HB 311 1st EditionLecture 9Current LectureThe Basis of Value • Securities are worth the present value of the future cash income associated with owningthem– 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 eachThese 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 bondmatures 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 $1,000Determining 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 priceMaturity 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 parFinding 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 returnCall Provisions • If interest rates have dropped substantially since a bond was originally issued, a firm maywish 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 givingup 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