Business Finance

BA303
Michael Dimond

Bonds
Bonds are long-term debt
contracts used to raise capital
Bonds are denominated in a
set amount (most U.S.
corporate bonds are $1,000)
and can be bought and sold
in a secondary market
The bond indenture specifies
the terms of the bond,
including the rights and
duties, the amounts and
dates involved, standard debt
provisions and restrictive
covenants.
Michael Dimond
School of Business

Bonds: Linking terminology to TVM

functions

PV = Price
FV = Face Value (also called Par Value. Usually $1,000)
n = Periods (usually semiannual)
i = Yield
PMT = Coupon Payment

The Coupon Rate is only used to determine the coupon

payment. For example, a 10% coupon rate on a $1,000 bond
would give a $100 annual payment, which would be $50
semiannually.

Michael Dimond
School of Business

Bond pricing, yields, etc.

Bond terminology is what gives most students problems.
Sometimes you need to make assumptions based on how
the question is worded.
Heres a typical sort of a bond question:
XYZ Company has a 10% bond with semiannual payments which matures in
12 years. The market rate for bonds of this risk is currently 8%. What is the
price of this bond?

The key to solving a question like this is to identify the

relevant information and organize it:

PV = Price = Unknown. This is what we are solving for.

FV = Face Value = Not stated, so we assume $1,000.
n = Periods = Semiannual for 12 years. 12 x 2 = 24, :. n = 24.
i = Yield = Return demanded Periods per year = 8% 2 = 4% semiannual
PMT = Coupon Payment = FV x Coupon Rate Periods per year = 1,000 x
10% 2 = 50, :. PMT = 50. The expression 10% bond means a bond with a
10% coupon annual rate.
Michael Dimond
School of Business

Bond pricing, yields, etc.

Entering this information in a financial calculator lets us find
an answer.

PV = Price = Unknown. This is what we are solving for.

FV = $1,000.
n = 24 semiannual
i = 4% semiannual
PMT = 50 semiannual
Solve for PV = -1,152.4696

Notice n, i and PMT are all semiannual values. These must

all be in the same scale: Annual, semiannual, etc.
The answer appears negative because it is a cash outflow.
The price will be $1,152.47
Heres another bond question:
XYZ Company has a 10% semiannual bond which matures in 12 years and is
selling for $1,050. What is the yield of this bond?
Michael Dimond
School of Business

Bond pricing, yields, etc.

Lets try another. Entering this information in a financial
calculator lets us find an answer, but it will be a semiannual
answer.

PV = -1,050 (remember, the price is a cash outflow, so it has a minus sign)

FV = 1,000
n = 24 semiannual
i = Unknown. This is what we are solving for.
PMT = 50 semiannual
Solve for i = 4.6499%

Remember, n, i and PMT are all semiannual values. The

result the calculator gives is the semiannual interest rate. To
annualize it, multiply it by 2:
Yield = 2 x semiannual i = 2 x 4.6499% = 9.2998%

Michael Dimond
School of Business

Bond pricing, yields, etc.

Heres one more:
XYZ Company has a 10% bond with semiannual payments which matures in
12 years and is selling for $1,000. What is the yield of this bond?

In this case, the price and the face value are both 1,000. This
means the bond is selling at par, which means the yield will
equal the coupon rate (10%). To test this:

PV = -1,000
FV = 1,000
n = 24 semiannual
PMT = 50 semiannual
Solve for i = 5.0000% semiannual
Yield = 2 x semiannual i = 2 x 5.0000% = 10%

Michael Dimond
School of Business

More about bonds

Provisions of bonds
Convertability: A conversion feature allows bondholders to exchange the bond
for a certain number of shares of stock.
Callability: A call feature allows the bond issuer to repurchase the bonds
before they mature (for a premium above the face value)
Warrants: A sweetener which allows the bondholders to purchase a certain
number of shares of stock at a specific price & time.

Current Yield vs Yield to Maturity vs Yield to Call

Current Yield: Annual Payment Price
YTM: Solve for i using the number of periods until the bond matures
(remember to annualize if appropriate)
YTC: Solve for i using the number of periods until the bond can be called
(remember to annualize if appropriate)

The approximation formula (PMT+((FV-PV)/n))/((FV+PV)/2)

works only when bonds are selling close to par
Michael Dimond
School of Business

Interest rates
The coupon rate and the yield of a bond both reflect interest
rates.
The coupon rate reflects the interest which the market was
demanding at the time the bond was planned.
Risk determines the rate of return which investors will bear. What risks do
bondholders face?

The yield reflects the interest which the market requires right
now. Again, this is based on the risk faced by holders of this
bond.
Can the riskiness of a company change between the time a bond is issued
and the time it matures?

The yield of a bond is the interest demanded by the market

and is the Cost of Debt (Kd).

Michael Dimond
School of Business

Capital: How a firm finances its

assets
All assets are backed by either equity or debt:
A = L + SE
Each type of capital has a different required rate of return
Debt has a yield demanded by investors (e.g. Bondholders)
Common stock (equity) has a return demanded by investors
Preferred stock (equity) has a return demanded by investors

Each type of capital bears a different amount of risk

Debt has the most structured arrangement
Common stock has the least structured arrangement
Because of risk, Kd < Kpfd < Ke

Capital Structure is the mixture of capital used in a company

Michael Dimond
School of Business

Perpetuity: The annuity which

doesn't end
What happens to PV as n increases?

