FIN 3701- Chapter3 : Valuation and Interest rate

“This is time to unlock your true power” Assumption University of Thailand Hillary Clinton

Debt Valuation and Chapter 3 FIN3701 Interest rate Corporate Debt Valuation Finance and Interest rate

Dr. Chainarin Srinutchasart

Source: http://www.prachachat.net/ 1 2

In this chapter, you will learn Principles Applied in This Chapter • The features of bonds • Principle 1: Money Has a Time Value. • Types of . • How to calculate intrinsic value of bonds. • Principle 2: There is a Risk-Return • Yield to , Yield to Call, Realized Tradeoff. Yield and . • The risks of bond investing and issuing. • Principle 3: Cash Flows Are the Source of Value

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Corporate Finance addresses the How to grow up a firm following 3 questions: Net DIV payout Income or 1. What long-term investments should the firm Share Repurchase engage in? Use retained earnings 2. How can the firm raise money for the Make tender offers Or Open market Or pay off some debt required investments? (Alternatives: Bonds, or doing nothing Stocks, Preferred Stocks=what is the Growth = increase the size of assets appropriate price?) Internal Growth vs. 3. How much short-term cash flow does a External growth company need to pay its bills? and how to Borrow money from banks (private debt), raise it Issue Bond(public debt), Issue Common/Preferred Stocks

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1 FIN 3701- Chapter3 :Debt Valuation and Interest rate

Corporate Borrowings Corporate Borrowings (cont.) • There are two main sources of borrowing • Smaller firms choose to raise money from for a corporation (External Growth): banks in the form of loans because of the high costs associated with issuing bonds (smaller firm higher risk). • Loan from a financial institution such as banks (known as private debt) • Larger firms generally raise money from banks for short-term needs and depend • Bonds (known as public debt since on the for long-term they can be traded in public financial markets> bond markets) financing needs.

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Borrowing Money in the Private Borrowing Money in the Private Financial Market Financial Market (Cont.)

• Financial Institutions are an important • In the private financial market, loans are source of capital for corporations. The typically floating rate loans i.e. the loan might be used to finance firm’s day- interest rate is periodically adjusted based to-day operations or it might be used for on a specific benchmark rate. the purchase of equipment or property. • Such loans are considered private • The most popular benchmark rate is the market transactions since it only London Interbank Offered Rate involves the two parties to the loan. (LIBOR)

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Borrowing Money in the Private Checkpoint Financial Market (Cont.) STEP 1: Picture the problem We can envision the problem solution by looking at a graph of the ceiling rate, the floor rate, and LIBOR plus the spread • A typical floating rate loan will specify the of 25 basis points. The rate of interest on the floating rate following: loan is based on LIBOR plus the spread but can never exceed the ceiling rate of 2.5%, nor can it ever drop below the floor • The spread or margin between the loan rate of 1.75%. rate and the benchmark rate expressed as basis points. • A maximum and a minimum annual rate, to which the rate can adjust, called the ceiling and floor. • A maturity date • Collateral

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2 FIN 3701- Chapter3 :Debt Valuation and Interest rate

The Balance-Sheet Model of the Firm The Capital Structure Decision (Ch. 12, 15, 18) (Financing Decision)

Current Liabilities Current Assets How can the Features of bonds This firm raise Long-Term Debt ch. the money Fixed Assets for the required 1 Tangible investments? Shareholders’ 2 Intangible Equity

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What is a bond? Characteristics of Bonds • A long-term contract under which a borrower • Bonds pay fixed (interest) (issuer) agrees to make payments of interest payments at fixed intervals (usually every and principal, on specific dates, to the holders six months) and pay the at of the bond (investors) maturity

$I $I $I $I $I $I+$M

0 1 2 . . . n

Source: http://pds.exblog.jp/ 15 16

What is a bond? (cont.) The major constituents of a bond consists of: • The issuer is obligated to pay the lenders/investors periodic coupon payments 1. Issuer – the issuing organization can be until the stated maturity. Thus, bond investor either a government-related body or a has the claim of the future cash flows from private entity. Issuer is the one who needs holding the bond. the additional capital, and thus is the • The information regarding the periodic borrower of the proceeds. Issuer is interest rates, frequency of the coupon obligated to pay the future cash flows in payments, term to maturity, par term of interest payments and repay the value of the bond, redemption value of the principal at the maturity of the issue. bond and any other provisions are all stated in the prospectus when a bond is issued. a.k.a. indenture 17 18

3 FIN 3701- Chapter3 :Debt Valuation and Interest rate

The major constituents of a bond The major constituents of a bond consists of: (Cont.) consists of: (Cont.)

