W7 Capital Market Trading

Capital Markets 2nd Semester AY:2020-2021 Lecture Notes
W7 Capital Market Trading
Learning Objectives:
• Describe capital market trading.

• Explain the nature and trading process of corporate bonds.
• Compare the characteristics of ordinary equity shares, preferred shares and bonds.
• Apply the formulas illustrated in this lesson.
Introduction
Capital market trading occurs in either the primary market or the secondary market. The primary market is
where new issues of stocks and bonds are introduced. Investment funds, corporations, and individual
investors can all purchase securities offered in the primary market. You can think of a primary market
transaction as one where the issuer of the security actually receives the proceeds of the sale. When firms
sell securities for the very first time, the issue is an initial public offering (IPO). Subsequent sales of a firm’s
new stocks or bonds to the public are simply primary market transactions (as opposed to an initial one).
The capital markets have well-developed secondary markets. A secondary market is where the sale of
previously issued securities takes place, and it is important because most investors plan to sell long-term
bonds before they reach maturity and eventually their holdings of stock as well. There are two types of
exchanges in the secondary market for capital securities: organized exchanges and over-the-counter
exchanges. Whereas most money market transactions originate over the phone, most capital market
transactions, measured by volume, occur in organized exchanges. An organized exchange has a building
where securities (including stocks, options, and features) trade. Exchange rules govern trading to ensure
the efficient and legal operation of the exchange, and the exchange’s board constantly reviews these rules
to ensure that they result in competitive trading.
A. BONDS
A bond is any long-term promissory note issued by the firm. A bond certificate is the tangible
evidence of debt issued by a corporation or a governmental body and represents a loan made by investors
to the issuer. Bonds are the most prevalent example of the interest only loan with investors receiving
exactly the same two sets of cash flows.
(1) the periodic interest payments and
(2) the principal (par value or face value) returned at maturity
Trading Process for Corporate Bonds
The initial or primary sale of corporate bond issues occurs either through a public offering using an
investment bank serving as a security underwriter or through a private placement to a small group of
investors (often financial institutions). Generally, when a firm issues bonds to the public, many investment
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banks are interested in underwriting the bonds. The bonds can generally be sold in a national market.
Resource: Cabrera, M.E., Cabrera, G.A. (2020).Financial Markets and Institutions.GIC Enterprises & Co., Inc
Teacher: Annaliza R. Marcojos, CPA
Most often, corporate bonds are offered publicly through investment banking firms as underwriters.
Normally, the investment bank facilitates this transaction using a firm commitment underwriting,
illustrated in Figure 1. The investment bank guarantees the firm a price for newly issued bonds by buying
the whole issue at a fixed price (the bid price) from the bond-issuing firm at a discount from par. The
investment bank then seeks to resell these securities to investors at a higher price (the offer price). As a
result, the investment bank takes a risk that it may not be able to resell the securities to investors at a
higher price. This may occur if a firm’s bond value suddenly falls due to an unexpected change in interest
rates or negative information being released about the issuing firm. If this occurs, the investment bank
takes a loss on its security underwriting. However, the bond issuer is protected by being able to sell the
whole issue.
Figure 1 https://images.app.goo.gl/kZjY7AmkPSKpUTjd8
Other arrangements can be as follows:
1. Competitive Sale
The investment bank can purchase the bonds through competitive bidding against other investment
banks or by directly negotiating with the issuer.
2. Negotiated Sale
With a negotiated sale, a single investment bank obtains the exclusive right to originate, underwrite
and distribute the new bonds through a one-on-one negotiation process. With a negotiated sale, the
investment bank provides the origination and advising services to the issuers.
3. Best Efforts Underwriting Basis

