Transcript Foundations of Finance
Chapter 7
Characteristics of Bonds
Bonds pay fixed coupon (interest) payments at fixed intervals (usually every 6 months) and pay the par value at maturity .
example: AT&T 8 24
par value = $1000
coupon = 8% of par value per year.
= $80 per year ( $40 every 6 months).
maturity = 24 years (matures in 2024 ).
issued by AT&T.
Types of Bonds
Debentures - unsecured bonds.
Subordinated debentures “junior” debt.
- unsecured
Mortgage bonds - secured bonds.
Zeros - bonds that pay only par value at maturity; no coupons. (example: Series EE government savings bonds.)
The Bond Indenture
The bond contract between the firm and the trustee representing the bondholders.
Lists all of the bond’s features: coupon, par value, maturity, etc.
Lists restrictive provisions which are designed to protect bondholders.
Describes repayment provisions.
Value
Book Value: value of an asset as shown on a firm’s balance sheet; historical cost.
Liquidation value: amount that could be received if an asset were sold individually.
Market value: observed value of an asset in the marketplace; determined by supply and demand.
Intrinsic value: economic or fair value of an asset; the present value of the asset’s expected future cash flows.
Security Valuation
In general, the intrinsic value of an asset = the present value of the stream of expected cash flows discounted at an appropriate required rate of return.
Can the intrinsic value of an asset differ from its market value ? (YES!)
Bond Valuation
Discount the bond’s cash flows at the investor’s required rate of return.
the coupon payment stream (an annuity).
the par value payment (a single sum).
Bond Example
Suppose our firm decides to issue 20-year bonds with a par value of $1,000 and annual coupon payments. The return on other corporate bonds of similar risk is currently 12%, so we decide to offer a 12% coupon interest rate.
What would be a fair price for these bonds?
0 120 1 120 2 120 . . . 1000 120 3 . . .
20 N = 20 I%YR = 12 FV = 1,000 PMT = 120 Solve PV = -$1,000 Note: If the coupon rate = discount rate , the bond will sell for par value .
Suppose interest rates fall immediately after we issue the bonds. The required return on bonds of similar risk drops to 10% .
What would happen to the bond’s intrinsic value?
N = 20 I%YR = 10 PMT = 120 FV = 1000 Solve PV = $1,170.27
Note: If the coupon rate > discount rate , the bond will sell for a premium .
Suppose interest rates rise immediately after we issue the bonds. The required return on bonds of similar risk rises to 14% .
What would happen to the bond’s intrinsic value?
N = 20 I%YR = 14 PMT = 120 FV = 1000 Solve PV = $867.54
Note: If the coupon rate < discount rate , the bond will sell for a discount .
Yield To Maturity
The expected rate of return on a bond.
The rate of return investors earn on a bond if they hold it to maturity.
YTM Example
Suppose we paid $898.90
for a $1,000 par 10% coupon bond with 8 years to maturity and semi-annual coupon payments.
What is our yield to maturity ?
YTM Example
N = 16 PV = -898.90
PMT = 50 FV = 1000 Solve I%YR = 6 % 6%*2 = 12%
Current 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 %