Fundamentals of Business Finance Chapter 7

Current Yield

=a bonds annual coupon/bond price or present value not face value

Formula for bond value:

=cash flows(1-(1/(1+r)^t))/r+ FV/(1+R)^T

Medium Grade

A: capacity to pay is strong, but more susceptible to changes; Baa and BBB is capacity to pay is adequate, adverse conditions will have more impact on the firms ability to pay.

High Grade bonds

AAA capacity to pay is extremely strong; AA

Low Grade

Ba and B, BB and B for s&p; considered possible that the capacity to pay will degenerate.

Bearer Form Bond

Bond is issued without record of the owner's name; payment is made to whomever holds the bond

Moody's & S&P

Bond rating firms that measure the creditworthiness of the issuer

Classifications of debt securities:

Collateral, mortgage, debenture, and notes

Bonds are usually what type of loan?

Interest-only loan

Very Low Grade Bonds

Moody's C and below, S&P C and below; these are income bonds with no interest being paid or in default with principal and interest in arrears.

Sinking Fund

an account managed by the bond trustee for early redemption requires a repurchase of a certain number of bonds each year

Debenture

an unsecured debt, usually with a maturity of 10 years or more; no specific pledge of property is made

Note

an unsecured debt, with maturity of 10 years or less;

Floating Rate Bonds

coupon rate floats depending on some index value ; adjustable rate mortgages, and inflation linked treasuries. coupons may have a cap or collar rate

Municipal Securities

debt of state and local government; varying degrees of default risk and the interest received is tax-exempt at the federal level.

Federal Government Bond Types

include T-bills, T-notes, and T-bonds, as well as municipal bonds

Seniority

indicates preference in position over other lenders; or who gets the right to the money first.

Real Rates

interest rates of return that have been adjusted for inflation

Price Risks with bonds

long term bonds have more price risk than short term bonds; low coupon rate bonds have more price risk than high coupon rate bonds

Debt Features

no ownership interest in the firm, creditors do not have voting rights, interest is considered a cost, creditors have legal recourse if interest payments are missed, and excess debt can also lead to bankruptcy. Debt can be a positive if it is used correctly.

Deferred Call Provision

prohibits company from redeeming a bond prior to a certain date.

T-Bills

pure discount bonds with original maturity of less than 1 year

What are the two terms of bonds?

registered form and bearer form

Mortgage

securities secured by a mortgage on the real property of the borrower

Coupon Rate

the annual coupon/face value of the bond

The indenture

the contract between the company and the lender detailing the terms of the debt issue

Coupons

the stated interest payment made on a bond

Call Protected

a bond that cannot be redeemed by the issuer for a certain period.

Zero Coupon Bonds

a bond that makes no coupon payments and is thus initially priced at a deep discount

Call Provision

an agreement giving the corporation the option to repurchase a bond at a specified price prior to maturity.

Bond Ratings

an assessment of creditworthiness of the corporate issuer and how likely firms are to default on debt and to protect creditors

Collateral

any asset pledged as payment of a debt

What is included in the indenture?

basic terms of the bond, total amount of bonds issued, a description of property used as security, sinking fund provisions, call provisions, and details of protective covenants.

T-Notes

coupon debt with original maturity between 1-10 years

T-Bonds

coupon debt with original maturity of greater than 10 years

Nominal Rates

interest rates of return that have not been adjusted for inflation

Definition of a bond:

issuing or selling debt securities by the government and or corporations.

Protective Covenants

limiting certain actions that might be taken during the term of the loan.

Bid Price

th eprice a dealer is willing to pay for a security

Call Premium

the amount by which the call price exceeds the par value of the bond.

Ask Price

the price a dealer is willing to take for a security

Dirty Price

the price of a bond including accrued interest, also known as the full or invoice price.

Clean Price

the price of abond net of accrued interest; this is the price quoted

Face Value of a bond

the principal amount of a bond that is repaid at the end of the term and is called the par value.

Yield to Maturity

the rate required in the market on bonds

Registered Form Bond

the registrar of the company records ownership of each bond; payment is made directly to the owner of record.

Term Structure interest rates

the relationship between nominal interest rates on default-free pure discount securities and time to maturity; pure TVM

The fischer-Effect

the relationship between real rates, nominal rates, and inflation; 1+R=(1+r)*(1+h), R is the nominal, h is the inflation, r is the real

Maturity

the specified date on which the principal amount of a bond is paid.

Reinvestment Rate Risk of bonds

uncertainty concerning rates which cash flows can be reinvested. Short term has greater reinvestment risk than long term bonds; high coupon rate bonds have a higher risk than low coupon rate bonds.

Discount bond

when a bond sells for less than its face value; less than 1,000. the YTM>coupon rate and the par value>bond price

Premium Bond

when a bond sells for more than its face value; more than 1,000. the YTM<coupon rate and the par value<bond price

Relationship between the interest rate and Present value:

when interest rates rise, the present value of the bonds cash flow decline and is worth less. when interest rates decline the bond is worth more

Relationship between current yield and yield to maturity

with a discount bond; the current yield<YTM With a premium bond; the current yield>YTM