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Lecture 4

Homework 5 Review &


Chapter 7

Homework 5 Review

Question 1
Sustainable Growth
Based on the following information, the
sustainable growth rate for Hendrix
Guitars, Inc., is 13.02%. The ROA is
11.52%.
Profit margin=6.4 %
Total asset turnover=1.80
Total debt ratio=0.60
Payout ratio=60 %

Question 1
We should begin by calculating the D/E ratio. We calculate the D/E
ratio as follows:
Total debt ratio = .60 = TD / TA
Inverting both sides we get:
1 / .60 = TA / TD
Next, we need to recognize that
TA / TD = 1 + TE / TD
Substituting this into the previous equation, we get:
1 / .60 = 1 + TE /TD
Subtract 1 (one) from both sides and inverting again, we get:
D/E = 1 / [(1 / .60) 1]
D/E = 1.5
With the D/E ratio, we can calculate the EM and solve for ROE using
the DuPont identity:

Question 1
ROE = (PM)(TAT)(EM)
ROE = (.064)(1.80)(1 + 1.5)
ROE = .2880 or 28.80%
Now, we use the ROE equation:
ROE = ROA(EM)
.2880 = ROA(2.5)
ROA = .1152 or 11.52%
Now we can calculate the retention ratio as:
b = 1 .60
b = .40
Finally, putting all the numbers we have calculated into the sustainable
growth rate equation, we get:
Sustainable growth rate = (ROE b) / [1 (ROE b)]
Sustainable growth rate = [.2880(.40)] / [1 .2880(.40)]
Sustainable growth rate = .1302 or 13.02%

Question 2
Sustainable Growth Rate
No Return, Inc., had equity of $165,000 at the beginning
of the year. At the end of the year, the company had
total assets of $250,000. During the year the company
sold no new equity. Net income for the year was
$80,000 and dividends were $49,000. (Input answers as
a percent rounded to 2 decimal places, without the
percent sign.)
The sustainable growth rate for the company is ___
percent.
The sustainable growth rate is ____ percent if you use the
formula and beginning of period equity. If you use end of
period equity in this formula, the sustainable growth rate
is ____ percent. Is this number too high or too low?
Why?

Question 2
Since the company issued no new equity,
shareholders equity increased by retained
earnings.
Retained earnings for the year were:
Retained earnings = NI Dividends
Retained earnings = $80,000 49,000
Retained earnings = $31,000
So, the equity at the end of the year was:
Ending equity = $165,000 + 31,000
Ending equity = $196,000

Question 2
The ROE based on the end of period equity is:
ROE = $80,000 / $196,000
ROE = 40.82%
The plowback ratio is:
Plowback ratio = Addition to retained earnings/NI
Plowback ratio = $31,000 / $80,000
Plowback ratio = .3875 or = 38.75%
Using the equation presented in the text for the sustainable growth rate,
we get:
Sustainable growth rate = (ROE b) / [1 (ROE b)]
Sustainable growth rate = [.4082(.3875)] / [1 .4082(.3875)]
Sustainable growth rate = .1879 or 18.79%
The ROE based on the beginning of period equity is
ROE = $80,000 / $165,000
ROE = .4848 or 48.48%

Question 2
Using the shortened equation for the sustainable growth rate and the
beginning of period ROE, we get:
Sustainable growth rate = ROE b
Sustainable growth rate = .4848 .3875
Sustainable growth rate = .1879 or 18.79%
Using the shortened equation for the sustainable growth rate and the
end of period ROE, we get:
Sustainable growth rate = ROE b
Sustainable growth rate = .4082 .3875
Sustainable growth rate = .1582 or 15.82%
Using the end of period ROE in the shortened sustainable growth rate
results in a growth rate that is too low. This will always occur
whenever the equity increases. If equity increases, the ROE based on
end of period equity is lower than the ROE based on the beginning of
period equity. The ROE (and sustainable growth rate) in the
abbreviated equation is based on equity that did not exist when the
net income was earned.

Question 2
Sustainable Growth Rate
No Return, Inc., had equity of $165,000 at the beginning of
the year. At the end of the year, the company had total
assets of $250,000. During the year the company sold
no new equity. Net income for the year was $80,000 and
dividends were $49,000. (Input answers as a percent
rounded to 2 decimal places, without the percent sign.)
The sustainable growth rate for the company is 18.79
percent.
The sustainable growth rate is 18.79% percent if you use
the (ROE x b) formula and beginning of period equity. If
you use end of period equity in this formula, the
sustainable growth rate is 15.82% percent. Is this
number too high or too low? This is too low because
equity has increased (see previous slide) Why?

