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The valuation of bonds ppt @ bec doms finance

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The valuation of bonds ppt @ bec doms finance

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The valuation of bonds ppt @ bec doms finance

  1. 1. The Valuation and Characteristics of Bonds
  2. 2. The Basis of Value <ul><li>A security’s value is equal to the present value of its expected cash flows. </li></ul><ul><ul><li>A security should sell in financial markets for a price close to that value </li></ul></ul><ul><ul><ul><li>Differences of opinion exist about a security’s price because of different assumptions about cash flows and interest rates for PV calculations </li></ul></ul></ul>2
  3. 3. The Basis for Value <ul><li>Investing </li></ul><ul><li>Using a resource to benefit the future rather than for current satisfaction </li></ul><ul><ul><li>Putting money to work to earn more money </li></ul></ul><ul><ul><li>Common types of investments </li></ul></ul><ul><ul><ul><li>Debt—lending money </li></ul></ul></ul><ul><ul><ul><li>Equity—buying ownership in a business </li></ul></ul></ul><ul><li>Return </li></ul><ul><li>What the investor receives for making an investment </li></ul><ul><li>For a 1 year investment the rate of return = </li></ul><ul><li>$ received / $ invested </li></ul><ul><li>Debt investors receive interest </li></ul>3
  4. 4. The Basis for Value <ul><li>Rate of return is the interest rate that equates the present value of an investment’s expected future cash flows with its current price </li></ul><ul><li>Return is also known as </li></ul><ul><ul><ul><li>Yield </li></ul></ul></ul><ul><ul><ul><li>Interest </li></ul></ul></ul><ul><ul><ul><ul><li>Debt investments only </li></ul></ul></ul></ul>4
  5. 5. Bond Valuation <ul><li>Bonds represent a debt relationship in which the issuing company borrows and the buyers lend. </li></ul><ul><ul><li>A bond issue represents borrowing from many lenders at one time under a single agreement </li></ul></ul>5
  6. 6. Bond Terminology and Practice <ul><li>A bond’s term (or maturity) is the time from the present until the principal is returned </li></ul><ul><ul><li>Bonds mature on the last day of their term </li></ul></ul><ul><ul><li>A bond’s term gets shorter as it ages </li></ul></ul><ul><li>A bond’s face (or par) value represents the amount the firm intends to borrow (the principal) at the coupon rate of interest </li></ul><ul><ul><li>Bonds are non-amortized debt - the entire principal is repaid at maturity </li></ul></ul>6
  7. 7. The Coupon Rate <ul><li>Coupon Rate – the fixed rate of interest paid by a bond </li></ul><ul><ul><li>Doesn’t change over the bond’s life </li></ul></ul><ul><li>In the past, bonds had “coupons” attached, today they are “registered” </li></ul><ul><li>Most bonds pay coupon interest semiannual </li></ul>7
  8. 8. Bond Valuation—Basic Ideas <ul><li>Adjusting to Interest Rate Changes </li></ul><ul><ul><li>Bonds are originally sold in the primary market and trade subsequently among investors in the secondary market . </li></ul></ul><ul><ul><li>Although bonds have fixed coupons , market interest rates constantly change . </li></ul></ul><ul><ul><ul><li>What happens to the price of a bond paying a fixed interest rate in the secondary market when interest rates change? </li></ul></ul></ul>8
  9. 9. Bond Valuation—Basic Ideas <ul><li>Buy a 20 year, $1000 par bond with a 10% coupon rate for $1,000. </li></ul><ul><ul><li>It promises 20 years of coupon payments of $100 each, and a principal repayment of $1,000 after 20 years </li></ul></ul><ul><li>Needing cash, you sell it early. </li></ul><ul><ul><li>Assume interest rates have risen and the market rate of return is 11% </li></ul></ul><ul><ul><li>Investors can now buy new bonds with an 11% coupon rate for $1,000 so they will not pay $1000 for your bond – but they will buy it for less than $1,000 </li></ul></ul><ul><li>Bond prices and interest rates move in opposite directions </li></ul><ul><li>Bonds adjust to changing yields by changing price </li></ul><ul><ul><li>Selling at a Premium – bond price above face value </li></ul></ul><ul><ul><li>Selling at a Discount – bond price below face value </li></ul></ul>9
  10. 10. Determining the Price of a Bond 10 0 1 5 10 $100 a year for 10 years $100 $1,000 $1,100 Example Q: A bond has 10 years to maturity, a par value of $1,000, and a coupon rate of 10%. What cash flows are expected from the bond? A:
  11. 11. Determining the Price of a Bond <ul><li>The Bond Valuation Formula </li></ul><ul><ul><li>The price of a bond is the present value of a stream of interest payments plus the present value of the principal repayment </li></ul></ul>11
  12. 12. Cash Flow Time Line for a Bond Figure 7.1 12 This is an ordinary annuity . This is a single sum.
