chapter 7. valuation and characteristics of bonds
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Chapter 7Chapter 7
Valuation and Characteristics Valuation and Characteristics of Bondsof Bonds
Chapter ObjectivesChapter Objectives
Different types of bondsFeatures of bondsTerm “Value”Process for valuing assetsValue of a bondExpected rate of returnRelationships in bond valuation
BondsBonds
Type of debt or long-term promissory note issued by a borrower, promising to pay the holder a fixed amount of interest per year.
Types of BondsTypes of Bonds
DebenturesSubordinated DebenturesMortgage BondsEuro BondsZero Coupon BondsJunk Bonds
DebenturesDebentures
Any unsecured long-term debtViewed as more risky than secured bonds
and provide a higher yield than secured bonds
Subordinated DebentureSubordinated Debenture
Hierarchy of payout in case of bankruptcyThe claims of subordinated debentures are
honored only after the claims of secured debt and unsubordinated debentures have been satisfied
Mortgage BondMortgage Bond
A bond secured by a lien on real propertyTypically the value of the real property is
greater than that of the bonds issued
Euro BondsEuro Bonds
Securities (bonds) issued in a country different from the one in whose currency the bond is denominated
Zero Coupon BondsZero Coupon Bonds
Do not make regular interest paymentsIssued at a significant discountReturn comes from appreciation of the
bond.Series EE government savings bonds—
purchase for $500, payback is $1,000
Junk BondsJunk Bonds
High risk debt with low ratings by Moody’s and Standard & Poor’s
High yield—typically pay Three to Five percent more than AAA grade long-term bonds
TerminologyTerminology
Claims on Assets and Income:In the event of insolvency, claims of debt , including bonds are honored before those of common or preferred stock.
Par Value: Face value of the bond, returned to the bondholder at maturity
Coupon Interest Rate: The percentage of the par value of the bond that will be paid out in the form of interest
Maturity: the length of time until the bond issuer returns the par value to the bondholder and terminates or redeems the bond.
Indenture: the legal agreement between the organization issuing the bond and the trustee who represents the bondholders
Current YieldCurrent Yield
Current yield: the ratio of the interest payment to the bond’s current market price.– Calculated by dividing the annual interest
payment by the market price of the bond– A $1,000 bond with 10% coupon rate and
market price of $700
Current yield = $100 / $700 = 14.286 %
Bond RatingsBond Ratings
Three agencies rate bonds:– Moody’s– Standard & Poor’s– Fitch Investor Services
The lower the rating, the higher the return demanded in the market
Bond RatingsBond Ratings
Bond ratings are favorably affected by:– Greater reliance on equity as opposed to debt
financing– Profitable operations– Low variability in past earnings– Large firms size– Little use of subordinated debt
Bond RatingsBond Ratings
AAA is the highest rating assigned by Standard & Poor’s
AAA indicates a strong capacity to pay principal and interest
ValueValue
Book value:value of an asset as shown on a firm’s balance sheet
Liquidation value: the dollar amount that could be realized if an asset were sold individually and not as part of a going concern.
Market value: the observed value for the asset in the marketplace
Intrinsic or economic value: also called fair value—the present value of the asset’s expected future cash flows
Efficient MarketEfficient Market
The values of all securities at any instant fully reflect all available public information, which results in the market value and the intrinsic value being the same
Determinants of ValueDeterminants of Value
For our purposes: The value of an asset is its intrinsic value or the present value of its expected future cash flows, when these cash flows are discounted back to the present using the investor’s required rate of return
Determinants:– Amount and timing of expected cash flows– Riskiness of the cash flows– Investor’s required rate of return for the investment
Bond ValuationBond Valuation
The value of a bond is a combination of:– The present value of the interest payments
Plus– The present value of the par or face value
Bond ValuationBond Valuation 1. The value of a bond is inversely related to
changes in the investor’s present required rate of return (the current interest rate). As interest rates increase, the value of the bond decreases.
2. The market value of a bond will be less than the par value if the investor’s required rate of return is above the coupon interest rate; the value will be above par value if the investor’s required rate of return is below the coupon interest rate.
3. Long-term bonds have greater interest rate risk than do short-term bonds.
Par ValuePar Value
When the investor’s required rate of return is equal to the coupon interest rate, the bond has a market value of par or face value
DiscountDiscount
The market value of a bond will be below the par or face when the investor’s required rate is greater than the coupon interest rate. The bond will sell at a Discount or below face value.
PremiumPremium
The market value of a bond will be above the par or face value when the investor’s required rate is lower than the coupon interest rate. The bond will sell at a Premium or above face value.
Price of a BondPrice of a BondCalculate the market value of price of a 5-year
$1,000 bond with an 8% coupon rate and the investor’s required rate of return is 8%.
Present Value of the interest payments --plus– the Present Value of the par or face value
Interest payments $1,000 x 8% = $80– 80 x 3.9927 = 319.42
PV of the face or par value– 1000 x .6806 = 680.60
Total value = $1,000
Price of a BondPrice of a Bond Calculate the market value of price of a 5-year
$1,000 bond with an 8% coupon rate and the investor’s required rate of return is 6%.
Present Value of the interest payments --plus– the Present Value of the par or face value
Interest payments $1,000 x 8% = $80– 80 x 4.2124 = 336.99
PV of the face or par value– 1000 x .7473 = 747.30
Total value = $1,084.29
Price of a BondPrice of a Bond
Calculate the market value of price of a 5-year $1,000 bond with an 8% coupon rate and the investor’s required rate of return is 10%.
Present Value of the interest payments --plus– the Present Value of the par or face value
Interest payments $1,000 x 8% = $80– 80 x 3.7908 = 303.26
PV of the face or par value– 1000 x .6209 = 620.90
Total value = $924.16
Present Value of $1Present Value of $1N 6% 8% 10% 12%
1 .9434 .9259 .9091 .8929
2 .8900 .8573 .8264 .7972
3 .8396 .7938 .7513 .7118
4 .7921 .7350 .6830 .6355
5 .7473 .6806 .6209 .5674
6 .7050 .6302 .5645 .5066
7 .6651 .5835 .5132 .4523
8 .6274 .5403 .4665 .4039
9 .5919 .5002 .4241 .3606
10 .5584 .4632 .3855 .3220
Present Value of AnnuityPresent Value of AnnuityN 6% 8% 10% 12%1 .9434 .9259 .9091 .89292 1.8334 1.7833 1.7355 1.69013 2.6730 2.5771 2.4869 2.40184 3.4651 3.3121 3.1699 3.03735 4.2124 3.9927 3.7908 3.60486 4.9173 4.6229 4.3553 4.11147 5.5824 5.2064 4.8684 4.56388 6.2098 5.7466 5.3349 4.96769 6.8017 6.2469 5.7590 5.328210 7.3601 6.7101 6.1446 5.6502
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