I have a question relating to the valuation of unlisted preference shares (unlisted preferred stock).
Let’s assume you have unlisted preferred stock (referred to as “stock”) that pays dividends based on a linked rate (let’s assume 65% of LIBOR). The stock is redeemable in two years’ time and pays dividends bi-annually. The stock was purchased at a stated value of CU100.
How would you value this type of investment?
My thoughts:
If I assume, taking into account CDS, credit ratings etc, that the discount rate would be equal to the rate at which dividends accrue (i.e. 65% of LIBOR) the cash flow relating to the dividends, would not have an impact on the fair value since (65% of LIBOR dividend) / (1+65% of LIBOR discount rate) would remain equal to currency unit (CU) 1.
The issue comes in with the capital amount. Because the stock will only be redeemed in two years’ time, time value of money dictates that you will receive the CU100 in two years, and as such, this would be worth less today.
In short – the cash flows from the dividend will have a zero impact on the fair value, but the time value of money impact on the capital amount to be received only in two years, will make the fair value less than the CU100 ceteris paribus.
What bothers me is the valuation we have performed relating to SWAPS where Schweser says that a variable rate bond will always trade at par. Why??? The capital will not be CU100 as it will only be “redeemed” in future? Time value of money would decrease this?
The issue here is when you said the cash flows don’t have an impact on the value, they do. If the cash flows are based on a market rate they will perfectly offset the time value of money discount on the par value. (it can be a bit different if you add complications such as when the cash flow is set (beginning or end of period) and other little things like that).
Thanks - and I totally agree, the Cash Flows (i.e. dividend payments) has an impact, but as you have indicated the time value of money would offset the cash flow assuming the dividend yield rate equals the discount rate.
My issue comes in with the capital amount - my issue is as follows:
If you discount this at the prevailing / determined discount rate, the capital amount will always be less than “par”
…
why will this not follow the same logic as a bond which is sais to always trade at par (I refer you to the valuation of swaps for example where this anology is explained by Schweser).
There is no issue. Unless interst rates are zero, the return of capital (principal) for all bonds is worth less than 100. It is the coupons that make up the difference. Let’s say your preferred shares pay $4/year/$100 and your discount rate is also flat at 4%/year. Then very roughly, the $100 you get back two years from now cost you $92 right now, with the $4/year costing you about $8 right now. (In reality the discount rate will need to be a bit higher than coupon rate because everything including all coupons and the principal will be discounted at the same rate but I didn’t want to introduce extraneous computations.)
Basically when you buy a bond at a fair price you are giving up $100 in exchange for $100 of PV of all future cash flows combined. There is no profit or loss. Of course you may not do the deal unless in your mind, the discount rate is smaller and you think you are getting more than $100 of PV.
For fixed coupons the risk is that prevailing interest rates for that category of bond (discount rate) will vary from the rate based on cash flows (return of capital + coupons.) For floaters, the rate is explicitly adjusted so that it is not a risk (upside or downside.)