stock. The importance of valuing stocks evolves from
the fact that the intrinsic value of a stock is not attached to its current price. By knowing a stock’s intrinsic value, an investor
may determine whether the stock is over- or under-valued at its current market price.

Stock valuation is the process of determining the intrinsic value of a share of common stock of a company.

Types of Stock Valuation

Stock valuation methods can be primarily categorized into two main types: absolute and relative.

1. Absolute Stock Valuation (the discounted cashflow method)

Absolute stock valuation relies on the company’s fundamental information. The method generally involves the
analysis of various financial information that can be found in or derived from a company’s financial statements. Many
techniques of absolute stock valuation primarily investigate the company’s cash flows, dividends, and growth rates. Notable
absolute stock valuation methods include the dividend discount model (DDM) and the discounted cash flow model (DCF).

3. Relative Stock Valuation (also called the comparables approach)

Relative stock valuation concerns the comparison of the investment with similar companies. The relative
stock valuation method deals with the calculation of the key financial ratios of similar companies and derivation of
the same ratio for the target company. The best example of relative stock valuation is comparable companies’
analysis.

How to Value a Stock?

Valuing stocks is an extremely complicated process that can be generally viewed as a combination of both art and
science. Investors may be overwhelmed by the amount of available information that can be potentially used in valuing
stocks (company’s financials, newspapers, economic reports, stock reports, etc.).

Therefore, an investor needs to be able to filter the relevant information from the unnecessary noise. Additionally,
an investor should know about major stock valuation methods and the scenarios in which such methods are applicable.

Popular Stock Valuation Methods

1. Dividend Discount Model (DDM)

The dividend discount model is one of the basic techniques of absolute stock valuation. The DDM is based on the
assumption that the company’s dividends represent the company’s cash flow to its shareholders.

Essentially, the model states that the intrinsic value of the company’s stock price equals the present value of the
company’s future dividends. Note that the dividend discount model is applicable only if a company distributes dividends
regularly and the distribution is stable.

2. Discounted Cash Flow Model (DCF)

The discounted cash flow model is another popular method of absolute stock valuation. Under the DCF approach,
the intrinsic value of a stock is calculated by discounting the company’s free cash flows to its present value.

The main advantage of the DCF model is that it does not require any assumptions regarding the distribution of
dividends. Thus, it is suitable for companies with unknown or unpredictable dividend distribution. However, the DCF model
is sophisticated from a technical perspective.

3. Comparable Companies Analysis

The comparable companies analysis is an example of relative stock valuation. Instead of determining the intrinsic
value of a stock using the company’s fundamentals, the comparable approach aims to derive a stock’s theoretical price
using the price multiples of similar companies.

The most commonly used multiples include the price-to-earnings (P/E), price-to-book (P/B), and enterprise value-to-
EBITDA (EV/EBITDA). The comparable companies’ analysis method is one of the simplest from a technical perspective.
However, the most challenging part is the determination of truly comparable companies.

