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Lecture Essentials of corporate finance (2/e) – Chap 6: Interest rates and bond valuation

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Chapter 6 introduces you to interest rates and bond valuation. In this chapter, you will learn: Know the important bond features and bond types, understand bond values and why they fluctuate, understand bond ratings and what they mean, understand the impact of inflation on interest rates, understand the term structure of interest rates and the determinants of bond yields.

Interest rates, bill and bond valuation Chapter Key concepts and skills • Know the important features and different types of bills and bonds • Understand how bills and bonds are valued and why they fluctuate • Understand bond ratings and what they mean • Understand the impact of inflation on interest rates • Understand the term structure of interest rates and the determinants of bond yields Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-2 Chapter outline • • • • • • • • • Bills of exchange and bill valuation Other short-term funding instruments Bonds and bond valuation More on bond features Bond ratings Some different types of bonds Bond markets Inflation and interest rates Determinants of bond yields Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-3 Bills of exchange and bill valuation • A bill is defined as: – ‘unconditional order in writing, addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand, or at a fixed or determinable future time, a sum certain in money to or to the order of a specified person, or to bearer’ • Face value – The principal amount that is repaid at the end of the term Also called par value • Maturity – Date on which the principal amount is paid Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-4 Bill values and yields • If a bill has: – a face value of F paid at maturity – t periods to maturity; and – a yield of r per period Bill Value F r x t (1 ) 365 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-5 Bill pricing— Example • Suppose the Edna Data Company was to issue a bill with a face value of $500 000 and 90 days to maturity, with a yield of 6.5% The acquirer of the bill will receive $500 000 in 90 days’ time What would this bill sell for? – PV = 500 000/(1+0.06/365*90)=$492 125.98 • Calculator: – 0.2465 [N] (90/365) – 6[I/Y] – 500 000 [+/-][FV] – [CPT][PV]= 492 125.98 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-6 More on bill features • Three parties to a bill of exchange: The drawer The acceptor The discounter (or endorser) • The amount of funds the drawer will receive depends on the face value of the bill and the prevailing market rates (discount rate) • The original discounter may hold the bill to maturity or sell it in the market before the maturity date • At the maturity date, the current holder of the bill will approach the acceptor for repayment The acceptor is liable to pay the face value of the bill to the current holder and will recover the money from the drawer Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-7 More on bill features (cont.) • Figure 6.1 • Figure 6.2 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-8 Other short-term funding instruments • Promissory notes – Promises to pay a lender an amount of money in the future; and – issued for short terms • Bank overdraft – An agreement under which a firm is authorised to overdraw its bank account up to a specified amount Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-9 Bond definitions • Bond – Debt contract – Interest-only loan • • • • • Par value (face value) ~ $1000 Coupon rate Coupon payment Maturity date Yield to maturity Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-10 Bond markets • Primarily over-the-counter transactions with dealers connected electronically • Extremely large number of bond issues, but generally low daily volume in single issues • Getting up-to-date prices is difficult, particularly on small company or municipal issues • Treasury securities are an exception Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-44 Bond price reporting • Corporate bond market associated with Australian Securities Exchange (ASX) • Click on information; which leads to Detailed search—prices, charts and announcements section for interest rate and hybrid security prices • The chart gives the buy/bid, sell/ask prices and other figures for corporate bonds Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-45 Treasury quotes Table 6.3 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-46 Treasury quotes Example 6.5 • In Table 6.3, for bond maturing Feb-2017 – Coupon rate? – Yield to maturity based on ask price (sell price)? – Bond trading at discount? • Bond we are looking at: – – – – – 6.00% Feb-17 5.250 1208 11748 YTM at last sale = 5.25% (Sale price > Face value) Bond’s years to maturity = (Assume today as 15/02/2010) Coupon rate = 6% (half yearly) = $3 YTM = 5.25/2=2.625 PV=3[1-1/(1+0.02625)14]/0.02625+100/ (1.02625)14=104.346 • The bond maturing in April 2020 is selling at discount Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-47 Work the Web—Example • • • • • Bond quotes are available online One good site is Bloomberg.com Go to Bloomberg’s website Follow the bond search Search a bond issue and see what you can find! Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-48 Inflation and interest rates • Real rate of interest—change in purchasing power • Nominal rate of interest—quoted rate of interest, change in purchasing power and inflation • The ex ante nominal rate of interest includes our desired real rate of return plus an adjustment for expected inflation Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-49 The Fisher effect • The Fisher effect defines the relationship between real rates, nominal rates and inflation: (1 + R) = (1 + r)(1 + h) R = nominal rate (quoted rate) r = real rate h = expected inflation rate Approximation: R = r + h Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-50 The Fisher effect Example 6.6 • If we require a 10% real return and we expect inflation to be 8%, what is the nominal rate? • R = (1.1)(1.08) – = 188 = 18.8% • Approximation: R = 10% + 8% = 18% • Because the real return and expected inflation are relatively high, there is a significant difference between the actual Fisher effect and the approximation Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-51 Determinants of bond yields Term structure of interest rates • Term structure is the relationship between time to maturity and yields, all else being equal • It is important to recognise that we pull out the effect of default risk, different coupons, etc • Yield curve—graphical representation of the term structure – Normal—upward-sloping, long-term yields are higher than short-term yields – Inverted—downward-sloping, long-term yields are lower than short-term yields Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-52 Upward-sloping yield curve— Figure 6.8A Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-53 Downward-sloping yield curve —Figure 6.8B Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-54 Government bond yield curve —Figure 6.9 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-55 Factors affecting required return • Default risk premium—bond ratings • Taxability premium—municipal versus taxable • Liquidity premium—bonds that have more frequent trading will generally have lower required returns • Maturity premium—longer term bonds will tend to have higher required returns Anything else that affects the risk of the cash flows to the bondholders will affect the Copyright © 2011 McGraw-Hill Australia Pty Ltd required PPTs t/a Essentialsreturns of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-56 Quick quiz • How you find the value of a bond and why bond prices change? • What is a bond trust deed and what are some of its important features? • What are bond ratings and why are they important? • How does inflation affect interest rates? • What is the term structure of interest rates? • What factors determine the required return on bonds? Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 6-57 Chapter END 6-58 ... short-term funding instruments Bonds and bond valuation More on bond features Bond ratings Some different types of bonds Bond markets Inflation and interest rates Determinants of bond yields Copyright... Understand the impact of inflation on interest rates • Understand the term structure of interest rates and the determinants of bond yields Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials. .. concepts and skills • Know the important features and different types of bills and bonds • Understand how bills and bonds are valued and why they fluctuate • Understand bond ratings and what

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