Valuation of Bonds: Understanding Intrinsic Value

1. Chapter 7 - The Valuation and Characteristics of Bonds Chapter 7 - The Valuation and Characteristics of Bonds

2. Valuation Valuation A systematic process through which the price at which a security should sell is established - Intrinsic value THE BASIS OF VALUE Real assets (houses, cars) have value due to services they provide Financial assets (paper) represent rights to future cash flows Value today is PV Different opinions about securities values come from different assumptions about cash flows and interest rates Stocks are hardest to value because future dividends and prices are never guaranteed.

3. The Basis of Value The Basis of Value Any securitys value is the present value of the cash flows expected from owning it. A security should sell for close to that value in financial markets 3

4. The Basis of Value The Basis of Value Investing Using a resource to benefit the future rather than for current satisfaction Putting money to work to earn more money Common types of investments Debt Equity Return What the investor receives for making an investment 1 year investments return = $ received / $ invested Debt investors receive interest. Equity investors get dividends + price change 4

5. Definition Definition The rate of return on an investment is the interest rate that equates the present value of its expected cash flows with its current price Return is also known as Yield, or Interest 5

6. Return On One Year Investment Return On One Year Investment Return is what the investor receives Can be expressed as a dollar amount or as a rate Rate of return is what the investor receives divided by what was invested For debt investments: the interest rate In terms of the time value of money: Invest PV at rate k and receive future cash flows of principal = PV, and interest = kPV at the end of a year, so FV 1 = PV + kPV FV 1 = PV(1+k)

7. The Basis for Value The Basis for Value Discount Rate The term discounted rate is often used for interest rate

8. Returns on Longer-Term Investments Returns on Longer-Term Investments 8

9. Bonds Bonds Bonds represent a debt relationship in which an issuing company borrows and buyers lend. A bond issue represents borrowing from many lenders at one time under a single agreement 9

10. Bond Terminology and Practice Bond Terminology and Practice A bonds term (or maturity) is the time from the present until the principal is returned A bonds face (or par) value represents the amount the firm intends to borrow (the principal) at the coupon rate of interest 10

11. Coupon Rates Coupon Rates Coupon Rate the fixed rate of interest paid by a bond In the past, bonds had coupons attached, today they are registered Most bonds pay coupon interest semiannual 11

12. Bond ValuationBasic Ideas Bond ValuationBasic Ideas Adjusting to Interest Rate Changes Bonds are originally sold in the primary market and trade subsequently among investors in the secondary market. Although bonds have fixed coupons, market interest rates constantly change. How does a bond paying a fixed interest rate remain salable (secondary market) when interest rates change? 12

13. Bond ValuationBasic Ideas Bond ValuationBasic Ideas Bonds adjust to changing yields by changing their prices Selling at a Premium bond price above face value Selling at a Discount bond price below face value Bond prices and interest rates move in opposite directions 13

14. Determining the Price of a Bond Determining the Price of a Bond The value (price) of a security is equal to the present value of the cash flows expected from owning it. In bonds, the expected cash flows are predictable. Interest payments are fixed, occurring at regular intervals. Principal is returned along with the last interest payment. 14

15. Determining the Price of a Bond Figure 7-1 Cash Flow Time Line for a Bond Determining the Price of a Bond Figure 7-1 Cash Flow Time Line for a Bond 15 This bond has 10 years until maturity, a par value of $1,000, and a coupon rate of 10%.?

16. Determining the Price of a Bond Determining the Price of a Bond The Bond Valuation Formula The price of a bond is the present value of a stream of interest payments plus the present value of the principal repayment 16

17. Determining the Price of a Bond Determining the Price of a Bond Two Interest Rates and One More Coupon Rate k - the current market yield on comparable bonds Current yield - annual interest payment divided by bonds current price Not used in valuation Info for investors 17

18. Figure 7-2 Bond Cash Flow and Valuation Concepts Figure 7-2 Bond Cash Flow and Valuation Concepts 18

19. Concept Connection Example 7-1 Finding the Price of a Bond Concept Connection Example 7-1 Finding the Price of a Bond Emory issued a $1,000, 8%, 25-year bond 15 years ago. Comparable bonds are yielding 10% today. What price will yield 10% to buyers today? What is the bonds current yield? Assume the bond pays interest semiannually.

