Practical financial managment 7e LASHER chapter 7

Bond Terminology and PracticeA bond’s term or maturity is the time from the present until the principal is returned A bond’s face or par value represents the amount the firm intends to b

Chapter 7 - The Valuation and Characteristics of Bonds

A systematic process through which the price at which a security should sell is established - Intrinsic value

THE BASIS OF VALUE

– Real assets (houses, cars) have value due to services they provide

– Financial assets (paper) represent rights to future cash flows

The Basis of Value

Any security’s value is the present value of the cash flows expected from owning it.

– A security should sell for close to that value in financial markets

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The Basis of Value

Investing

Using a resource to benefit the future

rather than for current satisfaction

– Putting money to work to earn more

– 1 year investments return = $ received / $ invested

– Debt investors receive interest Equity investors get dividends + price change

Return On One Year Investment

Return is what the investor receives Can be expressed as a dollar amount or as a rate Rate of return is what the investor receives divided by what was invested For debt investments: the interest rate

In terms of the time value of money:

Invest PV at rate k and receive future cash flows of

The Basis for Value

Discount Rate

The term discounted rate is often

used for interest rate

Returns on Longer-Term Investments

Bond Terminology and Practice

A bond’s term (or maturity) is the time from the present until the principal is returned

A bond’s face (or par) value represents the amount the firm intends to borrow (the principal) at the coupon rate of interest

Coupon Rates

Coupon Rate – the fixed rate of interest paid by a bond

In the past, bonds had “coupons” attached, today they are “registered” Most bonds pay coupon interest semiannual

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Bond Valuation—Basic Ideas

Adjusting to Interest Rate Changes

– Bonds are originally sold in the primary market and trade subsequently among investors

in the secondary market

– Although bonds have fixed coupons, market interest rates constantly change

– How does a bond paying a fixed interest rate remain salable (secondary market) when interest rates change?

Bond Valuation—Basic Ideas

Bonds adjust to changing yields by changing their prices

– Selling at a Premium – bond price above face value

– Selling at a Discount – bond price below face value

Bond prices and interest rates move in opposite directions

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Determining the Price of a Bond

The value (price) of a security is equal to the present value of the cash flows expected from owning it

In bonds, the expected cash flows are predictable.

– Interest payments are fixed, occurring at regular intervals

– Principal is returned along with the last interest payment

Determining the Price of a Bond Figure 7-1 Cash Flow Time Line for a Bond

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This bond has 10 years until maturity, a par value of $1,000, and a coupon rate of 10%.?

Determining the Price of a Bond

The Bond Valuation Formula

– The price of a bond is the present value of a stream of interest payments plus the present value of the principal repayment

k,n

Interest payments are annuities can use

the present value of an annuity form ula: Principal repayment is a lump sum in

PMT[PVFA

the futur

Determining the Price of a Bond

Two Interest Rates and One More

– k - the current market yield on comparable bonds

– “Current yield” - annual interest payment divided by bond’s current price

– Not used in valuation

– Info for investors

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Figure 7-2 Bond Cash Flow and

Valuation Concepts

Concept Connection Example 7-1 Finding the Price of a Bond

Emory issued a $1,000, 8%, 25-year bond 15 years ago

Comparable bonds are yielding 10% today

What price will yield 10% to buyers today?

What is the bond’s current yield?

Assume the bond pays interest semiannually

Concept Connection Example 7-1 Finding the Price of a Bond

Must solve for present value of bond’s expected cash flows at today’s interest rate Use Equation 7.4 :

k represents the periodic current market interest

rate, or 10% ÷ 2 = 5%

is received in the form of $40

every six months.

The future value is the principal repayment of $1,000.

Concept Connection Example 7-1 Finding the Price of a Bond

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Substituting :

This is the price at

which the bond must sell

to yield 10% It is

selling at a discount because

the current interest rate

is above the coupon rate

The bond’s current yield is

Maturity Risk Revisited

Related to the term of the debt

– Longer term bond prices fluctuate more in response to changes in interest rates than shorter term bonds

– AKA price risk and interest rate risk

Table 7-1 Price Changes at Different Terms Due to an Interest Rate Increase from 8% to 10%

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Figure 7.3 Price Progression with

Constant Interest Rate

Finding the Yield at a Given Price

Calculate a bond’s yield assuming it is selling at a given price

Trial and error – guess a yield – calculate price – compare to price given

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Involves solving for k, which is more complicated

because it involves both an annuity and a FV

Use trial and error to solve for k, or use a financial

calculator.

Concept Connection Example 7-3 Finding the Yield at a Price

Benson issued a $1,000, 8%, 30-year bond 14 years ago

– Bond is now selling for $718

– What is yield to an investor buying it today?