In their arrangement, the underwriter does not guarantee a firm price to the issuer. The investment
bank incurs no risk of mispricing the security since it simply seeks to sell the securities at the best
market price it can get for the issuing firm
Advantages of Using Bonds
1. Long-term debt is generally less expensive than other forms of financing because
a. Investors view debt as a relatively safe investment alternative and demand a lower rate of
return, and
b. Interest expenses are tax deductible.
2. Bondholders do not participate in extraordinary profits; the payments are limited to interest.
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3. Bondholders do not have voting rights.
4. Flotation costs of bonds are generally lower than those of ordinary (common) equity shares.
Disadvantages of Using Bonds
1. Debt (other than income bonds) results in interest payments that, if not met, can force the firm into
bankruptcy.
2. Debt (other than income bonds) produces fixed charges, increasing the firm’s financial leverage.
Although this may not be a disadvantage to all firms, it certainly is for some firms with unstable earnings
streams.
3. Debt must be repaid at maturity and thus at some point involves a major cash outflow.
4. The typically restrictive nature of indenture covenants may limit the firm’s future financial flexibility.
As of September 2019, the following are bond issuances by the government business firms in the
Philippines secured by Bond Funds and part of the Investment Portfolio of Mutual Funds:
ALFM Peso Bonds

Grepalife Bonds
Philam Bonds
Philequity Peso Bonds
Sun Life Prosperity Bonds
RCBC “Sustainability” Bonds
Robinsons Bank Fixed Rate Corporate Bonds
PH Samurai Bonds
Ayala Land Inc. (PH) Bonds
Bond Features and Prices

The various features of corporate bonds and some of the terminology associated with bonds follow:
• Par Value – The face value of the bond is returned to the bondholder at maturity.
• Coupon Interest Rate – The percentage of the par value of the bond that will be paid out annually
in the form of interest. Formula is:
Stated interest payment/ Par Value
• Maturity – The length of time until the bond issuer returns the par value to the bondholder and
terminates the bond.
• Indenture – The agreement the firm issuing the bonds and the bond trustee who represents the
bondholders. It provides the specific terms of the loan agreement, including the description of the
bonds, the rights of the bondholders, the rights of the issuing firm and the responsibilities of the
trustees.
• Current Yield – This refers to the ratio of the annual interest payment to the bond’s market price.
• Yield to Maturity – This refers to the bond’s internal rate of return. It is the discount rate that
equates the present value of the interest and principal payments with the current market price of
the bond.
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Formula:
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𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 − 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓𝑡ℎ𝑒 𝐵𝑜𝑛𝑑

𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 +
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠 𝑡𝑜 𝑀𝑎𝑡𝑢𝑟𝑖𝑡𝑦
𝐴𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑒 𝑌𝑖𝑒𝑙𝑑 =
. 6(𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐵𝑜𝑛𝑑) + .4 (𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑃𝑎𝑦𝑚𝑒𝑛𝑡)
Illustrative Problem 1: Determination of Bond Yield to maturity
Par value of bond : P1,000

Interest rate : 10%
Term : 10 years
Current price :P900
What is the bond’s approximate yield to maturity?
Solution:
1,000 − 900
100 +
𝐴𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑒 𝑌𝑖𝑒𝑙𝑑 = 10
. 6(900) + .4 (1,000)
110
= 940 𝑂𝑅 11.70%
What is the Yield to Maturity (YTM)?
Yield to Maturity (YTM) – otherwise referred to as redemption or book yield – is the speculative rate of return or
interest rate of a fixed-rate security, such as a bond. The YTM is based on the belief or understanding that an investor
purchases the security at the current market price and holds it until the security has matured (reached its full value),
and that all interest and coupon payments are made in a timely fashion.
Where:
C – Interest/coupon payment
FV – Face value of the security
PV – Present value/price of the security
t – How many years it takes the security to reach maturity
The formula’s purpose is to determine the yield of a bond (or other fixed-asset security) according to its most recent
market price. The YTM calculation is structured to show – based on compounding – the effective yield a security
should have once it reaches maturity. It is different from simple yield, which determines the yield a security should
have upon maturity, but is based on dividends and not compounded interest.
Approximated YTM
It’s important to understand that the formula above is only useful for an approximated YTM. In order to calculate the
true YTM, an analyst or investor must use the trial and error method. This is done by using a variety of rates that are
substituted into the current value slot of the formula. The true YTM is determined once the price matches that of the
security’s actual current market price.
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Illustrative Problem 2. Example of a YTM Calculation

