B d V l ti

MBA 540 Financial Management

Bond Valuation
1. Equity vs. Debt
2 V l i B d 2. Valuing Bonds
3. Convertible Bonds
1 Equity vs Debt 1. Equity vs. Debt
(1) Definition (1) Definition
(2) Comparison
(3) The Choices
2
1 Equity vs Debt 1. Equity vs. Debt
(1) Definition (1) Definition
Equity financing: Raising capital through the
l f h t i t sale of shares to investors.
Investors acquire ownership (partially).
Debt financing: Raising capital by selling
bonds, bills, or notes to investors.
Investors become creditors and receive a promise
that the principal and interest on the debt will be
repaid
3
repaid.
1 Equity vs Debt 1. Equity vs. Debt
(2) Comparison (2) Comparison
Debt Equity
Claim Fixed claim Residual Claim
Claim priority High Low
Tax shield Interest: tax deductible Dividends: no tax break
Life Fixed Infinite
Issuing cost Low High
(Default) Risk to firm High Low
Impact on control Low High
4
Impact on control Low High
1 Equity vs Debt 1. Equity vs. Debt
(3) The Choices (3) The Choices
Debt Equity
Public firms (1) Long-term: bonds Common stock
(2) Short-term: ( )
commerical paper
Private firms Bank loans Personal savings
Equity or bond? Information asymmetry
Angels/VCs/PEs
5
Equity or bond? Information asymmetry
2 Valuing Bonds 2. Valuing Bonds
(1) Terminologies (1) Terminologies
(2) Default-free Bonds
(3) Risky Bonds
(4) Interest Rate Risk (4) Interest Rate Risk
6
2 Valuing Bonds 2. Valuing Bonds
(1) Terminologies (1) Terminologies
Bond certificate: the terms of the bond,
i l di th t d d t f ll including the amounts and dates of all
payments to be made.
i h fi l d Maturity date: the final repayment date.
Term: the time remaining until the maturity
date.
Face value: the principal, the notional amount
7
used to compute the interest payments.
2 Valuing Bonds 2. Valuing Bonds
(1) Terminologies (1) Terminologies
Coupon: the promised interest payment.
Coupon rate: it determines the amount of each
coupon payment, expressed as an APR.
Coupon payment:
Coupon Rate Face Value Coupon Rate Face Value

Number of Coupon Payments per Year

= CPN
8
2 Valuing Bonds 2. Valuing Bonds
(1) Terminologies (1) Terminologies
Yield to Maturity (YTM): the discount rate
th t t th t l f th i d b d that sets the present value of the promised bond
payments equal to the current market price of
the bond the bond.
The Promised return
YTM C t i ld C t YTM vs. Current yield vs. Coupon rate
price market Current
payment Coupon
yield Current =
9
price market Current
2 Valuing Bonds 2. Valuing Bonds
(2) Default free Bonds (2) Default-free Bonds
Zero coupon bonds
For a zero-coupon bond with n periods to maturity:
, : price Bond or
FaceValue
P =
1 : Maturity to Yield
,
) 1 (
: p ce o d
1
P
FaceValue
YTM
o
YTM
n
n
n
n

|
.
|

\
|
=
+
". " about careful be : Note n
P
. \
YTM
10
=
n n
r YTM
2 Valuing Bonds 2. Valuing Bonds
(2) Default free Bonds (2) Default-free Bonds
Coupon bonds
1
1
) ( ) (
FaceValue CPN
value face PV coupons PV P
+
|
|
|

|
=
+ =
payments. coupon of number total the is N ,
) 1 ( ) 1 (
1
where
YTM YTM YTM
N N
+
+
|
|
.

\
+
=
YTM here is the rate per coupon interval. It may not
be an annual rate.
11
Converting to annual rate: APR = YTM * (# of
coupon per year)
2 Valuing Bonds 2. Valuing Bonds
(2) Default free Bonds (2) Default-free Bonds
Coupon bonds
Discounts, premiums, and pars
Bond is Price vs. Face value YTMvs. coupon rate Including current yield Bond is
traded
Price vs. Face value YTM vs. coupon rate Including current yield
(always in the middle)
at a discount P < face value YTM > coupon rate YTM > current% > CPN%
at a premium P > face value YTM < coupon rate YTM < current% < CPN%
at par P = face value YTM= coupon rate YTM = current% = CPN%
12
Current yield: refer to slide #9
2 Valuing Bonds 2. Valuing Bonds
(2) Default free Bonds (2) Default-free Bonds
Coupon bonds
Discounts, premiums, and pars
Bond Couponrate YTM YTMvs.couponrate Pvs.facevalue Conclusion p p
#1 10% 5% YTM<couponrate P>facevalue Atapremium
#2 5% 5% YTM=couponrate P=facevalue Atpar
#3 3% 5% YTM > coupon rate P < face value At a discount
13
#3 3% 5% YTM>couponrate P<facevalue Atadiscount
Note:Ifwecanfigureouttherule(ifYTM>,thenP<;orifYTM<,thenP>
),thenwedonothavetodothecalculationinordertoreachtheconclusion.
2 Valuing Bonds 2. Valuing Bonds
(2) Default free Bonds (2) Default-free Bonds
Coupon bonds
Valuing a coupon bond using zero-coupon bonds
Coupon bond
N t b th
p
=
1-yr zero-coupon bond
+
2-yr zero-coupon bond
+
Note: both
the coupon
bond and the
group of
+
3-yr zero-coupon bond
+

