9 9 Chapter The Valuation and Characteristics of Bonds Slides Developed by: Terry Fegarty Seneca College.

9 9 Chapter The Valuation and Characteristics of Bonds Slides Developed by: Terry Fegarty Seneca College

© 2006 by Nelson, a division of Thomson Canada Limited 2 Chapter 9: Outline (1) The Basis of Value Bond Valuation  Terminology and Practice  Finding the Yield  Determining the Price of a Bond  Solving Bond Problems with a Financial Calculator  Maturity Risk  Finding the Yield at a Given Price  Reading Bond Quotations

© 2006 by Nelson, a division of Thomson Canada Limited 3 Chapter 9: Outline (2)  Call Provisions  The Refunding Decision  Risky Issues  Institutional Characteristics of Bonds  Kinds of Bonds  Convertible Bonds  Bond Indentures—Controlling Default Risk  Bond Indentures

© 2006 by Nelson, a division of Thomson Canada Limited 4 Chapter 9: Outline (3) Appendix 9A: Leases  Lease Financing  Types of Leases  Leases and Accounting Practices  Leasing from the Perspective of the Lessor  Residual Values  Lease Versus Buy Analysis  Advantages of Leasing  Leveraged Leases  Disadvantages to Leasing

© 2006 by Nelson, a division of Thomson Canada Limited 5 The Basis for Security Values Securities are worth the present value of the future cash income from them (intrinsic value)  Should sell in financial markets for price 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

© 2006 by Nelson, a division of Thomson Canada Limited 6 The Basis for Security Values 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 — what investor receives divided by what he invests  Debt investors receive interest

© 2006 by Nelson, a division of Thomson Canada Limited 7 The Basis for Security Values Rate of return—interest rate that equates the present value of its expected future cash flows with its current price  PV of an amount to be received in 1 year:  Return is also known as Yield Interest return

© 2006 by Nelson, a division of Thomson Canada Limited 8 Value of a Security: Example Q.A financial asset is expected to generate a cash flow of $10,000 per year for five years. If the required return is 15%, what is the price of the asset now? Example

© 2006 by Nelson, a division of Thomson Canada Limited 10 Bond Terminology and Practice A bond issue represents borrowing from many lenders at one time under a single agreement Most bonds are purchased by institutional investors: banks, mutual funds, insurance companies, pension funds

© 2006 by Nelson, a division of Thomson Canada Limited 11 Bond Terminology and Practice A bond’s term (or maturity)—time from the present until principal is to be returned  Bonds mature on last day of their term A bond’s face value (or par)—amount the firm intends to borrow (the principal) at the coupon rate of interest  Denominations of $1,000  Bonds typically pay interest (coupon rate) every six months  Bonds are often non-amortized (meaning principal is repaid only when the bond matures rather than being repaid in installments)

© 2006 by Nelson, a division of Thomson Canada Limited 12 Bond Valuation—Basic Ideas Adjusting to interest rate changes  Bonds sold in both primary (original sale) and secondary markets (subsequent trading among investors)  Interest rates change all the time  Most bonds pay fixed interest rate What happens to the price of a bond paying a fixed interest rate in the secondary market when interest rates change?

© 2006 by Nelson, a division of Thomson Canada Limited 13 Bond Valuation—Basic Ideas Adjusting to interest rate changes  Bond prices respond to changes in market interest rates  Bond prices and interest rates move in opposite directions When interest rates decline, prices of bonds go up; when rates increase, prices go down Price changes keep yields (returns) on seasoned issues equal to yields on new issues of comparable risk and maturity

© 2006 by Nelson, a division of Thomson Canada Limited 14 Bond Valuation—Basic Ideas Bonds don’t generally sell for face values until close to maturity  Sell for more or less than face value ($1000), depending on where current interest rate is relative to their coupon rates  Bonds selling above face values—trading at a premium  Bonds selling below face value—trading at a discount

© 2006 by Nelson, a division of Thomson Canada Limited 15 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 Payment = $ value of the interest payment F = Face amount or principal repayment k = (Yield-to-maturity (Required rate of return) n = Maturity (years)

© 2006 by Nelson, a division of Thomson Canada Limited 18 Determining the Price of a Bond 01510 $100 a year for 10 years $100 $1,000 $1,100 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 In practice most bonds pay interest semiannually.

