CHAPTER 7 Bonds and Their Valuation

   

Key features of bonds Bond valuation Measuring yield Assessing risk

7-1

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.

7-2

Bond markets


Primarily traded in the over-the-counter (OTC) market. Most bonds are owned by and traded among large financial institutions. Full information on bond trades in the OTC market is not published, but a representative group of bonds is listed and traded on the bond division of the NYSE.
7-3

Key Features of a Bond

 

 

Par 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 - rate of return earned on a bond held until maturity (also called the promised yield ).
7-4

Effect of a call provision



Allows 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. Most bonds have a deferred call and a declining call premium.
7-5

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. But not good for investors if rates decline after issuance.
7-6

How are sinking funds executed?



Call x% of the issue at par, for sinking fund purposes.



Likely to be used if kd is below the coupon rate and the bond sells at a premium. Likely to be used if kd is above the coupon rate and the bond sells at a discount.

Buy bonds in the open market.



7-7

The value of financial assets

0 k Value CF1 CF2 1 2 n

...
CFn

CF1 CF2 CFn Value !   ...  1 2 n (1  k) (1  k) (1  k)

7-8

Other types (features) of bonds



Convertible bond may be exchanged for common stock of the firm, at the holder s option. 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. Income bond pays interest only when interest is earned by the firm. Indexed bond interest rate paid is based upon the rate of inflation. 7-9

What is the opportunity cost of debt capital?



The discount rate (ki ) is the opportunity cost of capital, and is the rate that could be earned on alternative investments of equal risk. ki = k* + IP + MRP + DRP + LP

7-10

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

0 k VB = ? 100 100 1 2 n

...
100 + 1,000

$100 $100 $1,000 VB !  ...   1 10 10 (1.10) (1.10) (1.10) VB ! $90.91  ...  $38.55  $385.54 VB ! $1,000
7-11

Using a financial calculator to value a bond



This bond has a $1,000 lump sum due at t = 10, and annual $100 coupon payments beginning at t = 1 and continuing through t = 10, the price of the bond can be found by solving for the PV of these cash flows.
INPUTS 10 N 10 I/YR PV
-1000
7-12

100 PMT

1000 FV

OUTPUT

An example: Increasing inflation and kd



Suppose inflation rises by 3%, causing kd = 13%. When kd rises above the coupon rate, the bond s value falls below par, and sells at a discount.
10 N 13 I/YR PV
-837.21
7-13

INPUTS

100 PMT

1000 FV

OUTPUT

An example: Decreasing inflation and kd



Suppose inflation falls by 3%, causing kd = 7%. When kd falls below the coupon rate, the bond s value rises above par, and sells at a premium.
10 N 7 I/YR PV
-1210.71
7-14

INPUTS

100 PMT

1000 FV

OUTPUT

The price path of a bond



VB

What 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?
kd = 7%. kd = 10%.

1,372 1,211 1,000 837 775

30 25 20 15 10

kd = 13%. 5 0 Years to Maturity

7-15

Bond values over time



At maturity, the value of any bond must equal its par value. If kd 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.
7-16

What is the YTM on a 10-year, 9% annual coupon, $1,000 par value bond, selling for $887?


Must find the kd that solves this model.

INT INT M VB !  ...   1 N (1  k d ) (1  k d ) (1  k d )N 90 90 1,000  ...   $887 ! 1 10 10 (1  k d ) (1  k d ) (1  k d )

7-17

Using a financial calculator to find YTM



Solving for I/YR, the YTM of this bond is 10.91%. This bond sells at a discount, because YTM > coupon rate.

INPUTS

10 N I/YR 10.91

- 887 PV

90 PMT

1000 FV

OUTPUT

7-18

Find YTM, if the bond price was $1,134.20.



Solving for I/YR, the YTM of this bond is 7.08%. This bond sells at a premium, because YTM < coupon rate.

