VYE PPCh06B

8/8/2019 VYE PPCh06B

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Chapter 6Chapter 6

(Interest Rates)(Interest Rates)And Bond ValuationAnd Bond Valuation


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Learning GoalsLearning Goals

1.1. (Describe interest rate fundamentals, the term(Describe interest rate fundamentals, the termstructure of interest rates, and risk premiums.)structure of interest rates, and risk premiums.)

2.2. Review the legal aspects of bond financingReview the legal aspects of bond financingand bond cost.and bond cost.

3.3. Discuss the general features, quotations,Discuss the general features, quotations,ratings, popular types, and international issuesratings, popular types, and international issuesof corporate bonds.of corporate bonds.

4.4. Understand the key inputs and basic modelUnderstand the key inputs and basic modelused in the valuation process.used in the valuation process.


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Learning Goals (cont.)Learning Goals (cont.)

5.5. Apply the basic valuation model to bonds andApply the basic valuation model to bonds anddescribe the impact of required return anddescribe the impact of required return andtime to maturity on bond values.time to maturity on bond values.

6.6. Explain the yield to maturity (YTM), itsExplain the yield to maturity (YTM), itscalculation, and the procedure used to valuecalculation, and the procedure used to valuebonds that pay interest semiannually.bonds that pay interest semiannually.


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Valuation FundamentalsValuation Fundamentals

Valuation is the process than links risk andValuation is the process than links risk andreturn to determine the worth of an asset.return to determine the worth of an asset.

Usually applied toUsually applied to expectedexpectedstreams of benefitsstreams of benefitsfrom bonds, stocks, income properties, etc.from bonds, stocks, income properties, etc.

To determine an assets worth at a given pointTo determine an assets worth at a given pointin time, the financial manager uses:in time, the financial manager uses:

Time value of money techniquesTime value of money techniques

Risk and return conceptsRisk and return concepts


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Key inputs to the valuation process:Key inputs to the valuation process:Cash flows (returns)Cash flows (returns)

TimingTiming

Measure of risk (which determines theMeasure of risk (which determines therequired return)required return)


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Valuation FundamentalsValuation Fundamentals Cash Flows (Returns) that is expected of anyCash Flows (Returns) that is expected of any

asset determines the value of this asset overasset determines the value of this asset overthe ownership period.the ownership period.

Not necessarily an annual cash flow; can beNot necessarily an annual cash flow; can beintermittent or even a single cash flow over theintermittent or even a single cash flow over theperiod.period.

The timing and cash flow combination fullyThe timing and cash flow combination fullydefines the return expected from the asset.defines the return expected from the asset.

The greater the risk of (or the less certain) aThe greater the risk of (or the less certain) acash flow, the lower its value.cash flow, the lower its value.

Greater risk can be incorporated into a valuationGreater risk can be incorporated into a valuation

analysis by using a higher required return oranalysis by using a higher required return ordiscount rate.discount rate.


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Valuation FundamentalsValuation FundamentalsCelia Sargent, financial analyst of Groton Corp., a

diversified holding co., wishes to estimate the value of

three of its assets with their cash flow estimates.

- Stock in Michaels Enterprises: Expectto receive cash

dividends of $300 per year indefinitely.- Oil well: Expectto receive cash flow of $2,000 at end

of year 1, $4,000 at end of year 2, and $10,000 at end of

year 4, when well is to be sold.

- Original painting: Expectto be able to sell the

painting in 5 years for $85,000.

These cash flow estimates is the first step toward

placing a value on each of these assets.


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Valuation FundamentalsValuation FundamentalsCelia Sargents task of placing a value on original

painting has two scenarios:

Scenario 1- Certainty:

A major art gallery has contracted to buy the painting for$85,000 at the end of 5 years. Considered a certain

situation viewed as money in the bank. Would use the

prevailing risk-free rate of9% as required return when

calculating the value of the painting.


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Celia Sargents task of placing a value on originalpainting has two scenarios:

Scenario 2- High Risk:

The values of original paintings by this artist havefluctuated widely over the past 10 years. Although Celiaexpects to be able to get $85,000 for the painting, sherealizes that its sale price in 5 years could range

between $30,000 to $140,000. Because of the highuncertainty surrounding the paintings value, Celiabelieves that a 15% required return is appropriate.

Note: Estimates of appropriate required returns to

capture risk is often subjective.


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Valuation FundamentalsValuation Fundamentals TheThe (market) value(market) value of any investment assetof any investment asset

is simply theis simply the present valuepresent value of all future cashof all future cashflows it is expected to provide over the relevantflows it is expected to provide over the relevanttime period.time period.

Time period can be any length, even infinity.Time period can be any length, even infinity.

The value of an asset is determined byThe value of an asset is determined bydiscounting the expected cash flows back todiscounting the expected cash flows back to

their present value.their present value.

The interest rate that these cash flows areThe interest rate that these cash flows arediscounted at is called the assetsdiscounted at is called the assets requiredrequired

returnreturn..


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The required return is a function of theThe required return is a function of theexpected rate ofexpected rate ofinflationinflation and the perceivedand the perceivedriskriskof the asset.of the asset.

Higher perceived risk results in a higherHigher perceived risk results in a higherrequired return and lower asset market values.required return and lower asset market values.


