Chapter 7The Valuation     andCharacteristics  of Bonds   Copyright © 2011 Pearson Prentice Hall.   All rights reserved.
Learning Objectives         1. Distinguish between different kinds of bonds.         2. Explain the more popular features ...
Slide Contents         Principles used in this Chapter         1. Types of Bonds         2. Bond Terminology         3. Bo...
Principles Applied in                                                     this Chapter          Principle 3:           Mo...
Bonds          Meaning: Type of debt or long-term           promissory note, issued by a borrower,           promising to...
1. Types of Bonds          Debentures          Subordinated Debentures          Mortgage Bonds          Eurobonds     ...
Debentures          Debentures are unsecured long-term           debt.          For issuing firm, debentures provide the...
Subordinated Debenture          There is a hierarchy of payout in case           of insolvency.          The claims of s...
Mortgage Bond          Mortgage bond is secured by a lien on           real property.          Typically, the value of t...
Eurobonds          Securities (bonds) issued in a country           different from the one in whose           currency th...
Convertible Bonds          Convertible bonds are debt securities           that can be converted into a firm’s stock     ...
2. Bond Terminology             Claims on assets and income             Par value             Current yield           ...
Claims on Assets and Income          Seniority in Claims: In the case of           insolvency, claims of debt, including ...
Par Value          Par value is the face value of the bond,           returned to the bondholder at maturity.          I...
Coupon Interest Rate          The percentage of the par value of the bond           that will be paid periodically in the...
Maturity          Maturity of bond refers to the length of           time until the bond issuer returns the           par...
Call Provision          Call provision (if it exists on a bond) gives           corporation the option to redeem the bond...
Indenture          An indenture is the legal agreement between           the firm issuing the bond and the trustee who   ...
Bond Ratings          Bond ratings reflect the future risk potential of           the bonds.          Three prominent bo...
Table 7-1© 2011 Pearson Prentice Hall. All rights reserved.               7-20
Favorable Factors affecting                                              Bond Rating          A greater reliance on equit...
Junk Bonds          Junk bonds are high-risk bonds with           ratings of BB or below by Moody’s and           Standar...
3. Valuing Bonds         Defining Value          Book value: Value of an asset as shown on a firm’s           balance she...
Value and Efficient Market          In an efficient market, the values of all           securities at any instant fully r...
What Determines Value?          Value of an Asset = Present value of its           expected future cash flows using the  ...
Bond Valuation          The value of a bond (V) is a combination of:                 C: Future expected cash flows in th...
Equation 7-1© 2011 Pearson Prentice Hall. All rights reserved.                  7-27
Typical cash flows on a Bond                                        (for Corporation)         Time                        ...
Typical cash flows on a Bond (for                                       bondholder)         Time                          ...
Example on Bond Valuation          Consider a bond issued by Toyota with           a maturity date of 2010 and a stated  ...
Toyota Bond Example          Step 1 (CF): Estimate amount and timing of           the expected future cash flows:        ...
Summary of Cash Flows                                                 (For One Bond)         Time                         ...
Toyota Bond Example          Step 2 (r) Determine the investor’s           required rate of return by evaluating the     ...
Toyota Bond Example          Step 3: Calculate the intrinsic value of           the bond.          Bond Value           ...
Toyota Bond Example         = PV ($43.5, for 5 years, r = 3.6%)           + PV ($1000 at year 5, i = 3.6%)         = PV of...
4. Bond Yields         Yield to Maturity (YTM)          YTM refers to the rate of return the investor           will earn...
Bond Yields         To find YTM, we need to know:              (a) current price (P)              (b) time left to maturit...
Current Yield          Current yield is the ratio of the interest payment           to the bond’s current market price.  ...
Total Yield          Total Yield from Bond = Current Yield           + Capital gain/loss from sale of bond.          Thu...
5. Bond Valuation: Three                                           Important Relationships         Relationship #1        ...
Bond Valuation: Three Important                                     Relationships         Relationship #2          The ma...
Discount Bonds          The market value of a bond will be           below the par when the investor’s           required...
Premium Bonds          The market value of a bond will be           above the par or face value when the           invest...
Bond Valuation: Three Important                                     Relationships         Relationship #3          Long-t...
Main Risks for Bondholders          Changes in current Interest rates (if interest           rates rise, the market value...