LEARNING ACTIVITY
Identify the word or group of words that is being
referred to in the sentence.
1. It refers to public
markets that exist for issuing, buying, and selling stocks
that trade on a stock exchange or over-the-counter.
2. It is primarily known
for trading stocks/equities, other financial securities - like
exchange traded funds (ETF), corporate bonds and
derivatives based on stocks, commodities, currencies,
and bonds.
3. These are also known
as equities, represent fractional ownership in a company.
4. It is generally a
subset of the stock market.
5. It is a similar
designated market for trading various kinds of securities
in a controlled, secure and managed environment.
6. It shoulders the
responsibility of ensuring price transparency, liquidity,
price discovery and fair dealings in such trading activities.
7. It is also known as
registered representatives and are the licensed
professionals who buy and sell securities on behalf of
investors and acts as intermediaries between the stock
exchanges and the investors by buying and selling stocks
on the investors' behalf.
8. These are
professionals who invest portfolios, or collections of
securities, for clients.
9. They represent
companies in various capacities, such as private
companies that want to go public via an IPO or
companies that are involved in pending mergers and
acquisitions and they take care of the listing process in
compliance with the regulatory requirements of the stock
market.
10. These are institution
holding customers' securities for safekeeping so as to
minimize the risk of their theft or loss, also operate in
sync with the exchange to transfer shares to/from the
respective accounts of transacting parties based on
trading on the stock market.
11. It refers to a broker-
dealer who facilitates the trading of shares by posting bid
and ask prices along with maintaining an inventory of
shares. He ensures sufficient liquidity in the market for a
particular (set of) share(s), and profits from the difference
between the bid and the ask price he quotes.
12. It operates as for-
profit institutes and charge a fee for their services and the
primary source of income are the revenues from the
transaction fees that are charged for each trade carried
out on its platform.
13. They typically invest
in well-established companies that have shown steady
profitability over a long period of time and may offer
regular dividend income. Value investing is more focused
on avoiding risk than growth.
14. They seek out
companies with exceptionally high growth
potential, hoping to realize maximum
appreciation in share price and they are usually less
concerned with dividend income and are more willing
to risk investing in relatively young companies
15. 16.It is the process
that occurs when stocks change ownership.
16. 17. It is the most
common stock transaction.
17. It refers to public
markets that exist for issuing, buying, and selling stocks
that trade on a stock exchange or over-the-counter.
18. When you're
ordering your brokerage firm to buy or sell a specified
number of stocks in a certain company at the current
market price and it is a simple buy and sell order and is
executed right away.
19. This order gives you
more control over how you want to buy or sell your
stocks.
20. It is a type of public
offering where shares of stock in a company are sold to
the general public, on a securities exchange, for the first
time.
21. It is a registered
offering of a large block of a security that has been
previously issued to the public.
22. It is a funding round
of securities which are sold not through a public offering,
but rather through a private offering, mostly to a small
number of chosen investors.
23. It is the reacquisition
by a company of its own stock.
24. 25. Stock valuation
is the process of determining the intrinsic value of a share
of common stock of a company.
25. It relies on the
company’s fundamental information and this method
generally involves the analysis of various financial
information that can be found in or derived from a
company’s financial statements.
26. It concerns the
comparison of the investment with similar companies and
the relative stock valuation method deals with the
calculation of the key financial ratios of similar companies
and derivation of the same ratio for the target company.
27. It is an extremely
complicated process that can be generally viewed as a
combination of both art and science and investors may
be overwhelmed by the amount of available information
that can be potentially used in valuing stocks.
28. It is one of the basic
techniques of absolute stock valuation. The DDM is
based on the assumption that the company’s dividends
represent the company’s cash flow to its shareholders.
29. It is another popular
method of absolute stock valuation and the intrinsic value
of a stock is calculated by discounting the company’s free
cash flows to its present value.
30. It is an example of
relative stock valuation and instead of determining the
intrinsic value of a stock using the company’s
fundamentals, the comparable approach aims to derive a
stock’s theoretical price using the price multiples of
similar companies.

Lesson 3 Bonds and its Features and Types of Bonds

Bonds

In finance, a bond is an instrument of indebtedness of the bond issuer to the holders.

Bonds are form of a long-term debt. A liability of a company that has a specified principal value, and maturity date.
Its principal is also called the face value, in which the amount of the bond is printed on the face, or its par value.

Company, as the debtor is the bond issuer; and investor, as creditor, is the bondholder. Bondholders receive
interest that is stated on the face of the bond. Interest is also called the yield expressed as: current yield or yield to maturity.

The bond is a debt security, under which the issuer owes the holders a debt and (depending on the terms of the
bond) is obliged to pay them interest (the coupon) or to repay the principal at a later date, termed the maturity date.

Interest is usually payable at fixed intervals (semi-annual, annual, sometimes monthly). Very often the bond is
negotiable, that is, the ownership of the instrument can be transferred in the secondary market. This means that once the
transfer agents at the bank medallion stamp the bond, it is highly liquid on the secondary market.

Thus a bond is a form of loan or IOU: the holder of the bond is the lender (creditor), the issuer of the bond is the
borrower (debtor), and the coupon is the interest. Bonds provide the borrower with external funds to finance long-term
investments, or, in the case of government bonds, to finance current expenditure.

Certificates of deposit (CDs) or short-term commercial paper are considered to be money market instruments and
not bonds: the main difference is the length of the term of the instrument.

Bonds and stocks are both securities, but the major difference between the two is that (capital) stockholders have
an equity stake in a company (that is, they are owners), whereas bondholders have a creditor stake in the company (that is,
they are lenders).

