Lecture 03: Applying the Time Value of Money to Security Valuation – Valuation of Bonds and Debt Securities

A bond or a debenture is a long term debt instrument carrying a fixed rate of interest which is known to investors. A bond is redeemable after a specified period. Bonds are also called gilt edged securities or gilt when issued by the government since it is free of default risk.

Features of a Bond or Debenture
• Face Value – Face value is called par value. A bond / debenture is generally issued at a par value and interest is paid on the par value. • Interest Rate – Interest rate is fixed and known to the bondholders / debenture holders. Interest paid on a bond is tax deductible. The interest rate is also called the coupon rate. • Maturity – A bond is issued for a specified period of time. It is repaid on maturity. • Redemption Value – The value which a bondholder will get on maturity is called redemption value. • Market Value – A bond / debenture may be traded on the stock exchange. The price at which it is currently sold or bought is called the market value of the bond / debenture.

A bond is a long-term promissory note that promises to pay the bondholder a predetermined, fixed amount of interest each year until maturity. At maturity, the principal will be paid to the bondholder. In the case of a firm's insolvency, a bondholder has a priority of claim to the firm's assets before the preferred and common stockholders. Also, bondholders must be paid interest due them before dividends can be distributed to the stockholders. A bond's par value is the amount that will be repaid by the firm when the bond matures. The contractual agreement of the bond specifies a coupon interest rate that is expressed either as a percent of the par value or as a flat amount of interest which the borrowing firm promises to pay the bondholder each year. For example: A $1,000 par value bond specifying a coupon interest rate of 9 percent is equivalent to...

...• Know the important bond features and bond types • Understand:
– Bond values and why they fluctuate – Bond ratings and what they mean – The impact of inflation on interest rates – The term structure of interest rates and the determinants of bond yields
6-2
Chapter Outline
6.1 6.2 6.3 6.4 6.5 6.6 6.7 Bonds and BondValuation More on Bond FeaturesBond Ratings Some Different Types of BondsBond Markets Inflation and Interest Rates Determinants of Bond Yields
6-3
6-1
Bond Definitions
• Bond
– Debt contract – Interest-only loan
• • • • •
Par value (face value) ~ $1,000 Coupon rate Coupon payment Maturity date Yield to maturity
6-4
Key Features of a Bond
• Par value:
– Face amount – Re-paid at maturity – Assume $1,000 for corporate bonds
• Coupon interest rate:
– Stated interest rate – Usually = YTM at issue – Multiply by par value to get coupon payment
6-5
Key Features of a Bond
• Maturity:
– Years until bond must be repaid
• Yield to maturity (YTM):
– The market required rate of return for bonds of similar risk and maturity – The discount rate used to value a bond – Return if bond held to maturity – Usually = coupon rate at issue –...

...Interest Rates and BondValuation
Chapter 6 6.2 More on Bond Features
Securities issued by corporations are classified as equity securities and debt securities. A debt in very simple terms represents something that must be paid as a result of borrowing money, when corporations borrow money they make regular interest payments as well as paying the principal amount at the end of the period. There are three main differences between debt and equity, which are: Debt is not ownership; creditors don't have any say in the firm's decisions. Interest is taxable, but dividends are not tax deductible. Unpaid debt is a liability on the firm; if the firm goes bankrupt creditors can legally claim assets of the firm. Debt can result to financial failure, but this is not the case when equity is issued. Is it Debt or Equity? Sometimes it is unclear if what the firm is offering is a debt or equity security. The main purpose behind doing this is so that firms offer debts that are actually equity securities so that they can obtain tax benefits from debts and the bankruptcy benefits of equity. Debt holders are usually paid before equity holders. The rewards for owning a debt is fixed according to the loan's amount, but there is no limit to the available rewards that can be gained from owning equity, the higher the profit the bigger the interest amount. Long-term Debt: The Basics Even though there is no...

...who is enrolled in an Investments class has picked a project on bond price theorems.
The two main theorems that she decided to illustrate dealt with coupon rate and term-to-maturity and how these factors influence the price. Thus she included 2 bonds with the same rating and term with a different coupon rate, as well as two bonds with the same rating and coupon rate with different terms.
She thought that if the bond markets were efficient, bonds with similar characteristics would be priced so that there would be little difference in the YTM.
Besides S&P, she also looked at Moody’s for additional information.
There was an increase in the interest rates over 1984-1986 and hence observed the actual YTM at different point in time. Three periods were selected: November 1, 1984, 1985, and 1986.
The theorem states that YTM and price, as well as coupon rate and price, should have an inverse relationship, while bond duration and price should have a direct relationship.
** Please refer to Annexure 1 for a summary on the Factual Numbers in the case.
Problems
The following are the problems of the case:
Q1: Using the prices given, calculate the percentage price changes for the three periods for the Boston Edison and American Brand bonds and explain the difference between the changes.
Q2: Using the prices given, calculate the percentage price changes for the three periods...