© 2006 by Nelson, a division of Thomson Canada Limited 19 Determining the Price of a Bond Interest Rates and Yields  Coupon rate Determines size of interest payments  k—yield to maturity (YTM) Long-term market yield on comparable bonds Discount rate that makes present value of payments equal to market price of bond  Current yield—annual interest payment divided by bond’s current price

© 2006 by Nelson, a division of Thomson Canada Limited 20 Solving Bond Problems with a Financial Calculator Financial calculators have five time value of money keys. For bond calculations:  N—number of periods until maturity  I/Y—yield-to-maturity (market interest rate)  PV—price of bond  FV—face value (par) of bond  PMT—coupon interest payment per period With calculators that have sign convention, price (PV) of bond is entered as negative value

© 2006 by Nelson, a division of Thomson Canada Limited 21 Determining the Price of a Bond— Example Q: The Emory Corporation issued an 8%, 25-year bond 15 years ago. The bond pays interest semiannually. 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? Calculate the bond’s current yield. Example

© 2006 by Nelson, a division of Thomson Canada Limited 22 Determining the Price of a Bond— Example 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 9.4 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.

© 2006 by Nelson, a division of Thomson Canada Limited 23 Determining the Price of a 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 I/Y PMT FV 20 5 40 1000 -875.39 PV Answer

© 2006 by Nelson, a division of Thomson Canada Limited 24 Maturity Risk Relates to term of 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, price of bond will approach par

© 2006 by Nelson, a division of Thomson Canada Limited 26 Finding the Yield at a Given Price To calculate bond yield based on current price, bond formula is; Calculating yield Involves solving for k, which is complicated because it involves both an annuity and a FV To solve for k, use trial and error, formula approach, a financial calculator, or spreadsheet.

© 2006 by Nelson, a division of Thomson Canada Limited 28 Example 9.2: Finding the Yield at a Given Price 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

© 2006 by Nelson, a division of Thomson Canada Limited 29 Example 9.2: Finding the Yield at a Given Price Example 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%. A: The bond is now selling below par. As interest rates rise, bond prices fall, so the yield must be above 8%. Using a guess of 10% and applying Equation 9.4 we obtain:

© 2006 by Nelson, a division of Thomson Canada Limited 32 Reading Bond Quotations Typical quote:  Issuer is Duke Energy  Bond has a coupon rate of 6.375% (6 3/8 %)  Bond matures in 2008  Current yield is 6.8%  $40,000 dollars traded yesterday  Closing price was $937.50 per $1,000 of face value  Closing price was down $2.50 from the previous day DukeEn 6 3 / 8 08 6.8 40 93¾ – 1 / 4

© 2006 by Nelson, a division of Thomson Canada Limited 33 Call Provisions If interest rates have dropped substantially since a bond was originally issued, firm may wish to ‘refinance,’ or retire old, high interest bonds To ensure that corporation can refinance their bonds if they wish, corporation can make the bonds callable

© 2006 by Nelson, a division of Thomson Canada Limited 34 Call Provisions Call provisions allow bond issuers to retire bonds before maturity by paying call premium (penalty) to bondholders Many corporations offer deferred call period (meaning the bond won’t be called for at least x years after issue)  Known as the call-protected period

© 2006 by Nelson, a division of Thomson Canada Limited 35 Call Provisions The Effect of A Call Provision on Price  When valuing bond that is probably going to be called when call-protected period is over Cannot use traditional bond valuation procedure Cash flows will not be received through maturity because bond will probably be called

© 2006 by Nelson, a division of Thomson Canada Limited 38 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).