Being a creditor, bondholders have priority over stockholders. This means they will be repaid in advance of
stockholders, but will rank behind secured creditors, in the event of bankruptcy. Another difference is that bonds usually
have a defined term, or maturity, after which the bond is redeemed, whereas stocks typically remain outstanding
indefinitely. An exception is an irredeemable bond, such as a consol, which is a perpetuity, that is, a bond with no maturity.

Features

Two features of a bond - the principal determinants of a bond's coupon rate

1. Credit Quality -If the issuer has a poor credit rating, the risk of default is greater, and these bonds pay more
interest.

2. Time to Maturity - Bonds that have a very long maturity date also usually pay a higher interest rate.
Characteristics of a Bond

 A bond is generally a form of debt which the investors pay to the issuers for a defined time frame. In a layman’s
language, bond holders offer credit to the company issuing the bond.

 Bonds generally have a fixed maturity date.

 All bonds repay the principal amount after the maturity date; however some bonds do pay the interest along with the
principal to the bond holders.

Types of Bonds

Bonds are rated based on the business and financial risk associated with the issuing company, the type of bond
also figures into the risk calculation. ( Brandt)

According to Type of Security

1. Secured bonds or mortgage bonds - are backed by the firmed-owned property. Mortgages are the most common
type of secured bonds and backed by real estate assets. Other form of collateral may depend on the nature of the
business of the bond issuer.

2. Debentures – are unsecured long-term bonds of a corporation. These debentures are paid after the secured
bondholders have been satisfied, making these bonds more risky than secured bonds. Companies with more than
one set of debentures often describe the hierarchy of payment in the indenture that accompanies the bond issue.

3. Assumed bonds – are those absorbed by the surviving corporation. They remained unchanged with the same
protection on mortgage lien given to the bond.

4. Guaranteed bonds – is a type of bond in which payment of interest, or principal, or both, is guaranteed by one or
more individuals or corporations. This assured additional protection on the part of the bondholder.

5. Joint Bonds – are owned by several companies. The same property may be used as security for a bond issue. The
companies bind themselves jointly as debtors in this issue.

According to Participation of Earnings

1. Municipal bonds or Government Bonds – are issued by country, cities, municipality or any authorized public
authority such a school boards, highway commissions, post districts. The funds appropriated by the citizens will be
paid over a period of time as stated in the levy proposal, but it allows the agency to sell bonds immediately to fund
the projects. Municipal bonds are able to offer a lower rate of interest than corporate bonds, because the interest
income is exempt from income taxes.

2. Pure discount bonds – promises to pay a certain amount at a specified time in the future. Before maturity, the
instrument trades at a price that is less than the promised future payment. The difference between the par value
and the selling price is the bond discount. Most corporate bonds are coupon bonds, where interest payments are
made regularly, as scheduled, between the original issue date and the maturity date.

3. Registered bonds – identify the names of the owners in the transfer books of the company. The owners receive
payment for interest and principal by checks drawn in their favor.

4. Income bonds – have fixed rate of interest payable only if earned and declared by the board of directors. If the
income of the company is insufficient to provide for the full contractual interest payment, no legal default results as
with the fixed interest bond.

5. Participating bonds – stipulates a fixed coupon rate but which also provides a method of receiving additional income
over and above the minimum sum. The additional income comes from the corporate earnings then available and
paid out as dividends.

6. Convertible bonds – are generally debenture bonds or junior-lien mortgage bonds wherein the owner as option to
exchange his bond for a specified number of shares of common stock, preferred stock or other types of bonds.

7. Bonds with warrants – has the option or right to purchase stock at a stated price during a stipulated period of time.
Detachable warrants are sold or exercised apart from the bond, while non-detachable warrant cannot be sold or
exercised separately from the bond.

According to Method of Retirement

 1. Serial bonds – mature semi-annually or annually instead of all on a single date. Staggered payments is the effect of
payment in series.

2. Sinking fund bonds – requires the issuer to deposit annually certain sum of money with the trustee of the issue for
the retirement of the part of the issue before maturity. This has periodic repayments of the obligation.

3. Callable bonds – has the provision that the issue can be cancelled or called. The call privilege enables the issuing
company to pay off a bond issue prior to maturity.

4. Perpetual bonds – are those which the holder cannot redeem payment. This is commonly used in public finance,
where the debtor, the government, may be assumed to have permanent existence.

All bonds can be classified as premium, par or discount bonds, depending on whether their current price exceeds,
is equal to, or is less than the face value.

At maturity, the price of the bond must equal the principal amount to be returned.

