Essay on Finance Chapter 6

6903 Words Nov 26th, 2013 28 Pages
Chapter 6
Bonds and their Valuation

OVERVIEW

This chapter presents a discussion of the key characteristics of bonds, and then uses time value of money concepts to determine bond values. Bonds are one of the most important types of securities to investors, and are a major source of financing for corporations and governments. The value of any financial asset is the present value of the cash flows expected from that asset. Therefore, once the cash flows have been estimated, and a discount rate determined, the value of the financial asset can be calculated. A bond is valued as the present value of the stream of interest payments (an annuity) plus the present value of the par value, which is the principal amount for the
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■ Municipal bonds are issued by state and local governments. The interest earned on most municipal bonds is exempt from federal taxes and state taxes if the holder is a resident of the issuing state.

■ Foreign bonds are issued by foreign governments or foreign corporations. These bonds are not only exposed to default risk, but are also exposed to an additional risk if the bonds are denominated in a currency other than that of the investor’s home currency.

Differences in contractual provisions, and in the underlying strength of the companies backing the bonds, lead to major differences in bonds’ risks, prices, and expected returns. It is important to understand both the key characteristics, which are common to all bonds, and how differences in these characteristics affect the values and risks of individual bonds.

■ The par value is the stated face value of a bond, usually $1,000. This is the amount of money that the firm borrows and promises to repay on the maturity date.

■ The coupon interest payment is the dollar amount that is paid annually to a bondholder by the issuer for use of the $1,000 loan. This payment is a fixed amount, established at the time the bond is issued. The coupon interest rate is obtained by dividing the coupon payment by the par value of the bond. ❑ In some cases, a bond’s coupon payment may vary over time. These bonds are called floating rate, or indexed, bonds. Floating rate debt

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