Question 3
Assets and costs are proportional to
sales. Debt and equity are not. A
dividend of $963.60 was paid, and
McGillicudy wishes to maintain a constant
payout ratio. Next year's sales are
projected to be $23,040. The external
financing needed is $ _____

Balance Sheet

Income Statement

Sales

$ 19,200

Costs

15,550

Assets

Taxes (34 %)

$ 3,650
1,241
========

Net income

$ 2,409
========

Debt
Equity

========
Taxable
income

$ 93,000
========

Total

$ 93,000
========

$ 20,400
72,600
========

Total

$ 93,000
========

Question 3
An increase of sales to $23,040 is an increase of:
Sales increase = ($23,040 19,200) / $19,200
Sales increase = .20 or 20%
Assuming costs and assets increase proportionally, the pro
forma financial statements will look like this:
Pro forma income statement
Sales
$23,040.00
Costs
18,660.00
EBIT
4,380.00
Taxes(34%)1,489.20
Net income$2,890.80

Pro forma balance sheet


Assets
$ 111,600
Total

111,600

Debt
Equity
Total

$20,400.00
74,334.48
$ 94,734.48

Question 3
The payout ratio is constant, so the dividends paid this year is the
payout ratio from last year times net income, or:
Dividends = ($963.60 / $2,409)($2,890.80)
Dividends = $1,156.32
The addition to retained earnings is:
Addition to retained earnings = $2,890.80 1,156.32
Addition to retained earnings = $1,734.48
And the new equity balance is:
Equity = $72,600 + 1,734.48
Equity = $74,334.48
So the EFN is:
EFN = Total assets Total liabilities and equity
EFN = $111,600 94,734.48
EFN = $16,865.52

Question 4
A 20 percent growth rate in sales is
projected. Prepare a pro forma income
statement assuming costs vary with
sales and the dividend payout ratio is
constant.

HEIR JORDAN CORPORATION


Income Statement
--------------------------------------------------------------------------------------------------------------------------Sales

$ 29,000

Costs

11,200
========

Taxable Income

$ 17,800

Taxes (34%)

6,052
========

Net income

$ 11,748
========

Dividends
Addition to retained earnings

$ 4,935
6,813

HEIR JORDAN CORPORATION


Pro Forma Income Statement
--------------------------------------------------------------------------------------------------------------------------Sales

=$29,000*1.2=$34,800

Costs

=$11,200*1.2=$13,440
========

Taxable Income

$21,360

Taxes (34%)

$7,262.40
========

Net income

$14,097.60
========

Dividends (Ratio = 4,935/11,748 = .42)

$ 5921.68

Addition to retained earnings

$ 8175.92

HEIR JORDAN CORPORATION


Balance Sheet
Assets

Liabilities and Owners' Equity


Percentage

Percentage

of Sales

Current assets
Cash

Current liabilities
$ 3,525

Accounts receivable

7,500

Inventory

6,000

========

========

$ 17,025

========

========

Total

Accounts
payable
Notes payable

Total

Long-term debt

Fixed assets
Net plant and
equipment

of Sales

$ 30,000

========

========

$ 3,000

7,500

========

========

$ 10,500

========

========

$ 19,500

========

========

$ 15,000

2,025

========

========

$ 17,025

========

========

$ 47,025

========

========

Owners' equity
Common stock
and paid-in surplus
Retained
earnings

Total

Total liabilities and


Total assets

$ 47,025

========

========

owners' equity

Question 5: Supply the missing information using the percentage of sales approach. Assume that
accounts payable vary with sales, whereas notes payable do not. (Input answers as a percent
rounded to 2 decimal places, without the percent sign.)(Enter "n/a" where needed.)
HEIR JORDAN CORPORATION
Balance Sheet
($)
(%)
Assets
Current assets
Cash
$3,525
A/R
7,500
Inventory 6,000
Total
$17,025
Fixed assets
Net P&E 30,000

($)

12.16
25.86
20.69
58.71
103.45

Total assets $47,025 162.16


Total liabilities and owners equity $47,025

n/a

(%)

Liabilities and Owners Equity


Current liabilities
A/P
$3,000
Notes payable
7,500
Total
$10,500
Long-term debt
19,500

10.34
n/a
n/a
n/a

Owners equity
CS & Paid surplus
Retained earnings

$15,000
2,025

n/a
n/a

Total

$17,025

n/a

Question 6: Prepare a pro forma balance sheet showing EFN, assuming a 15


percent increase in sales, no new external debt or equity financing, and a
constant payout ratio.
Assuming costs vary with sales and a 15 percent increase in sales, the pro forma income statement will
look like this:
HEIR JORDAN CORPORATION
Pro Forma Income Statement

Sales

$33,350.00

Costs

12,880.00

Taxable income

$20,470.00

Taxes (34%)

