Bond and Stock Valuation PEACHTREE SECURITIES, INC. (B) Laura Donahue, the recently hired utility analyst for Peachtree Securities, passed her first assignment with flying colors see Case 2, Peachtree Securities, Inc. (A). After presenting her seminar on risk and return, many customers were clamoring for a second lecture. Therefore, Jake Taylor, Peachtree's president, gave Donahue her second task: determine the value of TECO Energy's securities com mon stock, preferred stock, and bonds and prepare a seminar to explain the valuation process to the firm's customers. (Note that it is not necessary to work Case 2 prior to working this case) To begin, Donahue reviewed the Value Line Investment Survey data (see Figure 1 in Case 2 Next, Donahue examined TECO's latest Annual Report, especially Note E to the Consolidated Financial Statements. This note lists TECO's long-term debt obligations, including its first mortgage bonds, installment contracts, and term loans. Table I contains information on three of the first mortgage bonds listed in the Annual Report. TABLE 1 Partial Long-Term Debt Listing for TECO Energy Years to Face Amount Coupon Rate Maturity Year Maturity $ 48,000,000 1997 S 32,000,000 8 2007 $100,000,000 12'0 2017 Note The terms stated here are modified slightly from the actual terms to simplify the case A concern which immediately occurred to Donahue was the phenomenon of event risk Recently, many investors have shied away from the industrial bond market because of the wave of leveraged buyouts (LBOS) and debt financed corporate takeovers that took place during the 1980s These takeovers were financed by issuing large amounts of new debt often high-risk-junk bonds which caused the credit rating of the firm's existing bonds to drop, the required rate of return to increase, and the price of the bonds to decline Donahue wondered if this trend would affect the required returns on TECOs outstanding bonds Upon reflection, she concluded that TECO s bonds would be much less vulnerable to such event risk because TEC is a regulated public utility. Public utilities and banks are less vulnerable to takeovers and leveraged buyouts, primarily because their regulators would have to approve such restructurings. and it is unlikely that they would permit the level of debt needed for an LBO. Therefore, many Case 3 - Bonde Stock Case 03 Bond and Stock Valuation investors have turned to government bonds, mortgage backed issues, and utility bonds in lieu of pub licly traded corporate bonds. As a result, Donahue concluded that the effect, if any of the increased concern about event risk will be to lower TECO scost of bond financing With these considerations in mind, your task is to help Donahue pass her second hurdle at Peachtree Securities by answering the following questions QUESTIONS Preliminary note Some of our answers were generated using a computer model which carried out calculations fo 8 decimal places. Therefore, you can expect small rounding differences if your answers are obtained using a financial calculator These differences are not material 1. To begin, assume that it is now January 1, 1993, and that each bond in Table 1 matures on December 31 of the year listed. Further, assume that each bond has a $1,000 par value, each had a 30 year maturity when it was issued, and the bonds currently have a 10 percent required nominal rate of return. a. Why do the bonds coupon rates vary so widely? b. What would be the value of each bond if they had annual coupon payments? c. TECOs bonds, like virtually all bonds, actually pay interest semiannually What is each bond's value under these conditions? Are the bonds currently selling at a discount or at premium? d. What is the effective annual rate of return implied by the values obtained in Parte? c. Would you expect a semiannual payment bond to sell at a higher or lower price than an otherwise equivalent annual payment bond? Now look at the 5-year bond in Parts bande Are the prices shown consistent with your expectations? Explain 2. Now, regardless of your answers to Question I assume that the 5-year bond is selling for $80000, the 15-year bond is selling for 5865 49, and the 25-year bond is selling for $1.22000 Note. Use these prices and assume semiannual coupons for the remainder of the questions, a. Explain the meaning of the term yield to maturity b. What is the nominal tas opposed to effective annual yield to maturity YTM on cach bond? c. What is the effective annual YTM on each issue? d. In comparing bond yields with the yields on other securities, should the nominal or effe tive YTM be used? Explain 3. Suppose TECO has a second bond with 25 years left to maturity in addition to the one listed in Table I, which has a coupon rate of 75 percent and a market price of $74745 a. What is ch the nominal yield and the effective annual YTM on this bond? b. What is the current yield on each of the 25-year bonds? .. What is cach bonds expected price on January 1, 1994, and its capital gains yield for 1993, assuming no change in interest rates? Hint. Remember that the nominal required rate of return on cach bond is 10 18 percent . What would happen to the price of each bond over time? Again, assume constant future interest rates) c. What is the expected total percentage return on each bond during 1993? 