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1. 2. 3. 4. 5. 6. 7. Distinguish between different kinds of bonds. Explain the more popular features of bonds. Define the term value as used for several different purposes. Describe the basic process for valuing assets. Estimate the value of a bond. Compute a bondholders expected rate of return. Explain three important relationships that exist in bond valuation.

OBJECTIVE 1

TYPES OF BONDS

A bond is a type of debt or long-term promissory note, issued by the borrower, promising to pay its holder a predetermined and fixed amount of interest per year. However, there are a wide variety of such creatures. Just to mention a few, we have Debentures Subordinated debentures Mortgage bonds Eurobonds Zero and very low coupon bonds Junk bonds We will briefly explain each of these types of bonds.

Debentures

The term debentures applied to any unsecured long-term debt.

Subordinated debentures

Many firms have more than one issue of debentures outstanding. In this case a hierarchy may be specified, in which some debentures are given subordinated standing in case of insolvency.

Mortgage bonds

A mortgage bond is a bond secured by a lien on real property.

Eurobonds

Eurobonds are not so much a different type of security as they are securities, in this case bonds, issued in a country different from the one in whose currency the bond is denominated.

Zero and very low coupon bonds allow the issuing firm to issue bonds at a substantial discount from their $1,000 face value with a zero or very low coupon rate.

Junk bonds

Junk bonds are high-risk debt with ratings of BB or below by Moodys and Standard and Poors. Junk bonds are also called highyield bonds for the high interest rates they pay the investor, typically having an interesting rate of between 3 and 5 percent more than AAA grade long-term debt.

Take on Additional Risk Unless We Except to be Compensated with Additional Return.

Some of the more important terms and characteristics that you might hear about bonds are as follows: Claims on assets and income Par value Coupon interest rate Maturity Indenture Current yield Bond ratings Lets consider each in turn.

In the case of insolvency, claims of debt in general, including bonds, are honored before those of both common stock and preferred stock. However, different types of debt may also have a hierarchy among themselves as to the order of their claim on assets. Bonds also have a claim on income that comes ahead of common and preferred stock. In general if interest on bonds is not paid, the bond trustees can classify the firm as insolvent and force it into bankruptcy. Thus, the bondholders claim on income is more likely to be honored than that of common and preferred stockholders, whose dividends are paid at the discretion of the firms management.

Par value

The par value of a bond is its face value that is returned the bondholder at maturity.

The coupon interest rate on a bond indicates the percentage of the par value of the bond that will be paid out annually in the form of interest.

Maturity

The maturity of a bond indicates the length of time until the bond issuer returns the par value to the bondholder and terminates or redeems the bond.

Indenture

An Indenture is the legal agreement between the firm issuing the bonds and the bond trustee who represents the bondholders.

Current yield

The current yield on a bond refers to the ratio of the annual interest payment to the bonds current market price.

Bond Ratings

These ratings involve a judgment about the future risk potential of the bond. Bond ratings are favorably affected by (1) a greater reliance on equity as opposed to debt in financing the firm, (2) profitable operations, (3) a low variability in past earnings, (4) large firm size, and (5) little use of subordinated debt. The poorer the bond rating, the higher the rate of return demanded in the capital markets. Table 6-1 provides an example and description of these ratings.

Table 6-1 Standard and Poors Corporate Bond Ratings AAA This is the highest rating assigned by Standard and Poors for debt obligation and indicates an extremely strong capacity to pay principal and interest. AA Bonds rated AA also qualify as high-quality debt obligations. Their capacity to pay principal and interest is very strong, and in the majority of instances they differ from AAA issues only in small degree. A Bonds rated A have a strong capacity to pay principal and interest, although they are somewhat susceptible to the adverse effects of changes in circumstances and economic conditions. BBB Bonds rated BBB are regarded as having an adequate capacity to pay principal and interest. Whereas they normally exhibit adequate protection parameters, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay principal and interest for bonds in this category than for bonds n the A category. BB Bonds rated BB, B, CCC, and CC are regarded, on balance, as B predominantly speculative with respect to the issuers capacity to pay CCC interest and repay principal in accordance with the terms of the obligation. CC BB indicates the lowest degree of speculation and CC the highest. While such bonds will likely have some quality and protective characteristics, these are outweighed by large uncertainties or major risk exposures to adverse conditions. C The rating C is reserved for income bonds on which no interest is being paid D Bonds rated D are in default, and payment of principal and/or interest is in arrears. Plus (+) or Minus (-): To provide more detailed indications of credit quality, the ratings from AA to BB may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories.

