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Week 4 Notes

by: Dalton Anderson

Week 4 Notes FIN 3315 01

Dalton Anderson

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Notes from week 4 talking about bonds characteristics and valuation. talks about types of debt, common bonds, bond ratings, corporate bonds and much more.
Corporate Financial Management
Patti Calvert
Class Notes
bonds, Stocks, finance, Corporate, Money, investing
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This 3 page Class Notes was uploaded by Dalton Anderson on Wednesday February 10, 2016. The Class Notes belongs to FIN 3315 01 at Western Illinois University taught by Patti Calvert in Spring 2016. Since its upload, it has received 40 views. For similar materials see Corporate Financial Management in Finance at Western Illinois University.


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Date Created: 02/10/16
Finance 331 Corporate Financial Management Week 4 Note: For formulas, a Texas Instruments BAII Plus calculator was used. Chapter 6 A bond is a form of a loan. Bonds are 1. Advertised, 2. Sold to many investors, and 3. Offered to public. Debt Characteristics - Principle Value, Face Value, Maturity Value, and Par Value - Interest Payments – ???????????? ∗ ???????????????????????? = ???????????????????????????????? Par = $1000, Coupon Rate = 6% 1000(0.06) = 60/2 = $30 Interest on Bonds are paid twice a year - Maturity Date (3 months – 30 years) - Priority to Assets and Earnings – bankrupt = insolvent Bond holders will be paid before stockholders (Preferred stock then Common stock) - Bonds have no control of the firm Types of Short-Term Debt 1) Treasury Bills – U.S. Gov pays, $1,000 - $5mil, Sold at discount to par (Par = $1,000, Paid = $950). 2) Repurchase Agreement – Overnight – 2 weeks, Sell a security with a promise to repurchase it later at a higher price, security is collateral (lower yield). 3) Federal Funds – Overnight, unsecured, bank-to-bank loans, doesn’t involve consumer. 4) Banker’s Acceptance – A post-dated check, stamped paid, international trade, used to help work with a new partner overseas. 5) Commercial Paper – Large financially strong corporations, 1-270 days (under 9 months), Increments of $100,000, sold at a discount, if longer than 9 months they need to issue stocks. 6) Certificate of Deposit – Timed Deposit (1 month – 10 years), negotiable, can trade in market, $1mil - $5mil increments, covered under the FDIC. 7) Eurodollar Deposit – Deposit in a bank outside the U.S. not converted to the currency of that foreign country, dollar denominated, no exchange risk, less regulation, higher interest rate. 8) Money Market Mutual Funds – Investment funds pooled and managed. Long Term Debt 1) Term Loans – Private debt. Advantages – Speed, Flexibility, Low Issuance Cost. 2) Bonds – Long term contract  borrower agrees to pay principle and interest on the debt. Common Bonds 1) Government Bonds – U.S., State, and Local Governments issue A Treasury Note is for 1 year – 10 years A Treasury Bond is for 10 years – 30 years. Municipals  Income is tax free General Obligation (GO) is backed by the ability to tax Revenue – Backed by an income stream from the project 2) Corporate Bonds – Issued by corporations a) Mortgage Bond – Collateral is land and/or buildings. Safer  Lower Yield To Maturity (YTM) Finance 331 Corporate Financial Management Week 4 Note: For formulas, a Texas Instruments BAII Plus calculator was used. b) Debenture – Unsecured, if they don’t pay, you’re out of money. c) Subordinate Debenture – Subordinate (under) to a senior claim, Senior claim pays out first, it is riskier  Higher YTM Types of Corporate Bonds 1) Income Bond – Pays interest to holder only if that firm earns interest 2) Putable Bond – Can be redeemed at bondholder’s option 3) Indexed Bond – Interest payments based on inflation index, protects holder form inflation. If inflation index goes up, so does interest payments. 4) Floating-rate Bond – Rates “float” with the market interest rates, not with inflation rates. This is the safer choice. Zero Coupon Bonds – Bonds that pay no annual interest, sold at discount below par. Junk Bonds – High Yield, High risk, used to finance mergers, leverage buyouts, and troubled companies. Bond Contract Features  Indenture – A formal agreement between the issuer of the bond and the bondholders. Less risky, so lower yield. o Trustee – Someone who makes sure the bondholders interests are protected and that the terms or the agreement are carried out. o Restrictive Covenant – A provision in a debt contract that limits the actions of the borrower.  Call Provision – Gives the issuer the right to redeem the bonds under any specified terms before the maturity date. o Can redeem bond when rates start rising, even if to invest soon when rates are lower (smart idea).  Sinking Fund – A required annual payment designed to amortize a bond or preferred stock issue. Makes investment safer. o Firms can handle these 2 ways: 1. Call in for redemption a certain percentage of the bonds each year. 2. Buy the required amount of bonds on the open market.  Convertible Feature – Allows bonds to be turned into stocks. *Bonds may not be converted back after already converted to stocks. This is surely a gamble. Example: Conversion Ratio = 20, Par Value = $1,000 then 1,000/20 = $50, so as long as the stock price costs more than $50 (in this case) then it is a good idea. Though, the stock price could always drop lower, or vice versa. Bond Ratings - Very important - Tells you whether or not the bond is safe to invest in Finance 331 Corporate Financial Management Week 4 Note: For formulas, a Texas Instruments BAII Plus calculator was used. - Safest choice is always a “Blue-Chip Bond”, but anything in the “AAA” or “AA” are extremely safe. - An indicator of its default risk - Most bonds are purchased by institutional investors, they are legally restricted to investment-grade securities. - Changes in this can affect the firm’s ability to borrow long term capital and the cost of that capital. Investment Grade Bonds – The lowest rated bonds that many banks/institutions may hold by law. Bond Rating Criteria 1. Financial Strength 2. Collateral 3. Seniority of the debt 4. Restrictive Convents 5. Sinking Fund/Call Feature 6. Litigation 7. Regulation 8. Default Risk - Earnings - Pensions - Labor - Accounting - Business Overseas The value of anything is based on the present value of cash flows. The Basic Bond Valuation Model ????????= required rate of return on a debt instrument N = # of years before the bond matures INT = $ of interest paid a year (Coupon Rate × Par Value) M = Par value of the bond to be paid off at maturity Coupon Rate – The specified number of dollar of interest paid each period Calculator Example: Par = $1,000 10% = coupon rate 15 years 13% = interest rate So then the calculator functions would be, 1 N = 15 ???? = 13 PMT = -$100 FV = -$1,000 Then press CPT, PV and you should get $806.13


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