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Lecture 7

MGT 200 Lecture 7: Ch 10 Class & Book WOw

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Western Kentucky University
MGT 200

Debt security – claim on a specified periodic stream of income Bond- security issued in connection with a borrowing arrangement Borrower issues/sells a bond to the lender for some cash Issuer must make payments to the bondholder – semiannual coupon payments Issuer repays the debt by paying the bond’s par value/face value Coupon rate determines the interest payment = coupon rate x par value Treasury notes – maturities between 1 and 10 years Treasury bonds – maturities between 10 and 30 years Accrued interest = Annual coupon payment / 2 x Days since last coupon / Days separating coupons Call provisions on caorpoate bonds – issuer can repurchase the bond at a specified call price before the maturity date – pay for repurchase of existing higher coupon bonds to issue lower coupon bonds Have higher coupons and yields because of the risk that they might be called bacl Convertible bonds – can exchange bond for a # of shares of common stock Conversion ratio - # of shares for which each bond may be exchanged Market conversion value – current value of the shares for which the bonds may be exchanged Lower coupons rates and lower yuelds Puttable bonds – put bond gives the bondholder the option to extend or retire the bond at call date Can extend bond life (coupon rate > current market yields) Floating rate bonds – make interest rate payments tied to measure of current market rates Bond always pays approximately current market rates Preferred stock – the failure to pay the promised dividend doesn’t result in corporate bankruptcy, it just accumulates – perpetuity; provides cash flow indefinitely Not tax-deductible like bonds Nominal return = Interest + Price Appreciation / Initial Price Real Return = 1 + Nominal Return / 1+ Inflation Nominal risk free interest rate = real risk free rate + inflation premium Bond value = present value of coupons + present value of par value An 8% coupon, 30 year bond with par = $1000 pays 60 semiannual coupon payments of $40 The risk free rate is equal to 4 N = 60 I/Y = 4 FV = 1,000 PMT = 40 PV = ? THERE IS A NEGATIVE RELATIONSHIP BETWEEN PRICE AND YIELD Interest rate risk affects farther out bonds more than near term bonds – so a 30 yr bond is risk than a note Yield to maturity – discount rate that makes the present value of bond’s payments equal to its price An 8% coupon, 30 year bond is selling at $1,276.76. What is the average rate of return? N = 30, PV = 1276.76, PMT = 80, FV = 1,000  I/Y = 6% Current yield – bonds annual coupon payment / bond price An 8% coupon, 30 year bond is selling at $1,276.76 = 80 / 1276.76 = 6.27% Premium = coupon rate > current yield > YTM Discount = YTM > current yield > coupon rate Yield to call - 8% coupon, 30 year bond sells for $1,150 & is callable at 10 years at a call price of $1,100 Yield to Call Yield to Maturity Coupon payment $40 $40 # of semiannual periods 20
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