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Basic Valuation ModelBasic Valuation Model

Note: Regardless of the pattern of the expected cash flow froman asset, the basic valuation equation can be used to determine

its value.


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Basic Valuation ModelBasic Valuation Model


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Bond Valuation: Bond FundamentalsBond Valuation: Bond Fundamentals

The basic valuation equation can be customizedThe basic valuation equation can be customizedfor use in valuing specific securities: bonds,for use in valuing specific securities: bonds,common stock, and preferred stock.common stock, and preferred stock.

Bonds are longBonds are long--term debt instruments used byterm debt instruments used bybusinesses and government to raise large sumsbusinesses and government to raise large sumsof money, typically from a diverse group ofof money, typically from a diverse group oflenders.lenders.

Most bonds pay interest semiannually at aMost bonds pay interest semiannually at astated coupon interest rate, have an initialstated coupon interest rate, have an initialmaturity of 10 to 30 years, and have a parmaturity of 10 to 30 years, and have a parvalue (or face value) of $1,000 that must bevalue (or face value) of $1,000 that must be

repaid at maturity.repaid at maturity.


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Mills Company, a large defense contractor, on Jan.1,

2007, issued a 10% coupon interest rate, 10-year

bond with a $1,000 par value that pays interest

semiannually.

Investors who buy this bond receive the contractual right

to two cash flows:

(1)$100 annual interest (10% coupon interest rate x

$1,000 par value) distributed as $50= (1/2 x $100) atthe end of each 6 months,

(2)The $1,000 par value at the end of year 10.

Bond Valuation: Basic Bond ValuationBond Valuation: Basic Bond Valuation


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The value of a bond is the present value of theThe value of a bond is the present value of thepayments its issuer is contractually obligated topayments its issuer is contractually obligated tomake, from the current time until it matures.make, from the current time until it matures.


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Assuming that interest on the Mills Co. bond issue is

paid annually and that the required return is equal to

the bonds coupon interest rate, I = $100, kd= 10%, M

= $1,000, and n = 10 years.



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B0

= I x (PVIFA10%,10yrs

) + M x (PVIF10%,10yrs

)

= $100 x (PVIFA10%,10yrs) + $1,000 x (PVIF10%,10yrs)

= $100 x (6.145) + $1,000 x (0.386)

= $1,000.50



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Bond Valuation: Basic Bond BehaviorBond Valuation: Basic Bond Behavior

In practice, the value of a bond in theIn practice, the value of a bond in themarketplace is rarely equal to its par value.marketplace is rarely equal to its par value.

Below par (quoted below 100)Below par (quoted below 100)

Above par (quoted above 100)Above par (quoted above 100)

Value is affected by:Value is affected by:

A variety of forces in the economyA variety of forces in the economy

Passage of timePassage of time

These external forces are in no way controlledThese external forces are in no way controlledby bond issuers or investors.by bond issuers or investors.


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Bond Valuation: Basic Bond BehaviorBond Valuation: Basic Bond Behavior

Bond values affected by:Bond values affected by:Required returnRequired return

Time to maturityTime to maturity


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Bond Valuation:Bond Valuation:Required Returns & Bond ValuesRequired Returns & Bond Values

Whenever the required return on a bond differsWhenever the required return on a bond differsfrom the bonds coupon interest rate, thefrom the bonds coupon interest rate, thebonds value will differ from its par value.bonds value will differ from its par value.

Difference may be due to:Difference may be due to:

Economic conditions have changed, causing a shiftEconomic conditions have changed, causing a shiftin the basic cost of longin the basic cost of long--term fundsterm funds

The firms risk has changed.The firms risk has changed. Increases in basic cost of longIncreases in basic cost of long--term funds or in riskterm funds or in risk raise the required returnraise the required return

Decreases in cost of funds or in riskDecreases in cost of funds or in risk lower thelower the

required returnrequired return


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Relationship between the required returnRelationship between the required returnand the coupon interest rate:and the coupon interest rate:

When required return > coupon interest rate,When required return > coupon interest rate,the bond value Bthe bond value B00 < its par value M.< its par value M.

Bond sells at a discount = MBond sells at a discount = M BB00

When required return < coupon interest rate,When required return < coupon interest rate,the bond value Bthe bond value B00 > its par value M.> its par value M.

Bond sells at a premium = BBond sells at a premium = B00 -- MM


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Required Return = 12%

B0 = $100 x (PVIFA12%,10yrs) + $1,000 x (PVIF12%,10yrs)

= $100 x (5.650) + $1,000 x (0.322)

= $887.00

Required Return = 8%

B0 = $100 x (PVIFA8%,10yrs) + $1,000 x (PVIF8%,10yrs)

= $100 x (6.710) + $1,000 x (0.463)

= $1,134.00



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Note: There is an inverse relationship between bond value and

required return.


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Bond Valuation:Bond Valuation:Time to Maturity & Bond ValuesTime to Maturity & Bond Values

It is also importantIt is also importantto note that ato note that abonds price willbonds price will

approach par valueapproach par valueas it approachesas it approachesthe maturity date,the maturity date,regardless of theregardless of the

interest rate andinterest rate andregardless of theregardless of thecoupon rate.coupon rate.


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