6,959.80

Net income

$ 13,510.20

The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times net
income, or:
Dividends = ($4,935/$11,748)($13,510.20)
Dividends = $5,674.94
And the addition to retained earnings will be:
Addition to retained earnings = $13,240.20 5,674.94
Addition to retained earnings = $7,835.26
The new total addition to retained earnings on the pro forma balance sheet will be:
New total addition to retained earnings = $2,025 + 7,835.26
New total addition to retained earnings = $9,860.26

The pro forma balance sheet will look like this:


HEIR JORDAN CORPORATION
Pro Forma Balance Sheet
Assets
Current assets
Cash
$
Accounts receivable
Inventory
Total
$

4,053.75
8,625.00
6,900.00
19,578.75

Liabilities and Owners Equity


Current liabilities
Accounts payable
$
Notes payable
Total
$

3,450.00
7,500.00
10,950.00

Long-term debt

19,500.00

Owners equity
Common stock and
paid-in surplus
Retained earnings
Total
$
Total liabilities and owners equity $

$15,000.00
9,860.26
24,860.26
55,310.26

Fixed assets
Net plant and
equipment

Total assets

34,500.00

54,078.75

So the EFN is:


EFN = Total assets Total liabilities and equity
EFN = $54,078.75 55,310.26
EFN = $1,231.51

Question 7

Find the following financial ratios for Smolira


Golf Corp. (use year-end figures rather than
average values where appropriate):

For solvency and utilization ratios: (Round


answers to 2 decimal places.)

For profitability ratios: (Input answers as a


percent rounded to 2 decimal places, without a
percent sign.)

SMOLIRA GOLF CORP.


2004 and 2005 Balance Sheets
Assets

Liabilities and Owners'


Equity

2004

2005

2004

2005

$ 983

$ 1,292

Current
liabilities

Current assets
Cash

$ 815

$ 906

Accounts
payable

Accounts
receivable

2,405

2,510

Notes payable

720

840

Inventory

4,608

4,906

Other

105

188

$ 7,828

$ 8,322

Total

$ 1,808

$ 2,320

Long-term debt

$ 4,817

$ 4,960

$ 10,000

$ 10,000

6,367

10,209

Total

$ 16,367

$ 20,209

Total liabilities
and owners'
equity

$ 22,992

$ 27,489

Total
Fixed assets
Net plant and
equipment

Total assets

$ 15,164

$ 19,167

Owners' equity

========

========

Common
stock and paidin surplus

$ 22,992

$ 27,489

Retained
earnings

SMOLIRA GOLF CORP.


2005 Income Statement
Sales

$ 33,500

Costs of goods sold

18,970

Depreciation

1,980
========

Earnings before interest and taxes

$ 12,550

Interest paid

486
========

Taxable Income

$ 12,064

Taxes (35%)

4,222
========

Net income

$ 7,842
========

Dividends
Addition to retained earnings

$ 4,000
3,842

Short-term solvency ratios:

Current ratio = Current assets / Current liabilities


Current ratio 2004 = $7,828 / $1,808 = 4.33 times
Current ratio 2005 = $8,322 / $2,320 = 3.59 times
Quick ratio = (Current assets Inventory) / Current liabilities
Quick ratio 2004 = ($7,828 4,608) / $1,808 = 1.78 times
Quick ratio 2005 = ($8,322 4,906) / $2,320 = 1.47 times
Cash ratio = Cash / Current liabilities
Cash ratio 2004
= $815 / $1,808 = 0.45 times
Cash ratio 2005 = $906 / $2,320 = 0.39 times

Asset utilization ratios:


Total asset turnover = Sales / Total assets
Total asset turnover
= $33,500 / $27,489 = 1.22 times
Inventory turnover
= Cost of goods sold / Inventory
Inventory turnover
= $18,970 / $4,906 = 3.87 times
Receivables turnover
= Sales / Accounts receivable
Receivables turnover
= $33,500 / $2,510 = 13.35 times
Long-term solvency ratios:
Total debt ratio
= (Total assets Total equity) / Total assets
Total debt ratio 2004
= ($22,992 16,367) / $22,992 = 0.29
Total debt ratio 2005
= ($27,489 20,209) / $27,489 = 0.26
Debt-equity ratio
= Total debt / Total equity
Debt-equity ratio 2004
= ($1,808 + 4,817) / $16,367 = 0.40
Debt-equity ratio 2005
= ($2,320 + 4,960) / $20,209 = 0.36
Equity multiplier
= 1 + D/E
Equity multiplier 2004
= 1 + 0.40 = 1.40
Equity multiplier 2005
= 1 + 0.36 = 1.36
Times interest earned
= EBIT / Interest
Times interest earned
= $12,550 / $486 = 25.82 times
Cash coverage ratio= (EBIT + Depreciation) / Interest
Cash coverage ratio
= ($12,550 + 1,980) / $486 = 29.90 times

