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ch 10 - Chapter 10 Reporting and Interpreting Bonds(c...

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1 (c) Mikhail Pevzner and George Mason University Chapter 10 Reporting and Interpreting Bonds (c) Mikhail Pevzner and George Mason University Bonds A type of long-term debt; Generally traded on public markets (although need not be); Just as is with private loans, interest expense is tax deductible; Valuation is based on the prevailing market interest rates ; (c) Mikhail Pevzner and George Mason University Bonds (continued) Principal (aka face value, par value, maturity value); Bond is a combination of two future cash flows: Coupon payments (annuity) Principal payment (lump sum);
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2 (c) Mikhail Pevzner and George Mason University (c) Mikhail Pevzner and George Mason University Types of bonds Unsecured bonds (debentures) Secured bonds; Callable bonds; Convertible bonds; • Consols; (c) Mikhail Pevzner and George Mason University Bond valuation Bonds’ value is a function of bond yield, coupon payment, and amount of the principal (aka maturity value).
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3 (c) Mikhail Pevzner and George Mason University Stated vs. market interest rate Bonds consist of two cash flows: – coupon payments measured by stated interest rate (aka coupon rate ), i.e. amount of cash payable in addition to principal payments, – and of the principal payment ; (c) Mikhail Pevzner and George Mason University Bond Valuation Bond represents two types of cash payments: – Principal payment; – Interest payments; Thus, a bond cash flow is a combination of one time payment and an annuity. (c) Mikhail Pevzner and George Mason University Bond Valuation (continued) To find a value of a bond at the time of issuance, we need to: – Discount the principal payment back from the repayment date to issuance date using market discount (aka effective market) rate; – Compute present value of the stream of coupon payments (annuity) using effective market rate of interest.
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4 (c) Mikhail Pevzner and George Mason University Example On January 1, 2007 MBP issues bonds with face value of $1 million, stated (coupon) interest rate of 10%. Bonds mature in 10 years. Interest is payable in the end of every year. What is the value of a bond if market interest rate is – A) 8% – B) 10% – C) 12%? (c) Mikhail Pevzner and George Mason University Example-Case A Our bond is composed of two cash flows: 1) lump sum principal payment of $1 million and 2) ordinary annuity of 10 coupon payments of $100,000. Thus, we need to estimate present values of Lump-sum of $1 million in 10 years at 10% assumed market discount rate of 8% : $1 million/(1+0.08) 10 =$463,194 Ordinary annuity of 10 payments of $100K per year, discounted at market interest rate of 8%. Checking the annuity table shows that our annuity factor is 6.71. Thus, present value of interest payments is $671,000.
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