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
10
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
11
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?
12
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
13
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.
14
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%.?
15
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 ]
16
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
17
Figure 7-2 Bond Cash Flow and
Valuation Concepts
18
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.
20
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%.
21
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
22
Table 7-1 Price Changes at Different Terms Due to an
Interest Rate Increase from 8% to 10%
23
Figure 7.3 Price Progression with
Constant Interest Rate
24
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.
25
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%
27
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.
28
Figure 7-5 Valuation of
a Bond Subject to Call
29
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.
30
Call Provisions
The new formula becomes
PB = PMT[PVFAk,m] + CP[PVFk,m]
Where
m = time to call
CP = call price = FV + Call Premium
31
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.
35
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
36
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
37
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
38
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.
39
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
42
Concept Connection Example 7-5 Basics:
Investing in Convertible Bonds
43
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
45
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
46
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
47
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
48
Figure 7-6 Value of a Convertible Bond
49
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
50
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.
53
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
54
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
55
Bond RatingsTable 7.2
Figure 7-7 Yield Differentials between Highand Low-Quality Bonds
57
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
58
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
59
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
60
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
61
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
62
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
63
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
64
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
65
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
66
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
67
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
68
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
69
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
70
Figure 7A-1 Leveraged Leases
71