Book value is the value of an asset as shown on a firms balance sheet. Liquidation value is the dollar sum that could be realized if an asset were

value is the present value of the assets expected future cash flows. This value is the amount an investor should be willing to pay, given the amount, timing, and riskiness of future cash flows.

Axiom 6: Efficient Capital MarketsThe Markets Are Quick and the Prices Are Right. In an efficient market, the price reflects all available public information about the security, and therefore it is priced fairly.

VALUATION: AN OVERVIEW

For our purposes, the value of an asset is its intrinsic value or the present value of its expected future cash flows, where these cash flows are discounted back to the present using the investor's required rate of return. This statement is true for valuing all assets and serves as the basis of almost all that we do in finance. Thus, value is affected by three elements: 1. The amount and timing of the asset's expected cash flows 2. The riskiness of these cash flows 3. The investor's required rate of return for undertaking the investment

Axiom 1: The Risk-Return Trade-off--We Wont Take on Additional Risk Unless We Expect to Be Compensated With Additional Return. Axiom 2: The Time Value of Money--A Dollar Received Today Is Worth More Than a Dollar Received in the Future. Axiom 3: CashNot Profits--is King.

1. Assessing the asset's characteristics, which include the amount and timing of the expected cash flows and the riskiness of these cash flows; 2.Determining the investor's required rate of return, which embodies the investor's attitude about assuming risk and perception of the riskiness of the asset; and 3. Discounting the expected cash flows back to the present, using the investors required rate of return as the discount rate.

(1 k )

t 1

Ct

A basic security valuation model can be defined mathematically as follows: V = C1/(1+k)1 + C2/(1+k)2 + + Cn /(1+k)n where 6-2

Ct = cash flow to be received at time t V = the intrinsic value or present value of an asset producing expected future cash flows, Ct, in years 1 through n K=the investors required rate of return

Using equation (6-2), there are three basic steps in the valuation process: Step l: Estimate the Ct in equation (6-2), which is the amount and timing of the future cash flows the security is expected to provide. Step 2: Determine k, the investor's required rate of return. Step 3: Calculate the intrinsic value, V, as the present value of expected future cash flows discounted at the investor's required rate of return.

The valuation process for a bond, as depicted in Figure 6-2, requires knowledge of three essential elements: (1)the amount of the cash flows to be received by the investor, (2)the maturity date of the loan, and (3)the investors required rate of return.

EXAMPLE Consider a bond issued by American Airlines with a maturity date of 2016 and a stated coupon rate of 9 percent. In 1996, with 20 years left to maturity, investors owning the bonds were requiring an 8.4 percent rate of return. We can calculate the value of the bonds to these investors using the following three-step valuation procedure:

Step 1: Estimate the amount and timing of the expected future cash flows. Two

type of cash flows are received by the bondholder: a. Annual interest payments equal to the coupon rate of interest times the face value of the bond. In this example the bonds coupon interest rate is 9 percent; thus the annual interest payment is $90=0.09$1,000. Assuming that 1996 interest payments have already been made, these cash flows will be received by the bondholder in each of the 20 years before the bond matures (1997 through 2016 = 20 years). Figure 6-2 Data Requirements for Bond Valuation b. The face value of the bond of $l,000 to be received in 2016. To summarize, the cash flows received by the bondholder are as follows: YEARS 1 2 3 4 $90 $90 $90 $90 19 20 $90 $90 +$1,000 $1,090

the riskiness of the bond's future cash flows. An 8.4 percent required rate of return for the bondholders is given. In Chapter 8, we will learn how this rate is determined. For now, simply realize that the investors required rate of return is equal to a rate earned on a risk-free security plus a risk premium for assuming risk.

