FINC19011 – BUSINESS FINANCE-Wk04--revised

FINC19011 – BUSINESS FINANCE-Wk04--revised -...

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MODULE 4 (Wiley Resource - Chapter 8 – Customized  & Abridged)
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Chapter 8 Bond valuation and the structure of interest rates Prepared by Alex Proimos & Chee Jin Yap
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Bonds
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Corporate bonds Corporate bonds are long-term IOUs that represent claims against a company’s assets. Debt instruments where the interest income paid to investors is fixed for the life of the contract are called fixed-income securities.
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Corporate bonds Market for corporate bonds Only small number of existing total bonds actually trade on single day Result: corporate bond market is thin compared to market for money market securities or corporate shares Corporate bonds less marketable than securities with higher daily trading volumes Prices in corporate bond market also tend to be more volatile than that of securities sold in market with greater trading volumes
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Corporate bonds Market for Corporate Bonds Largest investors in corporate bonds are superannuation fund, investment funds and life insurance companies Trades in this market tend to be in very large blocks of securities Most secondary market corporate bond transactions take place through dealers in the over-the-counter (OTC) market.
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Types of Bonds
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Types of corporate bonds Three types of corporate bonds are – coupon bonds, zero coupon bonds, and convertible bonds.
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Types of corporate bonds Coupon bonds These bonds have coupon payments fixed for life of bond, and at maturity, principal is paid and bonds are retired Coupon bonds have no special provisions; provisions they do have are conventional and common to most bonds, e.g., a call provision Payments usually made annually or semiannually
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Types of corporate bonds Zero coupon bonds Companies sometimes issue bonds with no coupon payments, only offering one payment at maturity Zero coupon bonds sell well below their face value (at deep discount) because they offer no coupons Not frequently issued in Australia
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Types of corporate bonds Convertible bonds Bonds that can be converted into ordinary shares at pre-determined ratio at discretion of bondholder Convertible feature allows bondholders to share company’s good fortunes if the company’s shares rise above certain level Conversion ratio is set so company’s share price must appreciate 15%-20% before it is profitable to convert bonds into equity To secure this advantage, bondholders willing to pay a premium
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Bond Valuation
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Cash flows for a 3-year bond
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Bond valuation To calculate bond’s price, follow same process as to value any financial asset Estimate expected future cash flows – coupons and the principal of the bond Determine bond’s required rate of return, or discount rate.
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