Figure 7-1© 2011 Pearson Prentice Hall. All rights reserved.                7-46
Figure 7-2© 2011 Pearson Prentice Hall. All rights reserved.                7-47
Figure 7-3© 2011 Pearson Prentice Hall. All rights reserved.                7-48
Figure 7-4© 2011 Pearson Prentice Hall. All rights reserved.                7-49
Key Terms          Bond                                        Debenture          Book Value                           ...
Key Terms          High-yield bond                             Liquidation value          Indenture                    ...
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6. bond valuation

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6. bond valuation

  1. 1. Chapter 7The Valuation andCharacteristics of Bonds Copyright © 2011 Pearson Prentice Hall. All rights reserved.
  2. 2. Learning Objectives 1. Distinguish between different kinds of bonds. 2. Explain the more popular features of bonds. 3. Define the term value as used for several different purposes. 4. Explain the factors that determine value. 5. Describe the basic process for valuing assets. 6. Estimate the value of a bond. 7. Compute a bondholder’s expected rate of return. 8. Explain three important relationships that exist in bond valuation.© 2011 Pearson Prentice Hall. All rights reserved. 7-2
  3. 3. Slide Contents Principles used in this Chapter 1. Types of Bonds 2. Bond Terminology 3. Bond Valuation 4. Bond Yield 5. Bond Valuation: Important Relationships© 2011 Pearson Prentice Hall. All rights reserved. 7-3
  4. 4. Principles Applied in this Chapter  Principle 3: Money has time value  Principle 3: Risk requires reward  Principle 4: Market prices are generally right© 2011 Pearson Prentice Hall. All rights reserved. 7-4
  5. 5. Bonds  Meaning: 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 and repayment of principal at maturity.  Issuers or Borrowers: Corporations, US Government, State and Local Municipalities.© 2011 Pearson Prentice Hall. All rights reserved. 7-5
  6. 6. 1. Types of Bonds  Debentures  Subordinated Debentures  Mortgage Bonds  Eurobonds  Convertible Bonds© 2011 Pearson Prentice Hall. All rights reserved. 7-6
  7. 7. Debentures  Debentures are unsecured long-term debt.  For issuing firm, debentures provide the benefit of not tying up property as collateral.  For bondholders, debentures are more risky than secured bonds and provide a higher yield than secured bonds.© 2011 Pearson Prentice Hall. All rights reserved. 7-7
  8. 8. Subordinated Debenture  There is a 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.© 2011 Pearson Prentice Hall. All rights reserved. 7-8
  9. 9. Mortgage Bond  Mortgage bond is secured by a lien on real property.  Typically, the value of the real property is greater than that of the bonds issued.© 2011 Pearson Prentice Hall. All rights reserved. 7-9
  10. 10. Eurobonds  Securities (bonds) issued in a country different from the one in whose currency the bond is denominated.  For example, a bond issued by an American corporation in Japan that pays interest and principal in dollars.© 2011 Pearson Prentice Hall. All rights reserved. 7-10
  11. 11. Convertible Bonds  Convertible bonds are debt securities that can be converted into a firm’s stock at a pre-specified price.© 2011 Pearson Prentice Hall. All rights reserved. 7-11
  12. 12. 2. Bond Terminology  Claims on assets and income  Par value  Current yield  Coupon interest rate  Maturity  Call provision  Indenture  Bond ratings© 2011 Pearson Prentice Hall. All rights reserved. 7-12
  13. 13. Claims on Assets and Income  Seniority in Claims: In the case of insolvency, claims of debt, including bonds are honored before those of common or preferred stock.© 2011 Pearson Prentice Hall. All rights reserved. 7-13
  14. 14. Par Value  Par value is the face value of the bond, returned to the bondholder at maturity.  In general, corporate bonds are issued at denominations or par value of $1,000.  Prices are represented as a % of face value. Thus a bond quoted at 112 can be bought at 112% of its par value in the market. Bonds will return the par value at maturity, regardless of the price paid at the time of purchase.© 2011 Pearson Prentice Hall. All rights reserved. 7-14
  15. 15. Coupon Interest Rate  The percentage of the par value of the bond that will be paid periodically in the form of interest.  Example: A bond with a $1,000 par value and 5% coupon rate will pay $50 annually (.05*1000) or $25 (if interest is paid semi- annually).© 2011 Pearson Prentice Hall. All rights reserved. 7-15
  16. 16. Maturity  Maturity of bond refers to the length of time until the bond issuer returns the par value to the bondholder and terminates or redeems the bond.© 2011 Pearson Prentice Hall. All rights reserved. 7-16
  17. 17. Call Provision  Call provision (if it exists on a bond) gives corporation the option to redeem the bonds before the maturity date. For example, 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.© 2011 Pearson Prentice Hall. All rights reserved. 7-17
  18. 18. Indenture  An indenture is the legal agreement between the firm issuing the bond and the trustee who represents the bondholders.  It provides for specific terms of the loan agreement (such as rights of bondholders and issuing firm).  Many of the terms seek to protect the status of bonds from being weakened by managerial actions or by other security holders.© 2011 Pearson Prentice Hall. All rights reserved. 7-18
  19. 19. Bond Ratings  Bond ratings reflect the future risk potential of the bonds.  Three prominent bond rating agencies are Standard & Poor, Moody’s, and Fitch Investor Services.  Lower bond rating indicates higher probability of default. It also means that the rate of return demanded by the capital markets will be higher on such bonds.© 2011 Pearson Prentice Hall. All rights reserved. 7-19
  20. 20. Table 7-1© 2011 Pearson Prentice Hall. All rights reserved. 7-20
  21. 21. Favorable Factors affecting Bond 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© 2011 Pearson Prentice Hall. All rights reserved. 7-21
  22. 22. Junk Bonds  Junk bonds are high-risk bonds with ratings of BB or below by Moody’s and Standard & Poor’s. Junk bonds are also referred to as high-yield bonds as they pay high interest rate, 3-5% more than AAA rated bonds.© 2011 Pearson Prentice Hall. All rights reserved. 7-22
  23. 23. 3. Valuing Bonds Defining 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.© 2011 Pearson Prentice Hall. All rights reserved. 7-23
  24. 24. Value and Efficient Market  In an efficient market, the values of all securities at any instant fully reflect all available public information.  If the markets are efficient, the market value and the intrinsic value will be the same.© 2011 Pearson Prentice Hall. All rights reserved. 7-24
  25. 25. What Determines Value?  Value of an Asset = Present value of its expected future cash flows using the investor’s required rate of return as the discount rate.  Thus value is affected by three elements:  Amount and timing of the asset’s expected future cash flows  Riskiness of the cash flows  Investor’s required rate of return for undertaking the investment© 2011 Pearson Prentice Hall. All rights reserved. 7-25
  26. 26. Bond Valuation  The value of a bond (V) is a combination of:  C: Future expected cash flows in the form of interest and repayment of principal  n: The time to maturity of the loan  r: The investor’s required rate of return© 2011 Pearson Prentice Hall. All rights reserved. 7-26
  27. 27. Equation 7-1© 2011 Pearson Prentice Hall. All rights reserved. 7-27
  28. 28. Typical cash flows on a Bond (for Corporation) Time Cash flow 0 Cash inflow from Bond Issue 1–Maturity Pay Interest Maturity Repay Principal Exceptions: Bankruptcy, Bond Recalled and paid off before the due date, Mergers and acquisitions.© 2011 Pearson Prentice Hall. All rights reserved. 7-28
  29. 29. Typical cash flows on a Bond (for bondholder) Time Cash flow O Pay for bond (Buy) 1–Maturity Receive Interest Maturity Receive Par value back Exceptions: Bankruptcy, Bond Recalled, Bond sold by investor in the market before maturity date, Mergers & acquisitions.© 2011 Pearson Prentice Hall. All rights reserved. 7-29
  30. 30. Example on Bond Valuation  Consider a bond issued by Toyota with a maturity date of 2010 and a stated coupon of 4.35%. In December 2005, with 5 years left to maturity, investors owning the bonds are requiring a 3.6% rate of return.© 2011 Pearson Prentice Hall. All rights reserved. 7-30
  31. 31. Toyota Bond Example  Step 1 (CF): Estimate amount and timing of the expected future cash flows:  Annual Interest payments = .0435 × $1,000 = $43.50 every year for five years  The par value of $1,000 to be received in 2010© 2011 Pearson Prentice Hall. All rights reserved. 7-31
  32. 32. Summary of Cash Flows (For One Bond) Time Bondholder Corporation 0 Price = ? Price = ? 1–5 $43.5 –$43.5 5 +1,000 –1,000© 2011 Pearson Prentice Hall. All rights reserved. 7-32
