Mini-case Financing S & S Air’s Expansion Plans with a Bond Issue, economics homework help

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  1. Using a Word document, complete the requirements of the Mini-case “Financing S & S Air’s Expansion Plans with a Bond Issue” on page 238 in the textbook in the form of a memo, as explained in the case.
    1. For each of the ten bond features listed, briefly describe the likely impact of each of the features on the coupon rate demanded by potential bond investors when this new bond is issued.  Will it cause the necessary coupon rate to be higher or lower?
    2. In addition, for each of the ten bond features listed, briefly describe the advantages or disadvantages, from the company’s perspective, of implementing that feature with the newly issued bond.

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IEB Wireframe 1 of 11 http://textflow.mheducation.com/parser.php?secload=P3.7.f&fake&print 7.8 Summary and Conclusions This chapter has explored bonds, bond yields, and interest rates: 1. Determining bond prices and yields is an application of basic discounted cash flow principles. 2. Bond values move in the direction opposite that of interest rates, leading to potential gains or losses for bond investors. 3. Bonds have a variety of features spelled out in a document called the indenture. 4. Bonds are rated based on their default risk. Some bonds, such as Treasury bonds, have no risk of default, whereas so-called junk bonds have substantial default risk. 5. A wide variety of bonds exist, many of which contain exotic or unusual features. 6. Almost all bond trading is OTC, with little or no market transparency in many cases. As a result, bond price and volume information can be difficult to find for some types of bonds. 7. Bond yields and interest rates reflect the effect of six different things: the real interest rate and five premiums that investors demand as compensation for inflation, interest rate risk, default risk, taxability, and lack of liquidity. In closing, we note that bonds are a vital source of financing to governments and corporations of all types. Bond prices and yields are a rich subject, and our one chapter, necessarily, touches on only the most important concepts and ideas. There is a great deal more we could say, but, instead, we will move on to stocks in our next chapter. Page 231 CONNECT TO FINANCE Connect Finance Do you use Connect Finance to practice what you learned? If you don’t, you should - we can help you master the topics presented in this material. Log on to connect.mheducation.com to learn more! Can you answer the following Connect Quiz questions? Section 7.1 An 8 percent, semiannual coupon bond has a face value of $1,000 and a current market value of $1,030. What is the current yield? Section 7.3 The 10-year bonds issued by KP Enterprises were rated as BBB and Baa last year. This year, the bonds are rated as CC and Ca. What term best applies to these bonds today? 7/31/2016 2:27 PM IEB Wireframe 2 of 11 http://textflow.mheducation.com/parser.php?secload=P3.7.f&fake&print Section 7.4 What type of bonds is most apt to have a “collar”? Section 7.6 Kate wants to earn a 4 percent real rate of return. To do this, what nominal rate must she earn if the inflation rate is 3.6 percent? Section 7.7 The term structure of interest rates is based on what type of bonds? CHAPTER REVIEW AND SELF-TEST PROBLEMS 7.1 Bond Values A Microgates Industries bond has a 10 percent coupon rate and a $1,000 face value. Interest is paid semiannually, and the bond has 20 years to maturity. If investors require a 12 percent yield, what is the bond’s value? What is the effective annual yield on the bond? 7.2 Bond Yields A Macrohard Corp. bond carries an 8 percent coupon, paid semiannually. The par value is $1,000, and the bond matures in six years. If the bond currently sells for $911.37, what is its yield to maturity? What is the effective annual yield? ANSWERS TO CHAPTER REVIEW AND SELF-TEST PROBLEMS 7.1 Because the bond has a 10 percent coupon yield and investors require a 12 percent return, we know that the bond must sell at a discount. Notice that, because the bond pays interest semiannually, the coupons amount to $100/2 = $50 every six months. The required yield is 12%/2 = 6% every six months. Finally, the bond matures in 20 years, so there are a total of 40 six-month periods. The bond’s value is thus equal to the present value of $50 every six months for the next 40 six-month periods plus the present value of the $1,000 face amount: Notice that we discounted the $1,000 back 40 periods at 6 percent per period, rather than 20 years at 12 percent. The reason is that the effective annual yield on the bond is 1.062 − 1 = 12.36%, not 12 percent. We thus could have used 12.36 percent per year for 20 years when we calculated the present value of the $1,000 face amount, and the answer would have been the same. Page 232 7.2 7/31/2016 2:27 PM IEB Wireframe 3 of 11 http://textflow.mheducation.com/parser.php?secload=P3.7.f&fake&print The present value of the bond’s cash flows is its current price, $911.37. The coupon is $40 every six months for 12 periods. The face value is $1,000. So the bond’s yield is the unknown discount rate in the following: The bond sells at a discount. Because the coupon rate is 8 percent, the yield must be something in excess of that. If we were to solve this by trial and error, we might try 12 percent (or 6 percent per six