CORPORATE FINANCE

REVIEW –TIME VALUE OF MONEY

VALUATION OF BONDS
CHAPTER 5 : FINANCIAL MANAGEMENT THEORY AND PRACTICE:
EUGENE F. BRIGHAM
INSTRUCTOR : MEHNAZ KHAN
 TIME VALUE OF MONEY REVIEWED

The process of going to future values (FVs) from present

values (PVs) is called compounding.

To illustrate, refer back to our 3-year time line and assume that
you plan to deposit $100 in a bank that pays a guaranteed 5%
interest each year. How much would you have at the end of
Year 3?
Finding present values is called discounting
FINDING INTEREST RATES
ANNUITY
If payments are equal and are made at fixed intervals, then the series is an
annuity.
For example, $100 paid at the end of each of the next 3 years is a 3-year
annuity.
If payments occur at the end of each period, then we have an ordinary (or
deferred) annuity.
Payments on mortgages, car loans, and student loans are examples of
ordinary annuities.
If the payments are made at the beginning of each period, then we have an
annuity due. Rental payments for an apartment, life insurance premiums,
and lottery payoffs (if you are lucky enough to win one!) are examples of
annuities due.
Here are the time lines for a $100, 3-year, 5%, ordinary annuity and for the
same annuity on an annuity due basis. With the annuity due, each payment is
shifted back to the left by 1 year. A $100 deposit will be made each year, so
we show the payments with minus signs.
What is a Bond?

• Bond is a long-term contract under which a borrower agrees to make

payments of interest and principal, on specific dates, to the holders of the
bond.
• Bonds are Broadly classified into four main types:

• Treasury
• Corporate
• Municipal
• Foreign.

• Each type differs with respect to expected return and degree of risk.

• Default risk often is referred to as “credit risk,” and the larger the default or
credit risk, the higher the interest rate the issuer must pay

.
Treasury bonds: sometimes referred to as government bonds, are issued by
the federal government.

• It is reasonable to assume that the federal government will make good on

its promised payments, so these bonds have no default risk.
• However, Treasury bond prices decline when interest rates rise, so they are
not free of all risks

Corporate bonds: are issued by corporations.

• Unlike Treasury bonds, corporate bonds are exposed to default risk—if the
issuing company gets into trouble, it may be unable to make the promised
interest and principal payments.
• Different corporate bonds have different levels of default risk, depending on
the issuing company’s characteristics and the terms of the specific bond.
Municipal bonds, or “munis,” are issued by state and local governments.

• Like corporate bonds, munis have default risk.

• munis offer one major advantage over all other bonds: The interest
earned on most municipal bonds is exempt from federal taxes and also
from state taxes if the holder is a resident of the issuing state.
• Consequently, municipal bonds carry interest rates that are considerably
lower than those on corporate bonds with the same default risk.

Foreign bonds are issued by foreign governments or foreign

corporations.
• Foreign corporate bonds are, of course, exposed to default risk, and so
are some foreign government bonds
BOND CHARACTERICTICS
Par Value :
The par value is the stated face value of the bond;
for illustrative purposes we generally assume a par value of $1,000, although
any multiple of $1,000 (for example, $5,000) can be used. The par value
generally represents the amount of money the firm borrows and promises to
repay on the maturity date

COUPON:
Bonds require the company to pay a fixed number of dollars of interest each
year (or, more typically, each six months).
When this coupon payment, as it is called, is divided by the par value, the
result is the coupon interest rate.
For example, MicroDrive’s bonds have a $1,000 par value, and they pay
$100 in interest each year. The bond’s coupon interest is $100, so its
coupon interest rate is $100/$1,000 10%. The coupon payment, which is
fixed at the time the bond is issued, remains in force during the life of the
bond.

FLOATING RATE BOND

• In some cases, a bond’s coupon payment will vary over time.
• For these floating rate bonds, the coupon rate is set for, say, the initial
six-month period, after which it is adjusted every six months based on
some market rate.
• Some corporate issues are tied to the Treasury bond rate, while other
issues are tied to other rates, such as LIBOR.
• Many additional provisions can be included in floating-rate issues.
ZERO COUPON BONDS
Zero Coupon bonds pay no coupons at all, but are offered at a substantial
discount below their par values and hence provide capital appreciation rather
than interest income.

(OID) bond.
Other bonds pay some coupon interest but not enough to be issued at par. In
general, any bond originally offered at a price significantly below its par value is
called an original issue discount (OID) bond.

Payment-in kind bonds: Some bonds don’t pay cash coupons but pay
coupons consisting of additional bonds (or a percentage of an additional bond).
These are called payment-in kind bonds, or just PIK bonds. PIK bonds are
usually issued by companies with cash flow problems, which makes them risky
 Refunding operation.

• Suppose a company sold bonds when interest rates were relatively high.

• Provided the issue is callable, the company could sell a new issue of low-
yielding securities if and when interest rates drop.

• It could then use the proceeds of the new issue to retire the high-rate
issue and thus reduce its interest expense. This process is called a
refunding operation.
 CALL PROVISION:

• A call provision is valuable to the firm but potentially detrimental to investors.

• If interest rates go up, the company will not call the bond, and the investor will
be stuck with the original coupon rate on the bond, even though interest rates
in the economy have risen sharply.

• However, if interest rates fall, the company will call the bond and pay off
investors, who then must reinvest the proceeds at the current market interest
rate, which is lower than the rate they were getting on the original bond.
• In other words, the investor loses when interest rates go up, but he or she
doesn’t reap the gains when rates fall.
 Sinking Funds

• A sinking fund is maintained by companies for bond issues.

