Bonds Coupons Face Value and Other Market Concepts

Part A: Bond Features, Markets, and Pricing

1. Madeleine is correct. When an investor buys a bond, they lend money to the issuer with the expectation of receiving their initial investment back plus interest. Lexi is incorrect because buying a bond does not grant ownership in the company, which is what equity or stock does. Lauren's statement is overly simplistic and misleading; banks are significant buyers of bonds, but they are not the only participants. Bonds can be bought by individual investors, mutual funds, and other institutional investors.

2. Lexi's understanding of zero coupon bonds is partially correct; they are purchased at a discount to face value, not at face value, and mature at their face value without making regular interest payments. Lauren is incorrect because zero coupon bonds do not pay regular interest payments. Madeleine's statement is too general and not specific to zero coupon bonds, as not all bonds increase in value over time. Wally's statement is reversed; zero coupon bonds are bought at a discount, not a premium.

3. Both Wally and Ollie are incorrect. The feature described by Wally is known as a "call provision," not a sinking fund. A sinking fund provision requires the issuer to retire a portion of the bond issue each year, which helps protect bondholders by reducing default risk. A "repo provision" is not a standard term related to bond features.

4. Bonds with credit risk typically offer a higher yield than otherwise identical default-free bonds. This is because investors require a higher return as compensation for the increased risk of default associated with the bond.

5. The prices given indicate an upward-sloping yield curve, as the price decreases with longer maturities, implying higher yields for longer-dated bonds. This shape suggests that investors expect higher interest rates in the future, or it may reflect a premium for long-term investment risks.

6. To calculate the forward rate from year 2 to year 3, you use the formula that equates the investment return from investing in a 2-year bond and rolling over to a 1-year bond at the end of year 2, to investing in a 3-year bond directly. The forward rate reflects expectations of future interest rates and provides insight into the market's interest rate expectations.

7. To price Firm A's bonds, you adjust the Treasury yield by adding the credit spread. This gives the yield to maturity for Firm A's bonds. Using the bond pricing formula, you calculate the present value of future cash flows (coupon payments and principal repayment) discounted at the adjusted yield: $100 of face value.

Part B: Stock Markets and Share Pricing

8. To find the fair price, calculate the earnings per share (EPS) by dividing the net income by the number of shares outstanding. Then apply the average P/E ratio of competitors to TimCo's EPS to estimate its fair share price.

9. The share price can be determined using the dividend discount model (DDM) or by calculating the present value of expected dividends and share repurchases discounted back at the equity cost of capital, adjusted for growth.

10. Use the industry average market-to-book ratio. The fair value per share is then calculated by dividing this market value by the number of shares outstanding. This gives an industry-relative valuation based on book value.