Bonds: Debt securities that pay a rate of interest based upon the face amount or par value of the

bond

Price changes as market interest changes

Zero coupon bonds – no periodic payment (no interest reinvestment rate)

• Originally sold at a discount

Example CETES

Present value of cash flows as

Bond
rates change coupons are
bondvalueovc par
• Debt contract
pro annuity evaump sum
value
Bond
• Interest-only loan
asint rateincreasepvdecreaseandvice
interest decrease
versa
price
ratesincreasebona
as

PV bond PV coupons tPVCfinal payment

Key Features of a Bond

pv N Ct It in
Par value (face value):
It
• Face amount
I
• Repaid at maturity
coupon int
payment
• Assume $1, 000 for corporate bonds
Ct value
Ct coupon rate x face

Coupon interest rate:

F Face value
• Stated interest rate

• Usually = YTM at issue

y YTM
N Maturity
• Multiply by par value to get coupon payment

bond Fr t current price e

Premium

Maturity:

ormiston
• Years until bond must be repaid
f

Yield to maturity (YTM):

• The market required rate of return for bonds of

similar risk and maturity

• The discount rate used to value a bond

• Return if bond held to maturity

• Usually = coupon rate at issue

• Quoted as an APR

In October 2011 you purchase €100 of bonds in France which pay a 5% coupon every year. If the bond
matures in 2016 and the YTM is 2.4%, what is the value of the bond?

PV
4 5 112.11

E y
t

In july 2010 you purchase ¥200 of bonds in Japan which pay an 8% coupon every year. If the bond
matures in 2015 and the YTM is 4.5%, what is the value of the bond?

a 16

PV E to 71
t 23073

f I
In February 2012 you purchase a three-year U.S. government bond. The bond has an annual coupon
rate of 11.25%, paid semiannually. If investors demand a 0.085% semiannual return, what is the price
of the bond?

41

fj tiI.oo7ojsI 1331

PVI.IE

Take the same three-year U.S. government bond. If investors demand a 4.0% semiannual return, what
is the new price of the bond?

5 56 25

PV i.oss
i8t
t.YY.jo

E l

Cambio la yieldto Maturity

Consider a bond with a coupon rate of 10% and annual coupons. The par value is $1, 000 and the
bond has 5 years to maturity. The yield to maturity is 11%. What is the value of the bond?

PV 100 963.04

1 o.me s ciY

Suppose you are looking at a bond that has a 10% annual coupon and a face value of $1, 000. There
are 20 years to maturity and the yield to maturity is 8%. What is the price of this bond?

pv ofannuity Pirotlumpsum

00 tcY7ogo 1,196.36
o.og.ci

Prices and yields (required rates of return) have an inverse relationship

The bond price curve is convex

derivada

La primera

nos Va a dear
Segunda
zond

negativa La
price

derivada no va

1 A dear positiva

a w

dry ia

dy
ivcute

dpv et can 2 11 11t

city

Interest rate c 1.1 dy

Bond Prices: Relationship Between Coupon and Yield

If YTM = coupon rate, then par value = bond price

• If YTM > coupon rate, then par value > bond price

• Why?

I
• Selling at a discount, called a discount bond

• If YTM < coupon rate, then par value < bond price

• Why?

• Selling at a premium, called a premium bond

I
preciode un bono va a

tender a converger at face

value car el Tiempo

Bono premium se deprecian

can elpaso

deltiempo

Banos at a discount se

tienden

a apreaar
Semiannual Bonds

Bond yields are quoted like APRs; the quoted rate is equal to the actual rate per period multiplied by
the number of periods

Price Risk

• Change in price due to changes in interest rates

• Long-term bonds have more price risk than

short-term bonds

• Low coupon rate bonds have more price risk than high coupon rate bonds

• Bond prices are sensitive to the market interest rate

• If interest rates rise, the market value of bonds fall in order to compete with newly issued bonds with
higher coupon rates

Reinvestment Rate Risk

• Uncertainty concerning rates at which cash flows can be reinvested

• Short-term bonds have more reinvestment rate risk than long-term bonds

por
que no hay tanto tiempo paracubrirel pasosue necesitamos

• High coupon rate bonds have more reinvestment rate risk than low coupon rate
bonds

Mientras
mayor seu el Manto del cupon mayor Serai el

Riesgo a reinvertir

Computing Yield-to-Maturity

• Yield-to-maturity (YTM) = the market required rate of return implied by the current bond price

with Excel

Enter NPER pv PMT

andFV

signs
needtohave the samesign

putandEV

PVtheoppositesign

RATEfortheyield
Term Structure of Interest Rates

• From discount factors we can derive interest rates for various compounding frequencies

