Presentation on theme: "Chapter 7 - The Valuation and Characteristics of Bonds"— Presentation transcript:
1Chapter 7 - The Valuation and Characteristics of Bonds
2ValuationA systematic process through which the price at which a security should sell is established - Intrinsic valueTHE BASIS OF VALUEReal assets (houses, cars) have value due to services they provideFinancial assets (paper) represent rights to future cash flowsValue today is PVDifferent opinions about securities’ values come from different assumptions about cash flows and interest ratesStocks are hardest to value because future dividends and prices are never guaranteed.
3The Basis of ValueAny security’s value is the present value of the cash flows expected from owning it.A security should sell for close to that value in financial markets
4The Basis of Value Investing Using a resource to benefit the future rather than for current satisfactionPutting money to work to earn more moneyCommon types of investmentsDebtEquityReturnWhat the investor receives for making an investment1 year investments return = $ received / $ investedDebt investors receive interest. Equity investors get dividends + price change
5DefinitionThe rate of return on an investment is the interest rate that equates the present value of its expected cash flows with its current priceReturn is also known asYield, orInterest
6Return On One Year Investment Return is what the investor receivesCan be expressed as a dollar amount or as a rateRate of return is what the investor receives divided by what was investedFor debt investments: the interest rateIn terms of the time value of money:Invest PV at rate k and receive future cash flows ofprincipal = PV, andinterest = kPVat the end of a year, soFV1 = PV + kPVFV1 = PV(1+k)
7The Basis for ValueDiscount RateThe term discounted rate is often used for interest rate
9BondsBonds represent a debt relationship in which an issuing company borrows and buyers lend.A bond issue represents borrowing from many lenders at one time under a single agreement
10Bond Terminology and Practice A bond’s term (or maturity) is the time from the present until the principal is returnedA bond’s face (or par) value represents the amount the firm intends to borrow (the principal) at the coupon rate of interest
11Coupon Rates Coupon Rate – the fixed rate of interest paid by a bond In the past, bonds had “coupons” attached, today they are “registered”Most bonds pay coupon interest semiannual
12Bond Valuation—Basic Ideas Adjusting to Interest Rate ChangesBonds 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.How does a bond paying a fixed interest rate remain salable (secondary market) when interest rates change?
13Bond Valuation—Basic Ideas Bonds adjust to changing yields by changing their pricesSelling at a Premium – bond price above face valueSelling at a Discount – bond price below face valueBond prices and interest rates move in opposite directions
14Determining the Price of a Bond The value (price) of a security is equal to the present value of the cash flows expected from owning it.In bonds, the expected cash flows are predictable.Interest payments are fixed, occurring at regular intervals.Principal is returned along with the last interest payment.
15Determining the Price of a Bond Figure 7-1 Cash Flow Time Line for a Bond This bond has 10 years until maturity, a par value of $1,000, and a coupon rate of 10%.?
16Determining the Price of a Bond The Bond Valuation FormulaThe price of a bond is the present value of a stream of interest payments plus the present value of the principal repayment
17Determining the Price of a Bond Two Interest Rates and One MoreCoupon Ratek - the current market yield on comparable bonds“Current yield” - annual interest payment divided by bond’s current priceNot used in valuationInfo for investors
18Figure 7-2 Bond Cash Flow and Valuation Concepts
19Concept Connection Example 7-1 Finding the Price of a Bond Emory issued a $1,000, 8%, 25-year bond 15 years ago.Comparable bonds are yielding 10% today.What price will yield 10% to buyers today?What is the bond’s current yield?Assume the bond pays interest semiannually.
20Concept Connection Example 7-1 Finding the Price of a Bond Must solve for present value of bond’s expected cash flows at today’s interest rate. Use Equation 7.4 :k represents the periodic current market interest rate, or10% 2 = 5%.The payment is 8% x $1,000, or $80 annually. However, it is received in the form of $40 every six months.n represents the number of interest-paying periods until maturity, or10 years x 2 = 20.The future value is the principal repayment of $1,000.
