If a corporation needs to borrow
money to finance its activities, it can do 2 things:
1) Issue new stock to raise capital
(equity)
2) Issue bonds to raise money (debt)
Imagine you borrow $10,000 now at
a rate of 12% interest annually, for the next 30 years.
You will therefore pay 0.12 x $10,000 = $1200 per year
for the next 30 years. At the end of the 30 years, you
will also pay back the original $10,000 (principal amount).
What is the total amount you have paid?
$1200 per year x 30 years = $36000
(interest payments)
$10,000 (original principal)
Total payments = $36,000 + $10,000 = $46,000
This sounds like a pretty simple
example right? Yep, bonds are simple debt financing activities,
however they have a rich blend of terminology that you
must learn (in order to become a successful financial
manager).
1) Coupons:
In the above example, the $1200 a year payments
you must make are also known as "coupons."
They are the annual interest payments made on a
bond.
Note: Payments can be monthly, quarterly, semi-annually
or annually, depending on how the interest terms
are set out.
2) Face
Value: In the above example, the
$10,000 that must be repaid back at the end of the
30 years is known as the "Face Value"
of the bond. It is the original price at which the
bond was issued.
3) Coupon
Rate: In the above example, the
interest rate was 12% annually. Therefore, this
12% is known as the "Coupon Rate." It
is the pre-determined interest rate on the bond.
It can also be determined by diving 1200 / 1000
= 12%
4) Maturity
Date: The total # of years until
the original principal (face value) is repaid back
is called the "Maturity Date".
Therefore, the above bond example has a maturity
of 30 years.
5) Yield-to-Maturity
(YTM): The yield to maturity is
the interest rate that brings a bond's original
value, principal payments and interest payments
into equilibrium. It is the prevailing market interest
rate (subject to economic conditions and government
policies).
|
Bond
Terminology
Bonds can be sold either at Par,
Discount or Premium.
| |
Discount |
PAR |
Premium |
| Price of Bond |
Sold for less than face value |
Sold for equal to face value |
Sold for more than face value |
| Investor Requirement |
Higher return than coupon rate |
Equal to coupon rate |
Less return than coupon rate |
i) Bonds sold at Discount
For example, consider a bond selling
in 2005 for $10,000 with an annual coupon
payment of $1000. What is the coupon rate? $1000 / 10,000
= 10%
Now suppose that in 2006,
the same bond yields only 8% interest payments annually.
What is the coupon payment? 8% x 10,000 = $800 per year.
Which one would you prefer buying?
At 10% coupon rate or 8% coupon rate? Since the value
of the bond (cash flows produced) has depreciated from
$1000 per year to only $800 per year, this bond will have
to be sold at a cheaper price (or at DISCOUNT).
ii) Bonds sold at Premium
For example, consider a bond selling
in 2005 for $10,000 with an annual coupon
payment of $1000. What is the coupon rate? $1000 / 10,000
= 10%
Now suppose that in 2006,
the same bond yields an insane 15% in interest payments
annually. What is the coupon payment? 15% x 10,000 = $1500
per year.
Which one would you prefer buying?
At 10% coupon rate or 15% coupon rate? Since the value
of the bond (cash flows produced) has appreciated (gone
up) from $1000 per year to a huge $1500 per year, this
bond will have to be sold at a PREMIUM price (higher
than its original value).
iii) Bonds sold at Par
For example, consider a bond selling
for $10,000 with an annual coupon payment of $1000. Similar
type of bonds are also offering interest payments of $1000
a year. What is the coupon rate?
The coupon rate in this case is $1000
/ $10,000 = 10%. Since similar bonds are also offering
a 10% interest rate, this bond is sold at the original
price of $10,000 (at Par).
| Discount
(Less than Original) |
Premium
(More than Original) |
| Bonds sold at 97.5 of Face Value = |
Bonds sold at 101.5 of Face Value = |
Bond Price = $1000
Sold at 97.5 = 0.975 x $1000
Discounted
Bond Price = $975 |
Bond Price = $1000
Sold at 101.5 = 1.015 x $1000
Premium
Bond Price = $1015 |
Bond Valuation using Financial Analyst
BAII Plus Calculator:
To perform bond calculations, we
will use the above mentioned calculator. Here are the
calculator keys we will use:
N = # of Years x
Interest Payment Periods
I/Y = Market Rate of Return (Investor's
Yield)
PV = (+) Cash Received by issuing firm
NOW (Discount, Par or Premium)
PMT = (-) Interest payment by company
to investors each period
FV = (-) Face value to be repaid back
to Investors
P/Y = # of Interest Payments per Year
C/Y = # of Interest Payments per Year
