Fundamentals Of Corporate Finance Part 1: Bonds PDF

FUNDAMENTALS OF CORPORATE FINANCE PART 1: BONDS SOME PRELIMINARIES FROM BEFORE TO REFLECT UPON Risk and Return Time Value of Money Discounting Interest Rates  BONDS: INTRODUCTION Bonds  Fixed Income Wide variety of different types of bond Conventional government...

FUNDAMENTALS OF CORPORATE FINANCE PART 1: BONDS SOME PRELIMINARIES FROM BEFORE TO REFLECT UPON Risk and Return Time Value of Money Discounting Interest Rates  BONDS: INTRODUCTION Bonds  Fixed Income Wide variety of different types of bond Conventional government bond: usually pays a fixed amount (the coupon) every 6 months to the holder plus the redemption (face/par) value on a fixed maturity date Some government and corporate bonds can be redeemed or called prior to their maturity date  redeemables Some corporate bonds can be exchanged for common stock of the issuer  convertible bonds Bonds are usually issued to obtain longer-term finance Maturity generally between 1 and 30 years Some perpetuals Are issued in many currencies UK corporate issuing $ denominated bonds  BONDS: INTRODUCTION Bond Certificate Term Maturity Date Coupon Rate Principal/Face Value/Par Value/Redemption Value Issuers Governments Corporates Risk Government bonds  risk-free (Mexico, Russia, Greece, IRELAND!!!?) Sovereign Default Corporates  default risk  BOND BASICS – COUPONS & PRICE Zero Coupon Bonds No coupon payments A zero coupon bond has a single payout $M in n years time T-Bills (see next slide) Coupon Paying Bonds Provide a stream of income through coupon payments (C) which are known for all future periods, at the time the bond is purchased Most bonds are redeemable at a fixed date in the future for a known price  par value/redemption price/maturity value (M) Some bonds that pay coupons are irredeemable  perpetuities Yield calculations more complicated than zero coupon bonds Bond Prices  U.S. TREASURY Marketable Treasury securities are issued in various forms: Treasury Bills have a maturity of one year or less. Such short- term securities are issued at a discount and the face value is paid upon maturity. Bills represented about 21 percent of all outstanding marketable Treasury debt at the end of June 2024. Treasury Notes have maturities ranging from two to 10 years. Notes are coupon securities, which means that the semi-annual interest payments are set at the time of issuance and purchasers collect the principal at maturity. Notes are the single largest category of Treasury securities, representing about 52 percent of all marketable debt at the close of June 2024. Treasury Bonds have maturities of more than 10 years. They are also coupon securities and represented about 17 percent of all marketable debt at the end of June 2024.  PRICES, YIELDS AND RETURNS: PRICE Face Value – 1,000 Coupon – 10% Term – 3 years r = 8% 1 2 3 100 100 1,100 Pric e PRICES, YIELDS AND RETURNS: YTM Yield to Maturity/Redemption Yield The yield to maturity on a bond is the internal rate of return of the bond or … the yield to maturity is the constant rate y which equates the discounted present value of future cash flows with the market price C1 C2 (Cn  M ) P  ...  (1  y ) (1  y ) 2 (1  y ) n Utilising an annuity formula makes the formula more workable, but Excel better C  1  M P 1    (1  y ) n  (1  y ) n y    BASIC YIELD & PRICE CALCULATIONS Price the following bond? C = 4.5% (paid annually) T = 4 years Face value = 1,000 r = 4% What is the yield on the following bond Po = 1,011.42 C = 3% (paid annually) T = 3 years Face value = 1,000 PRICES, YIELDS AND RETURNS: YTM The yield to maturity on a bond Does not determine (in an economic sense) the price of the bond Is a convenient single figure which summarises the average annual return on the bond, given the market price The YTM measures the (annual compound) rate of return on the bond if It is held to maturity All the coupon payments can be reinvested (on receipt) at a rate of interest equal to the (current) YTM The YTM is made up of three elements: Coupon rate + interest on the coupons + capital gain or loss from the difference between the purchase price P and the maturity value M If any of the conditions above do not hold, then the YTM will not correctly measure the return on the bond DYNAMIC BEHAVIOUR OF BOND PRICES ZC Bonds always trade at a discount. CP Bonds Par  YTM = C Premium  YTM < C Discount  YTM > C Most issuers (first time of sale) choose a coupon rate so that the bonds will trade at close-to-par. Then … the market takes over. Time Market Interest Rates  BONDS AND INTEREST RATES You may have heard that bond prices rise when interest rates fall, and bond prices fall when interest rates rise. Why is this? You buy a bond for $1,000. It matures in 4 years. Its coupon rate is 4%, so it “pays” $40 a year. One year later interest rates rise to 5% and you decide to sell your bond because you need that $1,000. When you enter an order to sell, the order goes to the market, and potential buyers now compare your bond to other bond issues and offer a price. Since interest rates went up, a newly issued $1,000 bond which matures in three years (the time left before your bond matures) is paying 5% interest or $50 a year. If an investor buys your bond for $1,000 they would receive $40 x 3, or $120 in interest over  BOND AND INTEREST RATES There is no incentive to buy your bond at its face value of $1,000 since the investor would receive less interest than the newly issued bonds, thus the market adjusts the price of your bond to make it “equivalent.” In this set of circumstances you may receive an offer of about $970 for your bond. An investor who bought your bond for $970 would now receive the $120 of interest, plus the additional $30 of principal when the bond matures. Because they were able to pay less for the bond, they would receive the same dollar amount of profit, over the same time frame, as if they bought a newly issued bond paying a higher interest rate. This is a simplified example, as the final price of a bond depends on the credit quality, type of bond, maturity, and frequency of interest payments. In general, bonds with similar terms will adjust to interest rates in a like manner.  