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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

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

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%)

9

Characteristics of a Corporation

p

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

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

-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,

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%.

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.

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

US$649.93 today.

$ 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.

$ 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.

............ + [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.

$ 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

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

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:

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

, .

(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

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

issuer of the security.

42

Features of Fixed Income Securities

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

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:

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

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

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:

g

agrees to pay

p y above the reference rate.

50

Features of Fixed Income Securities

London Interbank Offered Rate (LIBOR),

(LIBOR) and the quoted margin

is 100 basis points, the coupon formula is

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

shape of the yield curve (which shows the relationship between

bond yields and maturity).

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

to the investor

investor, the price of a callable bond is lower relative to an

otherwise comparable option-free bond.

price of embedded call option.

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

income securitys issuer will deteriorate, increasing the required

rate of return and decreasing the securitys value.

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

foreign currency cash flows to an investor,

investor in terms of his home-

home

country currency.

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

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

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.

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.

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

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

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

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

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

expected

p cash flows:

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.

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

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

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.

change, a bonds 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

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