To get a better understanding of the YTM formula and how it works, let’s look at an example.
Assume that there is a bond on the market priced at $850 and that the bond comes with a face value of $1,000 (a
fairly common face value for bonds). On this bond, yearly coupons are $150. The coupon rate for the bond is 15% and
the bond will reach maturity in 7 years.
The formula for determining approximate YTM would look like below:
Importance of Yield to Maturity
The primary importance of yield to maturity is the fact that it enables investors to draw comparisons between
different securities and the returns they can expect from each. It is critical for determining which securities to add to
their portfolios. It’s also useful in that it also allows the investors to gain some understanding of how changes in market
conditions might affect their portfolio because when securities drop in price, yields rise, and vice versa.
https://corporatefinanceinstitute.com/resources/knowledge/finance/yield-to-maturity-ytm/
Credit Quality Risk
Credit quality risk is the chance that the bond issuer will not be able to make timely payments.
Bond ratings involves a judgment about the future risk potential of the bond provided by rating agencies such as
Moody’s, Standard and Poor’s and Fitch IBCA, Inc. Dominion Bond Rating Services. Bond ratings are favorably affected
by:
a) A low utilization of financial leverage;

b) Profitable operations;
c) A low variability of past earnings;
d) Large firm size;
e) Little use of subordinated debt.
The poorer the bond rating, the higher the rate of return demanded in the capital markets.
The bond credit ratings agencies assign similar rating based on detailed analyses of issuer’s financial condition, general
economic and credit market conditions, and the economic value of any underlying collateral. The agencies conduct
general economic analyses of companies’ business and analyze firm’s specific financial situations. A single company
for instance may carry several outstanding bond issues and if these issues feature fundamental differences, then they
may have different credit level risks. High quality corporate bonds are considered investment grade, while higher
credit risk bonds are speculative, also called junk bonds and high-yield bonds.
Types of Bonds
A. Unsecured Long-Term Bonds
Debentures
These are unsecured long-term debt and backed only by the reputation and financial stability of the corporation.
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Because these bonds are unsecured, the earning ability of the issuing corporation is of great concern to the
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bondholder. To provide some protection to the bondholder, the issuing firm may be prohibited from issuing future
secured long-term debt that would create additional encumbrance of assets. To the issuing firm, debentures will allow
it to incur indebtedness and still preserve some future borrowing power.
Subordinated Debentures
Claims of bondholders of subordinated debentures are honored only after the claims of secured debt and
unsubordinated debentures have been satisfied.
Income Bonds
An income bond requires interest payments only if earned and non-payment of interest does not lead to bankruptcy.
Usually issued during the reorganization of a firm facing financial difficulties, these bonds have longer maturity and
unpaid interest is generally allowed to accumulate for some period of time and must be paid prior to the payment of
any dividends to stockholders.
B. Secured Long-Term Bonds
Mortgage Bonds
A mortgage bond is a bond secured by a lien on real property. Typically, the market value of the real property is greater
than that of the mortgage bonds issued. This provides that mortgage bondholders with a margin of safety in the event
that the market value of the secured property declines. Should the issuing firm fail to pay the bonds at maturity; the
trustees can foreclose or sell the mortgaged property and use the proceeds to pay the bondholders.
Mortgage bonds can further be subclassified as follows:
a) First Mortgage Bonds – The first mortgage bonds have the senior claim on the secured assets if the same
property has been pledged on more than one more than one mortgage bond.
b) Second Mortgage Bonds – These bonds have the second claim on assets and are paid only after the claims
of the first mortgage bonds have been satisfied.
c) Blanket or General Mortgage Bonds – All the assets of the firm are used as security for this type of bonds.
d) Closed-end Mortgage Bonds – The closed-end mortgage bonds forbid the further use of the pledged assets
security for other bonds. This protects the bondholders from dilution of their claims on the assets by any
future mortgage bonds.
e) Open-end Mortgage Bonds – These bonds allow the issuance of additional mortgage bonds using the same
secured assets as security. However, a restriction may be placed upon the borrower, requiring that additional
assets should be added to the secured property if new debt is issued.
f) Limited Open-end Mortgage Bonds – These bonds allow the issuance of additional bonds up to a limited
amount at the same priority level using the already mortgaged assets as security.
Other Types of Bonds
1) Floating Rate or Variable Rate Bonds

