Everything You Wanted to Know About Bonds and Their ValueFINC 3610 ‐ YostEverything You Wanted to Know About Bonds and Their Value131What are bonds?• Yost Corporation wants to borrow money, and it decides to issue bonds. Each bondholder lends the firm money today y yfor 30 years at 12 percent interest. Yost Corporation pays each bondholder $120 per year and returns the principal ($1,000) back to the bondholder at the end of the 30 years.132Bond Terms• Coupon:The stated interest payment made on a bond.• Face Value: The principal amount of a bond that is repaid at the end of the term. Also called ___________.• Coupon Rate:The _______coupon divided by the face value of a bond. 133Everything You Wanted to Know About Bonds and Their ValueFINC 3610 ‐ YostMore Bond Terms• Maturity: Specific date on which the principal amount of a bond (i.e., the face value) is repaid.• Yield to Maturity (YTM): The rate required in the market on the bond. Also called the yield. This will be the “r” we use to calculate price and is quoted as ________. This is often not the same as the coupon rate.134Calculating the Price of a Bond• How do we calculate the price of a bond?• The price of a bond is equal to the f h bd’__________ ________ of the bond’s __________ _______________.135Pricing Coupon Bonds• Tigers, Inc. decides to issue $1,000 bonds with 5 years to maturity. The coupon rate is 10 percent, paid annually. The yield to maturity is also 10% What is the price of a Tigers Incalso 10%. What is the price of a Tigers, Inc. bond?0 1 2 3 4 5|‐‐‐‐‐‐‐‐‐‐‐|‐‐‐‐‐‐‐‐‐‐‐|‐‐‐‐‐‐‐‐‐‐‐|‐‐‐‐‐‐‐‐‐‐‐‐|‐‐‐‐‐‐‐‐‐‐‐|136Everything You Wanted to Know About Bonds and Their ValueFINC 3610 ‐ YostPricing Coupon Bonds• Now, assume the yield to maturity (i.e., the market interest rates) rises to 12 percent. What is the price of the bond now?0 1 2 3 4 5|‐‐‐‐‐‐‐‐‐‐‐|‐‐‐‐‐‐‐‐‐‐‐|‐‐‐‐‐‐‐‐‐‐‐|‐‐‐‐‐‐‐‐‐‐‐‐|‐‐‐‐‐‐‐‐‐‐‐|137Pricing Coupon Bonds• Now, assume the yield to maturity (i.e., the market interest rates) falls to 8 percent. What is the price of the bond now?0 1 2 3 4 5|‐‐‐‐‐‐‐‐‐‐‐|‐‐‐‐‐‐‐‐‐‐‐|‐‐‐‐‐‐‐‐‐‐‐|‐‐‐‐‐‐‐‐‐‐‐‐|‐‐‐‐‐‐‐‐‐‐‐|138Pricing Coupon Bonds• Assume the yield to maturity is 10 percent. What is the price of the bond if the coupon payments were made semiannually? 0 1 2 3 4 5|‐‐‐‐‐‐‐‐‐‐‐|‐‐‐‐‐‐‐‐‐‐‐|‐‐‐‐‐‐‐‐‐‐‐|‐‐‐‐‐‐‐‐‐‐‐‐|‐‐‐‐‐‐‐‐‐‐‐|139Everything You Wanted to Know About Bonds and Their ValueFINC 3610 ‐ YostCalculating YTM• You just purchased a DocYost, Inc. bond for $1,050. The bond has a $1,000 face value and an 8% coupon rate, paid semiannually. The bond matures in 10 ½ years What is its yieldbond matures in 10 ½ years. What is its yield to maturity?140Current Yield• Current Yield: ________coupon divided by current price.• What it is:• What it is not:141Another Example• There are two $1,000 bonds identical in every way (i.e., same risk) except for their coupons and their prices. Both have 3 years to maturity and annual coupons. The first has an 8 percent coupon rate and sells for $974.69. What is its yield to maturity (YTM)? • The second bond has a 10 percent coupon rate. If it has the same YTM as the first bond, what is its price?• Which is better?142Everything You Wanted to Know About Bonds and Their ValueFINC 3610 ‐ YostWhat about zero‐coupon bonds?• What are they?•How do I calculate their price?How do I calculate their price?• What is the price of a zero‐coupon bond that has a face value of $1,000 and matures in 10 years, if the YTM is 8%?143Interest Rate Risk• Interest Rate Risk: The risk of a change in the value of a bond because of a change in the interes t rate.1. Bond prices and market interest rates move in di ti_____________ directions.2. All other things being equal, the longer the time to maturity, the _______ the interest rate risk.3. All other things being equal, the lower the coupon rate, the _______the interest rate risk.144Other Bond Pricing Truths• When a bond’s coupon rate is _______ than the YTM (market’s required return), the bond’s price (market value) will be greater than its par value.• When a bond’s coupon rate is _______ the YTM (market’s required return), the bond’s price (market value) will be equal to its par value.• When a bond’s coupon rate is ___ than the YTM (market’s required return), the bond’s price (market value) will be less than its par value.145Everything You Wanted to Know About Bonds and Their ValueFINC 3610 ‐ YostThe Term Structure of Interest Rates• Term Structure: The relationship between interes t rates and time‐to‐maturity of a debt security.ld d• Yield on Bonds– Real Interest Rate– Inflation Premium– Interest Rate Risk Premium– Default Risk Premium– Liquidity/Marketability Premium146Bond Features• Indenture: The written agreement between the corporation and the lender detailing the terms of the debt issue.• Term s of a Bond• Security147Bond Features• Seniority• RepaymentSi ki Fd–Sinking Fund• Call Provision– Call Premium– Yield‐to‐Call• Protective Covenants148Everything You Wanted to Know About Bonds and Their ValueFINC 3610 ‐ YostDifferences Between Debt and Equity• Debt– Not an ownership interest– Creditors do not have voting rights• Equity– Ownership interest– Common stockholders vote for the board of directors and other issues– Interest is considered a cost of doing business and is tax deductible– Creditors have legal recourse if interest or principal payments are missed– Excess debt can lead to financial distress and bankruptcy– Dividends are not considered a cost of doing business and are not tax deductible– Dividends are not a liability of the firm