Fundamental of Corporate Finance,chpt7

8/3/2019 Fundamental of Corporate Finance,chpt7

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Chapter 7

Interest Rates and

Bond Valuation

Prepared and Taught by Lecturer : YIN SOKHNG

E-mail: [email protected]

Tel:(855) 16889872 / 17989972

Chapter Outline

7.1 Bond Definition

7.2 More about Bond Features

7.3 Bond Ratings

7.4 Different Types of Bonds

7.5 Bond Markets

7.6 Inflation and Interest Rates

7.7 Determinants of Bond Yields7.8 Bond Risky

2Instructed by YIN SOKHENG, Master in Finance

3

7.1 Bond Definition

The corporation or government are borrow moneyfrom the public by issuing or selling debt securitiesthat are generically called bonds.

Normally an interest-only loan (when issued at par),the principal is paid until the end of the loan.

Interest paid in the form of a periodic coupon.

Term basis:

Shortterm basis

Longterm basis.

Instructed by YIN SOKHENG, Master in Finance


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The Bond Indenture Contract between the corporation (borrower)

and the creditor (bondholders) that includes The basic terms of the bonds

The total amount of bonds issued

A description of property used as security, if

applicable

Repayment agreements

Call provisions

Details of protective covenants

7.2 More about Bond Features


5

The Indenture Forms of a Bond

Registered Form: The corporation keeps track of the

owner.

Bearer Form: Certificate is the only evidence of ownership.

Security

Collateralsecured by other securities

Mortgagesecured by real property, normally land or

buildings; Chattel Mortgage (mortgage on a specific

property)

Debenturesunsecured bond with original maturity of 10

years or more Notesunsecured bond with original maturity less than 10

years


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Bonds Compared to Stock

Bondholders arecreditors

Bonds a liability

Interest is fixedcharge

Interest is expense

Interest tax deductible

No voting

Stockholders are owners

Stock is equity

Dividends not fixedcharges

Dividends not expense

Dividends not taxdeductible

Voting



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Bond Term

Par value (face value), F

Coupon rate, R

Coupon payment, C

Maturity date, T

Discount rate or Yield to maturity, r or YTM


8

7.3 Bond Ratings

Investment Quality High Grade

Moodys Aaa and S&P AAA capacity to pay is

extremely strong

Moodys Aa and S&P AA capacity to pay is verystrong

Medium Grade

Moodys A and S&P A capacity to pay is strong, but

more susceptible to changes in circumstances

Moodys Baa and S&P BBB capacity to pay isadequate, adverse conditions will have more impacton the firms ability to pay


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Bond Ratings - Speculative

Low Grade

Moodys Ba, B, Caa and Ca S&P BB, B, CCC, CC

Considered speculative with respect to capacity to

pay. The B ratings are the lowest degree of

speculation.

Very Low Grade

Moodys C and S&P C income bonds with no

interest being paid

Moodys D and S&P D in default with principal andinterest in arrears



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7.4 Different Types of Bonds

zero coupon bonds or discount bonds

e.g. T-billsOne year and less, no coupons

fixed payment loanse.g. mortgages, car loans- Between 3 and 15years

coupon bonds

e.g. -T-notesBetween 2 and 10 years,

-T-bondsLonger than 10 years,

-Corporate bondsLonger than 10 years

consols: no maturity date (forever).


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Zero coupon bonds

discount bonds

purchased price less than face value, F > P

face value at maturity

no interest payments

365

)(1

TrFP

P = Current price F = Face value r = discount rate T = Number of maturity date

Tr

FP

)1( OR


12

Zero coupon bonds

Yield to maturity, YTM

OR

1

360

d

P

Fr

r =F - P

P

x360

d



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Fixed-payment loan

loan is repaid with equal (monthly) payment, PMT

each payment is combination of principal and

interest

Tmmmi

PMT

i

PMT

i

PMTPV

1...