• Money is set aside or saved to pay off a debt or bond.
• Bonds issued with sinking funds are lower risk since they are backed by the
collateral in the fund, and therefore carry lower yields.

Firm is given the right to handle the sinking fund in either of two ways:

1. The company can call in for redemption (at par value) a certain percentage of
the bonds each year; for example, it might be able to call 5% of the total original
amount of the issue at a price of $1,000 per bond. The bonds are numbered
serially, and those called for redemption are determined by a lottery
administered by the trustee.
2. The company may buy the required number of bonds on the open market.
 Convertible bonds

What Is a Convertible Bond?

• A convertible bond is a fixed-income corporate debt security that yields
interest payments, but can be converted into a predetermined number of
common stock or equity shares.
• The conversion from the bond to stock can be done at certain times during
the bond's life and is usually at the discretion of the bondholder.

Convertibles have a lower coupon rate than nonconvertible debt, but

they offer investors a chance for capital gains in exchange for the lower
coupon rate.
BOND VALUATION
 Solving for the Bond Price

Current Value of a Bond is the Present Value of all Coupon Payments plus PV of
Principal Payment discounted at the Bonds Required rate of return.
CALCULATING PRICE OF BOND ON EXCEL

USE PV FUNCTION
ENTER RATE
ENTER NUMBER OF TIME PERIODS
ENTER COUPON AMOUNT
ENTER FV WGICH IS THE PRINCIPAL THE BONDHOLDER GETS AT
MATURITY
• Whenever the going market rate of interest, rd, is equal to the
coupon rate,
• a fixed-rate bond will sell at its par value.

• Normally, the coupon rate is set at the going rate when a bond is issued,
causing it to sell at par initially.

• The coupon rate remains fixed after the bond is issued, but interest rates in
the market move up and down.

• Looking at Equation 5-1, we see that an increase in the market interest rate
(rd) will cause the price of an outstanding bond to fall, whereas a decrease
in rates will cause the bond’s price to rise.
 When market interest rates rise.

Whenever the going rate of interest rises above the coupon rate, a fixed-
rate bond’s price will fall below its par value, and it is called a discount bond

For example, if the market interest rate on MicroDrive’s bond increased to

15% immediately after it was issued, The price would fall to $707.63.
Notice that the bond would then sell at a price below its par value .
WHEN

Rd = COUPON (BOND SELLS AT PAR)

Rd< COUPON (BOND SELLS AT PREMIUM)

Rd> COUPON (BOND SELLS AT

DISCOUNT)
 When market interest rates fall.

In general, whenever the going interest rate falls below the coupon rate, a
fixed-rate bond’s price will rise above its par value, and it is called a premium
bond

For example, if the market interest rate on MicroDrive’s bond decreased to

5%, we would once again recalculate its price

In this case the price rises to $1,518.98. In general, whenever the going
interest rate falls below the coupon rate, a fixed-rate bond’s price will rise
above its par value, and it is called a premium bond
Yield to Maturity

Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until
it matures.Yield to maturity is considered a long-term bond yield but is expressed as an
annual rate.
In other words, it is the internal rate of return (IRR) of an investment in a bond if the
investor holds the bond until maturity, with all payments made as scheduled and
reinvested at the same rate.
In Excel:
Use Rate Function
DRAWBACKS OF YTM:

• YTM does NOT account for a bond’s reinvestment risk.

• The bond’s coupon payments are assumed to be reinvested at the same

rate as the YTM, which may not be an option in the future given
uncertainties regarding the markets.

• In effect, if coupons were to be reinvested at lower rates than the YTM,

the calculated YTM is going to turn out to have been inaccurate, as the
return on the bond would have been overstated.
 Yield to call (YTC)

Yield to call (YTC) is the return a bondholder receives if the bond is held until
the call date, which occurs sometime before it reaches maturity.

If current interest rates are well below an outstanding bond’s coupon rate,
then a callable bond is likely to be called, and investors will estimate its
expected rate of return as the yield to call (YTC) rather than as the yield to
maturity
• You can calculate the yield-to-call as the compound interest rate of the
present value of a bond's future call price when it becomes equal to its
current market price. Typically, bonds can be callable over several years
and can call premiums that are above initial values.
Suppose MicroDrive’s bonds had a provision that permitted the company, if
it desired, to call the bonds 10 years after the issue date at a price of $1,100.
Suppose further that interest rates had fallen, and one year after issuance
the going interest rate had declined, causing the price of the bonds to rise to
$1,494.93.
Yield-To-Call Example
As an example, consider a callable
bond that has a face value of $1,000
and pays a semiannual coupon of
10%. The bond is currently priced at
$1,175 and has the option to be called
at $1,100 five years from now. Note
that the remaining years until maturity
does not matter for this calculation.
Using the above formula, the
calculation would be set up as:
TO CALCULATE YTC ON EXCEL:
USE RATE FUNCTION.
ENTER TIME PERIODS (IN THIS CASE COUPON IS SEMI ANNUAL SO MULTIPLY NUMBER OF YEARS BY 2
I.E 5*2= 10
ENTER PMT I.E COUPON AMOUNT ( SINCE ITS SEMIANNUAL DIVIDE COUPON BY 2 100/2 = 50 )
ENTER PV ( THIS IS THE CURRENT MARKET PRICE . SINCE ITS AN OUTFLOW IT IS A NEGGATIVE VALUE)
ENTER FV WHICH IS THE CALL PRICE )