months): This is less than the actual value, so our discount rate is too high. We now know that the yield is somewhere between 8 and 12 percent. With further trial and error (or a little machine assistance), the yield works out to be 10 percent, or 5 percent every six months. By convention, the bond’s yield to maturity would be quoted as 2 × 5% = 10%. The effective yield is thus 1.052 − 1 = 10.25%. CONCEPTS REVIEW AND CRITICAL THINKING QUESTIONS 1. Treasury Bonds [LO1] Is it true that a U.S. Treasury security is risk-free? 2. Interest Rate Risk [LO2] Which has greater interest rate risk, a 30-year Treasury bond or a 30-year BB corporate bond? 3. Treasury Pricing [LO1] With regard to bid and ask prices on a Treasury bond, is it possible for the bid price to be higher? Why or why not? 4. Yield to Maturity [LO2] Treasury bid and ask quotes are sometimes given in terms of yields, so there would be a bid yield and an ask yield. Which do you think would be larger? Explain. 5. Call Provisions [LO1] A company is contemplating a long-term bond issue. It is debating whether to include a call provision. What are the benefits to the company from including a call provision? What are the costs? How do these answers change for a put provision? 6. Coupon Rate [LO1] How does a bond issuer decide on the appropriate coupon rate to set on its bonds? Explain the difference between the coupon rate and the required return on a bond. 7. Real and Nominal Returns [LO4] Are there any circumstances under which an investor might be more concerned about the nominal return on an investment than the real return? 8. Bond Ratings [LO3] Companies pay rating agencies such as Moody’s and S&P to rate their bonds, and the costs can be substantial. However, companies are not required to have their bonds rated; doing so is strictly voluntary. Why do you think they do it? 9. Bond Ratings [LO3] Often, junk bonds are not rated. Why? 10. Term Structure [LO5] What is the difference between the term structure of interest rates and the yield 7/31/2016 2:27 PM IEB Wireframe 4 of 11 http://textflow.mheducation.com/parser.php?secload=P3.7.f&fake&print curve? 11. Crossover Bonds [LO3] Looking back at the crossover bonds we discussed in the chapter, why do you think split ratings such as these occur? Page 233 12. Municipal Bonds [LO1] Why is it that municipal bonds are not taxed at the federal level, but are taxable across state lines? Why are U.S. Treasury bonds not taxable at the state level? (You may need to dust off the history books for this one.) 13. Bond Market [LO1] What are the implications for bond investors of the lack of transparency in the bond market? 14. Rating Agencies [LO3] A controversy erupted regarding bond-rating agencies when some agencies began to provide unsolicited bond ratings. Why do you think this is controversial? 15. Bonds as Equity [LO1] The 100-year bonds we discussed in the chapter have something in common with junk bonds. Critics charge that, in both cases, the issuers are really selling equity in disguise. What are the issues here? Why would a company want to sell “equity in disguise”? QUESTIONS AND PROBLEMS BASIC (Questions 1–17) 1. Interpreting Bond Yields [LO1] Is the yield to maturity on a bond the same thing as the required return? Is YTM the same thing as the coupon rate? Suppose today a 10 percent coupon bond sells at par. Two years from now, the required return on the same bond is 8 percent. What is the coupon rate on the bond then? The YTM? 2. Interpreting Bond Yields [LO2] Suppose you buy a 7 percent coupon, 20-year bond today when it’s first issued. If interest rates suddenly rise to 15 percent, what happens to the value of your bond? Why? 3. Valuing Bonds [LO2] Even though most corporate bonds in the United States make coupon payments semiannually, bonds issued elsewhere often have annual coupon payments. Suppose a German company issues a bond with a par value of €1,000, 23 years to maturity, and a coupon rate of 5.8 percent paid annually. If the yield to maturity is 4.7 percent, what is the current price of the bond? 4. Bond Yields [LO2] A Japanese company has a bond outstanding that sells for 91.53 percent of its ¥100,000 par value. The bond has a coupon rate of 3.4 percent paid annually and matures in 16 years. What is the yield to maturity of this bond? 5. Coupon Rates [LO2] Essary Enterprises has bonds on the market making annual payments, with eight years to maturity, a par value of $1,000, and selling for $948. At this price, the bonds yield 5.9 percent. What must the coupon rate be on the bonds? 7/31/2016 2:27 PM IEB Wireframe 5 of 11 6. http://textflow.mheducation.com/parser.php?secload=P3.7.f&fake&print Bond Prices [LO2] Sqeekers Co. issued 15-year bonds a year ago at a coupon rate of 4.1 percent. The bonds make semiannual payments and have a par value of $1,000. If the YTM on these bonds is 4.5 percent, what is the current bond price? 7. Bond Yields [LO2] Heginbotham Corp. issued 20-year bonds two years ago at a coupon rate of 5.3 percent. The bonds make semiannual payments. If these bonds currently sell for 105 percent of par value, what is the YTM? 8. Coupon Rates [LO2] DMA Corporation has bonds on the market with 14.5 years to maturity, a YTM of 5.3 percent, a par value of $1,000, and a current price of $965. The bonds make semiannual payments. What must the coupon rate be on these bonds? 