LESSON 5

INTEREST RATES, BONDS AND STOCKS VALUATION

TOPICS
1. Interest Rates and Required Returns;
2. Differences Between Debt and Equity Capital;
3. Corporate Bonds Fundamentals and Valuation; and
4. Ordinary and Preference Shares Fundamentals and Valuation

LEARNING OUTCOMES
At the end of the lesson, you should be able gauge interest rates, bonds
and stocks valuation and assess the risk inflicted in each transaction.

TOPIC 1: INTEREST RATES AND REQUIRED RETURNS

Interest is the additional payment, called the interest rate, on top of the principal paid to a lender
for the right to borrow money. The interest rate is expressed as an annual percentage rate, and
the payment could be a fixed amount of money (fixed rate) or rates paid on a sliding scale (known
as a variable payment.) Basically, interest is the toll you pay to travel on the credit highway, at a
specific price and for a specific period of time.

Know these five keys about interest when you're applying for credit or taking out a loan:

• The amount of interest paid depends on the terms of the loan, worked out between the
lender and the borrower.
• Interest represents the price you pay for taking out a loan - you still have to pay off the
base principal of the loan, too.
• Interest on loans is usually pegged to current banking interest rates.
• Your interest rate on a credit card, auto loan or another form of interest can also depend
largely on your credit score.
• In certain cases, like with credit cards, your interest rate can rise if you're late on a
payment, or don't make a payment.

If you dig down into the interest landscape, you'll see that there are multiple forms of interest
that may confront a borrower. Thus, it's in the best interest of a borrower to get to know the
various types of interest and how each may impact the acquisition of credit or a loan. After all,
the more knowledge gained from better understanding interest, and how it works in all of its
forms, can be leveraged to get you a better deal the next time you apply for a loan or a credit
account.

Here's a breakdown of the various forms of interest, and how each might impact consumers
seeking credit or a loan.

1. Fixed Interest

A fixed interest rate is as exactly as it sounds - a specific, fixed interest tied to a loan or a line of
credit that must be repaid, along with the principal. A fixed rate is the most common form of

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interest for consumers, as they are easy to calculate, easy to understand, and stable - both the
borrower and the lender know exactly what interest rate obligations are tied to a loan or credit
account.

For example, consider a loan of $10,000 from a bank to a borrower. Given a fixed interest rate of
5%, the actual cost of the loan, with principal and interest combined, is $10,500.

This is the amount that must be paid back by the borrower.

2. Variable Interest

Interest rates can fluctuate, too, and that's exactly what can happen with variable interest rates.
Variable interest is usually tied to the ongoing movement of base interest rates (like the so-called
"prime interest rate" that lenders use to set their interest rates.) Borrowers can benefit if a loan
is set up using variable rates, and the prime interest rate declines (usually in tougher economic
times.) That said, if base interest rates rise, then the variable rate loan borrower may be forced
to pay more interest, as loan interest rates rise when they're tied to the prime interest rate.

Banks do this to protect themselves from interest rates getting too out of whack, to the point
where the borrower may be paying less than the market value for interest on a loan or credit.
Conversely, borrowers gain an advantage, too. If the prime rate goes down after they're
approved for credit or a loan, they won't have to overpay for a loan with a variable rate that's
tied to the prime interest rate.

3. Annual Percentage Rate (APR)

The annual percentage rate is the amount of your total interest expressed annually on the total
cost of the loan. Credit card companies often use APR to set interest rates when consumers agree
to carry a balance on their credit card account.

APR is calculated fairly simply - it's the prime rate plus the margin the bank or lender charges the
consumer. The result is the annual percentage rate.

4. The Prime Rate

The prime rate is the interest that banks often give favored customers for loans, as it tends to be
relatively lower than the usual interest rate offered to customers. The prime rate is tied to the
U.S. federal funds rate, i.e., the rate banks turn to when borrowing and lending cash to each
other.

Even though Main Street Americans don't usually get the prime interest rate deal when they
borrow for a mortgage loan, auto loan, or personal loan, the rates banks do charge for those
loans are tied to the prime rate.

5. The Discount Rate

The discount rate is usually walled off from the general public - it's the interest rate the U.S.
Federal Reserve uses to lend money to financial institutions for short-term periods (even as short
as one day or overnight.)

Banks lean on the discount rate to cover daily funding shortages, to correct liquidity issues, or in
a genuine crisis, keep a bank from failing.

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6. Simple Interest

The term simple interest is a rate banks commonly used to calculate the interest rate they charge
borrowers (compound interest is the other common form of interest rate calculation used by
lenders.)