1. If you were a tax paying investor, which bond would you prefer? Why? What impact would this preference have on the prices, hence YTMs, of the two bonds? Case: 03 Bond and Stock Valuation 4. Consider the riskiness of the bonds a. Explain the difference between interest rate price risk and reinvestment rate risk. b. Which of the bonds listed in Table 1 has the most price risk? Why? C. Assume that you bought 5 year, 15 year, and 25-year bonds, all with a 10 percent coupon rate and semiannual coupons, at their $1.000 par values. Which bond's value would be most affected if interest rates rose to 13 percent? Which would be least affected? If you are using the Lotus model, calculate the new value of each bond. d. Assume that your investment horizon cor expected holding periods is 25 years. Which of the bonds listed in Table I has the greatest reinvestment rate risk? Why? What is a type of bond you could buy to climinate reinvestment rate risk? e. Assume that you plan to keep your money invested, and to reinvest all interest receipts, for 5 years. Assume further that you bought the 5-year bond for $800, and interest rates suddenly fell to 5 percent and remained at that level for 5 years. Set up a worksheet that could be used to calculate the actual realized rate of return on the bond, but do not neces sarily complete the calculations. Note that each interest receipt must be compounded to the terminal date and summed, along with the maturity value. Then, the rate of return that equates this terminal value to the initial value of the bond is the bond's realized return Assume that the answer is 9.16 percent. How does that value compare with your expected rate of return? What would have happened if interest rates had risen to 15 percent rather than fallen to 5 percent? How would the results have differed if you had bought the 25. year bond rather than the 5-year bond? Do these results suggest that you would be better offor worse off if you buy long term bonds and then rates change? Explain. 1. Today, many bond market participants are speculators, as opposed to long-term investors If you thought interest rates were going to fall from current levels, what type of bond would you buy to maximize short-term capital gains? 5. Now assume that the 15 year bond is callable after 5 years at $1,050. a. What is its yield to call (YTC)? b. Do you think it is likely that the bond will be called? 6 TECO has $54,956,000 of preferred stock outstanding Suppose its Series A, which has a $100 par value and pays a 4 32 percent cumulative div. idend, currently sells for $4800 per share. What is its nominal expected rate of return? Its cffective annual rate of return? (Hint: Remember that dividends are paid quarterly. Also, assume that this issue is perpetual b. Suppose Series F, with a $100 par value and a 9.75 percent cumulative dividend, has a mandatory sinking fund provision 60,000 of the 300,000 total shares outstanding must be redeemed annually at par beginning at the end of 1993. If the nominal required rate of return is 80 percent, what is the current January 1, 1993value per share? 7. Now consider TECO's common stock Value Line estimates TECO's 5 year dividend growth rate to be 60 percent See Figure 1 in Case 2. Assume that TECO s stock traded on January 1. 1992 for $22 26 Assume for now that the 60 percent growth rate is expected to continue indefinitely a. What was TECO's expected rate of return at the beginning of 1992 Hint: Value Line estimated Dl to be SI 80 at the start of 1992. See Figure 1 in Case 2) b. What was the expected dividend yield and expected capital gains yield on January 1, 1992? c. What is the relationship between dividend yield and capital gains yield over time under constant growth assumptions? Case 03 Bond and Stock Valuation d. What conditions must hold to use the constant growth Gordon model? Do many real world-stocks satisfy the constant growth assumptions? 