Exam 2 Book notesChapter 7Bonds 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 issued by corps may be classified roughly as equity securities and debt securities• 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 andis 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 equityo Equity holders are paid after debt holders • long term debt- basicso a bond is a secured debto issues with an original maturity of 1- years or less are often called notes while longer term issues are called bondso major forms of long term debt are public issue and privately placedo main difference bw them is that private bonds are directly placed with a lender and not offered to the publicIndenture (deed of trust)o Written agreement bw the corp and its creditorso Terms of a bondo Principal value is stated on the bond certificateo Registered form The form of bond issue in which the registrar of the company records ownership of each bondo Bearer form The form of bond issue in which the bond is issued without record of the owner’s nameo Securityo Collateral General term that means securities that are pledged as security for payment of debto Mortgage securitieso Secured by a mortgage on the real property of the borrower- Debentureo An unsecured bond (debt) usually with a maturity of over 10 years- Noteo An unsecured bond (debt) usually with a maturity under 10 yearsRepayment- Sinking fundo An account managed by the bond trustee for early bond redemptionCall provision- 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 premiumo The amount by which the call price exceeds the par value of the bond- Deferred call provisiono A call provision prohibiting the company from redeeming a bond prior to a certain date- Call protected bondo A bond that, during a certain period, can’t be redeemed by the issuerBond ratings- Standard and Poor’so Top to bottom§ AAA, AA, A, BBB, BB, B, CCC, CC, C, D- Moody’so Top to bottom§ Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C- Fitcho Uses pluses and minuses, similar to S&PTypes of bonds (discussed in class)- Gov bonds- Zero coupon bonds- Floating rate bondsBond markets- The # of bond issues far exceeds the # of stock issues- Under new regulations, corporate bond dealers are now required to report trade information through TRACE- Bid priceo The price a dealer is willing to pay for a security- Asked priceo The price a dealer is willing to take for a security- Bid- ask spreado The difference between the two- Clean priceo Price of a bond net of accrued interest- Dirty priceo 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 for expected future inflation-Interest rate risk premium- the compensation investors demand for bearing interest rate risk-Taxability premium- portion of a nominal interest rate or bond yield that represents compensation for unfavorable tax statusLiquidity premium- “ lack of liquidityChapter 8Stock valuationIt is more difficult to value common stock than a bond for 3 reasons1. Not even the promised cash flows are known2. The life of the investment is essentially forever3. 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
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