Like APR, the calculation for simple interest is basic in structure. Here's the calculus banks use
when determining simple interest:

Principal x interest rate x n = interest

For example, let's say you deposited $5,000 into a money market account that paid a 1.5% for
three years. Consequently, the interest the bank saver would earn over the three- year period
would be $450 < x .03 x 3 = $450.>

7. Compound Interest

Banks often use compound interest to calculate bank rates. In essence, compound rates are
calculated on the two key components of a loan - principal and interest. With compound interest,
the loan interest is calculated on an annual basis. Lenders include that interest amount to the
loan balance, and use that amount in calculating the next year's interest payments on a loan, or
what accountants call "interest on the interest" of a loan or credit account balance.

Use this calculus to determine the compound interest going forward:

Here's how you would calculate compound interest:

• Principal times interest equals interest for the first year of a loan.
• Principal plus interest earned equals the interest for the second year of a loan.
• Principal plus interest earned times interest equal interest for year three.

The key difference between simple interest and compound interest is time.

The required rate of return is the minimum return an investor will accept for owning a company's
stock, as compensation for a given level of risk associated with holding the stock. The RRR is also
used in corporate finance to analyze the profitability of potential investment projects.

The required rate of return is also known as the hurdle rate, which like RRR, denotes the
appropriate compensation needed for the level of risk present. Riskier projects usually have
higher hurdle rates or RRRs than those that are less risky.

The required rate of return RRR is a key concept in equity valuation and corporate finance. It's a
difficult metric to pinpoint due to the different investment goals and risk tolerance of individual
investors and companies. Risk-return preferences, inflation expectations, and a company’s
capital structure all play a role in determining the company's own required rate. Each one of
these and other factors can have major effects on a security's intrinsic value.

• The required rate of return is the minimum return an investor will accept for owning a
company's stock, that compensates them for a given level of risk.
• Inflation must also be factored into an RRR calculation, which finds the minimum rate of
return an investor considers acceptable, taking into account their cost of capital, inflation
and the return available on other investments.

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 • The RRR is a subjective minimum rate of return, and a retiree will have a lower risk
tolerance and therefore accept a smaller return than an investor who recently graduated
college.

TOPIC 2: DIFFERENCES BETWEEN DEBT AND EQUITY CAPITAL

Capital is the basic requirement of every business organization, to fulfill the long term and short-
term financial needs. To raise capital, an enterprise either used owned sources or borrowed ones.
Owned capital can be in the form of equity, whereas borrowed capital refers to the company’s
owed funds or say debt. Equity refers to the stock, indicating the ownership interest in the
company. On the contrary, debt is the sum of money borrowed by the company from bank or
external parties, that required to be repaid after certain years, along with interest. Almost all the
beginners suffer from this confusion that whether the debt financing would be better or equity
financing is suitable. So here, we will discuss the difference between debt and equity financing,
to help you understand which one is appropriate for your business type.

Debt
Money raised by the company in the form of borrowed capital is known as Debt. It represents
that the company owes money towards another person or entity. They are the cheapest source
of finance as their cost of capital is lower than the cost of equity and preference shares. Funds
raised through debt financing are to be repaid after the expiry of the specific term.
Debt can be in the form of term loans, debentures or bonds. Term loans are obtained from
financial institutions or banks while debentures and bonds are issued to the general public. Credit
Rating is mandatory for issuing debentures publicly. They carry fixed interest, which requires
timely payments. The interest is tax deductible in nature, so, the benefit of tax is also available.
However, the presence of debt in the capital structure of the company can lead to financial
leverage.
Debt can be secured or unsecured. Secured Debt requires pledging of an asset as security so that
if the money is not paid back within a reasonable time, the lender can forfeit the asset and
recover the money. In the case of unsecured debt, there is no obligation to pledge an asset for
getting the funds.

Equity
In finance, Equity refers to the Net Worth of the company. It is the source of permanent capital.
It is the owner’s funds which are divided into some shares. By investing in equity, an investor gets
an equal portion of ownership in the company, in which he has invested his money.
The investment in equity costs higher than investing in debt. Equity comprises of ordinary shares,
preference shares, and reserve & surplus. The dividend is to be paid to the equity holders as a
return on their investment. The dividend on ordinary shares (equity shares) is neither fixed nor
periodic whereas preference shares enjoy fixed returns on their investment, but they are also
irregular in nature. Although the dividend is not tax deductible in nature.
Investment in equity shares is the risky one as in the event of winding up of the company; they
will be paid at the end after the debt of all the other stakeholders is discharged. There are no
committed payments in equity shareholders i.e. the payment of dividend is voluntary. Apart from
that, equity shareholders will be paid off only at the time of liquidation while the preference
shares are redeemed after a specific period.

Key Differences Between Debt and Equity

The difference between debt and equity capital, are represented in detail, in the following points:

1. Debt is the company’s liability which needs to be paid off after a specific period. Money
raised by the company by issuing shares to the general public, which can be kept for a
long period is known as Equity.
2. Debt is the borrowed fund while Equity is owned fund.

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 3. Debt reflects money owed by the company towards another person or entity. Conversely,
Equity reflects the capital owned by the company.
4. Debt can be kept for a limited period and should be repaid back after the expiry of that
term. On the other hand, Equity can be kept for a long period.
5. Debt holders are the creditors whereas equity holders are the owners of the company.
6. Debt carries low risk as compared to Equity.
7. Debt can be in the form of term loans, debentures, and bonds, but Equity can be in the
form of shares and stock.
8. Return on debt is known as interest which is a charge against profit. In contrast to the
return on equity is called as a dividend which is an appropriation of profit.
9. Return on debt is fixed and regular, but it is just opposite in the case of return on equity.
10. Debt can be secured or unsecured, whereas equity is always unsecured.

Conclusion. It is essential for all the companies to maintain a balance between debt and equity
funds. The ideal debt-equity ratio is 2:1 i.e. equity should always be twice of the debt, only then
it can be assumed that the company can cover its losses effectively.

TOPIC 3: CORPORATE BONDS FUNDAMENTALS AND VALUATION

What are Corporate Bonds?

Corporate bonds are bonds issued by corporations to
finance various activities, including operations,
expansion, or M&A. Corporate bonds generally offer
higher yields than government bonds because they
usually come with a higher probability of default, making
them riskier. Additionally, there are different types of
corporate bonds that range in levels of risk and yield.
The valuation of corporate bonds is similar to that of any risky asset; it is dependent on the
present value of future expected cash flows, discounted at a risk-adjusted rate (similar to a DCF).
However, the probability of default for the bond and the payout ratio if the bond defaults (ratio
of face value received if bond defaults) must be factored into the valuation.
Different Kinds of Bonds

1. Treasury bonds
Treasuries are issued by the federal government to finance its budget deficits. Because
they're backed by Uncle Sam's awesome taxing authority, they're considered credit-risk
free. The downside: Their yields are always going to be lowest (except for tax-free munis).
But in economic downturns they perform better than higher-yielding bonds, and the
interest is exempt from state income taxes.
2. Investment-grade corporate bonds
Investment-grade corporates are issued by companies or financing vehicles with relatively
strong balance sheets. They carry ratings of at least triple-B from or both. (The scale is
triple-A as the highest, followed by double-A, single-A, then triple-B, and so on.) For
investment-grade bonds, the risk of default is considered pretty remote. Still, their yields
are higher than either Treasury or agency bonds, though like most agencies they are fully
taxable. In economic downturns, these bonds tend to underperform Treasuries and
agencies.
3. High-yield bonds
These bonds are issued by companies or financing vehicles with relatively weak balance
sheets. They carry ratings below triple-B. Default is a distinct possibility. As a result, high-

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 yield bond prices are more closely tied to the health of corporate balance sheets. They
track stock prices more closely than investment-grade bond prices.
4. Foreign bonds
These securities are something else altogether. Some are dollar-denominated, but the
average foreign bond fund has about a third of its assets in foreign-currency-denominated
debt, according to Lipper. With foreign-currency-denominated bonds, the issuer promises
to make fixed interest payments -- and to return the principal -- in another currency. The
size of those payments when they are converted into dollars depends on exchange rates.
If the dollar strengthens against foreign currencies, foreign interest payments convert
into smaller and smaller dollar amounts (if the dollar weakens, the opposite holds true).
Exchange rates, more than interest rates, can determine how a foreign bond fund
performs.
5. Mortgage-backed bonds
Mortgage-backeds, which have a face value of $25,000 compared to $1,000 or $5,000 for
other types of bonds, involve "prepayment risk." Because their value drops when the rate
of mortgage prepayments rises, they don't benefit from declining interest rates like most
other bonds do.
6. Municipal bonds
Municipal bonds -- often called "munis" are issued by U.S. states and local governments
or their agencies, and they come in both the investment-grade and high-yield varieties.
The interest is tax-free, but that doesn't mean everyone can benefit from them. Taxable
yields are higher than muni yields to compensate investors for the taxes, so depending
on your bracket, you might still come out ahead with taxable bonds.

