Chapter - The Valuation and Characteristics of Bonds Valuation 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 Value today is PV Different opinions about securities’ values come from different assumptions about cash flows and interest rates – Stocks are hardest to value because future dividends and prices are never guaranteed 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 The Basis of Value Investing Return Using a resource to benefit the future rather than for current satisfaction What the investor receives for making an investment – – Putting money to work to earn more money Common types of investments Debt – – year investments received / $ invested return = $ Debt investors receive interest Equity investors get dividends + price change Equity Definition The rate of return on an investment is the interest rate that equates the present value of its expected cash flows with its current price Return is also known as – – Yield, or Interest 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 principal = PV, and interest = kPV at the end of a year, so FV1 = PV + kPV FV1 = PV(1+k) PV = FV1 (1 + k) The Basis for Value Discount Rate The term discounted rate is often used for interest rate Returns on Longer-Term Investments Bonds Bonds represent a debt relationship in which an issuing company borrows and buyers lend – A bond issue represents borrowing from many lenders at one time under a single agreement 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 10 Figure 7-7 Yield Differentials between High- and Low-Quality Bonds 57 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 58 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 59 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” 60 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 61 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 62 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 63 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 64 Leasing from the Perspective of the Lessor Lessors are usually financial institutions - banks, finance or insurance companies Lease payments are calculated to offer the lessor a given return Lessor holds legal title—can repossess assets if lessee defaults Lessors get better treatment in bankruptcy proceedings than lenders 65 Residual Values Residual value—the value of asset at the end of the lease Makes lease pricing and return calculations more complex Important negotiating points between lessee and lessor 66 Lease Vs Buy The Lessee’s Perspective Broad financing possibilities – – – Equity Debt—available through bonds or banks Leasing—available through leasing companies Conduct a lease vs buy comparison – Choose the lowest cost option in a present value sense Leasing is almost always more expensive 67 The Advantages of Leasing Lessors usually require no down payment, lenders want significant money down Lessor’s restrictions less stringent than lenders’ Easier credit with manufacturers/lessors 68 The Advantages of Leasing Short leases transfer the risk of obsolescence to lessors Tax deducting the cost of land Increasing liquidity—the sale and leaseback Tax advantages for marginally profitable companies 69 Leveraged Leases The ability to depreciate assets reduces taxes – Government shares the cost of ownership Unprofitable firms lose this benefit as they pay no tax – But can get some benefits with a Leveraged Lease In a leveraged lease, a profitable lessor buys equipment financing a portion with borrowed money (hence a leveraged lease) – Leveraged Lessor receives the tax benefits of ownership Lessor shares those tax benefits with the lessee through lower lease payments – Lessee’s savings can be very substantial 70 Figure 7A-1 Leveraged Leases 71 [...]... opposite 13 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 14 Determining the Price of a Bond Figure 7-1 Cash Flow Time Line for a Bond This bond... 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 11 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... Coupon Rate 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 17 Figure 7-2 Bond Cash Flow and Valuation Concepts 18 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... compare to price given PB = PMT PVFA k, n  + FV PVFk, n  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 25 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... 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 28 Figure 7-5 Valuation of a Bond Subject to Call 29 Call Provisions Valuing the Sure-To-Be-Called Bond – Requires that two changes be made to bond valuation formula PB = PMT[PVFA k, n ] + FV[PVFk, n ] The future... plus n now represents the number of periods until the bond is likely to be called call premium) 30 Call Provisions The new formula becomes PB = PMT[PVFAk,m] + CP[PVFk,m] Where m = time to call CP = call price = FV + Call Premium 31 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... 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 $80 ÷ $875.39, or 9.14% 21 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 22 Table 7-1 Price Changes... 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 PB = PMT[PVFA k, n ] + FV[PVFk, n ] rate, or 10% ÷ 2 = 5% The payment is 8% x $1,000, or $80 annually However, it n represents the number of is received in the form of $40 every six months The future value is the principal... 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 PB (call) = PMT[PVFA k,m ] + CP[PVFk,m ] m = number of periods to call CP = call price = face value + call premium PMT =... premium Flotation costs –Broker fees, printing costs, etc 35 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 36