N-yr zero coupon bond

zero-coupon
bonds must
be default-
free bonds.
14
2 Valuing Bonds 2. Valuing Bonds
(2) Default free Bonds (2) Default-free Bonds
Coupon bonds
Valuing a coupon bond using zero-coupon bonds
(Bond Cash Flows) = PV PV
2
1 2
( )
V

1 (1 ) (1 )
+
= + + +
+ + +

n
n
CPN CPN CPN F
YTM YTM YTM
Note: the YTM
i
is the i-year zero-coupon bonds YTM.
Key idea: same cash flows at any point of time and same
i k l l h ld h h l
15
risk level => should have the same value.
2 Valuing Bonds 2. Valuing Bonds
(2) Default free Bonds (2) Default-free Bonds
Coupon bonds
Valuing a coupon bond using zero-coupon bonds
Example: We can replicate a three-year $1000 bond that
pays 10%annual coupon using three zero coupon bonds pays 10% annual coupon using three zero-coupon bonds.
16
2 Valuing Bonds 2. Valuing Bonds
(2) Default free Bonds (2) Default-free Bonds
Coupon bonds
Valuing a coupon bond using zero-coupon bonds
Example: Suppose we know the YTM and price of zero-
coupon bonds (face value $100) coupon bonds (face value $100).
( ) ( )
) 100 1000 ( 100 100
1 1
1
3
3
2
2
1
+
+
+
+
+
+
+
=
YTM
FaceValue CPN
YTM
CPN
YTM
CPN
PV
Note: be careful about the YTMs
17
00 . 1153 $ 93 . 963 45 . 92 62 . 96
%) 5 . 4 1 (
) 100 1000 (
%) 4
100
1 (
100
3 2
= + + =
+
+
+
+
+
+
=

(1 3.5%)

2 Valuing Bonds 2. Valuing Bonds
(3) Risky Bonds (3) Risky Bonds
Credit risk, expected return and YTM
A bonds expected return, E(r), will be less than the
yield to maturity (YTM), if there is a risk of default.
However, a higher YTM does not necessarily
imply that a bonds E(r) is higher.
Higher default risk => higher YTM Higher default risk => higher YTM.
More uncertainty => higher E(r)
Question: for the default-free bonds what is the
18
Question: for the default-free bonds, what is the
relationship between E(r) and YTM?
2 Valuing Bonds 2. Valuing Bonds
(3) Risky Bonds (3) Risky Bonds
Risk rating
How do we collect the default risk information of a
risky bond?
i diffi l d i ffi i f i di id l It is too difficult and inefficient for individuals to
investigate the default risk of every bond.
Several companies rate the creditworthiness of bonds and p
make the information available to investors. Example:
Standard & Poors; Moodys.
19
2 Valuing Bonds 2. Valuing Bonds
(4) Interest Rate Risk (4) Interest Rate Risk
The risk that arises for bond owners from
fl t ti i t t t fluctuating interest rates
Bond prices and interest rates always move in
opposite directions opposite directions.
If the bond is more sensitive to interest rate
fluctuation the interest rate risk is higher fluctuation, the interest rate risk is higher.
Term interest rate risk
Coupon rate interest rate risk
20
p
2 Valuing Bonds 2. Valuing Bonds
(4) Interest Rate Risk (4) Interest Rate Risk
Term structure: the relationship between the
t f t d t it h ldi ll th rate of return and maturity, holding all other
factors constant.
Y i f (%) Y-axis: rate of return (%);
X-axis: maturity (year)
21
2 Valuing Bonds 2. Valuing Bonds
(4) Interest Rate Risk (4) Interest Rate Risk
The yield curve
The graph of the term structure, most commonly of
U.S. Treasury securities.
Example:Yieldsof
U.S. Treasury U.S.Treasury
securities,Nov.1
st
,
2010
22
2 Valuing Bonds 2. Valuing Bonds
(4) Interest Rate Risk (4) Interest Rate Risk
The yield curve
Three shapes
23
2 Valuing Bonds 2. Valuing Bonds
(4) Interest Rate Risk (4) Interest Rate Risk
The yield curve
The Expectations Hypothesis
Yield curve shape Expectation for interest rates p p
(1) Upward sloping To rise in the future
(2) Downward sloping To fall in the future
(3) Flat A transition state between (1) and (2)
24
2 Valuing Bonds 2. Valuing Bonds
(4) Interest Rate Risk (4) Interest Rate Risk
The yield curve
The Expectations Hypothesis
Example:STvs.LT
U.S. Interest Rates U.S.InterestRates
andRecessions
Becauseinterest
ratestendtofallin
responsetoan
economicslowdown,
aninvertedyield
curve isoften
25
f
interpretedasa
negativeforecastfor
economicgrowth
2 Valuing Bonds 2. Valuing Bonds
(4) Interest Rate Risk (4) Interest Rate Risk
The yield curve
The Liquidity Preference Hypothesis
Reason: interest rate risk increases with maturity
Result: yield premium increases with maturity (demanding
higher yield)
Yield curve: greater upward tilt or lesser downward tilt Yield curve: greater upward tilt or lesser downward tilt
The Segmentation Hypothesis
Reason: different investors select certain maturity segments
26
Reason: different investors select certain maturity segments.
Yield curve: any type of curve can occur.
2 Valuing Bonds 2. Valuing Bonds
Z b d
YTM = r
f
P i d YTM
FaceValue
P
Default free
Zero-coupon bonds
Price and YTM:
( )
N
YTM
P
+
=
1
t CPN F V l
Zero-coupon bonds => Coupon bond
Coupon bond price
Coupon bond YTM
Default free
bonds
Coupon bonds
Coupon:
Price and YTM:
year per coupon of #
rate CPN FaceValue
CPN

