CASH FLOW CHARACTERISTICS These securities have different types of cash flows and the uncertainty of

CASH FLOW CHARACTERISTICS These securities have different types of cash flows and the uncertainty of

each is different. We briefly describe the characteristics of the cash flows for these securities. By necessity, our discussion does not cover the finer points associated with the investment characteristics of these securities. These points will be covered in later chapters when we describe com- mon stock (in Chapter 16), preferred stock (in Chapter 17), and various types of debt obligations (in Chapter 15).

If you invest in common stock, you buy shares that represent an ownership interest in a corporation. Shares of common stock are a per- petual security—there is no maturity. Owners of common stock have the right to receive a certain portion of any dividends—but dividends are not

a sure thing. Typically we see some pattern in the dividends companies pay—dividends are either constant or grow at a somewhat constant rate. There are three major differences between the dividends of preferred and common shares. First, the dividends on preferred stock usually are specified at a fixed contractual amount. This can be based on a fixed dividend rate or a variable dividend rate. The key point is that with the

THE FUNDAMENTALS OF VALUATION

exception of certain types of preferred stock which are rarely issued, the amount that the investor can receive cannot exceed a contractually spec- ified amount. Second, preferred shareholders’ dividends must be paid before any dividends are paid on common stock. Third, if the preferred stock has a cumulative feature, dividends not paid in one period accu- mulate and are carried over to the next period. Therefore, the dividends on preferred stock are more certain than those on common shares.

Notes and bonds are debt securities obligating the borrower to pay interest at regular intervals and to repay the principal amount bor- rowed, referred to as the face value. The repayment of the principal can

be at maturity or there can be scheduled principal repayments over the life of the debt obligation. Some notes and bonds can be paid off before the scheduled principal repayment date. The prepayment can be to retire the entire obligation at once by calling an issue before maturity or one or more scheduled payments before the maturity date. Debt securities are senior to equity securities. This means that the corporate borrower must satisfy its obligations to creditors before making payments to own- ers. Therefore, cash flows from debt securities are viewed as more cer- tain than cash flows from either preferred stock or common stock. The features of preferred stock, common stock, and corporate debt are sum- marized in Exhibit 9.1.

EXHIBIT 9.1 Summary of Features of Securities

Security Cash Flow Certainty of Cash Flow Maturity

Common Dividend, no fixed rate or No obligation to pay, but paid None stock

amount. at the discretion of the board of directors.

Preferred Dividend; can be either a No obligation to pay but pref- None stock

fixed rate or a contractu- erential to common stock if ally determined variable

dividends are paid. rate.

Debt Includes interest and princi- Legal obligation and given Fixed pal repayment. Many vari- preference over common ations. Interest can be a

and preferred stocks. Possi- fixed or a contractually

bility of early call or prepay- determined variable rate.

ments create uncertainty Principal repayment can be

about the cash flow pattern. at maturity or repaid over the life of the debt. The principal repayment provi- sion may allow the firm to prepay.

Valuation of Securities and Options