Profitability ratios:
Profit margin
Profit margin
Return on assets
Return on assets
Return on equity
Return on equity

= Net income / Sales


= $7,842 / $33,500 = 23.41%
= Net income / Total assets
= $7,842 / $27,489 = 28.53%
= Net income / Total equity
= $7,842 / $20,209 = 38.80%

Question 8

The most recent financial statements for Moose


Tours, Inc., follow. Sales for 2005 are projected to
grow by 20 percent. Interest expense will remain
constant; the tax rate and the dividend payout
rate will also remain constant. Costs, other
expenses, current assets, and accounts
payable increase spontaneously with sales. If
the firm is operating at full capacity and no new
debt or equity is issued, external financing in
the amount of $_____ is needed to support the
20 percent growth rate in sales.

MOOSE TOURS, INC.


2004 Income Statement
------------------------------------------------------------------------------------------------Sales

$ 905,000

Costs

710,000

Other expenses

12,000
========

Earnings before interest and taxes

$ 183,000

Interest paid

19,700
========

Taxable Income

$ 163,300

Taxes (35%)

57,155
========

Net income

$ 106,145
========

Dividends
Addition to retained earnings

$ 42,458
63,687

MOOSE TOURS, INC.


Balance Sheet as of December 31, 2004
Assets

Liabilities and Owners' Equity

Current assets
Cash

Current liabilities
$ 25,000

Accounts
receivable

43,000

Inventory

76,000

Total

$ 144,000

Accounts payable
Notes payable

$ 65,000
9,000

Total

$ 74,000

Long-term debt

$ 156,000

Owners' equity
Common stock
and

Fixed assets
Net plant and
equipment

$ 364,000

Total assets

$ 508,000

paid-in surplus
Retained
earnings
Total

$ 21,000
257,000
$ 278,000

Total liabilities and


owners' equity

$ 508,000

Assuming costs vary with sales and a 20 percent increase in sales, the pro forma income
statement will look like this:
MOOSE TOURS INC.
Pro Forma Income Statement
Sales $
1,086,000
Costs 852,000
Other expenses 14,400
EBIT $
219,600
Interest
19,700
Taxable income $199,900
Taxes(35%)
69,965
Net income
$129,935
The payout ratio is constant, so the dividends paid this year is the payout ratio from last
year times net income, or:
Dividends = ($42,458/$106,145)($129,935)
Dividends = $51,974
And the addition to retained earnings will be:
Addition to retained earnings = $129,935 51,974
Addition to retained earnings = $77,961

The new addition to retained earnings on the pro forma balance sheet will be:
New addition to retained earnings = $257,000 + 77,961
New addition to retained earnings = $334,961
The pro forma balance sheet will look like this:
MOOSE TOURS INC.
Pro Forma Balance Sheet
Assets
Liabilities and Owners Equity
Current assets
Current liabilities
Cash
$30,000 Accounts payable
$78,000
Accounts receivable 51,600
Notes payable
Inventory 91,200
Total
$87,000
Total
$
172,800 Long-term debt

9,000
156,000

Fixed assets
Net plant and equipment 436,800 Owners equity
Common stock and
paid-in surplus
$21,000
Retained earnings 334,961
Total $355,961
Total liabilities and owners
Total assets
$609,600 equity
$598,961

Question 8

The most recent financial statements for Moose


Tours, Inc., follow. Sales for 2005 are projected to
grow by 20 percent. Interest expense will remain
constant; the tax rate and the dividend payout
rate will also remain constant. Costs, other
expenses, current assets, and accounts
payable increase spontaneously with sales. If
the firm is operating at full capacity and no new
debt or equity is issued, external financing in
the amount of $_____ is needed to support the
20 percent growth rate in sales.

Question 8
So the EFN is:
EFN = Total assets Total liabilities and
equity
EFN = $609,600 598,961
EFN = $10,639

Question 9

The most recent financial statements for Moose


Tours, Inc., follow. Sales for 2005 are projected to
grow by 20 percent. Interest expense will remain
constant; the tax rate and the dividend payout
rate will also remain constant. Costs, other
expenses, current assets, and accounts payable
increase spontaneously with sales. If the firm is
operating at full capacity and wishes to keep its
debt-equity ratio constant, external financing in
the amount of $ is needed to support the 20
percent growth rate in sales.

