Chapter No.10

Chapter 10

The Capital Markets

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-2

Purpose of the Capital Market

• Original maturity is greater than one year, typically for long-term financing or investments

• Best known capital market securities:– Stocks and bonds


Capital Market Participants

• Primary issuers of securities:– Federal and local governments: debt issuers

– Corporations: equity and debt issuers

• Largest purchasers of securities:– You and me


Capital Market Trading

1. Primary market for initial sale (IPO)

2. Secondary market– Over-the-counter

– Organized exchanges (i.e., NYSE)


Types of Bonds

• Bonds are securities that represent debt owed by the issuer to the investor, and typically have specified payments on specifies dates.

• Types of bonds we will examine include long-term government bonds (T-bonds), municipal bonds, and corporate bonds.


Figure 10.1 Sohio/BP Corporate Bond

Types of Bonds: Sample Corporate Bond


Treasury Bonds

• The U.S. Treasury issues notes and bonds to finance its operations.

• The following table summarizes the maturity differences among the various Treasury securities.


Treasury Bonds


Treasury Bond Interest Rates

• No default risk since the Treasury can print money to payoff the debt

• Very low interest rates, often considered the risk-free rate (although inflation risk is still present)


Treasury Bonds: Recent Innovation

• Treasury Inflation-Indexed Securities: the principal amount is tied to the current rate of inflation to protect investor purchasing power


Municipal Bonds

• Issued by local, county, and state governments

• Used to finance public interest projects

• Tax-free municipal interest rate = taxable interest rate (1 marginal tax rate)


Municipal Bonds: Example

Suppose the rate on a corporate bond is 9% and the rate on a municipal bond is 6.75%. Which should you choose?

Answer: Find the marginal tax rate:

6.75% = 9% x (1 – MTR), or MTR = 25%

If you are in a marginal tax rate above 25%, the municipal bond offers a higher after-tax cash flow.


Municipal Bonds

• Two types– General obligation bonds

– Revenue bonds

• NOT default-free– Defaults in 1990 amounted to $1.4 billion in

this market


Corporate Bonds

• Typically have a face value of $1,000, although some have a face value of $5,000 or $10,000

• Pay interest semi-annually


Corporate Bonds

• Cannot be redeemed anytime the issuer wishes, unless a specific clause states this (call option).

• Degree of risk varies with each bond, and the required interest rate varies with level of risk.


Corporate Bonds: Characteristics of Corporate Bonds

• Registered Bonds– Replaced “bearer” bonds

– IRS can track interest income this way

• Restrictive Covenants

– Mitigates conflicts with shareholder interests

– May limit dividends, new debt, ratios, etc.



• Call Provisions – Higher yield

– Sinking fund

– Interest of the stockholders

– Alternative opportunities

• Conversion

– Some debt may be converted to equity



• Secured Bonds– Mortgage bonds

– Equipment trust certificates

• Unsecured Bonds– Debentures

– Subordinated debentures

– Variable-rate bonds


• Junk Bonds– Debt that is rated below BBB

– Often, trusts and insurance companies are not permitted to invest in junk debt



Financial Guarantees for Bonds

• Some debt issuers purchase financial guarantees to lower the risk of their debt.

• The guarantee provides for timely payment of interest and principal, and are usually backed by large insurance companies.


Investing in Stocks

1. Represents ownership in a firm

2. Earn a return in two ways– Price of the stock rises

over time

– Dividends are paid to the stockholder

3. Stockholders have claim on all assets

4. Right to vote for directors and on certain issues

5. Two types– Common stock

• Right to vote

• Receive dividends

– Preferred stock• Receive a fixed

dividend

• Do not usually vote


Investing in Stocks: Sample Corporate Stock Certificate

Figure 11.1 Wien Consolidated Airlines Stock


Investing in Stocks: How Stocks are Sold

• Organized exchanges – Account for over 72% of total dollar volume

– Larges U.S. Exchange is the NYSE

– Others include Nikkei, LSE, DAX, etc.

– Listing requirements exclude small firms

• Over-the-counter markets– Best example is NASDAQ

– Dealers stand ready to make a market


Computing the Price of Common Stock

Valuing common stock is, in theory, no different from valuing debt securities: determine the future cash flows and discount them to the present at an appropriate discount rate.

We will review four different methods for valuing stock, each with its advantages and drawbacks.


Computing the Price of Common Stock: The One-Period Valuation Model

• Simplest model, just taking using the expected dividend and price over the next year.

• Price = )1()1(11

ee k

P

k

Div


71.53)12.01(

60

)12.01(

16.0

Computing the Price of Common Stock: The One-Period Valuation Model

What is the price for a stock with an expected dividend and price next year of $0.16 and $60, respectively? Use a 12% discount rate

Answer:

Price =


Computing the Price of Common Stock: The Generalized Dividend Valuation Model

• Most general model, but the infinite sum may not converge.

• Price =

• Rather than worry about computational problems, we use a simpler version, known as the Gordon growth model.

1 )1(tt

e

t

k

Div


Computing the Price of Common Stock: The Gordon Growth Model

• Same as the previous model, but it assumes that dividend grow at a constant rate, g. That is,

Div(t+1) = Divt x (1 + g)

• Price = )()1(1

1 gk

D

k

Div

ett

e

t


Computing the Price of Common Stock: The Gordon Growth Model

The model is useful, with the following assumptions:

• Dividends do, indeed, grow at a constant rate forever

• The growth rate of dividends, g, is less than the required return on the equity, ke.


Computing the Price of Common Stock: The Generalized Dividend Valuation Model

• The price earnings ratio (PE) is a widely watched measure of much the market is willing to pay for $1.00 of earnings from the firms.

• Price = EE

P


Computing the Price of Common Stock: The Price Earnings Valuation Method

If the industry PE ratio for a firm is 16, what is the current stock price for a firm with earnings for $1.13 / share?

Answer:

Price = 16 x $1.13 = $18.08


How the Market Sets Security Prices

• Generally speaking, prices are set in competitive markets as the price set by the buyer willing to pay the most for an item.

• The buyer willing to pay the most for an asset is usually the buyer who can make the best use of the asset.

• Superior information can play an important role.


How the Market Sets Security Prices

• Consider the following three valuations for a stock with certain dividends but different perceived risk:

• Bud, who perceives the lowest risk, is willing to pay the most and will determine the “market” price.


Errors in Valuations

Although the pricing models are useful, market participants frequently encounter problems in using them. Any of these can have a significant impact on price in the Gordon model.

• Problems with Estimating Growth

• Problems with Estimating Risk

• Problems with Forecasting Dividends


Stock Market Indexes

• Stock market indexes are frequently used to monitor the behavior of a groups of stocks.

• Major indexes include the Dow Jones Industrial Average, the S&P 500, and the NASDAQ composite.

• The securities that make up the (current) DJIA are included on the next slide.


Buying Foreign Stocks

• Buying foreign stocks is useful from a diversification perspective. However, the purchase may be complicated if the shares are not traded in the U.S.

• American depository receipts (ADRs) allow foreign firms to trade on U.S. exchanges, facilitating their purchase. U.S. banks buy foreign shares and issue receipts against the shares in U.S. markets.

Chapter No.10

Economy & Finance

Transcript of Chapter No.10