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Business Finance Chapter 7-9

Notes for Chapters 7-9 + Homework questions from chapter 7 on Bonds
Course

Introduction to Finance (FIN2303)

71 Documents
Students shared 71 documents in this course
Academic year: 2015/2016
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Algonquin College

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Business Finance Chapter 7 HW & Assignment 1. Today, a bond has a coupon rate of 10%, par value of $1000, 13 years to maturity, YTM of 9%, and semiannual coupons with the next one due in 6 months. One year ago, the price of the bond was $1075. What is the current yield of the bond today? Coupon Pmt = 108/2 = 54 semi annual Bond Value Today N = 13 x 2 = 26 I = 9/2 FV = 1000 PMT = 54 PV = 1088 Current Yield Today = Annual Coupon/Bond Value Today  = 108/1088 = 0 = 9 2. 6 years ago, Allen Corp issued bonds that pay annual coupons, have a face value of $1000, have an annual coupon rate of 8, and are schedule to mature in 4 years. One year ago, you bought one of the bonds for $998. The bond just paid a coupon. If the percentage return on your bond was 4% over the past year, what is the price of the bond today? Percentage Return = (Coupon Payment + Capital Gain)/Initial Value 0 = (86 + CG)/998 CG = 0*998 - 86 CG = 45 - 86 CG = -40 Price Today = 998 + (-40) = 957 = 958 3. The coupon rate of Cafe bonds is less than the yield-to-maturity of these Cafe bonds. Which of the following assertions is most likely to be true? The Cafe bonds sell at a discount in the primary market. 4. Bond XYZ and bond ABC both pay annual coupons, mature in seven years, have a face value of $1000, and have the same yield-to-maturity. Bond XYZ has a coupon rate of 8% and is priced at $1035. Bond ABC has a coupon rate of 6%. What is the price of bond ABC? XYC                          ABC N 7                            7 PV -1035              CPT  PMT 85  (8%)         64 (6%) FV 1000                    1000                                    CPT I/Y 7             I/Y 7                                  PV = 925 1. Interpreting Bond Yields Is the yield to maturity on a bond the same thing as the required return?    For noncallable bonds, the yield to maturity and required rate of return are interchangeable terms. Is the YTM the same thing as the coupon rate?  The coupon rate is not a return used as the interest rate in bond cash flow valuation, but is a fixed percentage of par over the life of the bond used to set the coupon payment amount.  Suppose today a 10% coupon bond sells at par. Two years from now, the required return on the same bond is 8%. What is the coupon rate on the bond then? The YTM?   The coupon rate is constant at 10% The YTM is 8% 9. Calculating Real Rates of Return If Treasury bills are currently paying 7% and the inflation rate is 3%, what is the approximate real rate of interest? The exact real rate?   Approx = 7 - 3 = 3 Fisher equation shows the exact relationship between nominal and real and inflation o (1 + R) = (1 + r) x (1 + h) o (1 + 0) = (1 + r) x (1 + 0) o Exact r = 1.07/1 - 1 o r = 0 or 3% 10. Inflation and Nominal Returns Suppose the real rate is 3% and the inflation rate is 4%. What rate would you expect to see on a treasury bill? (1 + R) = (1 + 0) x (1 + 0) (1 + R) = 1 x 1 R = 1 - 1 = 0 or 7% 18. Interest Rate Risk  Both Bond Sam and Bond Dave have 9% coupons, make semiannual payments and are priced at par value. Bond Sam has 3 years to maturity, whereas Bond Dave has 20 years to maturity. If interest rates suddenly rise by 2%, what is the % change in the price of Bond Sam? Of Bond Dave?           Bonds sold at par have YTM equal to the coupon rate PV is 1000 right now We are looking for PV with an increased rate  Sam N 6 Dave N 40 I/Y = 11 Semi Annual Coupon 9% PMT = 45 FV 1000  Sam PV = 950 Dave PV 839 % Change o Sam -4%  o Dave -16% If rates were to suddenly fall by 2% instead, what would the % change in the price of Bond Sam be then? Of Bond Dave?        Sam N 6 Dave N 40 I/Y = 7 Semi Annual Coupon 9% PMT = 45 FV 1000  Sam PV = 1053 Dave PV 1213 % Change o Sam 5 Up o Dave 21 Up 24. Bond Prices vs. Yields o a. What is the relationship between the price of a bond and its YTM?  When interest rate rises, price goes down o b. Explain why some bonds sell at a premium over par value while other bonds sell at a discount. What do you know about the relationship between the coupon rate and the YTM for premium bonds? What about for discount bonds? For bonds selling at par value?   Coupon rates stay the same  If the coupon rate is higher than YTM, then bond will sell at premium  If the coupon rate is lower than YTM, then bond will sell at a discount o c. What is the relationship between the current yield and YTM for premium bonds? For discount bonds? For bonds selling at par value?  Current yield = annual coupon payment/current bond price  For premium bonds, current yield is less than YTM  For discount bonds, current yield is more than YTM  For bonds selling at par value, current yield is = YTM 26. Zero Coupon Bonds Suppose your company needs to raise $30 million and you want to issue 30-year bonds for this purpose. Assume the required return on your bond issue will be 8%, and you’re evaluating two issue alternatives: an 8% annual coupon bond and a zero coupon bond. Your company’s tax rate is 35%.     