Valuing bonds and shares Flashcards
What is a bond issuer and the issue date?
- issuer (borrower)
- issue date - when it was sold to a new issuer, when it begins to accrue interest
What is the maturity date?
when principal repayment is due, bond issuer pays back everything they owe to bondholders, bonds life ends and the principal is returned to the bond holder.
What is principal/par/nominal or face value?
is received at the end of the maturity date, amount of money the issuer agrees to pay the lender.
Principial is payed on redemption (redeemable bond)
What is the interest/coupon rate?
annual coupon payments paid by the issuer relative to the bonds face or par value.
Interest/coupon is paid annually or semi-annually during the life of the bond.
What does the owner of a bond get?
The owner is entitled to a fixed set of cash payments in the future.
How do you calculate the PV of the bond?
PV bond = (coupon payment x AF) + (principal repayment X DF)
What is bond value?
today’s market value is the PV of the future CF discounted at the market rate of interest.
What is Yield to Maturity (YTM)?
is the rate of return the investors will earn if the bond is held to maturity (or interest rate).
If YTM goes down the price goes up - can be affected by Bank of England’s policy - affecting markets & IRR.
YTM is also known as bond holders expected rate of return
What do you need to calculate YTM?
If we know the coupon, nominal value (face), the time to maturity and the current market value we can calculate the Yield to Maturity.
YTM = discount rate that equals to the PV of the future CF with the current market price of the bond, it is the IRR of the cash flows.
What is the calculation for YTM?
YTM = coupon payment + (face value - PV/years to maturity) / (face value + PV/2)
What is the calculation for current yield?
coupon payment/current market price of the bond
What is the calculation for total yield?
(coupon payment + capital gain/loss from sale of bond) / initial investment
What are bonds priced below its face value said to be?
bonds priced below its face value is said to sell at a discount and is known as a discount bond. Investors who buy a discount bond receive a capital gain over the life of the bond, so YTM on these bonds is always more than the coupon rate.
What are bonds priced above face value said to be?
bonds priced above face value sell at a premium and is known as a premium bond. Investors in premium bonds face a capital loss over the life of the bond, so the yield to maturity on a premium is less than the coupon rate.
What is involved in relationship 1 of bonds?
The value of bond is inversely related to change in the investors present YTM (based on market interest rate). As market interest increases, bondholders required return increases. The coupon is fixed. The YTM must = required return.
value of bond decreases.
What is involved in relationship 2 of bonds?
Market value of a bond will be:
- less then the face value if the investors required rate of return (YTM) is above the coupon rate (at a discount)
- greater then the face value if the investors required rate of return (YTM) is below the coupon rate (at a premium)
- At face value if the investors required rate of return (YTM) is = to coupon rate (at par)
What is involved in relationship 3 of bonds?
Changes in interest rate will cause a - small change in short term cash flows and it will have a larger impact on long term cash flows.
- Price of a long term bond is affected more by changes in interest rate than the price of short term bonds.
- If rate of return goes up the market value decreases, much more significant change in long term bonds than short term.
- long term bonds e.g. 10 yrs are more risky, but there is more potential for higher returns, yield increases and prices goes down.
What is default risk?
Risk that the bond issuer will not pay the coupon or will be unable to repay the principle.
Bond ratings provide reassurance about the default risk.
Highly rated bonds (AAA) rarely default.
What is interest rate risk?
if the interest rate in the market rise the value of bonds (which have a fixed coupon rate) will fall.
What is the market value of ordinary shares?
MV of a share is equal to the PV of the future CF. Future CFs are dividends.
What does the dividend growth model calculate?
The PV of a constantly increasing stream of dividends, received every year, thus calculating the market value of the share. Market value of the share is equal to the present value of future dividends.
What is the calculation for MV of ordinary share?
next dividend payment/(discount rate - growth rate)
MV ordinary share = D0 (1 +g)/(r-g)
= D1/(r-g)
D0 = dividend now
D1 = dividend in one year
g = growth rate
r = discount rate (required rate of return)
* Assumes constant rate of growth *
What is the market value of preference shares?
To acquire a preference share you must contact a company directly.
A preference share is a perpetuity, payments are subject to companies performance, must make profit to pay them.
Preference shares become ordinary shares and there is a fixed cash flow/dividend payment
What is the calculation for the MV of preference shares?
MV preference shares = preference dividend(fixed) /required return
= D/r
