1

Study Unit Four

Types of Securities

4.1 Bonds ............................................................................................................................... 2

4.2 Stock ................................................................................................................................. 9
4.3 Dividends .......................................................................................................................... 12

This study unit is the first of five on corporate finance. The relative weight assigned to this major
topic in Part 2 of the exam is 20%. The five study units are
● Study Unit 4: Types of Securities
● Study Unit 5: Financial Markets and Financing
● Study Unit 6: Valuation Methods and Cost of Capital
● Study Unit 7: Working Capital Management
● Study Unit 8: Corporate Restructuring, International Trade, and Exchange Rates

This study unit discusses introductory topics related to bonds, stocks, and dividends. Topics covered
in this study unit include
● Interest rate structures
● Basic features of bonds
● Valuation of bonds
● Characteristics of common stock and preferred stock
● Types of dividends
● Stock splits
● Dividend policy
● Share repurchases

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2 SU 4: Types of Securities

4.1 Bonds

Bonds are the principal form of long-term debt financing for corporations and governmental bodies.

A bond is a formal contractual obligation to pay an amount of money (called the par value, maturity
amount, or face amount) to the holder at a certain date, plus, in most cases, a series of cash
interest payments based on a specified percentage (called the stated rate or coupon rate) of the
face amount at specified intervals.
● The face amount (also called the maturity amount) is received on the bond’s maturity date, e.g.,
20 years after the initial purchase.

● The annual cash interest equals the bond’s face amount times the stated (or coupon) rate, e.g.,
$1,000 face amount × 4% stated rate = $40 annual cash interest.

All of the terms of the agreement are stated in a document called an indenture.
● The indenture includes matters such as whether the issuer can sell property purchased with bond
proceeds and the extent of maintenance the issuer must provide.

● The indenture also usually states that purchased property must be insured and cannot be pledged
as security for another loan.

In general, the longer the term of a bond, the higher will be the return (yield) demanded by investors
to compensate for increased risk.

Advantages of Bonds to the Issuer

◘ Interest paid on debt is tax deductible.

■ This is by far the most significant advantage of debt. For a corporation facing a 40%-50%
marginal tax rate, the tax savings produced by the deduction of interest can be substantial.

◘ Basic control of the firm is not shared with debtholders.

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 SU 4: Types of Securities 3

Disadvantages of Bonds to the Issuer

◙ Unlike returns on equity investments, the payment of interest and principal on debt is a legal
obligation. If cash flow is insufficient to service debt, the firm could become insolvent.

◙ The legal requirement to pay debt service raises a firm’s risk level.

■ Shareholders will demand higher capitalization rates on retained earnings, which may result in a
decline in the market price of the stock.

◙ The long-term nature of bond debt also affects risk profiles.

■ Debt originally appearing to be profitable may become a burden if interest rates fall and the firm
is unable to refinance.

◙ Certain managerial prerogatives are usually given up in the contractual relationship outlined in the
bond’s indenture contract.
■ For example, specific ratios must be kept above a certain level during the term of the loan.

◙ The amount of debt financing available to the individual firm is limited.

■ Generally accepted standards of the investment community will usually dictate a certain debt-
equity ratio for an individual firm.
■ Beyond this limit, the cost of debt may rise rapidly, or debt may not be available.

Debt covenants are restrictions or protective clauses that are imposed on a borrower by the creditor
in a formal debt agreement or an indenture.
● Examples of debt covenants include the following:

■ Limitations on issuing long-term or short-term debt

■ Limitations on dividend payments
■ Maintaining certain financial ratios
■ Maintaining specific collateral that backs the debt

● The more restrictive the debt covenant, the lower the risk that the borrower will not be able to
repay its debt. The less risky the investment is for creditors, the lower the interest rate on the debt
(since the risk premium is lower).

● If the debtor breaches the debt covenant, the debt becomes due immediately.

Call provisions allow the bond issuer to exercise an option to redeem the bonds earlier than the
specified maturity date.
● Since call provisions are undesirable to investors, investors usually demand a higher rate of return
when call provisions are included in the bond issue.