Yield to Maturity - The market interest rate that equates a bond’s PV of interest payments and principal repayment with its price  PV of bond = PV of cash flows + PV of Face Value  Rate = 5, 10 years, $1000 face value  PV of Bond = 420  + 579 = 1000  The bond sells for exactly its face value  Suppose in a year, market rate is 7. Find PV of 1000 paid in 9 years.  PV = 517 + 355 = 872  Bond sells for 873$ - discount bond  Will have a $127 gain at maturity, only because buyer gives up $20 worth of bond payments every year o Interest Rate Risk  Risk that arises for bond owners from fluctuating interest rates  Sensitivity depends on:  Time to Maturity  Coupon Rate  The longer the time/lower the coupon rate, the greater the interest rate risk o Finding the Yield to Maturity 7 More on Bond Features o Securities issued by corporations may be classified as equity/debt securities  Debt is not an ownership interest in the firm  Corporation’s payment of interest on debt is considered a cost of doing business and is tax deductible  Unpaid debt is a liability of the firm o Is it Debt or Equity?  Debt holders are paid before equity holders  Debt holders are limited to amount of loan, whereas there is no limit for reward of owning an equity interest o Long Term Debt Basics  Debt Securities are typically called notes/debentures/bonds o Indenture - Written agreement between the corporation (the borrower) and its creditors  Basic terms of bond  Face value (usually $1000)  Registered Form - Registrar of company records ownership of each bond; payment is made directly to the owner of record  Bearer Form - Bond issued without record of the owner’s name; payment is made to whoever holds the bond  Difficult to recover if lost  Company cannot notify bondholders of important events because it does not know who owns its bonds  Amount of bonds issued  Description of property used as security if bonds are secured  Security   Collateral - Pledged as security for payment of debt  Mortgage Securities - Secured by a mortgage on the real property of the borrower  Debenture - Unsecured bond usually with a maturity 10 years or more  Note - Unsecured debt, usually with a maturity under 10 years  Seniority - Preference in position over other lenders  Repayment arrangements  Can be repaid at maturity or in part/entirety before maturity  Sinking Fund - Account managed by the bond trustee for early bond redemption  Call provision  Call Provision - Agreement giving the corporation the option to repurchase the bond at a specified price before maturity  Call Premium - Amount by which the call price exceeds the par value of the bond  Deferred Call - Call provision prohibiting the company from redeeming the bond before a certain date  Call Protected - Bond during period in which it cannot be redeemed by the issuer  Details of protective covenants  Protective Covenant - Part of the indenture limiting certain transactions that can be taken during the term of the loan, usually to protect the lender’s interest 7 Bond Ratings o Highest rating a firm can have is AAA (best quality and lowest degree of risk) 7 Different Types of Bonds o Financial Engineering   Stripped/Zero-Coupon Bond - A bond that makes no coupon payments, initially priced at a deep discount  Floating Rate Bonds  Income Bonds  Retractable Bond - Bond that may be sold back to the issuer at a respecified price before maturity 7 Bond Markets 7 Inflation and Interest Rates o Fisher Effect  Interest rates and bond inverse relationship 10% Nominal = R + H Real rate is actual cost of lending money without any inflation risk R = 1 H? o 10 - 1 = 9% Fisher Effect o R = r+rh+h o    = 0 + (0*0) + 0            P0 = (D0 x (1 + g))/(r - g) = D1/(r - g)  Stock price at any point in time:  Pt = (Dt x (1 + g))/(r - g) = Dt+1/(r - g) 3. Non Constant Growth  Ex. Company isn’t paying dividends currently  In 5 years, will pay a dividend of $0/share  Required return is 20%  What is price of stock today?  Find what it will be worth once dividend are paid. Then calculate PV of the future price        P4 = D5/(r - g)  = 0/(0 - 0)  = $5  PV of FV of 5       P0 = $5/(1)^4   = $2  N 4 I/Y 20 FV 5 PV = 2  If dividends are not equal, you have to calculate each on separately, add them all then find PV  8 Common Stock Features  o Business Finance Chapter 9 Capital Budgeting Approaches 1. 2. 3. 4. 5. 6. Net Present Value (NPV)  Payback Rule  Discount Payback Rule  Internal Rate of Return Profitability Index  Mutually Exclusive Projects Net Cash Flow EBIT  + Depreciation - Tax  PV = Rate Cost NPV =  Year 0 = 165 000         1 = 63 120         2 = 70 800         3 = 91 080 Rate = 12% NPV = 21 627 = 0 Accept or reject = < 0 Reject because you’re spending money to work on project Invest 500 000 (Make Negative) 1 = 50 000 2 = -25 000 (Costs to maintain or close down) 3 = 125 000 4 = 175 000 5 = 450 000 6 = 100 000 7 = -25 000  Rate = 8% NPV = 107 414 Payback Rule  Year 1  -165 000 + 63 120 = -101 880 Management 2 Invest + Get = Still need Year 2  -101 880 + 70 800 = -31 080 Year 3  -31 080 + 91 080 = 60 000  31 080 / 91 080 = 0 In Reality Management will receive their money in 2 year therefore we accept Invest Management 4 Years and 4 Months Year 1  -150 000 + 75 000 = -75 000 Year 2  -75 000 +  -25 000 = -100 000 Year 3 -100 000 + 50 000 = -50 000 Year 4 -50 000 + 25 000 = -25 000 Year 5 