9. Zero Coupon Bonds [LO2] You find a zero coupon bond with a par value of $10,000 and 17 years to maturity. If the yield to maturity on this bond is 4.9 percent, what is the price of the bond? Assume semiannual compounding periods. 10. Valuing Bonds [LO2] Yan Yan Corp. has a $2,000 par value bond outstanding with a coupon rate of 4.9 percent paid semiannually and 13 years to maturity. The yield to maturity of the bond is 3.8 percent. What is the price of the bond? Page 234 11. Valuing Bonds [LO2] Union Local School District has a bond outstanding with a coupon rate of 3.7 percent paid semiannually and 16 years to maturity. The yield to maturity on this bond is 3.9 percent, and the bond has a par value of $5,000. What is the price of the bond? 12. Calculating Real Rates of Return [LO4] If Treasury bills are currently paying 5.1 percent and the inflation rate is 2.2 percent, what is the approximate real rate of interest? The exact real rate? 13. Inflation and Nominal Returns [LO4] Suppose the real rate is 1.9 percent and the inflation rate is 3.1 percent. What rate would you expect to see on a Treasury bill? 14. Nominal and Real Returns [LO4] An investment offers a total return of 11.5 percent over the coming year. Janice Yellen thinks the total real return on this investment will be only 9 percent. What does Janice believe the inflation rate will be over the next year? 15. Nominal versus Real Returns [LO4] Say you own an asset that had a total return last year of 11.65 percent. If the inflation rate last year was 3.4 percent, what was your real return? 16. Using Treasury Quotes [LO2] Locate the Treasury issue in Figure 7.4 maturing in February 2038. What is its coupon rate? What is its bid price? What was the previous day’s asked price? Assume a par value of $10,000. 17. Using Treasury Quotes [LO2] Locate the Treasury bond in Figure 7.4 maturing in August 2039. Is this a premium or a discount bond? What is its current yield? What is its yield to maturity? What is the bid–ask spread in dollars? Assume a par value of $10,000. INTERMEDIATE (Questions 18–31) 7/31/2016 2:27 PM IEB Wireframe 6 of 11 http://textflow.mheducation.com/parser.php?secload=P3.7.f&fake&print 18. Bond Price Movements [LO2] Bond X is a premium bond making semiannual payments. The bond pays a coupon rate of 8.5 percent, has a YTM of 7 percent, and has 13 years to maturity. Bond Y is a discount bond making semiannual payments. This bond pays a coupon rate of 7 percent, has a YTM of 8.5 percent, and also has 13 years to maturity. What is the price of each bond today? If interest rates remain unchanged, what do you expect the price of these bonds to be one year from now? In three years? In eight years? In 12 years? In 13 years? What’s going on here? Illustrate your answers by graphing bond prices versus time to maturity. 19. Interest Rate Risk [LO2] Both Bond Sam and Bond Dave have 6.5 percent 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 percent, what is the percentage change in the price of Bond Sam? Of Bond Dave? If rates were to suddenly fall by 2 percent instead, what would the percentage change in the price of Bond Sam be then? Of Bond Dave? Illustrate your answers by graphing bond prices versus YTM. What does this problem tell you about the interest rate risk of longer-term bonds? 20. Interest Rate Risk [LO2] Bond J has a coupon rate of 3 percent. Bond K has a coupon rate of 9 percent. Both bonds have 19 years to maturity, make semiannual payments, and have a YTM of 6 percent. If interest rates suddenly rise by 2 percent, what is the percentage price change of these bonds? What if rates suddenly fall by 2 percent instead? What does this problem tell you about the interest rate risk of lower-coupon bonds? 21. Bond Yields [LO2] Bourdon Software has 6.4 percent coupon bonds on the market with 18 years to maturity. The bonds make semiannual payments and currently sell for 106.8 percent of par. What is the current yield on the bonds? The YTM? The effective annual yield? Page 235 22. Bond Yields [LO2] Chamberlain Co. wants to issue new 20-year bonds for some much-needed expansion projects. The company currently has 7 percent coupon bonds on the market that sell for $1,083, make semiannual payments, and mature in 20 years. What coupon rate should the company set on its new bonds if it wants them to sell at par? 23. Accrued Interest [LO2] You purchase a bond with an invoice price of $1,035. The bond has a coupon rate of 5.9 percent, and there are four months to the next semi-annual coupon date. What is the clean price of the bond? 24. Accrued Interest [LO2] You purchase a bond with a coupon rate of 4.7 percent and a clean price of $951. If the next semiannual coupon payment is due in two months, what is the invoice price? 25. Finding the Bond Maturity [LO2] Shinoda Corp. has 8 percent coupon bonds making annual payments with a YTM of 7.2 percent. The current yield on these bonds is 7.55 percent. How many years do these bonds have left until they mature? 26. Using Bond Quotes [LO2] Suppose the following bond quotes for IOU Corporation appear in the financial page of today’s newspaper. Assume the bond has a face value of $2,000 and the current date is April 19, 2015. What is the yield to maturity of the bond? What is the current yield? Company (Ticker)CouponMaturity Last PriceLast YieldEST Vol (000s) 7/31/2016 2:27 PM IEB Wireframe 7 of 11 http://textflow.mheducation.com/parser.php?secload=P3.7.f&fake&print IOU (IOU) 5.7 Apr 19, 2028 108.96 27. Bond Prices versus Yields [LO2] ?? 1,827 1. What is the relationship between the price of a bond and its YTM? 2. 