Question 9
The D/E ratio of the company is:
D/E = ($156,000 + 74,000) / $278,000
D/E = .82734
So the new total debt amount will be:
New total debt = .82734($355,961)
New total debt = $294,500.11
So the EFN is:
EFN = $609,600 ($294,500.11 + 355,961) = $40,861.11
An interpretation of the answer is not that the company has a negative EFN. Looking
back at Question 8, we see that for the same sales growth, the EFN is $10,639. The
negative number in this case means the company has too much capital. There are
two possible solutions. First, the company can put the excess funds in cash, which
has the effect of changing the current asset growth rate. Second, the company can
use the excess funds to repurchase debt and equity. To maintain the current capital
structure, the repurchase must be in the same proportion as the current capital
structure.

At a 20 percent growth rate, and assuming the payout ratio is constant, the
dividends paid will be:
Dividends = ($42,458/$106,145)($129,935)
Dividends = $51,974
And the addition to retained earnings will be:
Addition to retained earnings = $129,935 51,974
Addition to retained earnings = $77,961
The new addition to retained earnings on the pro forma balance sheet will be:
New addition to retained earnings = $257,000 + 77,961
New addition to retained earnings = $334,961
The new total debt will be:
New total debt = .82734($334,961)
New total debt = $294,500
So, the new long-term debt will be the new total debt minus the new shortterm debt, or:
New long-term debt = $294,500 87,000
New long-term debt = $207,500

So the EFN is:


EFN = Total assets Total liabilities and equity
EFN = $609,600 650,461
EFN = $40,861

Question 10
EFN and Sustainable Growth
The most recent financial statements for Moose Tours, Inc., follow. Sales for
2005 are projected to grow by 30 percent. Interest expense will remain
constant; the tax rate and the dividend payout rate will also remain constant.
Costs, other expenses, current assets, and accounts payable increase
spontaneously with sales. If the firm is operating at full capacity and wishes
to keep its debt-equity ratio constant, external financing in the amount of
$_____ is needed to support the 30 percent growth rate in sales. (Round
answers to nearest whole dollar.)
If the projected sales growth rate for 2005 is 35 percent instead of 30 percent,
the amount of external financing needed is $_____.
At a sales growth rate of _____% percent, the EFN is equal to zero.
Note: This last question cannot be answered if you do not allow debt to
change to meet the debt-equity ratio at the beginning of the question.

MOOSE TOURS, INC.


2004 Income Statement
------------------------------------------------------------------------------------------------Sales

$ 905,000

Costs

710,000

Other expenses

12,000
========

Earnings before interest and taxes

$ 183,000

Interest paid

19,700
========

Taxable Income

$ 163,300

Taxes (35%)

57,155
========

Net income

$ 106,145
========

Dividends
Addition to retained earnings

$ 42,458
63,687

MOOSE TOURS, INC.


Balance Sheet as of December 31, 2004
Assets

Liabilities and Owners' Equity

Current assets
Cash

Current liabilities
$ 25,000

Accounts
receivable

43,000

Inventory

76,000

Total

$ 144,000

Accounts payable
Notes payable

$ 65,000
9,000

Total

$ 74,000

Long-term debt

$ 156,000

Owners' equity
Common stock
and

Fixed assets
Net plant and
equipment

$ 364,000

Total assets

$ 508,000

paid-in surplus
Retained
earnings
Total

$ 21,000
257,000
$ 278,000

Total liabilities and


owners' equity

$ 508,000

20% Sales
Growth

30% Sales
Growth

35% Sales
Growth

Sales

$1,086,000

$1,176,500

$1,221,750

Costs

852,000

923,000

958,500

14,400

15,600

16,200

$ 219,600

$ 237,900

$ 247,050

19,700

19,700

19,700

$ 199,900

$ 218,200

$ 227,350

69,965

76,370

79,573

$ 129,935

$ 141,830

$ 147,778

51,974

$ 56,732

77,961

85,098

Other expenses

EBIT

Interest

Taxable income

Taxes (35%)

Net income

Dividends

Add to RE

59,111

88,667

Under the sustainable growth rate assumption, the company maintains a constant debtequity ratio. The D/E ratio of the company is:
D/E = ($156,000 + 74,000) / $278,000
D/E = .82734
At a 30 percent growth rate, and assuming the payout ratio is constant, the dividends paid
will be:
Dividends = ($42,458/$106,145)($141,830) = $56,732
And the addition to retained earnings will be:
Addition to retained earnings = $141,830 56,732 = $85,098
The new addition to retained earnings on the pro forma balance sheet will be:
New addition to retained earnings = $257,000 + 85,098 = $342,098
The new total debt will be:
New total debt = .82734($342,098) = $300,405
So, the new long-term debt will be the new total debt minus the new short-term debt, or:
New long-term debt = $300,405 93,500 = $206,905

So the EFN is:


EFN = Total assets Total liabilities and equity
EFN = $660,400 663,503
EFN = $3,103

