Intro to Financial Management

1. Intro to Financial Management Bonds

2. Review Homework Expected rate of return Required rate of return Risk-free rate of return Market rate of return Systemic and idiosyncratic risk Beta? CAPM

3. Review • What is “the time value of money?” • How do you calculate and what do these mean? • Compounding interest • PV, FV (incl. solving for n) • Different flows • Non-annual periods • Simple annuity (PV?) • Amortized loans • APR • Perpetuity

4. Bonds • A bond is basically an IOU • Characteristics • Coupon rate • Predetermined, fixed amount of interest • Paid semi-annually • Maturity date • Par Value • Amount owed at maturity (normally $1000) • Prices are given as a % of par (face) value • E.g. bond at 125 can be bought at 125% of its par value • May be callable (redeemable) • Claim on assets

5. Types of Bonds • Corporate • Debenture – unsecured • Subordinated debentures – comes after debentures if insolvent • Secured • Government • U.S Treasury Bonds • Municipal Bonds (munis) • General obligation • Revenue • Eurobonds • Sovereign debt • Convertible • Mortgage bonds

6. Bond Ratings • Companies rate the creditworthiness of bonds • Standard & Poor’s (S&P) • Moody’s • Fitch • Typical ratings scale • AAA • AA • A • BBB • BB BB and below are “junk” bonds (also called “high yield”) • B • CCC • … • D in default

7. Value • Book value – shown in the financial statements • Liquidation value – value if assets were sold • Market value • Intrinsic / economic value • PV of future expected cash flows • PV of future cash flows affected by • Amount and timing of payments • Riskiness of payments • Required rate of return

8. PV of Future Cash Flows Ci is cash flow in period i n = time to maturity r = required rate of return Exercise - Compute value of example bonds.

9. Bond Yields • Yield to maturity • Expected rate of return • Use market price for PV • Use par value for FV • Use coupon interest rate for payments • Current yield • Interest payment / price • Use to compare to alternative investments

10. Bond Risk • Default risk • Will affect your required rate of return to take on the risk • Interest rate risk • If goes up, then required rate of return goes up • If retired rate of return goes up, price goes down • Inflation risk • If goes up, then required rate of return goes up • If retired rate of return goes up, price goes down • Maturity • The longer the maturity, the higher the risk • Why?

11. Bond Prices • Price will be below par if required rate of return is above coupon interest rate • And vice versa • Inverse relationships between bond prices and • Market interest rates • Inflation

12. Yield Curve