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Financial Management ­ MGT201
VU
Lesson 13
BONDS AND CLASSIFICATION OF BONDS
Learning Objectives:
After going through this lecture, you would be able to have an understanding of the following topic
·  Bonds
·  Classifications of bonds
Up to lecture no 12, we have discussed the investment decisions and capital budgeting as it relates
to real assets and properties.
Now, we discuss about the securities.
Difference between Real Assets & Securities
Real assets are physical property such as Land, Machinery, equipments and Building etc. Where
as securities basically, are legal contractual piece of paper.
Kinds of securities:
We have discussed about two types of securities.
Direct claim securities:
Stocks (Shares):
It is defined as equity paper representing ownership, shareholding. Appears on Liabilities side
of Balance Sheet
Bonds:
It is a debt paper representing loan or borrowing. These are long term debt instruments.
Classification of bonds on Balance sheet:
One should be very careful regarding the classifications of bonds on the balance sheet. Because,
when you are Issuing Bonds (i.e. borrowing money) then the Value of Bonds appears under Liabilities
side (as Long Term Debt) of Balance Sheet. If you are Investing (or buying) Bonds of other companies
then their Value appears under Assets side (as Marketable Securities) of Balance Sheet.
The Important thing to remember is that the stocks represent the ownership and bonds represent the debt.
Both are the direct claim securities.
When a company or investor rising funds he have two possible options available to him.
1) Equity
2) Debt
One form of the debt is bonds. Value of Direct Claim Security is directly will be determined by
the value of the underlying Real Asset. This concept explained with the help of the following example:
Textile Weaving Factory Case Study:
A Textile Weaving Factory uses thread to make cotton fabric and then sells cotton fabric to earn
cash receipts. It needs Rs.1 million to make a Capital Investment in looms and machinery. It has two
options he can raise money through
1. Equity, OR
2. Debt
Lets suppose that company decide to take Rs. 1 million in the form of debt It can raise money for a
period of 1 year by Debt Financing by Issuing a 1 year Mortgage Bond whereby it pays the Lender (i.e.
Investor or Bondholder) 15% p.a Coupon Interest Rate. You decided to divide 1 million in to 1 thousand
parts and each one of these parts in the form of paper that has a face or par value of Rs 1,000.Each Bond
paper worth Rs 1,000 and the total number of bonds is 1,000.Each bond paper carries the face value
which is printed on it and also carries coupon interest rate. Suppose that coupon interest rate on this
bond is 15% it means that this company would pay 15% of the face value to the lender. It is income for
the lender (Bond holder). The Bond also has the limited life. In this case we suppose that management
need money for the period of two years. The company pays the coupon rate to the bond holder for two
years and also returns the principle to the lender after two years at maturity date.
The Lender's (or Bond Holder's or Investor's) money is protected because the Mortgage Bond is
Backed (or Secured) by Real Property such as the land, factory building, and machinery.  Upon
Maturity, after 1 year, the Bond Issuer will return the Par or Face Value (or Principal Amount of Rs 1
million) to the Lender.
Now, we discuss different concepts which are common in different bonds. There are certain
advantages and disadvantages of raising money either through equity or through bonds.
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Financial Management ­ MGT201
VU
Why to raise money through a Debt (ie. Bond) rather than through Equity (i.e. Shares or Stocks)?
If the Company raises money using Bonds, then it will have to pay a fixed amount of interest
(or mark-up) regularly for a limited amount of time. You do not share the profits of the company. But
there as legal risk attached to the failure to pay interest can force company to close down.
If the Company raises money using Equity, then it is forced to bring in new shareholders who
can interfere in the management and will get a share of the net profits (or dividends) for as long as the
company is in operation! The amount of dividends can vary.
Value of the Bond:
The Value of the Bond can be calculated from the Cash Flows attached to the Bond. Bonds are
direct claim securities. The bond holder will receive the coupon interest rate and he will also receive his
principle amount at the time of maturity. Where are these cash flows come from? How the company is
able to pay interest to the bond holder. The company is making cash from operations. Those Cash Flows
depend on the Cash Flows from the Real Business i.e. the textile factory's cash flows from sale of fabric.
