1. Slides developed by: Pamela L. Hall, Western Washington University The Valuation and Characteristics of Bonds Chapter 6

2. 2 The Basis of Value Securities are worth the present value of the future cash income associated with owning them The security should sell in financial markets for a price very close to that value However, I might think Security A has a different intrinsic value then someone else thinks, because we have different estimates for the Discount rate Expected future cash flows

3. 3 The Basis for Value 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 an ownership in a business A return is what the investor receives divided by what s/he invests Debt investors receive interest

4. 4 The Basis for Value Rate of return is the interest rate that equates the present value of its expected future cash flows with its current price PV = FV  (1 + k) Return is also known as Yield Interest return

5. 5 Bond Valuation A bond issue represents borrowing from many lenders at one time under a single agreement While one person may not be willing to lend a single company $10 million, 10,000 investors may be willing to lend the firm $1,000 each

6. 6 Bond Terminology and Practice A bond’s term (or maturity) is the time from the present until the principal is to be returned Bond’s mature on the last day of their term A bond’s face value (or par) represents the amount the firm intends to borrow (the principal) at the coupon rate of interest Bonds typically pay interest (coupon rate) every six months Bonds are non-amortized (meaning the principal is repaid at once when the bond matures rather than being repaid in increments throughout the bond’s life)

7. 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.

8. 8 Bond Valuation—Basic Ideas Adjusting to interest rate changes Bonds are sold in both primary (original sale) and secondary markets (subsequent trading among investors) Interest rates change all the time Most bonds pay a fixed interest rate What happens to the price of a bond paying a fixed interest rate in the secondary market when interest rates change?

9. 9 Bond Valuation—Basic Ideas You buy a 20 year, $1000 par bond today for par (meaning you pay $1,000 for it) when the coupon rate is 10% This implies that your required rate of return was 10% For that purchase price, you are promised 20 years of coupon payments of $100 each, and a principal repayment of $1,000 in 20 years After you’ve held the bond investment for a week, you decide that you need the money (cash) more than you need the investment You decide to sell the bond Unfortunately, interest rates have risen Other investors now have a required rate of return of 11% They can buy new bonds with an 11% coupon rate in the market for $1,000 Will they buy your bond from you for $1,000? NO! They’ll buy it for less than $1,000

10. 10 Determining the Price of a Bond Remember, Intrinsic Value is the present value of all future expected cash flows With a bond, predicting the future cash flows is somewhat ‘easy,’ because the promised cash flows are specified. Interest (usually) Principal (usually) Maturity (in years) In practice most bonds pay interest semi- annually.

11. 11 Determining the Price of a Bond 01510 $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:

12. 12 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

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

14. 14 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 appropriate 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

15. 15 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—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 will be either the interest rate or the present value When solving for the interest rate, the price of the bond must be inputted as a negative value while the PMT and FV must be inputted as a positive value Sophisticated calculators have a ‘bond’ mode allowing easy calculations dealing with accrued interest

16. 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. 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

18. 18 Maturity Risk Revisited Relates to term of the debt Longer term bonds fluctuate more in response to changes in interest rates than shorter term bonds AKA price risk and interest rate risk As time passes, if interest rates don’t change the price of a bond will approach its par

19. 19 Table 6.1

20. 20 Maturity Risk Revisited

21. 21 Finding the Yield at a Given Price We’ve been calculating the intrinsic value of a bond, but we could calculate the bond yield (based on its current value in the market) and compare that yield to our required rate of return Involves solving for k, which is more complicated because it involves both an annuity and a FV Use trial and error to solve for k, or use a financial calculator.

22. 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%.

23. 23 Call Provisions If interest rates have dropped substantially since a bond was originally issued, a firm may wish to ‘refinance,’ or retire their old high interest bond issue However, the issuing corporation would have to get all the bondholders to agree to this From the bondholder’s viewpoint, this could be a bad idea—they would be giving up high coupon bonds and would have to reinvest their cash in a market with lower interest rates To ensure that the corporation can refinance their bonds should they wish to do so, the corporation makes the bonds ‘callable’

24. 24 Call Provisions Call provisions allow bond issuers to retire bonds before maturity by paying a premium (penalty) to bondholders Many corporations offer a deferred call period (meaning the bond won’t be called for at least x years after the initial issuing date) Known as the call-protected period

25. 25 Call Provisions The Effect of A Call Provision on Price When valuing a bond that is probably going to be called when the call-protected period is over Cannot use the traditional bond valuation procedure Cash flows will not be received through maturity because bond will probably be called

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

27. 27 Call Provisions Valuing the Sure-To-Be-Called Bond Requires that two changes be made to bond valuation formula N now represents the number of periods until the bond is likely to be called. The future value becomes the call price (face value plus call premium).