A floating rate bond is one in which the interest payment changes with market conditions. In periods of unstable
interest rates this type of debt offering becomes appealing to issuers and investors. To the issuers like banks and
finance companies, whose revenues go up when interest rates rise and decline as interest rates fall, this type of
debt eliminates some of the risk and variability in earnings that accompany interest rate swings. To the investor,
it eliminates major swings in the market value of the debt that would otherwise have occurred if interest rates
had changed.
A common feature of all the floating rate bonds is that an attempt is being made to counter uncertainty by
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allowing the interest rate to float [e.g., interest rates may be adjusted quarterly at 3% above the three-month
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London Interbank Offered Rate (LIBOR)]. In this way a change in cash inflows to the firm may be offset by an
adjustment in interest payments.
2) Junk or Low-Rated Bonds

Junk or low rated bonds are bonds rated BB or below. The major participants of this market are new firms that
do not have an established record of performance, although in recent years junk bonds have been increasingly
issued to finance corporate buyouts. Since junk bonds are of speculative grade, they carry a coupon rate of
between 3 to 5 percent or more than AA grade long-term debt. As a result, there is now an active market for
these new debt instruments. Because of the acceptance of junk or low-rated bonds, many new firms without
established performance records now have a viable financing alternative to secure financing through a public
offering, rather than being forced to rely on more-costly commercial bank loans.
3) Eurobonds
These are bonds payable or denominated in the borrower’s currency, but sold outside the country of the
borrower, usually by an international syndicate of investment bankers. This market is denominated by bonds
stated in U.S. dollars.
The Eurobond is usually sold by an international syndicate of investment bankers and includes bonds sold by
companies in Switzerland, Japan, Netherlands, Germany, the United States and Britain, to name the most popular
countries.
An example might be a bond of a U.S. company payable in dollars and sold in London, Paris, Tokyo or Frankfurt.
The use of Eurobonds by U.S. firms to raise funds has fluctuated dramatically with the relative interest rates an
abundance or lack of funds in the European markets dictating the degree to which they are used.
4) Treasury Bonds
Treasury bonds carry the “full-faith-and-credit” backing of the government and investors consider them among
the safest fixed-income investments in the world. The BSP sells Treasury securities through public auctions usually
to finance the government’s budget deficit. When the deficit is large, more bonds come to auction. In addition,
the BSP uses Treasury securities to implement monetary policy.
B. ORDINARY (COMMON) EQUITY SHARES
Ordinary equity shares (traditionally known as ordinary equity share) is a form of long-term equity that represents
ownership interest of the firm. Ordinary equity shareholders are called residual owners because their claim to
earnings and assets is what remains after satisfying the prior claims of various creditors and preferred shareholders.
Ordinary (common) equity shareholders are the true owners of the corporation and consequently bear the ultimate
risks and rewards of ownership.
Business firms organized as a corporation may choose to issue publicly traded stock (publicly owned corporation) or
keep ownership only among the original organizers (closely held corporation). As owners of the firm, ordinary
shareholders are considered to be residual domains. This means that ordinary shareholders have the right to claim
any cash flows or value after all other claimants have received what they are owed. These profits used to reinvest in
the firm to foster growth, pay out as dividends to shareholders, or a combination of the two.
Shareholders assume a limited liability because their risk of potential loss is limited to their investment in the
corporation’s equity shares.
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FEATURES OF ORDINARY EQUITY SHARES

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1) Par value/No par value

Ordinary equity share may be sold with or without par value. Whether or not ordinary equity share has any par
value is stated in the corporation’s charter. Par value of ordinary equity share is the stated value attached to a
single share at issuance. It has little significance except for accounting and legal purposes. If ordinary equity share
is initially sold for more than its par value, the issue price in excess of par is recorded as additional paid-in capital,
capital surplus, or capital in excess of par. A firm issuing no par share may either assign a stated value or place it
on the books at the price at which the equity share is sold.
2) Authorized, issued, and outstanding

