Solution manual financial management 10e by keown chapter 07

Expressed as a general present value equation, the value of an asset is found as follows: $C producing expected future cash flows, Ct, in years 1 through N payments and maturity value di

CHAPTER 7 Bonds Valuation

CHAPTER ORIENTATION

This chapter introduces the concepts that underlie asset valuation We are specificallyconcerned with bonds We also look at the concept of the bondholder's expected rate ofreturn on an investment

CHAPTER OUTLINE

event of liquidation than do other senior debtholders

as real estate

currency the bond is denominated; for instance, a bond issued in Europe orAsia that pays interest and principal in U.S dollars

substantial discount from their $1,000 face value with a zero or very lowcoupon

face an extremely large nondeductible cash outflow much greater thanthe cash inflow they experienced when the bonds were first issued

maturity

payments do not occur with zero coupon bonds

II Terminology and characteristics of bonds

predetermined, fixed amount of interest each year until maturity At maturity,the principal will be paid to the bondholder

firm's assets before the preferred and common stockholders Also,bondholders must be paid interest due them before dividends can bedistributed to the stockholders

bond matures, usually $1,000

expressed either as a percent of the par value or as a flat amount of interestwhich the borrowing firm promises to pay the bondholder each year Forexample: A $1,000 par value bond specifying a coupon interest rate of 9percent is equivalent to an annual interest payment of $90

to repay the loan principal

the bonds and the bond trustee who represents the bondholders It providesthe specific terms of the bond agreement such as the rights andresponsibilities of both parties

the bond’s market price

and Fitch Investor Services

the bond in question Bond ratings are extremely important in that afirm’s bond rating tells much about the cost of funds and the firm’saccess to the debt market

determined by its historical cost rather than its current worth

individually and not as part of a going concern

buyers and sellers negotiate an acceptable price for the asset

174

D Intrinsic value is the value based upon the expected cash flows from the

investment, the riskiness of the asset, and the investor's required rate ofreturn It is the value in the eyes of the investor and is the same as the presentvalue of expected future cash flows to be received from the investment

The value of an asset is found by computing the present value of all the future cash flows expected to be received from the asset Expressed as a general present value equation, the value of an asset is found as follows:

$C

producing expected future cash flows, Ct, in years 1 through N

payments and maturity value discounted at the bondholder's required rate ofreturn This may be expressed as:

$M )k(1

$I

payment

B If interest payments are received semiannually (as with most bonds), the

valuation equation becomes:

t

2

k1

$M

2

k12

$I

rate that gets the present value of the future interest payments and principalpayment just equal to the bond's current market price

if the bond is held to maturity, provided, of course, that the company issuingthe bond does not default on the payments

VIII Bond Value: Five Important Relationships

A decrease in interest rates (required rates of return) will cause the value of abond to increase; an interest rate increase will cause a decrease in value Thechange in value caused by changing interest rates is called interest rate risk

the coupon interest rate, the bond will sell at par, or maturity value

rate, the bond will sell below par value or at a "discount."

coupon rate, the bond will sell above par value or at a "premium."

As the maturity date approaches, the market value of a bond approaches itspar value

A bondholder owning a long-term bond is exposed to greater interest rate riskthan when owning a short-term bond

176

E Fifth relationship

The sensitivity of a bond's value to changing interest rates depends not only

on the length of time to maturity, but also on the pattern of cash flowsprovided by the bond

its price to a change in interest rates The greater the relativepercentage change in a bond price in response to a given percentagechange in the interest rate, the longer the duration

0

t b

t 1

P

)k(1

ANSWERS TO END-OF-CHAPTER QUESTIONS

cost minus accumulated depreciation Liquidation value is the dollar sum that could

be realized if the assets were sold individually and not as part of a going concern.Market value is the observed value for an asset in the marketplace where buyers andsellers negotiate a mutually acceptable price Intrinsic value is the present value ofthe asset's expected future cash flows discounted at an appropriate discount rate

the investor Hence, the terms value and present value are synonymous

expected cash flows and the riskiness of these cash flows The third consideration isthe investor's required rate of return The required rate of return reflects theinvestor's risk-return preference

