week 5 Flashcards
(34 cards)
As the owner of this equity (share) certificate, you
- are the owner of the company
- do not expect the company redeem the share.
- can expect annual dividend and capital gain, but they are not guaranteed
As the owner of this debt (bond) certificate
- are the creditor (lender) of the company.
- are promised that the company will redeem the bond at maturity.
- are promised that the company will pay you periodic coupon (interest).
How are preferred shares different from ordinary shares?
Ordinary shares usually grant the investor the right to vote on important corporate
decisions. Preferred equity does not.
Preferred shareholders have a higher priority claim than common shareholders
because common shareholders cannot receive dividends unless all dividends owed
to preferred shareholders have been paid. Both ordinary and preferred equity have
a lower priority claim than debt, however.
Finally, preferred dividends are usually set at a fixed percentage of par value,
while common dividends vary with the profitability of the company.
What is the relationship between the price of a financial asset and the return
that investors require on that asset, holding other factors constant?
Holding an asset’s cash flows constant, if investors pay a higher price for the
asset, then their return from holding the asset will be lower. In general, asset
prices are inversely correlated with returns.
Price of financial asset is summation of PV from its future CFs.
Mathematically, it can be explained by the below equation
If return, r, increases and CFs are held constant, each faction get smaller and the
summation of these fractions get smaller.
A company is looking to raise funds by issuing commercial paper with a face
value of $1,000,000 maturing in 110 days. How much will the company receive
if market interest rates are 3% pa?
Commercial paper is short-term debt security. If maturity is no longer than 1 year,
simple interest is assumed.
The funds raised from the issue is the price of commercial paper, equivalent to its price (present value). Use P0 formula in section 2.1. 𝑃𝑃0 = 𝐹𝐹𝐹𝐹 (1 + 𝑖𝑖 × 𝑁𝑁 365) FV = 1,000,000 (the company has to repay face value 1,000,000, FV can also be taken as the abbreviation of Face Value) i = 3% = 0.03 N = 110 𝑃𝑃0 = 𝐹𝐹𝐹𝐹 (1 + 𝑖𝑖 ×𝑁𝑁 365)= 1,000,000 (1 + 0.03 × 110 365)= 1,000,000 1.00904110 = 991,039.91 The company will receive $991,039.91.
explain valuation of financial assets
Different from real assets which are often valued by historical cost or replacement cost, financial assets are priced/valued by discounting all expected future cash flows.
Recall the definition of financial assets: ‘claim on cash flows’
The market price of a financial security/asset/instrument should be the summation of the present values of all future expected cash flows, given an “appropriate” discount (interest) rate.
Debt securities will provide holders with cash flows, including coupon (interest) and principal.
Equity will provide holders with cash flows, such as dividends.
Valuation of financial assets is an application of PV in topic 2 Financial Mathematics
Debt finance - Australian companies can borrow in two ways:
- Loans from banks and financial institutions
Indirect (Intermediated) finance: cash that are deposited or invested with a financial institutions is lent to a business.
Financial intermediary acts as a principal and the investors and the ultimate borrowers do not know each other - Issue debt securities
Direct finance: the company raise funds by issuing debt securities, such as 1) commercial paper, 2) bills of exchange and 3) corporate bonds, in the money or capital market.
Financial institutions, i.e. investment banks, act as agents to facilitate the process
Key characteristics of debt:
Debt holders are not the owners of the firms, so usually have no voting rights
Fixed and prior ranking contractual right to a return on capital (i.e. interest/coupon)
Interest/Coupon is paid in front of dividends.
Fixed and prior ranking contractual right to a return of capital (i.e. face value)
Debt face value is repaid on maturity before dividends (share buyback
If the borrower is required to support its promise to repay the debt with a pledge of real assets (‘collateral’), the debt is classified as secured debt.
Collateral will be liquidated to service the debt in case of the borrower’s bankruptcy.
If the debt is unsecured, the borrower has an obligation to repay the loan but this obligation is not supported by any pledge of assets.
Debt holders can force the company into liquidation and take control of the company’s assets if the company fails to meet its obligations.
‘Default’ or ‘ Credit Event’
explain short term debt securities
Typically mature in less than a year: classified as securities in money market
The issuer (the company) promises to pay a sum of money (face value) on a future date (maturity date).
Face value is typically $100,000 or its multiples.
No other payments will be made to investors (lenders) before maturity.
Sold at a discount, say, investor pays $95,000 for a $100,000 face-value short-term debt security
Profit (or ‘interest’) earned is the difference between the price paid and face value.
