Module 3 - Bond Valuation and Risk and Return (Chapters Five and Six)

All  page numbers are references to Corporate Finance: A Focused Approach, 5th  edition by Ehrhardt and Brigham (Cengage, 2013)

Chapter 5 applies Time Value of Money techniques to the valuation of bonds, defines some new terms, and discusses how interest rates are determined.  Chapter 6 focuses on the relation between risks and returns.  While for quiz and exam purposes, you must know everything from both chapters, you should focus on computing returns as we use that later in the course.

Things to Absorb.  From Chapter 5, know everything until section 5-14, although the likelihood of yield-to-call being on an exam is low.  This chapter develops the valuation techniques of fixed income securities.  Bonds are valued similar to an ordinary annuity.  You already know the valuation techniques from Chapter 4.  The most difficult part of this chapter is the terminology and learning the interrelationships between the various bond components.  The most important relationship is that "If the  market price decreases, this implies that the yield to maturity has increased," and this is often expressed as "rate up implies price down."  Also, since most bonds make coupon payments twice per year, make sure you can compute the price and yield to maturity on semiannual coupon bonds.  Finally, this chapter shows a conceptual way of determining the Yield/Interest Rate on Financial Securities as a function of the r* (Real risk-free rate) + IP (Inflation premium) + DRP (Default risk premium) +    LP (Liquidity premium) + MRP (Maturity risk premium).

Do not need to absorb - details about junk bonds or the bankruptcy code of the United States

Things to Read - You will need to read the chapter. 

Things to Do - Make 100 on the quiz.  Also, since most bonds make coupon payments twice per year, make sure you can compute the price and yield to maturity on semiannual coupon bonds.  You should be able to answer all of the end of chapter Questions and Problems.

Questions and Problems that you should be able to answer - Questions 1-3 and Problems - All.  Note, I have used variations of every one of the end of chapter Questions and Problems in past semesters’ quizzes and exams.  Problems 7 and 12-22 are questions types I have used on recent exams.

Calculator links

Simple and useful instructions for most calculators

Note, that your calculator is probably set to 12 payments per year and 2 decimal places.  You need to change this to 1 payment per year and at least 4 decimal places.

1. Watch  the Chapter  Introduction and Overview video. The Powerpoints for all of this chapter’s videos are located here.

2. Read pages 187-199.

3. Watch the Features, Terms and Basic Bond Valuation video.  After this, you should be able to answer most of the end of chapter questions and to solve problems 1 and 2.

4. Read pages 199-206.

5. Watch  the Advanced Bond Valuation video.  This video discusses bonds with semi-annual payments.  After this, you should be able to solve end of chapter problems 3-14, 21 and 22.

6. Read the rest of the chapter.

7. Watch the Determinants of Interest Rates video.  After this, you should be able to solve any remaining end of chapter questions and problems.

8. The is another chapter where you should spend your time solving problems such as the quiz and End-of-Chapter problems.  The only way to learn this material is to do this material. The list of suggested questions/problems is at the top of the page.  Here are audio solutions to common bond valuation problems.

a. Audio solution to: You are considering buying bonds in ACBB, Inc. The bonds have a par value of $1,000 and mature in 37 years. The annual coupon rate is 10.0% and the coupon payments are annual. If you believe that the appropriate discount rate for the bonds is 13.0%, what is the value of the bonds to you?

b. Audio solution to: XZYY, Inc. currently has an issue of bonds outstanding that will mature in 31 years. The bonds have a face value of $1,000 and a stated annual coupon rate of 20.0% with annual coupon payments. The bond is currently selling for $890. The bonds may be called in 4 years for 120.0% of the par value. What is your expected quoted annual rate of return if you buy the bonds and hold them until maturity?

c. Audio solution to: Again, Inc. bonds have a par value of $1,000, a 33 year maturity, and an annual coupon rate of 12.0% with annual coupon payments. The bonds are currently selling for $923. The bonds may be called in 4 years for 112.0% of par. What quoted annual rate of return do you expect to earn if you buy the bonds and company calls them when possible?

d. Audio solution to: Within Year, Inc. has bonds outstanding with a $1,000 par value and a maturity of 17 years. The bonds have an annual coupon rate of 17.0% with semi-annual coupon payments. You would expect a quoted annual return of 14.0% if you purchased these bonds. What are the bonds worth to you?

e. Audio solution to: Yes They May, Inc. has a bond issue outstanding with a $1,000 par value and a maturity of 40 years. The bonds have an annual coupon rate of 15.0% with quarterly coupon payments. The current market price for the bonds is $1,035. The bonds may be called in 4 years for 115.0% of par. What is the quoted annual yield-to-maturity for the bonds?

f. Audio solution to: Yes They Can, Inc. has a bond issue outstanding with a $1,000 par value and a maturity of 20 years. The annual coupon rate is 9.0% with semi-annual coupon payments. The bonds are currently selling for $859. The bonds may be called in 3 years for 109.0% of par. What is the quoted annual yield-to-call for these bonds?

g. Audio solution to: You are considering buying bonds in AZYX, Inc. The bonds have a par value of $1,000 and mature in 13 years. The annual coupon rate is 11.0% and the coupon payments are annual. The bonds are currently selling for $1,442.63 based on a yield-to-maturity of 6.0%. What is the bond's current yield?

h. Audio solution to: You are considering buying bonds in AZYX, Inc. The bonds have a par value of $1,000 and mature in 13 years. The annual coupon rate is 11.0% and the coupon payments are annual. The bonds are currently selling for $1,442.63 based on a yield-to-maturity of 6.0%. What is the bond's expected capital gain/loss if the bonds are held until maturity?

h. Audio solution to: Panther Enterprises has outstanding zero coupon bonds that have a face value of $1000 and mature in exactly 18 years. The market price of the bonds is $179.86. What will be the percentage change in the market price of the bonds if the yield to maturity falls by half?

