Valuation of Fixed Incomes

1
Valuation of Fixed Incomes

• Corporate Finance
• Class 5
• March 19 (LA) and March 8 (OCC)

2
Basic Steps to Valuation in Finance

• Estimate cash flows (CASH, TIME)
• Easy or hard depending on asset
• Look for patterns in cash flows
• Choose a discount rate (TIME, RISK)
• Risk adjusted
• Opportunity cost
• Calculate present value and net present value

3
Valuation in Finance

• Applies to all investment opportunities
• Applies to fixed plant and equipment
• Applies to new business opportunities
• Applies to bonds and stocks
• Applies to real estate
• Used by financial managers, stock and bond
  analysts, real estate investors

4
Valuation of Bonds and Stocks

• Calculation of present value of future cash flows
  at a risk-adjusted discount rate is estimate of
  intrinsic value or the value to the buyer (uses
  buyers assumptions and opportunity rates)
• Comparison of current price to intrinsic value
  (calculation of net present value) is fundamental
  analysis
• Fundamental analysis differs from technical
  analysis

5
Alternative to Present ValueTechniques in
Valuation

• If claims on similar cash flows trade in markets
  such that market values from them are available
• If claims on similar cash flows can be combined
  in a portfolio to replicate flows for investment
  at hand
• If arbitrage not hard, value of replicating
  portfolio must be identical to investment at hand

6
Examples of Arbitrage Pricing(We will study
later)

• Value of total claims on a firm consists of value
  of debt and equity claims
• Value of a given Treasury bonds must be the same
  as portfolio of corresponding stripped Treasuries
• Payoffs from contingent claims like options can
  be replicated with other assets

7
Review of PV Analysis

• General formulas
• Simplified cash flow formulas
• Sources of present value
• Geometric presentation from Class 4
• The timing and amounts of cash flows greatly
  affect their impact on valuation
• The notion of multipliers and capitalization or
  cap rates and their relation to each other depend
  on the use of simplified formulas (perpetuities,
  etc.) for easy interpretation

8
Pricing Bonds

• Five basic types of fixed income securities
• Discounted notes or bill
• Consols
• Self-amortizing loans (e.g. mortgages)
• Coupon bonds
• Equal principal repayment loans
• Projecting contractual cash flows is not
  difficult with fixed income securities

9
Types of Fixed Incomes
10
Capital Structure in PVFIRM05

• Market-traded debt
• Find quote and multiply by book value
• Estimated market values of debt
• Four pre-programmed formulas
• Enter book value and details, choose yield
• Non-standard debt - enter present values
• Floating rate debt - yield is always close to
  market rate, hence estimated value is par

11
Pricing Discounted Notes, Bills, and Coupon Bonds

• Bills and zeros (strips) - one cash flow
• Consols pay constant coupon cash flow
• Consols are extremely rare and are not included
  in PVFIRM05

12
Loans and Coupon Bonds

• Self-amortizing loan or lease (with payment
  X)
• Coupon bonds - an annuity and a single balloon
  payment

13
Bond Price Formula

• Book gives previous formula where CcF
• Market quotes in percent of face valuewhere
  p is decimal and c coupon rate

14
Constant Principal Payment

• Each period pay F/T in principal plus accrued
  interest at rate c of outstanding principal
• Not a standard formula (from textbooks) but
  demonstrates what can be done with formulas

15
Discount Rate on Bonds

• Risk-free rate (typically the rate on U.S.
  Treasuries) is lowest rate possible on taxable
  bonds
• Other rates must be adjusted for risk
• Default risk premiums are added to risk-free rate
  of the same maturity
• Sources and examples from Wall Street Journal,
  Standard and Poors Bond Guide, NASD Bondinfo,
  Bloomberg and Bondsonline

16
For Next Classes

• Review Chapter 5 and read Chapter 7
• Study Baldwin example (Chapter 7) carefully for
  class 7 discussion
• Read PVFIRM Introduction and Overview
• Put together documentation for your stock and
  bond price calculations including debt details
  and sources of assumptions
• Be prepared to discuss problems with data or
  other issues with me or TAs in time to hand in
  Part I by March 26 (LA) or 20 (OCC)