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Chapter 7 Notes

# Chapter 7 Notes - Chapter 7.1 Bond Valuation Bonds are...

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Chapter 7.1: Bond Valuation Bonds are usually interest only loans – borrow pays interest over the period and doesn’t pay principal until the end Coupon – the stated interest payment made on a bond Level Coupon bond – bond with constant coupon payments Par value (face value) – amount the will be repaid at the end of the loan Coupon rate – annual coupon divided by the face value Maturity – number of years until the face value must be paid When interest rates rise the present value of the bonds remaining cash flows declines and the bond is worth less (vice versa) Yield to Maturity – interest rate required in the market on a bond Bond cash flows usually have an annuity and lump sum payment o So we calculate the market value of the bond by getting the PV of these two and adding them together Discount bond – sells for less than face value o This happens when market interest rates rise above coupon rates Premium bond – sells for more than face value o This happens when market interest rate is below coupon rates Bond prices an interest rates ALWAYS move in opposite directions Interest rate risk – risk that arises from fluctuating interest rates Interest Rate Risk depends on how sensitive the price of the bond is to interest rate fluctuations o Time to Maturity and Coupon Rate are the two major factors affecting sensitivity The longer the time to maturity the greater the interest rate risk The lower the coupon rate the greater the interest rate risk Interest Rate Risk increases at a decreasing rate If two bonds with different coupon rates have the same maturity then the value of the one with the lower coupon is proportionately more dependent on the face amount to be received at maturity o Basically the value of the bond will fluctuate more as interest rates change o OR the bond with the higher coupon rate has a larger cash flow early in its life, so its value is less sensitive to changes in the discount rate (Yield to Maturity) Current Yield – a bond’s annual coupon divided by its price o May be low because it only considers the coupon portion of your return and not built in gain from a price discount For a premium bond the opposite is true (current yield would be higher because it ignores the built-in loss Chapter 7.2: More About Bond Features Securities can be classified as either debt or equity securities o Debt represents something that must be repaid Creditor (lender) – the person or firm making the loan Debtor (borrower) – the corporation borrowing the money Debt is not an ownership interest in a firm

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The corporations payment of interest on debt is considered a cost of doing business and is tax deductible Unpaid debt is a liability of the firm o So one of the costs of issuing debt is the possibility of financial failure The distinction between debt and equity is important for tax reasons
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