If a bond is selling at a premium, the price must fall toward face value as maturity approaches, even if interest rates
do not change.

If a bond is selling at a discount, the price must rise toward the face value as maturity approaches, even if interest
rates do not change.

The effect of a given change in interest rates on the price of the bond depends upon these variables:

 The maturity of the bond

 The coupon rate

 The level of interest rates at the time of the change in interest rates.

The interest rate risk is the risk that a bond’s price will change due to a change in interest rates. The bond price
moves inversely with interest rates. The longer the maturity of a bond, the more sensitive is its price to a change in interest
rates, holding other factors constant. The price sensitivity of bonds increases with maturity, but it increases at a decreasing
rate. The lower the coupon rate on a bind, the more sensitive is its price to a change in interest rates, holding other factors
constant, except for perpetuities.

Bonds as Differentiated from Stocks:

Bond is an instrument of debt, while stock an instrument of ownership in a business.

Bondholders are given priority in payment of obligations, over the stockholders

Bonds interests are fixed while dividends to stockholders vary with the income of the business and those declared by the
board of directors
Bonds have maturity date to pay the principal or interest, while stocks, as capital financing, do not have maturity dates.

Bondholders have no voting right nor influence in the management of the corporation, except if there are provisions in
the indenture agreement, while common stocks have voting rights.
LEARNING ACTIVITY
9. These bonds are
Identify the word or group of words that is being owned by several companies, the same property may be
referred to in the sentence. used as security for a bond issue and bind themselves
jointly as debtors in this issue.
1. These are form of a
long-term debt. 10. These are issued by
country, cities, municipality or any authorized public
2. It refers to the bond authority such a school boards, highway commissions,
issuer. post districts.

3. It refers to the 11. These are promises

bondholder. to pay a certain amount at a specified time in the future.

4. 1If the issuer has a 12. It identifies the

poor credit rating, the risk of default is greater, and these
bonds pay more interest.
5. These are backed by
the firmed-owned property. Mortgages are the most
common type of secured bonds and backed by real
estate assets.
6. These are unsecured
long-term bonds of a corporation and are paid after the
secured bondholders have been satisfied, making these
bonds more risky than secured bonds.
7. These are those
absorbed by the surviving corporation. They remained
unchanged with the same protection on mortgage lien
given to the bond.
8. It is a type of bond in
which payment of interest, or principal, or both, is
guaranteed by one or more individuals or corporations
and assured additional protection on the part of the
bondholder.
names of the owners in the transfer books of the
company and the owners receive payment for interest
and principal by checks drawn in their favor.
13. They have fixed rate
of interest payable only if earned and declared by the
board of directors and if the income of the company is
insufficient to provide for the full contractual interest
payment, no legal default results as with the fixed interest
bond.
14. It stipulates a fixed
coupon rate but which also provides a method of
receiving additional income over and above the minimum
sum and the additional income comes from the corporate
earnings then available and paid out as dividends.
15. These bonds are
generally debenture bonds or junior-lien mortgage bonds
wherein the owner as option to exchange his bond for a
specified number of shares of common stock, preferred
stock or other types of bonds.
 16. It has the option or
right to purchase stock at a stated price during a
stipulated period of time. Detachable warrants are sold or
exercised apart from the bond, while non-detachable
warrant cannot be sold or exercised separately from the
bond.
17. These bonds mature
semi-annually or annually instead of all on a single date.
privilege enables the issuing company to pay off a bond
issue prior to maturity.
20. These bonds are
those which the holder cannot redeem payment and this
is commonly used in public finance, where the debtor, the
government, may be assumed to have permanent
existence.

18. It requires the issuer

to deposit annually certain sum of money with the trustee Answer the following:
of the issue for the retirement of the part of the
issue before maturity and it has periodic repayments of 1. Discuss the characteristic of bonds.
the obligation.
2. Differentiate bonds from stocks.
19. It has the provision
that the issue can be cancelled or called and the call

Lesson 4 Bond Valuation, Bond Yield, and Bond Markets

Bond Valuation

Bond valuation is the determination of the fair price of a bond. As with any security or capital investment, the
theoretical fair value of a bond is the present value of the stream of cash flows it is expected to generate. Hence, the value
of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate.

In practice, this discount rate is often determined by reference to similar instruments, provided that such
instruments exist. Various related yield-measures are then calculated for the given price. Where the market price of bond is
less than its face value (par value), the bond is selling at a discount. Conversely, if the market price of bond is greater than
its face value, the bond is selling at a premium. For this and other relationships between price and yield.

