CSULB FIN 300 - CHAPTER 7 Bonds and Their Valuation

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CHAPTER 7 Bonds and Their ValuationWhat is a bond?Bond marketsKey Features of a BondEffect of a call provisionWhat is a sinking fund?How are sinking funds executed?The value of financial assetsOther types (features) of bondsWhat is the opportunity cost of debt capital?What is the value of a 10-year, 10% annual coupon bond, if kd = 10%?Using a financial calculator to value a bondAn example: Increasing inflation and kdAn example: Decreasing inflation and kdThe price path of a bondBond values over timeWhat is the YTM on a 10-year, 9% annual coupon, $1,000 par value bond, selling for $887?Using a financial calculator to find YTMFind YTM, if the bond price was $1,134.20.DefinitionsAn example: Current and capital gains yieldCalculating capital gains yieldWhat is interest rate (or price) risk?What is reinvestment rate risk?Reinvestment rate risk exampleConclusions about interest rate and reinvestment rate riskSemiannual bondsWhat is the value of a 10-year, 10% semiannual coupon bond, if kd = 13%?Would you prefer to buy a 10-year, 10% annual coupon bond or a 10-year, 10% semiannual coupon bond, all else equal?If the proper price for this semiannual bond is $1,000, what would be the proper price for the annual coupon bond?A 10-year, 10% semiannual coupon bond selling for $1,135.90 can be called in 4 years for $1,050, what is its yield to call (YTC)?Yield to callIf you bought these callable bonds, would you be more likely to earn the YTM or YTC?When is a call more likely to occur?Default riskTypes of bondsEvaluating default risk: Bond ratingsFactors affecting default risk and bond ratingsOther factors affecting default riskBankruptcyChapter 11 BankruptcyPriority of claims in liquidationReorganization7-1CHAPTER 7Bonds and Their ValuationKey features of bondsBond valuationMeasuring yieldAssessing risk7-2What is a bond?A long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond.7-3Bond marketsPrimarily traded in the over-the-counter (OTC) market.Most bonds are owned by and traded among large financial institutions.Full information on bond trades in the OTC market is not published, but a representative group of bonds is listed and traded on the bond division of the NYSE.7-4Key Features of a BondPar value – face amount of the bond, which is paid at maturity (assume $1,000).Coupon interest rate – stated interest rate (generally fixed) paid by the issuer. Multiply by par to get dollar payment of interest.Maturity date – years until the bond must be repaid.Issue date – when the bond was issued.Yield to maturity - rate of return earned on a bond held until maturity (also called the “promised yield”).7-5Effect of a call provisionAllows issuer to refund the bond issue if rates decline (helps the issuer, but hurts the investor).Borrowers are willing to pay more, and lenders require more, for callable bonds.Most bonds have a deferred call and a declining call premium.7-6What is a sinking fund?Provision to pay off a loan over its life rather than all at maturity.Similar to amortization on a term loan.Reduces risk to investor, shortens average maturity.But not good for investors if rates decline after issuance.7-7How are sinking funds executed?Call x% of the issue at par, for sinking fund purposes.Likely to be used if kd is below the coupon rate and the bond sells at a premium.Buy bonds in the open market.Likely to be used if kd is above the coupon rate and the bond sells at a discount.7-8The value of financial assetsnn2211k)(1CF ... k)(1CF k)(1CF Value0 1 2 nkCF1CFnCF2Value...7-9Other types (features) of bondsConvertible bond – may be exchanged for common stock of the firm, at the holder’s option.Warrant – long-term option to buy a stated number of shares of common stock at a specified price.Putable bond – allows holder to sell the bond back to the company prior to maturity.Income bond – pays interest only when interest is earned by the firm.Indexed bond – interest rate paid is based upon the rate of inflation.7-10What is the opportunity cost of debt capital?The discount rate (ki ) is the opportunity cost of capital, and is the rate that could be earned on alternative investments of equal risk.ki = k* + IP + MRP + DRP + LP7-11What is the value of a 10-year, 10% annual coupon bond, if kd = 10%?$1,000 V$385.54 $38.55 ... $90.91 V(1.10)$1,000 (1.10)$100 ... (1.10)$100 VBB10101B0 1 2 nk100100 + 1,000100VB = ?...7-12Using a financial calculator to value a bondThis bond has a $1,000 lump sum due at t = 10, and annual $100 coupon payments beginning at t = 1 and continuing through t = 10, the price of the bond can be found by solving for the PV of these cash flows.INPUTSOUTPUTN I/YR PMTPV FV10 10 100 1000-10007-13An example:Increasing inflation and kdSuppose inflation rises by 3%, causing kd = 13%. When kd rises above the coupon rate, the bond’s value falls below par, and sells at a discount.INPUTSOUTPUTN I/YR PMTPV FV10 13 100 1000-837.217-14An example:Decreasing inflation and kdSuppose inflation falls by 3%, causing kd = 7%. When kd falls below the coupon rate, the bond’s value rises above par, and sells at a premium.INPUTSOUTPUTN I/YR PMTPV FV10 7 100 1000-1210.717-15The price path of a bondWhat would happen to the value of this bond if its required rate of return remained at 10%, or at 13%, or at 7% until maturity?Years to Maturity1,3721,2111,00083777530 25 20 15 10 5 0kd = 7%.kd = 13%.kd = 10%.VB7-16Bond values over timeAt maturity, the value of any bond must equal its par value.If kd remains constant:The value of a premium bond would decrease over time, until it reached $1,000.The value of a discount bond would increase over time, until it reached $1,000.A value of a par bond stays at $1,000.7-17What is the YTM on a 10-year, 9% annual coupon, $1,000 par value bond, selling for $887?Must find the kd that solves this model.10d10d1dNdNd1dB)k(11,000 )k(190 ... )k(190 $887)k(1M )k(1INT ... )k(1INT V7-18Using a financial calculator to find YTMSolving for I/YR, the YTM of this bond is 10.91%. This bond sells at a discount, because YTM > coupon rate.INPUTSOUTPUTN I/YR PMTPV FV1010.9190 1000- 8877-19Find YTM, if the bond price was


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