CORPORATE FINANCE II

FUNDAMENTALS OF CAPITAL BUDGETING AND

FINANCIAL INVESTMENT

Chapter 1: Capital Budgeting Cash Flows

Chapter 2: Capital Budgeting Techniques

Chapter 3: Capital Budgeting in Practice

Chapter 4: Financial investment of companies

 Faculty of Corporate Finance
Department of Corporate Finance

CHAPTER 4
FINANCIAL INVESTMENT COMPANIES

Thu TRAN, PhD

 Content

4.1. Overview of financial investment of a company

4.2. Bonds and Bond Investment

4.3. Common Stock and Stock Investment

4.4. Preferred Stock and Investment in Preferred Stocks

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 Learning Objectives

• To understand the definition of financial investments of a

company.
• To identify the basic financial assets: bonds and stocks.
• To understand the features of bonds and the method for valuing
different types of bonds.
• To interpret the inverse relationship between the bond prices and
the interest rates.
• To calculate the bond yields.
• To understand the features of common stocks and methods for
valuing different types of common stock.
• To classify between the common stocks and preferred stocks.

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 4.1. Overview of financial investment

v Definition:
v refers to the activities of using capital to buy securities or other financial
instruments to maximize profitability and minimize risks for a company.
v Motives for financial investments:

v This chapter focuses on investing in bonds and stocks. Financial

managers need to value bonds and stocks and make sound investment
decision.

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 4.1. Overview of financial investment
v Perspective on Valuation:
v Discounted Cashflow Model: the value of a security is equal to the total
present value of the expected future cashflows that an investor could
receive in the future
𝒏
𝑪𝑭𝟏 𝑪𝑭𝟐 𝑪𝑭𝒏 𝑪𝑭𝒕
𝑽𝒂𝒍𝒖𝒆 = + + ⋯+ =*
(𝟏 + 𝒓)𝟏 (𝟏 + 𝒓)𝟐 (𝟏 + 𝒓)𝒏 (𝟏 + 𝒓)𝒕
𝒕%𝟏

CF: the cash flow that an investor would receive for the given year;

CF1 is for year 1, CFn is for year n. r: the discount rate

v Limitation of DCF:

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 4.2. Bonds and Bond Investment
v Definition:
v From investor side:

v From issuer side:

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 4.2. Bonds and Bond Investment

v Bond characteristics:
v Debt sercurities: Investors who buy bonds become the debt holders and
have a right to receive periodical interest plus principal timely.
v Face value: par value or nominal value, is the amount of money the bond
will be worth at maturity
v Coupon: the annual interest rate paid on a bond, expressed as a
percentage of the face value and paid from issue date until maturity
v Maturity: maturity defines the lifetime of the bond. This is the date on
which the bond issuers return the money lent to them by bond investors
and the issuer’s bond obligation ends

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 4.2. Bonds and Bond Investment
v Classfication:
Criteria Sub-cluster Features

Term bond Has a single maturity date at the end of its term
Maturity
Pattern A bond matures in stated amounts at regular intervals.
Serial bond
Investors can choose the maturity that suits their needs.
Variable bonds Interest depends on market conditions
Zero-coupon or
Valuation No periodic cash payments. The interest component consists
deep-discount
entirely of the bond’s discount
bonds
Commodity- These bonds are payable at prices related to a company such as
backed bonds gold.
This bond may be purchased by issuer at a specified price
Callable bonds
Redemption before maturity.
Provisions Convertible This bond may be converted into equity securities of the issuer
bonds at the option of the holder under certain conditions.
Mortgage bonds The bond is backed by specific assets, usually real estate.
This bond is backed by the issuer’s full faith and credit but not
Debentures by specific collateral. Thus, debentures are riskier to investors
Securitization than secured bonds.
This bond is used mostly by companies in the transportation
Equipment trust
industry. It is secured by a lien om a specific piece of
bonds
equipment, such as an airplane or a railroad car.
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 4.2. Bonds and Bond Investment
v Classfication:
Criteria Sub-cluster Features
Maturity
Term bond Has a single maturity date at the end of its term
Pattern
This bond is issued in the name of the holder.
Registered bonds Only the registered holder may receive interest
and principal payments.
Ownership
This bond does not require any registration.
Bearer bonds Anyone presenting the bond gets interest and
principal.
Subordinated
debentures and Junior securities with claim inferior to those of
Priority
second mortgage senior bonds.
bonds
Income bonds Interest is paid only if the issuer earns the interest.
Repayment
Provisions This bond is issued by government units and are
Revenue bonds
payable from specific revenue sources.

