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91 Aufrufe100 SeitenLecture 4

Apr 20, 2016

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Lecture 4

© All Rights Reserved

Als PPT, PDF, TXT **herunterladen** oder online auf Scribd lesen

91 Aufrufe

Lecture 4

© All Rights Reserved

Als PPT, PDF, TXT **herunterladen** oder online auf Scribd lesen

- Principles: Life and Work
- The Intelligent Investor, Rev. Ed
- The Total Money Makeover: Classic Edition: A Proven Plan for Financial Fitness
- Red Notice: A True Story of High Finance, Murder, and One Man's Fight for Justice
- Business Adventures: Twelve Classic Tales from the World of Wall Street
- MONEY Master the Game: 7 Simple Steps to Financial Freedom
- Secrets of the Millionaire Mind: Mastering the Inner Game of Wealth
- I Will Teach You to Be Rich, Second Edition: No Guilt. No Excuses. No BS. Just a 6-Week Program That Works
- Bad Blood: Secrets and Lies in a Silicon Valley Startup
- The Intelligent Investor Rev Ed.
- The Intelligent Investor
- Your Money or Your Life: 9 Steps to Transforming Your Relationship with Money and Achieving Financial Independence: Fully Revised and Updated for 2018
- Rich Dad's Guide to Investing: What the Rich Invest In, That the Poor and Middle Class Do Not!
- "J" is for Judgment: A Kinsey Millhone Novel
- Rich Dad's Increase your Financial IQ: Get Smarter with Your Money
- One Up On Wall Street: How To Use What You Already Know To Make Money In
- The Richest Man in Babylon
- The Forbes / CFA Institute Investment Course: Timeless Principles for Building Wealth

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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

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.

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

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

========

$ 5921.68

$ 8175.92

Balance Sheet

Assets

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 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 liabilities and owners equity $47,025

n/a

(%)

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

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

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

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

EFN = Total assets Total liabilities and equity

EFN = $54,078.75 55,310.26

EFN = $1,231.51

Question 7

Golf Corp. (use year-end figures rather than

average values where appropriate):

answers to 2 decimal places.)

percent rounded to 2 decimal places, without a

percent sign.)

2004 and 2005 Balance Sheets

Assets

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

2005 Income Statement

Sales

$ 33,500

18,970

Depreciation

1,980

========

$ 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

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

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

= $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

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.

2004 Income Statement

------------------------------------------------------------------------------------------------Sales

$ 905,000

Costs

710,000

Other expenses

12,000

========

$ 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

Balance Sheet as of December 31, 2004

Assets

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

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

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

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

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.

2004 Income Statement

------------------------------------------------------------------------------------------------Sales

$ 905,000

Costs

710,000

Other expenses

12,000

========

$ 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

Balance Sheet as of December 31, 2004

Assets

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

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

EFN = Total assets Total liabilities and equity

EFN = $660,400 663,503

EFN = $3,103

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

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

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

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

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

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:

B = 100[1 1/(1.11)5] / .11 + 1000 / (1.11) 5

B = 369.59 + 593.45 = 963.04

Using

N

the calculator:

CPT PV = -963.04

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 = 100[1 1/(1.08)20] / .08 + 1000 / (1.08)20

B = 981.81 + 214.55 = 1196.36

Using

the calculator:

CPT PV = -1196.36

Bond Price

Price and Yield-to-maturity

Yield-to-maturity

Between Coupon and Yield

If YTM = coupon rate, then par value = bond price

If YTM > coupon rate, then par value > bond price

Why?

Selling

If YTM < coupon rate, then par value < bond price

Why?

Selling

1

1

t

(1 r)

Bond Value C

r

F

t

(1 r)

Example 7.1

period

How

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

Price Risk

Change

Long-term bonds have more price risk than short-term bonds

Low coupon rate bonds have more price risk than high coupon

rate bonds

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

bonds are more volatile than those for

shorter-term bonds

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)

coupon rate, 15 years to maturity and a

par value of $1000. The current price is

$928.09.

Will

N = 15; PV = -928.09; FV = 1000; PMT = 100

CPT I/Y = 11%

semiannual coupons, has a face value of $1000,

20 years to maturity and is selling for $1197.93.

Is

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

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

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

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

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

Equity

Debt

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

bondholders and includes

The

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

Mortgage secured by real property, normally land or

buildings

Debentures unsecured

Notes unsecured debt with original maturity less than

10 years

Seniority

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

Subordinated debenture versus senior debt

A bond with a sinking fund versus one without

A callable bond versus a non-callable bond

Quality

High Grade

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

Medium Grade

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

Low Grade

Moodys

S&P BB, B, CCC, CC

Considered speculative with respect to capacity to pay. The B

ratings are the lowest degree of speculation.

Moodys

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

Municipal Securities

Debt

Varying degrees of default risk, rated similar to

corporate debt

Interest received is tax-exempt at the federal level

Example 7.4

bond has a yield of 6%

If

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

bonds?

8%(1 T) = 6%

T = 25%

Zero-Coupon Bonds

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

Examples adjustable rate mortgages and inflationlinked Treasuries

There is less price risk with floating rate bonds

The

substantially from the yield-to-maturity

above a specified ceiling or below a specified floor

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

Bond quotes are available online

One good site is Bonds Online

Click on the web surfer to go to the site

Follow

Choose a company, enter it under Express

Search Issue and see what you can find!

Treasury Quotations

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?

Dirty price: price actually paid = quoted price plus accrued

interest

Example: Consider T-bond in previous slide, assume today is

July 15, 2005

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

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 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

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.

Rates

may have different interest rates because the time

remaining to maturity is different

to maturity but the same risk, liquidity and tax considerations

short-term rates

Figure 7.7

Yield Curve

Yield Curve

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

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?

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