Bond Valuation Summary & Notes
Transcript of Bond Valuation Summary & Notes
Bond/ Debt Valuation (Ch 9 Titman, Ch 7 Keown)
VYE Summary & Notes
Chapter 9: Coverage • Corporate Debt
• Valuing Corporate Debt
• Bond Valuation- 4 Key Relationships
• Types of Bonds
• Inflation and rates of return
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Corporate Debt
• Firms can borrow
A. Private financial markets thru various types of financial institutions
1. Floating rate or fixed rate loans
(LIBOR rate, pdex)
2. Funds for working capital or transactions
3. Debt unsecured or unsecured
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Corporate Debt
• Firms can borrow B. Public financial markets by issuing corporate bonds which differ on a variety of features.
1. Bond indenture
2. Claim on assets
3. Par value
4. Coupon rate of interest
5. Maturity
6. Call provision or conversion feature
7. Bond ratings default risk 3
Corporate Debt
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Valuing Corporate Debt
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• Required/ expected rate of return = YTM
• Interest rate = coupon rate
• Par value = maturity value $1,000; date
• Bond value Vb = market value = intrinsic value
= present value of coupon interest payments
and the principal amount (par value)
• Purpose: higher returns, higher risk, but
cheaper than common stock
Valuing Corporate Debt
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Vb = PV of interest payments as an annuity
+ PV of maturity value
Vb = Interest pmt x PVIFA i, n + $1000 x PVIF i,n
Bond Valuation: Four Key Relationships
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1. Value inversely related to changes in
YTM
2. MV < $1,000 if YTM> i (discount)
MV > $1,000 if YTM< i (premium)
3. As n maturity, MV $1,000 par value
4. LT bonds have > interest risk than ST
bonds
Types of Bonds
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There are a variety of types of bonds depending
on their characteristics, usually a function of
the following bond attributes:
1. Secured vs unsecured
2. Priority of claim
3. Initial offering market
4. Abnormal risk
5. Coupon level
6. Amortizing or
non-amortizing
7. Convertibility
Types of Bonds
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Determinants of Interest Rates
• Interest rates are affected by the real rate
of interest and the inflation premium
•Risk of default = possibility that bond
issuer will fail to repay the borrowed
amount
Add a premium to interest rates to
reflect risk of default
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Determinants of Interest Rates
•As n (bond’s maturity) becomes longer,
the more the bond price fluctuates when
interest rates change.
A maturity premium reflects this risk
Term Structure of interest rates
reflects relationship between time to
maturity and interest rates (all other
variables constant)
Inflation, Rates of Return, and the Fisher Effect
Interest
Rates
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Conceptually:
Nominal
risk-free
Interest
Rate
rnominal
=
Real
risk-free
Interest
Rate
rreal
+
Inflation-
risk
premium
rinflation
Mathematically:
(1 + rnominal) = (1 + rreal) (1 + rinflation)
This relationship is known as the “Fisher Effect”
Interest Rates
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Interest Rates Suppose the real rate is 3%, and the nominal rate is 8%.
What is the inflation rate premium?
(1 + rnominal) = (1 + rreal) (1 + rinflation)
(1.08) = (1.03) (1 + rinflation)
(1 + rinflation) = (1.0485), so
rinflation = 4.85%
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Interest Rates
To simplify:
rnominal = rreal + rinflation + rreal x rinflation
r = R + i + R i
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REFERENCES:
Titman, S., Keown, A.j, Martin, J.D., (2011). Financial Management:
Principles and Applications. (11th Ed.). Pearson Education, Pearson/Prentice Hall
Keown, A.J., Martin, J.D., Petty, J.W., Scott Jr, D.F., Financial Management: Principles and Applications, 10th Edition, Pearson Prentice Hall 2005
Gitman, L. J. Principles of Managerial Finance, (11th ed.) Massachusetts: Addison Wesley Longman
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