28. 28 The Refunding Decision When current interest rates fall below the coupon rate on a bond, company has to decide whether or not to call in the issue Compare interest savings of issuing a new bond to the cost of making the call Calling in the bond requires the payment of a call premium Issuing a new bond to raise cash to pay off the old bond requires payment of administrative expenses and flotation costs

29. 29 Dangerous Bonds with Surprising Calls Some bonds have contingency call features buried in the fine print For instance, some issuers would like to retire a portion of their bond issue periodically Versus paying a huge principal repayment on the entire issue at maturity This feature does not require a call provision Rather, those bondholders who must retire their bond are determined by lottery

30. 30 Risky Issues Sometimes bonds sell for a price far below what valuation techniques suggest Investors are worried that company may not be able to pay promised cash flows Valuation model should determine a price similar to the market price if the correct discount rate is used Riskier loans should be discounted at a higher interest rate leading to a lower calculated price

31. 31 Convertible Bonds Unsecured bonds that are exchangeable for a fixed number of shares of the company’s stock at the bondholder's discretion Allows bondholders to participate in a stock’s price appreciation should the firm be successful Conversion ratio represents the number of shares of stock that will be received for each bond Conversion price is the implied stock price if bond is converted into a certain number of shares Usually set 15-30% higher than the stock’s market value at the time the bond is issued Can usually be issued at lower coupon rates

32. 32 Convertible Bonds The effect of conversion on financial statements and cash flow Upon conversion an accounting entry removes the convertible bonds from long-term debt and places it into the equity accounts There is no immediate cash flow impact, but ongoing cash flow implications exist Interest payments will stop If the firm’s stock pays a dividend the newly created shares are entitled to those dividends Improves debt management ratios

33. 33 Advantages of Convertible Bonds To issuing companies Convertible features are sweeteners that let the firm pay a lower interest rate (coupon) Can be viewed as a way to sell equity at a price above market Convertible bonds 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

34. 34 Forced Conversion A firm may want its bonds to be converted because Eliminates interest payments on bond Strengthens balance sheet 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 Rational investors will convert if the conversion value is greater than the call value

35. 35 Valuation (Pricing) Convertibles A convertible’s price can depend on Its value as a traditional bond or The market value of the stock into which it can be converted At any stock price the convertible is worth at least the larger of its value as a bond or as stock The market value will be greater due to the possibility that the stock’s price will rise

36. 36 Figure 6.7: Value of a Convertible Bond

37. 37 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 convertible bonds have the potential to dilute EPS Therefore convertible bonds will impact the calculation of Diluted EPS according to FASB 128

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

39. 39 Effect on Earnings Per Share— Diluted EPS—Example Example 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.

40. 40 Effect on Earnings Per Share— Diluted EPS—Example Adjust the net income figure in the numerator by the amount of interest saved: The 2,000 bonds pay 8% interest on a $1,000 par; therefore the first will save $160,000 in interest, or.08 x $1,000 x 2,000. However, the interest expense was tax deductible, so the firm’s taxable income will now rise by $160,000, resulting in an increase in taxes of $64,000, or $160,000 x 40%. Thus the firm’s Net Income will rise by $96,000 resulting in a new Net Income of $3,096,000. The firm’s Diluted EPS will be: $3,096,000 ÷ 1,080,000 = $2.87. Example

41. 41 Institutional Characteristics of Bonds Registration, Transfer Agents, and Owners of Record A record of registered securities is kept by a transfer agent Payments are sent to owners of record as the dates as of the dates the payments are made Bearer bonds vs. 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

42. 42 Kinds of Bonds Secured bonds and mortgage bonds Backed by collateral Debentures Unsecured bonds Subordinated debentures Lower in priority than senior debt Junk bonds Issued by risky companies and pay high interest rates

43. 43 Bond Ratings—Assessing Default Risk Bond rating agencies (such as Moody’s, S&P) evaluate bonds (and issuing firms) and assign a rating to each bond issued by a corporation These ratings gauge the probability that issuers will fail to meet their obligations

44. 44 Bond Ratings—Assessing Default Risk Why Ratings Are Important Ratings are the primary measure of the default risk associated with bonds Thus, ratings play a big part in the interest rate that investors demand The rating a firm’s bonds receive basically determines the rate at which the firm can borrow A lower quality rating implies a higher borrowing rate

45. 45 Bond Ratings—Assessing Default Risk The differential between the yields on high and low quality bonds is an indicators of the health of the economy The Differential Over Time The quality differential tends to be larger when interest rates are generally high May indicate a recession and marginal firms are more likely to fail, making them riskier The Significance of the Investment Grade Rating Many institutional investors are prohibited from trading below-investment-grade bonds