The market price of a bond is the present value of all expected future interest and principal payments of the bond,
here discounted at the bond's yield to maturity (i.e. rate of return). That relationship is the definition of the redemption yield
on the bond, which is likely to be close to the current market interest rate for other bonds with similar characteristics, as
otherwise there would be arbitrage opportunities. The yield and price of a bond are inversely related so that when market
interest rates rise, bond prices fall and vice versa.

The bond's market price is usually expressed as a percentage of nominal value: 100% of face value, "at par",
corresponds to a price of 100; prices can be above par (bond is priced at greater than 100), which is called trading at a
premium, or below par (bond is priced at less than 100), which is called trading at a discount.

The market price of a bond may be quoted including the accrued interest since the last coupon date. (Some bond
markets include accrued interest in the trading price and others add it on separately when settlement is made.)

The price including accrued interest is known as the "full" or "dirty price". The price excluding accrued interest is
known as the "flat" or "clean price".

Bonds are not necessarily issued at par (100% of face value, corresponding to a price of 100), but bond prices will
move towards par as they approach maturity (if the market expects the maturity payment to be made in full and on time) as
this is the price the issuer will pay to redeem the bond. This is referred to as "pull to par". At the time of issue of the bond,
the coupon paid, and other conditions of the bond, will have been influenced by a variety of factors, such as current market
interest rates, the length of the term and the creditworthiness of the issuer. These factors are likely to change over time, so
the market price of a bond will vary after it is issued.

The interest payment ("coupon payment") divided by the current price of the bond is called the current yield (this is
the nominal yield multiplied by the par value and divided by the price). There are other yield measures that exist such as the
yield to first call, yield to worst, yield to first par call, yield to put, cash flow yield and yield to maturity. The relationship
between yield and term to maturity (or alternatively between yield and the weighted mean term allowing for both interest and
capital repayment) for otherwise identical bonds derives the yield curve, a graph plotting this relationship.

If the bond includes embedded options, the valuation is more difficult and combines option pricing with discounting.
Depending on the type of option, the option price as calculated is either added to or subtracted from the price of the
"straight" portion.

Bond markets, unlike stock or share markets, sometimes do not have a centralized exchange or trading system.
Rather, in most developed bond markets such as the U.S., Japan and Western Europe, bonds trade in decentralized,
dealer-based over-the-counter markets. In such a market, market liquidity is provided by dealers and other market
participants committing risk capital to trading activity. In the bond market, when an investor buys or sells a bond, the
counterparty to the trade is almost always a bank or securities firm acting as a dealer. In some cases, when a dealer buys a
bond from an investor, the dealer carries the bond "in inventory", i.e. holds it for their own account. The dealer is then
subject to risks of price fluctuation. In other cases, the dealer immediately resells the bond to another investor.

Bond markets can also differ from stock markets in that, in some markets, investors sometimes do not pay
brokerage commissions to dealers with whom they buy or sell bonds. Rather, the dealers earn revenue by means of the
spread, or difference, between the price at which the dealer buys a bond from one investor—the "bid" price—and the price
at which he or she sells the same bond to another investor—the "ask" or "offer" price. The bid/offer spread represents the
total transaction cost associated with transferring a bond from one investor to another.

Bond Yield

Bond yield is the return an investor realizes on a bond. The bond yield can be defined in different ways. Setting the
bond yield equal to its coupon rate is the simplest definition. The current yield is a function of the bond's price and its
coupon or interest payment, which will be more accurate than the coupon yield if the price of the bond is different than its
face value. More complex calculations of a bond's yield will account for the time value of money and compounding interest
payments. These calculations include yield to maturity (YTM), bond equivalent yield (BEY) and effective annual yield (EAY).

The yield is the rate of return received from investing in the bond. It usually refers either to:

 The current yield, or running yield, which is simply the annual interest payment divided by the current market price
of the bond (often the clean price).

 The yield to maturity, or redemption yield, which is the internal rate of return earned by an investor who buys a bond
at a given market price, receives all interest and principal payments on schedule, and holds the bond to maturity.
Because it takes into account the present value of a bond's future interest payments, it is a more accurate measure
of the return on a bond than current yield.

