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Chapter 7

Chapter 7. The Valuation and Characteristics of Bonds. The Basis of Value. A security’s value is equal to the present value of its expected cash flows. A security should sell in financial markets for a price close to that value

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Chapter 7

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  1. Chapter 7 The Valuation and Characteristics of Bonds

  2. The Basis of Value A security’s value is equal to the present value of its expected cash flows. • A security should sell in financial markets for a price close to that value • Differences of opinion exist about a security’s price because of different assumptions about cash flows and interest rates for PV calculations

  3. Investing Using a resource to benefit the future rather than for current satisfaction Putting money to work to earn more money Common types of investments Debt—lending money Equity—buying ownership in a business Return What the investor receives for making an investment For a 1 year investment the rate of return = $ received / $ invested Debt investors receive interest The Basis for Value

  4. The Basis for Value • Rate of return is the interest rate that equates the present value of an investment’s expected future cash flows with its current price • Return is also known as • Yield • Interest • Debt investments only

  5. Bond Valuation • Bonds represent a debt relationship in which the issuing company borrows and the buyers lend. • A bond issue represents borrowing from many lenders at one time under a single agreement

  6. Bond Terminology and Practice • A bond’s term (or maturity) is the time from the present until the principal is returned • Bonds mature on the last day of their term • A bond’s term gets shorter as it ages • A bond’s face (or par) value represents the amount the firm intends to borrow (the principal) at the coupon rate of interest • Bonds are non-amortized debt - the entire principal is repaid at maturity

  7. The Coupon Rate • Coupon Rate – the fixed rate of interest paid by a bond • Doesn’t change over the bond’s life • In the past, bonds had “coupons” attached, today they are “registered” • Most bonds pay coupon interest semiannual

  8. Bond Valuation—Basic Ideas Adjusting to Interest Rate Changes • Bonds are originally sold in the primary market and trade subsequently among investors in the secondary market. • Although bonds have fixed coupons, market interest rates constantly change. • What happens to the price of a bond paying a fixed interest rate in the secondary market when interest rates change?

  9. Bond Valuation—Basic Ideas • Buy a 20 year, $1000 par bond with a 10% coupon rate for $1,000. • It promises 20 years of coupon payments of $100 each, and a principal repayment of $1,000 after 20 years • Needing cash, you sell it early. • Assume interest rates have risen and the market rate of return is 11% • 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 • Bond prices and interest rates move in opposite directions • Bonds adjust to changing yields by changing price • Selling at a Premium – bond price above face value • Selling at a Discount – bond price below face value

  10. 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: Example 0 1 5 10 a year for 10 years $100 $100 $1,000 $1,100 Determining the Price of a Bond

  11. Determining the Price of a Bond The Bond Valuation Formula • The price of a bond is the present value of a stream of interest payments plus the present value of the principal repayment

  12. Cash Flow Time Line for a BondFigure 7.1 This is an ordinary annuity. This is a single sum.

  13. Determining the Price of a Bond Two Interest Rates and One More • Coupon Rate • Determines the size of the interest payments • k—the current market yield on comparable bonds • The discount rate that makes the present value of the payments equal to the price of the bond in the market • AKA yield to maturity (YTM) • Current yield — annual interest payment divided by bond’s current price

  14. Solving Bond Problems with a Financial Calculator • Financial calculators have five time value of money keys • With a bond problem, all five keys are used • n—number of periods until maturity • I/Y—market interest rate • PV—price of bond • FV—face value (par) of bond • PMT—coupon interest payment per period • With calculators that have a sign convention the PMT and FV must be of one sign while the PV will be the other sign • The unknown is either interest rate or present value (Price) • Sophisticated calculators have a ‘bond’ mode allowing easy calculations dealing with accrued interest

  15. Determining the Price of a BondExample 7.1 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. A: Substituting the correct values into the equation gives us: N This can also be calculated via a financial calculator: PV FV Example PMT I/Y Bond Example ContinuedExample 7.1

  17. Maturity Risk Revisited • Relates to term of the debt • Longer term bond prices fluctuate more in response to changes in interest rates than shorter term bonds • AKA price risk and interest rate risk

  18. Price Changes at Different Terms due to an Interest Rate Increase from 8% to 10%Table 7.1

  19. Finding the Yield at a Given Price • Calculate a bond’s yield assuming it is selling at a given price • Trial and error – guess a yield – calculate price – compare to price given

  20. Finding the Yield at a Given PriceExample 7.3 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.) Example

  21. Call Provisions • If interest rates fall, a firm may wish to retire old, high interest bonds • “Refinance” with new lower interest debt • To ensure their ability to refinance bonds, corporations make bonds ‘callable’ • Call provision gives right to pay off the bond early • Investors don’t like calls – lose high interest • So issuers and investors Compromise • Call provisions usually have a call premium • Call protection means the bond won’t be called for a certain number of years.

