Unit 4: Financial Assets

(9 hours)

Introduction

Companies raise capital in two main forms: debt and equity. They may issue
bonds and sell stocks to generate money for business operations. When an
investor purchases company’s bonds, the investor is providing the company
with capital. In addition, when a firm issues bonds, the return that investors
require on the bonds represents the cost of debt capital to the firm. Thus,
financial managers must understand that valuation process, for two basic
reasons. First, the value of financial assets including the firm’s common stock
is determined in the securities markets. The way such values are determined
must be well understood as managers seek to accomplish the fundamental goal
of maximizing the value of the firm’s common stock. Second, as managers go
about managing the real assets of the firm, they must recognize how their
decisions will affect the firm’s common stock value. This chapter brings
together the fundamental concepts of the time value of money as it relates to
return in establishing the value of bonds, preferred stock and common stock.
An understanding of how a firm’s securities are valued its essential to
management as it pursues the value-maximization goal.

Learning Outcomes

At the end of this unit, students will be able to:

 Understand and compares the characteristics of the two main source of

company financing: bonds and stocks;
 Explain and compute the valuation of bonds and stocks

Financial Management Module 1

 Premises

VALUATION

 The Concepts of Valuation

 It is the process of determining (or at least estimating) how much an
asset is worth.
 Expected cash flows, their timing & their riskiness will determine the
value of a financial asset.
 Valuation Process
 To value an asset, one must discount the expected future cash flows from
that asset using the present value techniques.
 Other things being equal, the greater the perceived risk, the lower the
asset’s value.

EXAMPLE:
Assume that investments in the assets required producing and market two new
products, sweaters and suspenders are expected to bring annual cash flows of Php
10,000 from each for the next 10 years with no value at the end of the 10-year
period. The risk-free interest rate is 8%; the risk premium for the low-risk
sweaters is 2% and for the high-risk suspenders, 12%.

Calculation of the value of these assets

Asset Expected Discount Rate PVFA Value
(product) Annual (Risk-free +
Cash Flow Risk premium)
Sweaters Php 10,000 0.08+0.02=0.10 6.145 Php 61,450
Suspenders Php 10,000 0.08+0.12=0.20 4.192 Php 41,920
Note that the higher discount rate applied to suspenders, attributable entirely to
the higher risk, accounts for the lower PVFA factor and the resulting lower value
of the riskier asset.

The market value of a financial asset is determined by the forces of supply and
demand for that security at the time. The price of an asset will equal its value
when its market is in equilibrium.
o MARKET EQUILIBIRUM - is achieved when the forces of supply
and demand are equal.
o The EQUILIBRIUM VALUE of any financial asset is equal to the
discounted present value of future cash flows expected by those who
invest in it.

Key Elements in the Valuation Process for Financial Assets

1. Future cash flows expected by investors
2. The anticipated timing of these cash flows
3. The discount rate used by investors in reducing these future cash flows to
present values. (The discount rate, in turn, is the sum of the risk-free rate
of return and the premium for perceived risk.)

Financial Management Module 2

Topic 6: Bonds and Their Valuation

Putting Things in Perspective

In previous modules, you learned that companies raise capital in two main
forms: debt and equity. In this module, you will study the characteristics of
bonds and the various factors that influences its price.

This module would reinforce your learnings on our past topic “Time Value of
Money.” Simply to say, in this module we will be using case problems which
will let you apply the concepts of time value of money.

Learning Objectives

After successful completion of this topic, you should be able to:

 Identify the different features of corporate and government bonds.

 Discuss how bond prices are determined in the market, what the
relationship is between interest rates and bond prices, and how a
bond’s price changes over time as it approaches maturity.
 Calculate a bond’s yield to maturity and its yield to call if it is callable
and determine the “true” yield.
 Explain the different types of risk that bond investors and issuers face
and the way a bond’s terms and collateral can be changed to affect its
interest rate.

Financial Management Module 3

 Presentation of Contents

What is Bond?

A bond is a long-term contract/instrument under which a borrower agrees to

make payments of interest and principal on specific dates to the holders of the
bond.

Bond’s terms and conditions are contained in a legal contract between the
buyer and the seller, known as the indenture.

Bonds are issued by corporations and government agencies that are looking
for long-term debt capital.

Who issues Bonds?