=
Value Face PV coupons all PV P
(
+ = ) ( ) (
Bonds
( )
N N
YTM
Value Face
YTM YTM
CPN
+
+
(

+
=
1 ) 1 (
1
1
Expected CF and E(r):
| |

=
N
i
i
E
CF E
P
) ( 1
) (
Price and YTM
Risky bonds
p ( )
Promised CF and YTM:
Yield and default risk
| |
( )

=
=
+
=
+
N
i
i
i
i
i
i
YTM
CF
P
r E
0
0
1
) ( 1
27
Bond rating
Uncertainty and E(r)
3 Convertible Bonds 3. Convertible Bonds
(1) Introduction (1) Introduction
(2) Pricing
(3) Convertible Bonds vs. Preferred Stocks
28
3 Convertible Bonds 3. Convertible Bonds
(1) Introduction (1) Introduction
Convertible bonds are corporate bonds offered
b bli l t d d th t i th by a publicly traded company, that give the
bond holders the right to exchange the bonds
for a pre-determined quantity of stock for a pre-determined quantity of stock.
A bond with a built in call option
If t k i l lik di b d ith If stock price low: like an ordinary bond, with a
slightly lower YTM.
If stock price high: bond price goes and will move in
29
If stock price high: bond price goes and will move in
tandem with stock price.
3 Convertible Bonds 3. Convertible Bonds
(1) Introduction (1) Introduction
common
stock
i l t
rising stock price
Acts like a Stock
p
r
i
c
e
conversion price
equivalent
rising stock price
convertible
s
t
o
c
k

