lecture4&5-819

lecture4&5-819 - Bond Valuation Risk and Cost of...

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Bond Valuation, Risk and Cost of Capital and capital structure Where does the discount rate come from?
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FIN 819: lecture Today’s plan Bond valuation Yield to maturity Term structure of interest rates and yield curve Risk and returns How to measure risk Individual security risk Portfolio risk Diversification Unique risk Systematic risk or market risk Measure market risk: beta
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FIN 819: lecture Today’s plan (continue) Portfolio rules and diversification Measure market risk: beta CAPM WACC Levered betas and unlevered betas
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4 Bonds Bond – a security or a financial instrument that obligates the issuer (borrower) to make specified payments to the bondholder during some time horizon. Coupon - The interest payments made to the bondholder. Face Value (Par Value, Principal or Maturity Value) - Payment at the maturity of the bond. Coupon Rate - Annual interest payment, as a percentage of face value.
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5 Bonds A bond also has (legal) rights attached to it: if the borrower doesn’t make the required payments, bondholders can force bankruptcy proceedings in the event of bankruptcy, bond holders get paid before equity holders
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6 An example of a bond A coupon bond that pays coupon of 10% annually, with a face value of $1000, has a discount rate of 8% and matures in three years. The coupon payment is $100 annually The discount rate is different from the coupon rate. In the third year, the bondholder is supposed to get $100 coupon payment plus the face value of $1000. Can you visualize the cash flows pattern?
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7 Bonds WARNING WARNING The coupon rate IS NOT the discount rate used in the Present Value calculations. The coupon rate merely tells us what cash flow the bond will produce. Since the coupon rate is listed as a %, this misconception is quite common.
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8 Bond Valuation The price of a bond is the Present Value of all cash flows generated by the bond (i.e. coupons and face value) discounted at the required rate of return. N r cpn r cpn r cpn PV ) 1 ( 000 , 1 ... ) 1 ( ) 1 ( 2 1 + + + + + + + =
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9 Zero coupon bonds Zero coupon bonds are the simplest type of bond (also called stripped bonds, discount bonds) You buy a zero coupon bond today (cash outflow) and you get paid back the bond’s face value at some point in the future (called the bond’s maturity ) How much is a 10-yr zero coupon bond worth today if the face value is $1,000 and the effective annual rate is 8% ? PV Face value Time=t Time=0
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10 Zero coupon bonds (continue) P0=1000/1.08 10 =$463.2 So for the zero-coupon bond, the price is just the present value of the face value paid at the maturity of the bond Do you know why it is also called a discount bond?
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11 Coupon bond
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This note was uploaded on 10/05/2011 for the course FIN 819 taught by Professor Staff during the Spring '11 term at S.F. State.

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lecture4&5-819 - Bond Valuation Risk and Cost of...

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