FIN 300 Chapter Notes - Chapter 7: Unsecured Debt, Dirty Price, Sinking Fund
28 Jun 2018
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FIN – Chapter 7 – Interest Rates and Bond Valuation
Coupon – the stated interest payment made on a bond (120)
Face value – the principal amount of a bond that is repaid at the end of the term
(also called par value) (1000)
Coupon rate – the annual coupon divided by the face value of a bond (12%)
Maturity – the specified date on which the principal amount of a bond is paid (30
years)
Yield to maturity (YTM) – the rate required in the market on a bond
If a bond has (1) a face value of F paid at maturity, (2) a coupon of C paid per period,
(3) t periods to maturity and (4) a yield of r per period its value is:
Bond value = C x [1-1/(1+r)t]/r + F/(1+r)t
Bond value – Present Value of the coupons + Present value of the face amount
Bond prices and interest rates always move in opposite directions
The risk that arises for bond owners from fluctuating interest rates is called interest
rate risk
How much rate risk a bond has depends on how sensitive its price is to interest rate
changes
Sensitivity depends on: the time to maturity and the coupon rate
All other things equal, the longer the time to maturity, the greater the interest rate
risk
The lower the coupon rate, the greater the interest rate risk
The interest rate risk increases at a decreasing rate
Given a bond value, coupon, time to maturity, and face value, it is possible to find
the implicit discount rate, or yield to maturity, by trial and error only. To do this, try
different discount rates until the calculated bond value equals the given value.
Remember that increasing the rate decreases the bond value.
Securities issued by corporation may be classified as equity securities and debt
securities
Main differences are
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Debt is not an ownership interest in the firm, creditors generally do not have
voting power
Corporations payment of interest on debt is considered a cost of doing
business and is tax deductible, dividend paid to stockholders are not tax
deductible
Unpaid debt is a liability of the firm, thus one of the costs of issuing debt is
the possibility of financial failure. Does not happen with equity
As a general rule, equity represents an ownership interest and it's a residual claim
(equity holders are paid after debt holders)
That maturity of a long-term debt instrument is the length of time the debt remains
outstanding with some unpaid balance
Two major forms of long term debt are public issue and privately placed. The main
difference is that privately placed debt is directly placed with a lender and not
offered to the public (therefore the specific terms are up to the parties involved)
Indenture – the written agreement between the corporation and the lender
detailing the terms of the debt issues
The trust company must (1) make sure the terms of the indenture are obeyed (2)
manage the sinking fund and (3) represent the bondholders in default (if the
company defaults on its payments to them)
The bond indenture includes
The basic terms of the bonds
o Registered form – the form of bond issue in which the registrar of the
company records ownership of each bond; payment is made directly to
the owner of record
o Bearer form – the form of bond issues in which the bond is issued
without record of the owner’s name; payment is made to whomever
holds the bond
The total amount of bonds issued
A description of property used as security
o Collateral is a general term that frequently means securities that are
pledged as security for payment of debt
o Mortgage securities are secured by a mortgage on the real property of
the borrower
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Document Summary
Fin chapter 7 interest rates and bond valuation. Coupon the stated interest payment made on a bond (120) Face value the principal amount of a bond that is repaid at the end of the term (also called par value) (1000) Coupon rate the annual coupon divided by the face value of a bond (12%) Maturity the specified date on which the principal amount of a bond is paid (30 years) Yield to maturity (ytm) the rate required in the market on a bond. If a bond has (1) a face value of f paid at maturity, (2) a coupon of c paid per period, (3) t periods to maturity and (4) a yield of r per period its value is: Bond value = c x [1-1/(1+r)t]/r + f/(1+r)t. Bond value present value of the coupons + present value of the face amount. Bond prices and interest rates always move in opposite directions.
