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Chapter 7 - The Valuation and Characteristics of

Bonds

Valuation
A systematic process through which the price at which a
security should sell is established - Intrinsic value
THE BASIS OF VALUE
Real assets (houses, cars) have value due to services they provide
Financial assets (paper) represent rights to future cash flows
Value today is PV

Different opinions about securities values come from


different assumptions about cash flows and interest rates
Stocks are hardest to value because future dividends and prices are
never guaranteed.

The Basis of Value


Any securitys value is the present value of the
cash flows expected from owning it.
A security should sell for close to that value in
financial markets

The Basis of Value


Investing
Using a resource to
benefit the future rather
than for current
satisfaction
Putting money to
work to earn more
money
Common types of
investments
Debt
Equity

Return
What the investor
receives for making an
investment
1 year investments
return = $ received / $
invested
Debt investors receive
interest. Equity
investors get dividends
+ price change

Definition
The rate of return on an investment is the
interest rate that equates the present value of
its expected cash flows with its current price
Return is also known as
Yield, or
Interest

Return On One Year Investment


Return is what the investor receives
Can be expressed as a dollar amount or as a rate
Rate of return is what the investor receives divided by what was invested
For debt investments: the interest rate
In terms of the time value of money:
Invest PV at rate k and receive future cash flows of
principal = PV, and
interest = kPV
at the end of a year, so
FV1 = PV + kPV
FV1 = PV(1+k)
PV =

FV1
(1 + k)

The Basis for Value


Discount Rate
The term discounted rate is often
used for interest rate

Returns on Longer-Term Investments

Bonds
Bonds represent a debt relationship in which
an issuing company borrows and buyers lend.
A bond issue represents borrowing from many
lenders at one time under a single agreement

Bond Terminology and Practice


A bonds term (or maturity) is the time from the
present until the principal is returned
A bonds face (or par) value represents the
amount the firm intends to borrow (the
principal) at the coupon rate of interest

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Coupon Rates
Coupon Rate the fixed rate of interest paid
by a bond
In the past, bonds had coupons attached,
today they are registered
Most bonds pay coupon interest semiannual

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Bond ValuationBasic Ideas


Adjusting to Interest Rate Changes
Bonds are originally sold in the primary market and
trade subsequently among investors in the
secondary market.
Although bonds have fixed coupons, market
interest rates constantly change.
How does a bond paying a fixed interest rate
remain salable (secondary market) when interest
rates change?

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Bond ValuationBasic Ideas


Bonds adjust to changing yields by changing
their prices
Selling at a Premium bond price above face value
Selling at a Discount bond price below face value

Bond prices and interest rates move in


opposite directions

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Determining the Price of a Bond


The value (price) of a security is equal to the
present value of the cash flows expected from
owning it.
In bonds, the expected cash flows are
predictable.
Interest payments are fixed, occurring at regular
intervals.
Principal is returned along with the last interest
payment.

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Determining the Price of a Bond


Figure 7-1 Cash Flow Time Line for a Bond
This bond has 10 years until maturity, a par value of
$1,000, and a coupon rate of 10%.?

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Determining the Price of a Bond


The Bond Valuation Formula
The price of a bond is the present value of a stream
of interest payments plus the present value of the
principal repayment

PB PV(interest payments) + PV(principal repayment)


Interest payments are annuities--can use
the present value of an annuity formula:
PMT[PVFAk,n ]

Principal repayment is a lump sum in the


future--can use the future value formula:
FV[PVFk, n ]

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Determining the Price of a Bond


Two Interest Rates and One More
Coupon Rate
k - the current market yield on comparable bonds
Current yield - annual interest payment divided by
bonds current price
Not used in valuation
Info for investors

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Figure 7-2 Bond Cash Flow and


Valuation Concepts

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Concept Connection Example 7-1


Finding the Price of a Bond
Emory issued a $1,000, 8%, 25-year bond 15 years ago.
Comparable bonds are yielding 10% today.
What price will yield 10% to buyers today?
What is the bonds current yield?
Assume the bond pays interest semiannually.

Concept Connection Example 7-1


Finding the Price of a Bond
Must solve for present value of bonds expected cash flows at todays
interest rate. Use Equation 7.4 :

PB PMT[PVFA k, n ] + FV[PVFk, n ]
The payment is 8%
x $1,000, or $80
annually. However,
it is received in the
form of $40 every
six months.

The future value is


the principal
repayment of $1,000.

k represents the periodic current


market interest rate, or
10% 2 = 5%
.

n represents the
number of interestpaying periods until
maturity, or
10 years x 2 = 20.

