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