7-5 (a) The par value is the amount stated on the face of the bond This value does

not change and, therefore, is completely independent of the market value.However, the market value may change with changing economic conditionsand changes within the firm

the bond indenture As such, this rate is constant throughout the life of thebond The coupon interest rate indicates to the investor the amount of interest

to be received in each payment period On the other hand, the investor'srequired rate of return is equivalent to the bond’s current yield to maturity,which changes with the changing bond's market price This rate may bealtered as economic conditions change and/or the investor's attitude towardthe risk-return trade-off is altered

honored before those of both common stock and preferred stock However, differenttypes of debt may also have a hierarchy among themselves as to the order of theirclaim on assets

Bonds also have a claim on income that comes ahead of common and preferredstock If interest on bonds is not paid, the bond trustees can classify the firminsolvent and force it into bankruptcy Thus, the bondholder's claim on income ismore likely to be honored than that of common and preferred stockholders, whosedividends are paid at the discretion of the firm's management

deal with expectations, several historical factors seem to play a significant role intheir determination Bond ratings are favorably affected by (1) a greater reliance onequity, and not debt, in financing the firm, (2) profitable operations, (3) a lowvariability in past earnings, (4) large firm size, and (5) little use of subordinated debt

In turn, the rating a bond receives affects the rate of return demanded on the bond bythe investors The poorer the bond rating, the higher the rate of return demanded inthe capital markets

For the financial manager, bond ratings are extremely important They provide anindicator of default risk that in turn affects the rate of return that must be paid onborrowed funds

are unsecured, the earning ability of the issuing corporation is of great concern to thebondholder They are also viewed as being more risky than secured bonds and as aresult must provide investors with a higher yield than secured bonds provide Oftenthe issuing firm attempts to provide some protection to the holder through theprohibition of any additional encumbrance of assets This prohibits the futureissuance of secured long-term debt that would further tie up the firm's assets andleave the bondholders less protected To the issuing firm, the major advantage ofdebentures is that no property has to be secured by them This allows the firm toissue debt and still preserve some future borrowing power

178

A mortgage bond is a bond secured by a lien on real property Typically, the value of

the real property is greater than that of the mortgage bonds issued This provides themortgage bondholders with a margin of safety in the event the market value of thesecured property declines In the case of foreclosure, the trustees have the power tosell the secured property and use the proceeds to pay the bondholders In the eventthat the proceeds from this sale do not cover the bonds, the bondholders becomegeneral creditors, similar to debenture bondholders, for the unpaid portion of thedebt

in this case bonds, issued in a country different from the one in whosecurrency the bond is denominated For example, a bond that is issued inEurope or in Asia by an American company and that pays interest andprincipal to the lender in U.S dollars would be considered a Eurobond.Thus, even if the bond is not issued in Europe, it merely needs to be sold in acountry different from the one in whose currency it is denominated to beconsidered a Eurobond

substantial discount from their $1,000 face value with a zero or very lowcoupon The investor receives a large part (or all on the zero coupon bond) ofthe return from the appreciation of the bond at maturity

participants in this market are new firms that do not have an establishedrecord of performance Many junk bonds have been issued to financecorporate buyouts

7-10 The expected rate of return is the rate of return that may be expected from

purchasing a security at the prevailing market price Thus, the expected rate ofreturn is the rate that equates the present value of future cash flows with the actualselling price of the security in the market

7-11 When the coupon interest rate does not equal the bondholder's required rate of return,

the bond will be issued at either a premium or discount If the investor's requiredrate of return is higher than the coupon interest rate, the bond will be issued at adiscount to the investor If the coupon rate is higher that the investor's required rate,the bond will be issued at a premium

7-12 A premium bond is issued when the coupon rate is higher than the bondholder's

required rate of return The premium is the excess of the market value over the facevalue of the bond A discount bond is issued when the bondholder's required rate ofreturn is higher than the coupon rate The discount is the excess of the face value ofthe bond over the market value