  13. 13. Determining the Price of a Bond <ul><li>Two Interest Rates and One More </li></ul><ul><ul><li>Coupon Rate </li></ul></ul><ul><ul><ul><li>Determines the size of the interest payments </li></ul></ul></ul><ul><ul><li>k—the current market yield on comparable bonds </li></ul></ul><ul><ul><ul><li>The discount rate that makes the present value of the payments equal to the price of the bond in the market </li></ul></ul></ul><ul><ul><ul><ul><li>AKA yield to maturity (YTM) </li></ul></ul></ul></ul><ul><ul><li>Current yield — annual interest payment divided by bond’s current price </li></ul></ul>13
  14. 14. Solving Bond Problems with a Financial Calculator <ul><li>Financial calculators have five time value of money keys </li></ul><ul><li>With a bond problem, all five keys are used </li></ul><ul><ul><li>n—number of periods until maturity </li></ul></ul><ul><ul><li>I/Y—market interest rate </li></ul></ul><ul><ul><li>PV—price of bond </li></ul></ul><ul><ul><li>FV—face value (par) of bond </li></ul></ul><ul><ul><li>PMT—coupon interest payment per period </li></ul></ul><ul><ul><ul><li>With calculators that have a sign convention the PMT and FV must be of one sign while the PV will be the other sign </li></ul></ul></ul><ul><li>The unknown is either interest rate or present value (Price) </li></ul><ul><li>Sophisticated calculators have a ‘bond’ mode allowing easy calculations dealing with accrued interest </li></ul>14
  15. 15. Determining the Price of a Bond Example 7.1 15 Q: The Emory Corporation issued an 8%, 25-year bond 15 years ago. At the time of issue it sold for its par (face) value of $1,000. Comparable bonds are yielding 10% today. What must Emory’s bond sell for in today’s market to yield 10% (YTM) to the buyer? Assume the bond pays interest semiannually. Also calculate the bond’s current yield. Example
  16. 16. Bond Example Continued Example 7.1 16 A: Substituting the correct values into the equation gives us: Example This can also be calculated via a financial calculator: N PV PMT FV I/Y
  17. 17. Maturity Risk Revisited <ul><li>Relates to term of the debt </li></ul><ul><ul><li>Longer term bond prices fluctuate more in response to changes in interest rates than shorter term bonds </li></ul></ul><ul><ul><li>AKA price risk and interest rate risk </li></ul></ul>17
  18. 18. Price Changes at Different Terms due to an Interest Rate Increase from 8% to 10% Table 7.1 18
  19. 19. Finding the Yield at a Given Price <ul><li>Calculate a bond’s yield assuming it is selling at a given price </li></ul><ul><li>Trial and error – guess a yield – calculate price – compare to price given </li></ul>19
  20. 20. Finding the Yield at a Given Price Example 7.3 20 Example Q: The Benson Steel Company issued a 30-year bond 14 years ago with a face value of $1,000 and a coupon rate of 8%. The bond is currently selling for $718. What is the yield to an investor who buys it today at that price? (Assume semiannual interest.)
