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Coupon Bond Valuation

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Coupon Bond Valuation Long Term Financing Chapter 6 1st Paper What is long term financing (LT) Financing is a very important part of every business. Firms often need financing to pay for their assets, equipment, and other important items. Financing can be either long-term or short-term. Financing done for more than 5 year through instruments such as Bond, lease or stock etc. is called long term financing. Features of LT ▪ Duration: Duration exceeds 7- 15 years or more ▪ Sources of Fund: Debt or equity ▪ Objective: Used for purchase fixed assets or investment ▪ Size of Fund: Greater than short term fund ▪ Cost of Financing: Typically lower than others Sources of LT financing Long term financing Internal External Sources Sources Institutional Non-institutional Internal Sources of LT Owner’s Equity Retained Earning The fund raised Depreciation Fund within organization are internal sources Reserve fund of Long-term financing Sales of fixed asset Internal Sources Internal Bad debt provision Accrued Expence External sources of LT financing Commercial Bank Insurance Company The fund raised Leasing Company outside the The fund procured organization are Specialized Bank from other External sources of Institutions Long-term financing Development Bank Financial Institutional Sources Institutional Institution Underwriter External sources of LT financing Common Stock Preferred Stock The fund Collected from individual Bond/Indenture investor through different instruments is non-institutional Warrants source. Institutional Sources Institutional - Convertible Securities Non Money Market Lender Character of LT Finance 1. Amount of fund: Large amount of fund 2. Use of fund: For a longer period of time 3. Duration: More than 5 or 7 years up to 20 or more years 4. Methods of Repayment: Loan is repaid as per contract. Equity fund are repaid when company dissolves. 5. Security: Owner’s equity doesn’t require any security but fund borrowed from 3rd party may require security such as fixed assets. Character of LT Finance Continuation… 6. Participation in Management & Control: Long term financer has direct or indirect participation and control on management. Shareholders participate directly whereas bondholders sets strict rules and restriction over management. 7. Cost of Capital: Less than short-term and mid-term cost of finance. As investor secure a long-term return their expected return is also lower. Moreover Interest is tax free. 8. Formalities: Many formalities need to be accomplished before fund is managed. Objective of LT Finance 1. To bear initial cost like documentation, permission, registration etc 2. To bear construction cost like factories, office etc. other facilities. 3. To implement long term plan like financing decision, long term investment, management etc. 4. To face competition like modification of products or design 5. To replace fixed asset as their capacity decline or modification are required Sources of LT Finance What is Bond? Corporations sell bonds to borrow money from the investors. As a financial instrument, a bond represents a contractual agreement between the corporation and the bondholders. Eventually the corporation has to repay the principal to the investors and pay interest to them in the meantime. Issuer of Bond Bonds are debt instruments issued by corporations, as well as state, local, and foreign governments to raise funds for growth and financing of public projects Characteristics of Bond ❑ Debt Indenture: The indenture is the formal contract between the bondholders and the corporation. Written in legal language, the fine print spells out the rights and responsibilities of both parties. ❑ Maturity: There is a definite date when a bond matures. At that time, the corporation must pay the face value of the bonds to the bondholders. This could be from as little as 5 years to as long as 100 years. Denoted by n Characteristics of Bond Continuation… ❑ Interest: The coupon rate, c. The specific return from bond. ❑ Face value: The face value, F. The face value of a bond, or its principal, for example BDT 1000, which means that the investment in bonds is a multiple of BDT 1,000. The total value of the bonds issued by a company at a certain time could be millions of dollars. Types of Bond On the basis of Security when it is issued solely on the credibility of the issuer is known as unsecured debenture. A secured debenture is secured by the charge on some asset or set of assets which is known as secured or mortgage debenture Types of Bond On the basis of Repayment 1. Redeemable: carry a specific date of redemption on the certificate. The company is legally bound to repay the principal amount to the debenture holders on