Bond value is coming from the fabric sale. This is why the Bond is called a Direct Claim Security
whose value depends on the value of some underlying real asset.
Characteristics of bonds:
In Pakistan, the bonds take on the form of Term Finance Certificates (TFC's).These are traded
on three stock exchanges of Pakistan. It is quite common to trade bonds in the stock markets. In
Pakistan, the Par Value (or Face Value) of each TFC is generally Rs 1,000 but it can be different. The
Life of a Bond is generally limited (or finite) i.e. 6 months, 1 year, 3 years, 5 years..... The bonds can be
issued by any one (Public, Private) who is in need of money. Even individuals can issue bonds. For
example, Defense saving certificates, Treasury bills, T Bills (short term bonds) & FIB (Long term
bonds) are also classifieds as the bonds
Face value is the amount which is mentioned on the bond paper. Par value is fixed but the bonds are
traded in the markets. As the financial health (cash flows and income) of the company changes with
time, the Market Value (or Price) of the Bond changes (even though it's Par Value is fixed). Market
Prices also change depending on the Supply-Demand for the Bond (or TFC) and Investors' Perception.
Major reason is the change in interest rate effect the bond price we will discuss it in detail in upcoming
lectures. In case of Textile Company this company issued a bond at the fixed coupon interest rate is
15 % of par value. This rate is fixed and should be paid by the company. Non payment of this would
defult and result in the closing of the company.
However, the market interest rate keeps moving and it changes on daily basis. We have discussed the
factors that caused the changes in interest rate in the previous lectures.
Bonds: Definition
Bond is a type of Direct Claim Security (a legal contractual paper) whose value is secured by Real
Assets owned by the Issuer. Bond is issued by the Issuer (or Borrower) to the Bondholder (or Lender or
Investor or Financier) in exchange for the cash. Borrowers and lenders can be individual persons or
companies or governments.
Examples: Term Finance Certificate (TFC issued by Public Listed Industrial Companies), Defense
Saving Certificate (DSC issued by Government), T-Bill (issued by Government)Bond is a Legal
Contractual Paper Certificate that represents Long Term Debt (or Long-term Promissory Note).Bond
paper contains legal & numerical points
Bonds: Numerical Features
·  Maturity or Tenure or Life: Measured in years. On the Maturity Date when the bond expires,
the Issuer returns all the money (Principal/par and Interest/coupon) to the Investor (thereby
terminating or Redeeming the bond) ie. 6 months, 1 year, 3 years, 5 years, 10 years, ...
·  Par Value or Face Value: Principal Amount (generally printed on the bond paper) returned at
maturity ie. Rs 1,000 or Rs. 10,000. Contrast this to Market Value (or Actual Price based on
Supply/Demand) and Intrinsic or Fair Value (estimated using Bond Pricing or Present Value
Formula)
·  Coupon Interest Rate: percentage of Par Value paid out as interest irrespective of changes in
Market Value  ie. 5 % pa, 10 % pa, 15% pa, ... etc. Coupon Receipt = Coupon Rate x Par
Value.  Coupon Receipts can be paid out monthly, quarterly, six-monthly, annually...etc.
Contrast to Market Interest Rate (macro-economic).
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Financial Management ­ MGT201
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Bonds: Characteristics & Legal Points
Indenture":  Long Legal Agreement between the Issuer (or Borrower) and the Bond Trustee
(generally a bank of financial institution that acts as the representative for all Bondholders).
Basically protects Bondholders from mis-management by the bond issuer, default, other security
holders, etc.
Claims on Assets & Income:
Bondholders have the First Claim on Assets in case the company closes down (Before
Shareholders). The Financial Charges due to Bond Holders must be paid out from the Income before
any Net Income can be distributed to Stockholders in the form of Dividends (see P/L Statement). If
Issuer (or Borrower) does not pay the interest to the Bondholder (i.e. Default), then the firm can be
legally declared Insolvent, Bankrupt, and forced to close down.