If all other TVM factors are unchanged, PV gets smaller as n increases

100 (1+10%)1 = 90.9091
100 (1+10%)5 = 62.0921
100 (1+10%)20 = 14.8644
100 (1+10%)40 = 2.2095
100 (1+10%)60 = 0.3284
100 (1+10%)100 = 0.0073

What the value finally does

If n gets large enough, the PV of a single CF becomes almost zero:
100 (1+10%)1000 = 0.0000000000000000000000000000000000000004
This means any single additional cash flow does not significantly increase the
sum of the present values, even though all of the remaining CFs have value.

With a little math, the discounting of a perpetuity simplifies to:

PVperp = CF/r
Michael Dimond
School of Business

Valuing a perpetuity
Consider a $100 annual perpetuity ($100 per year forever).
What if you require a 12% annual return?
0

i = 12% APR
2

4
The timeline for a perpetuity has an arrow
at the right end to indicate there is no end
to the timeline

PV?

100

100

100

100

Rather than trying to discount a infinite number of cash flows, we use the
perpetuity formula.

The value of a perpetuity: PVperp = CF/r

100 0.12 = 833.3333 :. You would be willing to pay $833.33 right now to
receive $100 per year forever.
What would happen if your required rate of return was higher (15%)?
What would happen if your required rate of return was higher (8%)?
Michael Dimond
School of Business

Growing perpetuities
Consider a $100 annual perpetuity which grows 10% each
year.
What if you require a 12% annual return?
i = 12% APR
g = 10%
0

PV?

100

110

121

133.10

As long as the percent growth rate is constant, this formula

will give the present value: PVperp = CF/(r g)

PVperp = 100 (0.12 0.10) = 100 0.02 = 5,000

Expected growth has value
There is a rule: r > g
Notice this formula still works for a non-growing perpetuity. When growth =
0%, PVperp = CF/(r 0) = CF/r
Michael Dimond
School of Business

Growing perpetuities
The general formula for valuing any perpetuity:
PVperp = CF/(r-g)
What a share of stock does:
A stock which pays a dividend is a perpetuity. There is no anticipated end to
the timeline, and there is an expected cash flow which behaves in a
predictable fashion.
For example, IBM stock has paid a dividend regularly since 1962. Looking at
the quarterly amounts, the pattern is easy to see:
6-May-10
6-Aug-10
8-Nov-10
8-Feb-11
6-May-11
8-Aug-11
8-Nov-11
8-Feb-12
8-May-12
8-Aug-12

0.65 Dividend
0.65 Dividend
0.65 Dividend
0.65 Dividend
0.75 Dividend
0.75 Dividend
0.75 Dividend
0.75 Dividend
0.85 Dividend
0.85 Dividend

You could probably predict the next several dividends without much doubt.
Michael Dimond
School of Business

Stock: the Dividend Growth Model

Stock acts like a perpetuity, so we can adapt the value of a
perpetuity to value a share of stock:
P0 = D1/(r-g)
Notice the price (P0) is at time zero (right now) and the
expected dividend (D1) is the cash flow which determines the
current price.
In many cases, the most recent dividend is given instead of
the expected dividend. If this happens, you need to
determine the expected dividend:
D1 = D0 x (1+g)

Michael Dimond
School of Business

Dividend Growth Model examples

You require a 12% return on investment. If XYZ Company
stock just paid a $1.00 dividend and dividends are expected
to grow 4% per year forever, how much would you pay for a
share of this stock?
D0 = 1.00 :. D1 = 1.00 x (1 + 4%) = 1.04
1.04 (0.12 0.04) = 1.04 0.08 = 13.00
:. You would be willing to pay $13.00 per share for XYZ Company

If IBM stock has an expected annual dividend of $3.79 (four

quarters of dividends), a growth rate of 14.9% and you
require 16.8% return, what price would you pay for IBM
stock?
3.79 (0.168 0.149) = 3.79 0.0190 = 199.4737
:. You would be willing to pay $199.47 per share for IBM

Michael Dimond
School of Business

More about common stock

Shares authorized vs issued vs outstanding

Classes of common stock (Class A vs Class B)
Voting rights & proxy ballots
Preemptive rights
Flotation
Foreign stock on the U.S. Market (ADRs)

Michael Dimond
School of Business

About Preferred Stock

Preferred stock is an ownership stake (equity) which comes
with a contracted payout.
The dividend is frequently a percentage of the par value of
the stock.
For example, 5% preferred stock with a $10.00 par value would have an
annual dividend of $0.50.
Because it is a percent of the par value, the dividend does not grow.
The dividend is a perpetuity, so we use the perpetuity formula to value
preferred stock.

XYZ Company has preferred stock with a $3.00 dividend and

investors require a 9% return for this preferred equity. What is
the market price?
D0 = 3.00 :. D1 = 3.00
3.00 0.09 = 33.3333
:. The market price is $33.33 per share for XYZ Company Preferred Stock.
Michael Dimond
School of Business

More about preferred stock

Dividend does not grow
Par value
Flotation & uses

Michael Dimond
School of Business

Equity section of the Balance Sheet

Equity section line items usually include
Book value of common stock, sometimes divided into par value and additional
amounts paid to the company (APIC)
Book value of preferred stock, also showing par value and additional amounts
Retained earnings

Inferring events from the balance sheet & other data

The balance sheet shows a snapshot at the end of a period
Comparing two consecutive balance sheets can show changes
Retained earnings will increase based on profits (net income) and be reduced by
payouts (such as dividends). Can you rearrange this data to solve for missing
parts?
Stock issuance will affect both the stock at par value and the additional paid-in
capital. Can you determine the number of shares or the share price from data like
this?

Michael Dimond
School of Business

 If this company paid $180,000 in dividends during 2012

What was their 2012 Net Income?
How many shares did the company issue & sell during 2012?
What was the average price-per-share of the new stock sold in 2012?

Michael Dimond
School of Business