Review Session 2

(Finance-2021)

Nazanin Babol
What is Financial Management All About?

➢Capital
Financial
Markets:
Structure
1-bonds Decisions (1)
2-stocks
3-bank loans ➢Project
…
Evaluation
(4a)
➢Distribution
Policies (4b)
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Outline

➢ Bonds

➢ Principles
➢ Pricing a Bond
➢ Determinants of the Yield to Maturity
➢ Bonds with Embedded Options

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Bonds vs bank loans
➢ Borrowing cash for our projects from others

Bonds Bank loans

Longer tenure (flexible) Shorter tenure (less flexible)
Less restrictions Debt covenants
Hard to renegotiate Renegotiable
Issuing bonds is neither easy
nor cheap

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 Principle: Issuing & Trading Bonds
✓ Company gets support from investment banks to issue the bonds (underwriting):
• Value the bonds
• Sell the bonds to investors

✓ Trading Bonds:
Primary market
• Company sells bonds to investors.

Secondary market
• Investors buy and sell bonds to
each other.
• The company does not participate
in these transactions
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Principle: Cash Flows from a Bond
 Face value or par value
 Principal of the loan
 Standardized, e.g.$100 or $1000
 Paid off on maturity date

 Coupon payment
 Coupon rate determines the periodical payments
 Coupons could be made annually or semi-annually
 Can be zero
 Floating/variable versus fixed

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Pricing a Bond
 The price of a bond is the present value of the coupon payments and
the face value of the bond. 0 C C C C+F

0 1 2 ….. T-1 T
 This formula works for a bond with standard cashflow, general case
bond
𝐶 1 𝐹
 𝑃𝑉 = 1− +
𝑟 1+𝑟 𝑇 (1+𝑟)𝑇

PV (Coupon annuity) PV(F)

 C-the coupon paid each period

 T –the number of periods remaining until the maturity date
 F –the bond’s face value
 r –the discount rate or YTM, i.e Yield to Maturity (previously we called
interest rate when we talked about investment )

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Pricing a Bond

 Yield to maturity = coupon rate! the bond is selling at par

 Yield to maturity < coupon rate! the bond is selling at premium
 Yield to maturity > coupon rate! the bond is selling at discount

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Pricing a Bond
Q1 . All else equal, the market value of a corporate bond is always inversely related to its:

I. time to maturity. II. coupon rate III. yield-to-maturity.

A. I only
B. II only
C. III only
D. I and III only
➢ Bond value should be always inversely related to yield-to-
maturity. This is because YTM is the discount rate.
➢ Bond value is inversely related to time to maturity (the T in
𝐶 1 𝐹
𝑃𝑉 = 1− + the formula) when the coupon rate is smaller than YTM.
𝑟 1+𝑟 𝑇 (1 + 𝑟)𝑇 ➢ However, bond value should be positively related to time to
maturity when the coupon rate is greater than YTM.
➢ Bond price should be always positive related to coupon rate,
because coupon rate determines the C in the formula.
Bond Pricing via Excel

 A) Calculate Price Of A Zero-Coupon Bond In Excel

 B) Calculate Price Of An Annual Coupon Bond In Excel

 C) Calculate Price Of A Semi-Annual Coupon Bond In Excel

 Bond Pricing via Excel
A) Calculate Price Of A Zero-Coupon Bond In Excel
Q2. A company just issued zero-coupon bonds. The bond has a face value of $1,000 and
matures within 10 years from now. What is the market price of the bond, if the yield to
maturity (YTM) is 5%?

Yield to Maturity Yield to Maturity

x -1
=$613.91
Note: In above formula, B4 is the yield to maturity, B3 is the maturity year, 0 means no
coupon, and B2 is the face value.
Bond Pricing via Excel
 B ) Calculate Price Of An Annual Coupon Bond In Excel
Q3. A 10-year, 2.5 percent coupon bond pays interest annually. The bond has a face
value of $1,000. What is the price of this bond if the market yield is 4%?

Yield to Maturity Yield to Maturity

x -1
=$878.34

Note: In above formula, B11 is the yield to maturity, B12 is the maturity year, B10 is the face
value, and B10*B13 is the coupon you will get every year.
Bond Pricing via Excel

 Q4. Buddy Tyres is preparing a bond offering with a 2.5 percent coupon rate. The
bonds will be repaid in 10 years. The company plans to pay interest semi-annually.
The face value of the bond and YTM are $1000 and 4%, respectively. Given this,
price the bond?