At a 35 percent growth rate, and assuming the payout ratio is constant,


the dividends paid will be:
Dividends = ($42,458/$106,145)($147,778) = $59,111
And the addition to retained earnings will be:
Addition to retained earnings = $147,778 59,111 = $88,667
The new addition to retained earnings on the pro forma balance sheet
will be:
New addition to retained earnings = $257,000 + 88,667 = $345,667
The new total debt will be:
New total debt = .82734($366,667) = $303,357
So, the new long-term debt will be the new total debt minus the new
short-term debt, or:
New long-term debt = $303,357 96,750 = $206,607

So the EFN is:


EFN = Total assets Total liabilities and equity
EFN = $685,800 670,024
EFN = $15,776

Question 10
EFN and Sustainable Growth
Note: At 30% growth, there is a paydown in
external financing, while at 35% growth there is
a positive need for external financing
At a sales growth rate of 30.82%, the EFN is equal
to zero.
Why is this internal growth rate different from that
found by using the equation in the text?

Chapter 7
Interest Rates and Bond
Valuation

Key Concepts and Skills

Know the important bond features and bond types


Understand bond values and why they fluctuate
Understand bond ratings and what they mean
Understand the impact of inflation on interest
rates
Understand the term structure of interest rates
and the determinants of bond yields

Bond Definitions
Bond
Par value (face value)
Coupon rate
Coupon payment
Maturity date
Yield or Yield to maturity

Present Value of Cash Flows as


Rates Change
Bond Value = PV of coupons + PV of par
Bond Value = PV annuity + PV of lump
sum
Remember, as interest rates increase
present values decrease
So, as interest rates increase, bond prices
decrease and vice versa

Coupon BondYield to
Maturity
Using the same strategy used for the fixed-payment loan:
P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity date
C
C
C
C
F
P=

. . . +

2
3
n
1+i (1+i )
(1+i )
(1+i)
(1+i ) n

When the coupon bond is priced at its face value, the


yield to maturity equals the coupon rate
The price of a coupon bond and the yield to maturity
are negatively related
The yield to maturity is greater than the coupon rate
when the bond price is below its face value

Valuing a Discount Bond with


Annual
Coupons
Consider a bond with a coupon rate of 10% and annual coupons.

The par value is $1000 and the bond has 5 years to maturity. The
yield to maturity is 11%. What is the value of the bond?
Using

the formula:

= PV of annuity + PV of lump sum


B = 100[1 1/(1.11)5] / .11 + 1000 / (1.11) 5
B = 369.59 + 593.45 = 963.04
Using
N

the calculator:

= 5; I/Y = 11; PMT = 100; FV = 1000


CPT PV = -963.04

Valuing a Premium Bond with


Annual
Coupons
Suppose you are looking at a bond that has a 10% annual coupon
and a face value of $1000. There are 20 years to maturity and the
yield to maturity is 8%. What is the price of this bond?
Using

the formula:

B = PV of annuity + PV of lump sum


B = 100[1 1/(1.08)20] / .08 + 1000 / (1.08)20
B = 981.81 + 214.55 = 1196.36

Using

the calculator:

N = 20; I/Y = 8; PMT = 100; FV = 1000


CPT PV = -1196.36

Bond Price

Graphical Relationship Between


Price and Yield-to-maturity

Yield-to-maturity

Bond Prices: Relationship


Between Coupon and Yield
If YTM = coupon rate, then par value = bond price
If YTM > coupon rate, then par value > bond price

Why?
Selling

at a discount, called a discount bond

If YTM < coupon rate, then par value < bond price
Why?
Selling

at a premium, called a premium bond

The Bond-Pricing Equation

1
1
t

(1 r)
Bond Value C
r

F

t
(1 r)

Example 7.1

Find present values based on the payment


period
How

many coupon payments are there?


What is the semiannual coupon payment?
What is the semiannual yield?
B = 70[1 1/(1.08)14] / .08 + 1000 / (1.08)14 = 917.56
Or PMT = 70; N = 14; I/Y = 8; FV = 1000; CPT PV =
-917.56

Interest Rate Risk

Price Risk
Change

in price due to changes in interest rates


Long-term bonds have more price risk than short-term bonds
Low coupon rate bonds have more price risk than high coupon
rate bonds

Reinvestment Rate Risk

Uncertainty concerning rates at which cash flows can be reinvested


Short-term bonds have more reinvestment rate risk than long-term
bonds
High coupon rate bonds have more reinvestment rate risk than low
coupon rate bonds

Interest-Rate Risk

Prices and returns for long-term


bonds are more volatile than those for
shorter-term bonds

There is no interest-rate risk for any bond


whose time to maturity matches the
holding period

Figure 7.2

Computing Yield-to-maturity
Yield-to-maturity is the rate implied by the
current bond price
Finding the YTM requires trial and error if you
do not have a financial calculator and is similar
to the process for finding r with an annuity
If you have a financial calculator, enter N, PV,
PMT, and FV, remembering the sign convention
(PMT and FV need to have the same sign, PV
the opposite sign)

YTM with Annual Coupons

Consider a bond with a 10% annual


coupon rate, 15 years to maturity and a
par value of $1000. The current price is
$928.09.
Will

the yield be more or less than 10%?