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? 3. What is the relationship between the current yield and YTM for premium bonds? For discount bonds? For bonds selling at par value? 28. Interest on Zeroes [LO2] Imagination Dragons Corporation needs to raise funds to finance a plant expansion, and it has decided to issue 25-year zero coupon bonds with a par value of $1,000 each to raise the money. The required return on the bonds will be 5.8 percent. Assume semiannual compounding periods. 1. What will these bonds sell for at issuance? 2. Using the IRS amortization rule, what interest deduction can the company take on these bonds in the first year? In the last year? 3. Repeat part (b) using the straight-line method for the interest deduction. 4. Based on your answers in (b) and (c), which interest deduction method would the company prefer? Why? 29. Zero Coupon Bonds [LO2] Suppose your company needs to raise $47 million and you want to issue 20-year bonds for this purpose. Assume the required return on your bond issue will be 6 percent, and you're evaluating two issue alternatives: a semiannual coupon bond with a coupon rate of 6 percent and a zero coupon bond. Your company’s tax rate is 35 percent. Both bonds will have a par value of $1,000. 1. How many of the coupon bonds would you need to issue to raise the $47 million? How many of the zeroes would you need to issue? Page 236 2. In 20 years, what will your company’s repayment be if you issue the coupon bonds? What if you issue the zeroes? 3. Based on your answers in (a) and (b), why would you ever want to issue the zeroes? To answer, calculate the firm’s aftertax cash outflows for the first year under the two different scenarios. Assume the IRS amortization rules apply for the zero coupon bonds. 30. Finding the Maturity [LO2] You’ve just found a 10 percent coupon bond on the market that sells for par value. What is the maturity on this bond? 31. Real Cash Flows [LO4] You want to have $2.6 million in real dollars in an account when you retire in 40 years. The nominal return on your investment is 10.8 percent and the inflation rate is 3.7 percent. What real amount must you deposit each year to achieve your goal? 7/31/2016 2:27 PM IEB Wireframe 8 of 11 http://textflow.mheducation.com/parser.php?secload=P3.7.f&fake&print CHALLENGE (Questions 32–38) 32. Components of Bond Returns [LO2] Bond P is a premium bond with a coupon rate of 10 percent. Bond D has a coupon rate of 4 percent and is currently selling at a discount. Both bonds make annual payments, have a YTM of 7 percent, and have 10 years to maturity. What is the current yield for bond P? For bond D? If interest rates remain unchanged, what is the expected capital gains yield over the next year for bond P? For bond D? Explain your answers and the interrelationships among the various types of yields. 33. Holding Period Yield [LO2] The YTM on a bond is the interest rate you earn on your investment if interest rates don’t change. If you actually sell the bond before it matures, your realized return is known as the holding period yield (HPY). 1. Suppose that today you buy a bond with an annual coupon rate of 7 percent for $1,060. The bond has 17 years to maturity. What rate of return do you expect to earn on your investment? Assume a par value of $1,000. 2. Two years from now, the YTM on your bond has declined by 1 percent, and you decide to sell. What price will your bond sell for? What is the HPY on your investment? Compare this yield to the YTM when you first bought the bond. Why are they different? 34. Valuing Bonds [LO2] Jallouk Corporation has two different bonds currently outstanding. Bond M has a face value of $20,000 and matures in 20 years. The bond makes no payments for the first six years, then pays $1,100 every six months over the subsequent eight years, and finally pays $1,400 every six months over the last six years. Bond N also has a face value of $20,000 and a maturity of 20 years; it makes no coupon payments over the life of the bond. If the required return on both these bonds is 5.6 percent compounded semiannually, what is the current price of bond M? Of bond N? 35. Valuing the Call Feature [LO2] At one point, certain U.S. Treasury bonds were callable. Consider the prices in the following three Treasury issues as of May 15, 2014: 5/15/20206.500 106.31250106.37500−.312505.28 5/15/20208.250 103.43750103.50000−.093755.24 5/15/202012.000134.78125134.96875−.468755.32 The bond in the middle is callable in February 2015. What is the implied value of the call feature? Assume a par value of $1,000. (Hint: Is there a way to combine the two noncallable issues to create an issue that has the same coupon as the callable bond?) Page 237 36. Treasury Bonds [LO2] The following Treasury bond quote appeared in The Wall Street Journal on May 11, 2004: 5/15/20099.125100.09375100.125000−2.15 Why would anyone buy this Treasury bond with a negative yield to maturity? How is this possible? 