1. Treasury Bonds – Bonds issued by the government, generally called
Treasuries and sometimes referred to as government bonds.
- have no default risk (it is assumed that government will make good
on its promised payments).
2. Corporate Bonds – Issued by corporations.
- exposed to default risk - if the issuing company gets into trouble, it
may be unable to make the promised interest and principal payments
and bondholders may suffer losses.
3. Foreign Bonds – Bonds issued by foreign governments and corporations.

Source: Source:
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YzoDg&bih=657&biw=1366#imgrc=fWXxiS13BM-kVM

Financial Management Module 4

The Concepts of Bond
 It is a fixed income instrument that represents a loan made by an investor
to a borrower (typically corporate or governmental).
 It is a long-term contract under which a borrower agrees to make
payments of interest and principal on specific dates to the holders of the
bond.
 When an investor purchases a bond, they are "loaning" that money (called
the principal) to the bond issuer, which is usually raising money for some
project. When the bond matures, the issuer repays the principal to the
investor. In most cases, the investor will receive regular interest payments
from the issuer until the bond matures.
 It is a promise to pay the redemption value at a specified date and interest
rate called the redemption date and redemption rate, respectively and in
the meantime to make periodic payments or coupon payments at regular
intervals.
Example: A Php 20,000, 10% bond with semiannual payments is
redeemed at 105% at the end of 12 years. Find the coupon payment and
the redemption value.
F = 20,000 d = 1.05 b = 0.1 m=2 r = b/m = 0.1/2 = 0.05
a. The coupon payment is equal to the face value times the periodic rate
C = Fr = 20,000 x 0.05 = Php 1,000
b. The redemption value is equal to the face value times the redemption
rate.
S = Fd = 20,000 x 1.05 = Php 21,000

How Bonds Work?

 Many corporate and government bonds are publicly traded; others are
traded only over-the-counter (OTC) or privately between the borrower and
lender.
 When companies or other entities need to raise money to finance new
projects, maintain ongoing operations, or refinance existing debts, they may
issue bonds directly to investors. The borrower (issuer) issues a bond that
includes the terms of the loan, interest payments that will be made, and the
time at which the loaned funds (bond principal) must be paid back
(maturity date). The interest payment (the coupon) is part of the return that
bondholders earn for loaning their funds to the issuer. The interest rate that
determines the payment is called the coupon rate.
 Most bonds can be sold by the initial bondholder to other investors after
they have been issued. In other words, a bond investor does not have to
hold a bond all the way through to its maturity date. It is also common for
bonds to be repurchased by the borrower if interest rates decline, or if the
borrower’s credit has improved, and it can reissue new bonds at a lower
cost.

Financial Management Module 5

Key Characteristics of Bonds

a) Face Value - The face value (also known as the par value) of a bond is
the price at which the bond is sold to investors when first issued; it is also
the price at which the bond is redeemed at maturity. Usually, the face
value is ₱1,000 or a multiple of ₱1,000.
b) Coupon Payment - A bond’s coupon is the dollar value of the periodic
interest payment promised to bondholders; this equals the coupon rate
times the face value of the bond.
For example, if a bond issuer promises to pay an annual coupon rate of
5% to bond holders and the face value of the bond is ₱1,000, the bond
holders are being promised a coupon payment of (0.05)(₱1,000) = ₱50 per
year.
c) Coupon Interest Rate - The periodic interest payments promised to bond
holders are computed as a fixed percentage of the bond’s face value; this
percentage is known as the coupon rate.
d) Fixed-Rate Bonds - A bond whose interest rate is fixed for its entire life.
e) Floating-Rate Bond - A bond whose interest rate fluctuates with shifts in
the general level of interest rates.
f) Zero Coupon Bond - A bond that pays no annual interest but is sold at a
discount below par, thus compensating investors in the form of capital
appreciation.
g) Original Issue Discount (OID) Bond – Any bond originally offered at a
price below it par value.
h) Maturity Date – A specified date on which the par value of a bond must
be repaid.
i) Original Maturity – The number of years to maturity at the time a bond
is issued.
j) Call Provisions - Many bonds contain a provision that enables the issuer
to buy the bond back from the bondholder at a pre-specified price prior to
maturity. This price is known as the call price. A bond containing a call
provision is said to be callable. This provision enables issuers to reduce
their interest costs if rates fall after a bond is issued, since existing bonds
can then be replaced with lower yielding bonds. Since a call provision is
disadvantageous to the bond holder, the bond will offer a higher yield
than an otherwise identical bond with no call provision.
A call provision is known as an embedded option, since it can’t be bought
or sold separately from the bond.
k) Sinking Fund Provisions - Some bonds are issued with a provision that
requires the issuer to repurchase a fixed percentage of the outstanding
bonds each year, regardless of the level of interest rates. A sinking fund
reduces the possibility of default; default occurs when a bond issuer is
unable to make promised payments in a timely manner. Since a sinking
fund reduces credit risk to bond holders, these bonds can be offered with a
lower yield than an otherwise identical bond with no sinking fund.
l) Put Provisions - Some bonds contain a provision that enables the buyer
to sell the bond back to the issuer at a pre-specified price prior to
maturity. This price is known as the put price. A bond containing such a
provision is said to be putable. This provision enables bond holders to

