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# Corporate Finance FINC 3511

GPA 3.83

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This 18 page Study Guide was uploaded by Justus Rippin on Tuesday October 27, 2015. The Study Guide belongs to FINC 3511 at University of West Georgia taught by Ronald Best in Fall. Since its upload, it has received 61 views. For similar materials see /class/230217/finc-3511-university-of-west-georgia in Finance at University of West Georgia.

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Date Created: 10/27/15

CHAPTER 7 Bonds and Their Valuation Key features of bonds Bond valuation Measuring yield Assessing risk Key Features of a Bond 1 Par value Face amount paid at maturity Usually 1000 for corporate bonds 2 Maturity Years until bond must be repaid 3 Issue date Date when bond was issued Key Features of a Bond 4 Coupon interest rate Stated interest rate generally fixed Multiply by par to get of interest 5 Yield to maturity rate of return earned on a bond held until maturity also called the promised yield or expected return Effect of a call provision Allows issuer to refund the bond issue if rates decline helps the issuer but hurts the investor Borrowers are willing to pay more and lenders require more for callable bonds Most bonds have a deferred call and a declining call premium Other types features of bonds Convertible bond may be exChanged for common stOck of the rm at the holder s option Warrant longterm option to buy a stated number of shares of common stock at a speci ed price Putable bond allows holder to sell the bond back to the company prior to maturity Income bond pays interest only when interest is earned by the rm Indexed bond interest rate paid is based upon the rate of in ation Financial Asset Values The price of any asset should equal the present value based on an appropriate discount rate of its expected cash flows 2 n 11 1 CF2 CFn CF1 CF2 CFn V 1 2 1k 1k 1k The discount rate ki is the opportunity cost of capital ie the rate that could be earned on alternative investments of equal risk kikPMRPDRPLP The expected cash flows of a bond are the interest payments and the par value 7 What is the value of a 10year 10 coupon 1000 par bond if kd 10 1 2 10 10 I I I I I I V 100 100 100 1000 100 100 1000 B 1 10 10 1 kd 1 kd 1 kd 9091 3855 38554 1000 Formula I 2mg INTm Par B t11kdmt 1kdm N VB value of bond N number of years INT annual coupon payment Par par value kd annual discount rate m number of coupon pmts each year 9 Calculator The bond consists of a 10year 10 annuity of 100Iyear plus a 1000 lump sum at t 10 1o 10 100 1 61446 10 1000 10 IE 38554 1 61446 38554 PV annuity PV maturity value PV bond 1 The calculator can calculate the present value of the annuity and maturity value in one step always use end mode 1o 10 100 1000 E W 1ooo Bond Valuation using the calculator N total number of coupon payments discount rate expected return required return yieldtomaturity PV price of the bond FV Par value of bond PMT coupon payment each payment period USE THE END MODE What would happen if expected inflation rose by 3 causing k 100 1000 83721 When kcl rises above the coupon rate the bond s value falls below par so it sells at a discount What would happen if inflation fell and kd declined to 7 1o 7 100 1000 E 121o71 Price rises above par and bond sells ata premium if coupon gt kd If coupon rate lt kd discount If coupon rate kd par bond If coupon rate gt kd premium Nonannual Coupon Payments All calculator entries represent the same items if coupon payments are made during the year The only difference is that the N l and PMT must be adjusted to account for the nonannual payments Nonannual Coupon Payments What s the value of a 10year 12 quoted annual coupon bond with semiannual coupon payments if kd 10 m 2x10 102 1202 1000 E 112462 Find the value of 10year 10 coupon semiannual bond if kd 13 m 20 65 50 1000 E 83472 What is the yield to maturity YTM YTM is the rate of return earned on a bond held to maturity Also called the promised yield The yieldtomaturity is determined by solving for the discount rate implied by the current selling price of the bond All items are the same on the calculator you just solve for l What s the YTM on a 10year 9 annual coupon 1000 par value bond that sells for 887 887 90 1000 IIYR 1091 20 Find YTM if price were 113420 11342 90 1000 W R 708 Sells at a premium Because coupon 9 gt kcl 708 bond s value gt par 21 What s the quoted annual YTM on a 10year 9 coupon semiannual payment 1000 par value bond that sells for 887 10x2 887 902 1000 E IIYR 5441 Quoted annual YTM 5441 X 2 10882 22 How does adding a call provision affect a bond Issuer can refund if rates decline That helps the issuer but hurts the investor Therefore borrowers are willing to pay more and lenders require more on callable bonds Most bonds have a deferred call and a declining call premium 23 Yield to call using the calculator N total number39of coupon payments until bonds are callable YTC compute PV price of the bond FV Cal price of bond PMT coupon payment each payment period USE THE END MODE A 10year 10 semiannual coupon 1000 par value bond is selling for 113590 It can be called after 4 years at 1050 What is the bond s nominal yield to maturity YTM 10x2 11359 50 1000 E IIYR 400 YTM 400 X 2 800 25 What is the bond s nominal yield to call YTC To calculate YTC we replace N with the number of coupon payments prior to call and we replace FV with the price that must be paid to call the bonds 4x2 11359 50 1050 E IIYR 35684 YTC 35684 X 2 7137 26 Definitions Current yield A LLnnual co 0 mt Current price W Capital gaIns erld Beginning price Exp total Exp Exp cap return YTM Curr yld gains yld 27 Find current yield and capital gains yield for a 9 10year bond when the bond sells for 887 and YTM 1091 90 Currenterld 887 01015 1015 YTM Current yield Capital gains yield Cap gains yield YTM Current yield 1091 1015 076 28 What s interest rate or price Q Does a 1year or 10year 10 bond have more risk Interest rate risk Rising kcl causes bond s price to fall k51 Change 10year Change 5 1048 1386 gt48 gt386 10 1000 1000 gt 44 gt 251 15 956 749 29 What is reinvestment rate risk The risk that CFs will have to be reinvested in the future at lower rates reducing income If you invest in a multiyear bond you get the same interest rate each year until maturity If you invest in a oneyear bond you get the stated interest rate the first year The next year you have to reinvest at the prevailing interest rate 30 Ilnterest rate and Reinvestment rate risk I Longterm bonds High interest rate risk low reinvestment rate risk Shortterm bonds Low interest rate risk high reinvestment rate risk Nothing is completely riskless 31 Do all bonds of the same maturity have the same price and reinvestment rate risk No low coupon bonds have less reinvestment rate risk but more price risk than high coupon bonds 32 Types of Bonds Mortgage bon d a bond backed by fixed assets Debenture a longterm bond that is not secured by a mortgage on specific property Subordinated debenture a bond having a claim on assets only after the senior debt has bee paid off in the even of liquidation 33 Bond Default Risk If the issuer defaults investors receive less than the promised return Therefore the expected return on corporate and municipal bonds is less than the promised return The difference is dependent on the risk of default 34 Bond Ratings Provide One Measure of Default Risk Investment Grade Junk Bonds Moody s Aaa Aa A Baa Ba B Caa C SampP AAA AA A BBB BB B CCC D 35 What factors affect default risk and bond ratings Financial performance Debt ratio TIE ratio Current ratio Provisions in the bond contract Secured vs unsecured debt Senior vs subordinated debt Guarantee provisions Sinking fund provisions Debt maturity Other factors Earnings stability Regulatory environment Potential product liability Accounting policies 36

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