2. Type of bond – the specification of each 3. Term to maturity – the total amount of time bond is clearly identified in its prospectus between when a bond is issued and when when the bond is issued. There are many the same bond matures. varieties of bond that can be customized to the specific needs of the issuer. Some of the 4. Issue Date – the official issue date of the examples of bond that can be issued are bond. It is also the date in which the coupon straight bond, zero-coupon bond, step- interest starts to accumulate. up coupon bond, amortizing bond, , bond issued with warrant, etc.

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The major constituents of a bond The major constituents of a bond consists of: (Cont.) consists of: (Cont.)

5. Maturity Date – the date on which a debt 6. Par Value – par value is the promised becomes due for a completion of its interest amount repaid to investors by the issuer at payment and repayment of the principal. It maturity. Par value is sometimes referred to is simply the date in which the borrower as face value or redemption value of the must pay back the money they have bond. Bonds issued in Thailand generally borrowed through the issue of a bond. have a par value of 1,000 Baht.

Investors don’t need to buy at PAR value

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The major constituents of a bond The major constituents of a bond consists of: (Cont.) consists of: (Cont.)

7. Coupon Rate – the periodic interest 8. Payment Frequency – is the number of the payment on a bond is called “coupon”. It is coupon or interest payments, often on an the committed cash flow the issuer pays to annual basis. For example, a bond that is an investor. The coupon rate is then the quoted to have a frequency of 4 means the stated percentage rate of interest in which bond will pay interest payment on a the coupon payments will be determined. quarterly basis. (% of Par value)

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4 FIN 3701- Chapter3 :Debt Valuation and Interest rate

The major constituents of a bond AAA consists of: (Cont.) Highest rating. Issuer’s capacity to repay interest and principal is excellent. 9. Issue Rating – Securities and Exchange AA Commission, Thailand (SEC) sets the credit Very strong capacity to repay principal and interest. rating rules required for every bond issued and sold in Thailand. There are A two credit rating agencies in Thailand, Strong capacity to repay principal and interest. May Fitch and TRIS. The ratings are based on be susceptible to adverse changes in economic evaluation of an issuer’s financial strength conditions. to meet its payment obligations. Ratings BBB range between AAA to D, whereas any ratings above BBB are considered Adequate capacity to repay principal and interest. investment grade. Adverse economic conditions will likely lead to erosion in ability to pay. 25 26

Based on TIE ratio (EBIT/interest) BB BOND RATINGS2

Little near-term weakness but faces major ongoing Rating Agency uncertainties or exposure to adverse business, Moody’s Standard & Investment Quality Description financial, or economic conditions that could lead to Poor’s inadequate capacity to repay principal and interest. Aaa AAA Highest grade Very strong capacity to pay interest B and principal. Aa AA High grade Strong capacity to pay Currently has the ability to pay principal and interest. A A Medium Quality Bond is more susceptible to adverse changes. Poor economic or business conditions would likely Baa BBB impair the ability to repay principal and interest. Ba, B BB,B Low Quality Highly speculative in their ability to C meet interest and Ca, C CC,C Speculative principal obligations This rating is applied to debt that is subordinated to “Junk bonds”3 D D In default Interest and/or repayment are in senior debt that has been assigned a CCC rating. arrears. D Note: At times, both agencies use adjustments; S&P uses "+" or "-" to Debt is currently in default. indicated strength or weakness. Moody's uses 1,2, or 3, with 1 being the highest. 27 28

DEBT MARKET PRIMARY MARKET $

Issuer/Borrower Promised CFs Lender 1/ Buyer 1

“certificate” of ownership SECONDARY MARKET: Lender 1 sells bond to buyer 2

Issuer/Borrower Promised CFs Lender 2/ Buyer 2

market value of “certificate” bond ($) of ownership

Lender 1/ Buyer 1

Source: http://slideplayer.es/ 29 30

5 FIN 3701- Chapter3 :Debt Valuation and Interest rate

Secondary Market of Bonds Characteristics of Bonds • Bonds pay fixed coupon (interest) payments at fixed intervals (usually every six months) and pay the par value at maturity.

