Chapter 09

Bonds & Valuation

Determinants of Intrinsic Value: The Cost of

Debt
Net operating
profit after taxes

Required investments
in operating capital

Free cash flow

=
(FCF)

Value =

FCF1
(1 + WACC)1

FCF2
+
(1 + WACC)2

... + FCF
+
(1 +
WACC)

Weighted average
cost of capital
(WACC)
Market interest rates
Market risk aversion

Cost
Costof
ofdebt
debt
Cost of equity
Cost of equity

Firms debt/equity mix

Firms business risk
2

What is a bond?
A

long-term debt instrument in which a

borrower agrees to make payments of
principal and interest, on specific dates,
to the holders of the bond.

Bond markets
Traded in exchanges and private markets.
Most bonds are owned by and traded among
large financial institutions.

Key Features of a Bond

Par value face amount of the bond, which

is paid at maturity (assume $1,000).
Coupon interest rate stated interest rate (generally
fixed) paid by the issuer. Multiply by par to get dollar
payment of interest.
Maturity date years until the bond must be repaid.
Issue date when the bond was issued.
Yield to maturity (YTM)- rate of return earned on
a bond held until maturity (also called the promised
yield).
Yield to call (YTC) - rate of return earned on a bond
held until the call date.

Effect of a call provision

Allows

issuer to refund the bond issue if

rates decline (helps the issuer, but hurts
the investor).
Borrowers are willing to pay more, and
lenders require more, for callable bonds.

What is a sinking fund?

Provision

to pay off a loan over its life

rather than all at maturity.
Similar to amortization on a term loan.
Reduces risk to investor, shortens
average maturity.

Other types (features) of

bonds

Convertible bond may be exchanged for

common stock of the firm, at the holders
option.
Bond issued with Warrant long-term option to
buy a stated number of shares of common
stock at a specified price.
Putable bond allows holder to sell the bond
back to the company prior to maturity.

What is the opportunity cost of

debt capital?
The

discount rate (ri ) is the opportunity

cost of capital, and is the rate that could
be earned on alternative investments of
equal risk.
ri = r* + IP + MRP + DRP + LP

The value of financial assets

0

r
Value

...
CF1

CF2

CFn

CF1
CF2
CFn
Value

...
1
2
n
(1 r) (1 r)
(1 r)

What is the value of a 10-year, 10%

annual coupon bond, if rd = 10%?
0

r
VB = ?

...
100

100

100 + 1,000

$100
$100
$1,000
VB
...

1
10
(1.10)
(1.10)
(1.10)10
VB $90.91 ... $38.55 $385.54
VB $1,000

The price path of a bond

VB

What would happen to the value of this bond if

its required rate of return remained at 10%, or
at 13%, or at 7% until maturity?

1,372
1,211

rd = 7%.
rd = 10%.

1,000
837
775

rd = 13%.
30

25

20

15

10

Years
to Maturity

Bond values over time

At maturity, the value of any bond must
equal its par value.
If rd remains constant:

The value of a premium bond would

decrease over time, until it reached $1,000.
The value of a discount bond would increase
over time, until it reached $1,000.
A value of a par bond stays at $1,000.

What is the YTM on a 10-year, 9%

annual coupon, $1,000 par value
bond, selling for $887?

Must find the rd that solves this model.

INT
INT
M
VB
...

1
N
(1 rd )
(1 rd )
(1 rd ) N
90
90
1,000
$887
...

1
10
(1 rd )
(1 rd )
(1 rd )10
rd = 10.91%

What is the YTC on a 9-year, 10% annual

coupon, $1,000 par value, $1,100 call price
bond, selling for $1,495?
INT
INT
M
VB
...

1
N
(1 ytc )
(1 ytc)
(1 ytc ) N
90
90
1,100
$1,495
...

1
10
(1 ytc)
(1 ytc)
(1 ytc )10

ytc = 4.21%

Definitions
Annual coupon payment
Current yi
eld(CY)
Currentprice
Changein price
Capitalgainsyield(CGY)
Beginningprice
Expected
Expected

Expectedtotalreturn YTM
CY CGY

An example:
Current and capital gains yield
Find

the current yield and the capital gains

yield for a 10-year, 9% annual coupon
bond that sells for $887, and has a face
value of $1,000.
Current yield

= $90 / $887
= 0.1015 = 10.15%

Calculating capital gains yield

YTM = Current yield + Capital gains yield
CGY = YTM CY
= 10.91% - 10.15%
= 0.76%
Could also find the expected price one year from
now and divide the change in price by the beginning
price, which gives the same answer.

What is interest rate (or price)

risk?

Interest rate risk is the concern that rising rd will

cause the value of a bond to fall.

% change 1 yr
rd
10yr
% change
+4.8% $1,048
5%
$1,386
+38.6%
$1,000 10%
$1,000
-4.4%
$956 15%
$749
-25.1%

The 10-year bond is more sensitive to interest

rate changes, and hence has more interest rate
risk.