THE YIELD CURVE AND BOND ARBITRAGE We have looked at the relationship between the price of an individual bond and its YTM. We did this for discount bonds (ZC) and coupon paying bonds. Now, we are going to examine the relationship between the prices and yields of different bonds. Using the Law of One Price (we will see what this means as we progress through this session), we show that: given spot interest rates (yields on default- free zero-coupon bonds) we can determine the price and yield of any other default-free bond. As a result the yield curve provides the REPLICATING A (DEFAULT FREE) COUPON PAYING BOND USING ZCS We are going to replicate a coupon paying bond using zero-coupon bonds … so basically we want to replicate the cash flows of a coupon bond using the cash flows of zero-coupon bonds. 3-year, $1,000, 10% annual coupons 100 100 1,10 0 0 1 2 3  PRICING A COUPON BOND USING ZCS We are going to price a coupon bond using zero-coupon bonds – See Excel File! 3-year, $1,000, 10% annual coupons 100 100 1,100 0 1 2 3 Zero Coupon Data (Face Value, 100) Maturity 1 2 3 4 YTM 3.50% 4.00% 4.50% 4.75% YTM OF A COUPON BOND USING ZCS Given that we now know the price of the bond … we can calculate its YTM 100 100 (100  1,000) 1,153.00    (1  y ) (1  y ) 2 (1  y ) 3 So … y = 4.44%  The Yield Curve (Again) Yield curve is a term used to describe the plot of YTM against Term to Maturity, for bonds with similar risk characteristics. The shape of the Treasury Bills yield curve (default-free yield curve) is of considerable interest to practitioners in the financial markets. Yield curves are affected by present and expected future interest rates. Four shapes of yield curve have appeared with some frequency over time, in the financial markets around the world: Upward-sloping yield curve; Flat yield curve; Inverted yield curve, and Humped yield curve. THE YIELD CURVE Yield Curve  WHERE NEXT WITH BONDS? We know all about the characteristics of bonds now! Coupon, term, face value Riskless (default-free), risky Prices, yields So far we have priced bonds (and calculated YTMs) without incorporating the possibility of default, i.e., all of the bonds we have looked at have been “risk-free”. Pricing CP bonds using spot rates T-Bill Yield Curve Next we will look at corporate bonds that are risky (possibility of default) and also look at how bonds are traded. Credit Ratings CORPORATE BONDS AND RISK Corporate bonds (and some government bonds, see earlier video) bring with them a default possibility – the issuer of the bond (some corporate) may not pay back the full amount promised in the bond agreement (prospectus). The risk of default, which is known as the credit risk of the bond, means that the bond’s cash flows are not known with certainty.  CORPORATE BOND YIELDS How does the credit risk of default affect bond prices and yields? Think about this! Cash flows promised in bond agreement may not be paid => Risk Investors will pay less for a bond with such risk compared to an equivalent default-free bond  BOND RATINGS Credit ratings are the most common benchmark used when assessing corporate bond default risk. These securities are backed by the issuing companies, rather than by government/agency guarantees or insurance. Credit ratings provide an indication of an issuer's ability to make timely interest and principal payments on a bond. Therefore, it is very important to review a corporate bond's credit rating and the effect a rating change would have on the BOND RATINGS Simple Ratings Video Default and Bankruptcy  CLASS EXERCISE Prepare a brief report on an international bond market (A COUNTRY OF YOUR CHOICE) over the last 10 years “from a risk perspective”. Start by searching on line for “Country” Bond Yields, e.g., https:// tradingeconomics.com/france /government-bond-yield FUNDAMENTALS OF CORPORATE FINANCE PART 2: EQUITIES  CHARACTERISTICS OF EQUITY Issuer: companies, corporations Type of security: most common is the ordinary share or stock which gives the holder voting rights and the right to receive profit distributions from the company Currency of denomination: currency of the country in which the exchange is located Income payments: dividends at discretion of company Maturity: usually shares have no maturity Liquidity: can be traded on the secondary market; high – commission or bid/ask spread determines the extent Nominal capital value certainty: none  FAIR VALUE AND EFFICIENT MARKETS The fair value of a stock is the discounted present value of future expected dividends. Because future dividends are uncertain, the discount rate should reflect the riskiness of these dividend payments. Suppose investors use all available information to forecast future dividends and discount rates and they use the above method to calculate the fair value of the stock, which we assume to be equal to $10 If the actual (market