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Fixed-Income Securities: Characteristics and Valuation

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6. Fixed-Income Securities: Characteristics and Valuation. Introduction. This chapter focuses on the characteristics and valuation of fixed-income securities. Long-term debt Preferred stock. Classification of Long-Term (L-T) Debt. Mortgage bonds secured Debentures unsecured

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slide1

6

Fixed-Income Securities: Characteristics and Valuation

introduction
Introduction
  • This chapter focuses on the characteristics and valuation of fixed-income securities.
    • Long-term debt
    • Preferred stock
classification of long term l t debt
Classification of Long-Term (L-T) Debt
  • Mortgage bonds secured
  • Debentures unsecured
    • Subordinated and unsubordinated
      • Claims of subordinated debenture holders are considered only after the claims of unsubordinated debt holders
types of l t debt
Types of L-T Debt
  • Equipment trust certificates
  • Income bonds
  • Collateral trust bonds
  • Pollution control bonds
  • Industrial revenue bonds
characteristics of l t debt
Indenture

covenants

Trustee

TIA 1939

Call feature

Call premium

Sinking fund

Equity-linked debt

convertible

warrant

Coupon rates

Size $25–$200 million

Characteristics of L-T Debt
debt information
Debt Information
  • Corporate bonds
    • Majority traded in the over-the-counter market
    • Some larger issues traded on the NY Exchange
  • Quotations percent of par value $1000

DukeEn 63/8 08 6.8 40 93¾ –1/4

Meaning a Duke Energy bond with an interest rate (coupon rate) of 6.375 percent, maturing in 2008, yielding 6.8 percent, $40,000 dollars traded, closing price of $930.75, down $2.50 from the previous day.

  • Current information: http://www.etrade.com/
u s government debt securities
U.S. Government Debt Securities
  • U.S. Treasury bills S-T
    • Maturities of 3, 6, and 12 months
    • Minimum denominations of $10,000
    • Sold at a discount from maturity value
  • Treasury notes and bonds L-T
    • Notes 1–10 year maturity
    • Bonds 10–30 year maturity
bond ratings
Bond Ratings

http://www.standardandpoors.com/http://www.moodys.com/

ratings
Ratings
  • Higher rated bonds generally carry lower market yields.
  • Interest rate spread between ratings is less during prosperity than during recessions.
  • Junk bonds typically yield 3–6 percent or more.
l t debt advantages and disadvantages
L-T Debt: Advantages and Disadvantages
  • Advantages
    • Tax deductibility of interest
    • Financial leverage can increase EPS.
    • Ownership is not diluted.
  • Disadvantages
    • Increased financial risk
    • Indenture provisions restrict firms’ flexibility.
international bonds
International Bonds
  • Eurobonds
    • Issued outside of the issuer’s country
    • Denominated in the home currency
    • May have less regulatory interference
    • May have less disclosure requirements
  • Foreign bonds are issued in a single foreign country with interest and principal paid in that foreign currency.
value of an asset
Value of an Asset
  • Based on the expected future benefits over the life of the asset
  • Future benefits = cash flows (CFs)
  • Capitalization of cash flow method
    • PV of the stream of future benefits discounted at an appropriate required rate of return
market value of an asset
Market price

Demand & Supply(D&S)

Approximated value

Equilibrium

D&S Intersection

Consensus Judgment

Market Value of an Asset
bond prices and interest rates
Bond Prices and Interest Rates
  • Relationship between P0 and kd
    • There is an inverse relationship between a bond’s value, P0, and its required rate of return, kd.
  • L-T vs. S-T Bonds
    • A change in kd changes the value of a long-term bond more than the value of a short-term bond.
financial calculator example of bond valuation
Financial calculator example of bond valuation

This slide and the next two include steps for the first usage of the calculator.

Calcluator: TI BA II Plus

Start by resetting the calculator.

Press/EnterDisplay

0.00

 2nd 0.00

 RESET RST?

ENTER RST 0.00

 CE/C 0.00

set payments per year and compounding periods per year
Set payments per year and compounding periods per year.

Press/EnterDisplay

0.00

2nd 0.00

P/Y P/Y= 12.00

1 P/Y 1

ENTER P/Y= 1.00

C/Y= 1.00

QUIT 0.00

set the number of places after the decimal 4 places suggested
Set the number of places after the decimal. 4 places suggested.

Press/EnterDisplay

0.00

2nd 0.00

FORMAT DEC= 2.00

4 DEC 4

ENTER DEC= 4.0000

CE/C 4.0000

CE/C 0.0000

calculate the intrinsic value of a bond with annual coupon payments
Calculate the intrinsic value of a bond with annual coupon payments
  • Example on page 216 of MMK 9th Ed.
  • Calculate interest pmt amount: cM = (.06)(1000) = $60 per year

Press/EnterDisplay

0.0000

7 7

N N= 7.0000

8 8

I/Y I/Y= 8.0000

calculate the intrinsic value of a bond with annual payments 2
Calculate the intrinsic value of a bond with annual payments (2)

Press/EnterDisplay

60 60

PMT PMT= 60.0000

1000 1,000

FV FV= 1,000.0000

CPT FV= 1,000.0000

PV PV= -895.8726

calculate bond value for a bond with semiannual coupon payments
Calculate bond value for a bond with semiannual coupon payments
  • Example on page 219 of MMK 9th Ed.
  • Delete previous inputs: CE/C, 2nd, CLR TVM
  • Calculate semiannual interest amount: cM/2 = (.06)(1,000)/2 = $30
  • Find number of payments: n = years 2n = 2(7 years) = 14 payments
calculate bond value for a bond with semiannual payments 2
Calculate bond value for a bond with semiannual payments (2)

