Investors may disagree about the value of the venture based on their own subjective perceptions. For example, some investors may prefer venture which can yield high return despite risks, some may prefer venture with high credit rating which can preserve their original investment, others may prefer venture with high liquidity.
However, since an investment is expected to provide income or positive future cash flows, and may increase or decrease in value yielding the investor capital gains or losses [1]; assessing the cash flow can aid investors in evaluating the investment's opportunity, value as well as in judging the performance after the initial investment is made. As such, all commonly used criteria for evaluating the value of an investment in a new venture such as payback period, discounted payback period, net present value (NPV), and profitability index (PI), internal rate of return (IRR) and modified internal rate of return (MIRR), take cash flows into consideration.
The payback period of a venture: tells the number of years required to recover the initial investment. The payback period is calculated by adding the cash flows up until they are equal to the initial fixed investment. Discounted payback period: A variation of the payback period decision criterion that uses discounted net cash flows rather than actual undiscounted net cash flows in calculating the payback period and is defined as the number of years needed to recover the initial cash outlay from the discounted net cash flows. [2]
Net present value (NPV): defined as the present value of the cash inflows less the present value of the cash outflows. [2]
The profitability index (PI): the ratio of the present value of the expected future net cash flows to the initial cash outlay. [2]
Internal rate of return (IRR): is the discount rate that equates the present value of the project's future net cash flows with the project's initial outlay. [2]
Modified internal rate of return (MIRR): A variation of the IRR capital-budgeting decision criterion defined as the discount rate that equates the present value of the project's annual cash outlays with the present value of the project's terminal value, where the terminal value is defined as the sum of the future value of the project's free cash flows compounded to the project's termination at the project' required rate of return. [2]
Hence, although investors have different preferences, they still have to depend on the venture's potential to generate future cash flows so as to examine the value of an investment.
Debt offering is raising money for working capital or capital expenditures by selling bonds, bills, or notes to individual and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid.[3]
Equity Offerings is raising funds by offering ownership in a corporation to individual or institutional investors through the issuing of shares of a corporation's common or preferred stock. [4]
Debt offerings are more common than equity offerings and typically much larger as well. There are 3 main reasons for this. First, debt offerings are much cheaper. Second, debt matures and must be replaced, while equity does not. Third, it is much easier to determine the selling price for debt than it is for equity.
First, debt offerings are cheaper form of capital financing than equity offerings. An equity offering is typically more expensive to issue than a debt offering because of greater distribution costs. Interest paid on debt capital is tax deductible providing a favored tax treatment for debt issues, whereas dividend paid on equity is out of a company's profits, which are taxed before dividend payments can be made to stockholders. Also, during inflation, the company will be paying back the debt in cheaper dollars. [5]
Another reason is that debt offerings are redeemed, whereas equity offerings may be outstanding indefinitely. Debt obligations are limited to the loan repayment period, after which the lender has no further claim on the business, whereas equity investors' claim does not end until their stock is sold. [6]
The selling price of equity offerings are more challenging to calculate as equity offerings do not pay a predetermined constant dividend to its investors. The dividend is based on the probability of the firm, and on management's decision to pay dividends or to retain the profits to grow the firm. Thus, dividends will vary with a firm's profitability and its stage of growth. As such, the valuation model of equity offerings is dividend growth model which requires estimation of a dividend growth rate and also requires that certain conditions be hold before the dividend growth model can be applied. By contrast, debt offerings have a final maturity date and promised payments at fixed periods of time; so it is much easier to determine the selling price for debt offerings than it is for equity offerings. [7]
Therefore, cheaper form of capital financing, redeemable obligation, and easier to calculate selling price are reasons explaining debt offerings is more common and typically much larger compared to equity offerings.