Authorized shares are the maximum number of shares that a corporation may issue without amending its charter.
Issued shares are the number of authorized shares that have been sold.
Outstanding shares are those shares held by the public.
Both the firm’s dividends per share an earnings per share are based on the outstanding shares. The number of
issued shares may be greater than the number of outstanding shares because shares may be repurchased by the
issuing firm. Previously issued shares that are reacquired and held by the firm are called treasury shares. Thus,
outstanding share is issued share less treasury share.
3) No maturity
Ordinary equity share has no maturity and is a permanent form of long-term financing. Although ordinary share
is neither callable nor convertible, the firm can repurchase its shares in the secondary markets either through a
brokerage firm or tender offer. A tender offer is a formal offer to purchase shares of a corporation.
4) Voting rights
Each share of ordinary equity generally entitles the holder to vote on the selection of directors and in other
matters. Shareholders unable to attend the annual meting to vote may vote by proxy. A proxy is a temporary
transfer of the right to vote to another party. Proxy voting is done under the rules and regulations of the Securities
and Exchange Commissions, but proxy solicitations are the firm’s responsibility. Not all ordinary equity
shareholders have equal voting power. Some firms have more than one class of share. Class A ordinary (common)
equity share typically has limited or no voting rights while Class B has full voting rights.
There are two common systems of voting:

a. Majority voting is a voting system that entitles each shareholder to cast one vote for each share owned.
Majority voting is used to indicate the ordinary (common) equity shareholders’ approval or disapproval
of most proposed managerial actions on which shareholders may vote. The directors receiving the
majority of the votes are elected. If a group controls over 50 percent of the votes, it can elect all of the
directors and prevent minority shareholders from electing any directors.
b. Cumulative voting is a voting system that permits the shareholder to cast multiple votes for a single
director. Cumulative voting assists minority shareholders in electing at least one director. Cumulative
voting is required in some jurisdictions for electing the board of directors.
5) Book value per share

The accounting value of an ordinary equity share is equal to the ordinary share equity (ordinary share plus paid-
in capital plus retained earnings) divided by the number of shares outstanding.
6) Numerous rights of stockholders

Collective and individual rights of ordinary equity shareholders include among others:
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a) Right to vote on specific issues as prescribed by the corporate charter such as election of the board of
directors, selecting the firm’s independent auditors, amending the articles of incorporation and by laws,
increasing the amount of authorized stock, and so forth.
b) Right to receive dividends if declared by the firm’s board of directors.
c) Right to share in the residual assets in the event of liquidation.
d) Right to transfer their ownership in the firm to another party.
e) Right to examine the corporate banks.
f) Right to share proportionally in the purchase of any new issuance of equity shares. This is known as the
pre-emptive right.
VALUATION
Ordinary or common equity share valuation is complicated by the uncertainty of future returns and/or changes in the
share’s price.
The rate of dividend on equity shares is not known; also, the payment of equity dividend is discretionary. The earnings
and dividends on equity shares are generally expected to grow, unlike the interest on bonds and preference dividend.
(https://www.slideserve.com/jens/valuation-of-shares)
C. PREFERRED SHARE
Preferred share is a class of equity shares which has preference over ordinary (common) equity shares in the payment
of dividends and in the distribution of corporation assets in the event of liquidation.
Preference means only that the holders of the preferred share must receive a dividend (in the case of a going concern
firm) before holder of ordinary (common) equity shares are entitled to anything. Preferred shares generally has no
voting privileges but it is a form of equity from a legal and tax stand point.
The issuance of preferred shares is favored when the following conditions prevail:
1. Control problems exist with the issuance of ordinary share.

