*

Dr. Henry Prudente

 *
*These are obligations that are to
mature beyond one year
*Examples are bonds and stocks
(although stocks are technically not
considered as debt, they are a form
of long-term financing)
 *
*It is defined as a certificate of
indebtedness;
*Also known as a formal, unconditional
promise to pay a specified amount of
money at a determinable future date and
to make periodic interest payments at a
stated rate until the principal amount is
paid.
 *
*Indenture: the written agreement on bond
issues between the issuing company and the
bondholder.
*Bonds vs. Promissory notes: bonds are more
formal, they bear the seal of a corporation and
they have longer maturity. A promissory note is a
whole unit issued to one party; A bond liability is
divided into fractional parts and sold to
different investors or lenders.
 *
*Main classifications:
*According to tenor: short-term, medium term and
long term
*According to issuing entity: corporate, government
*According to maturity: straight, serial, convertible,
callable
*According to payment of interest: Coupon bonds,
zero-coupon
*According to coupon interest: fixed, floating
*According to transferability: bearer, registered,
coupon
 *
*There are three main parts to a bond:
*Face Value
*Coupon rate
*Maturity date
*These parts are integral to the understanding of
bond valuation since at its simplest, we use the
simple interest formula to compute for the
earnings from the bond.
 *
*A bond issuer has to determine the value of the
bonds (or the price at which investors would be
willing to buy the bonds), which is dependent
their desired rate of return.
*The value of the bonds is equal to the present
value of future cash flows that an investor may
expect from the bond, discounted at their
desired rate of return
 *
*Example: On January 1 2007, X Corp.
issued 10%, 5-year bonds with face value
of Php 1,000 each. Considering the risks
involved, investors desire a 12% rate of
return on their investments. What should
be the bond quotation to attract
investors?
 *
*Computation:
*VB: PV of annual interest of Php
100, discounted at 12% for 5 years +
PV of Php 1,000 discounted at 12%
for 5 years.
*VB = (Php 100 x 3.605) + (Php 1,000
x .567) = Php 360.50 + 567 = Php
927.50 or Php 928
 *
*An investor in bonds may determine the
approximate yield of the bond using the
following formula:
*AY= Interest per annum + [(principal –
value)/n]/ (principal + value)/2
*AY = Php 100 + [(Php 1,000 – 928)/5]/ (Php
1,000 + 928)/2 =Php 100 + 14.40)/Php 964
=11.86%
 *
*Bond premiums and discounts:
*When bonds are sold for higher than
face value, the difference is called the
bond premium, the reverse case is
called a bond discount.
*Bonds are quoted in percentages , thus
if a bond issue is at 96, it means the
issue price is 96% of face value.
 *
*Example: On January 1, 2006, XXX
Corp. issued Php 1,000,000 worth of
5-year 15% bonds with each bond
having a face value of Php
10,000,quoted at 96. Interest is
payable every December 31st, with
flotation cost amounting to Php
34,000. Bonds will mature on January
1, 2011.
 *
[Face Value of bonds (whole issue) x
discount] – flotation cost = net
proceeds
(Php 1,000,000 x 96%) – Php 34,000 =
Php 926,000
Original discount is at Php 40,000, but
with the flotation costs, total
discount is at Php 74,000.
 *
*A corporation’s capital stock may be
divided into two or more classes to attract
different kinds of investors.
*Classifications:
*Common: entitles holder to equal
division of profits without any advantage
or preference over other classes of stock
*Preferred: entitles holder to some
preferences over other classes of stock
 *
*Classifications of stock: (preferreds)
*Dividend claim: Cumulative vs. non-
cumulative
*Convertibility: Convertible vs. non-
convertible
*Callability: Callable vs. non callable
*Trading: Listed vs. Over-the-counter
*Participation: Participating vs. non-
participating
 *
*Refers to the amount of net assets (assets minus
liabilities) that a corporation has for every share
outstanding of its common stock. Also known as
net asset value (NAV)
*Book value = Common stock equity/no. of
common shares outstanding
*Common stock equity = Total Stockholder’s
Equity – Account balances relating to capital
stock other than common stock
 *
*Refers to earnings distribution in the form of
shares of capital stock.
*It entails no reduction in the resources of the
company because it is just a transfer from
retained earnings to contributed capital.
*Stock dividends of less than 20% are taken up at
market value while those of 20% or more are
taken up at par value.
 *
* Example: Alto Corporation issues a stock dividend on
Jan 15, 2006 when the market price per share of its
contributed capital is Php 120 and its stockholders’
equity shows:
* Capital Stock, par value Php 100: Php 500,000
* Retained earnings: Php 400,000
* Total stockholders’ equity: Php 900,000
How many shares are to be issued if the stock dividend rate
were a) 50% , b) 15%
 *
* A) Stock dividend rate is 50%
* The corporation issues 2,500 shares
* Par value of shares outstanding x stock dividend% = Php 500,000 x 50%
= Php250,000
* B) Stock dividend rate is 15%
* The corporation issues 750 shares
* [(Php500,000/Php100) x Php120] x 15% = Php 90,000; or (5000 shares
x 15%) x Php120
 *
* Refers to a decrease in par value per share requiring the issuance of
additional shares so that total par value of the contributed capital
remains the same.
* Given a company with:
* Contributed capital, 1M shares, par value Php10 = Php
10,000,000
* Retained earnings: Php 8,000,000
* Market price: Php 1,100 per share
What happens if there is a 2-for-1 stock split?
 *
*Par value is reduced to Php 5 per
share
*There is an issuance of 1,000,000
new shares at the new par value
*Thus the market price becomes Php
550 per share
 *

