ACC501 Highlighted Handouts by Mr Shahbaz

Highlighted by Mʀ Sɦǟɦɮǟʐ

LESSON 19 BOND PRICING THEOREMS

The following statements about bond pricing are always true: Bond prices and market interest rates move in opposite directions. When a bond’s coupon rate is (greater than / equal to / less than) the market’s required return, the bond’s market value will be (greater than / equal to / less than) its par value. Given two bonds identical but for maturity, the price of the longer-term bond will change more than that of the shorter-term bond, for a given change in market interest rates. Given two bonds identical but for coupon, the price of the lower-coupon bond will change more than that of the higher-coupon bond, for a given change in market interest rates.

Finding the Yield to Maturity

We have seen that the price of a bond can be written as the sum of its annuity and lump sum components. Knowing that there is an $80 coupon rate for 6 years and a $1000 face value, the price of the bond is:

$955.14 = $80 x [1 – 1/(1 + r)6]/r + 1000 / (1 + r)6

r is the unknown discount rate or the yield to maturity To solve the above equation for r we will have to use trial and error method, as we cannot explicitly calculate r We can speed up the trial and error process by using our knowledge about prices and yields Since the bond is selling at a discount, we know that the yield is greater than 8%. If we compute the price at 10%, price is $912.89 which is lower than the actual price, so 10% is too high. Rather it should be between 8% and 10% Computing at 9% reveals that this is in fact the bond’s yield to maturity.

Summary of Bond Valuation

I. Finding the value of a bond

Bond value = C x [1 - 1/(1 + r)t]/r + F/(1 + r)t Where: C = the promised coupon payment F = the promised face value t = number of periods until the bond matures r = the market’s required return, YTM

II. Finding the yield on a bond

Given a bond value, coupon, time to maturity, and face value, it is possible to find the implicit discount rate, or yield to maturity, by trial and error only. To do this, try different discount rates until the calculated bond value equals the given bond value. Remember that increasing the rate decreases the bond value.

Debt vs. Equity

Securities issued by the corporations may be classified roughly a:  o Equity Securities o Debt Securities When corporations borrow, they generally promise to o Make regular scheduled interest payments, and **Debt vs. Equity:**

Companies issue two main types of securities:

- **Equity Securities:** This is ownership in the company, like stocks. - **Debt Securities:** This is borrowing money from investors. Sure, I can summarize those statements for you:

1. **Interest Rate and Bond Price:** Bond prices move

opposite to market interest rates.

2. **Coupon Rate vs. Required Return:** If a bond's coupon rate

is less than the market's required return, its market value will be less than its par value.

3. **Maturity Impact on Price:** Longer-term bonds' prices o Repay the original amount borrowed (principal) The main differences between debt and equity are the following: o Debt is not an ownership interest in the firm. Creditors generally do not have voting power. o Corporation’s payment of interest on debt is considered as a cost of doing business and is fully tax deductible. While dividends paid to stockholders are not tax-deductible. o Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of the firm, resulting in bankruptcy or financial failure. This possibility does not arise when equity is issued.

Long Term Debt

Long term debt securities are promises made by the issuing firm to pay principal when due and to make timely interest payments on the unpaid balance. A number of features that distinguish the securities from one another o Maturity is the length of time debt remains outstanding with some unpaid balance. o Short-term debt (having maturity of one year or less) is sometimes referred to as unfunded debt o Debt securities are typically called notes, debentures or bonds Strictly speaking a bond is a secured debt, but the word bond refers to all kinds of secure and unsecured debt. Public-issue bonds o offered to general public Privately placed bonds  o placed with a private lender and not offered to general public

Features of a Super Stores Bond

Term

Explanation

Amount of Issue $125 Million The company will issue $125 million worth of bonds.

Date of Issue 28th Feb. 1986 The bonds were sold on 28th Feb. 1986.

Maturity 1st April. 2016 The principal will be paid in 30 years.

Face Value $1,000 The denomination of the bonds is $1,000.

Annual Coupon 9.25 % Each bondholder will receive $92.50 per bond per year (9.25% of the face value). Offer Price $1,000 The offer price will be 100% of the $1,000 face value per bond. Coupon Payment 1st Mar, 1st Sep. Coupons of $92.50/2 = $46.25 will be dates paid on these dates. Security None The bonds are debentures.

Sinking Fund Annual The firm will make annual payments toward the sinking fund. Beginning on 1st April, 1997 Not Callable The bonds have a deferred call feature before 28th Feb.

Call Price 106.48 Initially After 28th Feb. 1993, the company declining to 100 can buyback the bonds for $1,064.80 per bond, declining to $1,000 on 28th Feb. 2005. Rating A2 This is a higher rating. The bonds have a low probability of default.

LESSON 20 THE BOND INDENTURE

The bond indenture is a contract between the bond issuer and the bondholders. Usually, a trustee (perhaps a bank) is hired by the issuer to protect the bondholders’ interests. The trust company must: o Make sure the terms of indenture are obeyed o Manage the sinking fund o Represent the bondholders in default The indenture includes: o The basic terms of the bond issue o The total amount of bonds issued o A description of the security o The repayment arrangements o The call provisions o Details of the protective covenants

Terms of a Bond

Corporate bonds usually have a face value of $1000, called principal value and it is stated on the bond certificate. The par value (initial accounting value) of a bond is almost always same as the face value, and terms are used interchangeably. The corporate bonds are usually in registered form. The company keeps a register recording the ownership of each bond and any changes thereof. The company will pay the interest and principal by cheque mailed directly to the address of the owner of record. The bond may be registered and have attached coupons. To obtain the interest payment, the owner must separate a coupon from the bond certificate and send it to company registrar Alternatively, the bond could be in bearer form, in which case, the certificate is the evidence of ownership and the company will pay the bearer. Ownership is not recorded, and the holder of the bond certificate detaches coupons and sends to company to receive payments. Bearer bonds are difficult to recover if lost or stolen. Company having no record of ownership cannot notify the bondholders of important events.

Security

Debt securities are classified as collateral and mortgages used to protect the bondholders Collateral means securities (bonds, stocks) or any asset pledged as security for payment of debt.  Mortgage securities are secured by a mortgage on the real property of the borrower, involving usually real estate. Debenture is an unsecured bond for which no specific pledge of property is made  The term note is used for such instruments if the maturity of the bonds is less than 10 years when issued

Seniority

Seniority indicates preference in position over lenders, and debts are sometimes labeled as senior or junior to indicate seniority. In the event of default, the holders of subordinated debt must give preference to other specified creditors. However, debt cannot be subordinated to equity