– Semiannual interest

Concept Connection Example 7-3 Finding the Yield at a Price

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As interest rates rise, bond prices fall, so yield must be above 8%

Guess 10% and apply Equation 7.4

Next guess must be lower to drive price further down.

Answer is just below 12%

=

=

Call Provisions

If interest rates fall, a firm may wish to retire old, high interest bonds by

“refinancing” with new, lower interest debt

– To ensure ability to refinance, issuers make bonds ‘callable’

– Investors don’t like calls – lose high interest

– Issuers and investors compromise

– Call provisions usually have

A call premium

– Extra money paid if called

Period of call protection

– Guaranteed not to call for a number of years

Figure 7-5 Valuation of

a Bond Subject to Call

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Call Provisions

Valuing the Sure-To-Be-Called Bond

– Requires that two changes be made to bond valuation formula

n now represents the number of periods until the bond is likely to be called.

The future value becomes the call price (face value plus

call premium).

n

Concept Connection Example 7-4 Basics:

Pricing a “Likely to Be Called” Bond

Northern issued a $1,000, 25-year bond 5 years ago

Call provision: Can call after 10 years with the payment of one additional year’s interest at coupon rate.Coupon rate is 18% Market rate is now 8%

What is the bond worth today?

Interest payments are semiannual

Concept Connection Example 7-4 Basics: Pricing a “Likely to Be Called” Bond

The bond must yield the current rate of interest in either case

Concept Connection Example 7-4 Basics:

Pricing a “Likely to Be Called” Bond

m = number of periods to call

CP = call price = face value + call premium

] PMT[PVFA

(call)

The Refunding Decision

When current interest rates fall below the bond’s coupon rate, a firm must decide whether to call in the issue

– Compare interest savings to cost of making call:

Call premium

Flotation costs –Broker fees, printing costs, etc

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Dangerous Bonds with Surprising Calls

Bonds can have obscure call features buried in their contract terms.

– Most common type – a sinking fund provision – requires an issuer to call in and retire a fixed percentage of the issue each year

– Generally no call premium

Provision is for the benefit of the bondholder

Risky Issues

Sometimes bonds sell for a price far below what valuation techniques suggest

– Issuing company may be in financial trouble

Buying the bond is very risky

In theory riskier loans should be discounted at higher rates leading to lower calculated prices

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Convertible Bonds

Unsecured bonds exchangeable for a fixed number of shares of stock at the bondholder's discretion

Conversion ratio - the number of shares of stock received for each bond

Conversion price - the implied stock price if bond is converted into a certain

number of shares

Convertibles usually pay lower coupon rates

exchanged shares

ratio conversion = bond' conversion s par value price =

Concept Connection Example 7-5 Basics: Investing in Convertible Bonds

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Harry Jenson purchased one of Algo Corp.’s 9%, 25-year convertible bonds at its $1,000 par value a year ago when the company’s common stock was selling for $20 Similar bonds without

a conversion feature returned 12% at the time The bond is convertible into stock at a price of

$25 The stock is now selling for $29 Algo pays no dividends

Notice that this bond’s coupon rate was set below the market rate for nonconvertible issues

Concept Connection Example 7-5 Basics: Investing in Convertible Bonds

a Harry exercised the conversion feature today and immediately sold the stock

he received Calculate the total return on his investment.

b What would Harry’s return have been if he had invested $1,000 in Algo’s stock instead of the bond?

Concept Connection Example 7-5 Basics: Investing in Convertible Bonds

The proceeds from selling those shares at the current market price were

In addition the bond paid interest during the year of

So the total receipts from the bond investment were

price conversion

value par

exchanged

Concept Connection Example 7-5 Basics: Investing in Convertible Bonds

Concept Connection Example 7-5 Basics: Investing in Convertible Bonds

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Concept Connection Example 7-5 Basics: Investing in Convertible Bonds

Notice that the convertible enabled Harry to participate in some but not all of the rapid price appreciation of Algo’s stock.

Also notice that had the stock price fallen, an investment in it would have had a negative return, but the convertible would have returned the 9% coupon rate.