7/31/2016 2:27 PM IEB Wireframe 9 of 11 http://textflow.mheducation.com/parser.php?secload=P3.7.f&fake&print 37. Real Cash Flows [LO4] When Marilyn Monroe died, ex-husband Joe DiMaggio vowed to place fresh flowers on her grave every Sunday as long as he lived. The week after she died in 1962, a bunch of fresh flowers that the former baseball player thought appropriate for the star cost about $7. Based on actuarial tables, “Joltin' Joe” could expect to live for 30 years after the actress died. Assume that the EAR is 7.3 percent. Also, assume that the price of the flowers will increase at 3.7 percent per year, when expressed as an EAR. Assuming that each year has exactly 52 weeks, what is the present value of this commitment? Joe began purchasing flowers the week after Marilyn died. 38. Real Cash Flows [LO4] You are planning to save for retirement over the next 30 years. To save for retirement, you will invest $800 per month in a stock account in real dollars and $400 per month in a bond account in real dollars. The effective annual return of the stock account is expected to be 11 percent, and the bond account will earn 7 percent. When you retire, you will combine your money into an account with a an effective return of 9 percent. The returns are stated in nominal terms. The inflation rate over this period is expected to be 4 percent. How much can you withdraw each month from your account in real terms assuming a 25-year withdrawal period? What is the nominal dollar amount of your last withdrawal? EXCEL MASTER IT! PROBLEM Companies often buy bonds to meet a future liability or cash outlay. Such an investment is called a dedicated portfolio because the proceeds of the portfolio are dedicated to the future liability. In such a case, the portfolio is subject to reinvestment risk. Reinvestment risk occurs because the company will be reinvesting the coupon payments it receives. If the YTM on similar bonds falls, these coupon payments will be reinvested at a lower interest rate, which will result in a portfolio value that is lower than desired at maturity. Of course, if interest rates increase, the portfolio value at maturity will be higher than needed. Suppose Ice Cubes, Inc., has the following liability due in five years. The company is going to buy five-year bonds today to meet the future obligation. The liability and current YTM are below. Amount of liability:$100,000,000 Current YTM: 8% 1. At the current YTM, what is the face value of the bonds the company has to purchase today to meet its future obligation? Assume that the bonds in the relevant range will have the same coupon rate as the current YTM and these bonds make semiannual coupon payments. 2. Assume that the interest rates remain constant for the next five years. Thus, when the company reinvests the coupon payments, it will reinvest at the current YTM. What is the value of the portfolio in five years? Page 238 3. Assume that immediately after the company purchases the bonds, interest rates either rise or fall by one percent. What is the value of the portfolio in five years under these circumstances? One way to eliminate reinvestment risk is called immunization. Rather than buying bonds with the same maturity as the liability, the company instead buys bonds with the same duration as the liability. If you think 7/31/2016 2:27 PM IEB Wireframe 10 of 11 http://textflow.mheducation.com/parser.php?secload=P3.7.f&fake&print about the dedicated portfolio, if the interest rate falls, the future value of the reinvested coupon payments decreases. However, as interest rates fall, the price of the bond increases. These effects offset each other in an immunized portfolio. Another advantage of using duration to immunize a portfolio is that the duration of a portfolio is simply the weighted average of the duration of the assets in the portfolio. In other words, to find the duration of a portfolio, you simply take the weight of each asset multiplied by its duration and then sum the results. 4. What is the duration of the liability for Ice Cubes, Inc.? 5. Suppose the two bonds shown below are the only bonds available to immunize the liability. What face amount of each bond will the company need to purchase to immunize the portfolio? Bond A Bond B Settlement: 1/1/20001/1/2000 Maturity: 1/1/20031/1/2008 Coupon rate: 7.00% 8.00% YTM: 7.50% 9.00% Coupons per year: 2 2 MINICASE Financing S&S Air’s Expansion Plans with a Bond Issue Mark Sexton and Todd Story, the owners of S&S Air, have decided to expand their operations. They instructed their newly hired financial analyst, Chris Guthrie, to enlist an underwriter to help sell $35 million in new 10-year bonds to finance construction. Chris has entered into discussions with Renata Harper, an underwriter from the firm of Raines and Warren, about which bond features S&S Air should consider and what coupon rate the issue will likely have. Although Chris is aware of the bond features, he is uncertain about the costs and benefits of some features, so he isn’t sure how each feature would affect the coupon rate of the bond issue. You are Renata’s assistant, and she has asked you to prepare a memo to Chris describing the effect of each of the following bond features on the coupon rate of the bond. She would also like you to list any advantages or disadvantages of each feature. QUESTIONS 1. The security of the bond—that is, whether the bond has collateral. 2. The seniority of the bond. 3. The presence of a sinking fund. 4. A call provision with specified call dates and call prices. 5. A deferred call accompanying the call provision. 6. A make-whole call provision. 7. Any positive covenants. Also, discuss several possible positive covenants S&S Air might consider. 8. Any negative covenants. Also, discuss several possible negative covenants S&S Air might consider. 7/31/2016 2:27 PM IEB Wireframe 11 of 11 http://textflow.mheducation.com/parser.php?secload=P3.7.f&fake&print 9. A conversion feature (note that S&S Air is not a publicly traded company). 