FINA Text BK - MODULE 05 - Bond Val + Expect Theory

FINA Text BK - MODULE 05 - Bond Val + Expect Theory -...

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05: Page 1 of 36 MODULE 05 INVESTING IN AND FINANCING WITH BONDS Many features distinguish one bond from another. Most features affect the interest rate a company must pay. Financial managers need to be aware of these features to design bonds that reduce the cost of financing. And investors need to be informed about the different bond types because each type offers a unique mix of risk and return. The module begins with a review of the influences on the interest rate that issuers must pay for bond money. You then will learn how to interpret bond quotations from The Wall Street Journal . The module then turns to the differences in the bonds that companies issue. Differences may destroy your perception of corporate bonds. For example, some bonds pay interest that changes from payment to payment. Some issuers retire bonds before maturity, forcing investors to reinvest principal in lower- yielding bonds. And some bonds don’t pay interest at all! These and other features are topics of discussion in this module. When you finish this module you will be able to do the following: 1. Calculate intrinsic value of a coupon and zero-coupon bonds and determine when they are overpriced or underpriced. 2. Calculate yield to maturity and to see it as a measure of expected rate of return that differs from actual return (realized yield) when default occurs or the interest- rate environment changes. 3. Understand and measure the impact on the rate of interest of a sinking-fund requirement. 4. Understand the influences on the rate of interest a company pays for borrowed money and the role of agencies that evaluate exposure to default risk in a bond issue. 5. Recognize the relationship between default risk, coupon reinvestment risk, and price risk; know the differential impact of price risk arising from differing maturity. 6. Read and interpret bond quotations. 7. Discuss the bond indenture and its role in determining retirement of the issue; see the type of signal that various retirement methods provide investors. 8 List and discuss the types of secured and unsecured bonds and recognize three special feature bonds— put, floating rate, and income. UNDERSTANDING BOND VALUATION This module is heavy going if you didn’t spend enough time studying Module 3 because opportunity cost and the time value of money are the cornerstones of understanding bonds. Before you read further, look back at your notes from Module 3, then pick up the following discussion.
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05: Page 2 of 36 Intrinsic Value of a Bond Like any capital asset, a bond has an intrinsic value measured as the present value of expected cash flows. As you know from studying Module 3 and the time value of money, changing expected cash flows or the opportunity cost changes intrinsic value. Bonds issued in the primary (new-issues) market offer the issuing company a debt cash inflow. That’s finance-speak for the way an offering increases the issuer’s cash balance and amount of long-term debt outstanding. The issuer's cash inflow is
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FINA Text BK - MODULE 05 - Bond Val + Expect Theory -...

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