m3l2 - Fall 2011 Module 3 Accounting Finance Lecture 2 All...

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David Robinson © D. Robinson, 2011 Fall 2011 Module 3 Accounting & Finance Lecture 2: All About Bonds
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Accounting & Finance Accounting Finance Managerial Financial Auditing How investors use their money How firms raise money Three financial statements Forms of business Income St. Balance Sheet St. Cash Flows
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Lecture Outline Bonds—definition “fixed income securities” Interest rates and inflation Duration Concerns about very long durations Bonds as investments They can be resold at any time Corporate bonds and the risk premium
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Why would you borrow money? New subdivision—have to come up with a new grade school Cost $26 million Lot of money “up front” But grade school will last for 30 years. Let’s borrow the money Payoff over 30 years $26 million at 4.5 percent Need just $1.6 million a year to make the payments
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Definitions: Bond Terminology A bond is a financial instrument in which an issuer borrows money and promises to pay Fixed interest rate agreed in advance Periodic interest payments called “ coupon payments (every quarter, every 6 mths) Repay the entire sum ( principal ) on the due date If the issuer defaults (does not pay either interest or principal when due) bondholder can go to court and force bankruptcy
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Bond Coupons Bonds usually no longer exist on paper Just an electronic record (like you transcript!) We still sometimes refer to periodic interest payments as “the coupon”
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e.g. “Creditors will receive about 10 cents on the dollar = 1/10 th of what they were owed Definition: Bankruptcy A formal “time out”: Creditors have to go to court with evidence of the debt (here, the bond) Court adds up all that a firm owes and how much money it has and calculated what proportion (“ cents on the dollar ”) each creditor gets It’s an orderly process (you can’t pay your brother first) 1. Secured creditors (you get the plane back) 2. Bond holders 3. Unsecured creditors (e.g. workers, suppliers) 4. Common stock holders Someone who is owed money
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Bonds are “Fixed Income Financial Instruments” Unlike stocks, the payoff doesn’t vary at all Because there is less risk, the interest rate offered is lower than the return that stocks earn As soon as a bond has been issued, it can be sold from one person to another Just like you can sell your ugba-10 textbook if you drop the course
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Different types of bonds Issued by Federal government Also some “agency” bonds States, counties and cities Issued by firms Treasuries Muni’s Corporates Tax exempt
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What interest rate? If we don’t offer a high enough rate, no investor will buy our bonds
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The US 10-year bond is the “benchmark” The interest rate on US bonds is the standard to which we compare all other fixed income securities
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Treasury Rates are currently very low 1.83 percent 4.5 – 5 percent is more typical
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Where do interest rates come from?
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