112

i

i

m

T

m

PVPMT

)1(

11


14

r is annual rate

(effective annual interest rate, EAR)

but payments are monthly, & compoundmonthly

r = (1+ im)12 -1

im = (1+ r)1/12 -1

im is the periodic rate

note: APR (annual percentage rate)

APR = im

x 12


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Coupon Bond

purchase price, PV

promised of a series of payments until maturity face value at maturity, F (principal, par value)

coupon payments (6 months), C

size of coupon payment

annual coupon rate, R

face value

6 mo. pmt.,C = (F x R)/2



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Value of a coupon bond = PV of coupon payment annuity+ PV of face value

0

C$

1

C$

2

C$

1T

FC $$

T

Information needed to value coupon bonds:Coupon payment dates and time to maturity (T)

Coupon payment (C) per period and Face value (F)

Coupon rate (R) and Discount rate (r or YTM)

TTr

F

rr

CPV

)1()1(

11


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PV, F and YTM

PV = F then YTM = coupon rate

PV < F then YTM > coupon rate (at a discount)

PV > F then YTM < coupon rate (at a premium)

PV and YTM move in opposite directions

interest rates and value of debt securities move in

opposite directions

if rates rise, bond prices fall

if rates fall, bond prices rise


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Interest Rate Risk

Price Risk

Change in price due to changes in interest rates

Long-term bonds have more price risk than short-

term bonds

Reinvestment Rate Risk

Uncertainty concerning rates at which cash flows

can be reinvested

Short-term bonds have more reinvestment rate risk

than long-term bonds



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Figure 7.2


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Current yield,

approximation of YTM for coupon bonds

ic =annual coupon payment, C

bond price, PV

ic


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Yield-to-maturity

Yield-to-maturity is the rate implied by the current

bond price Finding the YTM requires trial and error if you do not

have a financial calculator and is similar to the process

for finding r with an annuity

YTM = [C + (FPV)/T]/(F + PV)/2

C = Coupon payment

F = Face/Par value of bond

PV = Current price of bond

T = Maturity date



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Holding period return sell bond before maturity

return depends on

holding period interest payments

resale price

t

tt

tP

PP

P

CRET

1

giRETc


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Holding period return

RET : Rate of Return at Holding Period

: Current yield

C : Coupon payment

: Price at T period

: Price at T+1 period

g : Rate of Capital Gains or the Change of

Price

ic

PtPt+1


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Consols Bond

0

C$

1

C$

2

C$ ...$C

forever

r

CPV



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7.5 Bond Markets

Primarily over-the-counter transactions with

dealers connected electronically

Extremely large number of bond issues, butgenerally low daily volume in single issues

Makes getting up-to-date prices difficult,

particularly on small company or municipal

issues

Treasury securities are an exception


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Bond Quotations

Highlighted quote:

ATT 7 06 7.7 554 97.63 -0.38

What company are we looking at?

What is the coupon rate? If the bond has a $1000 face

value, what is the coupon payment each year?

When does the bond mature?

What is the current yield? How is it computed?

How many bonds trade that day?

What is the quoted price? How much did the price change from the previous day?


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Treasury Quotations

Highlighted quote:

9.000 Nov 18 133:27 133.28 24 5.78

What is the coupon rate on the bond?

When does the bond mature?

What is the bid price? What does this mean?

What is the ask price? What does this mean?

How much did the price change from the previous

day?

What is the yield based on the ask price?



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7.6 Inflation and Interest Rates

Real rate of interestchange in purchasing

power

Nominal rate of interestquoted rate ofinterest, change in purchasing power and

inflation

The ex ante nominal rate of interest includes

our desired real rate of return plus an

adjustment for expected inflation


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Inflation

if inflation is high

lenders demand higher nominal rate, especially

for long term loans

long-term i depends A LOT on inflation

expectations


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The Fisher Effect

The Fisher Effect defines the relationship

between real rates, nominal rates and inflation

(1 + R) = (1 + r)(1 + h), where

R = nominal rate

r = real rate

h = expected inflation rate

Approximation

R = r + h



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Inflation and Present Value

rrCPV

T

1

11

r = Discount rate


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Term Structure of Interest Rates

Term structure is the relationship between timeto maturity and yields, all else equal

It is important to recognize that we pull out theeffect of default risk, different coupons, etc.

Yield curvegraphical representation of theterm structure

Normalupward-sloping, long-term yields are

higher than short-term yields Inverted downward-sloping, long-term yields are

lower than short-term yields

7.7 Determinants of Bond Yields


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Figure 7.6.A. Upward-Sloping Yield Curve



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Figure7.6. B. Downward-Sloping Yield Curve


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7.8 Bond risky

Why are bonds risky?

Default risk

Risk that the issuer fails to make promised payments on

time

Zero for govt debt

Other issuers: corporate, municipal, foreign have somedefault risk

Greater default risk means a greater yield


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Inflation risk Most bonds promise fixed dollar payments

Inflation erodes the real value of these payments

Future inflation is unknown

Larger for longer term bonds

Interest rate risk Changing interest rates change the value (price) of a bond

in the opposite direction.

All bonds have interest rate risk

But it is larger for the long term bonds


Fundamental of Corporate Finance,chpt7

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