Chapter 7: The Valuation and Characteristics of Bonds

Question 1

Distinguish between different kinds of bonds.

Answer 1

There is a variety of types of bonds, including:

• Debentures
• Subordinated debentures
• Mortgage bonds
• Eurobonds
• Convertible bonds

Question 2

Bonds

Answer 2

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.

Question 3

Debenture

Answer 3

Any unsecured long-term debt.

Question 4

Subordinated Debenture

Answer 4

A debenture that is subordinated to other debentures in terms of its payments in case of insolvency.

Question 5

Mortgage Bond

Answer 5

A bond secured by a lien on real property.

Question 6

Eurobond

Answer 6

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.

Question 7

Convertible Bond

Answer 7

A debt security that can be converted into a firm’s stock at a prespecified price.

Question 8

Explain the more popular features of bonds.

Answer 8

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

Question 9

Par Value

Answer 9

On the face of a bond, the stated amount that the firm is to repay upon the maturity date.

Question 10

Coupon Interest Rate

Answer 10

The interest rate contractually owed on a bond as a percent of its par value.

Question 11

Fixed-Rate Bond

Answer 11

A bond that pays a fixed amount of interest to the investor each year.

Question 12

Zero Coupon Bond

Answer 12

A bond issued at a substantial discount from its $1,000 face value and that pays little or no interest.

Question 13

Maturity

Answer 13

The length of time until the bond issuer returns the par value to the bondholder and terminates the bond.

Question 14

Callable Bonds (Redeemable Bond)

Answer 14

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.

Question 15

Call Protection Period

Answer 15

A prespecified time period during which a company cannot recall a bond.

Question 16

Indenture

Answer 16

The legal agreement between the firm issuing bonds and the bond trustee who represents the bondholders, providing the specific terms of the loan agreement.

Question 17

Junk Bond

Answer 17

Any bond rated BB or below.

Question 18

High-Yield Bond

Answer 18

See junk bond: Any bond rated BB or below.

Question 19

Define the term “value” as used for several different purposes.

Answer 19

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.

Question 20

Book Value

Answer 20

1. 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.
2. The depreciated value of a company’s assets (original cost less accumulated depreciation) less outstanding liabilities.

Question 21

Liquidation Value

Answer 21

The dollar sum that could be realized if an asset were sold.

Question 22

Market Value

Answer 22

The value observed in the marketplace.

Question 23

Intrinsic, or Economic, Value

Answer 23

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.

Question 24

Fair Value

Answer 24

The present value of an asset’s expected future cash flows.

Question 25

Efficient Market

Answer 25

Market where the values of all securities fully recognize all available public information.

Question 26

Behavioral Finance

Answer 26

The field of study examining when investors act rationally or irrationally when making investment decisions.

Question 27

Explain the factors that determine value.

Answer 27

Three basic factors determine an asset’s value:

1. The amount and timing of future cash flows
2. The riskiness of the cash flows
3. The investor’s attitude about the risk.

Question 28

Describe the basic process for valuing assets.

Answer 28

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.

Question 29

Asset Value (V) Equation

Answer 29

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)

Question 30

Estimate the value of a bond.

Answer 30

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.

Question 31

Bond Value (Vb) Equation

Answer 31

$ 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

Question 32

Compute a bond’s expected rate of return and its current yield.

Answer 32

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.

Question 33

Expected Rate of Return

Answer 33

1. 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.
2. The rate of return the investor expects to receive on an investment by paying the existing market price of the security.

Question 34

Yield to Maturity

Answer 34

The rate of return a bondholder will receive if the bond is held to maturity. (It is equivalent to the expected rate of return.)

Question 35

Current Yield

Answer 35

The ratio of a bond’s annual interest payment to its market price.

Question 36

Market Price (P0) Equation

Answer 36

($ 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

Question 37

Current Yield Equation

Answer 37

Annual interest payment/Current market price of the bond

Question 38

Explain three important relationships that exist in bond valuation.

Answer 38

Certain key relationships exist in bond valuation, these being:

1. 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.
2. 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.
3. A bondholder owning a long-term bond is exposed to greater interest rate risk than one owning a short-term bond.

Question 39

Interest Rate Risk

Answer 39

The variability in a bond’s value caused by changing interest rates.

Question 40

Discount Bond

Answer 40

A bond that sells at a discount, or below par value.

Question 41

Premium Bond

Answer 41

A bond that is selling above its par value.

Question 42

Asset Value Use

Answer 42

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.

Question 43

Bond Value Use

Answer 43

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.

Question 44

Bond Value When Interest is Paid Semiannually Use

Answer 44

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.

Question 45

Yield to Maturity or Expected Rate of Return Use

Answer 45

The expected rate of return (yield to maturity) of a bond if held until maturity, given its current market price.

Question 46

Current Yield Use

Answer 46

The yield today determined by dividing the interest payment by the current market price.