chapter 6 introduction

Hospitality Financial ManagementBy Robert E. Chatfield and Michael C. Dalbor

©2005 Pearson Education, Inc.Pearson Prentice HallUpper Saddle River, NJ 07458

6-1

Chapter 6Introduction

This chapter introduces bonds and preferred stock.

Bonds and preferred stock are known as fixed income securities because the cash return expected in the future is fixed and is not expected to vary.



6-2

Organization of Chapter 6 Bond topics

Terminology and bond features Bond ratings Valuation and yield to maturity computations

Preferred stock topics Terminology and preferred stock features Valuation and yield to maturity computations



6-3

Bond Terminology

A bond is essentially a long-term loan from the investor to the issuing corporation.

A bond’s par value is the amount paid back at maturity. Bond par values are usually $1,000.

Bonds usually pay interest every 6 months. The interest paid is called a coupon payment and the annual interest rate is called a coupon rate.



6-4

Bond Terminology

A mortgage bond is backed by collateral. A debenture is not secured by collateral but

is still backed by the corporation’s cash flow. A bond’s seniority refers to the order in

which debts are paid off in case of financial difficulty. Terms denoting seniority include: Senior and junior Unsubordinated and subordinated



6-5

Bond Features

An indenture is the contract governing a bond. The indenture describes the features of a bond, including:

Interest rate and maturity Call and put features Sinking funds Any equity links



6-6

Bond Features

An indenture will also include a number of restrictive covenants restricting the actions of the issuing corporation to include:

Limitations on dividend payments Limitations on additional debt Limitations on other specified activities that

could increase risk to the bond investor



6-7

Bond Ratings

Moody’s and S & P both rate bonds for the level of default risk.

Moody’s: Aaa, Aa, A, Baa, Ba … CC, C S & P: AAA, AA, A, BBB, BB, … CC, C, D

Higher bond ratings (Aaa or AAA) indicate lower default risk. Bonds with lower risk will have lower interest cost.



6-8

Valuing Corporate Bonds

The value of a bond is simply the present value of the cash flows an investor expects to receive. The cash flows are:

The coupon payment every 6 months. This is equal to the coupon rate times the par value divided by 2.

The par value at maturity.



6-9


Suppose a 15-year corporate bond has a 10% coupon rate and a $1,000 par value. For simplicity assume the coupon is paid once a year. What is the value of this bond today if an investor requires a 10% rate of return?

The value will be the present value of the coupon payment (an annuity) plus the present value of the par value (a lump sum).



6-10


The general equation for the value of a bond is:

Computing the bond value in this example:

( )( )nbb

nb

b i1$1,000

ii11 - 1

x C V+

+

⎥⎥⎥⎥

⎦

⎤

⎢⎢⎢⎢

⎣

⎡+=

( )( )

00.000,1$10%1

$1,00010%

10%11 - 1

x $100 V 15

15

b =+

+

⎥⎥⎥⎥

⎦

⎤

⎢⎢⎢⎢

⎣

⎡+=



6-11


In the last example the rate of return and the coupon rate were the same. What happens to a bond’s value when the market rate of interest is less than the coupon rate?

( )( )

19.171,1$%81

$1,0008%

8%11 - 1

x $100 V 15

15

b =+

+

⎥⎥⎥⎥

⎦

⎤

⎢⎢⎢⎢

⎣

⎡+=



6-12


In the last example the rate of return was less than the coupon rate. What happens to a bond’s value when the market rate of interest is greater than the coupon rate?

( )( )

78.863$%121

$1,00012%

12%11 - 1

x $100 V 15

15

b =+

+

⎥⎥⎥⎥

⎦

⎤

⎢⎢⎢⎢

⎣

⎡+=



6-13

Valuing Corporate Bonds Relationship between market rate of return, coupon

rate, and bond value.

Market rate > Coupon rate Bond value < Par value

Market rate = Coupon rate Bond value = Par value

Market rate < Coupon rate Bond value > Par value



6-14

Corporate Bonds’ Yield to Maturity

A bond’s yield to maturity is the investor’s rate of return if the investor buys the bond and holds it to maturity without any default.

We use the same bond valuation equation, except now we specify the bond’s value and solve for the market rate of interest.



6-15

Corporate Bonds’ Yield to Maturity

Suppose an investor buys our 15-year 10% coupon bond for $900. Use $900 for the value of the bond:

The investor’s yield to maturity is:

( )( )15

bb

15b

i1$1,000

ii11 - 1

x $100 $900.00+

+

⎥⎥⎥⎥

⎦

⎤

⎢⎢⎢⎢

⎣

⎡+=

11.42% ib =



6-16

Bonds with Semi-Annual Coupon Payments Most bonds pay interest every 6 months.

Adjust the bond valuation equation as follows: The annuity payment is the annual

coupon payment divided by 2. The number of annuity payments is the

number of 6 month coupon payments until maturity.

The appropriate interest rate is a 6-month rate.



6-17

Bonds with Semi-Annual Coupon Payments

Let’s use the earlier example of a 15-year bond with a 10% coupon rate, 15 years to maturity and a 12% required rate of return. If the coupon is paid semi-annually, the value is:

( )( )

35.862$%61

$1,0006%

6%11 - 1

x $50 V 30

30

b =+

+

⎥⎥⎥⎥

⎦

⎤

⎢⎢⎢⎢

⎣

⎡+=



6-18

Bonds with Semi-Annual Coupon Payments Assume this bond is selling for $900. What is the

investor’s yield to maturity?

The investor’s yield to maturity from the equation is 5.70% semi-annually. Multiply this by 2 to obtain an 11.40% nominal annual rate of return compounded semi-annually.

( )( )30

bb

30b

i1$1,000

ii11 - 1

x $50 $900+

+

⎥⎥⎥⎥

⎦

⎤

⎢⎢⎢⎢

⎣

⎡+=



6-19

Preferred Stock Preferred stock has a “preference” over

common stock on a firm’s cash flows and assets. This seniority of preferred stock over common stock is the source of the name “preferred.”

Preferred stock has a par value of $25, $50, or $100. The dividend is paid quarterly but is usually expressed as an annual amount.

“Six Flags $1.81 preferred” pays $1.81 in dividends annually.



6-20

Preferred Stock Features Dividends

Typically fixed Some adjustable-rate Some participating in firm’s earnings to a limited

extent

No stated maturity but may be redeemed through: A call feature A sinking fund

Most preferred stock is cumulative.



6-21

Valuing Preferred Stock

For introductory purposes we will assume preferred stock pays a dividend once a year and will not be redeemed in the future. If preferred stock has a fixed dividend and no redemption, then it can be viewed as a perpetuity and valued as follows:

p

pp i

d V =



6-22

Valuing Preferred Stock

If an investor requires an 11% rate of return on Sullivan Resorts $2.50 preferred, then the value of the preferred stock is:

73.22$11%$2.50 Vp ==



6-23

Computing Rate of Return on Preferred Stock

If an investor buys Sullivan Resorts $2.50 preferred for $20, what is the investor’s expected rate of return?

%50.12$20.00$2.50

Vd

ip

pp ===



6-24

Summary of Chapter 6 Topics

Corporate bonds Terminology and features Ratings Valuation and yield to maturity

Preferred stocks Terminology and features Valuation and rate of return

chapter 6 introduction

Documents