Chapter 7: Bonds and Their Valuation
Finance 335

  1. Capital is raised via:
    1. debt (bonds)
    2. common equity (stocks)
    3. preferred stock
  2. Bonds
    1. Bonds are long term promissory notes
    2. The Par Value of a Bond:
      1. Is the stated face value
        - It is usually $1,000 or multiples of $1,000
      2. The par value is the amount of money borrowed by firm.
      3. As well as the amount of money promised to be repaid at a future date
    3. Maturity Date
          - The date on which the par value is paid to the bondholders
    4. Coupon Interest Payment
      1. The yearly dollar amount paid to the holder of a bond
      2. It is a fixed amount determined at the time the bond is issued
    5. Coupon Interest Rate = Coupon Payment / Par Value
    6. New bond issues
      - The coupon payment is often set at a level that forces market price of bond to equal par value. (2 weeks prior to issue)
    7. Outstanding Bond
    8. Bond Valuation Model
      (Note: Most Bonds Make Semiannual Interest Payments):

       

      - OR -

       

      Where: n = number of years to maturity
                  r = current rate of interest for bonds
      Example: Consider a zero coupon bond (A bond that makes no coupon interest payments. It therefore sells at a discount from par.) What is the value of a five year zero coupon bond (based on annual discounting) if the discount rate is 12%?

       

      Notice that since there are no coupon interest payments this is simply a present value of a lump sum problem.
      Example: What is the value of a 5-year, 14% bond if the current rate of interest is 12% (Kd=12%)?

       

    9. Bond Prices are inversely related to interest rates
      1. Bonds sell at par when:    coupon rate = current interest rate
      2. Bonds sell below par when:    coupon rate < current int. rate
      3. Bonds sells above par when:    coupon rate > current int. rate
    10. Bonds sell at a premium when the coupon rate is greater than the current interest rate for bonds.    If a bond sells above par, its value is $1000 plus a premium.
    11. Bonds sell at a discount when the coupon rate is less than the current interest rate for bonds.    If a bond sells below par, its value is $1000 minus a the discount.
      Example: Suppose Kd = 17% on previous example:

       

      The bond sells at a discount of $98.42 ($98.42 = $1,000 - $901.58)
    12. As a bond's maturity increases:
      1. Larger price changes occur in response to movement in the market rate of interest.
      2. As a result long-term bond prices more sensitive than short-term bond prices to interest rate changes.
      3. Example: Compare the value of a 5 year bond with a coupon rate of 10 percent with that of a 30 year bond with the same coupon rate (10%) when the market interest rate changes:

    13. Yield to Maturity (YTM) - the interest rate earned on bond if it is held until the issuer of the bond redeems it (until maturity).
              
      1. YTM for bond at par = interest yield     
      2. YTM for a bond selling below par = interest yield + capital gain
      3. YTM for a bond selling above Par = interest yield - capital loss
    14. YTM Approximation Formula:

       

      YTM Approximation Formula Example: What is the yield to maturity on a 20 year bond with a current price of $900 if the coupon rate is 8 percent?

       

      A financial calculator can also be used to solve for yield to maturity.
    15. Resources:
  3. Preferred Stock (Chapter 8: pages 343-345)
    1. Considered a hybrid security because it has characteristics of both debt and equity.
    2. Valuing preferred stock is relatively simply because the dividend cash flows are a perpetual annuity. The valuation model is:

       

      Notice that there is no subscript on the Dividend since it is constant.
    3. Example: What is the value of an issue of preferred stock which pays a $2.00 dividend if the required rate of return is 11 percent:

       

    4. The expected return for preferred stock may be found using the following formula:

       

      Example: What is the expected return for the preferred stock of Xero Corp. if the price is currently $70 and the dividend is $7.50?