Once a bond is auctioned off the primary market, $I $I $I $I $I $I+$M the bond can be electronically traded in the secondary market, Bond Electronic Exchange 0 1 2 . . . n (BEX). “There will be Asian bond market (ABM)”

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Example: AT&T 6 ½ 32 Bonds can be categorized into several sub- sectors based on their criteria and their • Par value = $1,000 options. The followings are a few examples: • Straight bond, also known as an Option-free • Coupon = 6.5% or par value per year, or bond, is a bond that has no $65 per year ($32.50 every six months). in its structure. Coupons are paid periodically and the redemption value is fully disbursed at • Maturity = 20 years (matures in 2032). maturity. • Issued by AT&T. • Amortizing bond is a bond that has a schedule of periodic principal repayments $32.50 $32.50 $32.50 $32.50 $32.50 $32.50+$1000 over the life of the issue. The total principal is repaid in full at maturity. It implies, by its structure, that the bond price gradually 0 1 2 … 20 decreases as its face value has been amortized. 33 34

• Convertible bond is a bond giving the • Callable and puttable bond – for an option- bondholder the right, not an obligation, to free bond, the bond cannot be redeemed exchange the bond for a pre-specified prior to its maturity. However, some bonds number of shares of common stock. Such can be redeemed during its lives. It is feature allows the bondholder to take common for a bond issue to include a advantage of favorable movements in the provision in the indenture that gives either the price of the issuer’s common stock. bondholder and/or the issuer an option to Bondholders are likely to exercise the option take some action against the other party. The when conversion value is lower than the most common type of option embedded in a market price of the common stock. bond is a call feature, referred to as a . The provision grants the issuer the right to retire the debt, fully or partially, before the scheduled maturity date.

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6 FIN 3701- Chapter3 :Debt Valuation and Interest rate

Bonds can also be categorized into several sub- Callable and puttable bond (Cont.) sectors based on the issuers. The followings are • On the other hand, an issue may also include a few examples: a provision that allows the bondholder to • Treasury bonds = sometimes referred to as tender (put) the bond back to the issuer prior government bonds, are issued by the Federal to its maturity. An issue with this put provision government and are not exposed to default risk. (Treasury bond prices decline when is called putable bond. The advantage to the interest rates rise, so they are not free of all investor is that if interest rates rise, reducing risk) the bond’s price, the investor can force the • Corporate bonds (secured and unsecured issuer to redeem the bond at par value. ones) = are issued by corporations and are exposed to default risk. (Different corporate Who get benefit when interest rates rise? bonds have different levels of default risk, Puttable and callable depending on the issuing company’s characteristics and on the terms of the specific bond) 37 38

Other Types of Bonds CREDIT RATINGS MOODY'S STANDARD & POOR‘S FITCH • - unsecured bonds. STRONGEST Aaa AAA AAA • Subordinated debentures - unsecured Aa AA AA “junior” debt. A A A • - secured bonds. Baa BBB BBB Mortgage bonds GRADE INVESTMENT

• Zeros - bonds that pay only par value at Ba BB BB maturity; no coupons. B B B • Floating rate bonds – bonds with a coupon Caa CCC CCC payment that varies over time. Ca CC CC INVESTMENT GRADE INVESTMENT • Junk bonds - speculative or below- - C C C

investment grade bonds; rated BB and below. NON WEAKEST C D D High-yield bonds. * These credit ratings are reflective of obligations

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Rating Agencies in Thailand AAA Highest rating. Issuer’s capacity to repay interest • There are 2, approved by S.E.C., credit ratings agencies in and principal is excellent. Thailand; Fitch Ratings (Thailand) Limited and TRIS Rating Co., Ltd. AA • Credit risk comprises of three types of risk, Default risk, Very strong capacity to repay principal and interest. Credit spread risk, and Downgrade risk. A • After the evaluation, the rating agencies typically rank them in alphabetical orders. Traditionally, any ratings at or above Strong capacity to repay principal and interest. May “BBB-“ are considered to be investment grades, while be susceptible to adverse changes in economic anything below the same “BBB-“ rating are considered conditions. speculative, or high yield, or junk bonds. The higher the risk, the higher the required rate of return. Therefore, the BBB “AAA” bond will pay lower interest rate (or Adequate capacity to repay principal and interest. or required rate of return) than the “CCC” rating bond since Adverse economic conditions will likely lead to it is perceived to carry a lower credit risk. erosion in ability to pay. 41 42