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 4.2. Bonds and Bond Investment

v Corporate Bond Valuation:

v Definition: Determining the theoretical fair value of a particular bond
through discounting the bond’s future interest payments and the bond’s
value upon maturity at the relevant rate.
v Classification:
v Perpetual Bond Valuation
v Bonds with specific maturity date and coupon Valuation
v Regular Bond with semi-annual coupon payment Valuation
v Zero-coupon Bond Valuation

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 4.2. Bonds and Bond Investment
v Corporate Bond Valuation:
v Perpetual Bond Valuation

'
𝑰 𝑰 𝑰 𝑰 𝑰
𝑷𝒅 = + + ⋯ + = * =
(𝟏 + 𝒓𝒅 )𝟏 (𝟏 + 𝒓𝒅 )𝟐 (𝟏 + 𝒓𝒅 )' (𝟏 + 𝒓𝒅 )𝒕 𝒓𝒅
𝒕%𝟏
Where:
I = periodic coupon payment of the bond
rd = discount rate applied to the bond or the effective rate

Example 4.1:
If a perpetual bond pays VND 100,000 per year in perpetuity and the effective
rate is assumed to be 8%, the present value would be:
Present value = VND 100,000/8% = VND 1,250,000

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 4.2. Bonds and Bond Investment
v Corporate Bond Valuation:
v Bonds with specific maturity date and coupon Valuation: A bond with
a specific maturity date and coupon is also known as a regular bond or a
coupon bond. Investors buy the regular bonds in exchange of periodic
coupon payments and face value on maturity date.
𝑰 𝑰 𝑰 𝑴𝑽
𝑷𝒅 = + + ⋯ + +
(𝟏 + 𝒓𝒅 )𝟏 (𝟏 + 𝒓𝒅 )𝟐 𝟏 + 𝒓𝒅 𝒏 (𝟏 + 𝒓𝒅 )𝒏
𝒏
𝑰 𝑴𝑽
=* +
(𝟏 + 𝒓𝒅 )𝒕 (𝟏 + 𝒓𝒅 )𝒏
𝒕%𝟏
Where:
I = periodic coupon payment of the bond
rd = discount rate applied to the bond or the effective rate
MV = Face Value of the bond
n = the years to maturity

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 4.2. Bonds and Bond Investment
v Corporate Bond Valuation:
v Regular Bond with semi-annual coupon payment Valuation:
𝟐𝒏
𝑰/𝟐 𝑴𝑽
𝑷𝒅 = * 𝒓𝒅 𝒕 + 𝒓𝒅 𝟐𝒏
𝒕%𝟏
(𝟏 + 1𝟐) (𝟏 + 1𝟐)

Valuing bonds that pay interest semi-annually involves three steps:

- Convert bond’s annual interest (I) to semi-annual interest through dividing I by 2
- Convert the years to maturity (n) to semi-annual periods through multiplying n by 2
- Convert annual required return (rd) to semi-annual discount rate through dividing I by 2
Example 4.3: A corporate bond with a face value at VND 1,000,000, an annual
interest rate of 5%, making annual interest payments for 5 years, after which the
bond matures and the principal must be repaid. Assume a YTM of 7%. Suppose the
issuer pays interest semi-annually. What should be its price?

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 4.2. Bonds and Bond Investment
v Corporate Bond Valuation:
v Zero-coupon Bond Valuation: A zero-coupon bond is a bond that pays
no interest and trades at a discount to its face value. To calculate the price
of a zero-coupon bond, the following formula is applied:

𝑴𝑽
𝑷𝒅 =
(𝟏 + 𝒓𝒅)𝒏
v In reality, zero-coupon bonds are generally compounded semi-annually. In
such situation, refers to the below equation:
𝑴𝑽
𝑷𝒅 =
(𝟏 + 𝒓𝒅/𝟐)𝟐𝒏

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 4.2. Bonds and Bond Investment

v Analyzing the Volatility of Bond Price:

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 4.2. Bonds and Bond Investment

v Analyzing the Volatility of Bond Price:

v When market interest rate = coupon rate (stated rate),
v When market interest rate < coupon rate (stated rate),
v When market interest rate > coupon rate (stated rate),
v If the interest goes up, the bond price goes …….. and vice versa.
v The longer the maturity of the bond, the ………… the price change for
any given change in interest rate.

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 4.2. Bonds and Bond Investment
v Bond Yield:
v Yield to Maturity: YTM is the rate of return the bond offers at a specific
price, if held to maturity.

