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Unformatted text preview: CHAPTER 7 Valuation and Characteristics of Bonds CHAPTER ORIENTATION This chapter introduces the concepts that underlie asset valuation. We are specifically concerned with bonds. We also look at the concept of the bondholder's expected rate of return on an investment. CHAPTER OUTLINE I. Types of bonds A. Debentures : unsecured long-term debt. B. Subordinated debentures : bonds that have a lower claim on assets in the event of liquidation than do other senior debt holders. C. Mortgage bonds : bonds secured by a lien on specific assets of the firm, such as real estate. D. Eurobonds : bonds issued in a country different from the one in whose currency the bond is denominated; for instance, a bond issued in Europe or Asia that pays interest and principal in U.S. dollars. E. Zero and low coupon bonds allow the issuing firm to issue bonds at a substantial discount from their $1,000 face value with a zero or very low coupon. 1. The disadvantages are, when the bond matures, the issuing firm will face an extremely large nondeductible cash outflow much greater than the cash inflow they experienced when the bonds were first issued. 2. Discount bonds are not callable and can be retired only at maturity. 3. On the other hand, annual cash outflows associated with interest payments do not occur with zero coupon bonds. F. Junk bonds : bonds rated BB or below. 226 II. Terminology and characteristics of bonds A. A bond is a long-term promissory note that promises to pay the bondholder a predetermined, fixed amount of interest each year until maturity. At maturity, the principal will be paid to the bondholder. B. In the case of a firm's insolvency, a bondholder has a priority of claim to the firm's assets before the preferred and common stockholders. Also, bondholders must be paid interest due them before dividends can be distributed to the stockholders. C. A bond's par value is the amount that will be repaid by the firm when the bond matures, usually $1,000. D. The contractual agreement of the bond specifies a coupon interest rate that is expressed either as a percent of the par value or as a flat amount of interest which the borrowing firm promises to pay the bondholder each year. For example: A $1,000 par value bond specifying a coupon interest rate of nine percent is equivalent to an annual interest payment of $90. E. The bond has a maturity date , at which time the borrowing firm is committed to repay the loan principal. F. A convertible bond allows the investor to exchange the bond for a predetermined number of the firms shares of common stock. G. A bond is callable or redeemable when it provides the firm with the right to pay off the bond at some time before its maturity date. These bonds frequently have a call protection period which prevents the firm from calling the bond for a pre-specified time period....
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