Chapter 7: The Valuation and Characteristics of Bonds Flashcards
Distinguish between different kinds of bonds.
There is a variety of types of bonds, including:
- Debentures
- Subordinated debentures
- Mortgage bonds
- Eurobonds
- Convertible bonds
Bonds
A long-term (10-year or more) promissory note issued by the borrower, promising to pay the owner of the security a predetermined, fixed amount of interest each year.
Debenture
Any unsecured long-term debt.
Subordinated Debenture
A debenture that is subordinated to other debentures in terms of its payments in case of insolvency.
Mortgage Bond
A bond secured by a lien on real property.
Eurobond
A bond issued in a country different from the one in which the currency of the bond is denominated; for example, a bond issued in Europe or Asia by an American company that pays interest and principal to the lender in U.S. dollars.
Convertible Bond
A debt security that can be converted into a firm’s stock at a prespecified price.
Explain the more popular features of bonds.
Some of the more popular terms and characteristics used to describe bonds include the following:
- Claims on assets and income
- Par value
- Coupon interest rate
- Maturity
- Call provision
- Indenture
- Bond ratings
Par Value
On the face of a bond, the stated amount that the firm is to repay upon the maturity date.
Coupon Interest Rate
The interest rate contractually owed on a bond as a percent of its par value.
Fixed-Rate Bond
A bond that pays a fixed amount of interest to the investor each year.
Zero Coupon Bond
A bond issued at a substantial discount from its $1,000 face value and that pays little or no interest.
Maturity
The length of time until the bond issuer returns the par value to the bondholder and terminates the bond.
Callable Bonds (Redeemable Bond)
An option available to a company issuing a bond whereby the issuer can call (redeem) the bond before it matures. This is usually done if interest rates decline below what the firm is paying on the bond.
Call Protection Period
A prespecified time period during which a company cannot recall a bond.
Indenture
The legal agreement between the firm issuing bonds and the bond trustee who represents the bondholders, providing the specific terms of the loan agreement.
Junk Bond
Any bond rated BB or below.
High-Yield Bond
See junk bond: Any bond rated BB or below.
Define the term “value” as used for several different purposes.
Value is defined differently depending on the context. But for us, value is the present value of future cash flows expected to be received from an investment, discounted at the investor’s required rate of return.
Book Value
- The value of an asset as shown on the firm’s balance sheet. It represents the historical cost of the asset rather than its current market value or replacement cost.
- The depreciated value of a company’s assets (original cost less accumulated depreciation) less outstanding liabilities.
Liquidation Value
The dollar sum that could be realized if an asset were sold.
Market Value
The value observed in the marketplace.
Intrinsic, or Economic, Value
The present value of an asset’s expected future cash flows. This value is the amount the investor considers to be fair value, given the amount, timing, and riskiness of future cash flows.
Fair Value
The present value of an asset’s expected future cash flows.
Efficient Market
Market where the values of all securities fully recognize all available public information.
Behavioral Finance
The field of study examining when investors act rationally or irrationally when making investment decisions.
Explain the factors that determine value.
Three basic factors determine an asset’s value:
- The amount and timing of future cash flows
- The riskiness of the cash flows
- The investor’s attitude about the risk.
Describe the basic process for valuing assets.
The valuation process can be described as follows: it is assigning value to an asset by calculating the present value of its expected future cash flows using the investor’s required rate of return as the discount rate. The investor’s required rate of return, r, equals the risk-free rate of interest plus a risk premium to compensate the investor for assuming risk.
Asset Value (V) Equation
Cash flow in year 1/(1 + Required rate of returnor year 1) + Cash flow in year 2/(1 + Required rate of return of year 2) + . . . Cash flow in year n/(1 + Required rate of return of year n) = C1/(1 + r1) + C2/(1 + r2) + . . . Cn/(1+ rn)
Estimate the value of a bond.
The value of a bond is the present value of both future interest to be received and the par or maturity value of the bond.
Bond Value (Vb) Equation
$ interest in year 1/(1 + Required rate of return)^1 + $ interest in year 2/(1 + Required rate of return)^2 + $ interest in year 3/(1 + Required rate of return)^3 + . . . $ interest in year n/(1 + Required rate of return)^n + $ maturity value of bond/(1 + Required rate of return)^n
= $I1/(1 + rb)^1 + $I2/(1 + rb)^2 + $I3/(1 + rb)^3 + . . . + $In/(1 + rb)^n + $M/(1 + rb)^n
= ($I1/2)/(1 + rb/2)^1 + ($I2/2)/(1 + rb/2)^2 + ($I3/2)/(1 + rb/2)^3 + . . . + ($In/2)/(1 + rb/2)^2n + $M/(1 + rb/2)^2n
Compute a bond’s expected rate of return and its current yield.
To measure bondholder’s expected rate of return, we find the discount rate that equates the present value of the future cash flows (interest and maturity value) with the current market price of the bond. The expected rate of return for a bond is also the rate of return the investor will earn if the bond is held to maturity, or the yield to maturity. We may also compute the current yield as the annual interest payment divided by the bond’s current market price, but this is not an accurate measure of a bondholder’s expected rate of return.
Expected Rate of Return
- The discount rate that equates the present value of the future cash flows (interest and maturity value) of a bond with its current market price. It is the rate of return an investor will earn if the bond is held to maturity.
- The rate of return the investor expects to receive on an investment by paying the existing market price of the security.
Yield to Maturity
The rate of return a bondholder will receive if the bond is held to maturity. (It is equivalent to the expected rate of return.)
Current Yield
The ratio of a bond’s annual interest payment to its market price.
Market Price (P0) Equation
($ interest in year 1)/(1 + Expected rate of return)^1 + ($ interest in year 2)/(1 + Expected rate of return)^2 + ($ interest in year 3)/(1 + Expected rate of return)^3 + . . . +($ interest in year n)/(1 + Expected rate of return)^n + ($ maturity value of bond)/(1 + Expected rate of return)^n
Current Yield Equation
Annual interest payment/Current market price of the bond
Explain three important relationships that exist in bond valuation.
Certain key relationships exist in bond valuation, these being:
- A decrease in interest rates (the required rates of return) will cause the value of a bond to increase; by contrast, an interest rate increase will cause a decrease in value. The change in value caused by changing interest rates is called interest rate risk.
- If the required rate of return (current interest rate):
(a) Equals the coupon interest rate, the bond will sell at par, or maturity value.
(b) Exceeds the bond’s coupon rate, the bond will sell below par value, or at a discount.
(c) Is less than the bond’s coupon rate, the bond will sell above par value, or at a premium. - A bondholder owning a long-term bond is exposed to greater interest rate risk than one owning a short-term bond.
Interest Rate Risk
The variability in a bond’s value caused by changing interest rates.
Discount Bond
A bond that sells at a discount, or below par value.
Premium Bond
A bond that is selling above its par value.
Asset Value Use
Indicates that the value of an asset, be it a security or an investment in plant and equipment, is equal to the present value of future cash flows expected to be received from the investment.
Bond Value Use
Calculates the value of a bond as the present value both of future interest payments and the par value of the bond to be received at maturity.
Bond Value When Interest is Paid Semiannually Use
Calculates the value of a bond as the present value both of future interest payments received semiannually and the par value of the bond to be received at maturity.
Yield to Maturity or Expected Rate of Return Use
The expected rate of return (yield to maturity) of a bond if held until maturity, given its current market price.
Current Yield Use
The yield today determined by dividing the interest payment by the current market price.