9. If you  find yourself making lots of general valuation errors, rather than bonds specific errors, watch this  video that discusses the most common TVM errors.

10.  The quiz should take you about 60 minutes.  Be sure to bring have your financial calculator/spreadsheet available. The name of the quiz is Chapter 5. 

Chapter  6

Need to absorb - The main focus is on defining and measuring types of risk and return. You need to be able to calculate returns, standard deviations, of individual securities and returns and betas of portfolios.  You must be able to compute weighted average returns and portfolio betas.  Know that standard deviation is a measure of total risk.  Know that beta is a measure of systematic risk and is appropriate when analyzing portfolios.  Be able to understand the impact of diversification. You  should understand the Capital Asset Pricing Model (CAPM) as it is the predominant theory of the relationship between risk and return. You need to understand CAPM's uses and the inputs used in CAPM calculations.  You need to be able to understand and apply the concepts of the Efficient Markets Hypothesis and the implications for efficient capital markets. 

Do not need to absorb - You are not responsible for the Fama-French three factor model.  You should read about Behavioral Finance (applications of Psychological principles to financial decision making), but I will not test this on my exams. Behavioral Finance is an emerging area of finance, but the lessons and math are very complex.  Without a deep understanding of the topic, one should not attempt to apply this to the real world.

Need to Read - All until page 265, and the last section (6-11) on market efficiency.

Need to Do - Make 100 on the quiz.  You should be ale to answer all of the end of Questions and Problems 1-3, 5-14. Note, I have used variations of every one of the end of chapter Questions and Problems in recent semester exams.

Calculator  links

Simple  and useful instructions for most calculators

Note,  that your calculator is probably set to 12 payments per year and 2 decimal  places. You need to change this to 1 payment per year and at least 4 decimal  places.

1. Watch  the Chapter  Introduction and Overview video.  The Powerpoints for all of this chapter's videos are located here.

2.  Read pages 235-245.

3. Watch  the Computing  Returns and Standard Deviation video.  After this video, you should be able to solve end of chapter problems 5, 6, and 13.

4.  Read pages 246-249.

5. Watch  the Portfolio  Risk and 2-stock portfolio video.

6.  Read pages 250-259.

7. Watch  the Capital  Asset Pricing Model and Computing Beta video.  After this video, you should be able to solve end of chapter problems 1-3, 7, 8,  and 12.

8.  Read the rest of chapter.

9.  Watch the Shifts  in the Security Market Line, Computing Portfolio Betas and Returns and Market  Efficiency video.  After this video, you should be able to solve end of chapter problems 9, 10, 11,  and 14.

10.  Before the exam, you should be able to answer the following questions; Self test  Questions 1 and 2, All of the end of chapter questions, and All of the problems  except number 4. I have used variations on all of the end of chapter problems  in past semesters. Remember that the Learning Management websites has solutions  to end of chapter problems.

11.  Here  are audio solutions, created by Dr. Ronald Best, to several types of Risk and  Return problems;

a.  Audio Solution to:What is the expected return for  the following stock? (State your answer in percent with one decimal place.)  In the better economy, with probability of .5, the expected return is 32%. In  the same economy, with probability of .2, the expected return is 17%. In the  worse economy, with probability of .3, the expected return is  -10%.

b.  Audio Solution to:What is the expected return for  the following portfolio? (State your answer in percent with two  decimal places.)  Stock AAA with expected return of 31.2% has a total value of $190,000. Stock BBB  with expected return of 24.0% has a total value of $350,000. Stock CCC with  expected return of 18.6% has a total value of $200,000. Stock DDD with expected  return of 11.9% has a total value of $500,000.

c.  Audio Solution to:If the risk-free rate is 4.3%,  the expected return on the market is 15.7%, and the expected return  on Security  J is 21.5%, what is the beta for Security J? (Calculate your answer to two  decimal places.)

d.  Audio Solution to:You are considering buying a  stock with a beta of 0.73. If the risk-free rate of return is 6.9 percent,  and the  expected return for the market is 12.2 percent, what should the expected rate of  return be for this stock? (State your answer as a percentage.)

e.  Audio Solution to:If the risk-free rate is 6.9%,  the market risk premium is 7.0%, and the expected return on Security J  is 29.4%,  what is the beta for Security J? (Calculate your answer to two decimal  places.)

f.  Audio Solution to:You are considering buying a  stock with a beta of 2.05. If the risk-free rate of return is 6.9 percent,  and the  market risk premium is 10.8 percent, what should the expected rate of return be  for this stock? (State your answer as a percentage.)

g.  Audio Solution to:You are holding a stock that has  a beta of 2.4 and is currently in equilibrium. The required return on  the stock  is 20.4% and the return on a risk-free asset is 8%. What would be the return on  the stock if the stock's beta increased to 3.3 while the risk-free rate and  market return remained unchanged? (Calculate your answer to two decimal places  and state it as a percentage.)

h.  Audio Solution to: The risk-free return is 4.1% and  the market return is 14.0%. What is the expected return for the  following portfolio?  (State your answer in percent with two decimal places.) Stock AAA with Beta of  3.4 has a total value of $125,000. Stock BBB with Beta of 2.9 has a total value  of $330,000. Stock CCC with Beta of 1.3 has a total value of $230,000. Stock  DDD with Beta of .9 has a total value of $500,000.

12.  There is a quiz based on the above material. The name of the quiz is Chapter  6.

Revised January 25, 2016