  21. 21. Call Provisions <ul><li>If interest rates fall, a firm may wish to retire old, high interest bonds </li></ul><ul><ul><li>“ Refinance” with new lower interest debt </li></ul></ul><ul><li>To ensure their ability to refinance bonds, corporations make bonds ‘ callable ’ </li></ul><ul><ul><li>Call provision gives right to pay off the bond early </li></ul></ul><ul><li>Investors don’t like calls – lose high interest </li></ul><ul><li>So issuers and investors Compromise </li></ul><ul><ul><li>Call provisions usually have a call premium </li></ul></ul><ul><ul><li>Call protection means the bond won’t be called for a certain number of years. </li></ul></ul>21
  22. 22. The Refunding Decision <ul><li>When current interest rates fall below the bond’s coupon rate, a firm must decide whether to call in the issue </li></ul><ul><ul><li>Compare interest savings to the cost of making the call: </li></ul></ul><ul><ul><ul><li>Call premium – extra payment to bond holders </li></ul></ul></ul><ul><ul><ul><li>Flotation costs – incurred in issuing new bonds, includes brokerage fees, administrative expenses, printing, etc. </li></ul></ul></ul>22
  23. 23. Dangerous Bonds with Surprising Calls <ul><li>Bonds can have obscure call features buried in their contract terms. </li></ul><ul><ul><li>Most common type – a sinking fund provision – requires an issuer to call in and retire a fixed percentage of the issue each year </li></ul></ul><ul><ul><ul><li>Usually no call premium </li></ul></ul></ul><ul><ul><ul><li>Determined by lottery </li></ul></ul></ul>23
  24. 24. Convertible Bonds <ul><li>Unsecured bonds exchangeable for a fixed number of shares of stock at the bondholder's discretion </li></ul><ul><ul><li>Bondholders can participate in the stock’s price appreciation </li></ul></ul><ul><li>Conversion ratio - the number of shares of stock received for each bond </li></ul><ul><li>Conversion price - the implied stock price if bond is converted into a certain number of shares </li></ul><ul><ul><li>Usually set 15-30% above the stock’s market value when the bond is issued </li></ul></ul><ul><li>Usually issued at lower coupon rates </li></ul>24
  25. 25. Advantages of Convertible Bonds <ul><li>To Issuing Companies </li></ul><ul><li>Convertible features are “ sweeteners ” enabling a risky firm to pay a lower interest rate </li></ul><ul><li>Viewed as a way to sell equity at a price above market </li></ul><ul><li>Usually have few or no restrictions </li></ul><ul><li>To Buyers </li></ul><ul><li>Offer the chance to participate in stock price appreciation </li></ul><ul><li>Offer a way to limit risk associated with a stock investment </li></ul>25
  26. 26. Forced Conversion <ul><li>A firm may want bonds converted </li></ul><ul><ul><li>eliminates interest payments on bond </li></ul></ul><ul><ul><li>strengthens balance sheet </li></ul></ul><ul><ul><li>don’t want conversion at very high stock prices </li></ul></ul><ul><li>Convertible bonds are always issued with call features which can be used to force conversion </li></ul><ul><li>Issuers generally call convertibles when stock prices rise to 10-15% above conversion prices </li></ul>26
  27. 27. Effect on Earnings Per Share—Diluted EPS <ul><li>Upon conversion convertible bonds cause dilution in EPS </li></ul><ul><ul><li>EPS drops due to the increase in the number of shares of stock </li></ul></ul><ul><li>Thus outstanding convertibles represent a potential to dilution of EPS </li></ul>27
  28. 28. Effect on Earnings Per Share—Diluted EPS Example 7.7 28 Example Q: Montgomery Inc. is a small manufacturer of men’s clothing with operations in Southern California. It issued 2,000 convertible bonds in 1999 at a coupon rate of 8% and a par value of $1,000. Each bond is convertible into Montgomery’s common stock at $40 per share. Management expected the stock price to rise rapidly after the convertible was issued and lead to a quick conversion of the bond debt into equity. However, a recessionary climate has prevented that from happening, and the bonds are still outstanding. In 2003 Montgomery had net income of $3 million. One million shares of its stock were outstanding for the entire year, and its marginal tax rate is 40%. Calculate Montgomery’s basic and diluted EPS. A: Basic EPS is the firm’s net income divided by the number of shares outstanding, or $3,000,000 ÷ 1,000,000 = $3.00.
