Chap_5 - EMBA 807 Corporate Finance Dr Rodney Boehme...

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EMBA 807 Corporate Finance Dr. Rodney Boehme Page 1 CHAPTER 5: HOW TO VALUE BONDS AND STOCKS (Assigned problems are 1, 4, 5, 7, 8, 9, 13, 16, 17, 18, 21, 22, 23, 25, 26, 29, 31, and 33. Omit the Appendix to this chapter). This notes package contains two Addendums. I. BOND VALUATION Bonds are “Fixed Income” securities, since the cash flows that the bondholder will receive have been fixed or prespecified in the bond contract. The current fundamental or intrinsic value of a bond (or any other financial asset) is equal to the Present Value or PV 0 of all future expected cash flows. 1 An investor’s actual return on a bond, for any holding period, comes in two forms: (1) the coupon yield (from the payment of coupon interest) (2) the capital gain (bond’s change in price) Zero Coupon Bonds: a zero coupon bond will pay its stated face or par value at maturity. It pays no other future cash flows during its life. Zeroes are also known as pure discount bonds. The return here comes entirely as a capital gain . Example: A zero coupon bond will mature exactly 2 years from today. It was sold or issued by the U.S. Treasury and therefore is free of default risk. The par or face value is $100. This bond currently sells for $84.17 in the market. What annual rate of return does the market expect on this bond? From Chapter 4, we know: PV 0 = FV n /[1 + r] n . Here, PV 0 =$84.17, FV 2 =$100, and n=2 years. We need to solve for r . A time line of this bond is shown below: PV 0 = FV n /[1 + r] n r = [FV n /PV 0 ] 1/n – 1 = [100/84.17] 0.5 – 1 = 0.09 or 9.0% Actually, anytime we calculate the annual yield r by using the current bond price and future payments, the r is referred to as the Yield-to-Maturity or YTM. What will happen to this bond’s price tomorrow if the current market rate of interest or YTM on this and similar two-year bonds falls from 9.0% to 8.8%? 1 Intrinsic value refers to a private estimate of value – a private estimate of Present Value. This is not the same concept as market value, which refers to the current price at which a bond or stock is trading for. t=0 t=1 t=2 PV 0 = 84.17 FV 2 = 100
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EMBA 807 Corporate Finance Dr. Rodney Boehme Page 2 PV 0 = FV n /[1 + r] n = 100/[1+0.088] 2 = $84.48 . Here, the bond is now priced to yield the new lower market rate of interest of 8.8% per year. As yields fall , bond prices rise . Bond yields (interest rates) and prices are always inversely related. Coupon Bonds: most bonds pay coupon interest over their lives. Most coupon interest payments are paid every six months or semiannually. However we will cover annual coupon paying bonds first. We begin with an example. Example: A bond was issued 10 years ago as a 20-year bond. Today, it has 10 years remaining until maturity. The face or par value of the bond is $1000. The bond will pay an annual coupon interest payment equal to 9% of the par value. Each year this bond will pay (0.09)(1000) = $90 as a
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Chap_5 - EMBA 807 Corporate Finance Dr Rodney Boehme...

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