𝑰 𝑰 𝑰 𝑴𝑽
𝑷𝒅 = + + ⋯ + +
(𝟏 + 𝒀𝑻𝑴)𝟏 (𝟏 + 𝒀𝑻𝑴)𝟐 𝟏 + 𝒀𝑻𝑴 𝒏 (𝟏 + 𝒀𝑻𝑴)𝒏

𝒏
𝑰 𝑴𝑽
=* +
(𝟏 + 𝒀𝑻𝑴)𝒕 (𝟏 + 𝒀𝑻𝑴)𝒏
𝒕%𝟏

Example 4.4: A bond with par value VND 1,000,000, 5 years to maturity, a
coupon rate of 10%, is trading at VND 1,050,000. If an investor buys this bond
and hold to maturity, what is the YTM of this bond?

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 4.2. Bonds and Bond Investment
v Bond Yield:
v Yield to Call: Yield to call (YTC) is the returns a bondholder receives if
the bond is held until the call date

𝑰 𝑰 𝑰 𝑷𝒄
𝑷𝒅 = + + ⋯ + +
(𝟏 + 𝒀𝑻𝑪)𝟏 (𝟏 + 𝒀𝑻𝑪)𝟐 𝟏 + 𝒀𝑻𝑪 𝒏 (𝟏 + 𝒀𝑻𝑪)𝒏

𝒏
𝑰 𝑷𝒄
=* +
(𝟏 + 𝒀𝑻𝑪)𝒕 (𝟏 + 𝒀𝑻𝑪)𝒏
𝒕%𝟏

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 4.3. Common Stocks and Stock Investment
v Definition:
v Characteristics:
v It is one type of equity security, which indicates that holders have
particular rights related to ownership in a corporation.
v common stockholders have the right to receive dividend payments typically
from earnings if paying dividend is authorized by the board of directors
v common stockholders have the right to vote to elect directors and to approve
fundamental transactions of a company such as M&A, sales of assets, spin-
off, dissolutions
v common stockholders have the right to receive a proportionate distribution of
assets on corporate liquidation if dissolution is approved by BOD.
v Investors can receive two cash flows, one from the dividend payment and
the other from capital gains when they trade common stocks on the stock
exchange.

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 4.3. Common Stocks and Stock Investment
v Characteristics:
v Common stockholders have a residual claim to the income and assets of a
company
v If a company goes bankruptcy, the common stockholders do not get their
money until the creditors, bondholders, and preferred shareholders have
received their respective share
v When a company is unable to pay its debts, and the company is forced into
bankruptcy, common stockholders receive nothing and they loss the initial
investment in common stocks.
v Common shareholders ordinarily have pre-emptive rights. Preemptive
rights give common shareholders the right to purchase any additional
stock issuances in proportion to their current ownership percentages.

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 4.3. Common Stocks and Stock Investment
v Common Stock Valuation:
v Dividend Valuation Model:
𝑫𝟏 𝑫𝟐 𝑫𝒏 𝑷𝒏
𝑷𝑬 = + + ⋯+ +
(𝟏 + 𝒓𝑬 ) (𝟏 + 𝒓𝑬 )𝟐 (𝟏 + 𝒓𝑬 )𝒏 (𝟏 + 𝒓𝑬 )𝒏
Where:

PE = The stock value (the intrinsic value of a stock)

D1, D2, …, Dn is the dividend that an investor would receive at the end of a
particular year in the future

Pn = The resold price of a stock at the end of the investor’s horizon

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 4.3. Common Stocks and Stock Investment
v Common Stock Valuation:
v Valuing a common stock with Zero - Dividend
The simplest DCF model assumes constant dividends-zero growth. Thus, the
present value of a constant dividend stream is the present value of a perpetuity:
𝑫 𝑫 𝑫 𝑫
𝑷𝑬 = + + ⋯+ =
(𝟏 + 𝒓𝑬 )𝟏 (𝟏 + 𝒓𝑬 )𝟐 (𝟏 + 𝒓𝑬 )5 𝒓𝑬
v Valuing a common stock with constant dividend growth
𝑫𝟎 ∗(𝟏7𝒈) 𝑫𝟎 ∗(𝟏7𝒈)𝟐 𝑫𝟎 ∗(𝟏7𝒈)𝒏 𝑫𝟏
𝑷𝑬 = + + ⋯+ =
(𝟏7𝒓𝑬 )𝟏 (𝟏7𝒓𝑬 )𝟐 (𝟏7𝒓𝑬 )𝒏 𝒓𝑬 9𝒈

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 4.3. Common Stocks and Stock Investment
v Common Stock Valuation:
v Valuing a common stock with constant dividend growth
Example 4.5: Blue Diamond Corporation expects to have earnings per share of VND
12,000 in the coming year. Rather than reinvest these earnings and grow, the firm
plans to pay out all of its earnings as a dividend. With these expectation of no growth,
the firm’s current share price is VND 120,000.
Blue Diamond could cut its dividend pay-out rate to 75% for the foreseeable future
and use the retained earnings to open new stores. The return on its investment is
expected to be 12%.
Assuming its cost of equity is unchanged, what effect would this new policy have on
Blue Diamond’s stock price?

