FIN3403 Financial Management of the Firm Exam 2 Study Guide Definitions CHAPTER 7 1 Bond an interest only loan The borrower will pay the interest every period but none of the principal will be repaid until the end of the loan 2 Par Value or Face Value The principal amount of a bond that is repaid at the end of the term It is fixed when it is issued 3 Coupon The stated interest payment made on a bond Considered fixed when it is issued 4 Coupon Rate The annual coupon divided by the face value of a bond Considered fixed when it is issued 5 Maturity Date The specific date on which the principle amount of a bond is paid Considered fixed when issued 6 Yield or Yield Maturity or bond s yield The rate required in the market on a bond CHANGES during the life of the bond as market interest rates and the price of the bond changes in secondary markets 7 Current Yield A bonds annual coupon divided by its price 8 Indenture The written agreement between the corporation and the lender detailing the terms of the debt issue 9 Debenture An unsecured debt usually with a maturity of 10 years or more 10 Note An unsecure debt usually with a maturity under 10 years 11 Sinking Funds An account managed by the bond trustee for early bond redemption 12 Bid Price The price a dealer is willing to pay for a security 13 Asked Price The price a dealer is willing to take for a security 14 Bid Ask spread The difference between the bid price and the asked price 15 Clean Price The price of a bond net of accrued interest this is the price that is typically quoted 16 Dirty Price or full invoice price The price of a bond including accrued interest This is the price the buyer actually pays Present Values of Cash Flows as the Rate Changes Formulas Bond Value PV of coupons PV of par Bond Value PV of annuity PV of lump sum As interest rates increase present values decrease As interest rates increase bond prices decrease As interest rates decrease bond prices increase THERE IS AN INVERSE RELATIONSHIP BETWEEN THE PRICE OF THE BOND AND THE INTEREST RATE There are 2 different types of Bonds Premium Bond A premium bond is a bond with a current market price above the face value of the bond This would indicate that market interest rates have declined after the bond was issued which would increase the market price of the bond inverse relationship Discount Bond A discount bond is a bond with a current market price below the face value of the bond This would indicate that market interest rates have increased after the bond was issued which would decrease the market price of the bond inverse relationship Bond Prices Relationship Between Coupon and Yield If Yield to Maturity Coupon Rate then Par Value Bond Price If Yield to Maturity Coupon Rate then Par Value Bond Price This is because the discount provides yield above the coupon rate in the form of a Capital Gain In the case above the price is below par value so it is called a discount bond If Yield to Maturity Coupon Rate then Par Value Bond Price This is because the higher coupon rate causes value above par that the market will cancel out by pricing the bond higher than face value market equilibrium In this case the price is above par value so it is called a premium bond Graphical Relationship Between Price and Yield to maturity YTM 1500 1400 1300 1200 1100 1000 900 800 700 600 0 2 4 6 8 10 12 14 The Bond Pricing Equation Bond Value Bond Value C 1 1 1 r t r FV r t 1 Bond Value PV Coupon PMTs PV Face Value There are 2 types of Interest Rate Risks Price Risk The change in price due to changes in interest rates Long term bonds have more price risk than short term bonds Low coupon rate bonds have more price risk than high coupon rate bonds can be reinvested Reinvestment Rate Risk This is the uncertainty concerning rates that cash flows Short term bonds have more reinvestment rate risk than long term bonds High coupon rate bonds have more reinvestment rate risk than low coupon rate bonds All other things being equal the longer the time to maturity the greater the All other things being equal the lower the coupon rate the greater the interest interest risk rate risk Computing Yield to Maturity Yield to Maturity YTM is the rate implied by the current bond price IF YOU DO NOT HAVE THE FINANCIAL CALCULATOR Finding the YTM requires trial and error and is similar to the process for finding r with an annuity by the way if you don t have one by now you should for sure get one before this exam they are worth the 30 dollars at Wal Mart for this class IF YOU HAVE THE FINANCIAL CALCULATOR If you have a financial calculator enter N PV PMT and FV remembering the sign convention PMT and FV need to have the same sign PV the opposite sign Bond Pricing Theorems Bonds of similar risk and maturity will be priced to yield about the same return regardless of the coupon rate If you know the price of one bond you can estimate its YTM and use that to find the price of the second bond Ownership interest Not an ownership interest Differences Between Debt and Equity Creditors do not have voting rights DEBT vs EQUITY 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 Common stockholders vote for the board of directors and other issues Dividends are not considered a cost of doing business and are not tax deductible Dividends are not a liability of the firm and stockholders have no legal recourse if dividends are not paid An all equity firm can not go bankrupt merely due to debt since it has no debt Long Term Debt All long term debt securities are promises made by the issuing firm to pay principal when due and to make timely interest payments on the unpaid balance The maturity of a long term debt instrument is the length of time the debt remains outstanding with some unpaid balance Debt securities can be long or short also referred to as unfunded debt The two major forms of long term debt are public issue and privately placed The Bond Indenture Contract between the company and the bondholders that includes A description of property used as security if applicable The basic terms of the bonds The total amount of bonds issued Sinking fund provisions Call provisions Details of protective covenants Bond Classifications Registered Form The form of bond issue in which the registrar of the company records ownership of each bond Payment is made directly to the owner of
View Full Document
Unlocking...