...Asset Valuation
0 r 1 2 n
...
CF1 CF2 CFn
Value
PV =
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(1+ r )
1
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CF2
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2
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.
Prof. P. Yourougou
MBC 633 – Managerial Finance
Lect. 03 - 2
Various Interest Rate Measures
Coupon rate Coupon rate
periodic cash flow a bond issuer contractually periodic cash flow a bond issuer contractually promises to pay a bond holder promises to pay abond holder rates used by individual market participants to rates used by individual market participants to calculate fair present values (PV) calculate fair present values (PV) rates participants would earn by buying securities at rates participants would earn by buying securities at current market prices (P) current market prices (P) rates actually earned on investments rates actually earned on investments
Required rate of return (rrr) Required rate of return (rrr)
Expected rate of return (Err) Expected rate of return (Err) Realized rate of return (rr) Realized rate of return (rr)
Prof. P. Yourougou
MBC 633 – Managerial Finance
Lect. 03 - 3
BondValuation
Premium bond has Premium bond has
A coupon rate (INT) greater than the required A coupon rate (INT) greater than the required rate of return (rrr) and rate of return (rrr) and the fair present value of the bond (Vbb) is the fair present value...

...Colilla Barreiro
Asset Valuation
02/04/15
Questions for RJR Nabisco case
1. What was the value of RJR Nabisco under
Asset Beta:
= 0.50
= 0.92
Ba=(0.50+0.92)/2 = 0.7
Assume that Rf = 9% (from the Marriott Case)
Assume that Rp=8% (from the Marriott Case)
Ka = Rf + BARp
Ka = 9% + (0.7)(8%) = 14.6%
a) The pre-bid operating strategy?
b) The Management Group's strategy?
c) KKR's operating strategy?
2. What accounts for any difference in the value of three operating plans?
The distinction in estimation of each of the 3 working arrangements originates from the distinction in working methodologies by the 2 bidders. This brought about diverse capital income estimates which brought about the distinctive valuation. The administration bunch's proposed methodology was to offer piece of RJR Nabisco's sustenance organizations since they accepted that the business was underestimated by business sector. They accept that differentiating could help the business sector recognize the tobacco business and sustenance business and understand the genuine natural estimation of every business. They accept that doing this would help business sector understand the organization's esteem all the more proficiently and amplify shareholders'interests. It is likewise piece of an utilized buyout, some piece of which is financed by long haul obligation, adjusting the capital structure going advances. More obligation prompts a more noteworthy...

...
HW BondValuation and Bond Yields
Clifford Clark is a recent retiree who is interested in investing some of his savings in corporate bonds. His financial planner has suggested the following bonds:
• Bond A has a 7% annual coupon, matures in 12 years, and has a $1000 face value.
• Bond B has a 9% annual coupon, matures in 12 years, and has a $1000 face value.
• Bond C has an 11% annual coupon, matures in 12 years, and has a $1000 face value.
Each bond has a yield to maturity (YTM) of 9%.
1) Without calculation, indicate whether each bond is trading at a premium, discount, or at par.
In order to indicate whether each bond is trading at a premium, discount, or at par, you need to compare the yield to maturity (YTM). If the YTM is greater than the bond coupon rate, then the bond is considered to be trading at a premium. If the YTM is lesser than the bond coupon rate, then the bond is considered to be trading at a discount, and if the YTM is equal to the bond coupon rate, then the bond is considered to be trading at par.
Bond A: YTM = 9%, 9% > the coupon rate of 7%, therefore the bond is traded at a discount.
Bond B: YTM = 9%, 9% = the coupon rate of 9%, therefore the...

...This case discusses the valuation of stocks and bonds. It says that in textbooks, the valuation of stocks and bonds is simply stated as the present value of all the future cash flows expected from the security. The concept is logical, straightforward, and simple. The valuation of bonds is usually presented first, since the relatively certain cash flows are broken into an annuity and a payment of the par value at some specific date in the future. Preferred stock valuation follows bondvaluation and the value of preferred stock is shown to be the present value of perpetual annuity. The cash flows from the constant-size dividend are fairly certain, and most preferred stocks do not have a maturity date. Finally, common stock is presented but neither the future cash flows (from dividends) nor the final value is known with any degree of certainty.
The case describes Home Products, Inc, a leading manufacturer of prescription and ethical drugs; specialty foods and candies; and proprietary drugs. Total revenues in the last fiscal year were in excess of $9 billion. Company's capital structure is made up of 34% long-term debt, 3% preferred stock, and 63% common stock. The case describes the two largest domestic long-term debt, and close this issue disclosing that these two bonds are rated A by Moody's. Then, it talks about preferred stocks. 5.5...

...Assignment no. 1
Fixed Income Securities and Markets
Question A.1
Given the following bond:
|starting date |30/09/2011 |
|maturity date |30/09/2014 |
|coupon rate |4.00% |
|coupon frequency |annual |
|day count |act/act |
|nominal value |100 |
a) Calculate the price of the security on the 30/09/2011, if the yield to maturity is 5% (NB: Price=PV of future cash flows).
b) Given the price and the yield to maturity of the bond, calculate the three components of the (expected) total return of this investment (if you invest 100 Euro).
c) What will be the price of this bond after one year (on 30/09/2012) if its yield to maturity is 3%?
d) If on 30/09/2012 you decide to sell the bond at the price calculated in the previous question, what will be the return of your investment? How this differs from the expected return calculated in (b)? Comment.
Solution
a) Using the pricing formula for bonds:
[pic]
b) The three different components are:
a. Coupon: holding the bond until maturity, the investor will receive three coupons of size 4 Euro, therefore the coupon component will be nC=12
b. Capital gain: it is the difference between the price at...