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Callable Bonds. Callable bonds are bonds that are callable by the
company at a predetermined price for a specified period. That is,
the company has the right to require the bondholders to return
the bonds before the maturity date, with the company paying the
predetermined price and interest to date.
Characteristics of Bonds
Convertible Bonds. Convertible bonds are bonds that are
convertible into a predetermined number of shares. That is, the
owner of each bond has the right to exchange it for a
predetermined number of shares of the company. Thus, upon
conversion, the bondholder becomes a stockholder of the
company.
Serial Bonds. Serial bonds are bonds issued at one time, but
portions of the total face value mature in periodic installments at
different future dates. Bonds with several maturities.
Term Bonds. Term bonds are bonds that pay the entire principal
on one date, i.e. at the maturity date. Bonds with single maturity.
Income (Revenue) Bonds. These are bonds whose payment of interest
is conditional on income.
Other classifications include:
Treasury bonds
Corporate bonds
Municipal bonds
Foreign bonds
1). Coupon Bonds
These give a fixed interest payment each period as
well as paying the face value at maturity.
We are interested in determining the price that a
bond would sell for in the bond market.
If an investor was going to buy a bond, he would not
pay more for it than the present value of the cash
flows it provided to him.
Similarly, if an investor was going to sell a bond, he
would not sell it for less than the present value of the
cash flows.
Thus, the present value of the bond’s cash flows
must be the price of the bond in the market.
Example
The bonds of the Nordy Company have a coupon
interest rate of 9%. The interest on the bonds is paid
semiannually, the bonds mature in 8 years, and their
par value is $1,000. If the required rate of return is
8%, what is the value of each bond? What is the
value of each bond if the interest is paid annually?
2) Zero-Coupon Bonds (or Strip Bonds)
Bonds of this type make no interest payments; they
simply pay the face value at maturity. The holder of
this type of bond still earns interest because zero-
coupon bonds always sell at a discount to face
value.
Example :
A government Treasury bill is a zero-coupon bond. If
the term to maturity is one year and the government
wants to issue them at 8%, what is the price of a birr
1,000,000 Treasury bill?
Bond issues
When a bond sells at a price below its face value, it
is said to sell at a discount; selling at a price above
face value is selling at a premium; selling at face
value is selling at par.
Coupon rate interest rate in the market bonds
sell at a discount
Coupon rate interest rate in the market bonds
sell at premium
Coupon rate interest rate in the market bonds
sell at a par
In general, if the market rate of interest raises then
the price of a bond falls and vice versa.
Yield to Maturity (YTM)
YTM is the measure of a bond’s rate of return that
considers both the interest income and any capital
gain or loss. It is a bond’s internal rate of return.
Example:
Suppose that the market price of a bond is $883.40
(with a face value of $1,000). The bond will pay
interest at 6% per annum for 5 years, after which it
will be redeemed at par. What is the bond’s rate of
return?
Yield to Call (YTC)
A number of companies issue bonds with buy back
or call provision. Thus, a bond can be redeemed or
called before maturity.
Example:
Suppose the 10% 10 year $1,000 bond is
redeemable (callable) in 5 years at a call price of
$1,050. The bond is currently selling for $950. What
is bond’s YTC. The bond’s YTC is
Current Yield CY
It is the annual interest (coupon) payment on a bond
divided by the bond’s current market price.
Example:
The annual interest is $60 on the current investment
of $883.4. What is the current yield?
Common Stock
Common stock represents a part ownership of a firm
and entitles the holder to receive part of any profits that
are paid out to the owners in the form of dividends.
A common stock’s value is equal to the present value
of all future cash flows expected to be received by the
stockholder.
However, in contrast to bonds, common stock does not
promise its owners interest income or a maturity
payment at some specified time in the future.
When buying a stock, one cares about two things:
1. the dividends that one gets while the stock is held
2. the price for which the stock can be sold (capital
gains)
Expected Dividends as a Basis for Valuation