Copyright ©2003 South-Western /Thomson Learning Chapter 6 Fixed-Income Securities: Characteristics and Valuation

Introduction This chapter focuses on the characteristics and valuation of fixed- income securities. –Long-term debt –Preferred stock

Classification of Long-Term (L-T) Debt Mortgage bonds secured Debenturesunsecured –Subordinated and unsubordinated Claims of subordinated debenture holders are considered only after the claims of unsubordinated debt holders

Types of L-T Debt Equipment trust certificates Income bonds Collateral trust bonds Pollution control bonds Industrial revenue bonds

Characteristics of L-T Debt Indenture –covenants Trustee –TIA 1939 Call feature Call premium Sinking fund Equity-linked debt –convertible –warrant Coupon rates Size $25–$200 million

Debt Information Corporate bonds –Majority traded in the over-the-counter market –Some larger issues traded on the NY Exchange Quotations percent of par value $1000 DukeEn 6 3 / ¾ – 1 / 4 Meaning a Duke Energy bond with an interest rate (coupon rate) of percent, maturing in 2008, yielding 6.8 percent, $40,000 dollars traded, closing price of $930.75, down $2.50 from the previous day. Current information:

U.S. Government Debt Securities U.S. Treasury bills S-T –Maturities of 3, 6, and 12 months –Minimum denominations of $10,000 –Sold at a discount from maturity value Treasury notes and bondsL-T –Notes 1–10 year maturity –Bonds 10–30 year maturity

Bond Ratings QualityS & P’sMoody’s HighestAAAAaa HighAAAa Upper MediumAA MediumBBBBaa JunkBB,B,CCC,CC, C Ba,B,Caa,Ca, C DefaultD

Ratings Higher rated bonds generally carry lower market yields. Interest rate spread between ratings is less during prosperity than during recessions. Junk bonds typically yield 3–6 percent or more.

L-T Debt: Advantages and Disadvantages Advantages –Tax deductibility of interest –Financial leverage can increase EPS. –Ownership is not diluted. Disadvantages –Increased financial risk –Indenture provisions restrict firms’ flexibility.

International Bonds Eurobonds –Issued outside of the issuer’s country –Denominated in the home currency –May have less regulatory interference –May have less disclosure requirements Foreign bonds are issued in a single foreign country with interest and principal paid in that foreign currency.

Value of an Asset Based on the expected future benefits over the life of the asset Future benefits = cash flows (CFs) Capitalization of cash flow method –PV of the stream of future benefits discounted at an appropriate required rate of return

Market Value of an Asset Market price Demand & Supply (D&S) Approximated value Equilibrium D&S Intersection Consensus Judgment

The Value of a Bond is the Present Value of its Cash Flows

Bond Prices and Interest Rates Relationship between P 0 and k d –There is an inverse relationship between a bond’s value, P 0, and its required rate of return, k d. L-T vs. S-T Bonds –A change in k d changes the value of a long-term bond more than the value of a short-term bond.

Financial calculator example of bond valuation This slide and the next two include steps for the first usage of the calculator. Calcluator: TI BA II Plus Start by resetting the calculator. Press/EnterDisplay nd 0.00 RESETRST? ENTERRST0.00 CE/C0.00

Set payments per year and compounding periods per year. Press/EnterDisplay nd 0.00 P/YP/Y= P/Y1 ENTERP/Y=1.00 C/Y=1.00 QUIT0.00

Set the number of places after the decimal. 4 places suggested. Press/EnterDisplay nd 0.00 FORMATDEC=2.00 4DEC4 ENTERDEC= CE/C CE/C

Calculate the intrinsic value of a bond with annual coupon payments Example on page 216 of MMK 9 th Ed. Calculate interest pmt amount: cM = (.06)(1000) = $60 per year Press/EnterDisplay NN= I/YI/Y=8.0000

Calculate the intrinsic value of a bond with annual payments (2) Press/EnterDisplay 60 PMTPMT= ,000 FVFV= 1, CPTFV= 1, PVPV=

