Ch09 Bonds & valuation.ppt

Chapter 09Bonds & Valuation

Financial Management - Reza Masri

*Value = + + +FCF1FCF2FCF(1 + WACC)1(1 + WACC)(1 + WACC)2Free cash flow(FCF)Market interest ratesFirms business riskMarket risk aversionFirms debt/equity mixCost of debtCost of equityWeighted averagecost of capital(WACC)Net operatingprofit after taxesRequired investmentsin operating capital=Determinants of Intrinsic Value: The Cost of Debt...

What is a bond?A long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond.

Bond marketsTraded in exchanges and private markets.Most bonds are owned by and traded among large financial institutions.

Key Features of a BondPar value face amount of the bond, which is paid at maturity (assume $1,000).Coupon interest rate stated interest rate (generally fixed) paid by the issuer. Multiply by par to get dollar payment of interest.Maturity date years until the bond must be repaid.Issue date when the bond was issued.Yield to maturity (YTM)- rate of return earned on a bond held until maturity (also called the promised yield). Yield to call (YTC) - rate of return earned on a bond held until the call date.

Effect of a call provisionAllows issuer to refund the bond issue if rates decline (helps the issuer, but hurts the investor).Borrowers are willing to pay more, and lenders require more, for callable bonds.

What is a sinking fund?Provision to pay off a loan over its life rather than all at maturity.Similar to amortization on a term loan.Reduces risk to investor, shortens average maturity.

Other types (features) of bondsConvertible bond may be exchanged for common stock of the firm, at the holders option.Bond issued with Warrant long-term option to buy a stated number of shares of common stock at a specified price.Putable bond allows holder to sell the bond back to the company prior to maturity.

What is the opportunity cost of debt capital?The discount rate (ri ) is the opportunity cost of capital, and is the rate that could be earned on alternative investments of equal risk.

ri = r* + IP + MRP + DRP + LP

The value of financial assets

Financial Management - Reza Masri

What is the value of a 10-year, 10% annual coupon bond, if rd = 10%?

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The price path of a bondWhat would happen to the value of this bond if its required rate of return remained at 10%, or at 13%, or at 7% until maturity?

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Bond values over timeAt maturity, the value of any bond must equal its par value.If rd remains constant:The value of a premium bond would decrease over time, until it reached $1,000.The value of a discount bond would increase over time, until it reached $1,000.A value of a par bond stays at $1,000.

What is the YTM on a 10-year, 9% annual coupon, $1,000 par value bond, selling for $887?Must find the rd that solves this model.rd = 10.91%

Financial Management - Reza Masri

What is the YTC on a 9-year, 10% annual coupon, $1,000 par value, $1,100 call price bond, selling for $1,495?ytc = 4.21%

Financial Management - Reza Masri

Definitions

An example: Current and capital gains yieldFind the current yield and the capital gains yield for a 10-year, 9% annual coupon bond that sells for $887, and has a face value of $1,000.

Current yield = $90 / $887

= 0.1015 = 10.15%

Calculating capital gains yieldYTM = Current yield + Capital gains yield

CGY= YTM CY= 10.91% - 10.15%= 0.76%

Could also find the expected price one year from now and divide the change in price by the beginning price, which gives the same answer.

What is interest rate (or price) risk?Interest rate risk is the concern that rising rd will cause the value of a bond to fall.

% change 1 yr rd 10yr % change+4.8%$1,048 5% $1,386 +38.6%$1,00010% $1,000-4.4% $95615% $749 -25.1%

The 10-year bond is more sensitive to interest rate changes, and hence has more interest rate risk.

What is reinvestment rate risk?Reinvestment rate risk is the concern that rd will fall, and future CFs will have to be reinvested at lower rates, hence reducing income.

EXAMPLE: Suppose you just won$500,000 playing the lottery. You intend to invest the money and live off the interest.

