Bond/ Debt Valuation (Ch 9 Titman, Ch 7 Keown)

VYE Summary & Notes

Chapter 9: Coverage • Corporate Debt

• Valuing Corporate Debt

• Bond Valuation- 4 Key Relationships

• Types of Bonds

• Inflation and rates of return

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Corporate Debt

• Firms can borrow

A. Private financial markets thru various types of financial institutions

1. Floating rate or fixed rate loans

(LIBOR rate, pdex)

2. Funds for working capital or transactions

3. Debt unsecured or unsecured

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Corporate Debt

• Firms can borrow B. Public financial markets by issuing corporate bonds which differ on a variety of features.

1. Bond indenture

2. Claim on assets

3. Par value

4. Coupon rate of interest

5. Maturity

6. Call provision or conversion feature

7. Bond ratings default risk 3

Corporate Debt

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Valuing Corporate Debt

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• Required/ expected rate of return = YTM

• Interest rate = coupon rate

• Par value = maturity value $1,000; date

• Bond value Vb = market value = intrinsic value

= present value of coupon interest payments

and the principal amount (par value)

• Purpose: higher returns, higher risk, but

cheaper than common stock

Valuing Corporate Debt

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Vb = PV of interest payments as an annuity

+ PV of maturity value

Vb = Interest pmt x PVIFA i, n + $1000 x PVIF i,n

Bond Valuation: Four Key Relationships

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1. Value inversely related to changes in

YTM

2. MV < $1,000 if YTM> i (discount)

MV > $1,000 if YTM< i (premium)

3. As n maturity, MV $1,000 par value

4. LT bonds have > interest risk than ST

bonds

Types of Bonds

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There are a variety of types of bonds depending

on their characteristics, usually a function of

the following bond attributes:

1. Secured vs unsecured

2. Priority of claim

3. Initial offering market

4. Abnormal risk

5. Coupon level

6. Amortizing or

non-amortizing

7. Convertibility

Types of Bonds

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Determinants of Interest Rates

• Interest rates are affected by the real rate

of interest and the inflation premium

•Risk of default = possibility that bond

issuer will fail to repay the borrowed

amount

Add a premium to interest rates to

reflect risk of default

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Determinants of Interest Rates

•As n (bond’s maturity) becomes longer,

the more the bond price fluctuates when

interest rates change.

A maturity premium reflects this risk

Term Structure of interest rates

reflects relationship between time to

maturity and interest rates (all other

variables constant)

Inflation, Rates of Return, and the Fisher Effect

Interest

Rates

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Conceptually:

Nominal

risk-free

Interest

Rate

rnominal

=

Real

risk-free

Interest

Rate

rreal

+

Inflation-

risk

premium

rinflation

Mathematically:

(1 + rnominal) = (1 + rreal) (1 + rinflation)

This relationship is known as the “Fisher Effect”

Interest Rates

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Interest Rates Suppose the real rate is 3%, and the nominal rate is 8%.

What is the inflation rate premium?

(1 + rnominal) = (1 + rreal) (1 + rinflation)

(1.08) = (1.03) (1 + rinflation)

(1 + rinflation) = (1.0485), so

rinflation = 4.85%

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Interest Rates

To simplify:

rnominal = rreal + rinflation + rreal x rinflation

r = R + i + R i

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REFERENCES:

Titman, S., Keown, A.j, Martin, J.D., (2011). Financial Management:

Principles and Applications. (11th Ed.). Pearson Education, Pearson/Prentice Hall

Keown, A.J., Martin, J.D., Petty, J.W., Scott Jr, D.F., Financial Management: Principles and Applications, 10th Edition, Pearson Prentice Hall 2005

Gitman, L. J. Principles of Managerial Finance, (11th ed.) Massachusetts: Addison Wesley Longman

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