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Chapter 7

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Characteristics of Bonds Bonds pay fixed coupon (interest) payments at fixed intervals (usually every 6 months) and pay the par value at maturity.

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example: AT&T 8 24 n par value = $1000 n coupon = 8% of par value per year. = $80 per year ($40 every 6 months). = $80 per year ($40 every 6 months). n maturity = 24 years (matures in 2024). n issued by AT&T.

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Types of Bonds n Debentures - unsecured bonds. n Subordinated debentures - unsecured “junior” debt. n Mortgage bonds - secured bonds. n Zeros - bonds that pay only par value at maturity; no coupons. (example: Series EE government savings bonds.)

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The Bond Indenture n The bond contract between the firm and the trustee representing the bondholders. n Lists all of the bond’s features: coupon, par value, maturity, etc. coupon, par value, maturity, etc. n Lists restrictive provisions which are designed to protect bondholders. n Describes repayment provisions.

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Value n Book Value: value of an asset as shown on a firm’s balance sheet; historical cost. n Liquidation value: amount that could be received if an asset were sold individually. n Market value: observed value of an asset in the marketplace; determined by supply and demand. n Intrinsic value: economic or fair value of an asset; the present value of the asset’s expected future cash flows.

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Security Valuation n In general, the intrinsic value of an asset = the present value of the stream of expected cash flows discounted at an appropriate required rate of return. n Can the intrinsic value of an asset differ from its market value? (YES!)

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Bond Valuation n Discount the bond’s cash flows at the investor’s required rate of return. u the coupon payment stream (an annuity). u the par value payment (a single sum).

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Bond Example n Suppose our firm decides to issue 20-year bonds with a par value of $1,000 and annual coupon payments. The return on other corporate bonds of similar risk is currently 12%, so we decide to offer a 12% coupon interest rate. n What would be a fair price for these bonds?

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0 1 2 3...20 0 1 2 3...201000 120 120 120... 120 120 120 120... 120 N = 20 I%YR = 12 FV = 1,000 PMT = 120 Solve PV = -$1,000 Note: If the coupon rate = discount rate, the bond will sell for par value.

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n Suppose interest rates fall immediately after we issue the bonds. The required return on bonds of similar risk drops to 10%. n What would happen to the bond’s intrinsic value?

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N = 20 I%YR = 10 PMT = 120 FV = 1000 Solve PV = -$1,170.27 Note: If the coupon rate > discount rate, the bond will sell for a premium. the bond will sell for a premium.

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n Suppose interest rates rise immediately after we issue the bonds. The required return on bonds of similar risk rises to 14%. n What would happen to the bond’s intrinsic value?

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N = 20 I%YR = 14 PMT = 120 FV = 1000 Solve PV = -$867.54 Note: If the coupon rate < discount rate, the bond will sell for a discount.

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Yield To Maturity n The expected rate of return on a bond. n The rate of return investors earn on a bond if they hold it to maturity.

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YTM Example n Suppose we paid $898.90 for a $1,000 par 10% coupon bond with 8 years to maturity and semi-annual coupon payments. n What is our yield to maturity?

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N = 16 PV = -898.90 PMT = 50 FV = 1000 Solve I%YR = 6% 6%*2 = 12% YTM Example

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Current Yield n Current yield:the ratio of the interest payment to the bond’s current market price. u Calculated by dividing the annual interest payment by the market price of the bond u A $1,000 bond with 10% coupon rate and market price of $700 Current yield = $100 / $700 = 14.286 %

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