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Foundations of Finance Arthur J. Keown John D. Martin J. William Petty David F. Scott, Jr.

Foundations of Finance Arthur J. Keown John D. Martin J. William Petty David F. Scott, Jr. Chapter 7 Valuation and Characteristics of Bonds. Learning Objectives. Distinguish between different kinds of bonds. Explain the more popular features of bonds.

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Foundations of Finance Arthur J. Keown John D. Martin J. William Petty David F. Scott, Jr.

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  1. Foundations of FinanceArthur J. Keown John D. MartinJ. William Petty David F. Scott, Jr. Chapter 7 Valuation and Characteristics of Bonds

  2. Learning Objectives • Distinguish between different kinds of bonds. • Explain the more popular features of bonds. • Define the term value used for several different purposes. • Explain the factors that determine value. Foundations of Finance

  3. Learning Objectives • Describe the basic process for valuing assets. • Estimate the value of a bond. • Compute a bondholder’s expected rate of return. • Explain three important relationships that exist in bond valuation. Foundations of Finance

  4. Principles Used in this Chapter • Principle 1: The Risk-Return Trade-off – We Won’t Take on Additional Risk Unless We Expect to Be Compensated with Additional Return. • Principle 2: The Time Value of Money – A Dollar Received Today is Worth More Than a Dollar Received in the Future • Principle 3: Cash-Not Profits-Is King. Foundations of Finance

  5. Bonds • Type of debt or long-term promissory note, issued by a borrower, promising to its holder a predetermined and fixed amount of interest per year. Foundations of Finance

  6. Types of Bonds • Debentures • Subordinated Debentures • Mortgage Bonds • Eurobonds • Zero and Very Low Coupon Bonds • Junk Bonds (High-Yield Bonds) Foundations of Finance

  7. Debentures • Any unsecured long-term debt • Viewed as more risky than secured bonds and provide a higher yield than secured bonds Foundations of Finance

  8. Subordinated Debenture • Hierarchy of payout in case of insolvency • The claims of subordinated debentures are honored only after the claims of secured debt and unsubordinated debentures have been satisfied. Foundations of Finance

  9. Mortgage Bond • A bond secured by a lien on real property • Typically, the value of the real property is greater than that of the bonds issued. Foundations of Finance

  10. Eurobonds • Securities (bonds) issued in a country different from the one in whose currency the bond is denominated Foundations of Finance

  11. Zero and Very Low Coupon Bonds • Issued at a substantial discount from the $1,000 face value with a zero or very low coupon rate. • Return comes from appreciation of the bond Foundations of Finance

  12. Zero and Very Low Coupon Bonds • Disadvantage: • Issuer faces large cash outflow in excess of the cash inflow when the bond was issued • Advantages: • Cash outflows don’t occur with zero coupon bonds and are relatively low level with low coupon bonds • Strong investor demand tends to bid up prices and yields are bid down. Foundations of Finance

  13. Junk Bonds (High-Yield Bonds) • High risk debt with ratings of BB or below by Moody’s and Standard & Poor’s • High yield — typically pay 3%-5% more than AAA grade long-term bonds Foundations of Finance

  14. Terminology • Claims on assets and income • Par value • Current yield • Coupon interest rate • Maturity • Convertibility • Call provision • Indenture • Bond ratings Foundations of Finance

  15. Claims on Assets and Income • In the case of insolvency, claims of debt, including bonds are honored before those of common or preferred stock. Foundations of Finance

  16. Par Value • Face value of the bond, returned to the bondholder at maturity • In general, corporate bonds are issued at denominations of $1,000. • Prices are represented as a % of face value. Foundations of Finance

  17. Coupon Interest Rate • The percentage of the par value of the bond that will be paid out annually in the form of interest. Foundations of Finance

  18. Maturity • The length of time until the bond issuer returns the par value to the bondholder and terminates or redeems the bond. Foundations of Finance

  19. Convertibility • May allow the investor to exchange the bond for a predetermined number of the firm’s shares of common stock Foundations of Finance

  20. Call Provision • A provision such that if the prevailing interest rate declines, the firm may want to pay off the bonds early and reissue at a more favorable interest rate. • Issuer must pay the bondholders a premium • There is also a call protection period where the firm cannot call the bond for a specified period of time. Foundations of Finance

  21. Indenture • The legal agreement between the firm issuing the bond and the trustee who represents the bondholders • Provides for specific terms of the loan agreement Foundations of Finance