Overview of Bond Yield

When investors buy bonds, they essentially lend bond issuers money. In return, bond issuers agree to pay investors
interest on bonds through the life of the bond and to repay the face value of bonds upon maturity. The simplest way to
calculate a bond yield is to divide its coupon payment by the face value of the bond. This is called the coupon rate.

Annual Coupon Payment

If a bond has a face value of Php 1,000 and made interest or coupon payments of Php 100 per year, then its
coupon rate is 10% (Php 100 / Php 1,000 = 10%). However, sometimes a bond is purchased for more than its face value
(premium) or less than its face value (discount), which will change the yield an investor earns on the bond.

Bond Yield vs. Price

As bond prices increase, bond yields fall.

For example, assume an investor purchases a bond that matures in five years with a 10% annual coupon rate and
a face value of Php 1,000. Each year, the bond pays 10%, or Php 100, in interest. Its coupon rate is the interest divided by
its par value.

If interest rates rise above 10%, the bond's price will fall if the investor decides to sell it.
 For example, imagine interest rates for similar investments rise to 12.5%. The original bond still only makes a
coupon payment of Php 100, which would be unattractive to investors who can buy bonds that pay Php 125 now that
interest rates are higher.

If the original bond owner wants to sell her bond, the price can be lowered so that the coupon payments and
maturity value equal yield of 12%.

In this case, that means the investor would drop the price of the bond to Php 927.90. In order to fully understand
why that is the value of the bond, you need to understand a little more about how the time value of money is used in bond
pricing.

If interest rates were to fall in value, the bond's price would rise because its coupon payment is more attractive.

For example, if interest rates fell to 7.5% for similar investments, the bond seller could sell the bond for Php
1,101.15. The further rates fall, the higher the bond's price will rise, and the same is true in reverse when interest rates rise.

In either scenario, the coupon rate no longer has any meaning for a new investor. However, if the annual coupon
payment is divided by the bond's price, the investor can calculate the current yield and get a rough estimate of the bond's
true yield.

The current yield and the coupon rate are incomplete calculations for a bond's yield because they do not account
for the time value of money, maturity value or payment frequency. More complex calculations are needed to see the full
picture of a bond's yield.

Yield to Maturity

A bond's yield to maturity (YTM) is equal to the interest rate that makes the present value of all a bond's future cash
flows equal to its current price. These cash flows include all the coupon payments and its maturity value. Solving for YTM is
a trial and error process that can be done on a financial calculator, but the formula is as follows:

In the previous example, a bond with Php 1,000 face value, five years to maturity and Php 100 annual coupon
payments was worth Php 927.90 in order to match a YTM of 12%. In that case, the five coupon payments and the Php
1,000 maturity value were the bond's cash flows. Finding the present value of each of those six cash flows with a
discount or interest rate of 12% will determine what the bond's current price should be.

Bond Equivalent Yield – BEY

Bond yields are normally quoted as a bond equivalent yield (BEY), which makes an adjustment for the fact that
most bonds pay their annual coupon in two semi-annual payments. In the previous examples, the bonds' cash flows were
annual, so the YTM is equal to the BEY. However, if the coupon payments were made every six months, the semi-annual
YTM would be 5.979%.

The BEY is a simple annualized version of the semi-annual YTM and is calculated by multiplying the YTM by two. In
this example, the BEY of a bond that pays semi-annual coupon payments of Php 50 would be 11.958% (5.979% X 2 =
11.958%). The BEY does not account for the time value of money for the adjustment from a semi-annual YTM to an annual
rate.

Effective Annual Yield – EAY

Investors can find a more precise annual yield once they know the BEY for a bond if they account for the time value
of money in the calculation. In the case of a semi-annual coupon payment, the effective annual yield (EAY) would be
calculated as follows:

If an investor knows that the semi-annual YTM was 5.979%, then he or she could use the previous formula to find
the EAY of 12.32%. Because the extra compounding period is included, the EAY will be higher than the BEY.

To Further Discuss the Topics on:

Valuation of Bonds

Any organization intending to float bonds has to determine their value (or the price at which investors would be
willing to buy the bonds) which is dependent on their desired rate of return. Thus the value of the bonds is equal to the
present value of future cash flows that an investor may expect from the bond indenture discounted at their desired rate of
return.

For example:

On January 1, 2014, X Corp. is issuing 10%, 5-year bonds with face value of Php 1,000 each. Considering the risks
involved, investors desire a 12% rate of return on their investments. What should be the bond quotation to attract investor?