Financial Management Module 6

 benefit from rising interest rates since the bond can be sold and the
proceeds reinvested at a higher yield than the original bond. Since a put
provision is advantageous to the bond holder, the bond will offer a lower
yield than an otherwise identical bond with no put provision.
m) Convertible Bonds – a bond that is exchangeable at the option of the
holder for the issuing firm’s common stock.
n) Warrant – A long-term option to buy a stated number of shares of a
common stock at a specified price.
o) Income Bond – A bond that pays interest only if it is earned.
p) Indexed (Purchasing Power) Bond – A bond that has interest payments
based on a inflation index so as to protect the holder from inflation.

Bond Valuation

A bond’s price equals the present value of its expected future cash flows. The
rate of interest used to discount the bond’s cash flows is known as the yield to
maturity (YTM.)

A) Pricing Coupon Bonds

The following general equation can be solved to find the value of any bond:

Where:
rd = the market rate of interest on the bond. This is the discount rate used to
calculate the present value of the cash flows, which is also the bond’s
price.
N = the number of years before the bond matures. N declines over time after
the bond has been issued.
INT = dollars of interest paid each year. Coupon rate x Par value
M = the par, or maturity, value of the bond. This amount must be paid at
maturity.

This formula shows that the price of a bond is the present value of its
promised cash flows.

As an example, suppose that a bond has a face value of $1,000, a coupon rate
of 4% and a maturity of four years. The bond makes annual coupon payments.
If the yield to maturity is 4%, the bond’s price is determined as follows:

Financial Management Module 7

These results also demonstrate that there is an inverse relationship between
yields and bond prices:
 when yields rise, bond prices fall
 when yields fall, bond prices rise

B) Adjusting for Semi-Annual Coupons

For a bond that makes semi-annual coupon payments, the following
adjustments must be made to the pricing formula:
 the coupon payment is cut in half
 the yield is cut in half
 the number of periods is doubled
As an example, suppose that a bond has a face value of $1,000, a coupon rate
of 8% and a maturity of two years. The bond makes semi-annual coupon
payments, and the yield to maturity is 6%. The semi-annual coupon is $40,
the semi-annual yield is 3%, and the number of semi-annual periods is four.
The bond’s price is determined as follows:

= 38.83 + 37.70 + 36.61 + 924.03 = $1,037.17

C) Pricing Zero Coupon Bonds

A zero-coupon bond does not make any coupon payments; instead, it is sold to
investors at a discount from face value. The difference between the price paid
for the bond and the face value, known as a capital gain, is the return to the
investor. The pricing formula for a zero coupon bond is:

Financial Management Module 8

As an example, suppose that a one-year zero-coupon bond is issued with a
face value of $1,000. The discount rate for this bond is 8%. What is the
market price of this bond? In order to be consistent with coupon-bearing
bonds, where coupons are typically made on a semi-annual basis, the yield
will be divided by 2, and the number of periods will be multiplied by 2:

MORE EXAMPLES:
1. A friend of yours just invested in an outstanding bond with a 5% annual
coupon and a remaining maturity of 10 years. The bond has a par value of
Php 1,000 and the market interest rate is currently 7%. How much did
your friend pay for the bond? Is it a par, premium or discount bond?

