Valuation of Stocks & Bonds

Valuation of Stocks & Bonds - Valuation of Bonds...

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Long-term debt, preferred stock, and common stock are the major sources of capital for a firm. Bonds I. If a company borrows money in the capital markets, it issues long-term debt securities (bonds) to investors. Bonds are usually issued in denominations of $1,000 (principal amount), which constitutes a promise, by the firm to repay the principal by a particular date (the maturity date) and to pay a specified amount of interest at fixed intervals (usually twice a year). A. Long-term debt can be classified in a number of ways according to the security, repayment provisions and other features. 1. Debt issues that are secured by real estate the firm owns are called mortgage bonds; unsecured bonds are called debentures ( debs). 2. Senior debt issues have a higher priority claim to the earnings or assets of the firm than junior issues. 3. Debt may be subordinated or unsubordinated . In the event of liquidation or reorganization, claims of subordinated debenture holders are considered only after the claims of unsubordinated debt holders. The debt to which a debenture is subordinated varies from firm to firm. B. Special types of long-term debt can be created. 1. Equipment trust certificates are securities used largely by railroads and trucking companies to purchase specific assets such as rolling stock. Technically, the certificate holders own the equipment and lease it to the firm. Oversight and payments are through a trustee. 2. Collateral trust bonds are backed by securities of other corporations. These are used primarily by holding companies that borrow against their interest in their subsidiaries and then re-lend the funds to the subsidiaries. 3. Income bonds promise to pay interest only if the firm has sufficient income. These are not commonly used today. 4. Pollution control bonds and industrial revenue bonds are tax-exempt securities issued by local governments for the benefit of a firm that guarantees the bonds. 1
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C. Long-term debt contains a number of standard features and common optional features. 1. An indenture is a legal contract between the issuing firm and the lenders, which specifies payment procedures and contains any restrictive covenants intended to enhance the security of the debt issue. Typical restrictions apply to minimum levels of working capital, limitations on dividends, limitations on additional debt, and poison puts. (A poison put allows bondholders to sell their debt back to the company at par value in the event of a leveraged buyout transaction and a downgrade in the credit rating of the debt issue to below investment grade.) Debt covenants are used to resolve agency problems among debtholders, stockholders, and managers. 2.
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Valuation of Stocks & Bonds - Valuation of Bonds...

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