21Concept Connection Example 7-1 Finding the Price of a Bond Substituting :This is the price atwhich the bond must sellto yield 10%. It isselling at a discount becausethe current interest rateis above the coupon rate.The bond’s current yield is$80 $875.39, or 9.14%.
22Maturity Risk Revisited Related to the term of the debtLonger term bond prices fluctuate more in response to changes in interest rates than shorter term bondsAKA price risk and interest rate risk
23Table 7-1 Price Changes at Different Terms Due to an Interest Rate Increase from 8% to 10%
24Figure 7.3 Price Progression with Constant Interest Rate
25Finding the Yield at a Given Price Calculate a bond’s yield assuming it is selling at a given priceTrial and error – guess a yield – calculate price – compare to price givenInvolves solving for k, which is more complicated because it involves both an annuity and a FVUse trial and error to solve for k, or use a financial calculator.
26Concept Connection Example 7-3 Finding the Yield at a Price Benson issued a $1,000, 8%, 30-year bond 14 years ago.Bond is now selling for $718.What is yield to an investor buying it today?Semiannual interest.
27Concept Connection Example 7-3 Finding the Yield at a Price As interest rates rise, bond prices fall, so yield must be above 8%.Guess 10% and apply Equation 7.4Next guess must be lower to drive price further down.Answer is just below 12%
28Call ProvisionsIf interest rates fall, a firm may wish to retire old, high interest bonds by “refinancing” with new, lower interest debtTo ensure ability to refinance, issuers make bonds ‘callable’Investors don’t like calls – lose high interestIssuers and investors compromiseCall provisions usually haveA call premiumExtra money paid if calledPeriod of call protectionGuaranteed not to call for a number of years.
30Valuing the Sure-To-Be-Called Bond Call ProvisionsValuing the Sure-To-Be-Called BondRequires that two changes be made to bond valuation formulan 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).
31Call Provisions The new formula becomes PB = PMT[PVFAk,m] + CP[PVFk,m] Wherem = time to callCP = call price = FV + Call Premium
32Concept Connection Example 7-4 Basics: Pricing a “Likely to Be Called” Bond Northern issued a $1,000, 25-year bond 5 years ago.Call provision: Can call after 10 years with the payment of one additional year’s interest at coupon rate.Coupon rate is 18%. Market rate is now 8%.What is the bond worth today?Interest payments are semiannual.
33Concept Connection Example 7-4 Basics: Pricing a “Likely to Be Called” Bond The bond must yield the current rate of interest in either case.
34Concept Connection Example 7-4 Basics: Pricing a “Likely to Be Called” Bond m = number of periods to callCP = call price = face value + call premiumPMT = (.18 x $1,000) / 2 = $90m = 5 x 2 = 10k = 8% /2 = 4%CP = $1, ($1,000) = $1,180PB (call) = $90 [PVFA4,10] + $1,180 [PVF4,10]= $90[8.1109] + $1,000[.6756]= $ $797.21= $1,527.19
35The Refunding Decision When current interest rates fall below the bond’s coupon rate, a firm must decide whether to call in the issueCompare interest savings to cost of making call:Call premiumFlotation costs –Broker fees, printing costs, etc.
36Dangerous 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 yearGenerally no call premiumProvision is for the benefit of the bondholder
37Risky IssuesSometimes bonds sell for a price far below what valuation techniques suggestIssuing company may be in financial troubleBuying the bond is very riskyIn theory riskier loans should be discounted at higher rates leading to lower calculated prices
38Convertible BondsUnsecured bonds exchangeable for a fixed number of shares of stock at the bondholder's discretionConversion ratio - the number of shares of stock received for each bondConversion price - the implied stock price if bond is converted into a certain number of sharesConvertibles usually pay lower coupon rates
39Concept Connection Example 7-5 Basics: Investing in Convertible Bonds Harry Jenson purchased one of Algo Corp.’s 9%, 25-year convertible bonds at its $1,000 par value a year ago when the company’s common stock was selling for $20. Similar bonds without a conversion feature returned 12% at the time. The bond is convertible into stock at a price of $25. The stock is now selling for $29. Algo pays no dividends.Notice that this bond’s coupon rate was set below the market rate for nonconvertible issues.
