Textbook Notes (280,000)
US (110,000)
NU (1,000)
FINA (60)
Chapter 7

# FINA 2201 Chapter Notes - Chapter 7: Bankruptcy Act, Current Yield, Sinking Fund

Department
Finance & Insurance
Course Code
FINA 2201
Professor
Ma Linlin
Chapter
7

Page:
of 4
FINA 2201 Chapter 7: Bonds and their valuation
1
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10.1
\$1,000
10.1
\$100
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What is a bond?
Firms can issue bonds to raise capital
Bond is ---a loan: A long-term debt instrument.
When you buy a bond, you are lending money to the company who issues it
The company, in turn, promises you to pay periodic interest at specified dates and the principle when the bond
reaches the maturity date
Who issues bonds?
Treasury (Government) bonds: issued by the federal government.
Municipal bonds(Munis): issued by the state and local governments.
Corporate bonds: issued by business firms.
Foreign bonds: issued by foreign government or a foreign corporation.
Par Value: Stated face value of the bond
Amount of money firms repay you on the maturity date
Generally assume to be \$1,000
Coupon Payment: Periodic fixed interest payment (\$)
Set at bond issuance and remains in force during the bond’s life
Coupon Interest Rate: The stated annual interest rate on a bond.
Annual coupon payment
Par Value (\$1000 if not stated otherwise)
A bond has par value of \$1,000 and coupon rate 5%, pays coupons \$50 per year
Fixed-Rate Bond: A bond whose interest rate is fixed for its entire life.
Maturity Rate: A specified date on which the par value of a bond must be repaid.
Most bonds have maturities ranging from 10 to 40 years
Original Maturity: The number of years to maturity at the time a bond is issued.
Bond Valuation: The value of any financial assets is the present value of the future cash flows the asset is generating.
What is the value (PV) of a 10-year (N), 10% annual coupon bond, assuming the par value is 1,000 (FV) and the
discount rate is 10% (I).
PMT = 100
Yield to Maturity (YTM): the rate of return we expect to earn if we buy the bond today and hold it to maturity.
Unlike the coupon rate, which is fixed, the bond’s yield varies from day to day.
What is the YTM on a 10-year (N), 9% annual coupon, \$1,000 par value bond (FV), selling for \$887 (PV)?
PMT: \$900
Coupon Rate .9 = Annual Coupon Payment/Par Value
.09 = Annual Coupon Payment/1000
Annual Coupon Payment = \$90
Coupon Rate .10 = Annual Coupon Payment/Par Value
.10 = Annual Coupon Payment/1000
Annual Coupon Payment = \$100
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FINA 2201 Chapter 7: Bonds and their valuation
2
Discount Bond: A bond that sells below its par value; occurs whenever the going rate of interest is above the coupon rate.
Premium Bond: A bond that sells above its par value; occurs whenever the going rate of interest is below the coupon rate.
Bond Values over Time
At maturity, the value of any bond must equal its par value.
If discount rate remains constant:
o The value of a premium bond would decrease over time, until it reached \$1,000.
o The value of a discount bond would increase over time, until it reached \$1,000.
o The value of a par bond stays at \$1,000.
Changes in Bond Value over Time
Bonds with Semiannual Coupons
What is the value of a 10-year, 10% semiannual coupon bond, if rd = 13%?
A Bond’s Riskiness
Interest Rate (Price) Risk: The risk of a decline in a bond’s price due to an increase in interest rates.
When interest rates rise, the value of outstanding bonds decline.
Price risk is higher on bonds that have long maturities
Reinvestment Risk: The risk that a decline in interest rates will lead to a decline in income from a bond portfolio.
When interest rates fall, you need to replace it with the new bonds that offer you less income
Reinvestment risk is higher on bonds that have shorter maturities
Default Risk
If the issuer defaults, investors will receive less than the promised return.
The higher the probability of default, the higher the risk premium, thus the yield
Default risk on Treasuries is zero, but can be substantial for certain corporations
Influenced by the issuer’s financial strength and the terms of the bond contract.
Bond Ratings: Bond ratings are designed to reflect the probability of a bond issue going into default.
Investment-Grade Bond: Bonds rated triple-B or higher; many banks and other institutional investors are permitted by law
to hold only investment- grade bonds.
Junk Bond: A high-risk, high-yield bond.
bond is selling at par
coupon rate = discount rate
bond price=par value
bond is selling at a premium
coupon rate > discount rate
bond price>par value
bond is selling at a discount
coupon rate < discount rate
bond price<par value
N= 10 * 2 = 20
I = 13/2 = 6.5
Both Moodys and S&P use modifiersfor bonds rated below triple A.
S&P uses a plus and minus system.
A+ designates the strongest A-rated bonds; A-, the weakest.
Moody’s uses a 1, 2, or 3 designation, with 1 denoting the strongest and
3 denoting the weakest; thus, within the double-A category
Aa1 is the best, Aa2 is average, and Aa3 is the weakest.
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find more resources at oneclass.com
FINA 2201 Chapter 7: Bonds and their valuation
3
Bankruptcy
Two main chapters of the Federal Bankruptcy Act:
o Chapter 11, Reorganization
o Chapter 7, Liquidation
For large organizations, reorganization occurs more frequently than liquidation, particularly in those instances where
If company can’t meet its obligations
o It files under Chapter 11 to stop creditors from foreclosing, taking assets, and closing the business
o Management usually stays in control.
Company must demonstrate in its reorganization plan that it is “worth more alive than dead.”
o If not, judge will order liquidation under Chapter 7.
o Assets are auctioned off
Call Provisions: A provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms
prior to the normal maturity date.
Many corporate and municipal bonds contain a call provision that gives the issuer the right to call the bonds for
redemption
The issuer normally pay a call premium, which often equal to one year’s interest (compensation)
In most cases, bonds are not callable until several years after issue, generally 5-10 years
Companies call bonds when interest rates have declined significantly since bonds were issued
It reduces their interest expenses.
A call privilege is valuable to the firm but detrimental to long-term investors
Callable bonds have higher interest rate than the non-callable bonds
Yield to Call (YTC): The rate of return earned on a bond when it is called before its maturity date.
ABC Co.’s 10% coupon bonds had a deferred call provision that permitted the company to call them 10 years after their
issue date at a price of \$1,100 (FV). Suppose further that interest rates had fallen 1 year after the issuance, causing the
price rise to \$1,494.93 (PV), what is the Yield to Call (YTC)?
Sinking Funds Provision: A provision in a bond contract that requires the issuer to retire a portion of the bond issue each
year.
Some bonds include a sinking fund provision that require the issuer to buy back a specified percentage of the
issue each year
It is a mandatory payment
Although sinking funds are designed to protect investors but can be detrimental if the coupon rate is higher than
the current yield
Zero-coupon bond: A bond that pays no annual interest but is sold at a discount below par, thus compensating investors
in the form of capital appreciation.
Pays no periodic coupon
Receive the face value (usually \$1,000) at maturity
Price of a ZCB, PZCB
ABC Co issues a zero coupon bond (ZCB) (PMT=0) that has a price of \$800 (PV). The bond has 10 years (N) to maturity.
What is the cost of debt (yield/i) for the ZCB of ABC Co.?
PMT = .10 = X N= 10 1 = 9 yrs
1000
PMT = 100
N = # of years until the company can call the bond
Call price = price the company must pay in order to call the bond
(often set equal to the par value plus one year’s interest)
rd = YTC.
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find more resources at oneclass.com