7 FIN 3701- Chapter3 :Debt Valuation and Interest rate

BB Other Types of Bonds (cont) Little near-term weakness but faces major ongoing uncertainties or exposure to adverse business, • Municipal bonds = are issued by state and local financial, or economic conditions that could lead to governments. (The interest earned on most inadequate capacity to repay principal and interest. municipal bonds is exempt from federal taxes and B also from state taxes if then holder is a resident of the issuing state : Consequently, municipal bonds Currently has the ability to pay principal and interest. carry interest rates that are considerably lower Poor economic or business conditions would likely than those on corporate bonds with the same impair the ability to repay principal and interest. default risk) C • Foreign bonds = are issued by foreign This rating is applied to debt that is subordinated to governments or foreign corporations. (These senior debt that has been assigned a CCC rating. bonds are not only exposed to default risk, but are D also exposed to an additional risk if the bonds are Debt is currently in default. denominated in a currency other than that of the investor’s home currency) 43 44

Foreign Bonds Foreign Bonds (Cont.) • Foreign bonds are regulated by the domestic • Types of foreign bonds include bulldog market authorities and are usually given bonds, matador bonds, and samurai nicknames that refer to the domestic market bonds. in which they are being offered.

• Since investors in foreign bonds are usually the residents of the domestic country, investors find them attractive because they can add foreign content to their portfolios

without the added exchange rate exposure. Source: http://1.bp.blogspot.com/ | http:// Habeeb.com | http://www.reverbnation.com/

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Other Types of Bonds (cont) Other Types of Bonds (cont)

• Eurobonds - bonds denominated in one • Eurobonds - bonds denominated in one currency and sold in another country. currency and sold in another country. (Borrowing overseas.) (Borrowing overseas.)

• Example - suppose Disney decides to sell • Example - suppose Disney decides to sell $1,000 bonds in France. These are U.S. $1,000 bonds in France. These are U.S. denominated bonds trading in a foreign denominated bonds trading in a foreign country. Why do this? country. Why do this?

• If borrowing rates are lower in France. • To avoid SEC regulations. 47 48

8 FIN 3701- Chapter3 :Debt Valuation and Interest rate

Securities Analysis Securities Analysis Valuation Valuation “A legal contract representing the right to receive future benefits under a stated set of conditions.”

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Type of Value Security Valuation • Book value: value of an asset as shown on a • In general, the intrinsic value of an asset firm’s balance sheet; historical cost. = the present value of the stream of • Market value: observed value of an asset in expected cash flows discounted at an the marketplace; determined by supply and appropriate required rate of return.(or demand. the interest rate that you want: Ri = Rf • Intrinsic value: economic or fair value of an + Inflation +Risk Premium) asset; the present value of the asset’s expected future cash flows. • Can the intrinsic value of an asset differ from its market value?

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Step-by-Step :Valuing Bonds by Valuation Discounting Future Cash Flows • Step 1: Determine the amount and timing of n bondholder cash flows. The total cash flows $Ct equal the promised interest payments and t V = S (1 + k) principal payment. t = 1 • Annual Interest = Par value × coupon rate • Example : The annual interest for a bond with coupon interest rate of 7% and a par value of • Ct = cash flow to be received at time t. $1,000 is equal to $70, (.07 × $1,000 = $70). • k = the investor’s required rate of return. • V = the intrinsic value of the asset.

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9 FIN 3701- Chapter3 :Debt Valuation and Interest rate

Step-by-Step :Valuing Bonds by Step 2: Using Market Required Rate of Discounting Future Cash Flows (Cont.) Return (Market Rate of Return)Data • Step 2: Estimate the appropriate discount • Market yield to maturity (Required Rate of rate on a similar risk bond. Discount rate is Return) is regularly reported by a number of the return the bond will yield if it is held to investor services and is quoted in terms of maturity and all bond payments are made. credit spreads or spreads to Treasury bonds. • Discount rate can be either calculated or obtained from various sources (such as Yahoo! Finance). Ri = Rf + Inflation + Risk Premium

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(Cont.) 100 basis points = 1% • The spread values in next table represent basis points over a US Treasury security of the same maturity as the . For example, a 30-year Ba1/BB+ corporate bond has a spread of 275 basis points over a similar 30-year US Treasury bond.

• Thus this corporate bond should earn 2.75% over the 4.56% earned on treasury yield or 7.31%. 7.31%

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Step-by-Step: Valuing Bonds by Discounting Future Cash Flows (cont.) Valuation • Step 3: Calculate the present value of the bond’s interest and principal payments from n $CFt Step 1 using the discount rate estimated in t step 2. V = S (1 + k) t = 1 Present Value of the Present Value of the Bond Bond's Coupon Interest Principle Amount (par value) Value = + Payments of the Bond Issue • CFt = cash flow to be received at time t. • k = the investor’s required rate of return. • V = the intrinsic value of the asset.