  22. Bond Ratings • Bonds are rated by the future risk potential of the bond-default risk • The poorer the bond rating, the higher the rate of return demanded by the capital markets. Foundations of Finance

  23. Bond Ratings Three agencies rate bonds: • Moody’s • Standard & Poor’s Foundations of Finance

  24. Favorable Factors affecting Bonds Rating • A greater reliance on equity as opposed to debt in financing the firm • Profitable operations • Low variability in past earnings • Large firm size • Minimal use of subordinated debt Foundations of Finance

  25. Bond Ratings • AAA is the highest rating assigned by Standard & Poor’s • AAA indicates a strong capacity to pay principal and interest Foundations of Finance

  26. Value • Book value: value of an asset as shown on a firm’s balance sheet • Liquidation value: the dollar sum that could be realized if an asset were sold individually and not as part of a going concern. • Market value: the observed value for the asset in the marketplace • Intrinsic or economic value: also called fair value—the present value of the asset’s expected future cash flows Foundations of Finance

  27. Efficient Market • The values of all securities at any instant fully reflect all available public information, which results in the market and the intrinsic value being the same. Foundations of Finance

  28. Valuation: The Basic Process • Assigning a value to an asset by calculating the present value of its expected future cash flows using the investor’s required rate of return as the discount rate. Foundations of Finance

  29. Determinants of Value • Amount and timing of the asset’s expected cash flows to be received by the • Riskiness of the cash flows • Investor’s required rate of return for undertaking the investment Foundations of Finance

  30. Bond Valuation • The value of a bond is a combination of: • The amount and timing of the cash flows to be received by investors • The time to maturity of the loan • The investor’s required rate of return Foundations of Finance

  31. Bond Valuation using Calculators Consider a bond generating $5,000 per year for four years, given a 12% required rate of return, would be $15,186.75: INPUTS OUTPUT N 4 PV -1,069.62 I/YR 3.6 PMT 55 FV 1000 Foundations of Finance

  32. Price of a Bond Consider a bond issued by Toyota with a maturity date of 2008 and a stated coupon of 5.5%. In December 2004, with 4 years left to maturity, investors owning the bonds are requiring a 3.6% rate of return. Foundations of Finance

  33. Toyota Bond Example • Step 1: Estimate amount and timing of the expected future cash flows: Annual Interest payments .055 X $1,000= $55.00 for four years to Maturity The face value of $1,000 in 2008 $1,000 Foundations of Finance

  34. Toyota Bond Example • Step 2: Determine the investor’s required rate of return by evaluating the riskiness of the bond’s future cash flows. Remember the investors required rate of return equals the risk free rate plus a risk premium. Foundations of Finance

  35. Toyota Bond Example • Step 3: Calculate the intrinsic value of the bond at the present value of the expected future interest and principal payments discounted at the investor’s required rate of return. Foundations of Finance

  36. Yield to Maturity • To measure the bondholder’s expected rate of return, we would find the discount rate that equates the present value of the future cash flows with the current market price of the bond. • YTM and expected rate of return are used interchangeably when referring to bonds. Foundations of Finance

  37. Discount • The market value of a bond will be below the par or face when the investor’s required rate is greater than the coupon interest rate. The bond will sell at a discount or below face value. Foundations of Finance

  38. Premium • The market value of a bond will be above the par or face value when the investor’s required rate is lower than the coupon interest rate. The bond will sell at a premium or above face value. Foundations of Finance

  39. Current Yield • The ratio of the interest payment to the bond’s current market price. • Current Yield • Annual interest payment/current market price of the bond • A $1,000 bond with 8% coupon rate and market price of $700 Current yield = $80 / $700 = 11.4 % Foundations of Finance

  40. Bond Valuation: Three Important Relationships • The value of a bond is inversely related to changes in the investor’s present required rate of return (the current interest rate). • As interest rates increase(decrease), the value of the bond decreases(increases). Foundations of Finance

  41. Bond Valuation : Three Important Relationships • The market value of a bond will be less than the par value if the investor’s required rate of return is above the coupon interest rate, but it will be valued above par value if the investor’s required rate of return is below the coupon interest rate. Foundations of Finance

  42. Bond Valuation : Three Important Relationships • Long-term bonds have greater interest rate risk than do short-term bonds. Foundations of Finance

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