CHAPTER 4_BOND CHAPTER - INCLUDING CALCULATION.pptx

Financial management - Bond chapter

1. CHAPTER 4 BOND VALUATION Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

2. https://www.youtube.com/watch?v=ftsNgtx2haY https://www.youtube.com/watch?v=N_0d35JvuO0 Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

3. Define important bond features and types of bond Explain bond values and yields and why they fluctuate Describe bond ratings and what they mean Outline the impact of inflation on interest rates Illustrate the term structure of interest rates and the determinants of bond yields Key Concepts and Skills Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

4. Bond is a fixed-income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. Owners of bonds are debtholders, or creditors, of the issuer. Bond details include the end date when the principal of the loan is due to be paid to the bond owner and usually include the terms for variable or fixed interest payments made by the borrower. Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. What Is a Bond?

5. Bonds are debt instruments and represent loans made to the issuer. Governments (at all levels) and corporations commonly use bonds in order to borrow money. Governments need to fund roads, schools, dams, or other infrastructure. The sudden expense of war may also demand the need to raise funds. Similarly, corporations will often borrow to  grow their business , to buy property and equipment, to undertake profitable projects, for research and development, or to hire employees. The problem that large organizations run into is that they typically need far more money than the average bank can provide. Bonds provide a solution by allowing many individual investors to assume the role of the lender. Indeed, public debt markets let thousands of investors each lend a portion of the capital needed. Moreover, markets allow lenders to sell their bonds to other investors or to  buy bonds  from other individuals—long after the original issuing organization raised capital. Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Who Issues Bonds?

6. Feature Bonds Common Stock Preferred Stock Definition A debt investment where an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Equity ownership in a company, representing a claim on part of the company's assets and earnings. A type of ownership that typically has a higher claim on assets and earnings than common stock. Often pays dividends at a fixed rate and has priority over common stock in the payment of dividends and upon liquidation. Income Interest payments are typically fixed and paid regularly until the bond matures. Dividends are not guaranteed and can vary, depending on the company’s performance and decisions by the board of directors. Dividends are generally fixed and are paid out before any dividends are given to common stockholders. Voting Rights No voting rights. Common shareholders have voting rights, typically one vote per share owned. Generally no voting rights, except in certain conditions when dividends are unpaid. Risk Generally lower risk compared to stocks. The risk depends on the bond’s rating. Higher risk as shareholders are last to receive payout in case of liquidation. Stock values can fluctuate significantly. Generally lower risk than common stock but higher than bonds. Preferred stockholders are prioritized over common stockholders in asset distribution upon liquidation. Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7. Feature Bonds Common Stock Preferred Stock Return Potential Typically lower return potential compared to stocks, reflecting the lower risk. High return potential due to capital appreciation and dividends. Moderate return potential; generally higher than bonds but lower than common stocks due to fixed dividends. riority in Liquidation Higher priority over both types of stock. Bondholders are paid before shareholders in the event of liquidation. Lowest priority in liquidation. Common stockholders are the last to be paid out, after bondholders and preferred shareholders. Higher priority than common stock but lower than bonds. They are paid after bondholders and before common stockholders. Tax Treatment Interest from bonds is typically taxable. Certain municipal bonds may be tax-exempt. Dividends may be taxed at a lower rate than regular income depending on local regulations. Capital gains tax may apply if stocks are sold at a profit. Dividend income is taxed, often at a rate different from ordinary income, depending on local tax laws. Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8. Par value (face value) = principal amount, repaid at maturity Coupon = stated interest payment Coupon rate = annual coupon divided by face value Maturity date Yield or Yield to maturity = rate of return required in the market for the bond Bond characteristics Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

9. Bond Value = PV of coupons + PV of par Bond Value = PV of annuity + PV of lump sum As interest rates increase, present values decrease. So, as interest rates increase, bond prices decrease and vice versa. INTRINSIC VALUE Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

10. Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

11. For example, suppose the Xanth (pronounced “ zanth ”) Co. were to issue a bond with 10 years to maturity. The Xanth bond has an annual coupon of $80. Similar bonds have a yield to maturity of 8 percent. Based on our preceding discussion, the Xanth bond will pay $80 per year for the next 10 years in coupon interest. In 10 years, Xanth will pay $1,000 to the owner of the bond. The cash flows from the bond are shown in Figure 7.1. What would this bond sell for? As illustrated in Figure 7.1, Key: 10 years to maturity annual coupon of $80 yield to maturity of 8 percent $80 per year for the next 10 years in coupon interest In 10 years, Xanth will pay $1,000 to the owner of the bond Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. EXAMPLE 1

12. Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Bond Intrinsic Value

13. Consider a 3-year bond with a face value of $1,000 and an annual coupon rate of 5%. The bond is currently trading in the market at a yield to maturity (YTM) of 4%. We will calculate the intrinsic value of this bond. The bond pays an annual coupon of 5% of the face value, so the coupon payment each year will be $1,000 * 5% = $50. The YTM of the bond is given as 4%. This will be used as the discount rate in our calculation. Calculate the PV of CF and face value Intrinsic Value = PV(coupon payment Year 1) + PV(coupon payment Year 2) + PV(coupon payment Year 3) + PV(face value payment) Intrinsic Value = $48.08 + $46.30 + $44.67 + $884.51 Intrinsic Value = $1,023.56 Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Example 2

14. Consider a bond with a coupon rate of 10% and annual coupons. The par value is $1,000, and the bond has 5 years to maturity. The yield to maturity is 11%. What is the value of the bond? Using the formula: B = PV of annuity + PV of lump sum B = 100[1 – 1/(1.11) 5 ] / .11 + 1,000 / (1.11) 5 B = 369.59 + 593.45 = 963.04 Using the calculator: N = 5; I/Y = 11; PMT = 100; FV = 1,000 CPT PV = -963.04 EXAMPLE 3: Discount Bond with Annual Coupons Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

15. Suppose you are reviewing a bond that has a 10% annual coupon and a face value of $1000. There are 20 years to maturity, and the yield to maturity is 8%. What is the price of this bond? Using the formula: B = PV of annuity + PV of lump sum B = 100[1 – 1/(1.08) 20 ] / .08 + 1000 / (1.08) 20 B = 981.81 + 214.55 = 1196.36 Using the calculator: N = 20; I/Y = 8; PMT = 100; FV = 1000 CPT PV = -1,196.36 EXAMPLE 4: Valuing a Premium Bond with Annual Coupons Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16. Yield to Maturity (YTM) is the rate implied by the current bond price. Finding the YTM requires trial and error if you do not have a financial calculator and is similar to the process for finding r with an annuity. If you have a financial calculator, enter N, PV, PMT, and FV, remembering the sign convention (PMT and FV need to have the same sign, PV the opposite sign.) Computing Yield to Maturity Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

17. Consider a bond with a 10% annual coupon rate, 15 years to maturity, and a par value of $1,000. The current price is $928.09. Will the yield be more or less than 10%? N = 15; PV = -928.09; FV = 1,000; PMT = 100; CPT I/Y = 11% the YTM is more than the coupon since the price is less than par. YTM with Annual Coupons Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

18. Table 7.1 Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

19. Graphical Relationship Between Price and Yield-to-maturity (YTM) Yield-to-maturity (YTM) Bond characteristics: 10 year maturity, 8% coupon rate, $1,000 par value Yield-to-Maturity (YTM) Bond Price, in dollars Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

20. If YTM = coupon rate, then par value = bond price If YTM > coupon rate, then par value > bond price Why? The discount provides yield above coupon rate. Price below par value, called a discount bond If YTM < coupon rate, then par value < bond price Why? Higher coupon rate causes value above par. Price above par value, called a premium bond Bond Prices: Relationship Between Coupon and Yield Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

21. Price Risk Change in price due to changes in interest rates Long-term bonds have more price risk than short-term bonds. Low coupon rate bonds have more price risk than high coupon rate bonds. Reinvestment Rate Risk Uncertainty concerning rates at which cash flows can be reinvested Short-term bonds have more reinvestment rate risk than long-term bonds. High coupon rate bonds have more reinvestment rate risk than low coupon rate bonds. Interest Rate Risk Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

