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WELCOME TO

ISTANBUL BILGI UNIVERSITY

FEC521
CORPORATE FINANCE
COURSE
LECTURER
Emre Akyol, Ph.D.
emre.akyol2@gmail.com
0 533 744 38 68

2
Course Description
p
Corporate Finance is a broad area interlinked with every
decision made within a company; as every decision made has
some financial implications, and any decision which affects the
financial shape of the firm is considered as a corporate finance
decision

The primary goal of corporate finance is to maximize corporate


value, and therefore the shareholders wealth, while effectively
managing the firm
firmss risk

3
Course Description
p
The course is developed and taught in a way that the relevant
topics are first discussed in general terms and then by way of
examples that illustrate in more concrete terms how a corporate
manager might proceed in a given situation

While net present value (NPV) is treated as the basic concept


underlying corporate finance, every subject covered is firmly
rooted in valuation, and care is taken to explain how particular
decisions have valuation effects

4
Learning
g Objectives
j
define and discuss the basic characteristics of a corporation and
the objectives of the firm
explain the principles of capital budgeting and discuss common
capital budgeting pitfalls
value debt securities and calculate duration
demonstrate the use of financial statements
define and discuss capital structure, and calculate and interpret
the degree of operating leverage, financial leverage, and total
leverage

5
Learning
g Objectives
j
explain cash dividends, stock dividends, stock splits, reverse
stock splits and discuss their impact on shareholder value
define and discuss the objectives and core attributes of an
effective corporate governance system
calculate and interpret the weighted average cost of capital
(WACC)
value equities
explain the common motivations behind M&A activity, and
compare and contrast the major methods for valuing a target
company

6
The Course is towards Current and Potential
Business Consultants
Financial Analysts
y
M&A Specialists
Corporate and Commercial Bankers
Treasury Analysts and Managers
Strategic Planning Executives
Corporate Directors
CEOs & CFOs
Portfolio Managers

7
Course Material
1. Lecture Notes (Power Point Slides). Available through the
course web-page
2. Questions & Answers (Power Point Slides). Available
through the course web-page
3. Textbook: Fundamentals of Corporate Finance, Brealey,
Myers, and Marcus (BMM), Irwin/McGraw-Hill, 6th
Edition, 2009
4. Equity Research Reports. Available through the course web-
page
5. Fixed Income Research Reports. Available through the
co rse web-page
course eb page
8
ASSESSMENT / EVALUATION METHODS

1. Midterm: (40%)
2. Comprehensive Final: (60%)

TOTAL POINTS: (100%)

9
Characteristics of a Corporation
p

The corporation is a legal entity, and has rights similar to those


of a person
Corporations can raise very large amounts of capital by issuing
stocks or bonds to the investing public
Corporate shareholders need not be experts in the industry or
management of the business. Any individual with sufficient
money can own stock. Accordingly, the corporation can seek
capital from millions of investors both domestic and overseas
Corporate shareholders have limited liability

10
Characteristics of a Corporation
p

In its simplest form, the corporation comprises three sets of


distinct interests: the shareholders (owners), the directors, and the
corporation officers (the top management).
Traditionally, the shareholders control the corporations
direction, policies, and activities.
The shareholders elect a board of directors, who in turn select
top management. Top management serves as corporate officers
and manages the operations of the corporation in the best interest
of shareholders.

11
Characteristics of a Corporation
The financial management function is usually associated with a top
officer of the firm, such as a vice president of finance or some other
chief financial officer (CFO)
The CFO oversees both the treasurers and the controllers work.
He or she is deeply involved in the financial policy making and
corporate planning. Often will have general managerial
responsibilities
p beyond
y strictly
y financial issues and may
y also be a
member of the board of directors
The controllers office handles cost and financial accounting, tax
payments, and management information systems
The treasurers office is responsible for managing the firms cash
and credit, its financial planning, and its capital expenditures
12
Goals of the Corporation
p
Possible goals of for-profit businesses

-Avoid financial distress and bankruptcy


-Maximize sales or market share
-Minimize costs
-Maximize profits
-Maintain steady earnings growth

13
Goals of the Corporation
p
From the stockholders point of view, the goal of financial
management and corporate management is to maximize the
current value per share of the existing stock
Therefore, good corporate decisions increase the market value
of the shareholders equity and poor decisions decrease it.
In fact, we could have defined corporate finance as the study of
the relationship between business decisions and the value of the
stock in business.

