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finNotesBondValuation

# finNotesBondValuation - BOND VALUATION Basic Terminology...

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BOND VALUATION Basic Terminology Callable Bonds Convertible Bonds Internal Rate of Return Basic Terminology When a corporation such as IBM or General Motors wants to raise funds or capital it often will borrow the money by selling a large issue of its bonds to the public. Corporate bonds are essentially IOU's of the firm, and they can be purchased by institutional investors such as insurance companies, mutual funds or other corporations or by individuals such as yourself. Most corporate bonds state that the issuer (also called the borrower or the seller of the bond) agrees to pay the investor (also called the lender or the buyer of the bond) a series of fixed interest payments every six months plus a large sum when the bond matures. The amount of interest that a bond pays is determined by multiplying its COUPON RATE times the bond's PAR VALUE . Most corporate bonds have a PAR VALUE (also called the FACE VALUE or PRINCIPAL ) of \$1,000. This \$1,000 par value is printed on the bond. The coupon rate is also printed on the bond and never changes over the life of the bond. For example, if IBM issues a bond whose coupon rate is 12%, this means that the bond pays the holder .12 x 1,000 or \$120 per year. But since the interest payment is made semi-annually, the holder actually receives \$60 every six months. The coupon rate is always stated on an annual basis even though the actual payment is semi-annual. If another bond's coupon rate is 20%, then an investor in these bonds would receive \$100 every six months. The bond also has a stated MATURITY DATE at which time the firm retires the bond by making the last coupon payment and also paying the holder the par value or principal of \$1,000. If the IBM bond matures in 20 years and has a 12% coupon rate, the firm agrees to pay the investor \$60 every six months for 20 years plus \$1,000 at the end of the 20th year (or 40th period). In exchange for this stream of coupon payments and single principal payment, the investor must, of course, buy the bond for the prevailing MARKET PRICE . This market price that investors are willing to pay for the bond is a function of the investors' REQUIRED INTEREST RATE . Don't assume that because the bond has a par value of \$1,000 that this will be the price paid by the investors. This required interest rate is dependent upon several factors including the risk of the investment as perceived by the investors. Risk is affected by several factors: Because of its long history of profitability IBM will enjoy a better credit rating than unknown upstart Al's Business Machines. Because the soft drink industry is currently more profitable and stable than the steel industry, Coca Cola will be seen as being a safer investment than Bethlehem Steel.

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