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Concept Connection Example 7-1


Finding the Price of a Bond
Substituting :

PB $40[PVFA 5%, 20 ] + $1,000[PVF5%, 20 ]


$40[12.4622] + $1,000[0.3769]
$498.49 $376.90
$875.39

This is the price at


which the bond must sell
to yield 10%. It is
selling at a discount because
the current interest rate
is above the coupon rate.
The bonds current yield is
$80 $875.39, or 9.14%.

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Maturity Risk Revisited


Related to the term of the debt
Longer term bond prices fluctuate more in response
to changes in interest rates than shorter term bonds
AKA price risk and interest rate risk

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Table 7-1 Price Changes at Different Terms Due to an


Interest Rate Increase from 8% to 10%

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Figure 7.3 Price Progression with


Constant Interest Rate

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Finding the Yield at a Given Price


Calculate a bonds yield assuming it is selling
at a given price
Trial and error guess a yield calculate price
compare to price given

PB PMT PVFAk, n + FV PVFk, n


Involves solving for k, which is
more complicated because it
involves both an annuity and a
FV

Use trial and error to solve


for k, or use a financial
calculator.
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Concept Connection Example 7-3


Finding the Yield at a Price
Benson issued a $1,000, 8%, 30-year bond 14
years ago.
Bond is now selling for $718.
What is yield to an investor buying it today?
Semiannual interest.

Concept Connection Example 7-3


Finding the Yield at a Price
As interest rates rise, bond prices fall, so yield must
be above 8%.
Guess 10% and apply Equation 7.4
PB PMT PVFA k, n + FV PVFk, n
$40 PVFA 5, 32 + $1,000 PVF5, 32
$40 15.8027 + $1,000 0.2099
$842.01
Next guess must be lower to drive price further down.
Answer is just below 12%

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Call Provisions
If interest rates fall, a firm may wish to retire old, high
interest bonds by refinancing with new, lower interest
debt

To ensure ability to refinance, issuers make bonds callable


Investors dont like calls lose high interest
Issuers and investors compromise
Call provisions usually have
A call premium
Extra money paid if called

Period of call protection


Guaranteed not to call for a number of years.

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Figure 7-5 Valuation of


a Bond Subject to Call

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Call Provisions
Valuing the Sure-To-Be-Called Bond
Requires that two changes be made to bond
valuation formula

PB PMT[PVFA k, n ] + FV[PVFk, n ]

The future value


becomes the call
price (face value plus
call premium).

n now represents
the number of
periods until the
bond is likely to be
called.

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Call Provisions
The new formula becomes
PB = PMT[PVFAk,m] + CP[PVFk,m]
Where
m = time to call
CP = call price = FV + Call Premium

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Concept Connection Example 7-4 Basics:


Pricing a Likely to Be Called Bond
Northern issued a $1,000, 25-year bond 5 years ago.
Call provision: Can call after 10 years with the payment of
one additional years interest at coupon rate.
Coupon rate is 18%. Market rate is now 8%.
What is the bond worth today?
Interest payments are semiannual.

Concept Connection Example 7-4 Basics:


Pricing a Likely to Be Called Bond
The bond must yield the current rate of interest in either case.

Concept Connection Example 7-4 Basics:


Pricing a Likely to Be Called Bond

PB (call) PMT[PVFAk,m ] CP[PVFk,m ]


m = number of periods to call
CP = call price = face value + call premium
PMT
m
k
CP

= (.18 x $1,000) / 2 = $90


= 5 x 2 = 10
= 8% /2 = 4%
= $1,000 + .18($1,000) = $1,180

PB (call) = $90 [PVFA4,10] + $1,180 [PVF4,10]


= $90[8.1109] + $1,000[.6756]
= $729.98 + $797.21
= $1,527.19

The Refunding Decision


When current interest rates fall below the
bonds coupon rate, a firm must decide
whether to call in the issue
Compare interest savings to cost of making call:
Call premium
Flotation costs Broker fees, printing costs, etc.