14
Future Value of a Single
g Sum
Future value is the amount to which a current deposit will grow
over time when it is placed in an account paying compound interest

FV = PV * (1 + I/Y)N

where,

PV = amount of money invested today (the present value)


I/Y = rate of return per compounding period
N = total number of compounding periods

15
Future Value of a Single
g Sum
Example: Calculate the FV of a US$300 investment at the end
of 10 years if it earns an annually compounded rate of return of
8%.

FV = 300 * (1 + 0.08)10 = US$647.68

16
Present Value of a Single
g Sum
PV of a single sum is todays value of a cash flow that is to be
received at some point in the future. In other words, it is the amount
of money that must be invested today, at a given rate of return over a
given period of time, in order to end up with a specified FV.
The process for finding the PV of a cash flow is known as
discounting (such that future cash flows are discounted back to the
present)
The interest rate used in the discounting process is commonly
referred to as the discount rate but mayy also be referred to as the
opportunity cost, required rate of return, and the cost of capital.

PV = FV / (1 + I/Y) N
17
Present Value of a Single
g Sum
Example: Given a discount rate of 9%, calculate the PV of a
US$1,000 cash flow that will be received in five years.

PV = 1,000 / (1 + 0.09)5 = US$649.93

The PV computed here implies that at a rate of 9%, an investor


will be indifferent between US$1,000 in five years and
US$649.93 today.

Put another way, US$649.93


$ is the amount that must be
invested today at a 9% rate of return in order to generate a cash
flo of US$1,000
flow US$1 000 at the end of fi
fivee years.
ears
18
The Investment Decision Making Criteria
Net Present Value
Internal Rate of Return
Payback Period
Discounted Payback Period
Profitability Index
The Relative Advantages and Disadvantages of NPV and IRR
Ranking Conflicts between NPV and IRR
The Multiple IRR Problem and No IRR Problem
The Relationship Between NPV and Stock Price

19
Net Present Value
The Net Present Value of an investment project is the sum of
the present values of all the expected incremental cash flows, the
changes in cash flows that will occur if the project is undertaken

20
Net Present Value
The following four-step procedure may be used to compute NPV:
Identify all cash inflows and cash outflows associated with the
investment
Determine the appropriate discount rate or the opportunity cost
for the investment
Using the appropriate discount rate, find the PV of all cash flows
Compute the sum of the DCFs

21
Net Present Value
For a normal project, with an initial cash outflow followed by a
series of expected after-tax cash inflows, the NPV can be calculated
as:
NPV = CFO0 + [CF1 / (1 + k)1] + [CF2 / (1 + k)2] + ............ + [CFn /
(1 + k)n]
where
CF0 = the initial investment outflow
CFn = after-tax cash flow at time n
k = required rate of return for the project

22
Net Present Value
A positive NPV project is expected to increase shareholder
wealth, while a negative NPV project is expected to decrease
shareholder wealth
NPV decision rule is to accept any project with a positive NPV,
and reject any project with a negative NPV

23
Net Present Value
Example:
Calculate the NPV of the below investments, and determine for
each investment whether it should be accepted or rejected. Assume
that the discount rate is 10%.
1)Initial cost of US$2,000 and positive cash flows of US$1,000 at
the end of year 1, US$800 at the end of year 2, US$600 at the
end of year 3, and US$200 at the end of year 4.

2) Initial cost of US$2,000


$ and positive cash flows of US$200
$ at
the end of year 1, US$600 at the end of year 2, US$800 at the
end of year
ear 3,
3 and US$1,200
US$1 200 at the end of year
ear 4.
4
24
Internal Rate of Return (IRR)
The IRR is defined as the rate of return that equates the PV of
the expected after-tax cash inflows just equal to the expected
cash outflows.
In other words, the IRR may be defined as the discount rate
for which the NPV of an investment is zero.

