This chapter introduces the concepts that underlie asset valuation. We are specifically concerned with bonds. We also look at the concept of the bondholder's expected rate of return on an investment.
Types of bonds
Debentures: unsecured long-term debt.
Subordinated debentures: bonds that have a lower claim on assets in the event of liquidation than do other senior debtholders. C.
Mortgage bonds: bonds secured by a lien on specific assets of the firm, such as real estate. D.
Eurobonds: bonds issued in a country different from the one in whose currency the bond is denominated; for instance, a bond issued in Europe or Asia that pays interest and principal in U.S. dollars. E.
Zero and 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. 1.
The disadvantages are, when the bond matures, the issuing firm will face an extremely large nondeductible cash outflow much greater than the cash inflow they experienced when the bonds were first issued. 2.
Zero and low coupon bonds are not callable and can be retired only at maturity. 3.
On the other hand, annual cash outflows associated with interest payments do not occur with zero coupon bonds. F.
Junk bonds: bonds rated BB or below.
Terminology and characteristics of bonds
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. B.
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. C.
A bond's par value is the amount that will be repaid by the firm when the bond matures, usually $1,000. D.
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 an annual interest payment of $90. E.
The bond has a maturity date, at which time the borrowing firm is committed to repay the loan principal. F.
An indenture (or trust deed) is the legal agreement between the firm issuing the bonds and the bond trustee who represents the bondholders. It provides the specific terms of the bond agreement such as the rights and responsibilities of both parties. G.
The current yield on a bond refers to the ratio of annual interest payment to the bond’s market price. H.
1. Three primary rating agencies exist—Moody’s, Standard & Poor’s, and Fitch Investor Services. 2. Bond ratings are simply judgments about the future risk potential of the bond in question. Bond ratings are extremely important in that a firm’s bond rating tells much about the cost of funds and the firm’s access to the debt market. 3.
The different ratings and their implications are described. III.
Definitions of value
Book value is the value of an asset shown on a firm's balance sheet which is determined by its historical cost rather than its current worth. B.
Liquidation value is the amount that could be realized if an asset is sold individually and not as part of a going concern. C.
Market value is the observed value of an asset in the marketplace where buyers and sellers negotiate an acceptable price for the asset. D.
Intrinsic value is the value based upon the expected cash flows from the investment, the riskiness of the asset, and the investor's required rate of return. It is the value in the eyes of the investor and is the same as the present value of expected future cash flows to be received from the investment. IV.
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