Tài chính doanh nghiệp - Chapter 7: Bonds and their valuation

CHAPTER 7Bonds and Their ValuationKey features of bondsBond valuationMeasuring yieldAssessing riskWhat is a bond?A long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond.Bond marketsPrimarily traded in the over-the-counter (OTC) market.Most bonds are owned by and traded among large financial institutions.Full information on bond trades in the OTC market is not published, but a representative group of bonds is listed and traded on the bond division of the NYSE.Key Features of a BondPar value – face amount of the bond, which is paid at maturity (assume $1,000).Coupon interest rate – stated interest rate (generally fixed) paid by the issuer. Multiply by par to get dollar payment of interest.Maturity date – years until the bond must be repaid.Issue date – when the bond was issued.Yield to maturity - rate of return earned on a bond held until maturity (also called the “promised yield”).Effect of a call provisionAllows issuer to refund the bond issue if rates decline (helps the issuer, but hurts the investor).Borrowers are willing to pay more, and lenders require more, for callable bonds.Most bonds have a deferred call and a declining call premium.What is a sinking fund?Provision to pay off a loan over its life rather than all at maturity.Similar to amortization on a term loan.Reduces risk to investor, shortens average maturity.But not good for investors if rates decline after issuance.How are sinking funds executed?Call x% of the issue at par, for sinking fund purposes.Likely to be used if kd is below the coupon rate and the bond sells at a premium.Buy bonds in the open market.Likely to be used if kd is above the coupon rate and the bond sells at a discount.The value of financial assets012nkCF1CFnCF2Value...Other types (features) of bondsConvertible bond – may be exchanged for common stock of the firm, at the holder’s option.Warrant – long-term option to buy a stated number of shares of common stock at a specified price.Putable bond – allows holder to sell the bond back to the company prior to maturity.Income bond – pays interest only when interest is earned by the firm.Indexed bond – interest rate paid is based upon the rate of inflation.What is the opportunity cost of debt capital?The discount rate (ki ) is the opportunity cost of capital, and is the rate that could be earned on alternative investments of equal risk. ki = k* + IP + MRP + DRP + LPWhat is the value of a 10-year, 10% annual coupon bond, if kd = 10%?012nk100100 + 1,000100VB = ?...Using a financial calculator to value a bondThis bond has a $1,000 lump sum due at t = 10, and annual $100 coupon payments beginning at t = 1 and continuing through t = 10, the price of the bond can be found by solving for the PV of these cash flows.INPUTSOUTPUTNI/YRPMTPVFV10101001000-1000An example:Increasing inflation and kdSuppose inflation rises by 3%, causing kd = 13%. When kd rises above the coupon rate, the bond’s value falls below par, and sells at a discount.INPUTSOUTPUTNI/YRPMTPVFV10131001000-837.21An example:Decreasing inflation and kdSuppose inflation falls by 3%, causing kd = 7%. When kd falls below the coupon rate, the bond’s value rises above par, and sells at a premium.INPUTSOUTPUTNI/YRPMTPVFV1071001000-1210.71The price path of a bondWhat would happen to the value of this bond if its required rate of return remained at 10%, or at 13%, or at 7% until maturity?Years to Maturity1,3721,2111,00083777530 25 20 15 10 5 0kd = 7%.kd = 13%.kd = 10%.VBBond values over timeAt maturity, the value of any bond must equal its par value.If kd remains constant:The value of a premium bond would decrease over time, until it reached $1,000.The value of a discount bond would increase over time, until it reached $1,000.A value of a par bond stays at $1,000.What is the YTM on a 10-year, 9% annual coupon, $1,000 par value bond, selling for $887?Must find the kd that solves this model.Using a financial calculator to find YTMSolving for I/YR, the YTM of this bond is 10.91%. This bond sells at a discount, because YTM > coupon rate.INPUTSOUTPUTNI/YRPMTPVFV1010.91901000- 887Find YTM, if the bond price was $1,134.20.Solving for I/YR, the YTM of this bond is 7.08%. This bond sells at a premium, because YTM 10% (the annual bond’s effective rate), so you would prefer the semiannual bond.If the proper price for this semiannual bond is $1,000, what would be the proper price for the annual coupon bond?The semiannual coupon bond has an effective rate of 10.25%, and the annual coupon bond should earn the same EAR. At these prices, the annual and semiannual coupon bonds are in equilibrium, as they earn the same effective return.INPUTSOUTPUTNI/YRPMTPVFV1010.251001000- 984.80A 10-year, 10% semiannual coupon bond selling for $1,135.90 can be called in 4 years for $1,050, what is its yield to call (YTC)?The bond’s yield to maturity can be determined to be 8%. Solving for the YTC is identical to solving for YTM, except the time to call is used for N and the call premium is FV.INPUTSOUTPUTNI/YRPMTPVFV83.568501050- 1135.90Yield to call3.568% represents the periodic semiannual yield to call.YTCNOM = kNOM = 3.568% x 2 = 7.137% is the rate that a broker would quote.The effective yield to call can be calculatedYTCEFF = (1.03568)2 – 1 = 7.26%If you bought these callable bonds, would you be more likely to earn the YTM or YTC?The coupon rate = 10% compared to YTC = 7.137%. The firm could raise money by selling new bonds which pay 7.137%.Could replace bonds paying $100 per year with bonds paying only $71.37 per year.Investors should expect a call, and to earn the YTC of 7.137%, rather than the YTM of 8%.When is a call more likely to occur?In general, if a bond sells at a premium, then (1) coupon > kd, so (2) a call is more likely.So, expect to earn:YTC on premium bonds.YTM on par & discount bonds.Default riskIf an issuer defaults, investors receive less than the promised return. Therefore, the expected return on corporate and municipal bonds is less than the promised return.Influenced by the issuer’s financial strength and the terms of the bond contract.Types of bondsMortgage bondsDebenturesSubordinated debenturesInvestment-grade bondsJunk bondsEvaluating default risk:Bond ratingsBond ratings are designed to reflect the probability of a bond issue going into default.Investment GradeJunk BondsMoody’sAaa Aa A BaaBa B Caa CS & PAAA AA A BBBBB B CCC DFactors affecting default risk and bond ratingsFinancial performanceDebt ratioTIE ratioCurrent ratioBond contract provisionsSecured vs. Unsecured debtSenior vs. subordinated debtGuarantee and sinking fund provisionsDebt maturityOther factors affecting default riskEarnings stabilityRegulatory environmentPotential antitrust or product liabilitiesPension liabilitiesPotential labor problemsAccounting policiesBankruptcyTwo main chapters of the Federal Bankruptcy Act:Chapter 11, ReorganizationChapter 7, LiquidationTypically, a company wants Chapter 11, while creditors may prefer Chapter 7.Chapter 11 BankruptcyIf company can’t meet its obligations It files under Chapter 11 to stop creditors from foreclosing, taking assets, and closing the business.Has 120 days to file a reorganization plan.Court appoints a “trustee” to supervise reorganization. Management usually stays in control.Company must demonstrate in its reorganization plan that it is “worth more alive than dead”.If not, judge will order liquidation under Chapter 7.Priority of claims in liquidationSecured creditors from sales of secured assets.Trustee’s costsWages, subject to limitsTaxesUnfunded pension liabilitiesUnsecured creditorsPreferred stockCommon stockReorganizationIn a liquidation, unsecured creditors generally get zero. This makes them more willing to participate in reorganization even though their claims are greatly scaled back.Various groups of creditors vote on the reorganization plan. If both the majority of the creditors and the judge approve, company “emerges” from bankruptcy with lower debts, reduced interest charges, and a chance for success.