Reinvestment rate risk exampleYou may invest in either a 10-year bond or a series of ten 1-year bonds. Both 10-year and 1-year bonds currently yield 10%.If you choose the 1-year bond strategy:After Year 1, you receive $50,000 in income and have $500,000 to reinvest. But, if 1-year rates fall to 3%, your annual income would fall to $15,000.If you choose the 10-year bond strategy:You can lock in a 10% interest rate, and $50,000 annual income.

Conclusions about interest rate and reinvestment rate riskCONCLUSION: Nothing is riskless!

Short-term bondsLong-term bondsInterest rate riskLowHighReinvestment rate riskHighLow

Financial Management - Reza Masri

10-year, 10% annual coupon bond vs. a 10-year, 10% semiannual coupon bond?The semiannual bonds effective rate is:

10.25% > 10% (the annual bonds effective rate), so you would prefer the semiannual bond.

Default riskIf an issuer defaults, investors receive less than the promised return. Therefore, the expected return on bonds is less than the promised return.Influenced by the issuers financial strength and the terms of the bond contract.

*Bond Spreads, the DRP, and the LPA bond spread is often calculated as the difference between a corporate bonds yield and a Treasury securitys yield of the same maturity. Therefore:Spread = DRP + LP.Bonds of large, strong companies often have very small LPs. Bonds of small companies often have LPs as high as 2%.

Evaluating default risk:Bond ratingsBond ratings are designed to reflect the probability of a bond issue going into default.

Investment GradeJunk BondsMoodysAaa Aa A BaaBa B Caa CS & PAAA AA A BBBBB B CCC D

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*Source: Fitch Ratings

Bond Ratings% defaulting within:S&P and Fitch Moodys 1 yr. 5 yrs.Investment grade bonds:AAAAaa0.00.0AAAa0.00.1AA0.10.6BBBBaa0.32.9Junk bonds:BBBa1.48.2BB1.89.2CCCCaa22.336.9

Financial Management - Reza Masri

*Bond Ratings and Bond Spreads (YahooFinance, March 2009)

Long-term BondsYield (%)Spread (%) 10-Year T-bond2.68 AAA5.502.82 AA 5.622.94 A 5.793.11 BBB7.534.85 BB 11.628.94 B 13.7011.02 CCC26.3023.62

Financial Management - Reza Masri

Factors affecting default risk and bond ratingsFinancial performanceDebt ratioCoverage ratiosProfitability ratiosCurrent ratios

Bond contract provisionsSecured versus unsecured debtSenior versus subordinated debtGuarantee provisionsSinking fund provisionsDebt maturity

*Bond Ratings Median Ratios (S&P)

Interest coverageReturn on capital Debt to capitalAAA23.827.6%12.4%AA19.527.0%28.3%A8.017.5%37.5%BBB4.713.4%42.5%BB2.511.3%53.7%B1.28.7%75.9%CCC0.43.2%113.5%

Financial Management - Reza Masri

*The Maturity Risk PremiumLong-term bonds: High interest rate risk, low reinvestment rate risk.Short-term bonds: Low interest rate risk, high reinvestment rate risk.Nothing is riskless!Yields on longer term bonds usually are greater than on shorter term bonds, so the MRP is more affected by interest rate risk than by reinvestment rate risk.

BankruptcyBankruptcy alternatives::ReorganizationLiquidationTypically, a company wants Reorganization, while creditors may prefer Liquidation.

Priority of claims in liquidationSecured creditors from sales of secured assets.Trustees costsExpenses incurred after bankruptcy filingWages and unpaid benefit contributions, subject to limitsUnsecured customer deposits, subject to limitsTaxesUnfunded pension liabilitiesUnsecured creditorsPreferred stockCommon stock

ReorganizationIn a liquidation, unsecured creditors generally get zero. This makes them more willing to participate in reorganization even though their claims are greatly scaled back.Various groups of creditors vote on the reorganization plan. If both the majority of the creditors and the judge approve, company emerges from bankruptcy with lower debts, reduced interest charges, and a chance for success.

For value box in Ch 4 time value FM13.