Step 3: Calculate the intrinsic value of the bond as the present value

of the expected future interest and principal payments discounted at the investor's required rate of return. The present value of American Airlines bonds is found as follows: bond value = Vb =$ interest in yare 1/(1+required rate of return)1 +$ interest in year 2/(1+required rate of return)2 + +$ interest in year 20/(1+required rate of return)20 +$ par value of bond/(1+required rate of return)20

(6-3a)

In the preceding American Airlines illustration, the interest payments were assumed to be paid annually. However, companies typically pay interest to bondholders semi-annually. First, thinking in terms of periods instead of years, a bond with a life of n years paying interest semiannually has a life of 2n periods. In other words, a five-year bond (n=5) that remits its interest on a semiannual basis actually, makes 10 payments. Yet although the number of periods has doubled, the dollar amount of interest being sent to the investors for each period and the bondholders required rate of return are half of the equivalent annual figures. It becomes It /2 and kb is changed to kb /2; thus, for semiannual compounding, equation (6-3b) becomes (6-4)

Alternatively, using the notations introduced in Chapter 5 for discounting cash flows, the above equation may be restated as follows: Vb = ($It/2)(PVIFAkb/2,2n) + $M(PVIFkb/2,2n) (6-5)

To measure the bondholders expected rate of return, kb, we would find the discount rate that equates the present value of the future cash flows (interest and maturity value) with the current market price of the bond. The expected rate of return for a bond is also the rate of return the investor will earn if the bond is to maturity, or the yield to maturity. Thus, when referring to bonds, the terms expected rate of return and yield to maturity are often used interchangeably.

To illustrate this concept, consider the Brister Corporations bonds, which are selling for $1100. The bonds carry a coupon interest rate of 9 percent and mature in 10 years. (Remember, the coupon rate determines the interest payment----coupon rate*par value). In determining the expected rate of return (kb), implicit in the current market price, we need to find the rate that discounts the anticipated cash flows back to a present value of $l,1 00, the current market price (P0) for the bond. Finding the expected rate of return for a bond using the present value tables is done by trial and error. We have to keep trying new rates until we find the discount rate that results in the present value of the future interest and maturity value of the bond just equaling the current market value of the bond. If the expected rate is somewhere between rates in the present value tables, we then must interpolate between the rates.

We have now learned to find the value of a bond (Vb), given (1) the mount of interest payment (It), (2) the maturity value (M), (3) the length of time to maturity (n years), and (4) the investors required rate of return, kb. . We also know how to compute the expected rate of return (kb), which also happens to be the current interest rate on the bond, given (1) the current market value (P0), (2) the amount of interest payments (It), (3) the maturity value (M), and (4) the length of time to maturity (n years). We now have the basics. But lets go further in our understanding of bond valuation by studying several important relationships.

First Relationship

The value of a bond is inversely related to changes in the investors present required rate of return (the current interest rate). In other words, as interest rates increase (decrease), the value of the bond decreases (increases).

Second Relationship

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; but it will be valued above par value if the investor's required rate of return is below the coupon interest rate.

Third Relationship

Long-term bonds have greater interest rate risk than do short-term bonds. As already noted, a change in current interest rates (required rate of return) causes an inverse change in the market value of a bond. However, the impact on value is greater for long-term bonds than it is for short-term bonds. In Figure 6-3 we observed the effect of interest rate changes on a 5year bond paying a 12 percent coupon interest rate.

Figure 6-3 Value and Required Rates for a 5-Year Bond at 12 Percent Coupon Rate\

1,200 $1,117 1,100

Market value

1,000

$1,000

900

$899

800

10

12

14

16

MARKET VALUE FOR A 12% COUPON-RATE BOND MATURING IN REOUIRED RATE 5 YEARS 10 YEARS 9% $1,116.80 $1,192.16 12 1,000.00 1,000.00 15 899.24 849.28 Figure 6-4: Market Values of a 5-Year and a 10-Year Bond at Different Required Rates

1,200

1,100

Market value

1,000

900

5 -y ear bon 10 - ye d ar bo nd

800

10

12

14

16

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