N = 15; PV = -928.09; FV = 1000; PMT = 100
CPT I/Y = 11%

YTM with Semiannual Coupons

Suppose a bond with a 10% coupon rate and


semiannual coupons, has a face value of $1000,
20 years to maturity and is selling for $1197.93.
Is

the YTM more or less than 10%?


What is the semiannual coupon payment?
How many periods are there?
N = 40; PV = -1197.93; PMT = 50; FV = 1000; CPT
I/Y = 4% (Is this the YTM?)
YTM = 4%*2 = 8%

Table 7.1

Current Yield vs. Yield to Maturity

Current Yield = annual coupon / price


Yield to maturity = current yield + capital gains yield
Example: 10% coupon bond, with semiannual
coupons, face value of 1000, 20 years to maturity,
$1197.93 price
Current

yield = 100 / 1197.93 = .0835 = 8.35%


Price in one year, assuming no change in YTM = 1193.68
Capital gain yield = (1193.68 1197.93) / 1197.93 =
-.0035 = -.35%
YTM = 8.35 - .35 = 8%, which the same YTM computed
earlier

Bond Pricing Theorems


Bonds of similar risk (and maturity) will be
priced to yield about the same return,
regardless of the coupon rate
If you know the price of one bond, you can
estimate its YTM and use that to find the price
of the second bond
This is a useful concept that can be transferred
to valuing assets other than bonds

Bond Prices with a Spreadsheet

There is a specific formula for finding bond


prices on a spreadsheet
PRICE(Settlement,Maturity,Rate,Yld,Redemption,

Frequency,Basis)
YIELD(Settlement,Maturity,Rate,Pr,Redemption,
Frequency,Basis)
Settlement and maturity need to be actual dates
The redemption and Pr need to given as % of par value

Click on the Excel icon for an example

Differences Between Debt and


Equity

Debt

Not an ownership interest


Creditors do not have
voting rights
Interest is considered a
cost of doing business and
is tax deductible
Creditors have legal
recourse if interest or
principal payments are
missed
Excess debt can lead to
financial distress and
bankruptcy

Equity

Ownership interest
Common stockholders vote
for the board of directors
and other issues
Dividends are not
considered a cost of doing
business and are not tax
deductible
Dividends are not a liability
of the firm and stockholders
have no legal recourse if
dividends are not paid
An all equity firm can not go
bankrupt

The Bond Indenture

Contract between the company and the


bondholders and includes
The

basic terms of the bonds


The total amount of bonds issued
A description of property used as security, if applicable
Sinking fund provisions
Call provisions
Details of protective covenants

Bond Classifications
Registered vs. Bearer Forms
Security

Collateral

secured by financial securities


Mortgage secured by real property, normally land or
buildings
Debentures unsecured
Notes unsecured debt with original maturity less than
10 years

Seniority

Bond Characteristics and


Required Returns
The coupon rate depends on the risk
characteristics of the bond when issued
Which bonds will have the higher coupon, all
else equal?

Secured

debt versus a debenture


Subordinated debenture versus senior debt
A bond with a sinking fund versus one without
A callable bond versus a non-callable bond

Bond Ratings Investment


Quality

High Grade

Moodys Aaa and S&P AAA capacity to pay is extremely strong


Moodys Aa and S&P AA capacity to pay is very strong

Medium Grade

Moodys A and S&P A capacity to pay is strong, but more


susceptible to changes in circumstances
Moodys Baa and S&P BBB capacity to pay is adequate,
adverse conditions will have more impact on the firms ability to
pay

Bond Ratings - Speculative

Low Grade
Moodys

Ba, B, Caa and Ca


S&P BB, B, CCC, CC
Considered speculative with respect to capacity to pay. The B
ratings are the lowest degree of speculation.