Convertible Bonds

Effect of Conversion on Financial Statements and Cash Flow

– An accounting entry removes the value of convertible bonds from long-term debt placing

it into equity as if new shares were sold

– No immediate cash flow impact, but ongoing cash flow implications exist

Interest payments stop

But dividend payments may start

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Advantages of Convertible Bonds

To Issuing Companies

Convertible features are “sweeteners”

enabling a risky firm to pay a lower interest

Forced Conversion

A firm may want bonds converted

– As stock price rises convertible represents a lost opportunity to sell new equity at a higher price

Convertible bonds are always issued with call features which can be used to force conversion

Issuers generally call convertibles when stock prices rise to 10-15% above conversion prices

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Valuing (Pricing) Convertibles

A convertible’s price can depend on either

– its value as a traditional bond or

– the market value of the stock into which it can be converted

A convertible is always worth at least the larger of its value as a bond or as stock

Figure 7-6 Value of a Convertible Bond

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Effect on Earnings Per Share—Diluted EPS

Upon conversion convertible bonds cause dilution in EPS

– EPS drops due to the increase in the number of shares of stock outstanding

Thus outstanding convertibles represent a potential to dilution of EPS

Concept Connection Example 7-7 - Dilution

Montgomery Inc Issued two thousand $1,000, 8% coupon convertible bonds three years ago Each bond is convertible into stock at $25 per share All of the Bonds remain outstanding, i.e., none have converted Last year net income was $3 million One million shares stock were outstanding for the entire year, and the firm’s marginal tax rate was 40%

Calculate Montgomery’s basic and diluted EPS for the year.

Solution:

Basic EPS

net income ÷ number of shares

$3,000,000 ÷ 1,000,000 = $3.00.

Concept Connection Example 7-7 Dilution

Diluted EPS

Assumes all bonds are converted at beginning of year

1 Add the number of newly converted shares to denominator.

2 Adjust net income for after tax effect of interest saved.

1 Shares exchanged:

Par ÷ Conversion price = $1,000 ÷ $25 = 40 shares/bond

40 shares/bond × 2,000 bonds = 80,000 shares

New shares outstanding = 1,000,000 + 80,000 = 1,080,000

2 Adjust the net income by interest saved:

Interest paid on bonds: 08 x $1,000 x 2,000 = $160,000

After tax: $160,000 × (1-.4) = $96,000

New net income = $3,000,000 + $96,000 = $3,096,000

Diluted EPS: $3,096,000 ÷ 1,080,000 = $2.87

Institutional Characteristics of Bonds

Kinds of Bonds

Bonds are either bearer or registered

Registered, Owners of Record, Transfer Agents

Owners of registered bonds are recorded with a transfer agent

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Kinds of Bonds

Secured bonds and mortgage bonds

– Backed by specific assets - collateral

Bond Ratings—Assessing Default Risk

Bonds are assigned quality ratings reflecting their probability of default.

– Higher ratings mean lower default probability

– Higher rated bonds pay lower interest rates

Bond rating agencies (Moody’s, S&P) evaluate bonds (and issuers), and assign

a ratings

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Bond Ratings—Table 7.2

Figure 7-7 Yield Differentials between High- and Low-Quality Bonds

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Controlling Default Risk Bond Indentures

Bond indentures attempt to prevent borrowing firms from becoming riskier after bonds issued

– restrictive covenants – limit activities and payouts

Safety also provided by sinking funds

– Provide money for repayment of bond principal

Appendix 7-A - Lease Financing

A lease is a contract giving one party (lessee) the right to use an asset owned by another (lessor) for a periodic payment

– Individuals usually lease houses, apartments, and automobiles

– Companies lease equipment and real estate

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Leasing and Financial Statements

Originally leasing allowed use without ownership

– Lease payments recognized as income statement expenses, but

– No impact on balance sheets

No recognition of ownership or obligation to pay

Improved appearance of financial ratios

– Not real

Led to widespread use of lease financing

– The leading form of “off balance sheet financing”

Misleading Results

Off balance sheet financing makes financial statements misleading

– Missed lease payments can cause failure just like a missed interest payment on debt

– Not showing leases on the balance sheet can mislead investors into thinking a firm is stronger than it is

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FASB 13 Redefines Ownership

1970s: Concerns about leasing led to FASB 13

– Prior to FASB 13 an asset was owned for financial statement purposes by whoever held title

Regardless of who used it

– FASB 13 redefined ownership for financial reporting purposes in economic terms

– FASB 13 stated that the real owner of an asset is whoever enjoys its benefits and bears its risks and responsibilities

Operating and Capital (Financing) Leases

Under FASB 13 lessees must capitalize financing leases

– Puts the value of leased assets and the liability for payments on the balance sheet

– Long term leases for high value assets

Operating leases can still be listed off the balance sheet

– Short term leases for lower value items

Rules must be met for a lease to be classified as an operating lease

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Financial Statement Presentation of Leases by Lessees

Operating leases

– Recognize rent expense

– No balance sheet entries

Financing (Capital) leases

– Recognize asset and lease obligation on balance sheet

– Recognize depreciation expense for asset

– Amortize lease obligation like a loan