8. Suppose you believe that TECO's 60 percent dividend growth rate will only hold for 5 years. After that, the growth rate will return to TECO's historical 10-year average of 7.5 per- cent. Note that D6 - DS 1075. Again, see Figure 1 in Case 2) a. What was the value of TECO stock on January 1, 1992, if the required rate of return is 13.5 percent? b. What is the expected stock price at the end of 1992 assuming that the stock is in equilib rium? c. What is the expected dividend yield, capital gains yield, and total return for 1992? d. Suppose TECO's dividend was expected to remain constant at SI 80 for the next 5 years and then grow at a constant 6 percent rate. If the required rate of return is 135 percent, would TECO's stock value be higher or lower than your answer in Parta? If you are using the Lotus model for the case, calculate the dividend yield, capital gains yield, and total yield from 1992 through 1996 e. TECO's stock price was $22.26 at the beginning of 1992 Using the growth rates given in the introduction to this question, what is the stocks expected rate of return? f. Refer back to Figure 1 in Case 2 Look at the Eamed Common Equity-estimated for 1995 through 1997 and at the projected earnings and dividends per share for the same period Could those figures be used to develop an estimated long-run-sustainable growth rate? Does this figure support the 75 percent growth rate given in the problem? Hint Think of the formula g - br - Retention ratioROE 9. Common stocks are usually valued assuming annual dividends even though dividends are actually paid quarterly. This is because the dividend stream is so uncertain that the use of a quarterly model is not warranted. The quarterly constant growth valuation model is Dal (1-6,075. De2 (1-6050. Dq3 cl -6,025.De4d.k. where P, is the stock's value and Dqi is the dividend in Quarter i Note that this model assumes that dividend growth occurs once each year rather than at every quarter. Assume that TECO-s next four quarterly dividends are SI 804-50.45 cach; that k, the annual required rate of return, is 13.5 percent, and that g is a constant 60 percent What is TECOS value according to the quarterly model? 6. TECO has $54,956,000 of preferred stock outstanding, a. Suppose its Series A, which has a $100 par value and pays a 4.32 percent cumulative div- idend, currently sells for $48.00 per share. What is its nominal expected rate of return? Its effective annual rate of return? (Hint: Remember that dividends are paid quarterly. Also, assume that this issue is perpetual.) b. Suppose Series F, with a $100 par value and a 9.75 percent cumulative dividend, has a mandatory sinking fund provision 60,000 of the 300,000 total shares outstanding must be redeemed annually at par beginning at the end of 1993. If the nominal required rate of return is 80 percent, what is the current January 1, 1993) value per share? Bond and Stock Valuation PEACHTREE SECURITIES, INC. (B) Laura Donahue, the recently hired utility analyst for Peachtree Securities, passed her first assignment with flying colors see Case 2, Peachtree Securities, Inc. (A). After presenting her seminar on risk and return, many customers were clamoring for a second lecture. Therefore, Jake Taylor, Peachtree's president, gave Donahue her second task: determine the value of TECO Energy's securities com mon stock, preferred stock, and bonds and prepare a seminar to explain the valuation process to the firm's customers. (Note that it is not necessary to work Case 2 prior to working this case) To begin, Donahue reviewed the Value Line Investment Survey data (see Figure 1 in Case 2 Next, Donahue examined TECO's latest Annual Report, especially Note E to the Consolidated Financial Statements. This note lists TECO's long-term debt obligations, including its first mortgage bonds, installment contracts, and term loans. Table I contains information on three of the first mortgage bonds listed in the Annual Report. TABLE 1 Partial Long-Term Debt Listing for TECO Energy Years to Face Amount Coupon Rate Maturity Year Maturity $ 48,000,000 1997 S 32,000,000 8 2007 $100,000,000 12'0 2017 Note The terms stated here are modified slightly from the actual terms to simplify the case A concern which immediately occurred to Donahue was the phenomenon of event risk Recently, many investors have shied away from the industrial bond market because of the wave of leveraged buyouts (LBOS) and debt financed corporate takeovers that took place during the 1980s These takeovers were financed by issuing large amounts of new debt often high-risk-junk bonds which caused the credit rating of the firm's existing bonds to drop, the required rate of return to increase, and the price of the bonds to decline Donahue wondered if this trend would affect the required returns on TECOs outstanding bonds Upon reflection, she concluded that TECO s bonds would be much less vulnerable to such event risk because TEC is a regulated public utility. Public utilities and banks are less vulnerable to takeovers and leveraged buyouts, primarily because their regulators would have to approve such restructurings. and it is unlikely that they would permit the level of debt needed for an LBO. Therefore, many Case 3 - Bonde Stock Case 03 Bond and Stock Valuation investors have turned to government