NPV = 0 = CFO0 + [CF1 / (1 + IRR)1] + [CF2 / (1 + IRR)2] +


............ + [CFn / (1 + IRR)n]

25
Internal Rate of Return (IRR)
To calculate IRR, one may use 1) trial-and-error method,
which is guessing IRRs until you get the right one, or 2) a
financial calculator.
The IRR decision rule: 1) determine the required rate of return
for the investment, which is usually the firms cost of capital,
but the required rate of return may be higher or lower than the
firms cost of capital depending on the specific investments
risk and the firms average investment risk, 2) if IRR > the
required rate of return, accept the investment, 3) if IRR < the
req ired rate of return,
required ret rn reject the investment.
in estment
26
Internal Rate of Return (IRR)
( )
Example:
Calculate the IRR of the below investments, and determine for each
investment whether it should be accepted or rejected. Assume that
the discount rate is 10%.
1)Initial cost of US$2,000 and positive cash flows of US$1,000 at
the end of year 1, US$800 at the end of year 2, US$600 at the
end of year 3, and US$200 at the end of year 4.

2) Initial cost of US$2,000


$ and positive cash flows of US$200
$ at
the end of year 1, US$600 at the end of year 2, US$800 at the
end of year
ear 3,
3 and US$1,200
US$1 200 at the end of year
ear 4.
4
27
Payback
y Period (PBP)
( )
The PBP is the number of years it takes to recover the initial cost
of an investment. PBP = full years until recovery + (unrecovered
cost at the beginning of last year / cash flow during the last year)
Example:
Calculate the PBP of the below investments.
1)Initial cost of US$2,000 and positive cash flows of US$1,000 at
the end of year 1, US$800 at the end of year 2, US$600 at the
end of year 3, and US$200 at the end of year 4.
2) Initial cost of US$2,000
$ and positive cash flows of US$200
$ at
the end of year 1, US$600 at the end of year 2, US$800 at the
end of year
ear 3,
3 and US$1,200
US$1 200 at the end of year
ear 4.
4
28
Payback
y Period (PBP)
( )
The major benefit of the PBP is that it is a good measure of
liquidity. Firms with limited access to additional liquidity often set
a maximum payback period, and then use a measure of profitability,
such as NPV or IRR, to evaluate projects that satisfy the maximum
payback period constraint.
The major drawbacks of the PBP are that it does not take into
account the time value of money and the cash flows beyond the
payback period, which means terminal or salvage value would not
be considered.
Therefore, investment decisions should not be made on the basis
of their payback
pa back period alone.
alone
29
Discounted Payback
y Period (DPBP)
( )
The DPBP is the number of years it takes to recover the initial
cost of an investment, in present value terms.
Example:
Calculate the DPBP of the below investments.
1)Initial cost of US$2,000 and positive cash flows of US$1,000 at
the end of year 1, US$800 at the end of year 2, US$600 at the
end of year 3, and US$200 at the end of year 4.
2) Initial cost of US$2,000 and positive cash flows of US$200 at
the end of year 1, US$600
$ at the end of year 2, US$800
$ at the
end of year 3, and US$1,200 at the end of year 4.

30
Discounted Payback
y Period (DPBP)
( )
The DPBP solves one of the drawbacks of PBP by discounting
cash flows, but still does not consider any cash flows beyond the
payback period.
Therefore, investment decisions should not be based on DPBP
alone.

31
Profitability
y Index ((PI))
The PI is the present value of an investments future cash flows
divided by the initial cost.
PI = PV of future cash flows / CF0 = 1 + NPV / CF0
If the NPV of an investment is positive, then the PI will be greater
than one; if the NPV is negative, then the PI will be less than one.
Therefore,
if PI > 1.0, accept the investment
if PI < 1.0, reject the investment

32
Profitability
y Index ((PI))
Example:
Calculate the PI of the below investments.
1)Initial cost of US$2,000 and positive cash flows of US$1,000 at
the end of year 1, US$800 at the end of year 2, US$600 at the
end of year 3, and US$200 at the end of year 4.
2) Initial cost of US$2,000 and positive cash flows of US$200 at
the end of year 1, US$600 at the end of year 2, US$800 at the
end of year 3, and US$1,200 at the end of year 4.