that date • Callable Bond • Puttable Bond 2. Irredeemable: also known as perpetual debentures, do not carry any date of redemption. This means that there is no specific time of redemption of these debentures. They are redeemed either on the liquidation of the company or as per the terms of the issue when the company chooses to pay them off to reduce their liability by issues a due notice to the debenture holders beforehand. Types of Bond On the basis of Registration 1. Registered: the name, address, and other holding details are registered with the issuing company and whenever such debenture is transferred by the holder; it has to be informed to the issuing company for updating in its records. Otherwise, the interest and principal will go to the previous holder because the company will pay to the one who is registered 2. Unregistered: commonly known as bearer debenture. can be transferred by mere delivery to the new holder. They are considered as good as currency notes due to their easy transferability. The interest and principal are paid to the person who produces the coupons, which are attached to the debenture certificate. and the certificate respectively. Types of Bond On the basis of Convertibility 1. Convertible: Holders have an option of converting their holdings into equity shares. The rate of conversion and the period after which the conversion will take effect are declared in the terms and conditions of the agreement of debentures at the time of issue. • Fully Convertible • Partially Convertible 2. Non-convertible: Simple debentures with no such option of getting converted into equity. Their state will always remain of debt and will not become equity at any point in time. Types of Bond Others 1. Income Bond: a type of debt security in which only the face value of the bond is promised to be paid to the investor, with any coupon payments paid only if the issuing company has enough earnings to pay for the coupon payment. 2. Zero coupon bond: This do not carry any coupon rate. The debenture holder will not get any interest on these types of debentures. for compensating against no interest, companies issue them at a discounted price which is less compared to the face value of it. Types of Bond Others 3. Coupon Bond: All other bond except zero coupon bond. They provide specified rate of interest. 4. Junk Bond:: a high-yielding high-risk security, typically issued by a company seeking to raise capital quickly in order to finance a takeover. Valuation of Bond There are 3 types of formula for valuation of bond 1. Coupon Bond 2. Zero Coupon Bond 3. Perpetual Bond Coupon Bond Valuation Example: a firm wants to borrow $1,000 for 30 years and the actual interest rate on loans with similar risk characteristics is 12%, then the firm will pay a total of $120 in interest each year for 30 years and repay the $1,000 loan after 30 years. Coupon Bond Valuation Example: a firm wants to borrow $1,000 for 30 years and the actual interest rate on loans with similar risk characteristics is 12%, then the firm will pay a total of $120 in interest each year for 30 years and repay the $1,000 loan after 30 years. 1 1− 1+푘푑 푀푉 푉퐵 = I ( ) + 푘푑 1+푘푑 1 1− 1+0.1230 1000 푉 = 120 ( ) + 퐵 0.12 1+0.1230 = $1188.53 Zero Coupon Bond Valuation Example: The price of a zero-coupon bond with $1,000 face value and 22 years to maturity when the return on similar bonds is 6% is 푀푉 푉퐵 = 1+푘푑 1000 푉 = 퐵 1+0.0622 = $277.51 Clearly, a zero-coupon bond always sells at a discount. Perpetual Bond Valuation Example: The price of a bond with $1,000 face value, 10% coupon rate . When the return on similar bonds is 15%. 퐼 푉퐵 = 푘푑 100 푉 = 퐵 0.15 = $666.67 Yield from Bond Yield is the annual return on the investment that the investor expects . There are 3 types of Yield 1. Yield to Maturity 2. Yield to Call 3. Current Yield Yield to Maturity (YTM) YTM is the annual return to an individual buying the bond at its market price and holding it until maturity Example: The selling price of a bond is $2,100 with $2,000 face value, 10% coupon rate and 5 years maturity. What will the yield to maturity? 푀푉 −푆푉 퐼 + 푛 YTM = 푀푉+푆푉 X 100 2 2000 −2100 200+ 5 YTM = 2000+2100 X 100 2 = 8.78% Now if the investor expected return is below 8.78%, this bond can be selected. Yield to Call (YTC) YTC is the annual return to an individual buying the bond at its market price and holding it until it is called before maturity. Example: The selling price of a bond is $3,200 with $2,900 face value, 10% coupon rate and 12 years maturity but can be called after 8 years at the price of $3,000 . What will the yield to call? 퐶푃 −푆푉 퐼 + 푛 YTC = 퐶푃+푆푉 X 100 2 3000 −3200 290 + 8 YTC = 3000+3200 X 100 2 = 8.55% Now if the investor expected return is below 8.55%, this bond can be selected.
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