40Concept Connection Example 7-5 Basics: Investing in Convertible Bonds a. Harry exercised the conversion feature today and immediately sold the stock he received. Calculate the total return on his investment.b. What would Harry’s return have been if he had invested $1,000 in Algo’s stock instead of the bond?
41Concept Connection Example 7-5 Basics: Investing in Convertible Bonds The proceeds from selling those shares at the current market price wereIn addition the bond paid interest during the year ofSo the total receipts from the bond investment were
42Concept Connection Example 7-5 Basics: Investing in Convertible Bonds
43Concept Connection Example 7-5 Basics: Investing in Convertible Bonds
44Concept Connection Example 7-5 Basics: Investing in Convertible Bonds Notice that the convertible enabled Harry to participate in some but not all of the rapid price appreciation of Algo’s stock.Also notice that had the stock price fallen, an investment in it would have had a negative return, but the convertible would have returned the 9% coupon rate.
45Convertible BondsEffect of Conversion on Financial Statements and Cash FlowAn accounting entry removes the value of convertible bonds from long-term debt placing it into equity as if new shares were soldNo immediate cash flow impact, but ongoing cash flow implications existInterest payments stopBut dividend payments may start
46Advantages of Convertible Bonds To Issuing CompaniesConvertible features are “sweeteners” enabling a risky firm to pay a lower interest rateViewed as a way to sell equity at a price above marketUsually have few or no restrictionsTo BuyersOffer the chance to participate in stock price appreciationOffer a way to limit risk associated with a stock investment
47Forced Conversion A firm may want bonds converted As stock price rises convertible represents a lost opportunity to sell new equity at a higher priceConvertible bonds are always issued with call features which can be used to force conversionIssuers generally call convertibles when stock prices rise to 10-15% above conversion prices
48Valuing (Pricing) Convertibles A convertible’s price can depend on eitherits value as a traditional bond orthe market value of the stock into which it can be convertedA convertible is always worth at least the larger of its value as a bond or as stock
50Effect on Earnings Per Share—Diluted EPS Upon conversion convertible bonds cause dilution in EPSEPS drops due to the increase in the number of shares of stock outstandingThus outstanding convertibles represent a potential to dilution of EPS
51Concept Connection Example 7-7 - Dilution Montgomery Inc. Issued two thousand $1,000, 8% coupon convertible bonds three years ago. Each bond is convertible into stock at $25 per share. All of the Bonds remain outstanding, i.e., none have converted.Last year net income was $3 million. One million shares stock were outstanding for the entire year, and the firm’s marginal tax rate was 40%.Calculate Montgomery’s basic and diluted EPS for the year.Solution:Basic EPSnet income ÷ number of shares$3,000,000 ÷ 1,000,000 = $3.00.
52Concept Connection Example 7-7 Dilution Diluted EPSAssumes all bonds are converted at beginning of year. 1. Add the number of newly converted shares to denominator.2. Adjust net income for after tax effect of interest saved.1. Shares exchanged:Par ÷ Conversion price = $1,000 ÷ $25 = 40 shares/bond40 shares/bond × 2,000 bonds = 80,000 sharesNew shares outstanding = 1,000, ,000 = 1,080,0002. Adjust the net income by interest saved:Interest paid on bonds: .08 x $1,000 x 2,000 = $160,000After tax: $160,000 × (1-.4) = $96,000New net income = $3,000,000 + $96,000 = $3,096,000Diluted EPS: $3,096,000 ÷ 1,080,000 = $2.87
53Institutional Characteristics of Bonds Kinds of Bonds Bonds are either bearer or registeredRegistered, Owners of Record, Transfer AgentsOwners of registered bonds are recorded with a transfer agent.