In the above case, investors’ profit is $100,000 – $95,000 = $5,000 if holding it to maturity.
This $5,000 gain is classified as capital gain, rather than interest income, for taxation purpose
types of short term debt securities include
Commercial Paper: a.k.a. promissory notes
Issued by ‘Blue Chip’ companies with high credit ratings
The issuer/borrower (corporations) promises to pay a sum of money (face value, say, $500,000) on a stated future date.
Maturity: range from 30 days to 180 days (with some variations)
Unsecured: purely based on issuer’s creditworthiness
Marketability: very liquid in the secondary market
Bank-Accepted Bill (BAB)
A type of bill of exchange, accepted by bank
Similar to commercial papers, but the issuers often have no credit ratings.
Certificates of deposit (CD)
Very similar to commercial paper but issued by banks
Offer highly competitive returns (profits)
Treasury Notes (Australia) Similar to commercial papers and CD, but issued by Treasury Department Most liquid short-term debt securities
explain the valuation of short-term debt securities
Short term: no longer than one year, therefore we apply simple interest
The market price of short-term debt security is effectively the present value of its face value paid at maturity with simple interest assumption.
𝑃_0=𝐹𝑉/((1+𝑖×𝑁/365) )
P0 is the market price (present value) of short-term debt security;
FV is the face value (redemption value) at maturity.
i is yield to maturity (aka discount rate) per annum,
N is number of days to maturity.
Example: Suppose a firm draws a $1 million in 90-day Bank Accepted Bill (BAB) and the current market discount rate is 6.5% p.a. Calculate the market price of BAB today.
1,000,000/((1+0.065×90/365) )=1,000,000/1.01602740=$984,225.43
explain long term debt securities - bond
Typically with maturity beyond one year
Issuer has contractual obligation to make promised payments
Face (or par) value is the dollar amount repaid by issuer at maturity.
a.k.a. redemption price/value
Coupon rate is the interest rate promised by the issuer, expressed as a percentage of face value.
Coupon is the periodic payment made to debtholders (investors
explain fixed v floating rates (bond)
Fixed vs floating rates:
Floating-rate bond: coupon rate is tied with benchmark rates, such as LIBOR, Bank Bill Swap Rate (BBSW), Australian Government Bond Rate or etc.
For floating-rate bond, coupon rate is reset periodically, i.e. semi-annually or quarterly.
Floating rate = benchmark rate + Spread, i.e. 6M USD LIBOR + 3.5%.
expain secured v unsecured bonds
Unsecured bonds are backed only by general faith and credit of issuers.
Secured bonds are backed by specific assets (‘collateral’), i.e. mortgage backed bonds, collateral trust bonds and etc.
explain zero coupon bonds
Long-term debt security but have no coupon payment during the life of the bond.
Also known as discount bonds or pure discount bonds.
explain convertible bonds
A type of ‘hybrid’: classified as liability at issuance
Investors have the right but not obligation (‘option’) to convert the bond into ordinary shares of the issuer of the bond.
Should it be priced higher or lower than the normal (‘vanilla’) bonds with same features except for the conversion option?
explain callable and puttable bonds
Callable bonds: bond issuer has the right to repurchase the bonds at a specified price (call price).
Callable bonds: companies could retire and reissue debt if interest rates fall.
Puttable bonds: the investors have the right to sell the bonds to the issuer at the put price.
Which one should be priced higher, if other features are held the same?
define face value
the value that borrower repays at maturity
define coupon rate
the annual coupon as a % of face value
define coupon
periodic cash flows paid by borrower
Similar to interest paid on bank loan
CP = Coupon Rate × Face Value / m
m is coupon frequency, equivalent to compounding frequency in Topic 2
define yeild to maturity
the market interest rate for investment similar to the bond.
a.k.a. discount rate, opportunity cost of capital
define market price (p0)
the price investors pay for the bond NOW
explain bond ratings
Bond ratings: grades assigned to bond issues based on the degree of default risk
Rating agency: S&P Investor Service, Moody’s and Fitch
Investment grade (low default risk) vs junk (high default risk) bond
explain preferred or preference shares
Preferred shares (or preference shares)
‘Hybrid’: have features of both debt and equity, but classified as equity in the balance sheet
Promise a fixed annual dividend payment, but can be ‘in arrears’.
Claims on assets and cash flows rank senior to ordinary shares, but subordinated to debt securities
Preferred dividends are not tax deductible – similar to ordinary shares, but different from debt