A bond indenture may require the issuer to establish and maintain a bond sinking fund. The
objective of making payments into the fund is to segregate and accumulate sufficient assets to pay
the bond principal at maturity.
● The amounts transferred plus the revenue earned on investments provide the necessary funds to
pay the bonds.

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4 SU 4: Types of Securities

Types of Bonds

Bonds may be classified based on their maturity pattern.

● A term bond has a single maturity date at the end of its term.

● A serial bond matures in stated amounts at regular intervals. Investors can choose the maturity
that suits their needs.

Bonds may be classified based on characteristics of the bond’s interest rate.

● Variable rate bonds pay interest that is dependent on market conditions.

● Zero-coupon or deep-discount bonds bear no stated rate of interest and thus involve no periodic
cash payments; the interest component consists entirely of the bond’s discount.

● Commodity-backed bonds are payable at prices related to a commodity such as gold.

Redemption provisions are another way to classify bonds.

● Callable bonds may be repurchased by the issuer at a specified price before maturity.

● Convertible bonds may be converted into equity securities of the issuer at the option of the holder
under certain conditions.

Securitization refers to how a bond is secured by underlying assets.

● Mortgage bonds are backed by specific assets, usually real estate.

● Debentures are backed by the issuer’s full faith and credit but not by specific collateral. Thus,
debentures are riskier to investors than secured bonds.

● Equipment trust bonds are secured by a lien on a specific piece of equipment, such as an
airplane or a railroad car. They are used mostly by companies in the transportation industry.

Repayment provisions refer to how a bond pays interest.

● Income bonds pay interest only if the issuer earns the interest.
● Revenue bonds are issued by governmental units and are payable from specific revenue sources.

Subordinated debentures and second mortgage bonds are junior securities with claims inferior to
those of senior bonds.

Ownership of a bond can be via registered bonds or bearer bonds.

● Registered bonds are issued in the name of the holder. Only the registered holder may receive
interest and principal payments.

● Bearer bonds are not individually registered. Interest and principal are paid to whomever presents
the bond or interest coupon for payment.

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 SU 4: Types of Securities 5

Bond Ratings

Investors can judge the creditworthiness of a bond issue by consulting the rating assigned by a credit-
rating agency (such as Moody’s or Standard & Poor’s). The higher the rating, the more likely the firm
is to make good its commitment to pay the interest and principal.
● Investment-grade bonds are considered safe investments and thus are deemed to have moderate
risk.
■ The highest rating assigned is “triple-A.”

■ Some fiduciary organizations (such as banks and insurance companies) are only allowed to
invest in investment-grade bonds.

● Non-investment grade bonds, also called speculative-grade bonds, high-yield bonds, or junk
bonds, carry high risk.
■ A junk bond is a bond that is rated “BB” or lower because of its high default risk. Junk bonds
are high-risk, high-reward securities rated at less than investment grade.

The following figure displays a short list of widely available bonds ranked from the lowest rate of
return to the highest rate of return (and thus the lowest risk to the highest risk):

Figure 4-1

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6 SU 4: Types of Securities

Interest Rates
The term structure of interest rates is the relationship between yield to maturity and time to
maturity. It is important to corporate treasurers, who must decide whether to issue short- or long-term
debt, and to investors, who must decide whether to buy short- or long-term debt.
● Higher interest rates on bonds lead to increased demand for bond investments, which decreases
the demand for common stock, causing the price of common stock to fall.

It is important to understand how the long- and short-term rates are related and what causes shifts in
their positions. The term structure is graphically depicted by a yield curve.