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Bond Valuation • Discount the bond’s cash flows at the investor’s required rate of return. n $coupon $par • The coupon payment stream (an t Vb = t + n annuity). S(1 + kb) (1 + kb) t = 1 • The par value payment (a single sum).

Vb = $Ct (PVIFA kb, n) + $par (PVIF kb, n)

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When to buy, not to buy and not Bond Example to sell a bond? • Suppose our firm decides to issue 20-year VB AND THE “MARKET PRICE.” bonds with a par value of $1,000 and annual

VB price of bond sum of discounted CFs. coupon payments. The return on other "theoretical" price "formula" price "should be" price corporate bonds of similar risk is currently "intrinsic" value 12%, so we decide to offer a 12% coupon Market Mechanism: competition interest rate. If market price > VB → bond is overvalued → investors sell the bond → Supply for bond → market price • What would be a fair price (Intrinsic Value) until market price = V . B for these bonds? Obviously, if EMH (Efficient Market Hypothesis) holds, then there can be no such difference.

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1000 Bond Example 120 120 120 120 Mathematical Solution:

0 1 2 3 . . . 20 PV = PMT (PVIFA k, n ) + FV (PVIF k, n )

PV = 120 (PVIFA .12, 20 ) + 1000 (PVIF .12, 20 ) P/YR = 1 N = 20 1 I%YR = 12 n n FV = 1,000 PV = PMT 1 - (1 + i) + FV / (1 + i) PMT = 120 i Solve PV = -$1,000 1 20 20 Note: If the coupon rate = discount PV = 120 1 - (1.12 ) + 1000/ (1.12) = $1000 rate, the bond will sell for par value. .12

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• Suppose interest rates fall immediately after P/YR = 1 we issue the bonds. The required return on Mode = end bonds of similar risk drops to 10%. N = 20 I%YR = 10 • What would happen to the bond’s intrinsic PMT = 120 value? FV = 1000 Solve PV = -$1,170.27

Note: If the coupon rate > discount rate, the bond will sell for a premium.

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Bond Example • Suppose interest rates rise immediately Mathematical Solution: after we issue the bonds. The required return PV = PMT (PVIFA k, n ) + FV (PVIF k, n ) on bonds of similar risk rises to 14%. PV = 120 (PVIFA .10, 20 ) + 1000 (PVIF .10, 20 )

1 • What would happen to the bond’s intrinsic PV = PMT 1 - (1 + i)n + FV / (1 + i)n value? i

1 PV = 120 1 - (1.10 )20 + 1000/ (1.10) 20 = $1,170.27 .10

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Bond Example

P/YR = 1 Mathematical Solution:

Mode = end PV = PMT (PVIFA k, n ) + FV (PVIF k, n )

N = 20 PV = 120 (PVIFA .14, 20 ) + 1000 (PVIF .14, 20 ) I%YR = 14 PMT = 120 1 FV = 1000 PV = PMT 1 - (1 + i)n + FV / (1 + i)n Solve PV = -$867.54 i

Note: If the coupon rate < discount rate, 1 20 20 the bond will sell for a discount. PV = 120 1 - (1.14 ) + 1000/ (1.14) = $867.54 .14

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Yield To Maturity • The expected rate of return on a bond. • The rate of return investors earn on a bond if they hold it to maturity. Bond Returns • It is equal to Kd = the cost of the company

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Yield To Maturity What we want to do here is look at how • The expected rate of return on a bond. you might come up with the interest rate (YTM) on any bond that is trading in the • The rate of return investors earn on a secondary market. Thus, we are reversing bond if they hold it to maturity. the question here; we are asking the following: Given the market price of a bond and its coupons, what is its implied n $I $M YTM? P = t + 0 S (1 + k )t (1 + k )n Find YTM when you know the market price t = 1 b b

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YTM Example YTM Example • Suppose we paid $898.90 for a $1,000 par 10% coupon bond with 8 years to P/YR = 2 Mode = end maturity and semi-annual coupon N = 16 payments. PV = -898.90 PMT = 50 • What is our yield to maturity? FV = 1000 Solve I%YR = 12%

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Bond Example Example Mathematical Solution: PV = PMT (PVIFA ) + FV (PVIF ) Given: The following is information on a bond k, n k, n that is trading in the secondary market 898.90 = 50 (PVIFA k, 16 ) + 1000 (PVIF k, 16 ) with the following characteristics:

1 coupon rate = 6% ; years to maturity = PV = PMT 1 - (1 + i)n + FV / (1 + i)n 30; current i market bond price = $1,153.72

1 898.90 = 50 1 - (1 + i )16 + 1000 / (1 + i) 16 YTM=? i solve using trial and error

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Solution: Step 1: calculate coupon This equation has two unknowns: PVIFA and coupon = coupon rate x par value = 6% x $1,000 = $60 PVIF. Thus, unfortunately, other than using a calculator or a PC, there isn't an easy formula Step 2: calculate YTM to calculate YTM.