* Financial Market ratios:

* EPS: (Net income-preferred dividends) No. of common
shares outstanding
* Dividends per share: Dividends paid no. of common shares
outstanding
* Book value per share= Book value no. of common shares
outstanding
* P/E ratio= market price per share EPS
 *

* Dividend payout ratio: Dividends paid net income

* Price-to-book ratio: market price per share book value
per share
* Dividend yield: Dividends per share market price per
share
 *
* Discount rate for capital budgeting

* Cost of financing firm assets

* Capital components: debt, preferred stock, common equity
* Return on expenditures should exceed WACC

* Average risk of the projects that make up the firm

 WACC = wd [kd (1-t)] + wps (kps) + wce (kce)

* wi = percentage of component i in the capital

structure

* ki = cost of component i

* Capital components: Debt (d), Preferred stock

(ps), Common equity (ce)

*
* Interest paid on corporate debt is tax-
deductible.
* kd is adjusted to get after-tax return

* Typically, no deductions for payments to

common or preferred stockholders.
* kps and kce are not adjusted

*
Dexter’s target capital structure is as follows:
wd = 0.45
wps = 0.05
wce = 0.50

Its before-tax cost of debt is 8%, its cost of equity is

12%, its cost of preferred stock is 8.4%, and its
marginal tax rate is 40%.

Calculate Dexter’s WACC.

*
By preference
* Target capital structure. Use market values.

* Current capital structure. Use market values.

* Trend in capital structure (may be different from

current capital structure)

* Industry average capital structure as proxy for

target capital structure

*
The market values of a firm’s capital are as follows:

Debt outstanding P 8Mn

Preferred stock outstanding P 2Mn
Common stock outstanding P 10Mn

What is the firm’s target capital structure based on its

existing capital structure?

*
By preference
1. Use yield-to-maturity over coupon rate.

2. Use the yield of a similarly-rated issue.

*
* Assume: Non-callable, non-convertible

* Valuing a preferred stock

* P = Dps / kps
* Therefore: kps = Dps / P

*
* Required return on the firm’s common stock

* A firm can use its retained earnings to buy back

shares of its own stock.

* 3 estimation methods
* Capital Asset Pricing Method (CAPM) approach
* Dividend discount model (DDM) approach
* Bond yield plus risk premium approach

*
CAPM Approach
* kce = RFR + β[E(Rm) – RFR]

* Inputs
* Risk-free rate (RFR): Short-term Treasury bill rate
OR long-term Treasury bill rate

* Beta (β) is the stock’s risk measure

* Expected rate of return on the market, E(Rm)

*
Suppose RFR = 6%, Rmkt = 11% and Dexter has a
beta of 1.1. Estimate Dexter’s cost of equity.

*
DDM Approach
* Valuing a common stock
* P0 = D1 / (kce – g)
* Therefore: kce = (D1 / P0) + g
* Assumption: Dividends are expected to grow at a
constant rate, g.

* Estimating the growth rate

* Use projections by security analysts.
* Estimate a firm’s sustainable growth rate
g = retention rate (return on equity)
g = (1 – payout rate) (ROE)

*
Suppose Dexter’s stock sells for P 21.00, next
year’s dividend is expected to be P 1.00,
Dexter’s expected ROE is 12%, and Dexter is
expected to pay out 40% of its earnings. What is
Dexter’s cost of equity?

*
Bond yield plus risk premium approach
* Analysts add a risk premium (3 to 5 percentage
points) to the market yield on the firm’s long-
term debt.

* kce = bond yield + risk premium

*
Dexter’s interest rate on long-term debt is 8%.
Suppose the risk premium is estimated to be 5%.
Estimate Dexter’s cost of equity.