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

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

3. 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

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

5. 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

6. 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 / 8 08 6.8 40 93¾ – 1 / 4 Meaning a Duke Energy bond with an interest rate (coupon rate) of 6.375 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: http://www.etrade.com/http://www.etrade.com/

7. 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

8. Bond Ratings QualityS & P’sMoody’s HighestAAAAaa HighAAAa Upper MediumAA MediumBBBBaa JunkBB,B,CCC,CC, C Ba,B,Caa,Ca, C DefaultD http://www.standardandpoors.com/ http://www.moodys.com/

9. 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.

10. 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.

11. 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.

12. 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

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

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

15. 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.

16. 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 0.00 2 nd 0.00 RESETRST? ENTERRST0.00 CE/C0.00

17. Set payments per year and compounding periods per year. Press/EnterDisplay 0.00 2 nd 0.00 P/YP/Y= 12.00 1P/Y1 ENTERP/Y=1.00 C/Y=1.00 QUIT0.00

18. Set the number of places after the decimal. 4 places suggested. Press/EnterDisplay 0.00 2 nd 0.00 FORMATDEC=2.00 4DEC4 ENTERDEC= 4.0000 CE/C 4.0000 CE/C 0.0000

19. 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 0.00007 NN=7.00008 I/YI/Y=8.0000

20. Calculate the intrinsic value of a bond with annual payments (2) Press/EnterDisplay 60 PMTPMT= 60.0000 1000 1,000 FVFV= 1,000.0000 CPTFV= 1,000.0000 PVPV= -895.8726

21. 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

22. Calculate bond value for a bond with semiannual payments (2) (Display) 0.0000 14 NN=14.0000 4 I/YI/Y= 4.0000 30 PMTPMT=30.0000 1000 1,000 FVFV= 1,000.0000 CPTFV= 1,000.0000 PVPV= -894.3688

23. 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

24. Calculate yield to maturity for a bond with annual payments (2) (Display)0.00007 NN=7.0000 987.5 +/- -987.5 PVPV= -987.5000 60 PMTPMT= 60.0000 1000 1,000 FVFV= 1,000.0000 CPTFV= 1,000.0000 I/YI/Y= 6.2257

25. 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

26. Calculate YTM for a bond with semiannual coupon payments (2) (Display) 0.000010 NN=10.0000 900 +/- -900 PVPV= -900.0000 38.75 PMTPMT= 38.7500 1000 1,000 FVFV= 1,000.0000 CPTFV= 1,000.0000 I/YI/Y= 5.1815

27. Calculate YTM for a bond with semiannual coupon payments (3) I/Y = 5.1815 YTM = 2(I/Y) = 2(5.1815) = 10.3630%

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

29. 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

30. 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 = 3.8750%

31. 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?

32. Find YTM, semiannual payments Use Tables and interpolation (5) The $900 market price is bracketed. So, we can interpolate to find the YTM. 913.23 900 843.20 5% ? % 6% 13.23 70.03

33. Perpetual Bond

34. Zero Coupon Bonds formula table

35. 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.

36. 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.

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

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

39. Value of P/S

40. 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?

41. 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?