Figure 4-2

The graph above illustrates four common yield curves. Since short-term interest rates are usually
lower than long-term rates, the yield curve is usually upward sloping. However, other shapes do occur
sometimes. The various shapes are as follows:
1. Upward sloping (long-term rates are higher than short-term rates)
2. Flat (long-term rates are equal to short-term rates)
3. Downward sloping (long-term rates are lower than short-term rates)
4. Humped (intermediate-term rates are higher than other rates)

Interest Rate Risk

Interest rate risk is the risk that an investment security will fluctuate in value due to changes in
interest rates. The duration of a bond (its term) is the best measure of interest rate risk.
● Generally, the longer the time until maturity, the greater the degree of interest rate risk. This is why
the interest curve is usually upward sloping.
● The longer a bond’s term, the more time interest rate volatility may affect a bond’s price, and the
more sensitive its price is to interest rate changes.

The interest rate is also affected by inflation expectations, among other factors.
● The lower (higher) the expected inflation, the lower (higher) the interest rate.
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 SU 4: Types of Securities 7

Bond Valuation

A primary concern of a bond issuer is the amount of cash that will be received from investors on the
day the bonds are sold.
● This amount is equal to the present value of the cash flows associated with the bonds
discounted at the interest rate prevailing in the market at the time (called the market rate or
effective rate).
■ The cash flows associated with bonds are

► The face amount that is repaid at the maturity date

► Interest payments as scheduled periodically during the bond’s term to maturity

● Using the effective interest rate method ensures that the bonds’ yield to maturity (that is, their
ultimate rate of return to the investor) is equal to the rate of return prevailing in the market at the
time of the sale.

● Using the effective rate to determine the bonds’ present value also ensures that, upon maturity,
they will be valued at their face amount.

This present value calculation can result in cash proceeds equal to, less than, or greater than the face
amount of the bonds, depending on the relationship of the bonds’ stated rate of interest to the market
rate.
● If the bonds’ stated rate equals the market rate at the time of sale, the present value of the
bonds will exactly equal their face amount, and the bonds are said to be sold “at par.” It is rare,
however, for the coupon rate to precisely match the market rate at the time the bonds are ready for
sale.

● If the bonds’ stated rate is lower than the market rate, investors must be offered an incentive to
buy the bonds, since the bonds’ periodic interest payments are lower than those currently available
in the market.
■ In this case, the issuer receives less cash than the par value and the bonds are said to be sold
at a discount.

Example 4-1 Issuance of Bonds -- Discount

An entity issues 200 6%, 5-year, $5,000 bonds when the prevailing interest rate in the market is 8%. The
total face amount of bonds issued is therefore $1,000,000 ($5,000 face amount × 200 bonds). Annual cash
interest payments of $60,000 ($1,000,000 face amount × 6% stated rate) will be made at the end of each
year. The present value of the cash flows associated with this bond issue, discounted at the market rate of
8%, is calculated as follows:

Present value of face amount ($1,000,000 × 0.68058) $680,580

Present value of cash interest ($60,000 × 3.99271) 239,563 (rounded)
Cash proceeds from bond issue $920,143

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8 SU 4: Types of Securities

● If the bonds’ stated rate is higher than the market rate, investors are willing to pay more for
the bonds, since their periodic interest payments are higher than those currently available in the
market.
■ In this case, the issuer receives more cash than the par value and the bonds are said to be sold
at a premium.

Example 4-2 Issuance of Bonds -- Premium

An entity issues 200 8%, 5-year, $5,000 bonds when the prevailing interest rate in the market is 6%. The
total face amount of bonds issued is therefore $1,000,000 ($5,000 face amount × 200 bonds). Annual cash
interest payments of $80,000 ($1,000,000 face amount × 8% stated rate) will be made at the end of each
year. The present value of the cash flows associated with this bond issue, discounted at the market rate of
6%, is calculated as follows:

Present value of face amount ($1,000,000 × 0.74726) $ 747,260

Present value of cash interest ($80,000 × 4.21236) 336,989 (rounded)
Cash proceeds from bond issue $1,084,249

Sometimes the issue price is an exact percentage of the face amount. In these cases, the bonds are
said to be sold at, for example, “97,” “98,” “101,” “102,” etc.

Comparison of Cash
Rate Relationship Proceeds to Face Amount Bonds Are Issued at . . .