Very Low Grade


Moodys

C and S&P C income bonds with no interest being paid


Moodys D and S&P D in default with principal and interest in
arrears

Government Bonds

Treasury Securities
Federal

government debt
T-bills pure discount bonds with original maturity of
one year or less
T-notes coupon debt with original maturity between
one and ten years
T-bonds coupon debt with original maturity greater

than ten years

Municipal Securities
Debt

of state and local governments


Varying degrees of default risk, rated similar to
corporate debt
Interest received is tax-exempt at the federal level

Example 7.4

A taxable bond has a yield of 8% and a municipal


bond has a yield of 6%
If

you are in a 40% tax bracket, which bond do you


prefer?
8%(1 - .4) = 4.8%
The after-tax return on the corporate bond is 4.8%, compared
to a 6% return on the municipal

At

what tax rate would you be indifferent between the two


bonds?
8%(1 T) = 6%
T = 25%

Zero-Coupon Bonds

Make no periodic interest payments (coupon rate =


0%)
The entire yield-to-maturity comes from the difference
between the purchase price and the par value
Cannot sell for more than par value
Sometimes called zeroes, deep discount bonds, or
original issue discount bonds (OIDs)
Treasury Bills and principal-only Treasury strips are
good examples of zeroes

Floating Rate Bonds

Coupon rate floats depending on some index value


Examples adjustable rate mortgages and inflationlinked Treasuries
There is less price risk with floating rate bonds
The

coupon floats, so it is less likely to differ


substantially from the yield-to-maturity

Coupons may have a collar the rate cannot go


above a specified ceiling or below a specified floor

Other Bond Types


Disaster bonds
Income bonds
Convertible bonds
Put bonds
There are many other types of provisions that can be
added to a bond and many bonds have several provisions
it is important to recognize how these provisions affect
required returns

Bond Markets
Primarily over-the-counter transactions with
dealers connected electronically
Extremely large number of bond issues, but
generally low daily volume in single issues
Makes getting up-to-date prices difficult,
particularly on small company or municipal issues
Treasury securities are an exception

Work the Web Example


Bond quotes are available online
One good site is Bonds Online
Click on the web surfer to go to the site

Follow

the bond search, corporate links


Choose a company, enter it under Express
Search Issue and see what you can find!

Treasury Quotations

Highlighted quote in Figure 7.4


8

Nov 21
132:23
132:24
-12 5.14
What is the coupon rate on the bond?
When does the bond mature?
What is the bid price? What does this mean?
What is the ask price? What does this mean?
How much did the price change from the previous day?
What is the yield based on the ask price?

Clean vs. Dirty Prices

Clean price: quoted price


Dirty price: price actually paid = quoted price plus accrued
interest
Example: Consider T-bond in previous slide, assume today is
July 15, 2005

Prices (based on ask):

Number of days since last coupon = 61


Number of days in the coupon period = 184
Accrued interest = (61/184)(.04*100,000) = 1326.09
Clean price = 132,750
Dirty price = 132,750 + 1,326.09 = 134,076.09

So, you would actually pay $134,076.09 for the bond

Inflation and Interest Rates


Real rate of interest change in purchasing
power
Nominal rate of interest quoted rate of
interest, change in purchasing power and
inflation
The ex ante nominal rate of interest includes
our desired real rate of return plus an
adjustment for expected inflation

The Fisher Effect


The Fisher Effect defines the relationship
between real rates, nominal rates and inflation
(1 + R) = (1 + r)(1 + h), where

= nominal rate
r = real rate
h = expected inflation rate

Approximation
R

=r+h

Fisher Equation
i ir e
i = nominal interest rate
ir = real interest rate

e = expected inflation rate


When the real interest rate is low,
there are greater incentives to borrow and fewer incentives to lend.
The real interest rate is a better indicator of the incentives to
borrow and lend.

Example 7.6
If we require a 10% real return and we expect
inflation to be 8%, what is the nominal rate?
R = (1.1)(1.08) 1 = .188 = 18.8%
Approximation: R = 10% + 8% = 18%
Because the real return and expected inflation
are relatively high, there is significant difference
between the actual Fisher Effect and the
approximation.

Term Structure of Interest


Rates

Bonds with identical risk, liquidity, and tax characteristics


may have different interest rates because the time
remaining to maturity is different

Yield curvea plot of the yield on bonds with differing terms


to maturity but the same risk, liquidity and tax considerations

Upward-sloping long-term rates are above


short-term rates

Flat short- and long-term rates are the same

Inverted long-term rates are below short-term rates

Interpreting the Yield Curve

Figure 7.7

Figure 7.6 Upward-Sloping


Yield Curve

Figure 7.6 Downward-Sloping


Yield Curve

Factors Affecting Required


Return
Default risk premium remember bond ratings
Taxability premium remember municipal versus
taxable
Liquidity premium bonds that have more
frequent trading will generally have lower
required returns
Anything else that affects the risk of the cash
flows to the bondholders will affect the required
returns

Quick Quiz

How do you find the value of a bond and why do bond


prices change?
What is a bond indenture and what are some of the
important features?
What are bond ratings and why are they important?
How does inflation affect interest rates?
What is the term structure of interest rates?
What factors determine the required return on bonds?