22. Low Grade Moody’s Ba and B S&P BB and B Considered possible that the capacity to pay will degenerate. Very Low Grade Moody’s C (and below) and S&P C (and below) income bonds with no interest being paid, or in default with principal and interest in arrears Bond Ratings – Speculative Grade Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

23. Treasury Bonds: These bonds are issued by the government, specifically the Treasury Department. They are considered to have the lowest default risk and are backed by the full faith and credit of the government. Corporate Bonds: These bonds are issued by corporations to raise capital. They offer fixed interest payments and have varying levels of credit risk based on the issuing company's financial health. Municipal Bonds : Also known as " munis ," these bonds are issued by state or local governments to fund public projects such as infrastructure development. Municipal bonds offer tax advantages as the interest income is often exempt from federal and sometimes state income taxes. Government Agency Bonds: These bonds are issued by government-sponsored agencies such as Fannie Mae and Freddie Mac. They are not direct obligations of the government but still carry a level of perceived government backing. International Bonds: These bonds are issued by foreign governments or corporations outside of the issuer's home country. They provide exposure to international markets and carry additional risks associated with foreign exchange rates and political and economic conditions. Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Types of bond

24. High-Yield Bonds: Also known as "junk bonds," these bonds are issued by companies with lower credit ratings. They offer higher yields to compensate for the higher default risk associated with these issuers. Convertible Bonds: These bonds give bondholders the option to convert their bonds into a specified number of the issuer's common stock. They provide potential for capital appreciation if the issuer's stock price rises. Zero-Coupon Bonds: These bonds do not pay regular interest payments. Instead, they are issued at a discount to their face value and mature at face value, providing a return through capital appreciation. Floating-Rate Bonds: These bonds have variable interest rates that reset periodically based on a benchmark rate. The interest payments adjust to reflect changes in market rates, offering protection against interest rate fluctuations. Callable Bonds: These bonds allow the issuer to redeem them before the maturity date. Callable bonds provide flexibility for issuers but can expose bondholders to reinvestment risk if called early Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Cont …..

25. Sukuk are bonds that have been created to meet a demand for assets that comply with Shariah, or Islamic law. Shariah does not permit the charging or paying of interest. Sukuk are typically bought and held to maturity, and they are extremely illiquid. Sukuk Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

26. Roadside Markets has 8.45 percent coupon bonds outstanding that mature in 10.5 years. The bonds pay interest semiannually. What is the market price per bond if the face value is $1,000 and the yield to maturity is 7.2 percent? A) $1,199.80 B) $999.85 C) $903.42 D) $1,091.00   Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. LETS TRY

27. The Bond Pricing Equation Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

28. The relationship between bonds and interest rates is inverse, meaning that when interest rates rise, bond prices generally fall, and vice versa. This relationship is known as the interest rate risk of bonds. Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

29. Fixed Coupon Payments: Bonds typically pay fixed coupon payments at regular intervals. The coupon rate is determined when the bond is issued and remains constant throughout the bond's life. Present Value and Discounting: The value of future cash flows (coupon payments and the face value payment at maturity) is determined by discounting those cash flows to the present using a discount rate. The discount rate is often based on the prevailing interest rates in the market. Yield and Bond Prices: The yield of a bond is the effective interest rate earned by an investor holding the bond. When a bond is issued, its coupon rate is set to align with prevailing interest rates at that time. However, if interest rates rise after issuance, the bond's fixed coupon rate becomes relatively less attractive compared to new bonds offering higher coupon rates. As a result, the price of the existing bond decreases, increasing its yield to match the higher interest rates. Duration and Sensitivity: The relationship between bond prices and interest rates is also influenced by the bond's duration. Duration measures a bond's sensitivity to changes in interest rates. Bonds with longer durations are more sensitive to interest rate changes and tend to experience larger price fluctuations in response to interest rate movements. Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. the bond and interest rate relationship:

30. STOCK VALUATION CHAPTER 5 CONT… Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

31. Common Stock Valuation Some Features of Common and Preferred Stocks The Stock Markets Chapter Outline Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

32. If you buy a share of stock, you can receive cash in two ways: The company pays dividends. You sell your shares, either to another investor in the market or back to the company. As with bonds, the price of the stock is the present value of these expected cash flows. Cash Flows for Stockholders Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

33. Imagine that you are considering buying a share of stock today. You plan to sell the stock in one year. You somehow know that the stock will be worth $70 at that time. You predict that the stock will also pay a $10 per share dividend at the end of the year. If you require a 25 percent return on your investment, what is the most you would pay for the stock? In other words, what is the present value of the $10 dividend along with the $70 ending value at 25 percent ? If you buy the stock today and sell it at the end of the year, you will have a total of $80 in cash. At 25 percent: Present value = ($10 + 70)/1.25 = $64 Therefore, $64 is the value you would assign to the stock today. More generally, let P be the current price of the stock, and assign P 1 to be the price in one period. If D 1 is the cash dividend paid at the end of the period, then: Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

34. Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. General stock value calculation

35. Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

36. Suppose you are thinking of purchasing the stock of Moore Oil, Inc. You expect it to pay a $2 dividend in one year, and you believe that you can sell the stock for $14 at that time. If you require a return of 20% on investments of this risk, what is the maximum you would be willing to pay? Compute the PV of the expected cash flows. Price = (14 + 2) / (1.2) = $13.33 One-Period Example Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

37. Now, what if you decide to hold the stock for two years? In addition to the dividend in one year, you expect a dividend of $2.10 in two years and a stock price of $14.70 at the end of year 2. Now how much would you be willing to pay? PV = 2 / (1.2) + (2.10 + 14.70) / (1.2) 2 = 13.33 Two-Period Example Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

38. Finally, what if you decide to hold the stock for three years? In addition to the dividends at the end of years 1 and 2, you expect to receive a dividend of $2.205 at the end of year 3 and the stock price is expected to be $15.435. Now how much would you be willing to pay? PV = 2 / 1.2 + 2.10 / (1.2) 2 + (2.205 + 15.435) / (1.2) 3 = 13.33 Three-Period Example Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

39. You could continue to push back the year in which you will sell the stock. You would find that the price of the stock is really just the present value of all expected future dividends. So, how can we estimate all future dividend payments? Developing The Model Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

40. Constant dividend (i.e., zero growth) The firm will pay a constant dividend forever. This is like preferred stock. The price is computed using the perpetuity formula. Constant dividend growth The firm will increase the dividend by a constant percent every period. The price is computed using the growing perpetuity model. Supernormal growth Dividend growth is not consistent initially, but settles down to constant growth eventually. The price is computed using a multistage model. Estimating Dividends: Special Cases Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

41. If dividends are expected at regular intervals forever, then this is a perpetuity, and the present value of expected future dividends can be found using the perpetuity formula. P = D / R Suppose a stock is expected to pay a $0.50 dividend every quarter and the required return is 10% with quarterly compounding. What is the price? P = .50 / (.1 / 4) = $20 Zero Growth Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

42. Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

43. Dividends are expected to grow at a constant percent per period. P = D 1 /(1+R) + D 2 /(1+R) 2 + D 3 /(1+R) 3 + … P = D (1+g)/(1+R) + D (1+g) 2 /(1+R) 2 + D (1+g) 3 /(1+R) 3 + … With a little algebra and some series work, this reduces to: Dividend Growth Model Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

44. Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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47. Suppose Big T Inc., just paid a dividend of $0.50 per share. It is expected to increase its dividend by 2% per year. If the market requires a return of 15% on assets of this risk, how much should the stock be selling for? P = .50(1+.02) / (.15 - .02) = $3.92 DGM – Example 1 Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

48. Gordon Growth Company is expected to pay a dividend of $4 next period, and dividends are expected to grow at 6% per year. The required return is 16%. What is the current price? P = 4 / (0.16 - 0.06) = $40 Remember that we already have the dividend expected next year, so we don’t multiply the dividend by 1+g. Example 8.3: Gordon Growth Company - I Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