10. A floating-rate coupon. 7/31/2016 2:27 PM CHAPTER 7 INTEREST RATES AND BOND VALUATION Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. KEY CONCEPTS AND SKILLS • Know the important bond features and bond types • Understand bond values and why they fluctuate • Understand bond ratings and what they mean • Understand the impact of inflation on interest rates • Understand the term structure of interest rates and the determinants of bond yields Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-2 CHAPTER OUTLINE • Bonds and Bond Valuation • More about Bond Features • Bond Ratings • Some Different Types of Bonds • Bond Markets • Inflation and Interest Rates • Determinants of Bond Yields Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-3 BOND DEFINITIONS • Bond • Par value (face value) • Coupon rate • Coupon payment • Maturity date • Yield or Yield to maturity Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-4 PRESENT VALUE OF CASH FLOWS AS RATES CHANGE • Bond Value = PV of coupons + PV of par • Bond Value = PV of annuity + PV of lump sum • As interest rates increase, present values decrease • So, as interest rates increase, bond prices decrease and vice versa Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-5 VALUING A DISCOUNT BOND WITH ANNUAL COUPONS • Consider a bond with a coupon rate of 10% and annual coupons. The par value is $1,000, and the bond has 5 years to maturity. The yield to maturity is 11%. What is the value of the bond? ▪ Using the formula: • B = PV of annuity + PV of lump sum • B = 100[1 – 1/(1.11)5] / .11 + 1,000 / (1.11)5 • B = 369.59 + 593.45 = 963.04 ▪ Using the calculator: • N = 5; I/Y = 11; PMT = 100; FV = 1,000 • CPT PV = -963.04 Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-6 VALUING A PREMIUM BOND WITH ANNUAL COUPONS • Suppose you are reviewing a bond that has a 10% annual coupon and a face value of $1000. There are 20 years to maturity, and the yield to maturity is 8%. What is the price of this bond? ▪ Using the formula: • B = PV of annuity + PV of lump sum • B = 100[1 – 1/(1.08)20] / .08 + 1000 / (1.08)20 • B = 981.81 + 214.55 = 1196.36 ▪ Using the calculator: • N = 20; I/Y = 8; PMT = 100; FV = 1000 • CPT PV = -1,196.36 Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-7 GRAPHICAL RELATIONSHIP BETWEEN PRICE AND YIELD-TO-MATURITY (YTM) 1400 1300 1200 1100 1000 Bond Price Bond Price, in dollars 1500 900 800 700 600 0% 2% 4% 6% 8% 10% 12% 14% Yield-to-Maturity Yield-to-maturity (YTM) (YTM) Bond characteristics: 10 year maturity, 8% coupon rate, $1,000 par value Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-8 BOND PRICES: RELATIONSHIP BETWEEN COUPON AND YIELD • If YTM = coupon rate, then par value = bond price • If YTM > coupon rate, then par value > bond price ▪ Why? The discount provides yield above coupon rate ▪ Price below par value, called a discount bond • If YTM < coupon rate, then par value < bond price ▪ Why? Higher coupon rate causes value above par ▪ Price above par value, called a premium bond Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-9 THE BOND PRICING EQUATION 1  1  (1 + r) t Bond Value = C  r     FV + t  (1 + r)  Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-10 EXAMPLE 7.1 • If an ordinary bond has a coupon rate of 14 percent, then the owner will get a total of $140 per year, but this $140 will come in two payments of $70 each. The yield to maturity is quoted at 16 percent. The bond matures in seven years. • Note: Bond yields are quoted like APRs; the quoted rate is equal to the actual rate per period multiplied by the number of periods. Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. EXAMPLE 7.1 ▪ How many coupon payments are there? ▪ What is the semiannual coupon payment? ▪ What is the semiannual yield? ▪ What is the bond price? ▪ B = 70[1 – 1/(1.08)14] / .08 + 1,000 / (1.08)14 = 917.56 ▪ Or PMT = 70; N = 14; I/Y = 8; FV = 1,000; CPT PV = -917.56 Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-12 INTEREST RATE RISK • Price Risk ▪ Change in price due to changes in interest rates ▪ Long-term bonds have more price risk than shortterm 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 Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-13 FIGURE 7.2 Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-14 COMPUTING YIELD TO MATURITY • Yield to Maturity (YTM) 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 is similar to the process for finding r with an annuity • If you have a financial calculator, enter N, PV, PMT, and FV, remembering the sign convention (PMT and FV need to have the same sign, PV the opposite sign) Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-15 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%? ▪ N = 15; PV = -928.09; FV = 1,000; PMT = 100; CPT I/Y = 11% Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-16 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%? ▪ What is the semiannual coupon payment? ▪ How many periods are there? ▪ N = 40; PV = -1,197.93; PMT = 50; FV = 1,000; CPT I/Y = 4% (Is this the YTM?) ▪ YTM = 4%* 2 = 8% Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-17 TABLE 7.1 Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-18 CURRENT YIELD VS. YIELD TO MATURITY • Current Yield = annual coupon / price • Yield to maturity = current yield + capital gains yield • Example: 10% coupon bond, with semiannual coupons, face value of 1,000, 20 years to maturity, $1,197.93 