Stated rate = Market rate Cash proceeds = Face amount Par

Stated rate > Market rate Cash proceeds > Face amount Premium

Stated rate < Market rate Cash proceeds < Face amount Discount

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 SU 4: Types of Securities 9

4.2 Stock

Common Stock

The common shareholders are the owners of the corporation, and their rights as owners, although
reasonably uniform, depend on the laws of the state in which the firm is incorporated.
● Equity ownership involves risk because holders of common stock are not guaranteed a return and
are last in priority in a liquidation. Shareholders’ capital provides the cushion for creditors if any
losses occur on liquidation.

● As the corporation’s owners, the common shareholders have voting rights, that is, they select the
firm’s board of directors and vote on resolutions.

Advantages to the issuer include the following:

◘ Common stock does not require a fixed dividend (dividends are paid from profits when available).

◘ There is no fixed maturity date for repayment of the capital.

◘ The sale of common stock increases the creditworthiness of the firm by providing more equity.

◘ Common stock is frequently more attractive to investors than debt because it grows in value
with the success of the firm. The higher the common stock value, the more advantageous equity
financing is compared with debt financing.

Disadvantages to the issuer include the following:

◙ Cash dividends on common stock are not tax-deductible by the corporation, and so must be paid
out of after-tax profits.

◙ Control (voting rights) is usually diluted as more common stock is sold. (While this aspect is
disadvantageous to existing shareholders, management of the corporation may view it as an
advantage.)

◙ New common stock sales dilute earnings per share available to existing shareholders.

◙ Underwriting costs are typically higher for common stock issues.

◙ Too much equity may raise the average cost of capital of the firm above its optimal level.

◙ Inflation may increase the yields of new bond issues and decrease demand for common stock.
Moreover, higher interest costs reduce funds available for dividends.

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10 SU 4: Types of Securities

Common shareholders ordinarily have preemptive rights. Preemptive rights give common
shareholders the right to purchase any additional stock issuances in proportion to their current
ownership percentages.
● If applicable state law or the corporate charter does not provide preemptive rights, the firm may
nevertheless sell to the existing common shareholders in a rights offering.

● Each shareholder is issued a certificate or warrant that is an option to buy a certain number of
shares at a fixed price.

A stock’s par value represents legal capital. It is an arbitrary value assigned to stock before the stock
is issued. It also represents the maximum liability of a shareholder.

Preferred Stock

Preferred stock is a hybrid of debt and equity. It has a fixed charge and increases leverage, but
payment of dividends is not a legal obligation. A preferred stock’s yield to an investor is usually higher
than that of a bond from the same issuer. The preferred stock is slightly more risky than a bond.
● Preferred shareholders have a higher priority in bankruptcy than common shareholders but a lower
priority than debtholders.

Typical provisions of preferred stock issues include the following:

● If the firm goes bankrupt, the preferred shareholders have priority over common shareholders in
assets.

● If preferred dividends are cumulative, dividends in arrears must be paid before any common
dividends can be paid.

● Preferred stock may participate with common in excess earnings of the company.

■ For example, 8% participating preferred stock might pay a dividend each year greater than
8% when the corporation is extremely profitable, but nonparticipating preferred stock will
receive no more than is stated on the face of the stock.

● Par value is the liquidation value, and a percentage of par equals the preferred dividend.

● Some preferred stock may be redeemed at a given time or at the option of the holder or otherwise
at a time not controlled by the issuer.
■ This feature makes preferred stock more nearly akin to debt, particularly in the case of transient
preferred stock, which must be redeemed within a short time (e.g., 5 to 10 years).

● Holders of preferred stock are not ordinarily granted voting rights. However, voting rights may be
conferred if preferred dividends are in arrears for a stated period.

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 SU 4: Types of Securities 11

Retirement provisions include the following:

● Preferred stock issues may be convertible into common stock at the option of the shareholder.

● The issuer may have the right to repurchase the stock through a call provision. For example, the
stock may be noncallable for a stated period, after which it may be called if the issuer pays a call
premium (an amount exceeding par value).