20. Concept Connection Example 7-1 Finding the Price of a Bond Concept Connection Example 7-1 Finding the Price of a Bond 20 Must solve for present value of bonds expected cash flows at todays interest rate. Use Equation 7.4 : k represents the periodic current market interest rate, or 10% 2 = 5% . n represents the number of interest- paying periods until maturity, or 10 years x 2 = 20. The payment is 8% x $1,000, or $80 annually. However, it is received in the form of $40 every six months. The future value is the principal repayment of $1,000.

21. Concept Connection Example 7-1 Finding the Price of a Bond Concept Connection Example 7-1 Finding the Price of a Bond 21 Substituting : This is the price at which the bond must sell to yield 10%. It is selling at a discount because the current interest rate is above the coupon rate. The bonds current yield is $80 $875.39, or 9.14%.

22. Maturity Risk Revisited Maturity Risk Revisited Related to the term of the debt Longer term bond prices fluctuate more in response to changes in interest rates than shorter term bonds AKA price risk and interest rate risk 22

23. Table 7-1 Price Changes at Different Terms Due to an Interest Rate Increase from 8% to 10% Table 7-1 Price Changes at Different Terms Due to an Interest Rate Increase from 8% to 10% 23

24. Figure 7.3 Price Progression with Constant Interest Rate Figure 7.3 Price Progression with Constant Interest Rate 24

25. Finding the Yield at a Given Price Finding the Yield at a Given Price Calculate a bonds yield assuming it is selling at a given price Trial and error guess a yield calculate price compare to price given 25 Involves solving for k, which is more complicated because it involves both an annuity and a FV Use trial and error to solve for k, or use a financial calculator.

26. Concept Connection Example 7-3 Finding the Yield at a Price Concept Connection Example 7-3 Finding the Yield at a Price Benson issued a $1,000, 8%, 30-year bond 14 years ago. Bond is now selling for $718. What is yield to an investor buying it today? Semiannual interest.

27. Concept Connection Example 7-3 Finding the Yield at a Price Concept Connection Example 7-3 Finding the Yield at a Price 27 As interest rates rise, bond prices fall, so yield must be above 8%. Guess 10% and apply Equation 7.4 Next guess must be lower to drive price further down. Answer is just below 12%

28. Call Provisions Call Provisions If interest rates fall, a firm may wish to retire old, high interest bonds by refinancing with new, lower interest debt To ensure ability to refinance, issuers make bonds callable Investors dont like calls lose high interest Issuers and investors compromise Call provisions usually have A call premium Extra money paid if called Period of call protection Guaranteed not to call for a number of years. 28

29. Figure 7-5 Valuation of a Bond Subject to Call Figure 7-5 Valuation of a Bond Subject to Call 29

30. Call Provisions Call Provisions Valuing the Sure-To-Be-Called Bond Requires that two changes be made to bond valuation formula 30 n now represents the number of periods until the bond is likely to be called. The future value becomes the call price (face value plus call premium).

31. Call Provisions Call Provisions The new formula becomes P B = PMT[PVFA k,m ] + CP[PVF k,m ] Where m = time to call CP = call price = FV + Call Premium 31

32. Concept Connection Example 7-4 Basics: Pricing a Likely to Be Called Bond Concept Connection Example 7-4 Basics: Pricing a Likely to Be Called Bond Northern issued a $1,000, 25-year bond 5 years ago. Call provision: Can call after 10 years with the payment of one additional years interest at coupon rate. Coupon rate is 18%. Market rate is now 8%. What is the bond worth today? Interest payments are semiannual .