bonds, mortgage backed issues, and utility bonds in lieu of pub licly traded corporate bonds. As a result, Donahue concluded that the effect, if any of the increased concern about event risk will be to lower TECO scost of bond financing With these considerations in mind, your task is to help Donahue pass her second hurdle at Peachtree Securities by answering the following questions QUESTIONS Preliminary note Some of our answers were generated using a computer model which carried out calculations fo 8 decimal places. Therefore, you can expect small rounding differences if your answers are obtained using a financial calculator These differences are not material 1. To begin, assume that it is now January 1, 1993, and that each bond in Table 1 matures on December 31 of the year listed. Further, assume that each bond has a $1,000 par value, each had a 30 year maturity when it was issued, and the bonds currently have a 10 percent required nominal rate of return. a. Why do the bonds coupon rates vary so widely? b. What would be the value of each bond if they had annual coupon payments? c. TECOs bonds, like virtually all bonds, actually pay interest semiannually What is each bond's value under these conditions? Are the bonds currently selling at a discount or at premium? d. What is the effective annual rate of return implied by the values obtained in Parte? c. Would you expect a semiannual payment bond to sell at a higher or lower price than an otherwise equivalent annual payment bond? Now look at the 5-year bond in Parts bande Are the prices shown consistent with your expectations? Explain 2. Now, regardless of your answers to Question I assume that the 5-year bond is selling for $80000, the 15-year bond is selling for 5865 49, and the 25-year bond is selling for $1.22000 Note. Use these prices and assume semiannual coupons for the remainder of the questions, a. Explain the meaning of the term yield to maturity b. What is the nominal tas opposed to effective annual yield to maturity YTM on cach bond? c. What is the effective annual YTM on each issue? d. In comparing bond yields with the yields on other securities, should the nominal or effe tive YTM be used? Explain 3. Suppose TECO has a second bond with 25 years left to maturity in addition to the one listed in Table I, which has a coupon rate of 75 percent and a market price of $74745 a. What is ch the nominal yield and the effective annual YTM on this bond? b. What is the current yield on each of the 25-year bonds? .. What is cach bonds expected price on January 1, 1994, and its capital gains yield for 1993, assuming no change in interest rates? Hint. Remember that the nominal required rate of return on cach bond is 10 18 percent . What would happen to the price of each bond over time? Again, assume constant future interest rates) c. What is the expected total percentage return on each bond during 1993? 1. If you were a tax paying investor, which bond would you prefer? Why? What impact would this preference have on the prices, hence YTMs, of the two bonds? Case: 03 Bond and Stock Valuation 4. Consider the riskiness of the bonds a. Explain the difference between interest rate price risk and reinvestment rate risk. b. Which of the bonds listed in Table 1 has the most price risk? Why? C. Assume that you bought 5 year, 15 year, and 25-year bonds, all with a 10 percent coupon rate and semiannual coupons, at their $1.000 par values. Which bond's value would be most affected if interest rates rose to 13 percent? Which would be least affected? If you are using the Lotus model, calculate the new value of each bond. d. Assume that your investment horizon cor expected holding periods is 25 years. Which of the bonds listed in Table I has the greatest reinvestment rate risk? Why? What is a type of bond you could buy to climinate reinvestment rate risk? e. Assume that you plan to keep your money invested, and to reinvest all interest receipts, for 5 years. Assume further that you bought the 5-year bond for $800, and interest rates suddenly fell to 5 percent and remained at that level for 5 years. Set up a worksheet that could be used to calculate the actual realized rate of return on the bond, but do not neces sarily complete the calculations. Note that each interest receipt must be compounded to the terminal date and summed, along with the maturity value. Then, the rate of return that equates this terminal value to the initial value of the bond is the bond's realized return Assume that the answer is 9.16 percent. How does that value compare with your expected rate of return? What would have happened if interest rates had risen to 15 percent rather than fallen to 5 percent? How would the results have differed if you had bought the 25. year bond rather than the 5-year bond? Do these results suggest that you would be better offor worse off if you buy long term bonds and then rates change? Explain. 