Exam 2 Book notes Chapter 7 Bonds and bond valuation When a corp or gov wants to borrow money from the public on a long term basis it usually does so by issuing or selling debt securities that are called bonds Coupon that stated interest payment made on a bond Face par value the amount that will be repaid at teh end of the loan Coupon rate annual coupon divided by the face value of a bond Maturity the of years until the face value is paid When interest rates rise the present value of the bond s remaining cash flows declines and the bond is worth less Yield to maturity YTM rate required in the market on a bond When a bond sells for less than face value it is said to be a discount bond When a bond sells for more than face value it is said to be a premium bond The risk that arises from bond owners from fluctuating interest rates The longer the time to maturity the greater the interest rate risk The lower the coupon rate the greater the interest rate risk Interest rate risk increases at a decreasing rate A bond s yield to maturity should not be confused with its current yield which is simply a bond s annual coupon divided by its price Bond value C C 1 1 1 r t r F 1 r t C coupon paid each period r rate per period t of periods F bond s face value securities Securities issued by corps may be classified roughly as equity securities and debt Main differences bw debt and equity are the following o Debt is not an ownership interest in the firm Creditors do not have voting rights generally The corps payment of interest on debt is considered a cost of doing business and is fully tax deductible Unpaid debt is a liability of the firm If it is unpaid the creditors can legally claim the assets of the firm which can result in bankruptcy Is it debt or equity o A reason a corp may try to create a debt security that is really equity is to obtain the tax benefits of debt and the Bankruptcy benefits of equity o Equity holders are paid after debt holders long term debt basics o a bond is a secured debt o issues with an original maturity of 1 years or less are often called notes while longer term issues are called bonds o major forms of long term debt are public issue and privately placed o main difference bw them is that private bonds are directly placed with a lender and not offered to the public Indenture deed of trust o Written agreement bw the corp and its creditors o Terms of a bond o Principal value is stated on the bond certificate o Registered form The form of bond issue in which the registrar of the company records ownership of each bond The form of bond issue in which the bond is issued without record of the owner s name o Bearer form o Security o Collateral General term that means securities that are pledged as security for payment of debt o Mortgage securities o Secured by a mortgage on the real property of the borrower o An unsecured bond debt usually with a maturity of over 10 years o An unsecured bond debt usually with a maturity under 10 years Debenture Note Repayment Sinking fund Call provision o An account managed by the bond trustee for early bond redemption Allows the company to repurchase or call part or all of the bond issue at stated prices over a specific period Corporate bonds are usually callable Call premium o The amount by which the call price exceeds the par value of the bond Deferred call provision o A call provision prohibiting the company from redeeming a bond prior to a certain o A bond that during a certain period can t be redeemed by the issuer date Call protected bond Bond ratings Standard and Poor s o Top to bottom AAA AA A BBB BB B CCC CC C D Moody s o Top to bottom Fitch Aaa Aa A Baa Ba B Caa Ca C o Uses pluses and minuses similar to S P The of bond issues far exceeds the of stock issues Under new regulations corporate bond dealers are now required to report trade Types of bonds discussed in class Gov bonds Zero coupon bonds Floating rate bonds Bond markets information through TRACE Bid price o The price a dealer is willing to pay for a security Asked price o The price a dealer is willing to take for a security Bid ask spread o The difference between the two Clean price o Price of a bond net of accrued interest Dirty price o Price of a bond including accrued interest aka the price the buyer actually pays The nominal rate of an investment is the percentage change in the of dollars you have The real rate on an investment is the percentage change in how much you can buy with your dollars Fisher effect relationship bw nominal returns real returns and inflation Term structure of interest rates relationship bw nominal interest rates on default free pure discount securities and time to maturity the pure time value of Inflation premium the portion of a nominal interest rate that represents compensation Interest rate risk premium the compensation investors demand for bearing interest rate Taxability premium portion of a nominal interest rate or bond yield that represents for expected future inflation risk compensation for unfavorable tax status Liquidity premium lack of liquidity Chapter 8 Stock valuation It is more difficult to value common stock than a bond for 3 reasons 1 Not even the promised cash flows are known 2 The life of the investment is essentially forever 3 There is no way to easily observe the rate of return The price of a stock today is equal to the present value of all of the future dividends Zero growth D R D cash flow R required return Constant growth D sub 0 X 1 g t Dividend growth model a model that determines the current price of a stock as its dividend next period divided by the discount rate less the dividend growth rate D sub 0 X 1 g R g Dividend yield a stock s expected cash dividend divided by its current price Capital gains yield the dividend growth rate or the rate at which the value of an investment grows A PE ratio that is based on estimated future earnings is called a forward PE ratio Common stock equity without priority for dividends or in bankruptcy Directors are elected each year a an annual meeting with the idea one share one vote and the golden rule prevails Cumulative voting shareholders cast all votes for one member Straight voting shareholders may cast all votes for each member Staggered boards are often called classified boards because directors are placed into different classes with terms that expire at different times Staggering has two basic effects 1 More difficult for a minority to elect a …
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