Yield to Maturity

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Bond Pricing via Excel
 C) Calculate Price Of A Semi-Annual Coupon Bond In Excel

Yield to Maturity
Yield to Maturity

x -1
=$877.36

Note: Note: In above formula, B20 is the annual YTM, B22 is the number of
actual periods, B19*B23/2 gets the coupon, and B19 is the face value.
Pricing a Bond
Q5. A 12-year, 5 percent coupon bond pays interest annually. The bond has a face value
of $1,000. What is the change in the price of this bond if the market yield rises to 6
percent from the current level of 4.5 percent?

A. 11.11 percent decrease

B. 12.38 percent decrease
C. 12.38 percent increase
D. 14.13 percent decrease

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Solution
Step 1: Find the bond price before the interest rate change
$F = $1000
The bond pays annual coupons. $C = 5% * $1000 = $50
r = YTM = 4.5%
T = # of years to maturity = 12

Step 2: Find the bond price after the interest rate change
$F = $1000
The bond pays annual coupons. $C = 5% * $1000 = $50
r = YTM = 6%
T = # of years to maturity = 12

Step 3: Calculate the percentage o change in bond price= ($916.16 - $1045.59)/$1045.59 = -12.38%
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Determinants of the Yield to Maturity
➢ YTM reflects the discount rate used by the market to value the
bond
➢ One can view YTM as the sum of four major components
1) risk-free rate=yield on the short-term government debt (time value of
money)
2) default risk premium
3) interest-rate risk premium
4) risk premium/discount for embedded options

➢ Use the Rate function in Excel to find YTM

➢ rate (nper, pmt, -pv, fv)
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Determinants of the Yield to Maturity
Q6. The bonds issued by H&M Enterprises bear a 4 percent coupon which is payable
semi-annually. The bonds mature in 10 years and have a $1,000 face value. Currently,
the bonds sell at a price of $1020 per bond. What is the yield to maturity?
A. 1.88 percent
B. 3.76 percent Solution:
Rate (nper, pmt, -pv, fv)
C. 1.77 percent
D. 3.64 percent Semi-annually YTM =Rate(20, 20, -1020, 1000) = 1.88%

YTM = 2 * Semi-annually YTM = 3.76%

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Determinants of the Yield to Maturity
(Default Risk Premium)
Q7. Eagle Mining Co. has a B credit rating. The table below lists credit ratings and
credit spreads for a set of corporate bonds issued by other companies. The yield on
government bonds is 2.6%. Using the provided information, what is the estimated YTM
for a bond issued by Eagle Mining Co.? (i.e., credit spreads = default risk premium;
yield on government bonds = risk-free rate)

A. 6.32% Credit ratings and credit spreads for a set of corporate

B. 4.75% bonds issued by other companies
C. 4.25% Bond Credit rating Credit spread (%)
BN 1 A 2.75
D. 5.89% BN 2 B 4.22
BN 3 BB 4.65
BN 4 B 3.22
BN 5 BB 4.30
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 Estimating cost of debt when firm has no bonds
➢ Solution:
➢ Eagle Mining Co. has a B credit rating.
Credit ratings and credit spreads for a set of corporate bonds issued by other companies
Bond Credit rating Credit spread (%)
BN 1 A 2.75
BN 2 B 4.22
Step 1: BN 3 BB 4.65
BN 4 B 3.22
BN 5 BB 4.30

Step 2: Estimate Credit spread : (4.22% + 3.22%) / 2 = 3.72%

Step 3: Estimate YTM for the firm using the formula: YTM = RF + Credit Spread :
YTM = 2.6% + 3.72% = 6.32% 20
Bonds with Embedded Options
 Callable bond.
 option to call the bond back is favorable to the issuer
 will be traded at discount relative to a similar straight bond
 YTM on callable bond >YTM on a similar straight bond
 Convertible bond.
 option to convert the bond into company shares is favorable to the
 bond holder
 will be traded at premium relative to a similar straight bond
 YTM on convertible bond <YTM on a similar straight bond

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Bonds with Embedded Options
Q8. The embedded options for call found on most publicly issued bonds are
advantageous to the ______ because _____________________.

A. issuer; it allows issuing firms to purchase back the bonds if interest rates move
favourably
B. buyer; it allows buyers to sell back their bonds to the issuer if interest rates move up
C. government; issuing companies and buyers have to pay higher taxes on these bonds
D. buyer; these bonds typically have lower coupon rates

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Bonds with Embedded Options
Q9. Everything else the same, a Convertible bond price should be ___________ a
straight bond.

A. greater than
B. smaller than
C. the same as

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