2. Profit margins are adequate to make of additional leverage attractive.
3. Additional debt poses substantial risk.
4. Interest rates are low lowering the cost of preferred share.
5. The firm has a high debt ratio, suggesting infusion of equity financing is needed.
PREFERRED SHARE FEATURES
The following are the major features of preferred share:
1. Par value
Par value is the face value that appears on the stock certificate. In some cases, the liquidation value per share is
provided for in the certificate.
2. Dividends
Dividends are stated as a percentage of the par value and are commonly fixed and paid quarterly but are not
guaranteed by the issuing firm. Some recent preferred share issues called adjustable rate, variable rate, or floating
rate preferred, do not have a fixed dividend rate but peg dividends to an underlying index such as one of the
Treasury bill rate or other money market rates.
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3. Cumulative and Noncumulative dividends

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Dividends payable to preferred shares are either cumulative or noncumulative; most are cumulative. If preferred
dividends are not paid in a particular year, they will be carried forward as an arrearage. Usually, both accumulated
(past) preferred dividends and the current preferred dividends must be paid before the ordinary equity
shareholders receive anything. If the preferred dividends are noncumulative, dividends not declared in any
particular year are lost forever and the preferred shareholders cannot claim such anymore.
4. No definite maturity date

Preferred share is usually intended to be a permanent part of a firm’s equity and has no definite maturity date.
However, preferred share sometimes carries special retirement provisions. Almost all preferred shares have a call
feature that gives the issuing firm the option of purchasing the share directly from its owners, usually at a
premium above its par value. Some preferred shares have a sinking fund provision that requires the issuer to
repurchase and retire the share on a scheduled basis. Owners of convertible preferred share have the option of
exchanging their preferred share for ordinary (common) equity share based on specified terms and conditions.
5. Convertible preferred share

Owners of convertible preferred share have the option of exchanging their preferred share for ordinary (common)
equity share based on specified terms and conditions.
6. Voting rights
Preferred share does not ordinarily carry voting rights. Special voting procedures may take effect if the issuing
firm omits its preferred dividends for a specific time period. Preferred shareholders are then permitted to elect
a certain number of members to the board of directors in order to represent the preferred shareholder’s
interests.
7. Participating features
Participating preferred share entitles its holders to share in profits above and beyond the declared dividend, along
with ordinary (common) equity shareholders. Most preferred share issues are nonparticipating. Without
nonparticipated preferred, the return is limited to the stipulated dividend.
8. Protective features
Preferred share issues often contain covenants to assure the regular payment of preferred share dividends and
to improve the quality of preferred share. For example, covenants may restrict the amount of common share
cash dividends, specify minimum working capital levels, and limit the sale of securities senior to preferred share.
Preferred shareholders have priority over ordinary (common) equity shareholders with regard to earnings and
assets. Thus, dividends must be paid on preferred share before they can be paid on the ordinary (common) equity
share, and in the event of bankruptcy, the claims of the preferred shareholders receive anything. To reinforce
these features, most preferred shares have coverage requirements similar to those on bonds. These restrictions
limit the amount of preferred share a company can use, and they also require a minimum level of retained
earnings before common dividends can be paid.
9. Call provision
A call provision gives the issuing corporation the right to call in the preferred share for redemption. As in the case
of bonds, call provisions generally state that the company must pay an amount greater than the par value of the
preferred share, the additional sum being termed a call premium.
For example, Himaya Corporation’s 12 percent, P100 par value preferred share, issued in 2005, is noncallable for
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10 years, but it may be called at a price of P112 after 2015.

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10. Maturity
Three decades ago, most preferred share was perpetual – it had no maturity and never needed to be paid off.
However, today most new preferred share has a sinking fund and thus an effective maturity date.
PREFERRED SHARE VALUATION
Preferred share is share that has a claim against income and assets before ordinary share but after debt. Often,
preferred share considered a hybrid security because it possesses characteristics of both debt and equity. Generally,
preferred share is considered similar to ordinary (common) equity share because they do not have maturity and
similar to debt in that both securities have fixed payments, dividends for preferred share and interest for debt.
Preferred share valuation is relatively simple if the firm pays fixed dividends at the end of each year. If this condition
holds, then the stream of dividend payments can be treated in perpetuity and be discounted by the investor’s required
rate of return on a preferred share issue. A perpetuity is an annuity with an infinite life span. If the preferred share
has high risk, investors normally require a higher rate of return. This is because creditors have priority over preferred
share holders in their claims to both income and assets.
Thus, the intrinsic value of a share of preferred share (Po) is the sum of the present values of future dividends
discounted at the investor’s required rate of return. This also can be determined using the following valuation model.
𝐷𝑝
𝑃𝑜 =
𝐾𝑝
Where: 𝐷𝑝 = Per share cash dividend

