Question

1.What valuation techniques do we adopt for bonds and preferred/common stocks?

2. Understand the pros and cons of various forms of financing (bonds/preferred

stock/common stock)

Answer 1

Bonds can be valued based on following techniques:

• market discount rate
• spot rates & forward rates
• binomial interest rate trees
• matrix pricing

Preferred Stock Valuation = PV of future dividend payments discounted at the rate of return of stock

Common Stock valuation methods are as follows:

• Dividend Discount Model
• Discounted Cash Flow Model
• Comparable Companies Analysis

Pros & cons of various forms of financing are as follows:

Bonds

Pros

• Safer investments
• Less volatility
• Higher interest rate as compared to dividend payout
• Liquid investments

Cons

• Rising bond prices when markets fall
• credit risk

Preferred Stock

Pros

• Hybrid investment
• Pre-stated dividend
• Priority rights over common stock

Cons

• Since it's considered as equity, it has secondary rights after creditors & debentureholders in case of liquidation/insolvency
• Dividend Payments might be conditional
• Lack of voting rights
• No dividend growth

Common Stock

Pros

• Voting Rights
• Part owners based on shareholding
• No legal obligation to pay dividend
• No debt since funds raised as part of equity

Cons

• Risky investment
• No assured dividend payout
• Secondary rights post all creditors, debentureholders and preferred stock holders are paid during liquidation/insolvency