Download Session 3: Bond Valuation

Financial Analysis revised
Page 24 of 54 pages. Chapter: 13: Module 2.4: Capital Structure and Value...
Session 3: Bond Valuation
Bond represents the capital provided by the long term fund providers of the firm. Bond valuation is
important to know the status how much the debt of the firm worth.
Important Learning Terms
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Bond
Coupon Interest rate
Par value
Yield
Indenture
Mortgage bond
Eurobonds
Value
Bond Rating
Definitions and Characteristics of Bonds
A bond is a long-term promissory note that promises to pay the bondholder a predetermined, fixed
amount of interest each year until maturity. At maturity, the principal will be paid to the bondholder.
In the case of a firm's insolvency, a bondholder has a priority of claim to the firm's assets before the
preferred and common stockholders. Also, bondholders must be paid interest due them before
dividends can be distributed to the stockholders.
A bond's par value is the amount that will be repaid by the firm when the bond matures.
The contractual agreement of the bond specifies a coupon interest rate that is expressed either as a
percent of the par value or as a flat amount of interest which the borrowing firm promises to pay the
bondholder each year. For example: A $1,000 par value bond specifying a coupon interest rate of 9
percent is equivalent to an annual interest payment of $90.
The bond has a maturity date, at which time the borrowing firm is committed to repay the loan
principal.
An indenture (or trust deed) is the legal agreement between the firm issuing the bonds and the bond
trustee who represents the bondholders. It provides the specific terms of the bond agreement such as
the rights and responsibilities of both parties.
The current yield on a bond refers to the ratio of annual interest payment to the bond’s market price
Types of Bonds
Debentures: unsecured long-term debt.
Subordinated debentures: bonds that have a lower claim on assets in the event of liquidation than do
other senior debtholders.
Mortgage bonds: bonds secured by a lien on specific assets of the firm, such as real estate.
Eurobonds: bonds issued in a country different from the one in whose currency the bond is
denominated; for instance, a bond issued in Europe or Asia that pays interest and principal in U.S.
dollars.
Zero and low coupon bonds allow the issuing firm to issue bonds at a substantial discount from their
$1,000 face value with a zero or very low coupon.
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The disadvantages are, when the bond matures, the issuing firm will face an extremely large
nondeductible cash outflow much greater than the cash inflow they experienced when the
bonds were first issued.
Discount bonds are not callable and can be retired only at maturity.
On the other hand, annual cash outflows associated with interest payments do not occur with
zero coupon bonds.
Junk bonds: Bonds rated BB or below by the credit rating companies.
Bond Ratings
Bond ratings are simply judgments about the future risk potential of the bond in question. Bond
ratings are extremely important in that a firm’s bond rating tells much about the cost of funds and the
firm’s access to the debt market.
Three primary rating agencies exist—Moody’s, Standard & Poor’s, and Fitch Investor Services in the
United States.
Value
Definitions of value
Book value is the value of an asset shown on a firm's balance sheet which is determined by its
historical cost rather than its current worth.
Liquidation value is the amount that could be realized if an asset is sold individually and not as part of
a going concern.
Market value is the observed value of an asset in the marketplace where buyers and sellers negotiate
an acceptable price for the asset.
Intrinsic value is the value based upon the expected cash flows from the investment, the riskiness of
the asset, and the investor's required rate of return. It is the value in the eyes of the investor and is
the same as the present value of expected future cash flows to be received from the investment.
Valuation: An Overview
Value is a function of three elements:
1. The amount and timing of the asset's expected cash flow
2. The riskiness of these cash flows
3. The investors' required rate of return for undertaking the investment
Expected cash flows are used in measuring the returns from an investment.
If interest payments are received semiannually (as with most bonds) the valuation equation becomes
Bondholder's Expected Rate of Return (Yield to Maturity)
The bondholder's expected rate of return is the rate the investor will earn if the bond is held to
maturity, provided, of course, that the company issuing the bond does not default on the payments.
Computing Yield-to-Maturity on a Bond (YTM)
Note: The investor uses the bond's computed YTM by comparing it to his/her required rate of return
on the bond after considering all risk factors.
1) If the investor's required return is greater than the YTM, the investor should not buy the bond
2) If the investor's required return is less than the YTM, the investor should buy the bond
Bond Value: Three Important Relationships
First relationship
A decrease in interest rates (required rates of return) will cause the value of a bond to increase; an
interest rate increase will cause a decrease in value. The change in value caused by changing interest
rates is called interest rate risk.
Second relationship
1. If the bondholder's required rate of return (current interest rate) equals the coupon interest rate,
the bond will sell at par, or maturity value.
2. If the current interest rate exceeds the bond's coupon rate, the bond will sell below par value or at
a "discount."
3. If the current interest rate is less than the bond's coupon rate, the bond will sell above par value or
at a "premium."
Third relationship
A bondholder owning a long-term bond is exposed to greater interest rate risk than when owning a
short-term bonds.
Relationships on the YTM
• Since the bond's coupon rate, kc, is fixed for the life of bond, the following \
YTM/bond price relationship is created:
Discussion Questions
1. Telecom Tanzania Ltd issued a 20 year bond with a coupon rate of 9%, selling to yield 12% interest
rate ear annum. Calculate
a) The price of the bond
b) If the financial analyst in the Tanzania Communication Commission suggests that the yield basis
should be 10%, what is the price of the new bond?
2. TeleCel (Botwsana) Ltd. issued two bonds A and B. Both carry coupon rates of 8% and both require
a yield to maturity of 8%. Bond A have 5 years to maturity while bond 10 years to maturity. The
required market yield for each bond rises by 2 percentage points. Compare the percentage price
changes for the two bonds.
3. SamSon Telecoms Ltd, a Subsidiary of Samwel Mollel and Sons Inestment Ltd in Zimbabwe; issued
bonds in 1987 at $1,000 per bond. The bond had a 30 year life when issued and the annual interest
payment was then 11%. The return was in line with required returns by bondholders at that point as
described below.
4.
Rate of return 3%
Inflation premium 5
Risk premium 3
Total return 11%
Assume in 2002 the inflation premium was only 2% and it is appropriately reflected in the required
rate of return (or yield to maturity) of the bonds. The bonds have remaining 15 years to maturity.
Compute the market price of the bond.
5. Explain why do you think it is important that the telecommunication regulator should understand
the concept of capital structure and value of the firm.
What is
(i) Financial Leverage
(ii) Gearing
6. How the firm should balance between financial gearing and the capital structure of the firm?
Learning Activities
Individual
(1) Discuss with collegues how does the concept of cost of capital affect the value of a
telecommunication company? Present your solution on a discussion forum.
(2) Search in the internet leasing case studies relating to telecommunication. Summarize the case by
presenting the core issues in the case. Summarise what are the important leaning points. In your own
opinion why do you think many telecommunication or ICT companies do not like to use leasing a
source of financing their activities?. Cases can be selected from any continent. Present the summary in
the discussion forum. The summary should not be more than five (5) pages of font 12 time series
roman.