price) is $8 all informed investors will obviously buy thereby driving the price up towards the “fair value”  FAIR VALUE AND EFFICIENT MARKETS CTD’ In addition, as new information becomes available this will be reflected in the market price. For example, the announcement of a new contract would result in higher profits and dividends. Hence one might expect this to lead to a reappraisal of the fair value to say, $12, and for the market (actual) price to immediately rise to $12. => EFFICIENT MARKET HYPOTHESIS (NB) Investors use all available (relevant) information to calculate the fair value of the stock => informational efficiency/rational expectations Stock prices immediately move to reflect fair value Prices are “marked up” so quickly it is impossible to make abnormal profits EMH Video  CALCULATING FAIR VALUE Models! Dividend Discount Model Gordon’s Growth Model Capital Asset Pricing Model Others P/E  DIVIDEND DISCOUNT MODEL In the strictest sense, the only cash flow you receive from a firm when you buy publicly traded stock is the dividend. The simplest model for valuing equity is the dividend discount model. The value of a stock is the present value of expected dividends on it. While many analysts have turned away from the dividend discount model and viewed it as outmoded, much of the intuition that drives discounted cash flow valuation is embedded in the model.  DIVIDEND DISCOUNT MODEL The simplest approach to valuing stocks assumes a constant, non-growing dividend stream (and is the equivalent of a perpetuity). D1 P0  r So, for example say that a company is expected to pay a dividend of $0.20 and the appropriate discount rate is 12%, then: Po = 0.20/0.12 = $1.66  GORDON’S GROWTH MODEL A widely cited dividend valuation approach is the constant- growth model, which assumes that dividends will grow at a constant rate, but a rate that is less than the required rate of return. This model is commonly referred to as Gordon’s growth model. D1 P0  r  g So, for example say that a company is expected to pay a dividend of $0.30, which is expected to grow for the foreseeable future at 3%, and the appropriate discount rate is 9%, then: Po = 0.30/(0.09-0.03) = $5.00  GORDON’S GROWTH MODEL Three points on this model. First, while it may not look like the present value formulas that we did last week, that is all it is. The constant-growth model is not magical; it’s just a special case of present value and could be used to find the present value of any cash flow stream that is growing at a constant rate. Second, growth rates rarely remain constant over time. However if growth rates are relatively stable, this can be a close approximation. Third, this model only works when the required return exceeds the growth rate. This is not usually critical as it is impossible to maintain a growth rate higher than the required return indefinitely, but if you try applying this model when the growth rate exceeds the required return, you will get a negative value – which does not make sense as stock prices will not fall below  CAPITAL ASSET PRICING MODEL The CAPM is the “workhorse” asset pricing model (that has stood the test of time.) Single-factor model   is the key What does  measure? NB: WE WILL RETURN TO THE CAPM LATER IN THE COURSE E ( Ri ) R f   ( E ( Rm )  R f ) For example, if you were given the risk-free rate as 3%, the beta as 1.7 and the expected return on the market as 8%, then: E(R) = 0.03 + 1.7(0.08 – 0.03) = 11.5% OTHER PRICING METHODS/APPROACHES Book Value The book value represents the value that the company based upon the internal financial statements. Specifically, book value concerns the total value of company assets minus the total value of company liabilities. This amount will equal the owners equity in the firm and, likewise, equals the book value of the firm. Liquidation Value (ORDERLY v FORCED) Liquidation value is an asset-based method based upon the value that the business would immediately receive upon selling the asset on the open market. Immediately means selling the asset within a six to twelve month period. This method takes into consideration the age, wear, and technological innovations associated with this type of asset.  OTHER PRICING METHODS/APPROACHES  Price/Earnings Multiples  For example, if a company has earnings of $10 billion and has 2 billion shares outstanding, its EPS is $5. If its stock price is currently $120, its PE ratio would be 120 divided by 5, which comes out to 24. One way to put it is that the stock is trading 24 times higher than the company's earnings, or 24x.  A high P/E ratio suggests that investors expect a high level of earnings in the future, and that growth will be strong.  A low P/E ratio could mean that the company is undervalued or current earnings are exceeding past trends. WHAT DRIVES EQUITY MARKETS? Supply and Demand Interest Rates Economic Conditions INFORMATION World Events Sentiment People and Products M & A Activity Oil Prices Industry Prospects ANALYSIS: SOMEWHERE IN THE MIDDLE? Some Recent Market Analysis FUNDAMEN TECHNIC TAL AL ? SENTIMEN T  CLASS EXERCISE Prepare a brief report on the performance of an international EQUITY market (A COUNTRY OF YOUR CHOICE) over the last 10 years.  WHERE TO NEXT? We now have the tools to price bonds and shares … albeit at a basic level That will allow us to examine the “cost of debt” and the “cost of equity” in the context of the cost of capital (which feeds into the discount rate we apply in capital budgeting). That naturally leads us into capital structure theory.