1FI3300Corporate Finance 010Spring Semester 2010Dr. Isabel TkatchAssistant Professor of Finance1Learning Objectives☺ What is a financial security?☺ Identify the main differences between debt and equity securities☺ Describe & price various types of debt securities 2☺ Describe & price various types of equity securities ☺ Describe different types of securities markets ☺ Explain the risk-return relation for debt and equity securities☺ Describe the concepts underlying the cost of capital What is a financial security?☺ The financial security is a contract between the provider of funds and the user of funds.☺ The contract specifies:☺ The amount of money that has been provided☺ Terms & conditions: how the user is going to 3ggrepay the provider (amount and timing of CFs)☺ Provider: you (ordinary investor), the bank, venture capitalist, etc. ☺ User: entrepreneur or firm with good business idea/product but no (or not enough) money to execute the idea.Simple exampleBank loan as a financial security:You (user) borrow 7.5 million dollars, from a bank (provider) at 8 percent interest p.a. to start a new firm4start a new firm.Your contract stipulates that you will repay the bank loan in 10 equal yearly installments. Each installment is approximately 1.118 million dollars. Valuation of financial securitiesFor the owner of the financial security (investor):- The security is a represented by a stream of expected future cash flows- The value of the security is the PV of the CF stream5Valuation of financial securities:- Use the contract to determine the CF stream- Find the required rate of return- Use the appropriate TVM formula to calculate the PV of the CF streamCommon financial securities Debt Security Equity Security The owner of the security is a creditor of the firmCreditors have no control rights: no say in firm’s business decisionsThe owner of the security is the owner of the firmOwners have control rights: decide (vote) on firm’s business decisionsThe payment is fixed The payment is risky, not fixed6pypy y,Receives payment before anything is paid to firm owners (equity holders)Residual claim: receives whatever is left after all debt holders/creditors are paidIf the firm cannot pay, debt holders will take over its assetsIf the firm cannot pay its debt, equity holders loose their control rightsLimited liability Limited liability2Types of debt securitiesz Fixed-coupon bondz Zero-coupon bondz Consol (Perpetual bond)7z Variable-rate bondz Income bondz Convertible bondz Callable bondFixed-coupon bond☺Firm pays a fixed amount (‘coupon’)every period until the bond matures☺At maturity, firm pays the bond’s face l( l)8value(par value)☺The most common face value is $1,000 ☺The period can be one year, 6 months, one quarter (3 months) etc. How to ‘read’ a fixed-coupon bondA firm issues an 8%, 30-year bond with annual coupon payments. Par value is $1,000.Coupon rate = 8%Period = annual coupon paymentsPar (face) value CF = $1,000 paid at maturity9pyMaturity, T = 30 yearsCoupon CF = Coupon rate x Par = 8% x 1,000 = $80 paid every year, at the end of the year$80 $80 … $80 … $1,080 |------------|-----------|--------- … -----|----- … --------|----> time0 1 2 t T =30ExampleA firm issues an 8%, 30-year bond. The par value is $1,000 and the (effective) annual cost of capital is 10%.1. What is the value of the bond if coupon t l?10payments are annual?2. What is the value of the bond if coupon payments are semi-annual?Note the convention: Coupons are always annual.8% annual coupon + semi-annual payments imply (8% / 2) = 4% semi-annual coupon.ExampleA bond with par value of $1,000 matures in 30 years. The annual coupon rate is 10% with semiannual installments. 11The bond is expected to make the next semiannual coupon payment 6 months from now. The (effective) annual cost of capital is 8%. What is the price of the bond today?Read carefully: the coupon rate IS NOT the cost of capitalExampleA $1,000 par value bond has coupon rate of 5% and the coupon is paid semi-annually.The bond matures in 20 years and the (effective) annual required rate of return is 12q10%.Compute the bond price.3Fixed Coupon Bond☺ Firm pays a fixed amount (coupon) every period until the bond matures = CF ☺ At maturity, firm pays the bond’s face value (par value) = FV☺ The bond has T periods to maturityTh ff ti t f it l i d 13☺The effective cost of capital per period = rCF CF … CF+FV |------------|-----------|--------- … -----|-------------> time0 1 2 T ()1111TTCF FVPrice PVrrr⎡⎤⎛⎞== − +⎢⎥⎜⎟+⎝⎠ +⎢⎥⎣⎦Par value and the bond priceA $1,000 par value bond matures in 20 years. The (effective annual) required rate of return is r=10%. 1. Suppose annual coupon rate = 10%14pp pVerify that price = $1,000 = par value2. Suppose annual coupon rate = 12%Verify that price = $1,170.27 > par value3. Suppose annual coupon rate = 8% Verify that price = $829.73 < par valueTerminologyCoupon rate < discount rate Price < face value The bond is selling at a discountCoupon rate = discount ratePrice = face valueThe bond is 15Coupon rate discount ratePrice face valueThe bond is selling at parCoupon rate > discount rate Price > face value The bond is selling at a premiumExampleA 10-year annual-coupon bond was issued at par 4 years ago. Since then the bond’s yield to maturity (YTM) has decreased from 9% to 7%.Which of the following statements (about the current 16Which of the following statements (about the current market price of the bond) is true?a. The bond is selling at a discountb. The bond is selling at parc. The bond is selling at a premiumd. The bond is selling at book valuee. Insufficient informationExampleOne year ago Pell Inc. sold 20-year, $1,000 par value, annual-coupon bonds for $931.54 per bond. At that time the yield to maturity (market rate) was 9%.Today, the yield to maturity is 9.5%; therefore the bonds are currently selling:17bonds are currently selling:a. at a discountb. at a premiumc. at pard. above the market pricee. Insufficient informationExample: find the coupon rateABC Inc. just issued a twenty-year semi-annual coupon bond at a price of $787.39. The face value of the bond is $1,000, and the market required (effective annual) rate of return is 9%. 18What is the annual coupon rate?What if the bond pays coupons