HB 311 1st Edition Lecture 9 Current Lecture The Basis of Value Securities are worth the present value of the future cash income associated with owning them The security should sell in financial markets for a price very 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 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 is what the investor receives divided by what s he invests Debt investors receive interest Rate of return is the interest rate that equates the present value of its expected future cash flows with its current price PV FV 1 k Return is also known as Yield Interest Bond Valuation A bond issue represents borrowing from many lenders at one time under a single agreement While one person may not be willing to lend a single company 10 million 10 000 investors may be willing to lend the firm 1 000 each These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute Bond Terminology and Practice A bond s term or maturity is the time from the present until the principal is to be returned Bond s mature on the last day of their term A bond s face value or par represents the amount the firm intends to borrow the principal at the coupon rate of interest Bonds typically pay interest coupon rate every six months Bonds are non amortized meaning the principal is repaid at once when the bond matures rather than being repaid in increments throughout the bond s life Adjusting to interest rate changes Bonds are sold in both primary original sale and secondary markets subsequent trading among investors Interest rates change all the time Most bonds pay a fixed interest rate What happens to the price of a bond paying a fixed interest rate in the secondary market when interest rates change You buy a 20 year 1000 par bond today for par meaning you pay 1 000 for it when the coupon rate is 10 This implies that your required rate of return was 10 For that purchase price you are promised 20 years of coupon payments of 100 each and a principal repayment of 1 000 in 20 years After you ve held the bond investment for a week you decide that you need the money cash more than you need the investment You decide to sell the bond Unfortunately interest rates have risen Other investors now have a required rate of return of 11 They can buy new bonds with an 11 coupon rate in the market for 1 000 Will they buy your bond from you for 1 000 NO They ll buy it for less than 1 000 Determining the Price of a Bond Two Interest Rates and One More Coupon rate Determines the size of the interest payments K the current market yield on comparable bonds The appropriate discount rate that makes the present value of the payments equal to the price of the bond in the market AKA yield to maturity YTM Current yield annual interest payment divided by bond s current price Maturity Risk Relates to term of the 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 the price of a bond will approach its par Finding the Yield at a Given Price We ve been calculating the intrinsic value of a bond but we could calculate the bond yield based on its current value in the market and compare that yield to our required rate of return Call Provisions If interest rates have dropped substantially since a bond was originally issued a firm may wish to refinance or retire their old high interest bond issue However the issuing corporation would have to get all the bondholders to agree to this From the bondholder s viewpoint this could be a bad idea they would be giving up high coupon bonds and would have to reinvest their cash in a market with lower interest rates To ensure that the corporation can refinance their bonds should they wish to do so the corporation makes the bonds callable Call provisions allow bond issuers to retire bonds before maturity by paying a premium penalty to bondholders Many corporations offer a deferred call period meaning the bond won t be called for at least x years after the initial issuing date Known as the call protected period The Effect of A Call Provision on Price When valuing a bond that is probably going to be called when the call protected period is over Cannot use the traditional bond valuation procedure Cash flows will not be received through maturity because bond will probably be called