Pros And Cons Of Using Different Combinations Of Debt And Preferred Stock To Raise Funds

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Discussion 2

Investment Alternatives and Capital Budgeting Methodologies

Some companies’ common stocks pay cash dividends, while others’ do not. However, most bond issues do pay periodic interest. The preferred stock financing option also pays a dividend. Based on your readings, please respond to the following questions below:

  • From the investor’s point of view, analyze the advantages and disadvantages of the three investment alternatives—common stock, bonds, and preferred stock. Why would an investor select an investment in bonds over common stock, even if the return on the common stock investment is higher?
  • From the firm’s perspective, evaluate the pros and cons of using different combinations of debt, common stock, and preferred stock to raise funds. Why do some firms use preferred stock and others do not? Is it a matter of subjective preference, or are there sound theoretical reasons for the use of specific sources of funding?
  • How does an investor’s evaluation of the investment alternatives differ from the evaluation by a company trying to raise funds?
  • Among all the capital budgeting methodologies and their respective rules, which would you use and why? What are the advantages of one rule over another? Does the size or the nature of an investment have any impact on which method should be used? Why or why not? How might a rule be improved to make it more effective?
  • Textbook for this course should also be used.
  • Minimum 2 pages.

 

Valuation of Bonds

Bond: One of the means by which a company borrows money from the public and agrees to pay it back later.

Par value: The amount of money that a holder will get back once a bond matures. The bond generally has a par value of $1,000.

Bonds are valued at the present value of an ordinary annuity plus the present value of a lump sum.

Use the following equation to calculate the bond value:

Bond value =C x {(1+i)N – 1]/[(1+i)N x i]}+ F/(1+i)N

Where F = Par value of the bond

C = Coupon interest payment= F x Coupon rate

N =The time to maturity

I = The yield to maturity

Example Calculation: If a bond has a par value of $1,000, a yield to maturity of 10% per year with annual compounding, 5 years to maturity, and a coupon rate of 8%, what is its value?

Now, let’s identify the given values from the question after comparing with the equation.

  • The par value of the bond, i.e. F= $1,000
  • Coupon rate =8 % or 8/100 =0.08
  • Therefore, coupon interest payment, i.e., C = The par value of the bond x The coupon rate = $1,000 x 0.08 = 80
  • The time to maturity, i.e. N =5 years
  • The yield to maturity, i.e. i =10 % or 10/100 = 0.10

Now, let’s substitute all the given values in the equation. <Show one by one each value being substituted in the standard equation.>

  • Bond value =80 x [(1+0.10) 5 – 1]/[(1+ 0.10) 5 x 0.10]+ 1,000/(1+0.10)5
  • Solving the equation gives Bond value =$924.18

The resulting answer shows that the bond is selling for less than its par value.

Note: You can also use Microsoft Excel or a financial calculator to calculate the value of a bond.

 

Stock Valuation

If we have uneven cash-flow streams, a financial calculator and Microsoft Excel can help you to handle these problems without having to individually calculate each discounted cash flow.

timeline can help illustrate the payment streams (even or uneven). A timeline should be constructed in order to see when the cash flows occur, which allows one to see how many periods of compounding or discounting are required.

Simply draw a line and divide it into the relevant number of time periods (e.g.t=1).  Then identify what cash flows occur at the relevant time. Below is an example of a simple timeline.

A new company is expected to grow rapidly and pay dividends of $1, $2, and $3, for the first three years, respectively. We refer to this as a high, super growth phase.  After that time, the growth is expected to be at 5%. The required rate of return is 10%. You can use the PV and the Gordon growth model to estimate the value of the stock.

Stock Valuation: Perpetuity Model

The value of a stock is nothing more than the time value of the future cash flows. In the case of a stock, it is the discounted value of all the future dividends and other returns. The future returns of a stock are not as predictable as those of a bond. The value of stock is the present value of all expected dividends plus the present value of the terminal value at the end of the life of the company.

A preferred stock pays a constant dividend. The value of preferred stock is determined by treating it as a perpetuity.

 

Valuation of Preferred Stocks

A preferred stock is considered a hybrid security; it is a combination of a bond and a common stock. A preferred stock is like a bond because it pays a dividend just like the bonds pay interest, and it is like a common stock as it has a potential for capital gain, or price appreciation.

Let’s look at how to determine the value of a preferred stock.

A preferred stock is valued as perpetuity (an annuity that has no definite end or a stream of identical cash flows that continues forever).

You can calculate the preferred stock’s value by dividing its dividend by its required rate of return:

Value of the preferred stock =  Preferred stock’s dividend / Preferred stock’s required rate of return

An Example:

Let’s assume that a company’s preferred stock’s annual dividend is $20 and the required rate of return on the preferred stock is 8 percent.

Based on this information, let’s compute the value of the preferred stock.

Substituting $20 as the preferred stock dividend and 0.08 as the rate of return on the preferred stock in the above formula, you will arrive at $250 as the value of the preferred stock.

From your course textbook, Corporate Finance, read the following chapters:

  • Discounted Cash Flow Valuation
  • Net Present Value and Other Investment Rules
  • Interest Rates and Bond Valuation
  • Stock Valuation

 

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