33
The Relative Advantages and Disadvantages of NPV and IRR
NPV is theoretically and practically the best method, as it is a direct
measure of the expected increase in the value of the firm. Its major
weakness is that it does not take the size of the investment into
consideration. For example, an NPV of US$1,000 is great for an
investment costing US$2,000, but not so great for an investment costing
US$2,000,000.
The major advantage of IRR is that it measures profitability as a
percentage.
p g Therefore, it pprovides information on the margin
g of safetyy
that the NPV does not. Via the IRR, one can tell how much below the
IRR the actual investment return could fall, in percentage terms, before
the
h iinvestment becomes
b uneconomic
i (has
(h a negative
i NPV).
) The
h major
j
drawbacks of the IRR are 1) the possibility of producing rankings of
mutually exclusive projects different from those from NPV analysis, 2)
the possibility of multiple IRRs, or no IRR for an investment.
34
Conflicting
g Project
j Rankings
g
The NPV and IRR may give conflicting project rankings
depending on the project sizes. The smaller project may have
a higher IRR, but the increase in the firm value (NPV) may be
small compared to the increase in the firm value (NPV) of the
larger project, even though the IRR is lower.

35
Multiple
p IRR and No IRR Problems
If the project has non-normal cash-flow pattern, meaning that
there are cash-outflows during the life or at the end of the project,
mathematically speaking 1) there may be more than one IRR, that
is, there may be more than one discount rate that will produce an
NPV equal to zero, or 2) there may be no IRR, meaning that there
is no discount rate that results in a zero NPV, while the project
might be a profitable one.
Neither of these problems can arise with the NPV method, as it
produces the theoretically correct accept / reject decisions for
projects with non-normal cash-flow patterns.

36
Replacement
p Chain - Mutually
y Exclusive Projects
j with
Different Lives
When two projects are mutually exclusive, the firm may choose
one project or the other, but not both
If mutually exclusive projects have different lives, and the
projects are expected to be replaced indefinitely as they wear out,
an adjustment needs to be made in the decision-making process,
which is called the least common multiple of lives approach

37
Replacement Chain - Mutually Exclusive Projects with Different Lives
Example: Company XYZ is planning to modernize its production
facilities. It is considering either 1) Machine A with a useful life of six years,
or 2) Machine B, which has a useful life of three years. The time lines
presented
t d below
b l show h theth cashh flows
fl andd NPVs
NPV off these
th two
t mutually
t ll
exclusive projects

Expected
p Cash Flows For Machine A ((in dollars))
0 1 2 3 4 5 6
-20,000 4,000 7,000 6,500 6,000 5,500 5,000

NPV = US$3
US$3,245.47
245 47

Expected Cash Flows For Machine B (in dollars)


0 1 2 3
-10,000 3,500 6,500 6,000

NPV = US$2,577.44

38
Replacement
p Chain - Mutually
y Exclusive Projects
j with Different Lives
Answer:
The NPVs indicate that Machine A should be selected as

NPV Machine A = US$3,245.47 > NPV Machine B = US$2,577.44

However, in order to make the comparison meaningful, we should find the


NPVs for the two projects over the least common multiple of lives.
In this case, the least common multiple of lives is six years, which means
that, for Machine B, we will need to buy another 3-year Machine B in year 3
to make it comparable to the 6-year Machine A.

39
Replacement
p Chain - Mutually
y Exclusive Projects
j with Different Lives
Answer:
Assuming no changes in annual cash flows and a constant cost of capital of
12%, we can compute the NPV of the two back-to-back Machine Bs as follows:

Replacement Chain For Machine B


0 1 2 3 4 5 6
-10,000
10 000 3 500
3,500 6 500
6,500 6 000
6,000 3 500
3,500 6 500
6,500 6 000
6,000
-10,000
-4,000
NPV
V = US$
US$4,412.01
, .

Since the US$4,412 extended NPV of two Chained-together 3-year Machine Bs


(six years total) is greater than the US$3,245 NPV of Machine A, the Machine B
should be selected.
A project where equipment will need to be replaced every few years is often
called a replacement chain; and the key is to analyze the entire chain and not just
the first link in the chain.
chain

40
The Relationship Between NPV and Stock Price
As the NPV is a direct measure of the expected change in firm value, it is
also the criterion most related to stock prices. A positive NPV project
should
h ld cause a proportionate
ti t increase
i in
i a firms
fi stock
t k price.
i
Example:
Company XYZ is investing US$500mn in a new equipment. The present
value of the future expected incremental after-tax cash flows resulting
from the equipment is US$750mn. The Company XYZ has 100m shares
outstanding,
t t di withith a currentt market
k t price
i off US$45 per share.
h Assuming
A i
that the investment is a new information, and is independent of other
expectations about the company, calculate the effect of the new
investment on the value of the Company XYZ, and its stock price.