  22. The Refunding Decision When current interest rates fall below the bond’s coupon rate, a firm must decide whether to call in the issue • Compare interest savings to the cost of making the call: • Call premium – extra payment to bond holders • Flotation costs – incurred in issuing new bonds, includes brokerage fees, administrative expenses, printing, etc.

  23. Dangerous Bonds with Surprising Calls Bonds can have obscure call features buried in their contract terms. • Most common type – a sinking fund provision – requires an issuer to call in and retire a fixed percentage of the issue each year • Usually no call premium • Determined by lottery

  24. Convertible Bonds • Unsecured bonds exchangeable for a fixed number of shares of stock at the bondholder's discretion • Bondholders can participate in the stock’s price appreciation • Conversion ratio - the number of shares of stock received for each bond • Conversion price - the implied stock price if bond is converted into a certain number of shares • Usually set 15-30% above the stock’s market value when the bond is issued • Usually issued at lower coupon rates

  25. To Issuing Companies Convertible features are “sweeteners” enabling a risky firm to pay a lower interest rate Viewed as a way to sell equity at a price above market Usually have few or no restrictions To Buyers Offer the chance to participate in stock price appreciation Offer a way to limit risk associated with a stock investment Advantages of Convertible Bonds

  26. Forced Conversion • A firm may want bonds converted • eliminates interest payments on bond • strengthens balance sheet • don’t want conversion at very high stock prices • Convertible bonds are always issued with call features which can be used to force conversion • Issuers generally call convertibles when stock prices rise to 10-15% above conversion prices

  27. Effect on Earnings Per Share—Diluted EPS • Upon conversion convertible bonds cause dilution in EPS • EPS drops due to the increase in the number of shares of stock • Thus outstanding convertibles represent a potential to dilution of EPS

  28. 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. Example Effect on Earnings Per Share—Diluted EPSExample 7.7

  29. Diluted EPS assumes all convertible bonds are converted at the beginning of the year. Two adjustments need to be made: • Add the number of newly converted shares to the denominator: • Shares exchanged: • Bond’s par ÷ Conversion price = $1,000 ÷ $25 = 40 • 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. Example Effect on Earnings Per Share—Diluted EPSExample 7.7

  30. Institutional Characteristics of Bonds Registration, Transfer Agents, and Owners of Record • Classify bonds as either bearer or registered bonds. • Bearer bonds — interest payment is made to the bearer of the bond • Registered bonds — interest payment is made to the holder of record • Owners of registered bonds are recorded with a transfer agent. • Keeps track of bonds for issuing companies • Sends payments to owners of record • Transfers ownership when bond is sold to another investor

  31. Kinds of Bonds • Secured bonds and mortgage bonds • Backed by the value of specific assets - collateral • Debentures • Unsecured bonds issued with higher interest rates • Subordinated debentures • Lower in priority than senior debt • Junk bonds • Issued by risky companies and pay high interest rates

  32. Bond Ratings—Assessing Default Risk • Bonds are assigned quality ratings reflecting their probability of default. • Higher ratings mean lower default probability • Bond rating agencies (such as Moody’s, S&P) evaluate bonds (and issuers), and assign a rating • Examine the financial and market conditions of the issuer

  33. Bond Ratings—Assessing Default Risk • Why Ratings Are Important • Ratings are the primary measure of the default risk associated with bonds • The rating determines the rate at which the firm can borrow • A lower quality rating implies a higher borrowing rate • A differential exists between the rates required on high and low quality issues.

  34. Moody’s and S&P Bond RatingsTable 7.2

  35. Bond Indentures—Controlling Default Risk • Bond indentures attempt to prevent firms from becoming riskier after bonds are purchased by including restrictive covenants: • Preclude entering high risk businesses • Limit further borrowing • Require certain financial ratios • Safety is also provided by sinking funds • Provide money for repayment of bond principal

  36. The Advantages of LeasingAppendix 7-A • No money down • Lenders generally require a down payment • lessors usually do not • Restrictions • Lenders require covenants/indentures, lessors have few, if any, restrictions • Easier credit with manufacturers/lessors • Equipment manufacturers may lease their own products and will sometimes lease to marginally creditworthy customers

  37. The Advantages of LeasingAppendix 7-A • Avoiding the risk obsolescence • Short leases transfer this risk to lessors • Tax deducting the cost of land • If real estate is leased - the lease payment can be deducted as an expense • If land is owned - it is not depreciable • Increasing liquidity—the sale and leaseback • A firm may sell an asset to a financial institution and lease back the same asset — frees up cash • Tax advantages for marginally profitable companies

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