33. Concept Connection Example 7-4 Basics: Pricing a Likely to Be Called Bond Concept Connection Example 7-4 Basics: Pricing a Likely to Be Called Bond The bond must yield the current rate of interest in either case.

34. Concept Connection Example 7-4 Basics: Pricing a Likely to Be Called Bond Concept Connection Example 7-4 Basics: Pricing a Likely to Be Called Bond m = number of periods to call CP = call price = face value + call premium PMT = (.18 x $1,000) / 2 = $90 m = 5 x 2 = 10 k = 8% /2 = 4% CP = $1,000 + .18($1,000) = $1,180 P B (call) = $90 [PVFA 4,10 ] + $1,180 [PVF 4,10 ] = $90[8.1109] + $1,000[.6756] = $729.98 + $797.21 = $1,527.19

35. The Refunding Decision The Refunding Decision When current interest rates fall below the bonds coupon rate, a firm must decide whether to call in the issue Compare interest savings to cost of making call: Call premium Flotation costs Broker fees, printing costs, etc. 35

36. Dangerous Bonds with Surprising Calls Dangerous Bonds with Surprising Calls Bonds can have obscure call features buried in their contract terms. Most common type a sinking fund provision requires an issuer to call in and retire a fixed percentage of the issue each year Generally no call premium Provision is for the benefit of the bondholder 36

37. Risky Issues Risky Issues Sometimes bonds sell for a price far below what valuation techniques suggest Issuing company may be in financial trouble Buying the bond is very risky In theory riskier loans should be discounted at higher rates leading to lower calculated prices 37

38. Convertible Bonds Convertible Bonds Unsecured bonds exchangeable for a fixed number of shares of stock at the bondholder's discretion Conversion ratio - the number of shares of stock received for each bond Conversion price - the implied stock price if bond is converted into a certain number of shares Convertibles usually pay lower coupon rates 38

39. Concept Connection Example 7-5 Basics: Investing in Convertible Bonds Concept Connection Example 7-5 Basics: Investing in Convertible Bonds 39 Harry Jenson purchased one of Algo Corp.s 9%, 25- year convertible bonds at its $1,000 par value a year ago when the companys common stock was selling for $20. Similar bonds without a conversion feature returned 12% at the time. The bond is convertible into stock at a price of $25. The stock is now selling for $29. Algo pays no dividends. Notice that this bonds coupon rate was set below the market rate for nonconvertible issues.

40. Concept Connection Example 7-5 Basics: Investing in Convertible Bonds Concept Connection Example 7-5 Basics: Investing in Convertible Bonds a. Harry exercised the conversion feature today and immediately sold the stock he received. Calculate the total return on his investment. b. What would Harrys return have been if he had invested $1,000 in Algos stock instead of the bond?

41. Concept Connection Example 7-5 Basics: Investing in Convertible Bonds Concept Connection Example 7-5 Basics: Investing in Convertible Bonds The proceeds from selling those shares at the current market price were In addition the bond paid interest during the year of So the total receipts from the bond investment were

42. Concept Connection Example 7-5 Basics: Investing in Convertible Bonds Concept Connection Example 7-5 Basics: Investing in Convertible Bonds 42

43. Concept Connection Example 7-5 Basics: Investing in Convertible Bonds Concept Connection Example 7-5 Basics: Investing in Convertible Bonds 43

44. Concept Connection Example 7-5 Basics: Investing in Convertible Bonds Concept Connection Example 7-5 Basics: Investing in Convertible Bonds Notice that the convertible enabled Harry to participate in some but not all of the rapid price appreciation of Algos stock. Also notice that had the stock price fallen, an investment in it would have had a negative return, but the convertible would have returned the 9% coupon rate.