54Kinds of Bonds Secured bonds and mortgage bonds Debentures Backed by specific assets - collateralDebenturesUnsecured bonds - riskierSubordinated debenturesLower in payment priority than senior debtJunk bondsRisky companies - high interest rates
55Bond Ratings—Assessing Default Risk Bonds are assigned quality ratings reflecting their probability of default.Higher ratings mean lower default probabilityHigher rated bonds pay lower interest ratesBond rating agencies (Moody’s, S&P) evaluate bonds (and issuers), and assign a ratings
57Figure 7-7 Yield Differentials between High- and Low-Quality Bonds
58Controlling Default Risk Bond Indentures Bond indentures attempt to prevent borrowing firms from becoming riskier after bonds issuedrestrictive covenants – limit activities and payoutsSafety also provided by sinking fundsProvide money for repayment of bond principal
59Appendix 7-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 paymentIndividuals usually lease houses, apartments, and automobilesCompanies lease equipment and real estate
60Leasing and Financial Statements Originally leasing allowed use without ownershipLease payments recognized as income statement expenses, butNo impact on balance sheetsNo recognition of ownership or obligation to payImproved appearance of financial ratiosNot realLed to widespread use of lease financingThe leading form of “off balance sheet financing”
61Misleading ResultsOff balance sheet financing makes financial statements misleadingMissed lease payments can cause failure just like a missed interest payment on debtNot showing leases on the balance sheet can mislead investors into thinking a firm is stronger than it is
62FASB 13 Redefines Ownership 1970s: Concerns about leasing led to FASB 13Prior to FASB 13 an asset was owned for financial statement purposes by whoever held titleRegardless of who used itFASB 13 redefined ownership for financial reporting purposes in economic termsFASB 13 stated that the real owner of an asset is whoever enjoys its benefits and bears its risks and responsibilities
63Operating and Capital (Financing) Leases Under FASB 13 lessees must capitalize financing leasesPuts the value of leased assets and the liability for payments on the balance sheetLong term leases for high value assetsOperating leases can still be listed off the balance sheetShort term leases for lower value itemsRules must be met for a lease to be classified as an operating lease
64Financial Statement Presentation of Leases by Lessees Operating leasesRecognize rent expenseNo balance sheet entriesFinancing (Capital) leasesRecognize asset and lease obligation on balance sheetRecognize depreciation expense for assetAmortize lease obligation like a loan
65Leasing from the Perspective of the Lessor Lessors are usually financial institutions - banks, finance or insurance companiesLease payments are calculated to offer the lessor a given returnLessor holds legal title—can repossess assets if lessee defaultsLessors get better treatment in bankruptcy proceedings than lenders
66Residual ValuesResidual value—the value of asset at the end of the leaseMakes lease pricing and return calculations more complexImportant negotiating points between lessee and lessor
67Lease Vs. Buy The Lessee’s Perspective Broad financing possibilitiesEquityDebt—available through bonds or banksLeasing—available through leasing companiesConduct a lease vs. buy comparisonChoose the lowest cost option in a present value senseLeasing is almost always more expensive
68The Advantages of Leasing Lessors usually require no down payment, lenders want significant money downLessor’s restrictions less stringent than lenders’Easier credit with manufacturers/lessors
69The Advantages of Leasing Short leases transfer the risk of obsolescence to lessorsTax deducting the cost of landIncreasing liquidity—the sale and leasebackTax advantages for marginally profitable companies
70Leveraged Leases The ability to depreciate assets reduces taxes Government shares the cost of ownershipUnprofitable firms lose this benefit as they pay no taxBut can get some benefits with a Leveraged LeaseIn a leveraged lease, a profitable lessor buys equipment financing a portion with borrowed money (hence a leveraged lease)Leveraged Lessor receives the tax benefits of ownershipLessor shares those tax benefits with the lessee through lower lease paymentsLessee’s savings can be very substantial