Topic 3 Valuation Part 1 Bonds - TOPIC 3 VALUATION Content...

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1 TOPIC 3 VALUATION Content Characteristics of Debt and Equity Valuing Bonds Bond Yields Interest rate risk Term Structure of Interest Rates Dividend Valuation model Constant growth Model Non Constant Growth Model Additional Questions
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Sources of F inance Debt Debt providers have a contractual right to cash flows generated by real assets Equity Equity holders have a residual claim to cash flows generated by real assets
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Debt vs Equity DEBT EQUITY Interest Dividends Periodic cash flow Periodic cash flow Fixed Variable Maturity Maturity Fixed Term Infinite Redemption Redemption Yes No Face Value Relative riskiness Relative riskiness Low High
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Debt Securities Debt securities are issued when a company (or government) wishes to borrow money from the public on a long-term basis. Bonds are issued by the government. Debentures are secured and issued by a corporation. Notes are unsecured corporate securities . Investor has claims to a fixed sequence of cash flows and the repayment of the face value on maturity
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Bonds Terminology Terminology Face value or par Face value or par value value Maturity date Maturity date Coupon interest Coupon interest rate rate Bonds pay fixed Bonds pay fixed coupon payments coupon payments at fixed intervals at fixed intervals and pay the face and pay the face value at maturity value at maturity 0 0 1 1 2 2 n n $coupon $coupon $coupon $coupon $coupon $coupon +$FV +$FV
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where where Bond price is the Bond price is the present value present value of a debt security of a debt security PMT= coupon interest payment to be received at end of period n PMT= coupon interest payment to be received at end of period n FV = face value or par value to be received at end of period n FV = face value or par value to be received at end of period n r r d = the investor’s required rate of return (cost of debt) = the investor’s required rate of return (cost of debt) Debt Security Valuation Model Determine the present value of future cash flows from the  ownership of a debt security ( 29 + - = - d n d r r 1 1 PMT Bondprice ( 29 n d r 1 FV + +
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How is the cost of debt determined? At least the risk free rate of interest plus Compensation for anticipated inflation Risk premium commensurate with the risk of the cash flows to cover default risk. The risk that the borrower will not make interest payments or the principal payment either on time and/or in full. Risk premium due to the term to maturity. The risk relating to the term structure of interest rates, arising because interest rates change over time.
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Bond yields Yield to maturity represents: 1. The required rate of return that investors expect to receive from the bond investment (cost of debt) 1. The market interest rate that equates a bond’s present value of interest payments plus principal repayment with its price.
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