INPUTS

10 N I/YR 7.08

-1134.2

90 PMT

1000 FV

PV

OUTPUT

7-19

Definitions
Annual coupon payment Current yield (CY) ! Current price Change in price Capital gains yield (CGY) ! Beginning price Expected Expected  Expected total return ! YTM ! CY CGY
7-20

An example: Current and capital gains yield



Find 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%
7-21

Calculating capital gains yield

YTM = 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.
7-22

What is interest rate (or price) risk?



Interest rate risk is the concern that rising kd will cause the value of a bond to fall.
kd 5% 10% 15% 10yr $1,386 $1,000 $749 % change +38.6% -25.1%

% change 1 yr +4.8% $1,048 $1,000 -4.4% $956

The 10-year bond is more sensitive to interest rate changes, and hence has more interest rate risk.
7-23

What is reinvestment rate risk?



Reinvestment rate risk is the concern that kd 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.
7-24

Reinvestment rate risk example



You 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 1year 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.
7-25

Conclusions about interest rate and reinvestment rate risk

Short-term AND/OR Long-term AND/OR High coupon bonds Low coupon bonds Interest rate risk Reinvestment rate risk


Low High

High Low

CONCLUSION: Nothing is riskless!

7-26

Semiannual bonds
1. 2.

3.

Multiply years by 2 : number of periods = 2n. Divide nominal rate by 2 : periodic rate (I/YR) = kd / 2. Divide annual coupon by 2 : PMT = ann cpn / 2.
2n N kd / 2 I/YR OK PV cpn / 2 PMT OK FV

INPUTS

OUTPUT
7-27

What is the value of a 10-year, 10% semiannual coupon bond, if kd = 13%?

1. 2. 3.

Multiply years by 2 : N = 2 * 10 = 20. Divide nominal rate by 2 : I/YR = 13 / 2 = 6.5. Divide annual coupon by 2 : PMT = 100 / 2 = 50.

INPUTS

20 N

6.5 I/YR PV - 834.72

50 PMT

1000 FV

OUTPUT

7-28

Would you prefer to buy a 10-year, 10% annual coupon bond or a 10-year, 10% semiannual coupon bond, all else equal? The semiannual bond s effective rate is:
0.10 iNom EFF% ! 1   1 ! 10.25%  1 ! 1  m 2
m 2

10.25% > 10% (the annual bond s effective rate), so you would prefer the semiannual bond.
7-29

If the proper price for this semiannual bond is $1,000, what would be the proper price for the annual coupon bond?


The semiannual coupon bond has an effective rate of 10.25%, and the annual coupon bond should earn the same EAR. At these prices, the annual and semiannual coupon bonds are in equilibrium, as they earn the same effective return.
10 N 10.25 I/YR PV - 984.80
7-30

INPUTS

100 PMT

1000 FV

OUTPUT

A 10-year, 10% semiannual coupon bond selling for $1,135.90 can be called in 4 years for $1,050, what is its yield to call (YTC)?


The bond s yield to maturity can be determined to be 8%. Solving for the YTC is identical to solving for YTM, except the time to call is used for N and the call premium is FV.

INPUTS

8 N I/YR
3.568

- 1135.90

50 PMT

1050 FV

PV

OUTPUT

7-31

Yield to call


3.568% represents the periodic semiannual yield to call. YTCNOM = kNOM = 3.568% x 2 = 7.137% is the rate that a broker would quote. The effective yield to call can be calculated


YTCEFF = (1.03568)2

1 = 7.26%
7-32

If you bought these callable bonds, would you be more likely to earn the YTM or YTC?


The coupon rate = 10% compared to YTC = 7.137%. The firm could raise money by selling new bonds which pay 7.137%. Could replace bonds paying $100 per year with bonds paying only $71.37 per year. Investors should expect a call, and to earn the YTC of 7.137%, rather than the YTM of 8%.

7-33

When is a call more likely to occur?