41
Features of Fixed Income Securities

Fixed income securities, normally, are promises to pay a


stream of payments (annual, semiannual, or other) for a number
of given years and then repay the loan amount at the maturity
d
date, after
f when
h the
h ddebt
b will
ill cease to exist.
i

The entity that promises to make the payment is called the


issuer of the security.

42
Features of Fixed Income Securities

Fixed income securities fall into two general categories: debt


obligations and preferred stock.
stock
In the case of a debt obligation, the issuer is called the
borrower; and the investor who purchases such a fixed income
security is said to be the lender or creditor.
The promised payments that the issuer agrees to make at the
specified dates consist of two components: interest and principal
(repayments of funds borrowed).
Fixed income securities that are debt obligations include bonds,
mortgage-backed securities, asset-backed securities, and bank
loans.
43
Features of Fixed Income Securities
In contrast to a fixed income security that represents a debt obligation,
preferred stocks represents an ownership interest in the corporation.
Dividend p
payments
y are made to the ppreferred stockholder and represent
p a
distribution of the corporations profit.
Unlike investors who own a corporations common stock, investors who
own the preferred stock can only realize a contractually fixed dividend
payment.
Moreover,, the ppayments
y that must be made to ppreferred stockholders have
priority over the payments that a corporation pays to common stockholders.
In the case of bankruptcy of a corporation, preferred stockholders are
given preference over common stockholders.
Consequently, preferred stock is a form of equity that has characteristics
similar to bonds.

44
Features of Fixed Income Securities

The promises of the issuer and the right of the bondholders are
set forth in great detail in a bond
bondss indenture.
indenture
The affirmative covenants set forth activities that the
borrower promises to do, such as paying interest and principal on
a timely basis.
Negative covenants set forth certain limitations and restrictions
on the borrowers activities, such as imposing limitations on the
borrowers ability to incur additional debt unless certain tests are
satisfied. Another example could be a limitation on the amount of
dividend to be paid to stockholders.

45
Features of Fixed Income Securities

The term to maturity of a bond is the number of years the debt


is outstanding or the number of years remaining prior to final
principal payment.
Th maturity
The i ddate off a bbond
d iis always
l id
identified
ifi d when
h
describing a bond. For example, a describtion of a bond might
state due
due 16 / 7 / 2030.
2030
Generally speaking, bonds with a maturity between 1 and 5
years are wieved as short
short-term
term, 5
5-12
12 years as intermediate
intermediate-
term, and over 12 years as long-term.

46
Features of Fixed Income Securities
The par value (principal value, face value, redemption value, maturity
value) of a bond is the amount that the issuer agrees to repay the
bondholder at the maturity date
date.
As bonds have different par values, the practice is to quote the price of
a bond as a percentage of its par value. A value of 100 means, 100% of
par value. So, for example, if a bond has a par value of US$1,000 and
the issue is selling for US$900, this bond would be selling at 90. If a
bond with a par value of US$5,000
$ is selling for US$5,500,
$ the bond is
said to be selling for 110.
When a bond trades below its par value, it is said to be trading at a
discount.
When a bond trades above its par value, it is said to be trading at a
premium.
47
Features of Fixed Income Securities
The coupon rate (nominal rate), is the interest rate that the
issuer agrees to pay each year.
Th annuall amountt off the
The th interest
i t t paymentt made
d to
t
bondholders during the term of the bond is called the coupon,
which is determined by multiplying the coupon rate by the par
value of a bond, such as:

coupon = coupon rate x par value

For example, a bond with a 12% coupon rate and a par value of
US$1,000 will pay annual interest (coupon) of US$120 ( =
US$1,000 x 0.12).
48

Features of Fixed Income Securities

Bonds that are not contracted to make periodic coupon


payments are called zero-coupon bonds.
The holder of a zero-coupon bond realizes interest by buying
the
h bond
b d substantially
b i ll below
b l its
i par value
l (at
( discount),
di ) so that
h
interest is then paid at the maturity date, with the interest being
the difference between the par value and the price paid for the
bond.
For example,
example if an investor purchases a zero-coupon
zero coupon bond for
80, the interest is 20.

49
Features of Fixed Income Securities

A floating-rate security (variable-rate security) have coupon


payments not fixed over the bonds life, but reset periodically
according to some reference rate.
Th typical
The i l formula
f l (the
( h coupon formula)
f l ) on certain
i
determination dates when the coupon rate is reset is as follows:

coupon rate = reference rate + quoted margin

The quoted margin is the additional amount that the issuer


g
agrees to pay
p y above the reference rate.

50
Features of Fixed Income Securities

For example, suppose that the reference rate is the 12-month


London Interbank Offered Rate (LIBOR),
(LIBOR) and the quoted margin
is 100 basis points, the coupon formula is

coupon rate = 12-month LIBOR + 100 basis points

If 12-month LIBOR on the coupon reset date is 6%, the coupon


rate is reset for that period at 7% (6% + 100 basis points)

51
Risks Associated with Investing in Bonds
Interest Rate Risk
Yield Curve Risk
Prepayment Risk
Call Risk
C di Risk
Credit Ri k
Liquidity Risk
Currency Risk
Inflation Risk
Volatility Risk
Event Risk
Sovereign
g Risk

52
Risks Associated with Investing in Bonds
Interest rate risk, which is generally considered as the major
risk a fixed income security investor faces, refers to the effect of
changes in the prevailing market rate of interest on bond values,
such that bond values fall, when interest rates rise.
Thi is
This i the
h source off interest
i rate risk
i k which
hi h is
i approximated
i d by
b
a measure called duration.
For example,
example suppose investor X purchases a 12% coupon 10
10-
year bond at a price equal to par (100). If the market interest rate
rises to 13% when the investor X wants to sell this bond,
bond as the
coupon rate is fixed, he/she will have to sell the bond at a
discount,, meaning
g at a pprice below 100.

53
Risks Associated with Investing in Bonds

Yield curve risk arises from the possibility of changes in the


shape of the yield curve (which shows the relationship between
bond yields and maturity).

Changes in the shape of yield curve mean that yields (interest


rates) change by different amounts for bonds with different
maturities.

54
Risks Associated with Investing in Bonds
Call risk arises when a bond includes a provision that allows the
issuer to retire, or call, all or part of the issue before the maturity date;
and there are three major disadvantages of this feature from the
investors perspective:
1) The cash-flow pattern of a callable bond is not known with certainty
as it is not known when the bond will be called.
2) As the issuer is likely to call the bonds when the interest rates decline
below the bonds coupon rate, the investor is exposed to reinvestment
risk, such that the investor will have to reinvest the proceeds when the
bond is called, at interest rates lower than the bond
bondss coupon rate.
3) The price appreciation potential of a bond will be reduced relative to
an otherwise comparable option-free bond.

55
Risks Associated with Investing in Bonds

As the call option is a benefit to the issuer and a disadvantage


to the investor
investor, the price of a callable bond is lower relative to an
otherwise comparable option-free bond.

price of a callable bond = price of option-free bond


price of embedded call option.

The same disadvantages apply to mortgage-backed and asset-


backed securities where the borrower can repay principal prior to
scheduled principal payment dates. This risk is referred to as
prepayment risk.
56
Risks Associated with Investing in Bonds

Credit risk is the risk that the creditworhiness of a fixed-


income securitys issuer will deteriorate, increasing the required
rate of return and decreasing the securitys value.

Liquidity risk arises when the sale of a fixed-income security


must be made at a price less than the fair market value because of
a lack of liquidity for a particular issue.

57
Risks Associated with Investing in Bonds

Currency risk arises from the uncertainty about the value of


foreign currency cash flows to an investor,
investor in terms of his home-
home
country currency.

Inflation risk (purchasing power risk) arises from the decline


in the value of a securitys cash flows due to inflation, which is
measured in terms of purchasing power.

58
Risks Associated with Investing in Bonds

Volatility risk is present for fixed-income securities that have


embedded options,
options such as call options,
options prepayment options,
options or put
options. Changes in interest rate volatility affect the value of these
options, and therefore the securities.
Event risk arises from dramatical and unexpected changes in the
ability of an issuer to make interest and principal payments due to the
events such as a natural disaster (earthquake), or an industrial accident.
Sovereign risk arises when an investor acquires a bond issued by a
foreign entity (such as a French investor acquiring a Brazilian
government bond), due to potential changes in governmental attitudes
and policies toward the repayment and servicing of debt.

59
Valuation of Fixed Income Securities

Valuation is the process of determining the fair value of a financial


asset.

The fundamental principle of financial asset valuation (or any asset


valuation) is to take the present values of all the expected cash flows
and add them up to get the value of the security.

