《Chapter 5 - Interest Rates and Bond Valuation》.ppt

7-*; 7-*; See the bond definitions and risks. Critical thought question: Rank the following in order of their claim on the issuing firm. From safest (1) to most risky (5): 1 Mortgage Bonds (secured) 2 Debentures (unsecured) 3 Subordinated debentures 4 Preferred Stock 5 Common Stock (residual claim) CN88 Bond Pricing The value of a security depends on: AMOUNT of cash flows it generates (coupons and par value) TIMING of cash flows (coupon payment period and maturity) RISK (likelihood that payments will be made as promised, which incorporates investors’ required rate of return, based upon relative risk, and rates offered on other similar investments, which represents the so-called opportunity cost of funds) CN88 To price a bond, we take the present value of all of the promised payments of the bond, including coupon payments (if any) and the face value. These cash flows are discounted at the appropriate discount rate, called the cost of debt, or YTM mentioned earlier. We will abbreviate YTM as rd which is an “APR-like” measure. We can think of a bond as a package of cash flows, consisting of the ordinary annuity of coupon payments, and the lump sump payment at maturity (face value). The promised cash flows don’t change over the life of a typical bond… the time line only grows shorter as the bond moves toward maturity. CN88 A bond with 10 years to maturity has a coupon rate of 10% with annual coupon payments, and a face value of $1,000. First, draw the timeline for the bond: N = 10 PMT = (coup. rate x face) = (.10 x $1,000) = $100 # PMTs per year 1 FV = 1,000 0 1 2 3 4 5 6 7 8 9 10 $0 $100 $100 $100 $100 $100 $100 $100 $100 $100 $100 $1,000 CN88 5.1a-c. Compute the present v