46. 46 Table 6.2

47. 47 Bond Indentures—Controlling Default Risk As a bondholder, you would like to ensure that you will receive your promised interest and principal payments Bond indentures attempt to prevent firms from becoming riskier after the bonds are purchased, and includes such protective covenants as: Limits to management’s salary Limits to dividends Maintenance of certain financial ratios Restrictions on additional debt issues Sinking funds provide money for the repayment of bond principal

48. 48 Appendix 6-A: Lease Financing A lease is a contract giving one party (lessee) the right to use an asset owned by another (lessor) for a periodic payment Individuals may lease houses, apartments and automobiles Corporations may lease equipment and real estate Approximately 30% of all equipment today is leased

49. 49 Appendix 6-A: Leasing and Financial Statements Originally leasing allowed the lessee to use the asset without ownership Lease payments were recognized as expenses on the income statement Had no impact on balance sheet Led to large use of lease financing Became the leading form of off balance sheet financing

50. 50 Appendix 6-A: Misleading Results Off balance sheet financing makes financial statements misleading Missed lease payments can cause the firm to fail just like a missed interest payment on debt Thus long-term leases are effectively the same as debt Not having leases appear on the balance sheet can mislead investors to think a firm is stronger than it is

51. 51 Appendix 6-A: Misleading Results By the early 1970s concerns led to FASB 13 Prior to FASB 13 an asset was owned by whoever held its title regardless of who used the asset FASB 13 stated that the real owner of an asset is whoever enjoys its benefits and deals with the risks and responsibilities

52. 52 Appendix 6-A: Operating and Capital (Financing) Leases Under FASB 13 lessees must capitalize financing leases Puts the value of leased assets and liabilities on the balance sheet Makes the balance sheet similar to what it would have been had the asset been purchased with borrowed money Operating leases can still be listed off the balance sheet

53. 53 Appendix 6-A: Operating and Capital (Financing) Leases Rules that must be met for a lease to be classified as an operating lease Lease must not transfer legal ownership to the lessee at its end Must not be a bargain purchase option at the end of the lease Lease term must be < 75% of the asset’s estimated economic life Present value of the lease payments must be < 90% of the asset’s fair market value at the beginning of the lease

54. 54 Appendix 6-A: Financial Statement Presentation of Leases by Lessees Operating leases No balance sheet entries Lease payments are treated as an expense Details must be listed in footnotes Financing leases Lessee must record an asset on balance sheet Lessee must record an offsetting liability Both of the above amounts are usually the present value of the stream of committed lease payments The interest rate is generally the rate the lessee would pay if it were borrowing money at the time the lease begins The asset is depreciated while the Lease Obligation is treated like a loan

55. 55 Appendix 6-A: Leasing from the Perspective of the Lessor Lessors are usually banks, finance companies and insurance companies Companies buy the equipment and lease it to customer Lease payments are calculated to offer the lessor a given return The interest rate is called the lessor’s return or the rate implicit in the lease Lessor holds legal title—can repossess assets if lessee defaults Lessors get better treatment in bankruptcy proceedings than lenders

56. 56 Appendix 6-A: Residual Values Residual value—the value of an asset at the end of the lease term Lessee may buy the equipment Lessor may sell it to someone else Asset may be re-leased (usually only with operating leases) Makes lease pricing and return calculations more complex Often are important negotiating points between lessee and lessor

57. 57 Appendix 6-A: Lease Vs. Buy—The Lessee’s Perspective Broad financing possibilities Equity Debt—available through bonds or banks Leasing—available through leasing companies Should conduct a lease vs. buy comparison Choose the lowest cost in a present value sense

58. 58 Appendix 6-A: The Advantages of Leasing No money down Lenders typically require some downpayment; whereas lessors usually do not Restrictions Lenders usually require covenants/indentures, whereas lessors have few, if any, restrictions Easier credit with manufacturers/lessors Equipment manufacturers sometimes lease their own products and will lease to marginally creditworthy customers

59. 59 Appendix 6-A: The Advantages of Leasing 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, whereas if the land is owned it is not depreciable Increasing liquidity—the sale and leaseback A firm may sale an asset (to generate cash) and lease the same asset back—used to free up cash invested in real estate Tax advantages for marginally profitable companies

60. 60 Appendix 6-A: Leveraged Leases The ability to depreciate an asset reduces taxes If a company is not making a profit (and not paying taxes) then depreciation is not saving the firm any money A lessor buys equipment but finances a portion of the price of the equipment (hence, the term leveraged) and is allowed to depreciate the leased assets and gain the tax benefits The lessor passes along some of the benefits to the lessee in the form of lower lease payments