• Advantage of using interest rates instead of discount factors when we analyze the time value of
money: their units can be made uniform across maturities by annualizing them

• The following example illustrates the point

Discount

factors decrease with maturity
Como

anualizar tasas can cap cant

r z 1ti

lf

Term Structure of Interest Rates

• The term structure of interest rates, or spot rate curve, or yield curve, at a certain time t defines the
relationship between the level of interest rates and their time to maturity T − t

• The term spread, or slope, is the difference between the long-term interest rates (e.g. 10-year rate)
and the short-term interest rates (e.g. 3-month rate)

liatuidos
A

Medi da en que aumenta el tiempo los activos se uneven memos

Term structure of interest rates

• Relationship between the yield to maturity and

maturity of bonds with the same risk

The shape of the yield curve changes over a business cycle

• Downward sloping, upward sloping, and relatively flat

• Upward sloping yield curve is considered “normal”

Varying Interest Rates (Spot Rates)

pv N

cti uf

• These rates are the spot rates for different

periods

• The spot rate is the effective annual interest rate of a zero coupon bond (i.e. stripped bonds, or
strips) with a one-time payment at time t

Law of One Price

• All interest-bearing instruments priced to fit term structure

• Accomplished by modifying asset price

• Modified price creates new yield, which fits term

structure

• New yield called yield to maturity (YTM)

Expected Return and Yield to Maturity

• Expected return on an investment in a zero coupon bond:

Return on zero coupon bond =

1

2 It T
This is the return between t and T (measured in years)

• Annualize this amount

• Annualized return on zero coupon bond =

t.ie F 1

For true or false in the exam

yield gagging
current
annualpriggurion

Leer la parte de default

55730061855

HOW

common stocksare valued

Expected Return

• Percentage yield forecast from specific investment over time period

• Sometimes called market capitalization rate (or opportunity cost of capital)

• Expected return = r =

Divttppt
• Value of a stock = present value of future cash flows

PODY.IR

• Price of share of stock is present value of future cash flows.

• For a stock, future cash flows are dividends and ultimate sales price.

Price = P0 =

• All stocks in the same risk class of Fledgling have to be priced to offer the same expected rate of
return

Market Capitalization Rate

• Can be estimated using perpetuity formula

• Example: Constant dividend growth model

• Growth rate is also capital gains yield

• Stock price = P0 =

Dirt
r g

capitalgainyield
• Capitalization rate = r =
1fguquo

Dividendyield

• It is not correct to say that the value of a share is equal to the sum of the discounted stream of
earnings per share.

—> Earnings are generally larger than dividends.

Dividendgrowth models

Zerogrowth Po Div
R

constantgrowth Po Div

R g

Differential growth Po Divllts 1

I Rt zivIt t RIT

estimating costof equitycapital

Return measurements

Divyield D

Po

Return on equity

Roe
Bookeat Plshare

Dividend growthrate

Payoutratio Div

EPs
payoutbratio

PIowbackrat.io

g return on equity plow back ratio

g ROE b

ChecarPreguntade stocksdel examendel Sem Pasado

Valuing constant growth

non

4,7 i7 t
a tI

PH Div
r g

STOCK PRICE AND EARNINGS PER SHARE

• Investors separate growth stocks from income stocks

- They buy growth stocks primarily for the expectation of capital gains, and they are interested in the
future growth of earnings rather than in next year’s dividends

- They buy income stocks primarily for the cash dividends

In general, we can think of stock price as the capitalized value of average earnings under a no-growth
policy, plus PVGO:

Po Eps PVGO

if

solvefor earningsprice ratio

rf M
1

Investment decisions

wealth

discount value UPfrontcosts

Rule

1 Onlycashflow is relevant

cashreceived cashpaid out

Cashflow accounting income

Capitalexpenses Recordwhentheyoccur

TOdet Ctfrom ace income back depreciation capitalexpenditure

Gt cashoutflow cashpayment

workingcapital Companyshort
term assets liabilities

Rule2
estimateCF on an incremental Basis

Rule3 Treat inflation

consistently

Realdiscount Itnominaldiscountrate 1

Lt inflationrate
Use real interest rates to discount real cash flows

Same results from real and nominal figures

Rule 4 separate investment andFinancing Decisions

Regardless of financing, treat cash outflows required for project as coming from stockholders (all-
equity-financed).

Regardless of financing, treat cash inflows as going to stockholders.

You should neither subtract the debt proceeds from the required investment nor recognize the interest

and principal payments on the debt as cash flows.