PV = SUM of discounted CFs One solution is to use the Trial & Error → $1,153.75 = 60(PVIFAYTM,30) + $1,000(PVIFYTM,30) Method, which states: choose YTM such that

Left Hand Side = Right Hand Side of equation

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Yield to Maturity The Approximation Approach

If you try YTM = 5% you will get it right.

YTM = kd = 5% Thus, at YTM = 5%

60 x [PVIFA5%, 30]+1,000x[PVIF5%,30]=1,153.72=price of bond 83 84

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The Approximation Formula Example • F = Face Value = Par Value = $1,000 • Find the yield-to-maturity of a 5 year 6% • P = Bond Price coupon bond that is currently priced at $850. (the coupon interest is paid semi-annually.) • C = the annual coupon interest • Therefore there is coupon interest of $30 • N = number of periods left to maturity paid semi-annually F - P • There are 10 semi-annual periods left until  C maturity Semi - annual Yield to Maturity  n F  P 2 YTM  2 semi - annual YTM 2 YTM  (1 semi - annual YTM) 1 85 86

Example – with solution The logic of the estimated YTM equation Find the yield-to-maturity of a 5 year 6% coupon bond that is currently priced at $850. (the coupon interest is paid semi-annually.) • The numerator simply represents the average semi-annual returns on the F - P $1,000  $850  C  $30 10 $15  $30 investment…it is made up of two Semi - annual Yield to Maturity  n    0.0486 F  P $1,850 $925 components: 2 2 YTM  2  semi - annual YTM  0.0486  2  0.09273  9.3% APR • The first component is the average capital YTM  (1 semi - annual YTM)2 1  (1.0486) 2 1  9.97% APY Used when to gain (if it is a discount bond) or capital loss compare rates (if it is a premium priced bond) per semi- The actual answer is 9.88%...so of course, the annual period. approximation approach only gives us an approximate answer…You got to use trial & error • The second component is the semi-annual with interpolation anyway coupon interest received. 87 88

The logic of the estimated YTM A callable bond equation (Cont.) That’s why it is called • The denominator represents the average price of the bond. • If current interest rates are well below and • Therefore the formula is basically, average outstanding bond’s coupon rate, then a semi-annual return on average investment. callable bond is likely to be called, and • Of course, we annualize the semi-annual investors should estimate the expected rate return so that we can compare this return to of return on the bond as the “yield to call other returns on other investments for (YTC)” rather than as the yield to maturity comparison purposes.

Make APY to compare

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Yield To Call Promised Yield to Call (Yc) A 10 years to maturity, 8% semi annual coupon • The expected rate of return on a bond when bond is currently traded at $1,033. It is expected called. to be called at 10% premium of par in the next • The rate of return investors earn on a bond if 3 years. Find Yc they hold until called. Call Price = Par + 1yr interest 40 + 40 + 40 + - - - + 40 +1,100 1,033= 6 6 (1+y )1 (1+y )2 (1+y )3 (1+y ) (1+y ) n c c c c c $coupont $call price P0 = t + n S (1 + YTC) (1 + YTC) Yc = 4.83% -- semi annual t = 1 Annual Yc = 4.83% * 2 = 9.66%

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Calculating Future Bond Prices Calculating Future Bond Prices

• Expected future bond prices are an important 2n2hp Ci / 2 Pp calculation in several instances: P   f  t 2n2hp • When computing horizon yield, we need an t1 (1  Ym / 2) (1  Ym / 2) estimated future selling price • When issues are quoted on a promised Where: yield, as with municipals Pf = estimated future price of the bond C = annual coupon payment • For portfolio managers who frequently i trade bonds n = number of years to maturity hp = holding period of the bond in years

