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Chapter 7

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Valuation and Characteristics of Bonds

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Chapter Objectives Different types of bonds Features of bonds Term “Value” Process for valuing assets Value of a bond Expected rate of return Relationships in bond valuation

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Bonds Type of debt or long-term promissory note issued by a borrower, promising to pay the holder a fixed amount of interest per year.

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Types of Bonds Debentures Subordinated Debentures Mortgage Bonds Euro Bonds Zero Coupon Bonds Junk Bonds

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Debentures Any unsecured long-term debt Viewed as more risky than secured bonds and provide a higher yield than secured bonds

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Subordinated Debenture Hierarchy of payout in case of bankruptcy The claims of subordinated debentures are honored only after the claims of secured debt and unsubordinated debentures have been satisfied

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Mortgage Bond A bond secured by a lien on real property Typically the value of the real property is greater than that of the bonds issued

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Euro Bonds Securities (bonds) issued in a country different from the one in whose currency the bond is denominated

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Zero Coupon Bonds Do not make regular interest payments Issued at a significant discount Return comes from appreciation of the bond. Series EE government savings bonds— purchase for $500, payback is $1,000

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Junk Bonds High risk debt with low ratings by Moody’s and Standard & Poor’s High yield—typically pay Three to Five percent more than AAA grade long-term bonds

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Terminology Claims on Assets and Income:In the event of insolvency, claims of debt, including bonds are honored before those of common or preferred stock. Par Value: Face value of the bond, returned to the bondholder at maturity Coupon Interest Rate:The percentage of the par value of the bond that will be paid out in the form of interest

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Maturity:the length of time until the bond issuer returns the par value to the bondholder and terminates or redeems the bond. Indenture:the legal agreement between the organization issuing the bond and the trustee who represents the bondholders

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

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Bond Ratings Three agencies rate bonds: – Moody’s – Standard & Poor’s – Fitch Investor Services The lower the rating, the higher the return demanded in the market

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Bond Ratings Bond ratings are favorably affected by: – Greater reliance on equity as opposed to debt financing – Profitable operations – Low variability in past earnings – Large firms size – Little use of subordinated debt

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Bond Ratings AAA is the highest rating assigned by Standard & Poor’s AAA indicates a strong capacity to pay principal and interest

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Value Book value:value of an asset as shown on a firm’s balance sheet Liquidation value:the dollar amount that could be realized if an asset were sold individually and not as part of a going concern. Market value:the observed value for the asset in the marketplace Intrinsic or economic value:also called fair value—the present value of the asset’s expected future cash flows

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Efficient Market The values of all securities at any instant fully reflect all available public information, which results in the market value and the intrinsic value being the same

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Determinants of Value For our purposes:The value of an asset is its intrinsic value or the present value of its expected future cash flows, when these cash flows are discounted back to the present using the investor’s required rate of return Determinants: – Amount and timing of expected cash flows – Riskiness of the cash flows – Investor’s required rate of return for the investment

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Bond Valuation The value of a bond is a combination of: – The present value of the interest payments Plus – The present value of the par or face value

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Bond Valuation 1.The value of a bond is inversely related to changes in the investor’s present required rate of return (the current interest rate). As interest rates increase, the value of the bond decreases. 2.The market value of a bond will be less than the par value if the investor’s required rate of return is above the coupon interest rate; the value will be above par value if the investor’s required rate of return is below the coupon interest rate. 3.Long-term bonds have greater interest rate risk than do short-term bonds.

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Par Value When the investor’s required rate of return is equal to the coupon interest rate, the bond has a market value of par or face value

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Discount The market value of a bond will be below the par or face when the investor’s required rate is greater than the coupon interest rate. The bond will sell at a Discount or below face value.

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Premium The market value of a bond will be above the par or face value when the investor’s required rate is lower than the coupon interest rate. The bond will sell at a Premium or above face value.

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Price of a Bond Calculate the market value of price of a 5-year $1,000 bond with an 8% coupon rate and the investor’s required rate of return is 8%. Present Value of the interest payments --plus– the Present Value of the par or face value Interest payments $1,000 x 8% = $80 – 80 x 3.9927 = 319.42 PV of the face or par value – 1000 x.6806 = 680.60 Total value = $1,000

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Price of a Bond Calculate the market value of price of a 5-year $1,000 bond with an 8% coupon rate and the investor’s required rate of return is 6%. Present Value of the interest payments --plus– the Present Value of the par or face value Interest payments $1,000 x 8% = $80 – 80 x 4.2124 = 336.99 PV of the face or par value – 1000 x.7473 = 747.30 Total value = $1,084.29

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Price of a Bond Calculate the market value of price of a 5-year $1,000 bond with an 8% coupon rate and the investor’s required rate of return is 10%. Present Value of the interest payments --plus– the Present Value of the par or face value Interest payments $1,000 x 8% = $80 – 80 x 3.7908 = 303.26 PV of the face or par value – 1000 x.6209 = 620.90 Total value = $924.16

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Present Value of $1 N6%8%10%12% 1.9434.9259.9091.8929 2.8900.8573.8264.7972 3.8396.7938.7513.7118 4.7921.7350.6830.6355 5.7473.6806.6209.5674 6.7050.6302.5645.5066 7.6651.5835.5132.4523 8.6274.5403.4665.4039 9.5919.5002.4241.3606 10.5584.4632.3855.3220

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Present Value of Annuity N6%8%10%12% 1.9434.9259.9091.8929 21.83341.78331.73551.6901 32.67302.57712.48692.4018 43.46513.31213.16993.0373 54.21243.99273.79083.6048 64.91734.62294.35534.1114 75.58245.20644.86844.5638 86.20985.74665.33494.9676 96.80176.24695.75905.3282 107.36016.71016.14465.6502

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