TOPIC 4: ORDINARY AND PREFERENCE SHARES FUNDAMENTALS AND VALUATION

An ordinary share represents equity ownership in a company proportionally with all other
ordinary shareholders, according to their percentage of ownership in the company. All additional
shares of a company's stock are, by definition, preferred shares. Ordinary shares must be issued
by all corporations, as defined in their articles of association, with companies requiring to issue
at least one ordinary share to a shareholder. In other words, someone has to be the owner of the
corporation.

• Ordinary shares provide investors with voting rights (one vote per share) and represent
proportionate ownership of a company.
• Ordinary stock shareholders receive fluctuating dividend payments depending on a
company’s performance.
• Ordinary stock shareholders receive their dividend payment after preferred stock
shareholders.
• Market forces, the value of the underlying business and investor sentiment determine the
market value that investors pay for ordinary shares.

Ordinary shares

Ordinary shares are sometimes known as ‘common stock’. Gives holders the right to vote at
meetings as well as take dividends from the company’s profits. Voting rights mean you have a
say on issues such as salaries and the future direction of the business. Although you do have the
right to dividends when they are paid, companies are not obliged to distribute them should a
decision be made to the contrary. This may be because profits are lower than expected, or
because it has been decided that these profits are to be reinvested straight back into the business
to fuel further growth instead.

Ordinary shareholders have the right to a corporation's residual profits. In other words, they are
entitled to receive dividends if any are available after the company pays dividends on preferred
shares. They are also entitled to their share of the residual economic value of the company should
the business unwind; however, they are last in line after bondholders and preferred shareholders

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for receiving business proceeds. As such, ordinary shareholders are considered unsecured
creditors.

While ordinary shareholders face greater financial risk than creditors and preferred shareholders
of a corporation, they can also reap greater rewards. If a company makes large profits, the
creditors and preferred shareholders do not receive more than the fixed amounts to which they
are entitled, while the ordinary shareholders divide the large profits among themselves. The
same occurs when companies, such as start-ups, are sold to larger corporations. Ordinary
shareholders usually profit the most.

The only obligation that an ordinary shareholder has is to pay the price of the share to the
company when it's issued. In addition to the shareholder's right to residual profits, they are
entitled to vote for the company's board members (although some preferred shareholders may
also vote) and to receive and approve the company's annual financial statements.

Value of Ordinary Shares

Ordinary shares include those traded privately as well as shares that trade on the various public
stock exchanges. In many jurisdictions, ordinary shares have a stated "par value," but this value
is more of a technicality, and is rarely more than a few cents per share. Market forces, the value
of the underlying business and investor sentiment toward the company determine the market
value that investors pay for ordinary shares.

Preference shares

Preference shares come with no voting rights but they do provide an advantage over ordinary
shareholders when it comes to receiving dividends. Preference shareholders are first in line for
dividend payments, both when the business is operating, and also in the event of the company
entering liquidation in the future. Dividend payments for preference shareholders are often at
an agreed level and are made at defined points throughout the year. Due to this preference
shares are often seen as a less risky investment, although payment amounts may be lower in light
of this. Should the company experience a period of growth with profits to match, preference
shareholders will not see the benefit in this when it comes to receiving their dividend payment.
However, this works both ways, and many individuals investing in this way appreciate the
element of certainty that comes with it.

Despite this, companies may choose not to make a dividend payment in certain instances. Even
if you hold preferred stock, you will still not be able to receive a dividend payment if the company
decides not to issue them. What happens in this situation depends on the type of preference
share which is held.

Cumulative and non-cumulative preference shares

There are two main types of preference shares: cumulative and non-cumulative

• Cumulative – If you hold cumulative preference shares, the amount of the missed
dividend will roll over to the next dividend date. If dividends are issued at this point then
you will receive both amounts; if dividend payments are again vetoed then both amounts
will roll over to the next date and so on.
• Non-cumulative – Should the company make the decision not to pay dividends for a
period, this amount will not be paid at any point in the future; essentially the shareholder
loses this dividend payment for good.

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References
Anastacio, Ma. Flordeliza et al (2010). Fundamentals of Financial Management (with Industry-
Based Perspective). Philippines. Rex Bookstore Inc.

Cabrera, Ma. Elenita B. (2012-2013) edition. Financial Management Principles and Application.

Gitman, Lawrence J., (2014). Introduction to Managerial Finance. Singapore. Pearson Education
South Asia Pte Ltd.

Titman, S., etal. (2011). Financial Management: Principles and Applications. Singapore. Pearson
Education South Asia Pte Ltd.