Answers to Test Questions

CHAPTER 7

THE VALUATION AND CHARACTERISTICS OF BONDS

FOCUS

The discussion of bonds is presented in two parts. First we concentrate on understanding the calculations associated with pricing bonds including consideration of call provisions and convertibles. After that we take a close look at the nature of the bondholder-issuer relationship and the institutional characteristics of the bond instrument. Since leasing is increasingly an alternative to debt, a detailed treatment of lease financing is included as an appendix.

PEDAGOGY

The chapter begins with a general introduction to valuation that establishes an exact definition of the

relationship between the price of a security and its return. Then, before beginning bond calculations, we go through a careful illustration of just why interest rate changes drive bond prices. This background helps to avoid confusion later on.

TEACHING OBJECTIVES

In this chapter, students should:

1. Gain an understanding of the basis for valuation of traditional and convertible debt securities.

2. Develop the ability to calculate bond prices and yields.

3. Learn a few of the basic institutional characteristics of bonds.

4. Develop and understanding of leasing as an alternative to debt. (Appendix A)

OUTLINE

I. THE BASIS OF VALUE

A financial asset's value is the present value of its future cash flows.

A. Investment

Investment is using a resource to improve the future.

B. Return

Return as the discount rate that makes the present value of a security's cash flows equal to its price.

II. BOND VALUATION

A bond allows one organization to borrow from many lenders at one time.

A. Bond Terminology and Practice

A little vocabulary, term coupon rate etc.

B. Bond Valuation - Basic Ideas

Why bond prices adjust to interest rate changes.

C. Determining the Price of a Bond

The time line representation of a bond's