45. Convertible Bonds Convertible Bonds Effect of Conversion on Financial Statements and Cash Flow An accounting entry removes the value of convertible bonds from long-term debt placing it into equity as if new shares were sold No immediate cash flow impact, but ongoing cash flow implications exist Interest payments stop But dividend payments may start 45

46. Advantages of Convertible Bonds Advantages of Convertible Bonds To Issuing Companies Convertible features are sweeteners enabling a risky firm to pay a lower interest rate Viewed as a way to sell equity at a price above market Usually have few or no restrictions To Buyers Offer the chance to participate in stock price appreciation Offer a way to limit risk associated with a stock investment 46

47. Forced Conversion Forced Conversion A firm may want bonds converted As stock price rises convertible represents a lost opportunity to sell new equity at a higher price Convertible bonds are always issued with call features which can be used to force conversion Issuers generally call convertibles when stock prices rise to 10-15% above conversion prices 47

48. Valuing (Pricing) Convertibles Valuing (Pricing) Convertibles A convertibles price can depend on either its value as a traditional bond or the market value of the stock into which it can be converted A convertible is always worth at least the larger of its value as a bond or as stock 48

49. Figure 7-6 Value of a Convertible Bond Figure 7-6 Value of a Convertible Bond 49

50. Effect on Earnings Per ShareDiluted EPS Effect on Earnings Per ShareDiluted EPS Upon conversion convertible bonds cause dilution in EPS EPS drops due to the increase in the number of shares of stock outstanding Thus outstanding convertibles represent a potential to dilution of EPS 50

51. Concept Connection Example 7-7 - Dilution Concept Connection Example 7-7 - Dilution Montgomery Inc. Issued two thousand $1,000, 8% coupon convertible bonds three years ago. Each bond is convertible into stock at $25 per share. All of the Bonds remain outstanding, i.e., none have converted. Last year net income was $3 million. One million shares stock were outstanding for the entire year, and the firms marginal tax rate was 40%. Calculate Montgomerys basic and diluted EPS for the year. Solution: Basic EPS net income number of shares $3,000,000 1,000,000 = $3.00.

52. Concept Connection Example 7-7 Dilution Concept Connection Example 7-7 Dilution Diluted EPS Assumes all bonds are converted at beginning of year. 1. Add the number of newly converted shares to denominator. 2. Adjust net income for after tax effect of interest saved. 1. Shares exchanged: Par Conversion price = $1,000 $25 = 40 shares/bond 40 shares/bond 2,000 bonds = 80,000 shares New shares outstanding = 1,000,000 + 80,000 = 1,080,000 2. Adjust the net income by interest saved : Interest paid on bonds: .08 x $1,000 x 2,000 = $160,000 After tax: $160,000 (1-.4) = $96,000 New net income = $3,000,000 + $96,000 = $3,096,000 Diluted EPS: $ 3,096,000 1,080,000 = $2.87

53. Institutional Characteristics of Bonds Kinds of Bonds Institutional Characteristics of Bonds Kinds of Bonds Bonds are either bearer or registered Registered, Owners of Record, Transfer Agents Owners of registered bonds are recorded with a transfer agent. 53

54. Kinds of Bonds Kinds of Bonds Secured bonds and mortgage bonds Backed by specific assets - collateral Debentures Unsecured bonds - riskier Subordinated debentures Lower in payment priority than senior debt Junk bonds Risky companies - high interest rate s 54

55. Bond RatingsAssessing Default Risk Bond RatingsAssessing Default Risk Bonds are assigned quality ratings reflecting their probability of default. Higher ratings mean lower default probability Higher rated bonds pay lower interest rates Bond rating agencies (Moodys, S&P) evaluate bonds (and issuers), and assign a ratings 55

56. Bond RatingsTable 7.2 Bond RatingsTable 7.2

57. Figure 7-7 Yield Differentials between High- and Low-Quality Bonds Figure 7-7 Yield Differentials between High- and Low-Quality Bonds 57