Applying

Npr rule

Twosteps 1 Askwhether the project has a NPV assuming allequity financing

2 If Npv is Ct youundertake separateanalysis ofthebest financing strategy

 e cas CS ow o capitainvestmen an disposal cash low om s n wor ng capital

operatingcashflow

revenues cashexpenses taxes

operating cashflow

Taxshield depreciation x taxrate

working

cap inventory accrec accpay

Additional

investment inworkcap increase in inventory increase in acc rec increase in acerec

RISK AND RETURN

Probability distributions When an investment is risky, there are different returns it may earn. Each
possible return has some likelihood of occurring. This information is summarized with a probability
distribution, which assigns a probability, PR , that each possible return, R, will occur.

Expected meantreturn calculated as a weighted average of the possible returns where the

weights correspond to the probabilities

ER ECR Pr x R

Variance Expected squared deviation from the mean

Var R E CR ECR I Prx R ECR12

standarddeviation square root of variance

SDCRI V
Both are measures of the risk of a probability distribution.

computinghistorical returns

Realized Return

Thereturn thatactually occurs over a particular

time Period

Computing Historical Returns:

To focus on the return of a single security, let’s assume that all dividends are immediately reinvested
and used to purchase additional shares of the same stock or security.

If a stock pays dividends at the end of each quarter, with realized returns RQ1, ..., RQ4 each quarter,
then its annual realized return, Rannual , is computed as:

pi T CR R2 t Rt f Rt II
Where Rt is the realized return of a security in year t, for

the years 1 through T

Variance EstimateUsing Realized Returns

Varcrl IE Crr E 2

Compound annual return

111 12,1 1 it Rdx x i Rt 1

It is equivalent to the IRR of the investment over the period:
FinalValueinitial investment T t

Commonrisk

iRisk thatis perfectly correlated

i Riskthatattects an securities

Independent
risk Riskthatis uncorrelated

Riskthat affects a particular security

Diversification iaveraging outof

independent
risks in a large portfolio

Beta B

Theexpected change in theexcess returnof a security for a 1 change in theexcess

return of the marketportolio

 I measu w a eo I

sistematic risk

Estimatingthe riskpremium
The market risk premium is the reward investors expect to earn for holding a portfolio with a beta of 1

MarketRisk Premium E RmKt Rf

Adjusting for Beta

EIR Riskfreeinterestrate Riskpremium

rt B X ELRmKt rt

Portfolioweights

Xi valueotinvestmenti

totalvalueof portfolio

Return

of a portfolio

Rio X R XzRat xnRn E XiRi

Correlation

Corr Ri R covcri.rs

sDcrilsDcr

o Signo en clases Juliana

For a two sec port

var Rp Cov RpRp

Thevarianceof a two stock Portfolio

Var Rp N var Ri Hzvar Rz 2x x CovCRRa

Investing in RiskFree securities

E RxPT f t x ELRp rft

standard

deviations
DCR xp Va var Rio

xSD Rp

Tantoet riesgocomo et return son lineales auedependen de X

Sharpe ratio Portfolioexcessret ELRP slope

Portfolio volatility SD Rp

Haysue maximizar et sharpe ratio Para encontrarel efficient portfolio

CAPM

Whenthe tangentlinegoesthrough is called capitalmarket line CML

Marketportfolio Efficientportfolio

B traccionderiesgosistema tico

Marketriskandbeta

ECri ri rt BixCecrmkH

riskpremium ofsecurity i

Nivel
deriesgo deMercado Y diversificable no compensado paret mercado

Securitymarket line ExpectedreturnVs Beta

Immuttweights mmuitcmatrit cov Transposer weights varianza

Mkt Divyield expected div growth

Dpi s
Debt Yields

• If there is little risk the firm will default, yield to

maturity is a reasonable estimate of investors’ expected

rate of return.

• If there is significant risk of default, yield to maturity will

overstate investors’ expected return.

Firm'sassets costof capital

- Expected return required by investors to hold the firm’s underlying assets

• Weighted average of the firm’s equity and debt costs of capital

ru E re D no

ETD ED

Firm'sasset
beta

Bu D
pe E D Bo
e

Since the risk of the firm’s enterprise value (i.e. the combined market value of firm’s equity and debt,
less any excess cash) is what we are concerned with, leverage should be measured in terms of net
debt

Netdebt Debt Excess cash andshort term investments

Taxes

• When interest payments on debt are tax deductible, the net cost to the firm is given by:

Effafter tax i rate L Ect

• Weighted Average Cost of Capital (WACC)

Vivace E D

re ro Ct Ect
E to E to tax
• Given a target leverage ratio:

rwacc ru D Eero
So the expected E return
to of the bond is:
l P It p y L y PL

ITM Probdefault Expected lossrate

PROJECT ANALYSIS
sensitivity
scenarios
Breakevenanalysis
accounting profitBreakeven point
Fixedcosts