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Corporate Finance

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Corporate Finance ­FIN 622
VU
Lesson 05
BOND
Bond is a contract between an investor and the issuer ­ a company. It is a debt instrument that a company
uses to raise the capital and in return pay interest to the investors at per the terms of contract. Bonds are
redeemable ­ it means that after a period of time the company (issuer) returns the money to the investors
and liquidates its liability. The rate at which issuer pays interest to investors is known as coupon rate.
Features of Bond:
Coupon Interest: stated interest payments per period
Face value: also Par value or the principal amount
Coupon rate: interest payments stated in annualized term.
Duration or maturity date: The date on which company returns the principal amount back to investors.
Current yield: Annual coupon payments divided by bond price.
Discount Bond: A bond which is sold less than the face or par value is discount bond.
Premium Bond: A bond which is sold more than the face or par value is premium bond.
Interest Rate Risk & Bonds
The risk arising from fluctuating interest rate is known as interest rate risk.
Interest rate risk depends on how sensitive bond price is to interest rate change.
This sensitivity depends upon two things:
- Time to maturity
- Coupon rate
A small change in interest rate will have greater impact on the on YTM and bond value.
BOND VALUATION:
Bond valuation is the process of determining the fair price of a bond. As with any security, the fair value of
a bond is the present value of the stream of cash flows it is expected to generate. Hence, the price or value
of a bond is determined by discounting the bond's expected cash flows to the present using the appropriate
discount rate.
General relationships
Bond pricing
1) General relationships:
a) The present value relationship:
The fair price of a straight bond is determined by discounting the expected cash flows:
Cash flows:
The periodic coupon payments C, each of which is made once every period;
The par or face value F, which is payable at maturity of the bond after T periods.
Discount rate:
r is the market interest rate for new bond issues with similar risk ratings
Bond Price =
Because the price is the present value of the cash flows, there is an inverse relationship between price and
discount rate: the higher the discount rates the lower the value of the bond (and vice versa). A bond trading
below its face value is trading at a discount; a bond trading above its face value is at a premium.
b) Coupon yield:
The coupon yield is simply the coupon payment (C) as a percentage of the face value (F). Coupon yield is
also called nominal yield.
Coupon yield = C / F
c) Current yield:
The current yield is simply the coupon payment (C) as a percentage of the bond price (P).
Current yield = C / P0
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Corporate Finance ­FIN 622
VU
d) Yield to Maturity:
The yield to maturity (YTM), is the discount rate which returns the maket price of the bond. It is thus the
internal rate of return of an investment in the bond made at the observed price. YTM can also be used to
price a bond, where it is used as the required return on the bond.
Solve for YTM where
Market Price =
To achieve a return equal to YTM, the bond owner must invest each coupon received at this rate.
Points to remember:
For a bond selling above the face value is said to sell at premium. It means investor who buys it at a
premium face a capital loss over the life of bond. So return on bond will be less than the current yield.
For a bond selling below the face value is said to sell at discount. This means capital gain at maturity. The
return on this bond is greater than its current yield.
If interest rates do not change, the bond price changes with time so that total return on the bond is equal to
yield to maturity.
If YTM increases, the rate of return will be less than yield.
If the YTM decreases, the rate of return will be greater than yield.
2) Bond pricing:
a) Relative price approach:
Here the bond will be priced relative to a benchmark, usually a government security. The discount rate used
to value the bond is determined based on the bond's rating relative to a government security with similar
maturity. The better the quality of the bond, the smaller the spread between its required return and the
YTM of the benchmark. This required return is then used to discount the bond cash flows.
b) Arbitrage free pricing approach:
In this approach, the bond price will reflect its arbitrage free price. Here, each cash flow is priced separately
and is discounted at the same rate as the corresponding government issue Zero coupon bond. Since each
bond cash flow is known with certainty, the bond price today must be equal to the sum of each of its cash
flows discounted at the corresponding risk free rate - i.e. the corresponding government security.
Here the discount rate per cash flow, rt, must match that of the corresponding zero coupon bond's rate.
Bond Price =
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Table of Contents:
  1. INTRODUCTION TO SUBJECT
  2. COMPARISON OF FINANCIAL STATEMENTS
  3. TIME VALUE OF MONEY
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  6. TERM STRUCTURE OF INTEREST RATES
  7. COMMON STOCK VALUATION
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  10. METHODS OF PROJECT EVALUATIONS 2
  11. METHODS OF PROJECT EVALUATIONS 3
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  42. FOREIGN EXCHANGE MARKET’S OPTIONS
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk