Finance: Bond Valuation & Bond Markets, NPV & Alternatives, DCF Analysis

Required Returns

Required Returns

Required return is linked to uncertainty (risk) about future cash flows; the more uncertain the cashflows, the higher the risk; higher risk results in Higher Required Return

As cashflow estimates increase

market prices increase

As investor required returns increase

market prices decline

Bonds trade in prices

investors estimate future cashflows and discount them using require return to establish the price

Bond

financial asset issued when some institution wants to borrow money; loans linked to particular security

Primary Market

first time bond is sold; one time CF to borrower (ex. auctions/treasuries, investment banks)

Secondary Markets

transferring right to future CF of bond (ex. OTC markets, dealers & brokers)

Maturity Date

redemption date – last payment

Principal/Face Value/Par Value

value that the Issuer agrees to repay, this is the amount on which interest is generally calculated ( large amount repaid on maturity date)

Coupon Rate

determines the CF dollar amounts, interest rate paid, usually the same as the market rate; fixed until maturity

If the discount rate increases

the price (value) of the bond decreases

Yield to maturity

single discount rate used to calculate the market price of the bond; expected return; assumes the bond is held to maturity and different than coupon rate

"discount bond"

coupon rate < yield – price < face value

"premium bond"

coupon rate > yield –> price > face value

"par bond"

coupon rate = yield –> price = face value, most bonds issued at par

Interest Rate Risk

risk increases as maturity increases; as rates change, prices will change; longer bond periods respond greater than short maturity

Effect of Time on Bond Prices

"pull to par/face value", price approaches face value; there is a coupon rate difference where you are willing to pay more closer to coupon payment; willing to pay more for higher coupon

Default premium

difference between treasury YTM and corporate YTM; higher the perceived risk in the corporate bond, the higher the YTM, so corporate issuers need to offer higher YTM (lower price today, higher future yield)

Bond Ratings

Lower risk (AAA), higher risk of default (AA-BBB) (BB-CCC), already defaulting (CC-D)

Callable Bonds

"callability" bonds where a right (option) is granted to the issuer to buy back the bond, usually at face value before maturity date; choice is with issuer; might choose to call if interest rates lowering or could refinance to pay lower rate

Convertible Bonds

bonds where a right (option) is granted to the investor to exchange the bond for some other specified security, usually common stock before maturity date; willing to pay more than identical, regular bond; choose to convert when high YTM –> low price relative to value of equity

Zero-Coupon Bonds

no coupons (rate is 0%), treasury bills (<1 yr)

Price =

PV(all the bonds CF discounted at yield)

For ALL potential projects, if required return increases, NPV will...

maybe increase, maybe decrease

NPV

best evaluation method; measuring value created today by considering all cash flows; PV(benefits)-PV(costs), projects should be accepted if NPV is positive (following this rule increases firm value); maximization of shareholder value

Cost of Capital

(discount rate/required return) best available expected return offered on an investment of comparable risk and term (timing)

Internal Rate of Return (IRR)

interest rate that makes project equal to 0; accept the project if IRR is greater than cost of capital used to calculate the NPV [intuitive]

Challenges of IRR

IRR and NPV are not always equivalent rules, (1) are we lending or borrowing (2) multiple IRRs [certain CF can generate NPV=0 at two different discount rates (3) mutually exclusive projects [only reasonable compare with same initial investments]

MIRR fixes issues with the IRR method including...

multiple IRRs and lending/borrowing issue (NOT issue of scale)

Modified Internal Rate of Return (MIRR)

modify CF to deal with the problem of multiple IRRs, rearranges so there is only one sign change of CFs (if there's only two CF you can explicitly calculate)

Profitability Index (PI)

incorporating NPV into limited resource idea; want it to be positive; firms choose the set of projects with the largest profitability indices until it runs out of resources, NPV projects that create the greatest total value for stockholders

Payback Period

length of time until you make your money back; quicker is better and accept if payback is less than some pre-specified number of years (firm discretion)

Advantages of Payback

simple to use, no need to estimate cost of capital, and is a crude measure of liquidity (ease & speed to access cash)

Drawbacks of Payback

how is cut off supposed to be determined?, bias against long term projects, ignores time value of money (NPV), ignores cash flows after cut off point (what happens after payback period), and inconsistent with maximization of shareholder value (might take negative NPV projects) BETTER OPTION: DISCOUNTED PAYBACK

Discounted Payback

takes into account liquidity

Incremental Cash Flows

(relevant CF) for project valuation, any changes in future CF that are a direct consequence of accepting project; CF w/ project – CF without

Sunk Costs

a cost that is already paid and cannot be recovered

Opportunity cost

cost of lost options; ex. renovating projects

Erosion (side effect)

negative impact on CFs of an existing product from the introduction of a new product; substitute

Spillover (side effect)

positive impact on CFs of an existing product from the introduction of a new product; complement

Net Working Capital (NWC)

(inventory) investment needed to start operations; initial investment in inventories, AR to cover credit sales, AP to pay for credit purchases; always recovered at the end of the project for finite lived projects

Marginal Tax Rate

the percentage paid on the next dollar earned, can move around, "what we care about"

Average Tax Rate

tax bill divided by taxable income

Depreciation

affects taxable income and book value, capitalized asset, straight-line depreciation = (initial cost – salvage value)/number of years

After-Tax Salvage

Salvage – Tax(salvage – book value); tax effect if there is difference from book value

Financing costs

not included in our evaluations, financing activities should have NPV = 0

How do we know NPV is accurate?

Capital rationing, sensitivity, scenario, simulation, and breakeven analysis

Sensitivity Analysis

testing various individual assumptions to see the result on NPV; identifies critical assumptions; various CF's assumptions are optimistic, expected, and pessimistic

Scenario Analysis

testing particular combinations of assumptions to measure change in NPV (interrelated assumptions); alternative business environment

Simulation Analysis

expanded version of scenario analysis using statistical tools to test multiple scenarios to look at possible outcomes, probability distribution; identifies risk not apparent using traditional scenario analysis, but requires definition of probability distribution of inputs and model that defines interactions of various assumptions

Break-even Analysis

level of sales (or other variable) at which the company "breaks even", performance target

Accounting Break-Even

point where Net Income becomes positive; annual revenue – variable costs – fixed costs – depreciation = 0

Economic Break-Even

point where NPV is greater than zero; this one we use; NPV = 0