p
time
Acts like a Bond
co e t b e
bond
busted
convertible
declining or slow
rising stock price
Acts like a Bond
30
3 Convertible Bonds 3. Convertible Bonds
(1) Introduction (1) Introduction
Why firms issue convertible bonds?
Lower financing cost: the YTM is less than the
YTM of a con-convertible bond with the same
characteristics characteristics.
Good for firms with lower credit rating.
Wh i t b tibl b d ? Why investors buy convertible bonds?
Safe when stock price low
31
Price appreciation when stock price high
3 Convertible Bonds 3. Convertible Bonds
(1) Introduction (1) Introduction
Terminologies
Conversion price: the price per share at which a
convertible bond can be converted into common
shares shares.
Conversion ratio: the number of common shares
received at the time of conversion for each
convertible bond.
bond e convertibl of value Par
ratio Conversion =
32
price Conversion
ratio Conversion
3 Convertible Bonds 3. Convertible Bonds
(1) Introduction (1) Introduction
Terminologies
Conversion premium: the amount by which the price of a
convertible bond exceeds the current market value of the
corresponding common stock corresponding common stock.
Example: We spend $1050 to purchase a convertible bond
with $1,000 face value; and stock price is $10 at the time , ; p
of purchase. Given the conversion price to be $20.
$550 50 * $10 - $1050 or, 110 1
50 * 10
1050
premium Conv. 50;
20
1000
ratio Conv. = = = = = = %,
33
50 * 10
p
20
3 Convertible Bonds 3. Convertible Bonds
(2) Pricing (2) Pricing
Traditional Break-even Analysis
Calculate the premium payback period (aka the
break-even period)
i h i i d f h h d i f h It is the time required for the enhanced income from the
bond, relative to the equivalent number of stock shares, to
offset the premium paid over the conversion value.
Convertible bonds with break-even period of less
than three years are generally considered
acceptable investments
34
acceptable investments.
3 Convertible Bonds 3. Convertible Bonds
(2) Pricing (2) Pricing
Traditional Break-even Analysis
If buy bond If buy stock Difference
pay bond mkt price stock mkt price conversion premium p y p p p
receive coupon payment dividend payment annual enhanced income
break-even conversion premium = premium payback period * annual enhanced income
35
3 Convertible Bonds 3. Convertible Bonds
(2) Pricing (2) Pricing
Example:
Market price of convertible bond = $650;
Conversion ratio = 29.19 shares;
Annual interest on convertible bond = $65;
Market price for stock = $10.16/share;
Annual dividends on stock = $0.31/share.
Question: is this a good investment? (should we buy
36
Q g ( y
the convertible bonds?)
3 Convertible Bonds 3. Convertible Bonds
(2) Pricing (2) Pricing
Example:
Premium paid if we buy convertible bonds
We paid $650 for a bond with par value of $1,000. The
bond can be converted to 29 19 shares bond can be converted to 29.19 shares.
Or, we could buy the 29.19 shares directly from the stock
market. We would then pay the current value for the 29.19
shares, which is $296.57 (=29.19*10.16).
Thus, the premium we paid = 650 296.57 = $353.43
37
3 Convertible Bonds 3. Convertible Bonds
(2) Pricing (2) Pricing
Example:
How to cover the premium payment?
By holding the convertible bonds, we receive annual
coupon payments however we give up the corresponding coupon payments, however, we give up the corresponding
dividend payments from buying the shares.
We receive: coupon = $65
We give up: dividend payments = 29.19 * 0.31 = $9.05
Annual difference = 65 9.05 = $55.95 , i.e., we receive
t $55 95 th h ldi t k
38
an extra $55.95 more than holding stocks every year.
3 Convertible Bonds 3. Convertible Bonds
(2) Pricing (2) Pricing
Example:
Premium payback period (PPP)
years 32 6
353.43
=
Premium
= PPP =
Investing decision
years 32 . 6
55.95 difference Annual
PPP =
Premium payback period > 3 years
Do not buy the convertible bonds.
39
3 Convertible Bonds 3. Convertible Bonds
(3) Convertible Bonds vs Preferred Stocks (3) Convertible Bonds vs. Preferred Stocks
Preferred stock
Paid dividends stock
Equity ownership stock
Fixed dividends bond
Prior claim bond
No voting rights
Callable (convertible)
40
( )
3 Convertible Bonds 3. Convertible Bonds
(3) Convertible Bonds vs Preferred Stocks (3) Convertible Bonds vs. Preferred Stocks
Similarities
Market value affected by interest rate
Convertibility
Priority over common stocks
Differences
Bonds vs. Equity
Preferred stocks more accessible to investors
41
Preferred stocks more accessible to investors
because of lower face values.
Review Review
Equity vs Debt Equity vs. Debt
Comparison
Financing decision: more affected by the level of
information asymmetry
Recall the pecking order theory and the trade-off
theory in IPO Prelude discussion.
Bonds: public traded firms, long-term debts
42
Review Review
Bond pricing Bond pricing
Zero-coupon bonds
YTM = r
f
Price and YTM:
( )
N
YTM
FaceValue
P
+
=
1
Zero-coupon bonds => Coupon bond
Default free
bonds
Coupon bonds
Coupon:
year per coupon of #
rate CPN FaceValue
CPN

=
p p
Coupon bond price
Coupon bond YTM
Bonds
Price and YTM:
( )
N N
YTM
Value Face
YTM YTM
CPN
Value Face PV coupons all PV P
+
+
(

+
=
+ =
1

) 1 (
1
1
) ( ) (
Ri k b d
( )

) (
Expected CF and E(r):
Promised CF and YTM:
| |

=
=
+
=
N
i
N
i
i
i
i
CF
P
r E
CF E
P
0
) ( 1
) (
43
Risky bonds
Yield and default risk
Uncertainty and E(r)
( )

=
+
=
i
i
YTM
P
0
1
Review Review
Convertible bonds Convertible bonds
Characteristics
Why issue it? Why buy it?
Parameters calculation
Conversion price
Conversion ratio Conversion ratio
Conversion premium
44
Review Review
Convertible bonds Convertible bonds
Traditional break-even analysis
Steps & calculation
If premium payback period < 3 years,
Convertible bonds vs. Preferred stocks
Similarities
45