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CHAPTER TWENTY-ONE

CHAPTER TWENTY-ONE. BOND ANALYSIS. CAPITALIZATION OF INCOME METHOD. PROMISED YIELD-TO-MATURITY In equation form where P=the current market price of bond n=the number of years to maturity C t =the annual coupon payment y=the prevailing yield to maturity.

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CHAPTER TWENTY-ONE

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  1. CHAPTER TWENTY-ONE BOND ANALYSIS

  2. CAPITALIZATION OF INCOME METHOD • PROMISED YIELD-TO-MATURITY • In equation form where P=the current market price of bond n=the number of years to maturity Ct=the annual coupon payment y=the prevailing yield to maturity

  3. CAPITALIZATION OF INCOME METHOD • INTRINSIC VALUE • In equation form

  4. CAPITALIZATION OF INCOME METHOD • SOLVING FOR V, • Given the current market price (P), the investment decision is • if V is the intrinsic value and V>P buy the bond V<P don’t buy

  5. CAPITALIZATION OF INCOME METHOD • ALTERNATIVELY • SOLVING FOR y* y*>y bond overprice y*<y bond underpriced

  6. BOND ATTRIBUTES • SIX ATTRIBUTES that affect a bond’s value • LENGTH OF TIME TO MATURITY • COUPON RATE • CALL PROVISIONS • TAX STATUS • MARKETABILITY • LIKELIHOOD OF DEFAULT

  7. LENGTH OF TIME TO MATURITY • COUPON RATE AND LENGTH TO MATURITY • these attributes determine size and timing of cash flow • yield-to-maturity

  8. TAX STRUCTURE • TAX STRUCTURE • Taxation affects bond prices and yields • low-coupon bonds selling at a discount provide return in • coupon payments • gains from price appreciations • taxes on appreciations may be deferred until bond sale or maturity • discount bonds have a tax advantage

  9. TAX STRUCTURE • TAX STRUCTURE • Taxation affects bond prices and yields • because of tax effect, discount bonds should have a slightly lower before-tax yield • low-coupon bonds will have a slightly higher intrinsic value

  10. MARKETABILITY • MARKETABILITY • refers to the ability of the investor to resell

  11. MARKETABILITY • MARKETABILITY • bid-ask spread is one indicator of marketability • the higher the spread, the less marketable • the lower the spread, the more marketable • bonds that are actively traded should have a lower YTM and a higher V

  12. MARKETABILITY • MARKETABILITY • bonds that are actively traded should have a lower YTM and a higher V

  13. LIKELIHOOD OF DEFAULT • LIKELILHOOD OF DEFAULT • Bond ratings provided by professional services.

  14. LIKELIHOOD OF DEFAULT • LIKELILHOOD OF DEFAULT • Two most famous include • Moody’s Investors Services, Inc. • Standard & Poor’s Corporate ratings

  15. LIKELIHOOD OF DEFAULT • LIKELIHOOD OF DEFAULT • Categories • investment grade usually the bonds in the top four ratings • speculative • often called junk bonds

  16. LIKELIHOOD OF DEFAULT • LIKELIHOOD OF DEFAULT • Bond ratings provided by professional services. • better ratings are generally associated with • larger financial leverage • larger firm size • larger and steadier profits • large cash flows • lack of subordination to other debt series

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