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Dangerous Bonds with


Surprising Calls
Bonds can have obscure call features buried
in their contract terms.
Most common type a sinking fund provision
requires an issuer to call in and retire a fixed
percentage of the issue each year
Generally no call premium
Provision is for the benefit of the bondholder

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Risky Issues
Sometimes bonds sell for a price far below
what valuation techniques suggest
Issuing company may be in financial trouble
Buying the bond is very risky
In theory riskier loans should be discounted at
higher rates leading to lower calculated prices

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Convertible Bonds
Unsecured bonds exchangeable for a fixed
number of shares of stock at the bondholder's
discretion
Conversion ratio - the number of shares of stock
received for each bond
conversion ratio

bond's par value


shares exchanged
conversionprice

Conversion price - the implied stock price if bond


is converted into a certain number of shares
Convertibles usually pay lower coupon rates

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Concept Connection Example 7-5 Basics:


Investing in Convertible Bonds
Harry Jenson purchased one of Algo Corp.s 9%, 25year convertible bonds at its $1,000 par value a year
ago when the companys common stock was selling for
$20. Similar bonds without a conversion feature
returned 12% at the time. The bond is convertible into
stock at a price of $25. The stock is now selling for $29.
Algo pays no dividends.
Notice that this bonds coupon rate was set below the
market rate for nonconvertible issues.

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Concept Connection Example 7-5 Basics:


Investing in Convertible Bonds
a. Harry exercised the conversion feature
today and immediately sold the stock he
received. Calculate the total return on his
investment.
b. What would Harrys return have been if he
had invested $1,000 in Algos stock instead of
the bond?

Concept Connection Example 7-5 Basics:


Investing in Convertible Bonds
shares exchanged

par value
conversion price

$1,000

$25

40 shares

The proceeds from selling those shares at the current market price were

40 x $29 $ 1,160
In addition the bond paid interest during the year of

$1,000 x .09 $90


So the total receipts from the bond investment were

$1,160 $90 $ 1,250

Concept Connection Example 7-5 Basics:


Investing in Convertible Bonds

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Concept Connection Example 7-5 Basics:


Investing in Convertible Bonds

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Concept Connection Example 7-5 Basics:


Investing in Convertible Bonds
Notice that the convertible enabled Harry to
participate in some but not all of the rapid price
appreciation of Algos stock.
Also notice that had the stock price fallen, an
investment in it would have had a negative
return, but the convertible would have returned
the 9% coupon rate.

Convertible Bonds
Effect of Conversion on Financial Statements
and Cash Flow
An accounting entry removes the value of
convertible bonds from long-term debt placing it
into equity as if new shares were sold
No immediate cash flow impact, but ongoing cash
flow implications exist
Interest payments stop
But dividend payments may start

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Advantages of Convertible Bonds


To Issuing Companies

To Buyers

Convertible features are


sweeteners enabling a
risky firm to pay a lower
interest rate
Viewed as a way to sell
equity at a price above
market
Usually have few or no
restrictions

Offer the chance to


participate in stock price
appreciation
Offer a way to limit risk
associated with a stock
investment

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Forced Conversion
A firm may want bonds converted
As stock price rises convertible represents a lost
opportunity to sell new equity at a higher price

Convertible bonds are always issued with call


features which can be used to force
conversion
Issuers generally call convertibles when stock
prices rise to 10-15% above conversion prices

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Valuing (Pricing) Convertibles


A convertibles price can depend on either
its value as a traditional bond or
the market value of the stock into which it can be
converted

A convertible is always worth at least the


larger of its value as a bond or as stock

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Figure 7-6 Value of a Convertible Bond

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Effect on Earnings Per ShareDiluted EPS


Upon conversion convertible bonds cause
dilution in EPS
EPS drops due to the increase in the number of
shares of stock outstanding

Thus outstanding convertibles represent a


potential to dilution of EPS

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Concept Connection Example 7-7 - Dilution


Montgomery Inc. Issued two thousand $1,000, 8% coupon
convertible bonds three years ago. Each bond is convertible into
stock at $25 per share. All of the Bonds remain outstanding, i.e.,
none have converted.
Last year net income was $3 million. One million shares stock
were outstanding for the entire year, and the firms marginal tax
rate was 40%.
Calculate Montgomerys basic and diluted EPS for the year.
Solution:
Basic EPS
net income number of shares
$3,000,000 1,000,000 = $3.00.

Concept Connection Example 7-7 Dilution


Diluted EPS
Assumes all bonds are converted at beginning of year.
1. Add the number of newly converted shares to denominator.
2. Adjust net income for after tax effect of interest saved.
1. Shares exchanged:
Par Conversion price = $1,000 $25 = 40 shares/bond
40 shares/bond 2,000 bonds = 80,000 shares
New shares outstanding = 1,000,000 + 80,000 = 1,080,000
2. Adjust the net income by interest saved:
Interest paid on bonds: .08 x $1,000 x 2,000 = $160,000
After tax: $160,000 (1-.4) = $96,000
New net income = $3,000,000 + $96,000 = $3,096,000

Diluted EPS: $3,096,000 1,080,000 = $2.87

Institutional Characteristics of Bonds


Kinds of Bonds
Bonds are either bearer or registered
Registered, Owners of Record, Transfer Agents
Owners of registered bonds are recorded with a
transfer agent.