Disregarding income tax effects, the computation for the price acceptable to investors is based on the 12% desired
rate of return and the future cash flows as shown in the following diagram.

Year 1 Year 2 Year 3 Year 4 Year 5

Php 100 Php 100 Php 100 Php 100 Php 100

Php 1,000

The computation is as follows:

PV of Annual interest of Php 100 PV of Php 1,000 Discounted

Valuation of Bonds (VB) = x

Discounted at 12% for 5 years at 12% for 5 years

= (Php 100 x 3.605) + (Php 1,000 X 0.567)

= Php 360.50 + Php 567. 50

= Php 927.50 or Php 928

Note:
 The Present Value (PV) PV of Annual interest of Php 100 Discounted at 12% for 5 years (3.605) and PV of Php
1,000 Discounted at 12% for 5 years (0.567). (From the Financial Table).

The following schedule proves this:

Date 12% Income Payments to Value of Bonds

Investor

Jan. 1, 2014 Php 928

Dec.31, 2014 Php 111 1,039

Jan.1, 2015 Php 100 939

Dec.31, 2015 113 1,052

Jan.1, 2016 100 952

Dec.31, 2016 114 1,066

Jan.1, 2017 100 966

Dec.31, 2017 116 1,082

Jan.1, 2018 100 982

Dec.31, 2018 118 1,100

Jan. 1, 2019 100 1,000

1,000 0

Based on the foregoing computations, the bonds should be quoted at 92.8 at most to attract investors.

Bond Premiums / Bond Discounts and Yield on Bonds

Acquisition of bonds at a discount raises yield thereon and vice versa. This is due to the fact that periodic interest
payments are based on face value of the bonds regardless of whether they are issued at a premium or at a discount.

In the preceding example, 10%, 5-year bonds of Php 1,000 earn 12% or 2 % higher than face or par value if issued
at 92.8 or for Php 928 each.

Yield on Bonds

An investor in bonds may determine the yield thereon using the trial-and-error approach whereby he uses one rate
after another in discounting cash flows until he arrives at a present value equal to the value of the bonds

(or acquisition cost). A simpler way of doing it is to first approximate the rate of return by using the formula given below and
then use the present value factors at at rates that are more or less equal to the approximate rate as arrived at.

To approximate yield on bonds, the following formula is used:

Interest per annum + [(Principal –Value)/n]

Approximate yield = ---------------------------------------------------------

(Principal + Value)/2

Or

I + [(P –V)/n]

Approximate yield = ----------------------

(P + V)/2
 Applying the formula on the given example, approximate yield is arrived at as follows:

I + [(P –V)/n]

Approximate yield = ----------------------

(P + V)/2

Php 100 + [(Php 1,000 – Php 928)/5

= ---------------------------------------------
(Php 1,000 + Php 928)/2

Php 100 + Php 72/5

= ----------------------------------
(Php 1,000 + Php 928)/2

Php 100 + Php 14.40

= ------------------------------
Php 1,928/2

Php 114.40
= -------------------
Php 964

= 0.118672 or 11.867% or 11.87%

With approximate yield on bonds equal to 11.87% or more or less 12% cash flows may be discounted at this rate to
determine if the present value thereof would be equal to Php 928.

Flotation Issue Costs

Floating of bonds involves costs such as legal fees, underwriter’s commissions, printing and advertising. These
require cash outlays and are deducted from bond issue price in arriving at net proceeds from bond flotation.

Bond Quotations, Premiums and Discounts

Bonds are quoted in percentages (unlike shares of stock which are quoted in pesos). Thus, if a bond issue is at Php
96, it means that the issue price is 96% of face value.

Example:

On January 1, 2014, DEF, Inc. issues Php 1 Million worth of 5-year, 15% bonds at 96 with each bonds having face
value of Php 10,000. Interest is payable every December 31 st. Flotation costs amount to Php 34,000.

The bonds will mature on January 1, 2019. Annual interest is Php 150,000 (or Php 1,000,000 x 15%). Net proceeds
from the bond issue amount to Php 926,000, arrived at as follows:

Face Value of Bonds (100 bonds x Php 10,000) Php 1,000,000

Issued at 96%

Issue Price Php 960,000

Less: Flotation Costs 34,000

Net Proceeds Php 926,000

Bond Premium and Discount

 When bonds are sold at prices higher than the face (or par) value, the difference is called bond premium. In a
reverse case, the difference is called bond discount. In the given example above, the discount is originally Php 40,000.
However, with the flotation cost of Php 34,000, the discount, in effect, becomes Php 74,000 (or the difference between face
value of Php 1,000,000 and the net proceeds of Php 926,000).