SOLUTION:
𝟏 − (𝟏+𝒊)−𝒏
Po = I ⌈ 𝒊
⌉ + M (1+i)-n
1 − (1+0.07)−10
= (1,000 x 0.05) ⌈ ⌉ + (1,000)(1+0.07)-10
0.07
= (50 x 7.0235815414) + (1000 x 0.5083492921)
= 351.17907707 + 508.3492921
= 859.53
 The bond’s value is equal to 859.53
 Since the bond’s coupon rate (5%) is less than the current market
interest rate (7%), the bond is a discount bond – reflecting that interest
rates have increased since this bond was originally issued.

2. A Php 10,000 bond with interest 12% converted quarterly is redeemable

at 115% in 10 years. Find the coupon payment, redemption value,
purchase price and premium that yields the purchaser 10% compounded
quarterly.

SOLUTIONS:
a. Coupon Payment = Face Value x bond rate per interest period
= 10000 x (12%/4)
= 300

b. Redemption Value = Face Value x redemption rate

= 10,000 x 115%
= 11,500

c. i = r/m = 10%/4 = 0.025 n = t(m) = 10 x 4 = 40

𝟏 − (𝟏+𝒊)−𝒏
Purchase Price =I⌈ ⌉ + M (1+i)-n
𝒊
1 − (1+0.025)−40
= 300 ⌈ ⌉ + 11,500 (1+0.025)-40
0.025
= 7,530.8325156263 + 4,282.9521725248
= 11,813.78

Financial Management Module 9

 d. Bond Premium = Purchase Price – Redemption Value
= 11,813.78 – 11,500
= 313.78
BOND YIELDS
 To be most useful, the bond’s yield should give an estimate of the rate of
return one would earn if we purchased the bond today and held it over its
remaining life.

 YIELD TO MATURITY (YTM) – the rate of return earned on a bond if

it is held to maturity.
𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒−𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒
𝐶𝑜𝑢𝑝𝑜𝑛+
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑃𝑒𝑟𝑖𝑜𝑑𝑠
YTM = 𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒+𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒
2

EXAMPLE: Suppose you were offered a 14-year, 10% annual coupon,

1,000 par value bond at a price of 1,494.93. What rate of
interest would you earn on your investment if you bought the
bond, held it to maturity and received the promised interest and
maturity payments?
𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒−𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒
𝐶𝑜𝑢𝑝𝑜𝑛+
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑃𝑒𝑟𝑖𝑜𝑑𝑠
YTM = 𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒+𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒
2

1,000−1,494.93
(1,000𝑥10%) +( )
14
= 1,000 + 1,494.93
( )
2

100 – 35.3521428571
= 1247.465

= 5.18%

 YIELD TO CALL (YTC) – the rate of return earned on a bond when it

is called before its maturity date.
𝐶𝑎𝑙𝑙 𝑃𝑟𝑖𝑐𝑒−𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝐶𝑜𝑢𝑝𝑜𝑛 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 +
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠 𝑢𝑛𝑡𝑖𝑙 𝐶𝑎𝑙𝑙
YTC = 𝐶𝑎𝑙𝑙 𝑃𝑟𝑖𝑐𝑒+𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
2

EXAMPLE: You have just purchase an outstanding 15-year bond with a

par value of 1,000 for 1,145.68. Its annual coupon payment is
75. Assume that this bond is callable in 7 years at a price of
1,075. What is the bond’s YTC?

Financial Management Module 10

 𝐶𝑎𝑙𝑙 𝑃𝑟𝑖𝑐𝑒−𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝐶𝑜𝑢𝑝𝑜𝑛 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 +
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠 𝑢𝑛𝑡𝑖𝑙 𝐶𝑎𝑙𝑙
YTC = 𝐶𝑎𝑙𝑙 𝑃𝑟𝑖𝑐𝑒+𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
2

1075−1145.68
75+
7
= 1075 +1145.68
2

64.9028571429
= 1110.34

= 5.85%

Application

Short Problem

The Washington Corporation issued a new series of bonds on January 1, 2005.

The bonds were sold at par (₱1,000); had a 12% coupon; and mature in 30
years, on December 31, 2034. Coupon payments are made semi-annually (on
June 30 and December 31).
a) What was the YTM on January 1, 2005?
b) What was the price of the bonds on January 1, 2010, 5 years later,
assuming that interest rates had fallen to 10%?
c) Find the current yield, capital gains yield, and total return on January 1,
2010, given the price as determined in Part b.

Feedback

Think about these questions

1. What is bond?
2. What are the key characteristics of bonds?
3. How to compute the value of the bonds?

Now you are ready to take an oral quiz for today’s discussion.

Financial Management Module 11