There are three steps in the valuation of fixed income securities:

Estimate the cash flows over the life of the security. For a bond, there
are two types of cash flows: 1) the coupon payments, and 2) the return
of principal.

Determine the appropriate discount rate or rates based on the risk of


(uncertainty about) the receipt of the estimated cash flows.

Calculate the present value of the estimated cash flows by multiplying


the bonds expected cash flows by the appropriate discount factors.
60
Valuation of Fixed Income Securities

The cash flows of a security are the collection of each periods cash flow.
In the case of a fixed income security, it does not make any difference
whether the cash flow is interest income or payment of principal.

We can identify three situations where estimating future cah flows poses
difficulties:

The principal repayment stream is not known with certainty. This category
includes bonds with embedded options. Callable bonds, mortgage-backed
securities, and asset-backed securities are examples of asset classes with
such an uncertainty.

The coupon payments are not known with certainty. With floating-rate
securities, the coupon payments may depend on the price of a commodity,
the rate of inflation over some future period,
period or market interest rates.
rates

The bond is convertible or exchangeable into another security. Without


information about future stock prices and interest rates, we dont know when
the
h cashh flows
fl will
ill come or how
h large
l they
h willill be.

61
Discounting the Expected Cash Flows

The present value of a cash flow will depend on 1) when a cash


flow will be received (timing of the cash flow), and 2) the
i t
interest
t rate
t usedd to
t calculate
l l t the
th cashh flow.
fl

present value t = expected cah flow in period t / (1 + i)t

The value of a financial asset is then the sum of the present


value of all the expected cash flows. Assuming there are N
expected
p cash flows:

value = present value 1 + present value 2 + ....... + present value N

62
Discounting the Expected Cash Flows

Example:

Calculate
C l l t the
th value
l off a bond
b d that
th t matures
t in
i four
f years, has
h an
annual coupon rate of 10%, and has a maturity value (par value)
of US$100. The discount rate to be used is 8%.

63
Discounting the Expected Cash Flows

Example:

Calculate
C l l t the
th value
l off a bond
b d that
th t matures
t in
i four
f years, has
h an
annual coupon rate of 10%, and has a maturity value (par value)
of US$100. The discount rate to be used is 12%.

64
Present Value Properties

For a given discount rate, the further into the future a cash flow
is received, the lower its present value.

The higher the discount rate, the lower the present value.

Since the value of a security is the present value of its expected


cash flows, the higher the discount rate, the lower a securitys
value; and the lower the discount rate, the higher a securitys
value.

65
Relationship between Coupon Rate, Discount Rate, and Price
Relative to Par

coupon rate = yield required by the market, therefore price =


par value
l

coupon rate < yield required by the market, therefore price <
par value (discount)

coupon rate > yield required by the market, therefore price >
ppar value (p
(premium))

66
Change in a Bonds Value as It Moves toward Maturity

As a bond moves toward its maturity date, its value changes.

At the
th maturity
t it date,
d t the
th bonds
b d value
l isi equall to
t its
it par value,
l
so over time as the bond moves toward its maturity date, its price
will move to its par value.

More specifically, assuming that the discount rate does not


change, a bonds value:

decreases over time if the bond is selling at a premium

increases over time if the bond is selling at a discount

is unchanged if the bond is selling at par value

67
Change in a Bonds Value as It Moves toward Maturity

Example:

Now suppose th
N thatt the
th bbonds
d price
i iis iinitially
iti ll below
b l par value.
l If
the discount rate is 12%, the 4-year 10% coupon bonds value is
US$93.9253. Assuming the discount rate remains at 12%, one
year later the cash flows and the present value of cash flows
would be as below:

68
Change in a Bonds Value as It Moves toward Maturity

Example:

Consider
C id once again i the
th 4-year
4 10% coupon bbond. d Wh
When the
th
discount rate is 8%, the bonds price is US$106.6243. Suppose
that one year later, the discount rate is still 8%. There are only
three cash flows remaining since the bond is now a 3-year
security. The cash flows and the present value of the cash flows
are:

69
Change in a Bonds Value as Yields Change and It Moves
toward Maturity

Example:

Suppose that the discount rate for the 4-year 10% coupon is 8%,
so that the bond is selling for US$106.6243. One year later, the
discount rate appropriate for a 3-year 10% coupon increases from
8% to 9%. The cash flows and the present value of the cash
flows are:

70