In general, if a bond sells at a premium, then (1) coupon > kd, so (2) a call is more likely. So, expect to earn:
 

YTC on premium bonds. YTM on par & discount bonds.

7-34

Default risk


If an issuer defaults, investors receive less than the promised return. Therefore, the expected return on corporate and municipal bonds is less than the promised return. Influenced by the issuer s financial strength and the terms of the bond contract.
7-35

Types of bonds
    

Mortgage bonds Debentures Subordinated debentures Investment-grade bonds Junk bonds

7-36

Evaluating default risk: Bond ratings

Investment Grade Moody s S&P Junk Bonds

Aaa Aa A Baa AAA AA A BBB

Ba B Caa C BB B CCC D

Bond ratings are designed to reflect the probability of a bond issue going into default.
7-37

Factors affecting default risk and bond ratings



Financial performance
  

Debt ratio TIE ratio Current ratio Secured vs. Unsecured debt Senior vs. subordinated debt Guarantee and sinking fund provisions Debt maturity
7-38

Bond contract provisions

   

Other factors affecting default risk

     

Earnings stability Regulatory environment Potential antitrust or product liabilities Pension liabilities Potential labor problems Accounting policies
7-39

Bankruptcy


Two main chapters of the Federal Bankruptcy Act:

 

Chapter 11, Reorganization Chapter 7, Liquidation

Typically, a company wants Chapter 11, while creditors may prefer Chapter 7.

7-40

Chapter 11 Bankruptcy


If company can t meet its obligations



 

It files under Chapter 11 to stop creditors from foreclosing, taking assets, and closing the business. Has 120 days to file a reorganization plan. Court appoints a trustee to supervise reorganization. Management usually stays in control.

Company must demonstrate in its reorganization plan that it is worth more alive than dead .


If not, judge will order liquidation under Chapter 7.

7-41

Priority of claims in liquidation

1. 2. 3. 4. 5. 6. 7. 8.

Secured creditors from sales of secured assets. Trustee s costs Wages, subject to limits Taxes Unfunded pension liabilities Unsecured creditors Preferred stock Common stock
7-42

Reorganization


In 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.
7-43

CHAPTER 8 Stocks and Their Valuation

   

Features of common stock Determining common stock values Efficient markets Preferred stock
7-44

Facts about common stock

    

Represents ownership Ownership implies control Stockholders elect directors Directors elect management Management s goal: Maximize the stock price

7-45

Social/Ethical Question


Should management be equally concerned about employees, customers, suppliers, and the public, or just the stockholders? In an enterprise economy, management should work for stockholders subject to constraints (environmental, fair hiring, etc.) and competition.

7-46

Types of stock market transactions

  

Secondary market Primary market Initial public offering market ( going public )

7-47

Different approaches for valuing common stock

  

Dividend growth model Corporate value model Using the multiples of comparable firms

7-48

Dividend growth model



Value of a stock is the present value of the future dividends expected to be generated by the stock.

D1 D2 D3 Dg P0 !    ...  1 2 3 g (1  k s ) (1  k s ) (1  k s ) (1  k s )
^

7-49

Constant growth stock



A stock whose dividends are expected to grow forever at a constant rate, g.

D1 = D0 (1+g)1 D2 = D0 (1+g)2 Dt = D0 (1+g)t

If g is constant, the dividend growth formula converges to:

D0 (1  g) D1 ! P0 ! ks - g ks - g
^

7-50

Future dividends and their present values

$

D t ! D0 ( 1  g )

0.25

Dt PVD t ! t (1  k )

P0 ! PVD t
0 Years (t)
7-51

What happens if g > ks?



If g > ks, the constant growth formula leads to a negative stock price, which does not make sense. The constant growth model can only be used if:
 

ks > g g is expected to be constant forever

7-52

If kRF = 7%, kM = 12%, and = 1.2, what is the required rate of return on the firm s stock?


