Perpetual bonds are those bonds that do not have a maturity so the company only pays the coupon amount while the principle does not have to be paid unless there is liquidation. Bonds have fixed return rate and get paid regardless of the profitability of the company or market fluctuation.
Preferred stock holders are investors and hold ownership to the company and also enjoy a fixed dividend and have seniority over common stock but lower rights than bonds. A company however may decide to reduce or discontinue payment of dividend to preferred stock holders if it is going through difficult times.
Common stock holders are the owners of the company and their dividend payment depends on the profit of the company. They will also be the last receivers in case of liquidation and so hold more risks.
Perpetual bonds without fixed maturity are like equity as their principle amount does not need to be paid just like preferred stock. Therefore, perpetual bonds, preferred stock and common stock all become a type of equity.
With zero growth rate and a constant dividend, these three securities valuation will be the same as all the valuation of all these securities will be brought to the present value by discounting the cash flow. Using the dividend discounted model, since all the securities have equal dividend payment without any chances of increment growth in future as there is zero growth rate, all their present value will be almost identical.
Valuation of perpetual bond
"Convertible bonds have features of equity securities since they can be conditionally converted into shares. This makes them more sensitive to company-specific news and less sensitive to systematic economic conditions, at least when compared with traditional bonds. (post, 2015)”
Po = I/Kd
Where, Po is the valuation of bond, I is the interest rate of the debenture and Kd is the rate of return required from the bond considering the risk associated with it.
When, Value of the bond = Rs. 1000, Interest rate is 5% and Rate of return is 10% then valuation of perpetual bond is
Po = 50/0.10
Rs. 500 is the value of the bond
Valuation of preferred stock
"Because many preferred stock issues do not have maturity dates, the cash flows from holding no-maturity preferred stock can be treated as a perpetual stream of payments, or a perpetuity. (Moyer, McGuigan, Rao, & Kretlow, 2012)”
Po = Dp/Kp
Where, Dp is the dividend payment, and Kp is the rate of return. Since we are talking about a constant dividend rate and no growth, let us assume the the dividend payment will be, Rs. 40 and rate of return will be 10%.
So Po= 40/0.10
= Rs. 400
Valuation of Common Stock
Po= D/Ke
Where, D is the Dividend per share and Ke is the required rate of return with Rs. 40, required rate being 10% then using the formula
Po= 40/0.10
= 400
Valuation for a perpetual bond, preferred stock, and common stock with constant dividend payments (zero growth) are virtually identical since all their denomination is the same expected rate of return. The numerator is the return received from the security. With no growth and perpetuity cash flow will be the same every year and so present value will also be similar.
References
Moyer, C. R., McGuigan, J. R., Rao, R., & Kretlow, W. J. (2012). Contemporary Financial Management. Natorp Boulevard: South-Western, Cengage Learning.
post, W. (2015, April 27). Investopedia Stock Analysis: How is convertible bond valuation different than traditional bond valuation? Newstex Finance & Accounting Blogs.
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Perpetual bonds are those bonds that do not have a maturity so the company only pays the coupon amount while the principle does not have to be paid unless there is liquidation. Bonds have fixed return rate and get paid regardless of the profitability of the company or market fluctuation.
Preferred stock holders are investors and hold ownership to the company and also enjoy a fixed dividend and have seniority over common stock but lower rights than bonds. A company however may decide to reduce or discontinue payment of dividend to preferred stock holders if it is going through difficult times.
Common stock holders are the owners of the company and their dividend payment depends on the profit of the company. They will also be the last receivers in case of liquidation and so hold more risks.
Perpetual bonds without fixed maturity are like equity as their principle amount does not need to be paid just like preferred stock. Therefore, perpetual bonds, preferred stock and common stock all become a type of equity.
With zero growth rate and a constant dividend, these three securities valuation will be the same as all the valuation of all these securities will be brought to the present value by discounting the cash flow. Using the dividend discounted model, since all the securities have equal dividend payment without any chances of increment growth in future as there is zero growth rate, all their present value will be almost identical.
Valuation of perpetual bond
"Convertible bonds have features of equity securities since they can be conditionally converted into shares. This makes them more sensitive to company-specific news and less sensitive to systematic economic conditions, at least when compared with traditional bonds. (post, 2015)”
Po = I/Kd
Where, Po is the valuation of bond, I is the interest rate of the debenture and Kd is the rate of return required from the bond considering the risk associated with it.
When, Value of the bond = Rs. 1000, Interest rate is 5% and Rate of return is 10% then valuation of perpetual bond is
Po = 50/0.10
Rs. 500 is the value of the bond
Valuation of preferred stock
"Because many preferred stock issues do not have maturity dates, the cash flows from holding no-maturity preferred stock can be treated as a perpetual stream of payments, or a perpetuity. (Moyer, McGuigan, Rao, & Kretlow, 2012)”
Po = Dp/Kp
Where, Dp is the dividend payment, and Kp is the rate of return. Since we are talking about a constant dividend rate and no growth, let us assume the the dividend payment will be, Rs. 40 and rate of return will be 10%.
So Po= 40/0.10
= Rs. 400
Valuation of Common Stock
Po= D/Ke
Where, D is the Dividend per share and Ke is the required rate of return with Rs. 40, required rate being 10% then using the formula
Po= 40/0.10
= 400
Valuation for a perpetual bond, preferred stock, and common stock with constant dividend payments (zero growth) are virtually identical since all their denomination is the same expected rate of return. The numerator is the return received from the security. With no growth and perpetuity cash flow will be the same every year and so present value will also be similar.
References
Moyer, C. R., McGuigan, J. R., Rao, R., & Kretlow, W. J. (2012). Contemporary Financial Management. Natorp Boulevard: South-Western, Cengage Learning.
post, W. (2015, April 27). Investopedia Stock Analysis: How is convertible bond valuation different than traditional bond valuation? Newstex Finance & Accounting Blogs.