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Ch05 Show - Chapter 5 Bonds, Bond Valuation, and Interest...

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1 Chapter 5 Bonds, Bond Valuation,  and Interest Rates
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2 Topics in Chapter n Key features of bonds n Bond valuation n Measuring yield n Assessing risk
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3 Value =                         +                         +     + FCF1 FCF2 FCF∞ (1 + WACC)1 (1 + WACC)∞ (1 + WACC)2 Free cash  flow (FCF) Market interest rates Firm’s business risk Market risk aversion Firm’s debt/equity mix Cost of debt Cost of equity Weighted  average cost of capital (WACC) Net operating profit after taxes Required investments in operating capital = Determinants of Intrinsic Value: The Cost of Debt ...
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4 Key Features of a Bond n Par value:  Face amount; paid at  maturity. Assume $1,000. n Coupon interest rate:  Stated interest  rate.  Multiply by par value to get dollars  of interest. Generally fixed. (More…)
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5 n Maturity:  Years until bond must be  repaid.  Declines. n Issue date:  Date when bond was  issued. n Default risk:  Risk that issuer will not  make interest or principal payments.
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6 Call Provision n Issuer can refund if rates decline.  That  helps the issuer but hurts the investor. n Therefore, borrowers are willing to pay  more, and lenders require more, on  callable bonds. n Most bonds have a deferred call and a  declining call premium.
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7 What’s a sinking fund? n Provision to pay off a loan over its life  rather than all at maturity. n Similar to amortization on a term loan. n Reduces risk to investor, shortens  average maturity. n But not good for investors if rates  decline after issuance.
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8 Sinking funds are generally  handled in 2 ways n Call x% at par per year for sinking  fund purposes. n Call if rd is below the coupon rate and bond  sells at a premium. n Buy bonds on open market. n Use open market purchase if rd is above  coupon rate and bond sells at a discount.
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9 Value of a 10-year, 10%  coupon bond if rd = 10% V B = $100 $1,000  . . .  + $100 100 100 0 1 2 10 10% 100 + 1,000 V = ? ... =  $90.91 +    . . .   + $38.55   + $385.54 =  $1,000. + + (1 + rd)1 (1 + rd)N (1 + rd)N
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10 10 10 100 1000 N I/YR PV PMT FV -1,000 $   614.46       385.54     $1,000.00 PV annuity             PV maturity value  Value of bond              = = = INPUTS OUTPUT The bond consists of a 10-year, 10%  annuity of $100/year plus a $1,000 lump  sum at t = 10:
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When rd rises, above  the coupon rate, the  bond’s value falls below  par, so it sells at  a discount. 10
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Ch05 Show - Chapter 5 Bonds, Bond Valuation, and Interest...

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