Security:
Mortgage Bonds are backed by real property (ie. Land, building,, machinery, inventory) whose
value is generally higher than that of the value of the bonds issued. Debentures and Subordinated Bonds
are not secured by real property but they are backed by personal and corporate guarantees and their
security and value is tied to the anticipated future cash in-flows of the business.
Call Provision:
The right (or option) of the Issuer to call back (redeem) or retire the bond by paying-off the
Bondholders before the Maturity Date. When market interest rates drop, Issuers (or Borrowers) often
call back the old bonds and issue new ones at lower interest rates.
Bond Ratings & Risk
Bonds are rated by various Rating Agencies:
Internationally: Moody's, S&P.
In Pakistan: Pacra, VIS.
Based on future Risk Potential of the company that is the Issuer of the bond.
Bond risk increases with:
Operating losses (check Cash Flow Statement and P/L)
Excessive borrowings or debt (check Balance Sheet)
Large variations in income
Small size of business
Country and foreign exchange rate risk
International Bond Rating Scale (starting from the best or least risky): AAA, AA, A, BBB, BB, B, CCC,
CC, C, D. Also + is better and - is worse. So A+ is better than A. A- is worse than A.
Types of Bonds:
Mortgage Bonds: backed & secured by real assets
Subordinated Debt and General Credit: lower rank and claim than Mortgage Bonds.
Debentures:
These are not secured by real property, risky
Floating Rate Bond:
It is defined as a type of bond bearing a yield that may rise and fall within a specified range
according to fluctuations in the market. The bond has been used in the housing bond market
Eurobonds: it issued from a foreign country
Zero Bonds & Low Coupon Bonds: no regular interest payments (+ for lender), not callable (+ for
investor)
Junk Bonds & High Yield Bonds: Corporations that are small in size, or lack an established operating
track record are also likely to be considered speculative grade.  Junk bonds are most commonly
associated with corporate issuers. They are high-risk debt with rating below BB by S&P
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Financial Management ­ MGT201
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Convertible Bonds:
A convertible bond is a bond which can be converted into the company's common stock. You
can exercise the convertible bond and exchange the bond into a predetermined amount of shares in the
company. The conversion ratio can vary from bond to bond. You can find the terms of the convertible,
such as the exact number of shares or the method of determining how many shares the bond is converted
into, in the indenture. For example a conversion ratio of 40:1 means that for every bond (with Rs.1,000
par value) you hold you can exchange for 40 shares of stock. Occasionally, the indenture might have a
provision that states the conversion ratio will change through the years, but this is rare. Convertibles
typically offer a lower yield than a regular bond because there is the option to convert the shares into
stock and collect the capital gain. But, should the company go bankrupt, convertibles are ranked the
same as regular bonds so you have a better chance of getting some of your money back
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Table of Contents:
  1. INTRODUCTION TO FINANCIAL MANAGEMENT:Corporate Financing & Capital Structure,
  2. OBJECTIVES OF FINANCIAL MANAGEMENT, FINANCIAL ASSETS AND FINANCIAL MARKETS:Real Assets, Bond
  3. ANALYSIS OF FINANCIAL STATEMENTS:Basic Financial Statements, Profit & Loss account or Income Statement
  4. TIME VALUE OF MONEY:Discounting & Net Present Value (NPV), Interest Theory