What is reinvestment rate

risk?

Reinvestment rate risk is the concern that rd

will fall, and future CFs will have to be
reinvested at lower rates, hence reducing
income.
EXAMPLE: Suppose you just won
$500,000 playing the lottery. You
intend to invest the money and
live off the interest.

Reinvestment rate risk

example

You may invest in either a 10-year bond or a

series of ten 1-year bonds. Both 10-year and 1year bonds currently yield 10%.
If you choose the 1-year bond strategy:
After Year 1, you receive $50,000 in income
and have $500,000 to reinvest. But, if 1-year
rates fall to 3%, your annual income would fall
to $15,000.
If you choose the 10-year bond strategy:
You can lock in a 10% interest rate, and
$50,000 annual income.

Conclusions about interest rate

and reinvestment rate risk
Short-term bonds Long-term bonds
Interest
rate risk

Low

High

Reinvestme
nt rate risk

High

Low

CONCLUSION:

Nothing is riskless!

10-year, 10% annual coupon

bond vs. a 10-year, 10%
semiannual coupon bond?
The semiannual bonds effective rate is:

iNom
EFF% 1

0.10
1 1
1 10.25%
2

10.25% > 10% (the annual bonds effective

rate), so you would prefer the semiannual
bond.

Default risk
If

an issuer defaults, investors receive

less than the promised return.
Therefore, the expected return on bonds
is less than the promised return.
Influenced by the issuers financial
strength and the terms of the bond
contract.

Bond Spreads, the DRP, and

the LP

A bond spread is often calculated as the

difference between a corporate bonds yield and
a Treasury securitys yield of the same maturity.
Therefore:

Spread = DRP + LP.

Bonds of large, strong companies often have

very small LPs. Bonds of small companies
often have LPs as high as 2%.

25

Evaluating default risk:

Bond ratings
Investment Grade

Junk Bonds

Moody
s

Aaa Aa A Baa

Ba B Caa C

S&P

AAA AA A BBB

BB B CCC
D

Bond

ratings are designed to reflect the

probability of a bond issue going into
default.

Bond Ratings

% defaulting within:

S&P and
Moody
1 yr.
Fitch
s
Investment grade bonds:
AAA
Aaa
0.0
AA
Aa
0.0
A
A
0.1
BBB
Baa
0.3
Junk bonds:
BB
Ba
1.4
B
B
1.8
CCC
Caa
22.3
Source: Fitch Ratings

5 yrs.

0.0
0.1
0.6
2.9
8.2
9.2
36.9

27

Bond Ratings and Bond

Spreads (YahooFinance, March 2009)
Long-term Bonds
10-Year T-bond
AAA
AA
A
BBB
BB
B
CCC

Yield (%)

Spread (%)

2.68
5.50
5.62
5.79
7.53
11.62
13.70
26.30

2.82
2.94
3.11
4.85
8.94
11.02
23.62

28

Factors affecting default risk and

bond ratings
Financial

Debt ratio
Coverage ratios
Profitability ratios
Current ratios

Bond

performance

contract provisions

Secured versus unsecured debt

Senior versus subordinated debt
Guarantee provisions
Sinking fund provisions
Debt maturity

Bond Ratings Median Ratios

(S&P)

AAA
AA
A
BBB
BB
B

Interest
coverag
e

Return on
capital

Debt to
capital

23.8
19.5
8.0
4.7
2.5
1.2

27.6%
27.0%
17.5%
13.4%
11.3%
8.7%

12.4%
28.3%
37.5%
42.5%
53.7%
75.9%

30

The Maturity Risk Premium

Long-term bonds: High interest rate risk, low
reinvestment rate risk.
Short-term bonds: Low interest rate risk, high
reinvestment rate risk.
Nothing is riskless!
Yields on longer term bonds usually are greater
than on shorter term bonds, so the MRP is more
affected by interest rate risk than by
reinvestment rate risk.

31

Bankruptcy
Bankruptcy

alternatives::

Reorganization
Liquidation

Typically,

a company wants Reorganization,

while creditors may prefer Liquidation.

Priority of claims in liquidation

Secured creditors from sales of secured assets.

Trustees costs
Expenses incurred after bankruptcy filing
Wages and unpaid benefit contributions, subject
to limits
Unsecured customer deposits, subject to limits
Taxes
Unfunded pension liabilities
Unsecured creditors
Preferred stock
Common stock

Reorganization
In

a liquidation, unsecured creditors

generally get zero. This makes them more
willing to participate in reorganization even
though their claims are greatly scaled back.
Various groups of creditors vote on the
reorganization plan. If both the majority of
the creditors and the judge approve,
company emerges from bankruptcy with
lower debts, reduced interest charges, and
a chance for success.