49. What is the price expected to be in year 4? P 4 = D 4 (1 + g) / (R – g) = D 5 / (R – g) P 4 = 4(1+.06) 4 / (.16 - .06) = 50.50 What is the implied return given the change in price during the four year period? 50.50 = 40(1+return) 4 ; return = 6% The price is assumed to grow at the same rate as the dividends. Example 8.3: Gordon Growth Company - II Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

50. Suppose a firm is expected to increase dividends by 20% in one year and by 15% in two years. After that, dividends will increase at a rate of 5% per year indefinitely. If the last dividend was $1 and the required return is 20%, what is the price of the stock? Remember that we have to find the PV of all expected future dividends. Nonconstant Growth Example - I Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

51. Compute the dividends until growth levels off. D 1 = 1(1.2) = $1.20 D 2 = 1.20(1.15) = $1.38 D 3 = 1.38(1.05) = $1.449 Find the expected future price. P 2 = D 3 / (R – g) = 1.449 / (.2 - .05) = 9.66 Find the present value of the expected future cash flows. P = 1.20 / (1.2) + (1.38 + 9.66) / (1.2) 2 = 8.67 Nonconstant Growth Example - II Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

52. Start with the DGM: Using the DGM to Find R Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

53. Suppose a firm’s stock is selling for $10.50. It just paid a $1 dividend, and dividends are expected to grow at 5% per year. What is the required return? R = [1(1.05)/10.50] + .05 = 15% What is the dividend yield? 1(1.05) / 10.50 = 10% What is the capital gains yield? g = 5% Example: Finding the Required Return Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

54. Table 8.1 – Stock Valuation Summary (1) Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

55. Table 8.1 – Stock Valuation Summary (2) Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

56. Voting Rights Proxy voting Classes of stock Other Rights Share proportionally in declared dividends Share proportionally in remaining assets during liquidation Preemptive right – first shot at new stock issue to maintain proportional ownership if desired Features of Common Stock Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

57. Dividends are not a liability of the firm until a dividend has been declared by the Board. Consequently, a firm cannot go bankrupt for not declaring dividends. Dividends and Taxes Dividend payments are not considered a business expense; therefore, they are not tax deductible. The taxation of dividends received by individuals depends on the holding period. Dividends received by corporations have a minimum 70% exclusion from taxable income. Dividend Characteristics Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

58. Investors use the price-to-earnings ratio (P/E ratio) as a valuation tool because it provides a straightforward and easily comparable measure of a company's stock price relative to its earnings. While the dividend growth model can be useful for assessing the value of dividend-paying stocks, it has limitations that make the P/E ratio a more widely used metric. Here are some reasons why investors prefer the P/E ratio: Simplicity and Accessibility Comprehensive Valuation: Industry and Market Comparisons: Forward-Looking Perspective Non-Dividend Paying Stocks Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. DGM vs p/e ratio

59. The common stock of Water Town Mills pays a constant annual dividend of $2.25 a share. What is one share of this stock worth at a discount rate of 16.2 percent? A) $13.89 B) $14.01 C) $14.56 D) $13.79   Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

60. The UpTowner just paid an annual dividend of $4.12. The company has a policy of increasing the dividend by 2.5 percent annually. You would like to purchase shares of stock in this firm but realize that you will not have the funds to do so for another four years. If you require a rate of return of 16.7 percent, how much will you be willing to pay per share when you can afford to make this investment? A) $32.03 B) $32.83 C) $33.12 D) $33.65   Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

61. The Sly Fox pays a constant dividend of $1.46 a share. The company announced today that it will continue to pay the dividend for another 2 years and then in Year 3 it will pay a final liquidating dividend of $15.25 a share. What is one share of this stock worth today at a required return of 18.5 percent? A) $12.92 B) $11.44 C) $12.07 D) $13.09 E) $14.20   Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

62. Sew 'N More just paid an annual dividend of $1.42 a share. The firm plans to pay annual dividends of $1.45, $1.50, and $1.53 over the next 3 years, respectively. After that time, the dividends will be held constant at $1.60 per share. What is this stock worth today at a discount rate of 11.7 percent? A) $12.39 B) $13.30 C) $13.67 D ) $13.41 Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

63. PREFERRED STOCK

64. What Is a Preferred Stock? The term "stock" refers to ownership or equity in a firm. There are two types of equity— common stock  and preferred stock. Preferred stockholders have a higher claim to  dividends  or asset distribution than common stockholders. The details of each preferred stock depend on the issue. 

65. CONT…. Preferred shareholders have priority over common stockholders when it comes to dividends, which generally yield more than common stock and can be paid monthly or quarterly. These dividends can be fixed or set in terms of a benchmark interest rate like the  London InterBank Offered Rate  (LIBOR)​, and are often quoted as a percentage in the issuing description. Adjustable-rate shares specify certain factors that influence the dividend yield, and participating shares can pay additional dividends that are reckoned in terms of common stock dividends or the company's profits. The decision to pay the dividend is at the discretion of a company's board of directors.

66. Unique Features of Preferred Stock Preferred shares differ from common shares in that they have a preferential claim on the assets of the company. That means in the event of a  bankruptcy , the preferred shareholders get paid before  common shareholders . Preferred shareholders receive a fixed payment that's similar to a bond issued by the company. The payment is in the form of a quarterly, monthly, or yearly dividend, depending on the company's policy, and is the basis of the valuation method for a preferred share.

67. KEY TAKEAWAYS Preferred stock is a different type of equity that represents ownership of a company and the right to claim income from the company's operations. Preferred stockholders have a higher claim on distributions (e.g. dividends) than common stockholders. Preferred stockholders usually have no or limited, voting rights in corporate governance. In the event of a liquidation, preferred stockholders' claim on assets is greater than common stockholders but less than bondholders. Preferred stock has characteristics of both bonds and common stock which enhances its appeal to certain investors.

68. Valuation Models If preferred stocks have a fixed dividend, then we can calculate the value by discounting each of these payments to the present day. This fixed dividend is not guaranteed in common shares. If you take these payments and calculate the sum of the present values into perpetuity, you will find the value of the stock. For example, if ABC Company pays a 25-cent dividend every month and the required rate of return is 6% per year, then the expected value of the stock, using the dividend discount approach, would be $50. The discount rate was divided by 12 to get 0.005, but you could also use the yearly dividend of $3 (0.25 x 12) and divide it by the yearly discount rate of 0.06 to get $50. In other words, you need to discount each dividend payment that's issued in the future back to the present, then add each value together.

69. What Are the Advantages of a Preferred Stock? A preferred stock is a class of stock that is granted certain rights that differ from common stock. Namely, preferred stock often possesses higher dividend payments, and a higher claim to assets in the event of liquidation. preferred stock can have a callable feature , which means that the issuer has the right to redeem the shares at a predetermined price and date as indicated in the prospectus. In many ways, preferred stock shares similar characteristics to bonds, and because of this are sometimes referred to as hybrid securities. 

70. Preferred Stock vs Common Stock Preferred Stock Equity ownership of a company Tradable on public exchanges (for public companies) Have first right to dividends and must be paid before common stockholders Typically do not have as much capital appreciation Typically has no voting rights May have the option to be convertible to common stock Receives better treatment during liquidations Common Stock Equity ownership of a company Tradable on public exchanges (for public companies) No guarantee of dividends; must wait until preferred stockholders are made whole Often has higher capital appreciation Typically has voting rights Do not have the option to be convertible to preferred stock Receives worse treatment during liquidations

71. Preferred Stock VS Bonds Preferred Stock Often issues periodic, ongoing cash payments Issued at par value (which is independent of market value) Dividends may increase, decrease, or end at a company's discretion Preferred stockholders are behind bondholders during bankruptcy or liquidations Often do not have an end date Bonds Often issues periodic, ongoing cash payments Issued at par value (which is independent of market value) Interest is fixed and will not change not change over the life of the bond Bondholders preferential treatment during bankruptcy or liquidations Have a fixed term or maturity date