Ym = expected semiannual rate at the end of the holding period

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Calculating Future Bond Prices Realized Yield (cont.) A 7 years to maturity, 6% semi annual coupon bond is currently traded at $ 1,125. It is expected to be sold in the next 5 years. The expected yield 30 + 30 + 30 + - - - + 30 + 976.21 1,125 = is 7.3%. How much is the expected price? 1 2 3 10 10 (1+yR) (1+yR) (1+yR) (1+yR) (1+yR)

30 + 30 + 30 +1,030 P = 5 1 2 3 4 YR = 1.43% -- semi annual (1+ym) (1+ym) (1+ym) (1+ym)

Annual YR = 1.43% * 2 = 2.84%

Where Ym = 7.3% → semi Ym = 3.65% P5 = $976.21

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The current yield The current yield (Cont.) • The annual interest payment divided by the • The current yield does not take account of bond’s current price. capital gains or losses that will be realized if • The current yield provides information the bond is held until maturity (or call), so it regarding the amount of cash income that a does not provide an accurate measure of bond will generate in a given year. the bond’s total expected return. (Since zeros pay no annual income, they always have a current yield of zero. This indicates that the bond will not provide any cash interest income, but since the bond will appreciate in value over time, its total rate of return clearly exceeds zero.

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Zero Coupon Bonds • No coupon interest payments. Required Rate of Return • The bond holder’s return is determined (YTM, YTC or YR) entirely by the price discount. = Current Yield + Capital Gain Yield

Source: http://blog.eriebasin.com/

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Zero Example Zero Example • Suppose you pay $508 for a zero coupon bond that has 10 years left to maturity. P/YR = 1 • What is your yield to maturity? Mode = End N = 10 PV = -508 -$508 $1000 FV = 1000 Solve: I%YR = 7% 0 10

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Zero Example

PV = -508 FV = 1000

0 10 Relationship between Mathematical Solution: PV = FV (PVIF i, n ) bond value and interest rate, 508 = 1000 (PVIF i, 10 ) .508 = (PVIF i, 10 ) [use PVIF table] Bond Risk

PV = FV /(1 + i) 10 508 = 1000 /(1 + i)10 1.9685 = (1 + i)10 i = 7%

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Bond Valuation: Four Key Bond Valuation: Four Key Relationships (Cont.) Bond Value and the Market’s Required Yield to Maturity Relationships (5-Year Bond, 12% Coupon Rate) Bond prices and yields to maturity vary inversely. Since principle and • First Relationship The value of bond is interest payments are fixed, the price of the bond must adjust such that inversely related to changes in the yield to the bond yields the market’s current yield to maturity. For example, if the market yield to maturity were to increase from 12% to 15%, the price of maturity. the bond would have to fall from $1,000 to $899 in order for an investor who bought the bond today to earn 15%. YTM rises to YTM = 12% 15% Par value $1,000 $1,000 Coupon rate 12% 12% Maturity date 5 years 5 years

Bond Value $1,000 $899.44 Bond Value Drops

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Bond Valuation: Four Key Bond Valuation: Four Key Relationships (Cont.) Relationships (Cont.)

• Since future interest rates cannot be • Second Relationship: The market value of a predicted, a bond investor is exposed to the bond will be less than its par value if the yield risk of changing values of bonds as interest to maturity (Investor’s required rate of return) rates change. is above the coupon interest rate and will be valued above par value if the yield to maturity is below the coupon interest rate. • The risk to the investor that the value of his or her investment will change is known as interest rate risk.

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Bond Valuation: Four Key Bond Valuation: Four Key Relationships (Cont.) Relationships (Cont.)

• There are two sources of return from bond • When a bond can be bought for less than its investment: par value, it is called discount bond. For • Periodic interest payments example, buying a $1,000 par value bond for $950. • Capital gain or loss when the bond is sold

• Bonds will trade at a discount when the yield Required Rate of Return to maturity on the bond exceeds the coupon = Current Yield + Capital Gain Yield rate.

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Bond Valuation: Four Key Relationships (Cont.) • When a bond can be bought for more than its Will you buy par value, it is called premium bond. For example, buying a $1,000 par value bond for a discount/premium or $1,110. something else bond?

• Bonds will trade at a premium when the yield Discount vs.undervalued bond to maturity on the bond is less than the coupon rate.