(Display) 0.0000

14 14

N N= 14.0000

4 4

I/Y I/Y= 4.0000

30 30

PMT PMT= 30.0000

1000 1,000

FV FV= 1,000.0000

CPT FV= 1,000.0000

PV PV= -894.3688

calculate yield to maturity for a bond with annual coupon payments
Calculate yield to maturity for a bond with annual coupon payments
  • Example on page 220 of MMK 9th Ed.
  • Delete previous inputs:CE/C, 2nd, CLR TVM
  • Calculate annual interest amount: cM = (.06)(1,000) = $60
calculate yield to maturity for a bond with annual payments 2
Calculate yield to maturity for a bond with annual payments (2)

(Display) 0.0000

7 7

N N= 7.0000

987.5 987.5

+/- -987.5

PV PV= -987.5000

60 60

PMT PMT= 60.0000

1000 1,000

FV FV= 1,000.0000

CPT FV= 1,000.0000

I/Y I/Y= 6.2257

calculate ytm for a bond with semiannual coupon payments
Calculate YTM for a bond with semiannual coupon payments
  • Problem 13b, page 231, with Semiannual PMTs
  • Delete previous inputs:CE/C, 2nd, CLR TVM
  • Calculate semiannual interest amount: cM/2 = (.0775)(1,000)/2 = $38.75
  • Find number of payments: n = years 2n = 2(5 years) = 10 payments
calculate ytm for a bond with semiannual coupon payments 2
Calculate YTM for a bond with semiannual coupon payments (2)

(Display) 0.0000

10 10

N N= 10.0000

900 900

+/- -900

PV PV= -900.0000

38.75 38.75

PMT PMT= 38.7500

1000 1,000

FV FV= 1,000.0000

CPT FV= 1,000.0000

I/Y I/Y= 5.1815

calculate ytm for a bond with semiannual coupon payments 3
Calculate YTM for a bond with semiannual coupon payments (3)

I/Y = 5.1815

YTM = 2(I/Y) = 2(5.1815) = 10.3630%

find ytm semiannual payments use tables and interpolation 1
Find YTM, semiannual payments Use Tables and interpolation (1)

Ch. 6, problem 13b with semiannual interest payments

Bond valuation formula with semiannual pmts:

find ytm semiannual payments use tables and interpolation 2
Find YTM, semiannual payments Use Tables and interpolation (2)
  • Convert inputs to semiannual basis:
  • Annual Coupon rate “c” = 7 3/4% = 7.75% per year
  • Semiannual interest pmt:

cM/2 = (0.0775)(1000)/2 = $38.75

  • Five years remain until maturity.  
  • So, 2n = (2 pmts per year)(5 years) = 10 payments
find ytm semiannual payments use tables and interpolation 3
Find YTM, semiannual payments Use Tables and interpolation (3)

Bond valuation formula with inputs:

Start iterative process of finding the YTM:

Since the price of the bond is less than $1,000,

try a required rate of return that is greater than the semiannual coupon rate.

Semiannual cpn rate: c/2 = (7.75%)/2 = 3.8750%

find ytm semiannual payments use tables and interpolation 4
Find YTM, semiannual payments Use Tables and interpolation (4)

Try kd/2 = 5%: Is this true?

Try kd/2 = 6%: Is this true?

find ytm semiannual payments use tables and interpolation 5
Find YTM, semiannual payments Use Tables and interpolation (5)

The $900 market price is bracketed.

So, we can interpolate to find the YTM.

5% ? % 6%

913.23 900 843.20

13.23

70.03

zero coupon bonds
Zero Coupon Bonds

formula

table

ethical issue
Ethical Issue
  • In many leveraged buyouts (LBOs), the buyer of the firm financed the purchase with a large amount of debt.
  • Often, stockholders made a large gain while bond prices plummeted because of the higher leverage the firm has assumed.
preferred stock p s
Preferred Stock (P/S)
  • Is in an intermediate position between C/S and L-T debt
  • Part of equity while increasing financial leverage
  • Dividends on P/S are not tax deductible.
  • Has preference over C/S with regard to earnings and assets
  • Dividends can not be paid on C/S unless the preferred dividend for the period has been paid.
characteristics of p s
Selling price

Par value

Adjusted rate P/S

Cumulative

Participation

Maturity

Call feature

Voting rights

Characteristics of P/S
p s advantages and disadvantages
Advantages

Flexible

Can increase financial leverage

Corporate tax advantage

Disadvantages

High after-tax cost

Dividends are not tax deductible

P/S Advantages and Disadvantages
set 1 of bonus questions for ch 6
Set 1 of Bonus Questions for Ch. 6
  • What is a debenture?
  • What is an indenture with respect to bonds?
  • How are bond prices quoted in the financial press?
  • What do bond ratings primarily signify?
  • Can you give two advantages of long-term debt financing?
set 2 of bonus questions for ch 6
Set 2 of Bonus Questions for Ch. 6
  • How is an intrinsic value (P) calculated for a bond?
  • What is the yield to maturity of a bond?
  • How are zero coupon bonds initially priced?
  • What equation is typically used to find the intrinsic value (P) for a preferred stock?
  • What is a junk bond?
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