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Business Finance Chapter 7-9

Course: Introduction to Finance (FIN2303)

71 Documents
Students shared 71 documents in this course

University: Algonquin College

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Business Finance Chapter 7 HW & Assignment
1. Today, a bond has a coupon rate of 10.8%, par value of $1000, 13 years to maturity, YTM
of 9.6%, and semiannual coupons with the next one due in 6 months. One year ago, the
price of the bond was $1075. What is the current yield of the bond today?
Coupon Pmt = 108/2 = 54 semi annual
Bond Value Today
N = 13 x 2 = 26
I = 9.6/2
FV = 1000
PMT = 54
PV = 1088.06
Current Yield Today = Annual Coupon/Bond Value Today
= 108/1088.06 = 0.0993 = 9.93
2. 6 years ago, Allen Corp issued bonds that pay annual coupons, have a face value of
$1000, have an annual coupon rate of 8.6, and are schedule to mature in 4 years. One
year ago, you bought one of the bonds for $998. The bond just paid a coupon. If the
percentage return on your bond was 4.6% over the past year, what is the price of the bond
today?
Percentage Return = (Coupon Payment + Capital Gain)/Initial Value
0.046 = (86 + CG)/998
CG = 0.046*998 - 86
CG = 45.91 - 86
CG = -40.09
Price Today = 998 + (-40.09) = 957.91 = 958
3. The coupon rate of Cafe bonds is less than the yield-to-maturity of these Cafe bonds.
Which of the following assertions is most likely to be true?
The Cafe bonds sell at a discount in the primary market.

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