Use the SML to calculate the required rate of return (ks): ks = kRF + (kM kRF) = 7% + (12% - 7%)1.2 = 13%

7-53

If D0 = $2 and g is a constant 6%, find the expected dividend stream for the next 3 years, and their PVs.

g = 6%

1 2.12
ks = 13%

2 2.247

3 2.382

D0 = 2.00 1.8761 1.7599 1.6509

7-54

What is the stock s market value?



Using the constant growth model:

D1 $2.12 ! P0 ! k s - g 0.13 - 0.06 $2.12 ! 0.07 ! $30.29

7-55

What is the expected market price of the stock, one year from now?


D1 will have been paid out already. So, P1 is the present value (as of year 1) of D2, D3, D4, etc. ^ D2 $2.247 ! P1 ! k s - g 0.13 - 0.06 ! $32.10 Could also find expected P1 as:
^

P1 ! P0 (1.06) ! $32.10
7-56

What is the expected dividend yield, capital gains yield, and total return during the first year?


Dividend yield
= D1 / P0 = $2.12 / $30.29 = 7.0%

Capital gains yield

= (P1 P0) / P0 = ($32.10 - $30.29) / $30.29 = 6.0%

Total return (ks)

= Dividend Yield + Capital Gains Yield = 7.0% + 6.0% = 13.0%
7-57

What would the expected price today be, if g = 0?



The dividend stream would be a perpetuity.

ks = 13%

...
2.00 2.00 2.00

PMT $2.00 P0 ! ! ! $15.38 k 0.13

^

7-58

Supernormal growth: What if g = 30% for 3 years before achieving long-run growth of 6%?


Can no longer use just the constant growth model to find stock value. However, the growth does become constant after 3 years.

7-59

Valuing common stock with nonconstant growth

0 k = 13% 1 s
g = 30% g = 30%

2
g = 30%

3
g = 6%

...

D0 = 2.00 2.301 2.647 3.045 46.114 54.107

2.600

3.380

4.394

4.658

 P !
3

4.658 0.13  0.06

! $66.54
7-60

= P0

Find expected dividend and capital gains yields during the first and fourth years.


Dividend yield (first year)

= $2.60 / $54.11 = 4.81%

Capital gains yield (first year)

= 13.00% - 4.81% = 8.19%

During nonconstant growth, dividend yield and capital gains yield are not constant, and capital gains yield g. After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%.
7-61

Nonconstant growth: What if g = 0% for 3 years before longrun growth of 6%?

0 k = 13% 1 s
g = 0% g = 0%

2
g = 0%

3
g = 6%

...

D0 = 2.00 1.77 1.57 1.39 20.99 25.72

2.00

2.00

2.00

2.12

 P !
3

2.12 0.13  0.06

! $30.29
7-62

= P0

Find expected dividend and capital gains yields during the first and fourth years.


Dividend yield (first year)

= $2.00 / $25.72 = 7.78%

Capital gains yield (first year)

= 13.00% - 7.78% = 5.22%

After t = 3, the stock has constant growth and dividend yield = 7%, while capital gains yield = 6%.
7-63

If the stock was expected to have negative growth (g = -6%), would anyone buy the stock, and what is its value?


The firm still has earnings and pays dividends, even though they may be declining, they still have value.

D1 D0 ( 1  g ) ! P0 ! ks - g ks - g
^

$2.00 (0.94) $1.88 ! ! ! $9.89 0.13 - (-0.06) 0.19

7-64

Find expected annual dividend and capital gains yields.



Capital gains yield

= g = -6.00%

Dividend yield
= 13.00% - (-6.00%) = 19.00%

Since the stock is experiencing constant growth, dividend yield and capital gains yield are constant. Dividend yield is sufficiently large (19%) to offset a negative capital gains.
7-65

Corporate value model



Also called the free cash flow method. Suggests the value of the entire firm equals the present value of the firm s free cash flows. Remember, free cash flow is the firm s after-tax operating income less the net capital investment


FCF = NOPAT

Net capital investment

7-66

Applying the corporate value model



Find the market value (MV) of the firm.