  29. 29. Effect on Earnings Per Share—Diluted EPS Example 7.7 29 Example <ul><li>Diluted EPS assumes all convertible bonds are converted at the beginning of the year. Two adjustments need to be made: </li></ul><ul><ul><li>Add the number of newly converted shares to the denominator: </li></ul></ul><ul><ul><ul><li>Shares exchanged: </li></ul></ul></ul><ul><ul><ul><li>Bond’s par ÷ Conversion price = $1,000 ÷ $25 = 40 </li></ul></ul></ul><ul><ul><ul><ul><li>Since each bond can be converted into 40 shares of stock and there are 2,000 bonds, the newly converted shares totals 80,000, or 40 x 2,000, bringing the total number of shares outstanding to 1,080,000. </li></ul></ul></ul></ul>
  30. 30. Institutional Characteristics of Bonds <ul><li>Registration, Transfer Agents, and Owners of Record </li></ul><ul><li>Classify bonds as either bearer or registered bonds. </li></ul><ul><ul><li>Bearer bonds — interest payment is made to the bearer of the bond </li></ul></ul><ul><ul><li>Registered bonds — interest payment is made to the holder of record </li></ul></ul><ul><li>Owners of registered bonds are recorded with a transfer agent . </li></ul><ul><ul><li>Keeps track of bonds for issuing companies </li></ul></ul><ul><ul><li>Sends payments to owners of record </li></ul></ul><ul><ul><li>Transfers ownership when bond is sold to another investor </li></ul></ul>30
  31. 31. Kinds of Bonds <ul><li>Secured bonds and mortgage bonds </li></ul><ul><ul><li>Backed by the value of specific assets - collateral </li></ul></ul><ul><li>Debentures </li></ul><ul><ul><li>Unsecured bonds issued with higher interest rates </li></ul></ul><ul><li>Subordinated debentures </li></ul><ul><ul><li>Lower in priority than senior debt </li></ul></ul><ul><li>Junk bonds </li></ul><ul><ul><li>Issued by risky companies and pay high interest rates </li></ul></ul>31
  32. 32. Bond Ratings—Assessing Default Risk <ul><li>Bonds are assigned quality ratings reflecting their probability of default. </li></ul><ul><ul><li>Higher ratings mean lower default probability </li></ul></ul><ul><li>Bond rating agencies (such as Moody’s, S&P) evaluate bonds (and issuers), and assign a rating </li></ul><ul><ul><li>Examine the financial and market conditions of the issuer </li></ul></ul>32
  33. 33. Bond Ratings—Assessing Default Risk <ul><li>Why Ratings Are Important </li></ul><ul><ul><li>Ratings are the primary measure of the default risk associated with bonds </li></ul></ul><ul><ul><li>The rating determines the rate at which the firm can borrow </li></ul></ul><ul><ul><ul><ul><li>A lower quality rating implies a higher borrowing rate </li></ul></ul></ul></ul><ul><ul><ul><ul><li>A differential exists between the rates required on high and low quality issues. </li></ul></ul></ul></ul>33
  34. 34. Moody’s and S&P Bond Ratings Table 7.2 34
  35. 35. Bond Indentures—Controlling Default Risk <ul><li>Bond indentures attempt to prevent firms from becoming riskier after bonds are purchased by including restrictive covenants: </li></ul><ul><ul><li>Preclude entering high risk businesses </li></ul></ul><ul><ul><li>Limit further borrowing </li></ul></ul><ul><ul><li>Require certain financial ratios </li></ul></ul><ul><li>Safety is also provided by sinking funds </li></ul><ul><ul><li>Provide money for repayment of bond principal </li></ul></ul>35
  36. 36. The Advantages of Leasing Appendix 7-A <ul><li>No money down </li></ul><ul><ul><li>Lenders generally require a down payment </li></ul></ul><ul><ul><li>lessors usually do not </li></ul></ul><ul><li>Restrictions </li></ul><ul><ul><li>Lenders require covenants/indentures, lessors have few, if any, restrictions </li></ul></ul><ul><li>Easier credit with manufacturers/lessors </li></ul><ul><ul><li>Equipment manufacturers may lease their own products and will sometimes lease to marginally creditworthy customers </li></ul></ul>36
  37. 37. The Advantages of Leasing Appendix 7-A <ul><li>Avoiding the risk obsolescence </li></ul><ul><ul><li>Short leases transfer this risk to lessors </li></ul></ul><ul><li>Tax deducting the cost of land </li></ul><ul><ul><li>If real estate is leased - the lease payment can be deducted as an expense </li></ul></ul><ul><ul><li>If land is owned - it is not depreciable </li></ul></ul><ul><li>Increasing liquidity—the sale and leaseback </li></ul><ul><ul><li>A firm may sell an asset to a financial institution and lease back the same asset — frees up cash </li></ul></ul><ul><li>Tax advantages for marginally profitable companies </li></ul>37

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