The given investor has jus implied the bonds have the same yields and Default risk (bond ratings) which is the danger that the bond's issuer will be unable to pay the contractual interest or principal on the bond in a timely manner, or at all [8]. There are other determinants of bond yield such as interest rate risk, taxability risk, reinvestment risk and liquidity risk that might make a given investor prefer one of these bonds over the other:
Interest rate risk arises when interest rate changes that result in changing the price of bond. The price of a typical bond will change in the opposite direction from a change in interest rates. As interest rates rise, the price of a bond will fall; as interest rates fall, the price of a bond will rise. Longer-term bonds have much greater risk of loss due to changes in interest rates than do shorter-term bonds when their prices are more sensitive to interest rate changes. Investors are aware of this risk, and they require added compensation in the form of higher rates for assuming it. This added compensation is called the interest rate risk premium. The longer the time to maturity, the greater the interest rate risk, thus the interest rate risk premium raises with maturity. [8, 9, 10] In the given case of the same yields, the bond with lower interest risk may be preferred by investors over the other.
Taxability risk can arise from the unfavorable changes in tax rates or reclassification of tax status of bond to investors. Therefore, the investors demand a taxability premium which compensates for unfavorable tax status of certain classes of bonds. As a result, bonds whose cash flows are subject to less taxes trade at lower yields than bonds that are subject to more taxes. [9, 10] In the given case that two bonds have the same yields, investors may prefer bond with more favor tax treatment over the other.
Reinvestment risk: the uncertainty that the bond issuer buy back the bond, forcing the investor to reinvest in the market with lower interest rate. Many corporate bonds are callable that means the bond issuer keeps the right to "call" the bond before maturity and pay off the debt. Issuers tend to call bonds when interest rates fall, as such the investor will get back the principal, but he will not be able to find a new, comparable bond in which to invest that principal. [8, 10]In the given case that two bonds have the same yields, investors may prefer non-callable bond over the other.
Liquidity risk describes the danger that when you need to sell a bond, you won't be able to. Bonds have varying degree of liquidity and do not trade on a regular basis. As a result, if you want to sell quickly, you would probably not get as good a price as you could otherwise. Investors prefer liquid bonds to illiquid ones, so they demand a liquid premium, which compensates for holding bonds that are difficult to convert to cash at their true value, on top of all other premiums. As a result, all else being the same, less liquid bonds will have higher required returns than more liquid bonds. [8, 9, 10] In the given case, if two bonds have the same yields, investors may prefer bond with more liquid over the other.
For bond, the value of a bond is the present value both of future interest to be received and the par or maturity value of the bond. Most bonds pay interest semiannually. Since the coupon rate, final maturity date, and the face value of $1000 are known, valuing a bond requires knowing three essential elements: (1) the semiannual coupon payment which is calculated be multiplying one half of the coupon rate by the bond's face value, (2) the number of seminal periods until the bond matures which is calculated by multiplying the number of years to maturity by 2, and (3) the investor's appropriate discount rate which is the current market rate being earned by investors on comparable bonds with the same maturity and the same credit quality. Hence, once an appropriate discount rate is established, valuing a bond is relatively simple. [11]
For stocks, unlike bonds, have no final maturity date, is frequently held for many years, and dividends are not specified. The valuation model is the dividend discount model (DDM), the value of a stock today is the discounted value of all future dividends. The dividend growth rate version of DDM is used most often: V = D1/(k - g). The dividend growth model requires estimation of a dividend growth rate and also requires certain assumptions to be made in order before the dividend growth model can be applied. The certain assumptions that must meet [12] are:
The stock pays dividends.
Dividends grow at a constant rate (g).
The constant growth rate will continue forever.
The required rate of return is greater than the growth rate; otherwise the model breaks down since the denominator is negative.
Normally, all of the information required to find the yield on a publicly traded bond is publicly available on morning newspaper, in the financial media such as The Wall Street Journal, Investor's Business Daily, on many sites, and business news channels such as CNBC; while only the price and the most current dividend are available for stocks.
Hence, it is easier to find the required return on a publicly traded bond than on a publicly traded stock.