price ▪ Current yield = 100 / 1,197.93 = .0835 = 8.35% ▪ Price in one year, assuming no change in YTM = 1,193.68 ▪ Capital gain yield = (1,193.68 – 1,197.93) / 1,197.93 = -.0035 = -.35% ▪ YTM = 8.35 - .35 = 8%, which is the same YTM computed earlier Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-19 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 • This is a useful concept that can be transferred to valuing assets other than bonds Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-20 BOND PRICES WITH A SPREADSHEET • There is a specific formula for finding bond prices on a spreadsheet ▪ PRICE(Settlement,Maturity,Rate,Yld,Redemption, Frequency,Basis) ▪ YIELD(Settlement,Maturity,Rate,Pr,Redemption, Frequency,Basis) ▪ Settlement and maturity need to be actual dates ▪ The redemption and Pr need to be input as % of par value • Click on the Excel icon for an example Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-21 DIFFERENCES BETWEEN DEBT AND EQUITY • Debt ▪ Not an ownership interest ▪ Creditors do not have voting rights ▪ Interest is considered a cost of doing business and is tax deductible ▪ Creditors have legal recourse if interest or principal payments are missed ▪ Excess debt can lead to financial distress and bankruptcy • Equity ▪ Ownership interest ▪ Common stockholders vote for the board of directors and other issues ▪ Dividends are not considered a cost of doing business and are not tax deductible ▪ Dividends are not a liability of the firm, and stockholders have no legal recourse if dividends are not paid ▪ An all equity firm can not go bankrupt merely due to debt since it has no debt Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-22 THE BOND INDENTURE • Contract between the company and the bondholders that includes ▪ The basic terms of the bonds ▪ The total amount of bonds issued ▪ A description of property used as security, if applicable ▪ Sinking fund provisions ▪ Call provisions ▪ Details of protective covenants Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-23 BOND CLASSIFICATIONS • Registered vs. Bearer Forms • Security ▪ Collateral – secured by financial securities ▪ Mortgage – secured by real property, normally land or buildings ▪ Debentures – unsecured ▪ Notes – unsecured debt with original maturity less than 10 years • Seniority Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-24 BOND CHARACTERISTICS AND REQUIRED RETURNS • The coupon rate depends on the risk characteristics of the bond when issued • Which bonds will have the higher coupon, all else equal? ▪ ▪ ▪ ▪ Secured debt versus a debenture Subordinated debenture versus senior debt A bond with a sinking fund versus one without A callable bond versus a non-callable bond Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-25 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 Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-26 BOND RATINGS – SPECULATIVE GRADE • Low Grade ▪ Moody’s Ba and B ▪ S&P BB and B ▪ Considered possible that the capacity to pay will degenerate. • Very Low Grade ▪ Moody’s C (and below) and S&P C (and below) • income bonds with no interest being paid, or • in default with principal and interest in arrears Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-27 GOVERNMENT BONDS • Treasury Securities ▪ Federal government debt ▪ T-bills – pure discount bonds with original maturity of one year or less ▪ 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 Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-28 EXAMPLE 7.4 • A taxable bond has a yield of 8%, and a municipal bond has a yield of 6%. ▪ If you 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% Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-29 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 • Sometimes called zeroes, deep discount bonds, or original issue discount bonds (OIDs) • Treasury Bills and principal-only Treasury strips are good examples of zeroes Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-30 FLOATING-RATE BONDS • Coupon rate floats depending on some index value • Examples – adjustable rate mortgages and inflationlinked Treasuries • There is less price risk with floating rate bonds ▪ The coupon floats, so it is less likely to differ substantially from the yield-to-maturity • Coupons may have a “collar” – the rate cannot go above a specified “ceiling” or below a specified “floor” Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-31 OTHER BOND TYPES • Disaster bonds • Income bonds • Convertible bonds • Put bonds • There are many other types of provisions that can be added to a bond and many bonds have several provisions – it is important to recognize how these provisions affect required returns Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-32 SUKUK • Sukuk are bonds have been created to meet a demand for assets that comply with Shariah, or Islamic law • Shariah does not permit the charging or paying of interest • Sukuk are typically bought and held to maturity, and are extremely illiquid Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-33 BOND MARKETS • Primarily over-the-counter transactions with dealers connected electronically • Extremely large number of bond issues, but generally low daily volume in single issues • Makes getting up-to-date prices difficult, particularly on small company or municipal issues • Treasury securities are an exception Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-34 WORK THE WEB EXAMPLE • Bond quotes are available online • One good site is FINRA’s Market Data Center • Click on the web surfer to go to the site ▪ Choose a company, enter it in the Issuer Name bar, choose Corporate, and see what you can find! Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-35 TREASURY QUOTATIONS • Highlighted quote in Figure 7.4 Maturity yield 5/15/2030 Coupon 6.250 Bid 136.8359 Asked Chg Asked 136.9141 -0.7813 3.289 ▪ What is the coupon rate on the bond? ▪ When does the bond mature? ▪ What is the bid price? What does this mean? ▪ What is the ask price? What does this mean? ▪ How much did the price change from the previous day? ▪ What is the yield based on the ask price? Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-36 CLEAN VS. DIRTY PRICES • Clean price: quoted price • Dirty price: price actually paid = quoted price plus accrued interest • Example: Consider a T-bond with a 4% semiannual yield and a clean price of $1,282.50: ▪ ▪ ▪ ▪ Number of days since last coupon = 61 Number of days in the coupon period = 184 Accrued interest = (61/184)(.04*1000) = $13.26 Dirty price = $1,282.50 + $13.26 = $1,295.76 • So, you would actually pay $ 1,295.76 for the bond Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-37 INFLATION AND INTEREST RATES • Real rate of interest – change in purchasing power • Nominal rate of interest – quoted rate of interest, change in actual number of dollars • The ex ante nominal rate of interest includes our desired real rate of return plus an adjustment for expected inflation Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-38 THE FISHER EFFECT • The Fisher Effect defines the relationship between real rates, nominal rates, and inflation • (1 + R) = (1 + r)(1 + h), where ▪ R = nominal rate ▪ r = real rate ▪ h = expected inflation rate • Approximation ▪R=r+h Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-39 EXAMPLE 7.5 • If we require a 10% real return and we expect inflation to be 8%, what is the nominal rate? • R = (1.1)(1.08) – 1 = .188 = 18.8% • Approximation: R = 10% + 8% = 18% • Because the real return and expected inflation are relatively high, there is significant difference between the actual Fisher Effect and the approximation. Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-40 TERM STRUCTURE OF INTEREST RATES • Term structure is the relationship between time to maturity and yields, all else equal • It is important to recognize that we pull out the effect of default risk, different coupons, etc. • Yield curve – graphical representation of the term structure ▪ Normal – upward-sloping; long-term yields are higher than short-term yields ▪ Inverted – downward-sloping; long-term yields are lower than short-term yields Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-41 FIGURE 7.6 – UPWARD-SLOPING YIELD CURVE Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-42 FIGURE 7.6 – DOWNWARDSLOPING YIELD CURVE Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-43 FIGURE 7.7 Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-44 FACTORS AFFECTING BOND YIELDS • Real rate of interest • Expected future inflation premium • Interest rate risk premium • Default risk premium • Taxability premium • Liquidity premium Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-45 QUICK QUIZ • How do you find the value of a bond, and why do bond prices change? • What is a bond indenture, and what are some of the important features? • What are bond ratings, and why are they important? • How does inflation affect interest rates? • What is the term structure of interest rates? • What factors determine the required return on bonds? Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-46 ETHICS ISSUES • In 1996, allegations were made against Moody’s that it was issuing ratings on bonds it had not been hired to rate, in order to pressure issuers to pay for their service. • The government conducted an inquiry, but charges of antitrust violations were dropped. Even though no legal action was taken, does an ethical issue exist? Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-47 COMPREHENSIVE PROBLEM • What is the price of a $1,000 par value bond with a 6% coupon rate paid semiannually, if the bond is priced to yield 5% and it has 9 years to maturity? • What would be the price of the bond if the yield rose to 7%. • What is the current yield on the bond if the YTM is 7%? Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-48 CHAPTER 7 END OF CHAPTER Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 7-49
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Explanation & Answer

 
 
 
 
                      To : Chris 
 
                      From : Your Name 
 
                      Date : 3/8/2016 
 
 
                       Re : Describing the effect of each of the following bond features on 
the coupon rate of the bond. 
 
 
 
 
1.   ​The security of the bond; that is, whether or not the bond has collateral. 
 
 
The coupon rate will be lower when bond has collateral .Bondholders have an order on 
collateral .Because collateral provide savings to bondholders which can give them lower risk 
.The negative side of collateral is that company have not ability to sell that savings used as 
collateral and they have in general to leave the saving good active regulation.  
  
 
 
      2.     ​The seniority of the bond. 
 
 
 The coupon rate is lower when the bond is more senior .As senior bonds obtain entire pay in 
bankruptcy transfers subjec...


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