58. Controlling Default Risk Bond Indentures Controlling Default Risk Bond Indentures Bond indentures attempt to prevent borrowing firms from becoming riskier after bonds issued restrictive covenants limit activities and payouts Safety also provided by sinking funds Provide money for repayment of bond principal 58

59. Appendix 7-A - Lease Financing Appendix 7-A - Lease Financing A lease is a contract giving one party (lessee) the right to use an asset owned by another (lessor) for a periodic payment Individuals usually lease houses, apartments, and automobiles Companies lease equipment and real estate 59

60. Leasing and Financial Statements Leasing and Financial Statements Originally leasing allowed use without ownership Lease payments recognized as income statement expenses, but No impact on balance sheets No recognition of ownership or obligation to pay Improved appearance of financial ratios Not real Led to widespread use of lease financing The leading form of off balance sheet financing 60

61. Misleading Results Misleading Results Off balance sheet financing makes financial statements misleading Missed lease payments can cause failure just like a missed interest payment on debt Not showing leases on the balance sheet can mislead investors into thinking a firm is stronger than it is 61

62. FASB 13 Redefines Ownership FASB 13 Redefines Ownership 1970s: Concerns about leasing led to FASB 13 Prior to FASB 13 an asset was owned for financial statement purposes by whoever held title Regardless of who used it FASB 13 redefined ownership for financial reporting purposes in economic terms FASB 13 stated that the real owner of an asset is whoever enjoys its benefits and bears its risks and responsibilities 62

63. Operating and Capital (Financing) Leases Operating and Capital (Financing) Leases Under FASB 13 lessees must capitalize financing leases Puts the value of leased assets and the liability for payments on the balance sheet Long term leases for high value assets Operating leases can still be listed off the balance sheet Short term leases for lower value items Rules must be met for a lease to be classified as an operating lease 63

64. Financial Statement Presentation of Leases by Lessees Financial Statement Presentation of Leases by Lessees Operating leases Recognize rent expense No balance sheet entries Financing (Capital) leases Recognize asset and lease obligation on balance sheet Recognize depreciation expense for asset Amortize lease obligation like a loan 64

65. Leasing from the Perspective of the Lessor Leasing from the Perspective of the Lessor Lessors are usually financial institutions - banks, finance or insurance companies Lease payments are calculated to offer the lessor a given return Lessor holds legal titlecan repossess assets if lessee defaults Lessors get better treatment in bankruptcy proceedings than lenders 65

66. Residual Values Residual Values Residual valuethe value of asset at the end of the lease Makes lease pricing and return calculations more complex Important negotiating points between lessee and lessor 66

67. Lease Vs. Buy The Lessees Perspective Lease Vs. Buy The Lessees Perspective Broad financing possibilities Equity Debtavailable through bonds or banks Leasingavailable through leasing companies Conduct a lease vs. buy comparison Choose the lowest cost option in a present value sense Leasing is almost always more expensive 67

68. The Advantages of Leasing The Advantages of Leasing Lessors usually require no down payment, lenders want significant money down Lessors restrictions less stringent than lenders Easier credit with manufacturers/lessors 68

69. The Advantages of Leasing The Advantages of Leasing Short leases transfer the risk of obsolescence to lessors Tax deducting the cost of land Increasing liquiditythe sale and leaseback Tax advantages for marginally profitable companies 69

70. Leveraged Leases Leveraged Leases The ability to depreciate assets reduces taxes Government shares the cost of ownership Unprofitable firms lose this benefit as they pay no tax But can get some benefits with a Leveraged Lease In a leveraged lease, a profitable lessor buys equipment financing a portion with borrowed money (hence a leveraged lease) Leveraged Lessor receives the tax benefits of ownership Lessor shares those tax benefits with the lessee through lower lease payments Lessees savings can be very substantial 70

71. Figure 7A-1 Leveraged Leases Figure 7A-1 Leveraged Leases 71