Bond Markets

The bond market (also debt market or credit market) is a

financial market where participants can issue new debt, known as
the primary market, or buy and sell debt securities, known as the
secondary market. This is usually in the form of bonds, but it may
include notes, bills, and so on.

The market price of a tradable bond will be influenced,

amongst other factors, by the amounts, currency and timing of the interest payments and capital repayment due, the quality
of the bond, and the available redemption yield of other comparable bonds which can be traded in the markets.

The price can be quoted as clean or dirty. "Dirty" includes the present value of all future cash flows, including
accrued interest, and is most often used in Europe. "Clean" does not include accrued interest, and is most often used in the
U.S.

The issue price at which investors buy the bonds when they are first issued will typically be approximately equal to
the nominal amount. The net proceeds that the issuer receives are thus the issue price, less issuance fees. The market
price of the bond will vary over its life: it may trade at a premium (above par, usually because market interest rates have
fallen since issue), or at a discount (price below par, if market rates have risen or there is a high probability of default on the
bond).

Pricing Bonds

Bonds are generally priced at a face value (also called par) of Php 1,000 per bond, but once the bond hits the open
market, the asking price can be priced lower than the face value, called a discount, or higher, called premium.

If a bond is priced at a premium, the investor will receive a lower coupon yield, because they paid more for the
bond.

If it's priced at a discount, the investor will receive a higher coupon yield, because they paid less than the face
value.

Bond prices tend to be less volatile than stocks and they often responds more to interest rate changes than other
market conditions. This is why investors looking for safety and income often prefer bonds over stocks as they get closer to
retirement.

A bond's duration is its price sensitivity to changes in interest rates—as interest rates rise bond prices fall, and vice-
versa. Duration can be calculated on a single bond or for an entire portfolio of bonds.

LEARNING ACTIVITY 6. The price excluding

accrued interest of the bond.
Identify the word or group of words that is being
referred to in the sentence. 7. It is the return an
investor realizes on a bond.
1. It refers to the
determination of the fair price of a bond. 8. It is a function of the
bond's price and its coupon or interest payment, which
2. Where the market will be more accurate than the coupon yield if the price of
price of bond is selling less than its face value (par the bond is different than its face value.
value),
9. It is the internal rate
3. If the market price of of return earned by an investor who buys a bond at a
bond is selling greater than its face value. given market price, receives all interest and principal
payments on schedule, and holds the bond to maturity.
4. It is the present value
of all expected future interest and principal payments of 10. It is equal to the
the bond. interest rate that makes the present value of all a bond's
future cash flows equal to its current price.
5. The price including
accrued interest of the bond.
Problem: Solve the following. Lesson 4 consists of the bond valuation, bond yield, and
bond markets.
For each of the following independent case,
determine; Congratulations! You have just studied Module II.
Now you are ready to evaluate how much you have
(a) Net proceeds benefited from your reading by answering the summative
test. Good Luck!!!
(b) Annual Interest Payments
SUMMATIVE TEST
Case I Case II Case III
Principal Php Php Php Answer the following:
100,000 75,000 150,000
1. Enumerate and discuss the characteristics
Issued at 96 105 98
and features of preferred shares.
Flotation 15,000 7,500 17,500
Cost 2. Discuss the significance of the stock market.
Interest Rate 6% 8% 5%
3. Discuss the difference between equity
shares and preference share.

4. The liability of equity shareholders is limited

to the extent of their investment. Comment.

5. Identify bonds market and how it works.

MODULE SUMMARY 6. The interest rate risk is the risk that a bond’s
price will change due to a change in interest
In Module II, you have learned about the nature rates. Why? Support your answer.
and features of preferred shares, and nature and features
of ordinary equity shares, market for stocks, types of
stock market transactions, and stock valuation, bonds
and its features and types of bonds, bond valuation, bond
yield, and bond markets.

There are four lessons in Module II.

Lesson 1 consists of the nature and features of preferred

shares, and nature and features of ordinary equity
shares.

Lesson 2 deals with the market for stocks, types of stock

market transactions, and stock valuation.

Lesson 3 deals with the bonds and its features and types
of bonds.