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 4.3. Common Stocks and Stock Investment
v Common Stock Valuation:
v Valuing a common stock with changing dividend growth
𝒏
𝑫𝒕 𝟏 𝑫𝒏 ∗ (𝟏 + 𝒈)
𝑷𝑬 = : + ∗
(𝟏 + 𝒓𝑬 )𝒕 (𝟏 + 𝒓𝑬 )𝒏 𝒓𝑬 − 𝒈
𝒕<𝟏

Example 4.6: Considering a stock of Corporation X with the most recent dividend of VND
3,000 per share. Corporation X expects that in the next three years, the dividend growth
rate will be 5%, 6%, 7% respectively, then remaining at 6% forever. If the required rate of
return of shareholders on the stock of Corporation X is 16% per year. What would be the
stock price of Corporation X?

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 4.3. Common Stocks and Stock Investment
v Common Stock Valuation:
v Discount Cashflow Model:

Procedure FCFF approach FCFE approach

Step 1: Estimate annual cash FCFF = EBIT – Tax – FCFE = EBIT – I – Tax –
flows from a particular Investment in assets + Investment in assets +
company Depreciation + any capital Depreciation + any capital
raised raised
Step 2: Discount obtained Discount at the overall Discount at the cost of equity
cash flows at an appropriate Weighted Average Cost of (rE ) to calculate the present
cost of capital Capital (WACC) to calculate value of the equity.
the present value of the
company. This value will be
used for valuing a whole
company
Value of Equity = Total Value
– The Value of Debt

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 4.4. Preferred Stocks and Preferred Stock Investment
v Definition: securities that represent ownership in a corporation, and
the preferred stockholders have more senior claims on the earnings and
assets of a corporation than holders of common stocks.
v Characteristics:
v One type of equity, reflecting the ownership in a corporation
v Preferred stock is also a type of debt. It has a fixed charge and increases
leverage
v Preferred stockholders have priority over common stockholders in
dividend payment
v Preferred stockholders have limited rights compared to common
stockholders. Generally, the shares do not assign voting rights to their
holders. Some preferred stocks allow its holders to vote on extraordinary
events

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 4.4. Preferred Stocks and Preferred Stock Investment
v Classification:
v Convertible preferred stock: the shares can be converted to a
predetermined number of common shares.
v Cumulative preferred stock: The missed dividend payment will be
accumulated.
v Exchangeable preferred stock: The shares can be exchanged for some
type of security.
v Perpetual preferred stock: Preferred stock with no fixed date on which
the shareholders will get the invested capital back.

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 4.4. Preferred Stocks and Preferred Stock Investment

v Preferred Stock Valuation:

𝑫 𝑫 𝑫 𝑫
𝑷𝑷 = 𝟏 + 𝟐 + ⋯+ + =
(𝟏 + 𝒓𝑷 ) (𝟏 + 𝒓𝑷 ) (𝟏 + 𝒓𝑷 ) 𝒓𝑷
Where:
D = annual dividend of a preferred share
rP = The required rate of return of investors investing in preferred stocks

Example 4.8: Blue Diamond Corporation is considering an investment in

preferred stocks issued by Company X with the following information:
- Par value: VND 1,000,000
- Dividend rate of 8% paid annually at the end of each year.
- The required rate of return on the preferred stocks is (a) 7.5%; (b) 8.5%.
Determining the value of the preferred stock of Company X.

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 Summary

o Financial investments
ü Definition and the importance to a company
ü Valuation perspective: present value of future cash flows
o Bonds and Bond Valuation
ü Debt security
ü Characteristics and classification
ü Bond Valuation: with or without coupon
ü Bond yield
ü Bond price and market interest rate
o Common Stock
ü Equity security
ü Common share rights
ü Characteristics and classification
ü Valuation: Dividend growth model and cash flows discount model
o Preferred Stock
ü Hybrid security
ü Classification
ü Valuation
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 KEY TERMS

Financial investment Face value Constant growth rate stock

Bonds Par value Changing growth rate
Coupon rate Yield to Maturity (YTM) stock
Coupon payment Yield to Call (YTC) Pay-out ratio
Semi-annual coupon payment Dividend Discount Model Retention rate
Perpetual bond Zero-coupon bond Preferred stock
Maturity Coupon bond Overpriced
Zero growth stock Fair Priced
Under-priced

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