FINC311 Study Guide - Final Guide: Net Present Value, Systematic Risk, Preferred Stock
27 Jun 2018
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Chapter 6 -- Interest Rates and Bond Valuation
I. Overview of Bonds
A. What is a Bond?
1. Debt contract between borrower (corporate or government) and investor
a) Borrower pays only interest every period
b) Principal paid back at end of term
2. Fixed-income securities
B. Bond Features
1. Par Value (Face Value) -- principal amount of bond; repaid at end of term
2. Coupon Payment -- stated interest payment made on a bond
3. Coupon Rate -- annual coupon payment divided by face value of bond
4. Maturity -- number of years until bond repaid
5. Yield-to-Maturity -- interest rate required in the market on a bond
a) Discount rate used to value a bond
b) If bond held till maturity, this = actual realized return
c) At initial bond issuance YTM = coupon rate
C. Bond Indenture “Deed of Trust”
1. Contract between issuing company and bondholders includes:
a) Basic term of bonds
b) Total amount of bonds issued
c) Secured vs unsecured
d) Sinking fund provisions
e) Call provisions (deferred call , call premium)
f) Details of protective covenants
D. Bond Classifications
1. Registered vs Bearer Bonds
2. Security
a) Collateral -- secured by financial securities
b) Mortgage -- secured by real property, normally land or buildings
c) Debentures -- unsecured
d) Notes -- unsecured debt with original maturity less than 10 years
3. Seniority
a) Senior vs Junior
b) Subordinated
E. Bond Characteristics and Required Returns
1. Coupon Rate
2. Which bonds will have the higher coupon all else equal?
a) Secured debt vs a debenture
b) Subordinated debenture vs senior debt
c) Bond with a sinking fund vs one without
d) Callable bond vs non-callable bond
F. Government Bonds
1. Municipal Securities
a) Debt of state and local governments
b) Varying degrees of default risk, rated similar to corporate debt
c) Interest received is tax-exempt at the federal level
d) Interest usually exempt from state tax in issuing state
2. Treasury Securities = Federal government debt
a) Treasury Bills (T-bills)
(1) Pure discount bonds
(2) Original maturity of one year or less
b) Treasury notes
(1) Coupon debt
(2) Original maturity between one and ten years
c) Treasury bonds
(1) Coupon debt
(2) Original maturity greater than 10 years
G. Zero Coupon Bonds
1. Make no periodic interest payments (coupon rate = 0%)
2. Entire yield-to-maturity comes from the difference between the purchase price and the
par value (capital gains)
3. Cannot sell for more than par value
4. Sometimes called zeroes or deep discount bonds
5. Treasury Bills and US Savings bonds are good examples of zeroes
II. Bond Value = Present Value of the Coupons + Present Value of the Face Value
A. Present Value Formulas
1. Present Value of an Annuity = C * r
1 − 1
(1+r)t
2. Present Value of a Lump Sum = F V
(1+r)t
B. Present Value Formulas for Bonds
1. C
a) Bond -- coupon payment
b) Annuity / Lump Sum -- annuity payment
2. r
a) Bond -- YTM
b) Annuity / Lump Sum -- interest rate
3. FV
a) Face value of bond
b) Future Value of lump sum
4. t
a) Bond -- time to maturity
b) Annuity / lump sum -- # of payments
C. Bond Pricing Terminology
1. AT PAR
a) YTM = Coupon Rate
b) Bond Price = Par
2. PREMIUM
a) YTM < Coupon Rate
b) Bond Price > Par
3. DISCOUNT
a) YTM > Coupon Rate
b) Bond Price < Par
D. Bond Prices and Interest Rates
1. If interest rates increase, then present values decrease, bond prices decrease
2. If interest rates decrease, then present values increase, bond prices increase
III. Interest Rates
A. Interest Rate Risk
1. Risk to bondholders resulting from fluctuating interest rates
2. Interest Rate Risk -- As interest rates change, the price of the bond will change (“price
risk”)
a) Bond prices decrease as interest rates rise
b) Bond prices increase as interest rates decline
3. Nominal rate of interest includes our desired real rate of return plus an adjustment for
expected inflation
B. Fisher Effect
1. Defines relationship between real rates, nominal rates and inflation
a) (1 + R) = (1 + r) (1 + h)
(1) R is nominal rate
(2) r is real rate
(3) h is expected inflation rate
C. Term Structure of Interest Rates
1. Term Structure: the relationship between time to maturity and yields, all else equal
a) Effect of default risk, different coupons, etc. has been removed
2. Yield Curve: graphical representation of the term structure
a) Normal = upward-sloping → L/T > S/T
b) Inverted = downward-sloping → L/T < S/T
D. Default Risk
1. Risk to bondholders resulting from a company not paying the interest and principal on
their bonds
a) Bond ratings provide an indication or risk
E. Factors Affecting Required Return
1. Real rate of interest
2. Premiums for the following:
Document Summary
Chapter 6 -- interest rates and bond valuation. Interest received is tax-exempt at the federal level. Bond value = present value of the coupons + present value of the face value: present value formulas, present value of an annuity = c , present value of a lump sum = f v. 1 1 (1+r)t r (1+r)t: present value formulas for bonds, c. If interest rates increase, then present values decrease, bond prices decrease. If interest rates decrease, then present values increase, bond prices increase. Interest rate risk: risk to bondholders resulting from fluctuating interest rates. Chapter 7 -- equity markets and stock valuation. Overview of corporate financing options: options to finance a business, debt, bank loans, bonds, equity, debt, not an ownership interest, no voting rights. 3: creditors have legal recourse if interest or principal payments are missed, excess debt can lead to financial distress and bankruptcy.
