Corporate Finance
FIN3303 03
T TR 8:00 9:20 pm
Aymane Chetibi, CFA
a.chetibi@aui.ma
Office 11/Building 10
Bond basics and valuation
Before we go any further, we need to answer the following
philosophical question:
What is the difference between price and value ?
Before we go any further, we need to answer the following
philosophical question:
What is the difference between price and value ?
… and now what is the difference between:
liquidation value, book value, intrinsic value
and market value.
What is Value?
Liquidation value represents the amount
of money that could be realized if an
asset or group of assets is sold
separately from its operating
organization.
Going-concern value represents the
amount a firm could be sold for as a
continuing operating business.
What is Value?
Book value represents either
(1) an asset: the accounting value of
an asset -- the asset’s cost minus
its accumulated depreciation;
(2) a firm: total assets minus liabilities and
preferred stock as listed on the balance
sheet.
What is Value?
Market value represents the
market price at which an asset
trades.
Intrinsic value represents the price a security “ought
to have” based on all factors bearing on valuation
including assets, earnings, future prospects,
management etc. AKA Economic Value. In efficient
markets, M.V. should be near the I.V.
Bonds and Bond Valuation
A bondis a legally binding agreement between a
borrower and a lender that specifies the:
Par(face) value
Coupon rate
Coupon payment
Maturity Date
The yield to maturity is the required market
interest rate on the bond.
This is determined by the market.
Bond Valuation
Primary Principle:
Value of financial securities = PV of expected
future cash flows
Bond value is, therefore, determined by the
present value of the coupon payments and par
value.
Interest rates are inversely related to present
(i.e., bond) values.
The Bond-Pricing Equation
Which is simply what we have been working
with in time value of money chapter!
Bond Value = (PV annuity) + (PV of a single
payment)
Bond Example
Consider a U.S. government bond with as 6 3/8%
coupon that expires in December 2016.
The Par Value of the bond is $1,000.
Coupon payments are made semiannually (June 30 and
December 31 for this particular bond).
Since the coupon rate is 6 3/8%, the payment is $31.875.
On January 1, 2012 the size and timing of cash flows are:
$31.875 $31.875 $31.875 $1,031.875
1 / 1 / 12 6 / 30 / 12 12 / 31 / 12 6 / 30 / 16 12 / 31 / 16
Bond Example
On January 1, 2012, the required yield is 5%.
The current value is:
Or, using our spreadsheets:
Bond Example
Now assume that the required yield is
11%.
How does this change the bond’s price?
YTM and Bond Value
When the YTM < coupon, the bond
1300 trades at a premium.
Bond Value
1200
1100 When the YTM = coupon, the
bond trades at par.
1000
800
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
6 3/8 Discount Rate
When the YTM > coupon, the bond trades at a discount.
Illustrate: set YTM=Coupon Rate
When these
rates are equal
Bond Value
will equal the
Face or Par
Value
Bond Concepts
Bond prices and market interest rates move
in opposite directions.
When coupon rate = YTM, price = par
value
When coupon rate > YTM, price > par
value (premium bond)
When coupon rate < YTM, price < par
value (discount bond)
Interest Rate Risk
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.
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.
High coupon rate bonds have more reinvestment rate risk than low
coupon rate bonds.
Maturity and Bond Price
sensitivity
Bond Value
Consider two otherwise identical bonds.
The price of a long-maturity bond will have much more
sensitivity with respect to changes in the discount rate.
Par
Short Maturity Bond
C Discount Rate
Long Maturity
Bond
Computing Yield to Maturity
Yield to maturity is the rate implied by the
current bond price.
Finding the YTM requires trial and error if you
do not have a financial calculator, and it is
similar to the process for finding r with an
annuity.
You can always use your financial calculator or
“goal seek” on a spreadsheet to find YTM.
YTM with Annual Coupons
Consider a bond with a
10% annual coupon rate,
15 years to maturity, and
a par value of $1,000.
The current price is
$928.09.
Will the yield be more or less than
10%? Must be > 10%!
Spreadsheet solution using Goal
Seek. Set Bond value=928.09 by
changing the YTM cell.