Calculate bond value for a bond with semiannual coupon payments Example on page 219 of MMK 9 th Ed. Delete previous inputs: CE/C, 2 nd, CLR TVM Calculate semiannual interest amount: cM/2 = (.06)(1,000)/2 = $30 Find number of payments: n = years 2n = 2(7 years) = 14 payments

Calculate bond value for a bond with semiannual payments (2) (Display) NN= I/YI/Y= PMTPMT= ,000 FVFV= 1, CPTFV= 1, PVPV=

Calculate yield to maturity for a bond with annual coupon payments Example on page 220 of MMK 9 th Ed. Delete previous inputs:CE/C, 2 nd, CLR TVM Calculate annual interest amount: cM = (.06)(1,000) = $60

Calculate yield to maturity for a bond with annual payments (2) (Display) NN= / PVPV= PMTPMT= ,000 FVFV= 1, CPTFV= 1, I/YI/Y=

Calculate YTM for a bond with semiannual coupon payments Problem 13b, page 231, with Semiannual PMTs Delete previous inputs:CE/C, 2 nd, CLR TVM Calculate semiannual interest amount: cM/2 = (.0775)(1,000)/2 = $38.75 Find number of payments: n = years 2n = 2(5 years) = 10 payments

Calculate YTM for a bond with semiannual coupon payments (2) (Display) NN= / PVPV= PMTPMT= ,000 FVFV= 1, CPTFV= 1, I/YI/Y=

Calculate YTM for a bond with semiannual coupon payments (3) I/Y = YTM = 2(I/Y) = 2(5.1815) = %

Ch. 6, problem 13b with semiannual interest payments Bond valuation formula with semiannual pmts: Find YTM, semiannual payments Use Tables and interpolation (1)

Find YTM, semiannual payments Use Tables and interpolation (2) Convert inputs to semiannual basis: Annual Coupon rate “c” = 7 3/4% = 7.75% per year Semiannual interest pmt: cM/2 = (0.0775)(1000)/2 = $38.75 Five years remain until maturity. So, 2n = (2 pmts per year)(5 years) = 10 payments

Find YTM, semiannual payments Use Tables and interpolation (3) Bond valuation formula with inputs: Start iterative process of finding the YTM: Since the price of the bond is less than $1,000, try a required rate of return that is greater than the semiannual coupon rate. Semiannual cpn rate: c/2 = (7.75%)/2 = %

Find YTM, semiannual payments Use Tables and interpolation (4) Try k d /2 = 5%: Is this true? Try k d /2 = 6%: Is this true?

Find YTM, semiannual payments Use Tables and interpolation (5) The $900 market price is bracketed. So, we can interpolate to find the YTM % ? % 6%

Perpetual Bond

Zero Coupon Bonds formula table

Ethical Issue In many leveraged buyouts (LBOs), the buyer of the firm financed the purchase with a large amount of debt. Often, stockholders made a large gain while bond prices plummeted because of the higher leverage the firm has assumed.

Preferred Stock (P/S) Is in an intermediate position between C/S and L-T debt Part of equity while increasing financial leverage Dividends on P/S are not tax deductible. Has preference over C/S with regard to earnings and assets Dividends can not be paid on C/S unless the preferred dividend for the period has been paid.

Characteristics of P/S Selling price Par value Adjusted rate P/S Cumulative Participation Maturity Call feature Voting rights

P/S Advantages and Disadvantages Advantages –Flexible –Can increase financial leverage –Corporate tax advantage Disadvantages –High after-tax cost –Dividends are not tax deductible

Value of P/S

Set 1 of Bonus Questions for Ch. 6 What is a debenture? What is an indenture with respect to bonds? How are bond prices quoted in the financial press? What do bond ratings primarily signify? Can you give two advantages of long- term debt financing?

Set 2 of Bonus Questions for Ch. 6 How is an intrinsic value (P) calculated for a bond? What is the yield to maturity of a bond? How are zero coupon bonds initially priced? What equation is typically used to find the intrinsic value (P) for a preferred stock? What is a junk bond?