FINANCIAL MANAGEMENT PART 6

1. The Valuation and Characteristics of Bonds Chapter 6

7. Interest Rates for Various Treasury Securities of Differing Maturities Note that bonds with a longer maturity generally have a higher interest rate and that interest rates on Treasury securities move in tandem.

11. Determining the Price of a Bond 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:

13. Figure 6.1: Cash Flow Time Line for a Bond This is a single sum. This is an ordinary annuity.

16. Determining the Price of a Bond—Example 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. A: We need to solve for the present value of the bond’s expected cash flows at today’s interest rate. We’ll use Equation 6.4 to do so: Example K represents the periodic current market interest rate, or 10%  2. N represents the number of interest-paying periods until maturity, or 10 years x 2 = 20. The payment is 8% x $1,000, or $80 annually. However, it is received in the form of $40 every six months. The future value is the principal repayment of $1,000.

17. Bond Example A: Substituting the correct values into the equation gives us: Example This is the price at which the bond must sell to yield 10%. It is selling at a discount because the current interest rate is above the coupon rate. The bond’s current yield is $80  $875.39, or 9.14%. This could also be calculated via a financial calculator: N PV PMT FV 20 -875.39 40 1000 5 I/Y Answer

19. Table 6.1

20. Maturity Risk Revisited

22. Finding the Yield at a Given Price—Example 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.) A: Since the bond is now selling below par we can make an educated guess about the yield. As interest rates rise, bond prices fall, so the yield must be above 8%. Using a guess of 10% and applying Equation 6.4 we obtain: Clearly, 10% is not high enough. Recalculating the price of the bond at 14% gives us $620.56, which means that 14% is too high. The correct answer is 12%.

26. Figure 6.5: Valuation of a Bond Subject to Call

36. Figure 6.7: Value of a Convertible Bond

38. Effect on Earnings Per Share—Diluted EPS—Example 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.

46. Table 6.2