  33. 33. Toyota Bond Example  Step 2 (r) 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. Here, the required rate of return (r) is given as 3.6%© 2011 Pearson Prentice Hall. All rights reserved. 7-33
  34. 34. Toyota Bond Example  Step 3: Calculate the intrinsic value of the bond.  Bond Value = PV (Interest, received every year) + PV (Par, received at maturity)© 2011 Pearson Prentice Hall. All rights reserved. 7-34
  35. 35. Toyota Bond Example = PV ($43.5, for 5 years, r = 3.6%) + PV ($1000 at year 5, i = 3.6%) = PV of Annuity (A = 43.5; N = 5; r = 3.6%) + PV of single cash flow (FV = $1,000, N = 5, i = 3.6%) = $195.84 + $837.73 = $1,033.57© 2011 Pearson Prentice Hall. All rights reserved. 7-35
  36. 36. 4. Bond Yields Yield to Maturity (YTM)  YTM refers to the rate of return the investor will earn if the bond is held to maturity. YTM is also known as bondholder’s expected rate of return.  YTM = Discount rate that equates the present value of the future cash flows with the current market price of the bond.© 2011 Pearson Prentice Hall. All rights reserved. 7-36
  37. 37. Bond Yields To find YTM, we need to know: (a) current price (P) (b) time left to maturity (n) (c) par Value and (M) (d) annual interest payment (C)  Formula = C + (M-P)/n  (M+P) 2© 2011 Pearson Prentice Hall. All rights reserved. 7-37
  38. 38. Current Yield  Current yield is the ratio of the interest payment to the bond’s current market price.  Current Yield = Annual interest payment/ current market price of the bond Example: The current yield on a $1,000 par value bond with 8% coupon rate and market price of $700 = $80 / $700 = 11.4 %© 2011 Pearson Prentice Hall. All rights reserved. 7-38
  39. 39. Total Yield  Total Yield from Bond = Current Yield + Capital gain/loss from sale of bond.  Thus in the previous example, if the bond was bought for $700 and sold for $725. Total Yield = 80 + (725 – 700) = $105 or 105/700 = 15%© 2011 Pearson Prentice Hall. All rights reserved. 7-39
  40. 40. 5. Bond Valuation: Three Important Relationships Relationship #1  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).© 2011 Pearson Prentice Hall. All rights reserved. 7-40
  41. 41. Bond Valuation: Three Important Relationships Relationship #2  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.  Bond will be valued above par value if the investor’s required rate of return is below the coupon interest rate.© 2011 Pearson Prentice Hall. All rights reserved. 7-41
  42. 42. Discount Bonds  The market value of a bond will be below the par when the investor’s required rate is greater than the coupon interest rate. These bonds are known as discount bonds.© 2011 Pearson Prentice Hall. All rights reserved. 7-42
  43. 43. Premium Bonds  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. These bonds are known as premium bonds.  If investor’s required rate of return is equal to the coupon interest rate, the bonds will trade at par.© 2011 Pearson Prentice Hall. All rights reserved. 7-43
  44. 44. Bond Valuation: Three Important Relationships Relationship #3  Long-term bonds have greater interest rate risk than do short-term bonds.  In other words, a change in interest rate will have relatively greater impact on long-term bonds.© 2011 Pearson Prentice Hall. All rights reserved. 7-44
  45. 45. Main Risks for Bondholders  Changes in current Interest rates (if interest rates rise, the market value of bonds will fall)  Default Risk (this may mean no or partial payment on debt as in bankruptcy cases)  Call Risk (If bonds are called before maturity date)… bond are generally called when interest rates decrease. Thus investors will have to reinvest the money received from corporation at a lower rate.© 2011 Pearson Prentice Hall. All rights reserved. 7-45
  46. 46. Figure 7-1© 2011 Pearson Prentice Hall. All rights reserved. 7-46
  47. 47. Figure 7-2© 2011 Pearson Prentice Hall. All rights reserved. 7-47
  48. 48. Figure 7-3© 2011 Pearson Prentice Hall. All rights reserved. 7-48
  49. 49. Figure 7-4© 2011 Pearson Prentice Hall. All rights reserved. 7-49
  50. 50. Key Terms  Bond  Debenture  Book Value  Discount bond  Callable Bond  Eurobond  Call protection  Expected rate of period return  Coupon interest rate  Fair value  Current Yield© 2011 Pearson Prentice Hall. All rights reserved. 7-50
  51. 51. Key Terms  High-yield bond  Liquidation value  Indenture  Discount bond  Interest rate risk  Eurobond  Intrinsic value  Expected rate of return  Junk bond  Fair value© 2011 Pearson Prentice Hall. All rights reserved. 7-51

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