1. Today, many bond market participants are speculators, as opposed to long-term investors If you thought interest rates were going to fall from current levels, what type of bond would you buy to maximize short-term capital gains? 5. Now assume that the 15 year bond is callable after 5 years at $1,050. a. What is its yield to call (YTC)? b. Do you think it is likely that the bond will be called? 6 TECO has $54,956,000 of preferred stock outstanding Suppose its Series A, which has a $100 par value and pays a 4 32 percent cumulative div. idend, currently sells for $4800 per share. What is its nominal expected rate of return? Its cffective annual rate of return? (Hint: Remember that dividends are paid quarterly. Also, assume that this issue is perpetual b. Suppose Series F, with a $100 par value and a 9.75 percent cumulative dividend, has a mandatory sinking fund provision 60,000 of the 300,000 total shares outstanding must be redeemed annually at par beginning at the end of 1993. If the nominal required rate of return is 80 percent, what is the current January 1, 1993value per share? 7. Now consider TECO's common stock Value Line estimates TECO's 5 year dividend growth rate to be 60 percent See Figure 1 in Case 2. Assume that TECO s stock traded on January 1. 1992 for $22 26 Assume for now that the 60 percent growth rate is expected to continue indefinitely a. What was TECO's expected rate of return at the beginning of 1992 Hint: Value Line estimated Dl to be SI 80 at the start of 1992. See Figure 1 in Case 2) b. What was the expected dividend yield and expected capital gains yield on January 1, 1992? c. What is the relationship between dividend yield and capital gains yield over time under constant growth assumptions? Case 03 Bond and Stock Valuation d. What conditions must hold to use the constant growth Gordon model? Do many real world-stocks satisfy the constant growth assumptions? 8. Suppose you believe that TECO's 60 percent dividend growth rate will only hold for 5 years. After that, the growth rate will return to TECO's historical 10-year average of 7.5 per- cent. Note that D6 - DS 1075. Again, see Figure 1 in Case 2) a. What was the value of TECO stock on January 1, 1992, if the required rate of return is 13.5 percent? b. What is the expected stock price at the end of 1992 assuming that the stock is in equilib rium? c. What is the expected dividend yield, capital gains yield, and total return for 1992? d. Suppose TECO's dividend was expected to remain constant at SI 80 for the next 5 years and then grow at a constant 6 percent rate. If the required rate of return is 135 percent, would TECO's stock value be higher or lower than your answer in Parta? If you are using the Lotus model for the case, calculate the dividend yield, capital gains yield, and total yield from 1992 through 1996 e. TECO's stock price was $22.26 at the beginning of 1992 Using the growth rates given in the introduction to this question, what is the stocks expected rate of return? f. Refer back to Figure 1 in Case 2 Look at the Eamed Common Equity-estimated for 1995 through 1997 and at the projected earnings and dividends per share for the same period Could those figures be used to develop an estimated long-run-sustainable growth rate? Does this figure support the 75 percent growth rate given in the problem? Hint Think of the formula g - br - Retention ratioROE 9. Common stocks are usually valued assuming annual dividends even though dividends are actually paid quarterly. This is because the dividend stream is so uncertain that the use of a quarterly model is not warranted. The quarterly constant growth valuation model is Dal (1-6,075. De2 (1-6050. Dq3 cl -6,025.De4d.k. where P, is the stock's value and Dqi is the dividend in Quarter i Note that this model assumes that dividend growth occurs once each year rather than at every quarter. Assume that TECO-s next four quarterly dividends are SI 804-50.45 cach; that k, the annual required rate of return, is 13.5 percent, and that g is a constant 60 percent What is TECOS value according to the quarterly model? 6. TECO has $54,956,000 of preferred stock outstanding, a. Suppose its Series A, which has a $100 par value and pays a 4.32 percent cumulative div- idend, currently sells for $48.00 per share. What is its nominal expected rate of return? Its effective annual rate of return? (Hint: Remember that dividends are paid quarterly. Also, assume that this issue is perpetual.) b. Suppose Series F, with a $100 par value and a 9.75 percent cumulative dividend, has a mandatory sinking fund provision 60,000 of the 300,000 total shares outstanding must be redeemed annually at par beginning at the end of 1993. If the nominal required rate of return is 80 percent, what is the current January 1, 1993) value per share