● Preferred stock may have a sinking fund that allows for the purchase of a given annual
percentage of the outstanding shares.
Advantages to the issuer include the following:
◘ It is a form of equity and therefore builds the creditworthiness of the firm.
◘ Control is still held by common shareholders.
◘ Superior earnings of the firm are usually still reserved for the common shareholders.

Disadvantages to the issuer include the following:

◙ Cash dividends on preferred stock are not deductible as a tax expense and are paid with after-tax
income. The result is a substantially greater cost relative to bonds.

◙ In periods of economic difficulty, accumulated unpaid dividends (called dividends in arrears) may
create major managerial and financial problems for the firm.

Holding preferred stock rather than bonds provides corporations a major tax advantage. At least
70% of the dividends received from preferred stock is tax deductible, but all bond interest received is
taxable. The dividends-received deduction also applies to common stock.

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12 SU 4: Types of Securities

4.3 Dividends

The CMA exam tests one’s understanding of what influences a company’s dividends
policy along with the importance of a stable policy. A candidate will need to identify the
types of dividend payouts and when and how a company would use each.

Dividend Policy

A dividend represents a distribution of earnings. Dividend policy determines what portion of a

corporation’s net income is distributed to shareholders and what portion is retained for reinvestment.
● A high dividend rate means a slower rate of growth.
● A high growth rate usually means a low dividend rate.

Because both a high growth rate and a high dividend rate are desirable, the financial manager
attempts to achieve the balance that maximizes the firm’s share price. The most important factor to
consider is the future planned uses of cash.

Normally, corporations try to maintain a stable level of dividends, even though profits may fluctuate
considerably, because many shareholders buy stock with the expectation of receiving a certain
dividend every year. Hence, management tends not to raise dividends if the payout cannot be
sustained.
● The desire for stability has led theorists to propound the signaling hypothesis, which states that
a change in dividend policy is a signal to the market regarding management’s forecast of future
earnings. Thus, firms generally have an active policy strategy with respect to dividends.

● This stability often results in a stock that sells at a higher market price because shareholders
perceive less risk in receiving their dividends.

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 SU 4: Types of Securities 13

Factors Influencing a Company’s Dividend Policy

Many factors influence a company’s dividend policy, including the following:

● Legal Restrictions

■ Dividends ordinarily cannot be paid out of paid-in capital. A corporation must have a balance in
its retained earnings account before dividends can be paid.

● Stability of Earnings

■ A company whose earnings fluctuate greatly from year to year will tend to pay out a smaller
dividend during good years so that the same dividend can be paid even if profits are much
lower.
► For example, a company with fluctuating earnings might pay out $1 every year whether
earnings per share are $10 (10% payout rate) or $1 (100% payout rate).

● Rate of Growth

■ A company with a faster growth rate will have a greater need to finance that growth with
retained earnings. Thus, growth companies usually have lower dividend payout ratios.
Shareholders hope to be able to obtain larger capital gains in the future.

● Cash Position

■ Regardless of a firm’s earnings record, cash must be available before a dividend can be paid.

● Restrictions in Debt Agreements

■ Restrictive covenants in bond indentures and other debt agreements often limit the dividends
that a firm can declare.

● Tax Position of Shareholders

■ In corporations, the shareholders may not want regular dividends because the individual owners
are in such high tax brackets. They may want to forgo dividends in exchange for future capital
gains or wait to receive dividends in future years when they are in lower tax brackets.
■ However, an accumulated earnings tax is assessed on a corporation if it has accumulated
retained earnings beyond its reasonably expected needs.

● Residual Theory of Dividends

■ The amount (residual) of earnings paid as dividends depends on the available investment
opportunities and the debt-equity ratio at which cost of capital is minimized. The rational
investor should prefer reinvestment of retained earnings when the return exceeds what the
investor could earn on investments of equal risk. However, the firm may prefer to pay dividends
when investment opportunities are poor and the use of internal equity financing would move the
firm away from its ideal capital structure.