© 2006 by Nelson, a division of Thomson Canada Limited 39 The Refunding Decision When current interest rates fall below the coupon rate on bond, company has to decide whether or not to call in the issue  Compare interest savings of issuing new bond to costs of calling in old bond Calling in old bond requires payment of call premium Issuing new bond to raise cash to pay off old bond requires payment of administrative expenses and flotation costs

© 2006 by Nelson, a division of Thomson Canada Limited 40 Call Provisions Some issuers retire a portion of bond issue periodically Versus repaying entire issue at maturity Often required by sinking funds  Does not require a call premium Rather, those bondholders who must retire their bond are determined by lottery

© 2006 by Nelson, a division of Thomson Canada Limited 41 Risky Issues Sometimes bonds sell for price far below intrinsic (calculated) values  Investors worried that company may not be able to pay promised cash flows Valuation model should determine price similar to the market price if the correct discount rate is used  Riskier bonds should be discounted at higher interest rate leading to a lower calculated price

© 2006 by Nelson, a division of Thomson Canada Limited 42 Institutional Characteristics of Bonds Bearer bonds vs. registered bonds  Bearer bonds—interest payment is made to bearer of the bond  Registered bonds—interest payment is made to holder of record Registration, Transfer Agents, and Owners of Record  Record of registered securities is kept by transfer agent  Payments are sent to owners of record as of the dates the payments are due

© 2006 by Nelson, a division of Thomson Canada Limited 43 Kinds of Bonds Secured bonds and mortgage bonds  Backed by collateral Debentures  Unsecured bonds  Pay higher interest Subordinated debentures  Lower in priority than senior debt Junk bonds  Issued by risky companies and pay high interest rates

© 2006 by Nelson, a division of Thomson Canada Limited 44 Convertible Bonds Bonds exchangeable for a specified number of shares at option of bondholder  Bondholders convert if price of shares rises enough Conversion ratio—number of shares that will be received for each bond Conversion price—implied share price if bond converted into certain number of shares  Usually set 15-30% higher than share’s price when bond issued Can usually be issued at lower coupon rates

© 2006 by Nelson, a division of Thomson Canada Limited 45 Bond Ratings—Assessing Default Risk Bond rating agencies evaluate bonds (and issuing firms)  Assign a rating to each bond issued Ratings assess probability that issuers will default: fail to meet obligations 2 Canadian rating agencies  Dominion Bond Rating Service  S&P Ratings Direct Canada

© 2006 by Nelson, a division of Thomson Canada Limited 47 Bond Ratings—Assessing Default Risk Why Ratings Are Important  Primary measure of the risk of default  Basically determine rate at which firms can borrow Lower quality rating implies higher borrowing rate  Many institutional investors are prohibited from buying below-investment-grade bonds

© 2006 by Nelson, a division of Thomson Canada Limited 48 Bond Ratings Interest rate spread between each bond rating is less during market expansions than during market contractions  In recession marginal firms are more likely to fail, making them riskier Yield Yield Spread

© 2006 by Nelson, a division of Thomson Canada Limited 49 Bond Indentures—Controlling Default Risk Bond indentures attempt to prevent firms from becoming riskier after bonds are issued  Include restrictive covenants such as: Avoiding high-risk businesses Maintenance of debt management ratios Restrictions on additional debt issues  Sinking funds require some repayment of bond principal before maturity

© 2006 by Nelson, a division of Thomson Canada Limited 50 Appendix 9-A: Lease Financing Lease—contract giving one party (lessee) the right to use an asset owned by another (lessor) for a periodic payment  Long-term leases are effectively the same as debt Missed lease payments can cause the firm to fail just like a missed interest payment on debt  Corporations may lease automobiles, equipment and real estate Approximately 30% of all equipment today is leased

© 2006 by Nelson, a division of Thomson Canada Limited 51 Types of Leases For accounting purposes there are 2 types:  Financing leases  Operating leases Canadian accounting standards for leases are contained in the CICA handbook (CICA 3065)

© 2006 by Nelson, a division of Thomson Canada Limited 52 Types of Leases Financing Lease  Sometimes called capital lease  Initial term usually equal to expected economic life of the asset  Not cancelable by lessee  Lessee responsible for maintenance, insurance and property taxes  Lessee effectively acquires ownership of the leased asset

© 2006 by Nelson, a division of Thomson Canada Limited 53 Types of Leases Operating Lease  Sometimes called service or maintenance lease  Term of lease is short (say 1-3 years) Less than economic life of the asset For example, lease for photocopier  Usually cancelable by lessee on short notice  Lessor maintains and services asset  Lessor pays property taxes and insurance

