1. Finance 300 Financial Markets Lecture 18 Professor J. Petry, Fall, 2002© http://www.cba.uiuc.edu/jpetry/Fin_300_fa02/ http://webboard.cites.uiuc.edu/

2. 2 Housekeeping Agenda –Bonds for the Bond Analysis Project will be posted on the web today, available for sign-up on Tuesday, October 29 th. –The next exam is Tuesday, November 5 th. –Will cover chapters VI, VII and VIII. –Stewardship report are due Thursday, November 7 th.

3. 3 Chapter VII – Corporate & Other Issues Corporate Bonds Sinking Fund Provisions: Some bonds require the issue to be repaid on a regular basis before maturity. A Sinking Fund is one way to accomplish this. A reserve account is established to repay the principal on the bond once it becomes due. If the firm is unable to meet the sinking fund requirements, the bondholders can demand that the issue be redeemed. Call provisions Allows the issuer to redeem all or part of the issue prior to maturity. Terms vary, but they typically provide that the issuer can call the bond at par value plus a declining premium. Many callable bonds are restricted in the first few years of the issue, some bonds are non-callable, and some are non-callable for refunding. Being non- callable for refunding means the firm cannot use new bond funding to call back their previous bond, though they can use other funds to call the bond. Bond callability significantly impacts the value of the bond for issuer and buyer.

4. 4 Chapter VII – Corporate & Other Issues Corporate Bonds Call provisions impact on issuer: The call provision gives the issuer an option to call the old bond and refinance in whatever way they would like if circumstances so warrant. Generally, if interest rates go down, they will want to refinance, taking advantage of lower interest rates. Assume Discovery Café (DVC) issues a 30 year bond at 7% on June 30 th 1995. (As usual, assume interest rates are 7% at the time of issuance.) Therefore DVC is agreeing to pay $35 dollars every six months per $1000 face value of bond issued—let’s assume they issue 10,000 such bonds for a total face value of $10,000,000.00. Assume this bond is callable after 10 years, with a 10% premium to face value which declines ½ % every year thereafter. It is now June 30 th, 2005, and interest rates have fallen from 7% to 5%. Without the callable feature what should the investor in this bond be able to sell this bond for? According to the terms of the indenture, on June 30 th, the call price of the bond would be_____ in 2000, ______ in 2005, ______ in 2010, _____in 2025?

5. 5 Chapter VII – Corporate & Other Issues Call10,000 7% bonds at $1,100 each (2005)-$11,000,000.00 Issue 11,000 5% bonds at $1,000 each (2005) $11,000,000.00 0.00 Principal Payment in 2025 under 5% bond-$11,000,000.00 Principal Payment in 2025 under 7% bond Less-$10,000,000.00 Additional Principal Owed at maturity with 5% bond- $1,000,000.00 Semi-annual Coupon under 7% bond($35*10,000=) $350,000.00 Semi-annual Coupon under 5% bond ($25*11,000=) Less $275,000.00 Semi-annual coupon savings under 5% bond+ $ 75,000.00 The value of having the call under these conditions is equivalent to the summation of these cash flows. The corporation has to pay an additional $1,000,000 in principal at maturity of the 5% bond compared to the 7% bond, but gains the benefit of having the lower coupon payments along the way.

6. 6 Chapter VII – Corporate & Other Issues

7. 7 Corporate Bonds Call provisions impact on issuer (cont’d): We could also use the price valuation formula to help us find out what these flows net out to be worth to the corporation: Recall that this equation did nothing more than find the NPV of a series of constant cash flows evaluated at a constant interest rate (the first portion of the equation), and then add this value to the NPV of a single cash flow (the second portion of the equation). Here Price is the price difference between two principal values owed in ’25 (which favors the 7% bond) and C is the $75,000 per period (which favors the 5% bond). n=20, y=.05.

8. 8 Chapter VII – Corporate & Other Issues Corporate Bonds Looking at this same series of cash flows from the investors’ viewpoint, we want to calculate a series of rates of returns for this bond. With a little thought, you should be able to calculate all but the Realized Yield (1995 to 2025). The first one, you can do easily, just assume no call features. On the rest, I get you started with the following slides:

9. 9 Chapter VII – Corporate & Other Issues

10. 10 Chapter VII – Corporate & Other Issues

11. 11 Chapter VII – Corporate & Other Issues Calculating the Realized Yield to Maturity of bondholder: Calculating the Realized yield to maturity requires calculating what the combined yield for 10 years (7%) assuming purchase of the original bonds, and the yield from the 20 year (5%) bonds which he purchased with the proceeds of the called 10 year bonds. We do this by tracking the cash flows: In June 1995 he purchases 10 ‘25 with 7% coupon for $1,000 each –net cost of 10,000 –he receives 350 every 6 months for 10 years (20 payments). We have to NPV this cash flow to determine its worth. –he also receives $1,100 for each of 10 bonds ($11,000), which he trades in for 11 new $1,000 bonds with a 5% coupon. This is net cash flow of zero. –He then receives 275 every 6 months for 19-1/2 years, plus the final payment of 11,275 at maturity. Both of these cash flows also must be NPV’d. –When done in the calculator, this is a semi-annual rate, so you have to x2.

12. 12 Chapter VII – Corporate & Other Issues Corporate Bonds Call provisions impact on issuer (cont’d):

13. 13 Chapter VII – Corporate & Other Issues Corporate Bonds—Example: TTD VII-2 In 2000 P&G issues at par 10,000,000 in 7% bonds maturing October 2, 2030. The bond is callable after 10 years with a call premium of 10%, declining ½% per year after that. –What is the yield to maturity? –What is the yield to call? Assume that in 2010 the market yield for P&G 7% 2030 bond is 7%. –What is the call price of the bond? –What would be the price of the bond if it were not callable? –If P&G calls the issue and finances the recall with a new 15 year bond issue at 5% how much does P&G save on its semi-annual coupon payment and principal repayment? –What is the net present value of this saving? –If John Q. Investor purchased $10,000 in P&G bonds at par in 2000 and uses the proceeds from the callable bonds to buy the new P&G 5% 2030 bonds, what is his realized yield-to-maturity on the original bond purchase?