Find PV of firm s future FCFs

Subtract MV of firm s debt and preferred stock to get MV of common stock.



MV of = MV of common stock firm

MV of debt and preferred

Divide MV of common stock by the number of shares outstanding to get intrinsic stock price (value).


P0 = MV of common stock / # of shares

7-67

Issues regarding the corporate value model



Often preferred to the dividend growth model, especially when considering number of firms that don t pay dividends or when dividends are hard to forecast. Similar to dividend growth model, assumes at some point free cash flow will grow at a constant rate. Terminal value (TVn) represents value of firm at the point that growth becomes constant.
7-68

Given the long-run gFCF = 6%, and WACC of 10%, use the corporate value model to find the firm s intrinsic value.

0 k = 10%

1 -5

2 10

3 20
g = 6%

...

21.20

-4.545 8.264 15.026 398.197 416.942

21.20

530 =

0.10 - 0.06

= TV3
7-69

If the firm has $40 million in debt and has 10 million shares of stock, what is the firm s intrinsic value per share?


MV of equity = MV of firm MV of debt = $416.94m - $40m = $376.94 million Value per share = MV of equity / # of shares = $376.94m / 10m = $37.69

7-70

Firm multiples method



Analysts often use the following multiples to value stocks.

  

P/E P / CF P / Sales

EXAMPLE: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings to back out an estimate of the stock price.
7-71

What is market equilibrium?



In equilibrium, stock prices are stable and there is no general tendency for people to buy versus to sell. In equilibrium, expected returns must equal required returns.

D1 ks ! g P0
^

k s ! k RF  (k M  k RF )F

7-72

Market equilibrium


Expected returns are obtained by estimating dividends and expected capital gains. Required returns are obtained by estimating risk and applying the CAPM.

7-73

How is market equilibrium established?



If expected return exceeds required return



The current price (P0) is too low and offers a bargain. Buy orders will be greater than sell orders. P0 will be bid up until expected return equals required return
7-74

Factors that affect stock price



Required return (ks) could change



Changing inflation could cause kRF to change Market risk premium or exposure to market risk ( ) could change Due to economic (market) conditions Due to firm conditions
7-75

Growth rate (g) could change

 

What is the Efficient Market Hypothesis (EMH)?



Securities are normally in equilibrium and are fairly priced. Investors cannot beat the market except through good luck or better information. Levels of market efficiency
  

Weak-form efficiency Semistrong-form efficiency Strong-form efficiency

7-76

Weak-form efficiency


Can t profit by looking at past trends. A recent decline is no reason to think stocks will go up (or down) in the future. Evidence supports weak-form EMH, but technical analysis is still used.

7-77

Semistrong-form efficiency


All publicly available information is reflected in stock prices, so it doesn t pay to over analyze annual reports looking for undervalued stocks. Largely true, but superior analysts can still profit by finding and using new information
7-78

Strong-form efficiency


All information, even inside information, is embedded in stock prices. Not true--insiders can gain by trading on the basis of insider information, but that s illegal.

7-79

Is the stock market efficient?



Empirical studies have been conducted to test the three forms of efficiency. Most of which suggest the stock market was:
  

Highly efficient in the weak form. Reasonably efficient in the semistrong form. Not efficient in the strong form. Insiders could and did make abnormal (and sometimes illegal) profits.

Behavioral finance incorporates elements of cognitive psychology to better understand how individuals and markets respond to different situations.

7-80

Preferred stock
 

Hybrid security Like bonds, preferred stockholders receive a fixed dividend that must be paid before dividends are paid to common stockholders. However, companies can omit preferred dividend payments without fear of pushing the firm into bankruptcy.
7-81

If preferred stock with an annual dividend of $5 sells for $50, what is the preferred stock s expected return? V p = D / kp $50 = $5 / kp kp = $5 / $50 = 0.10 = 10%

7-82