© 2006 by Nelson, a division of Thomson Canada Limited 54 Leases and Accounting Practices According to the CICA, lease is financing lease if:  1. Lease will transfer legal ownership to the lessee at its end, either automatically or after making payment of a bargain purchase option at end of the lease, or  2. Lease term is longer than 75% of asset’s estimated economic life, or  3. Present value of lease payments is more than 90% of asset’s fair market value at beginning of the lease

© 2006 by Nelson, a division of Thomson Canada Limited 55 Leases and Accounting Practices Financing Leases  Firms are normally required to capitalize financing leases on balance sheet Value of leased assets in assets Future lease payments in liabilities Makes balance sheet similar to what it would have been if asset purchased with borrowed money

© 2006 by Nelson, a division of Thomson Canada Limited 56 Leases and Accounting Practices Capitalized value of financing lease  Equals present value of lease payments Interest rate is generally rate the lessee would pay if it were borrowing money when lease begins Both asset and liability are amortized (independently) over lease

© 2006 by Nelson, a division of Thomson Canada Limited 57 Example 9A.1: Leases and Accounting Practices Example of Reporting for Financing Lease Emeral Inc. Balance Sheet ($000) Current assets$ 20Current liabilities$ 10 Leased crane 218Lease obligation 218 Capital assets 180Long-term debt 90 Total assets$418Equity 100 Total debt & equity$418 Example

© 2006 by Nelson, a division of Thomson Canada Limited 58 Leases and Accounting Practices Operating leases  No balance sheet entries  Lease payments are treated as expense  Details must be listed in footnotes

© 2006 by Nelson, a division of Thomson Canada Limited 59 Leasing from the Perspective of the Lessor Lessors are usually banks, finance companies and insurance companies  Companies buy equipment and lease it to customer Lease payments are calculated to provide given return to lessor  Interest rate—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

© 2006 by Nelson, a division of Thomson Canada Limited 60 Residual Values Residual value—value of asset at end of lease term  Lessee may exercise option to buy equipment  Lessor may sell to someone else  Asset may be re-leased (usually only with operating leases) Makes lease pricing and return calculations more complex Often is important negotiating point between lessee and lessor

© 2006 by Nelson, a division of Thomson Canada Limited 61 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 (present value)

© 2006 by Nelson, a division of Thomson Canada Limited 62 Lease Versus Buy Analysis Approach: Determine cash flows, after tax, if you buy the asset Determine cash flows, after tax, if you lease the asset Calculate present value of each  Discount rate is current rate on new long- term debt, after tax Choose option with lowest cost (present value)

© 2006 by Nelson, a division of Thomson Canada Limited 63 Lease Versus Buy Analysis Compare incremental cost of leasing versus borrowing and buying the asset Compare: Present Value of Cost of Leasing Present Value of Cost of Owning against

© 2006 by Nelson, a division of Thomson Canada Limited 64 The Advantages of Leasing No money down  Lenders typically require down payment lessors usually do not Restrictions  Lenders usually require covenants/indentures 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

© 2006 by Nelson, a division of Thomson Canada Limited 65 The Advantages of Leasing Avoiding risk of obsolescence  Lessee can return obsolete equipment at end of lease Tax deduction for cost of land  Lease payments for land are deductible No Capital Cost Allowance (tax amortization) for land Sale and leaseback  Used to free up cash invested in real estate Tax advantages for marginally profitable companies (leveraged leases)

© 2006 by Nelson, a division of Thomson Canada Limited 66 Leveraged Leases Ability to amortize an asset reduces taxes If company is not making profit (and not paying taxes), amortization is not saving any money Lessor buys equipment but borrows most of cost (leveraged)  Amortizes leased assets, deducts interest, and gains tax benefits Lessor passes along some of tax benefits to lessee  lower lease payments

© 2006 by Nelson, a division of Thomson Canada Limited 67 Disadvantages to Leasing May be more expensive than borrowing Lessor retains salvage value, including any capital gain May be difficult to obtain approval for modifications Often subject to cancellation penalty

9 9 Chapter The Valuation and Characteristics of Bonds Slides Developed by: Terry Fegarty Seneca College.

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9 9 Chapter The Valuation and Characteristics of Bonds Slides Developed by: Terry Fegarty Seneca College.

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Presentation on theme: "9 9 Chapter The Valuation and Characteristics of Bonds Slides Developed by: Terry Fegarty Seneca College."— Presentation transcript:

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