Week3 Bond valuatiion

Introduction to Corporate Bonds

• Corporate Finance Purpose: Raising finance to maximize company value and shareholder wealth.

• Types of Capital:

  • Debt Capital: Involves bonds and loans.

  • Equity Capital: Comprises ordinary shares.

Learning Objectives

• Identify sources of external finance available to companies.

• Explain characteristics of bonds and types of corporate bonds.

• Understand bond ratings and valuations.

• Interpret bond price quotations from financial media.

External Sources of Finance

• External sources require agreements from parties outside the company.

• Example: Banks, investors, etc.

• Types:

  • Long-term sources (maturity > 1 year): Ordinary shares, preference shares, corporate borrowings.

  • Short-term sources (maturity < 1 year): Loans, bank overdrafts, and asset-based finance.

Long-term Finance:

• Ordinary Shares (Common Stock): Variable income securities.

• Preference Shares: Fixed income with certain fixed dividends.

• Corporate Bonds: Also fixed income; constant interest payments.

Short-term Finance:

• Examples include bank overdrafts and factoring debt.

• Debt Factoring: Raising finance against trade receivables, collateralized by account receivables.

Debt vs. Equity Financing

• Debt: Typically cheaper and involves fixed payments, lower risk.

• Equity: More expensive; offers higher returns due to its risk.

• Characteristics of Debt:

  • No voting rights for lenders.

  • Debt holders have priority claims in liquidation.

Corporate Bonds

• Definition: Securities promising to pay interest and principal at maturity.

• Key Features:

  • Par Value: Value at maturity; usually returned.

  • Coupon Rate: Interest rate paid to bondholders.

  • Maturity Date: When the bond principal is repaid.

• Bond Indenture: Legal agreement including terms and conditions of the bond.

Types of Corporate Bonds

• Unsecured Bonds (Debentures): Higher risk, contingent on company's earnings.

• Secured Bonds (Mortgage Bonds): Backed by collateral.

• Subordinated Bonds: Lower claim in case of liquidation.

• Zero-Coupon Bonds: Sold at a discount, no interest paid until maturity.

• Convertible Bonds: Can be converted into shares at a predetermined price.

• Callable Bonds: Issuer can redeem before maturity under specific conditions.

• Irredeemable Bonds: No maturity date, perpetual.

• Junk Bonds: High yield, high risk, rated below investment grade.

Bond Ratings and Valuation

• Major Credit Rating Agencies: Moody's, Standard & Poor's, and Fitch.

  • Ratings signify creditworthiness and risk of default.

• Valuation Formula: Present value of future cash flows discounted by the market's required rate of return.

• Factors affecting bond valuation: market interest rates, coupon rates, and time to maturity.

Bond Price Quotations

• Bonds trading above par are premium bonds; below par are discount bonds.

• Market price examples to demonstrate computation.

Securitization of Assets

• Definition: Bundling assets to provide backing for bond issuance.

• Example: Mortgage securitization peaked during the financial crisis of 2008-2009.

• SPVs (Special Purpose Vehicles): Used to separate assets from the originating institution facilitating better liquidity.

• Historical context: Securitization by individuals like David Bowie for musical royalties.

Key Advantages and Disadvantages of Debt Financing

• Advantages:

  • Lower cost compared to equity.

  • Tax deductibility of interest payments.

  • Does not require equity dilution.

• Disadvantages:

  • Obligation to service debt regardless of financial performance.

  • Potential restrictive covenants that limit operational flexibility.

Conclusion

• Understanding bonds and their valuation is critical for corporate finance.

• Both corporate bonds and other debt instruments serve distinct roles in capital management and financing strategies.

• The use and mixing of debt/equity financing impact company operations, shareholder returns, and overall market perceptions.