A treasurer choosing among a 10-year bond, perpetual preferred, or convertible debt needs to price each, weigh tax shields, and check how the resulting capital mix moves the hurdle rate on the next project.
The yield curve plots yield against maturity. Shapes: normal (upward), inverted (recession signal), flat. Three theories: expectations (forward rates predict future short rates), liquidity preference (long bonds need a term premium), market segmentation (supply and demand differ by maturity bucket). The Fisher relation ties nominal yield to real plus expected inflation. Rising inflation lifts nominal yields, so bond and stock prices fall.
KEY: Inverted curves historically lead recessions by 6 to 18 months.
Common stock carries voting rights, residual claim, and variable dividends. Preferred stock pays a fixed dividend, sits senior to common in liquidation, usually non-voting. Variants: cumulative (missed dividends accrue), participating, callable, convertible. Preferred dividends are not deductible to the issuer.
The indenture is the contract. Core terms: par (usually $1,000), coupon rate, maturity, call (issuer redeems early), put (investor sells back), sinking fund, conversion, covenants (coverage minimums, dividend limits).
Common mistakes
- Book weights in WACC. Use market values. Book distorts the cost of the next dollar.
- Historical cost on new projects. Sunk financing does not bind. Hurdle = MCC.
- DDM applied when . The formula explodes. Switch to two-stage DDM.
Bottom line
- WACC weights after-tax cost of debt, preferred, and equity at market weights. Use marginal cost, not historical.
- Bond price = PV of coupons + PV of par at YTM. Modified duration = % price change per 1% yield move; longer maturity and lower coupon raise it.
- DCF prices every security: bond, preferred (), and common via DDM. Two-stage DDM handles high-then-stable growth.
- Constant-growth DDM: , valid only when .
Exam shortcut
For refinancing, take after-tax coupon savings, discount at the after-tax new yield, then subtract after-tax call premium plus flotation. Positive NPV refinances. For project hurdle rates, use MCC at the relevant break point, risk-adjusted, not the historical book WACC. For stock valuation, verify before applying ; if near-term g exceeds r, switch to two-stage DDM.
The full lesson (about 1,657 words, 11 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- 2B2
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