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Kinds of Bonds
Secured bonds and mortgage bonds
Backed by specific assets - collateral

Debentures
Unsecured bonds - riskier

Subordinated debentures
Lower in payment priority than senior debt

Junk bonds
Risky companies - high interest rates

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Bond RatingsAssessing Default Risk


Bonds are assigned quality ratings reflecting
their probability of default.
Higher ratings mean lower default probability
Higher rated bonds pay lower interest rates

Bond rating agencies (Moodys, S&P) evaluate


bonds (and issuers), and assign a ratings

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Bond RatingsTable 7.2

Figure 7-7 Yield Differentials between Highand Low-Quality Bonds

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Controlling Default Risk


Bond Indentures
Bond indentures attempt to prevent borrowing
firms from becoming riskier after bonds issued
restrictive covenants limit activities and payouts

Safety also provided by sinking funds


Provide money for repayment of bond principal

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Appendix 7-A - Lease Financing


A lease is a contract giving one party (lessee)
the right to use an asset owned by another
(lessor) for a periodic payment
Individuals usually lease houses, apartments, and
automobiles
Companies lease equipment and real estate

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Leasing and Financial Statements


Originally leasing allowed use without ownership
Lease payments recognized as income statement
expenses, but
No impact on balance sheets
No recognition of ownership or obligation to pay

Improved appearance of financial ratios


Not real

Led to widespread use of lease financing


The leading form of off balance sheet financing

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Misleading Results
Off balance sheet financing makes financial
statements misleading
Missed lease payments can cause failure just like
a missed interest payment on debt
Not showing leases on the balance sheet can
mislead investors into thinking a firm is stronger
than it is

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FASB 13 Redefines Ownership


1970s: Concerns about leasing led to FASB 13
Prior to FASB 13 an asset was owned for financial
statement purposes by whoever held title
Regardless of who used it
FASB 13 redefined ownership for financial reporting
purposes in economic terms
FASB 13 stated that the real owner of an asset is
whoever enjoys its benefits and bears its risks and
responsibilities

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Operating and Capital (Financing)


Leases
Under FASB 13 lessees must capitalize
financing leases
Puts the value of leased assets and the liability for
payments on the balance sheet
Long term leases for high value assets

Operating leases can still be listed off the


balance sheet
Short term leases for lower value items

Rules must be met for a lease to be classified


as an operating lease
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Financial Statement Presentation of


Leases by Lessees
Operating leases
Recognize rent expense
No balance sheet entries

Financing (Capital) leases


Recognize asset and lease obligation on balance
sheet
Recognize depreciation expense for asset
Amortize lease obligation like a loan

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Leasing from the Perspective


of the Lessor
Lessors are usually financial institutions banks, finance or insurance companies
Lease payments are calculated to offer the
lessor a given return
Lessor holds legal titlecan repossess assets
if lessee defaults
Lessors get better treatment in bankruptcy
proceedings than lenders

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Residual Values
Residual valuethe value of asset at the end
of the lease
Makes lease pricing and return calculations
more complex
Important negotiating points between lessee
and lessor

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Lease Vs. Buy


The Lessees Perspective
Broad financing possibilities
Equity
Debtavailable through bonds or banks
Leasingavailable through leasing companies

Conduct a lease vs. buy comparison


Choose the lowest cost option in a present value
sense

Leasing is almost always more expensive

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The Advantages of Leasing


Lessors usually require no down payment,
lenders want significant money down
Lessors restrictions less stringent than
lenders
Easier credit with manufacturers/lessors

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The Advantages of Leasing


Short leases transfer the risk of obsolescence
to lessors
Tax deducting the cost of land
Increasing liquiditythe sale and leaseback
Tax advantages for marginally profitable
companies

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Leveraged Leases
The ability to depreciate assets reduces taxes
Government shares the cost of ownership
Unprofitable firms lose this benefit as they pay no tax
But can get some benefits with a Leveraged Lease

In a leveraged lease, a profitable lessor buys


equipment financing a portion with borrowed money
(hence a leveraged lease)
Leveraged Lessor receives the tax benefits of ownership

Lessor shares those tax benefits with the lessee


through lower lease payments
Lessees savings can be very substantial

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Figure 7A-1 Leveraged Leases

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