3.Chapter 07(2)

3.Chapter 07(2) - Chapter 7 Interest Rates and Bond...

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Chapter 7: Interest Rates and Bond Valuation
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Chapter Outline Background on Bonds Bonds and Bond Valuation Bond Risk Some Different Types of Bonds Preferred Stock
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Background on Bonds Bonds represent long-term debt securities Contractual Promise to pay future cash flows to investors The issuer of the bond is obligated to pay: Interest (or coupon) payments periodically usually semiannually Par or face value (principal) at maturity
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Differences Between Debt and Equity Debt Not an ownership interest Creditors do not have voting rights Interest is considered a cost of doing business and is tax-deductible Creditors have legal recourse if interest or principal payments are missed Excess debt can lead to financial distress and bankruptcy Equity Ownership interest Common stockholders vote to elect the board of directors and on other issues Dividends are not a liability of the firm until declared. Stockholders have no legal recourse if dividends are not declared An all-equity firm cannot go bankrupt
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The Bond Indenture Contract between the company and the bondholders and includes The basic terms of the bonds The total amount of bonds issued A description of property used as security, if applicable Sinking fund provisions Call provisions Details of protective covenants
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Valuation: Key Features of Bonds Coupon Rate How much interest is paid to the bondholder each year? Maturity How long until the principal is repaid? Face value Amount of principal – also known as par value
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Valuation of Bonds Capitalization of Cash Flows Method Find PV of all cash flows Annuity of coupons Lump-sum repayment of principal ( 29 ( 29 = + + + = n t n d t d k M k I P 1 0 1 1
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PV of Cash Flows as Rates Change Bond Value = PV of coupons + PV of par Bond Value = PV annuity + PV of lump sum Remember, as interest rates increase, the PVs decrease So, as interest rates increase, bond prices decrease, and vice versa
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Valuation of Bonds A bond is just a special case of an annuity where the last payment differs from the others Calculator: PV = price of bond N = # of periods left until maturity I/Y = yield-to-maturity (or current mkt. rates) / 2 CF or PMT = coupon payment FV = face value of bond
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Special Cases Zero coupon bonds Also known as a pure discount bond Pays no interest payments Instead, is sold at a discount so investor makes her return through price appreciation I.e., pay $500 today for a bond that will repay you $1,000 in eight years Perpetual bonds Pay same interest each period forever Never repays principal
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This note was uploaded on 04/30/2011 for the course MBA 862 taught by Professor Phi during the Fall '11 term at Clemson.

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3.Chapter 07(2) - Chapter 7 Interest Rates and Bond...

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