𝐾𝑝 = Investor’s required rate of return on preferred share
For example, Federal Electric and Power Company has an issue of preferred share outstanding that pays a yearly
dividend of P10.80. Investors require a 12% return on this preferred share.
Determine the intrinsic value of the preferred share.
Solution:
10.80
𝑃𝑜 = = 𝑃90
12%
In the Philippines, the following preferred shares are actively traded in the Philippine Stock Exchange:
First Philippine Holding – Preferred

San Miguel Purefoods – Preferred
Petron Corporation Perpetual – Preferred
Swift Foods, Inc. – Convertible Preferred
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Comparative Features of Ordinary Equity Shares, Preferred Shares and Bonds
The characteristics of ordinary shares, preferred shares and bonds are compared in the following table.
Ordinary Equity Shares Preferred Shares Bonds

a. Ownership and control Belongs to ordinary equity Limited rights when dividends Limited rights under default in
of the firm shareholders through voting right are missed interest payments
and residual claim to income
b. Obligation to provide None Must receive payment before Contractual obligation
return ordinary shareholder
c. Claim to assets in Lowest claim of any security holder Bondholders and creditors Highest claim
bankruptcy must be satisfied first
d. Cost of distribution Highest Moderate Lowest
e. Risk-return trade off Highest risk, highest return (at least Moderate risk, moderate Lowest risk, moderate return
in theory) return
f. Tax status of payment of Not deductible Not deductible Tax deductible Cost = Interest
corporation payment x (1-Tax rate)
g. Tax status of payment to A portion of Dividend paid to Same as ordinary shares Government bond interest is tax
recipient another corporation is tax exempt exempt
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Capital Markets 2nd Semester AY:2020-2021 Lecture Notes

W7 Capital Market Trading

• Describe capital market trading.

(1) the periodic interest payments and

(2) the principal (par value or face value) returned at maturity

Trading Process for Corporate Bonds

Other arrangements can be as follows:

3. Best Efforts Underwriting Basis

Advantages of Using Bonds

3. Bondholders do not have voting rights.

Disadvantages of Using Bonds

ALFM Peso Bonds

Bond Features and Prices

𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 − 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓𝑡ℎ𝑒 𝐵𝑜𝑛𝑑

Illustrative Problem 1: Determination of Bond Yield to maturity

Par value of bond : P1,000

What is the bond’s approximate yield to maturity?

What is the Yield to Maturity (YTM)?

Illustrative Problem 2. Example of a YTM Calculation

Importance of Yield to Maturity

Credit Quality Risk

a) A low utilization of financial leverage;

A. Unsecured Long-Term Bonds

B. Secured Long-Term Bonds

Mortgage bonds can further be subclassified as follows:

Other Types of Bonds

1) Floating Rate or Variable Rate Bonds

2) Junk or Low-Rated Bonds

B. ORDINARY (COMMON) EQUITY SHARES

FEATURES OF ORDINARY EQUITY SHARES

1) Par value/No par value

2) Authorized, issued, and outstanding

There are two common systems of voting:

5) Book value per share

6) Numerous rights of stockholders

1. Control problems exist with the issuance of ordinary share.

PREFERRED SHARE FEATURES

The following are the major features of preferred share:

3. Cumulative and Noncumulative dividends

4. No definite maturity date

5. Convertible preferred share

10 years, but it may be called at a price of P112 after 2015.

PREFERRED SHARE VALUATION

Where: 𝐷𝑝 = Per share cash dividend

Determine the intrinsic value of the preferred share.

First Philippine Holding – Preferred

Comparative Features of Ordinary Equity Shares, Preferred Shares and Bonds

Ordinary Equity Shares Preferred Shares Bonds

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