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14 SU 4: Types of Securities

Important Dates Relative to Dividends

The date of declaration is the date the directors meet and formally vote to declare a dividend. On
this date, the dividend becomes a liability of the corporation.

The date of record is the date as of which the corporation determines the shareholders who will
receive the declared dividend.
● Only those shareholders who own the stock on the date of record will receive the dividend. It
typically falls from 2 to 6 weeks after the declaration date.

The date of distribution is the date on which the dividend is actually paid (when the checks are put
into the mail to the investors). The payment date is usually from 2 to 4 weeks after the date of record.

The ex-dividend date is a date established by the stock exchanges, such as 2 business days before
the date of record. Unlike the other dates previously mentioned, it is not established by the corporate
board of directors.
● The period between the ex-dividend date and the date of record gives the stock exchange
members time to process any transactions so that new shareholders will receive the dividends to
which they are entitled.

● An investor who buys a share of stock before the ex-dividend date will receive the dividend that
has been previously declared.

● An investor who buys the stock on or after the ex-dividend date (but before the date of record or
payment date) will not receive the declared dividend. Instead, the individual who sold the stock will
receive the dividend because (s)he owned it on the ex-dividend date.

● Usually, a stock price will drop on the ex-dividend date by the amount of the dividend because the
new investor will not receive it.

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 SU 4: Types of Securities 15

Stock Dividends and Stock Splits

Stock dividends and splits involve issuance of additional shares to existing shareholders.

A stock dividend is an issuance of stock and entails the transfer of a sum from the retained earnings
account to a paid-in capital account.
● Usually, the corporation wants to give something to the shareholders but without paying out a cash
dividend because the funds are needed in the business.

● Casual investors may believe they are receiving something of value when in essence their
previous holdings are merely being divided into more pieces.

● Stock dividends are often used by growing companies that wish to retain earnings in the business
while placating shareholders.

A stock split does not involve any accounting entries. Instead, the existing shares are divided into
more shares so that the market price per share will be reduced. The greater the number of shares
issued, the lower the resulting share price.

Example 4-3 Stock Split

If a corporation has 1 million shares outstanding, each of which sells for $90, a 2-for-1 stock split will result
in 2 million shares outstanding, each of which sells for about $45.

Advantages of issuing stock splits and dividends include the following:

◘ Because more shares will be outstanding, the price per share will be lower. The lower price per
share will induce more small investors to purchase the company’s stock. Thus, because demand
for the stock is greater, the price may increase.

Example 4-4 Stock Split

In Example 4-3, the additional investors interested in the company at the lower price may drive the price
up to $46 or $47, or slightly higher than the theoretically correct price of $45. Consequently, current
shareholders will benefit from the split (or dividend) after all.

◘ A dividend or split can be a publicity gesture. Because shareholders may believe they are
receiving something of value (and actually may be indirectly), they will have a better opinion of
their company.

◘ The more shares a corporation has outstanding, the larger the number of shareholders, who are
usually good customers of their company’s products.

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16 SU 4: Types of Securities

Reverse stock splits reduce the shares outstanding, thereby increasing the market price per share.
● On rare occasions, a firm may use a reverse stock split to raise the market price per share. A
reverse stock split usually is issued when a stock is selling for a very low price, such as under $1
per share. It can also be used to reduce the number of shareholders.
■ For example, a 1-for-10 stock split would require shareholders to turn in 10 old shares to
receive 1 new share.

Share Repurchases

A share repurchase takes place when a corporation buys its own stock back on the open market.
Once in the firm’s possession, these shares are called treasury shares.

Among the motives for a share repurchase are

● Mergers

● Share options

■ For example, to meet the share option issued or planned to be issued, a corporation may need
to repurchase shares from the open market if not enough shares are currently available in
treasury stock.

● Stock dividends

● Tax advantages to shareholders (e.g., favorable capital gains rates)

● To increase earnings per share and other ratios (e.g., increase financial leverage)

● To prevent a hostile takeover

● To eliminate a particular ownership interest

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