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Bond Valuation: Four Key Bond Prices Relative to Maturity Date Regardless of whether a bond is selling at a premium or discount, Relationships (Cont.) its price will approach its par value as the bond nears maturity. Bond prices are calculated for a $1,000 par value bond that pays • Third Relationship As the maturity date a 12% coupon that span the five years up to the time the bond approaches, the market value of a bond matures. Three interest rate or yield scenarios are considered: a par scenario in which case the market's required yield to maturity approaches its par value. (coz.. Credit and and coupon rate of the bond are equal, a discount bond scenario interest rate risks become smaller) in which the market's required to maturity 15% but pays a coupon of only 12% and finally a premium bond scenario in which case the market's required yield to maturity only 9% but pays a coupon • Regardless of whether the bond was trading of 12%. at a discount or at a premium, the price of bond will converge towards par value as the maturity date approaches.

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19 FIN 3701- Chapter3 :Debt Valuation and Interest rate

Bond Valuation: Four Key Relationships (Cont.)

• Fourth Relationship Long term bonds have greater interest rate risk than short-term bonds.

• While all bonds are affected by a change in interest rates, long-term bonds are exposed to greater volatility as interest rates change.

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Bond Prices Fluctuations for Bonds with Different Maturities The longer the term to maturity, the greater will be the changes in bond prices in response to a given change in the market rate of interest.

Bond Risks

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Risks of Bondholders Interest-Rate Risk. • Interest rate risk • Typical bond price will change in the opposite • Financial risk direction from a change in interest rates. • Credit risk When interest rates rise, bond price drops, • Reinvestment risk and vice versa. Therefore, the volatility in the • Country risk market interest rates lead to the price • Inflation risk volatility. If an investor had to liquidate a bond • Exchange rate risk prior to its maturity, an increase in interest • Liquidity Risk - the size of the spread rate will have an adverse effect on the sell between bid and ask prices price. This type of risk is referred to as • Default risk (subset of credit risk) "interest-rate risk". • Downgrade risk (subset of credit risk)

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20 FIN 3701- Chapter3 :Debt Valuation and Interest rate

Credit Risk. Liquidity Risk. • Credit risk, also known as "Default risk", is the • Liquidity risk can also be referred to as risk that the issuer of a bond may default. The "Marketability risk". One of the primary credit risk is gauged by credit rating agencies. measures of liquidity is the size of the spread There are two credit rating agencies in between bid and ask prices. The wider the Thailand, Fitch and TRIS. A change in bond spread, the lower the liquidity, and thus the credit rating will have a direct and immediate higher the liquidity risk. Transparency and consequence with the value of a bond. uniformity create liquidity, and thus Bond Electronic Exchange, BEX, was established to oversee the bond's secondary market development.

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Step-by-Step issuing a corporate Step-by-Step issuing a corporate bond bond

1. Financial advisor will be appointed in helping 4. In addition, the company must appoint an to provide opinions on the type, conditions, underwriter who will allocate the bond to and other relevant details of bond issuance. investors after receiving the SEC's approval. 2. The financial advisor helps in preparing all In some cases, issuers may decide to go the necessary documents regarding the through the process without the help of a bonds being issued in order to obtain SEC’s financial advisor or underwriter. permission. 5. There are two types of bond offerings. The 3. Then, the advisor will go through the course of getting the bond rated by one of the two first one is private placement, PP, where the SEC’s approved rating agencies. offer is made to fewer than 10 investors or the issue size is less than 100 million Baht.

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Step-by-Step issuing a corporate Website bond • www.asiabondportal.com 6. The second type is public offering, PO, which • www.bex.or.th can be further subdivided into two additional • www.bbl.co.th categories. The first subset is a bond that is • www.bot.or.th offered to a limited group of investors, • www.investinginbond.com particularly institutional investors. • www.kasikornbank.com • www.sec.or.th • www.set.or.th • www.tsi-thailand.org

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21 FIN 3701- Chapter3 :Debt Valuation and Interest rate

Reference References for Images

• Sheridan Titman, Arthur J. Keown, John D. Martin, • http://www.prachachat.net/news_detail.php?newsid=134 Financial Management: Principles and 7548918 Applications(12thed). New Jersey: Pearson & • http://pds.exblog.jp/pds/1/201312/19/35/d0263635_2159 Prentice Hall Inc, 2014. 2645.jpg • http://slideplayer.es/slide/1087399/ • http://1.bp.blogspot.com/-f4f_3AxGimA/Tjx7XS4xBcI/ AAAAAAAAACk/RAVUFkmyC-k/s1600/bulldog3.jpg • http:// Habeeb.com • http://www.reverbnation.com/lilsamurai • http://blog.eriebasin.com/post/213085312/pictures-from- the-nyse-floor-of-sad-and-happy

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