YTM with Semiannual Coupons
Suppose a bond with a
10% coupon rate and
semiannual coupons
has a face value of
$1,000, 20 years to
maturity, and is
selling for $1,197.93.
Is the YTM more or
less than 10%? Must
be less than 10%.
Current Yield vs. Yield to Maturity
Current Yield = annual coupon / bond value
Yield to maturity = current yield + capital gains yield
Example: 10% coupon bond, with semi-annual
coupons, face value of 1,000, 20 years to maturity,
$1,197.93 price
Current yield = 100 / 1197.93 = .0835 = 8.35%
Price in one year, assuming no change in YTM = 1,193.68
Capital gain yield = (1193.68 – 1197.93) / 1197.93 =
-.0035 = -.35%
YTM = 8.35 - .35 = 8%, which is the same YTM computed
earlier
Current Yield and YTM
Using our spreadsheet:
Bond Pricing Theorems
Bonds of similar risk (and maturity) will be
priced to yield about the same return, regardless
of the coupon rate.
If you know the price of one bond, you can estimate
its YTM and use that to find the price of the second
bond.
Thisis a useful concept that can be transferred to
valuing assets other than bonds, and is used by
underwriters to price new bonds prior to trading.
Zero Coupon Bonds
Make no periodic interest payments (coupon rate = 0%)
The entire yield to maturity comes from the difference
between the purchase price and the par value
Cannot sell for more than par value, unless rates are
negative
Sometimes called zeroes, deep discount bonds, or
original issue discount bonds (OIDs)
Treasury Bills and principal-only Treasury strips are
good examples of zeroes
Pure Discount Bonds
Information needed for valuing pure discount bonds:
Time to maturity (T) = Maturity date - today’s date
Face value (F)
Discount rate (r)
$0 $0 $0 $F
0 1 2 T 1 T
Present value of a pure discount bond at time 0:
Pure Discount Bonds: Example
Find the value of a 15-year zero-coupon bond
with a $1,000 par value and a YTM of 12%.
$0 $0 $0 $1,000
$0 $0 $1,0
1 02 29 30
0 1 2 29 30
Same example with our
spreadsheet
Just set coupon rate=0
Government Bonds
Treasury Securities
Federal government debt
T-bills – pure discount bonds with original maturity less
than one year
T-notes – coupon debt with original maturity between one
and ten years
T-bonds – coupon debt with original maturity greater than
ten years
Municipal Securities
Debt of state and local governments
Varying degrees of default risk, rated similar to corporate
debt
Interest received is tax-exempt at the federal level
After-tax Yields
A taxable
bond has a yield of 8%, and a
municipal bond has a yield of 6%.
Ifyou are in a 40% tax bracket, which bond do you
prefer?
• 8%(1 - .4) = 4.8%
• The after-tax return on the corporate bond is 4.8%,
compared to a 6% return on the municipal
At what tax rate would you be indifferent between
the two bonds?
• 8%(1 – T) = 6%
• T = 25%
Corporate Bonds
Greater default risk relative to government
bonds
The promised yield (YTM) may be higher than
the expected return due to this added default
risk
Bond Ratings – Investment
Quality
High Grade
Moody’s Aaa and S&P AAA – capacity to pay is
extremely strong
Moody’s Aa and S&P AA – capacity to pay is very
strong
Medium Grade
Moody’s A and S&P A – capacity to pay is strong, but
more susceptible to changes in circumstances
Moody’s Baa and S&P BBB – capacity to pay is
adequate, adverse conditions will have more impact on
the firm’s ability to pay
Bond Ratings - Speculative
Low Grade (sometimes called “Junk Bonds”)
Moody’s Ba and B
S&P BB and B
Considered speculative with respect to capacity to pay.
Very Low Grade (definite “Junk Bonds”)
Moody’s C
S&P C & D
Highly uncertain repayment and, in many cases, already
in default, with principal and interest in arrears.
Eurobonds
Bonds issued by a country or corporation in a currency
that is different from its local currency.
Example: Moroccan Eurobonds – MOROC 2027 USD /
MOROC 2031 EUR / OCP 2045 USD
End of Chapter 2