  5. FINANCIAL FORECASTING AND FINANCIAL PLANNING:Planning Documents, Drawback of Percent of Sales Method
  6. PRESENT VALUE AND DISCOUNTING:Interest Rates for Discounting Calculations
  7. DISCOUNTING CASH FLOW ANALYSIS, ANNUITIES AND PERPETUITIES:Multiple Compounding
  8. CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES:Techniques of capital budgeting, Pay back period
  9. NET PRESENT VALUE (NPV) AND INTERNAL RATE OF RETURN (IRR):RANKING TWO DIFFERENT INVESTMENTS
  10. PROJECT CASH FLOWS, PROJECT TIMING, COMPARING PROJECTS, AND MODIFIED INTERNAL RATE OF RETURN (MIRR)
  11. SOME SPECIAL AREAS OF CAPITAL BUDGETING:SOME SPECIAL AREAS OF CAPITAL BUDGETING, SOME SPECIAL AREAS OF CAPITAL BUDGETING
  12. CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL.:Types of Problems in Capital Rationing
  13. BONDS AND CLASSIFICATION OF BONDS:Textile Weaving Factory Case Study, Characteristics of bonds, Convertible Bonds
  14. BONDS’ VALUATION:Long Bond - Risk Theory, Bond Portfolio Theory, Interest Rate Tradeoff
  15. BONDS VALUATION AND YIELD ON BONDS:Present Value formula for the bond
  16. INTRODUCTION TO STOCKS AND STOCK VALUATION:Share Concept, Finite Investment
  17. COMMON STOCK PRICING AND DIVIDEND GROWTH MODELS:Preferred Stock, Perpetual Investment
  18. COMMON STOCKS – RATE OF RETURN AND EPS PRICING MODEL:Earnings per Share (EPS) Pricing Model
  19. INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT:Diversifiable Risk, Diversification
  20. RISK FOR A SINGLE STOCK INVESTMENT, PROBABILITY GRAPHS AND COEFFICIENT OF VARIATION
  21. 2- STOCK PORTFOLIO THEORY, RISK AND EXPECTED RETURN:Diversification, Definition of Terms
  22. PORTFOLIO RISK ANALYSIS AND EFFICIENT PORTFOLIO MAPS
  23. EFFICIENT PORTFOLIOS, MARKET RISK AND CAPITAL MARKET LINE (CML):Market Risk & Portfolio Theory
  24. STOCK BETA, PORTFOLIO BETA AND INTRODUCTION TO SECURITY MARKET LINE:MARKET, Calculating Portfolio Beta
  25. STOCK BETAS &RISK, SML& RETURN AND STOCK PRICES IN EFFICIENT MARKS:Interpretation of Result
  26. SML GRAPH AND CAPITAL ASSET PRICING MODEL:NPV Calculations & Capital Budgeting
  27. RISK AND PORTFOLIO THEORY, CAPM, CRITICISM OF CAPM AND APPLICATION OF RISK THEORY:Think Out of the Box
  28. INTRODUCTION TO DEBT, EFFICIENT MARKETS AND COST OF CAPITAL:Real Assets Markets, Debt vs. Equity
  29. WEIGHTED AVERAGE COST OF CAPITAL (WACC):Summary of Formulas
  30. BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT& RETURN ON EQUITY
  31. OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND BUSINESS RISK
  32. FINANCIAL LEVERAGE AND CAPITAL STRUCTURE:Capital Structure Theory
  33. MODIFICATIONS IN MILLAR MODIGLIANI CAPITAL STRUCTURE THEORY:Modified MM - With Bankruptcy Cost
  34. APPLICATION OF MILLER MODIGLIANI AND OTHER CAPITAL STRUCTURE THEORIES:Problem of the theory
  35. NET INCOME AND TAX SHIELD APPROACHES TO WACC:Traditionalists -Real Markets Example
  36. MANAGEMENT OF CAPITAL STRUCTURE:Practical Capital Structure Management
  37. DIVIDEND PAYOUT:Other Factors Affecting Dividend Policy, Residual Dividend Model
  38. APPLICATION OF RESIDUAL DIVIDEND MODEL:Dividend Payout Procedure, Dividend Schemes for Optimizing Share Price
  39. WORKING CAPITAL MANAGEMENT:Impact of working capital on Firm Value, Monthly Cash Budget
  40. CASH MANAGEMENT AND WORKING CAPITAL FINANCING:Inventory Management, Accounts Receivables Management:
  41. SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING:
  42. LEASE FINANCING AND TYPES OF LEASE FINANCING:Sale & Lease-Back, Lease Analyses & Calculations
  43. MERGERS AND ACQUISITIONS:Leveraged Buy-Outs (LBO’s), Mergers - Good or Bad?
  44. INTERNATIONAL FINANCE (MULTINATIONAL FINANCE):Major Issues Faced by Multinationals
  45. FINAL REVIEW OF ENTIRE COURSE ON FINANCIAL MANAGEMENT:Financial Statements and Ratios