Over time, the premium or discount on a bond is amortized This amortization

7-13 A change in current interest rates (required rate of return) causes a change in the

market value of a bond However, the impact on value is greater for long-term bondsthan it is for short-term bonds The reason long-term bond prices fluctuate more thanshort-term bond prices in response to interest rate changes is simple Assume aninvestor bought a 10-year bond yielding a 12 percent interest rate If the currentinterest rate for bonds of similar risk increased to 15 percent, the investor would belocked into the lower rate for 10 years If, on the other hand, a shorter-term bond hadbeen purchased, say one maturing in 2 years, the investor would have to accept thelower return for only 2 years and not the full 10 years At the end of year 2, theinvestor would receive the maturity value of $1,000 and could buy a bond offeringthe higher 15 percent rate for the remaining 8 years Thus, interest rate risk isdetermined, at least in part, by the length of time an investor is required to commit to

an investment

7-14 The duration of a bond is simply a measure of the responsiveness of its price to a

change in interest rates The greater the relative percentage change in a bond price inresponse to a given percentage change in the interest rate, the longer the duration

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

.12) (1

$80

7-2A If the interest is paid semiannually:

(1.04)

$45

∑

=16

(1.08)

$90

/2)k (1

$40

20

900

40

1000

The rate is equivalent to 9.6 percent annual rate compounded semiannually, or 9.8

)k (1

$90

+

++

∑

=20

)k (1

$70

)k (1

$80

(1.10)

$80

of return of 10 percent, the bond is not an acceptable investment This fact isalso evident because the market price, $1,085, exceeds the value of thesecurity to the investor of $847.88

the result of "interest-rate risk." Thus, the greater the investor's required rate

of return, the greater will be his/her discount on the bond Conversely, theless his/her required rate of return below that of the coupon rate, the greaterthe premium will be

investor is exposed to, resulting in greater premiums and discounts

7-8A $1,250 = ∑

= + + +

15 1

t b t (1 kb)15

$1,000

)k (1

$90

1

$1,000

(1.09)

$110

1

$1,000

(1.12)

$110

(b) (ii) Vb = ∑

=

+20

1

$1,000

(1.06)

$110

7-11A a $1,100 = ∑

= + + +

7 1

t b t (1 kb)7

$1,000

)k (1

$90

1

$1,000

(1.07)

$90

rate of return of 7 percent, the bond is an acceptable investment This fact isalso evident because the market price, $1,100, is less than the value of thesecurity to the investor of $1,107.79

= + + +

12 1

t b t (1 kb)12

$1,000

)k (1

$50

return(6%), you should not purchase the bond

Bond I II III IV V

Bond

Value $1,323.36 $1,095.33 $1,317.71 $1,225.51 $1,070.24 Years C t tPV(C t ) C t tPV(C t ) C t tPV(C t ) C t tPV(C t ) C t tPV(C t )

1

$1,000

(1.09)

$85

1

$1,000

(1.11)

$85

85

1000

9%, you should purchase the bond Thus, if your required rate of returndecreases to 7%, you should purchase the bond

SOLUTION TO INTEGRATIVE PROBLEM

= + + +

10 1

t t ( 06)10

000,1 )06.1(

00.78

$

t t ( 09)17

000,1 )09.1(

00.75

$

Entertainment, Inc Bond Value (Vb) = 4

4 1

t t (1 08)

$1,000

.08) (1

$79.75

+

++

)k (1

$78

)k (1

$75

Entertainment, Inc.: $1,035 = 4

b

4 1

$1,000

)k (1

$79.75

+

++

09) (1

$78

ResortsThomas

= + + +

17 1

t t ( 12)17

000,1 )12.1(

00.75

$

t t ( 11)4

000,1 )11 (

75.79

$

t t (1 03)10

$1,000

.03) (1

$78

ResortsThomas

= + + +

17 1

t t (1 06)17

$1,000

06) (1

$75.00

t t (1 05)4

$1,000

05)(1

$79.75

depending on the length of time to maturity and whether the investor's required rate

of return is above or below the coupon interest rate If the investor’s required rate ofreturn is above the coupon interest rate, the bond will sell at a discount (below parvalue), but if the investor’s required rate of return is below the coupon interest rate,the bond will sell at a price above its par value (premium)

terms to maturity, the duration of the two bonds is very similar These two bondswill likely have similar sensitivity to changes in interest rates as evidenced by theirduration values.

return than your required rate of return Young Corporation’s expected rate of return

is greater than your required rate of return So we would buy Young Corporation andnot Entertainment, Inc or Thomas Resorts

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