Chapter 2. Valuing bonds.

The list of bonds issued by Walt Disney Company and its main characteristics are presented in the table below (20.11.2012):

Table 4 Bonds Valuation, bonds are sorted by maturity date

#	Bonds issue	Type	Credit rating	Quantity available, $ mln	Coupon rate, %	Coupon payment frequency, times per year	First Coupon Date	Maturity date	Callable	Secured	Price, %	YTM, %
1	DISNEY WALT CO MTNS BE	Corp	A	55	6.2	2	12/20/2002	6/20/2014	No	No	115.51	0.114
2	DISNEY WALT CO MTNS BE	Corp	A	110	1.35	2	2/16/2012	8/16/2016	No	No	101.51	1.02
3	DISNEY WALT CO MTNS BE	Corp	A	50	5.625	2	3/15/2007	9/15/2016	No	No	120.59	1.189
4	DISNEY WALT CO MTNS BE	Corp	A	250	5.5	2	9/15/2009	3/15/2019	No	No	122.89	2.097
5	DISNEY WALT CO MTNS BE	Corp	A	50	3.75	2	12/1/2011	6/1/2021	No	No	113.31	2.19
6	DISNEY WALT CO MTNS BE	Corp	A	200	2.75	2	2/16/2012	8/16/2021	No	No	103.16	2.383
7	DISNEY WALT CO MTNS BE	Corp	A	10	7	2	9/1/2002	3/1/2032	No	No	149.01	3.577

In this table we can see that all the bonds are evidently corporate, have the Fitch’s credit rating of “A”. Disney’s bonds have typical available quantity of $50—100 million, ranging from $10 million to the $250 million. Coupon rates are widely spread along the interval of 1—7%, but have an average of some 5%. All the coupons are semi-annual. Currently available bonds have the date of issue in the 2000s and maturity dates ranging from 2014 to 2032 year. They all are not callable, and none of them is secured by particular assets. They have different YTMs, but they have a usual trend of growth. The weighted average YTM is 1.83%¹.

The company’s bonds are issued to raise money for general corporate purposes, mergers & acquisitions and implementations of different projects. For instance, in the 24 of October, 2001 Disney acquires Fox Family Channel for $3 billion, plus the assumption of $2.3 billion in debt, and renames it ABC Family². The acquisition of the company with Fox Family Channel was seen as a means of beefing up its portfolio of cable networks as well as strengthening Disney's position with younger viewers.

The graphs below show the price and yields dynamics of one of the Disney’s recent bonds³ — DISNEY WALT CO MTNS BE_16-Feb-2012 (#8 in the Table above). The data is shown for the 2012-year period. The relationship between yield and price is inverse: when price goes up, yield goes down and vice versa.

Price dynamics 2012

Yield dynamics 2012

A strong company such as Disney with high credit ratings means that the chance of defaulting on a bond is very small. A credit grade served to the Company incredibly well over the past decade including when liquidity dried up for most companies in 2008. During the financial crisis the Disney Company’s net income dropped to $4.4 billion from $4.7 billion. Decline in advertising hurt two Disney properties, ABC and ESPN, leading to a 4% drop in income at the media networks unit. Income at the theme parks also dropped 4% because of lower bookings at Disneyland and higher costs at Walt Disney World. The Disney’s strategy during the crisis was to decrease prices on its entertainment services, and these discounts helped Disney sustain attendance levels despite the tough economic environment. There was the same and even more visitors as the year before, but with the special deals Disney was not making more money out of it.

Disney’s long-term debt for 5 years, $ bln

Fair value

Fair value of a bond denotes a monetary value (fair price) that represents the value of the bond computed using its objective constituents. Let us look at the formula of the bond value with semiannual payments:

Fair value formula⁴

where:

• PRICE is fair value

• settlement is the bond’s settlement date (date the security was purchased)

• maturity is the bond’s maturity date

• rate is the bond’s annual coupon rate

• yld is the bond’s yield to maturity (YTM)

• redemption is the bond’s redemption value per $100 face value (usually $100)

• frequency is the number of coupon payments per year

• basis is the type of day count basis to use

• DSC is number of days from settlement to next coupon date

• E is number of days in coupon period in which the settlement date falls

• N is number of coupons payable between settlement date and redemption date

• A is number of days from beginning of coupon period to settlement date

The fair value of a bond is based only on one measure that is estimated subjectively. It is called yield to maturity (in the sequel referred to as YTM) or required rate of return. All other variables are objective and can be taken exactly without any analysis. Given that, the problem of bond’s fair value estimation is tight bound to the estimation of its YTM.

YTM is the internal rate of return (IRR) of a bond and determines the level of yield of this bond. However, it’s defined by the extent of risks on this particular bond rather than its price. YTM for bonds consist of the market-formed component (which is determined by the market) and the component determined by the company’s financial situation.

This company-determined component includes liquidity premium (LP) and default risk premium (DRP). The first summand, the liquidity premium, is the premium incurred from the costs to sell this security. The rare this security is, the higher this liquidity premium will be, and vice versa. The default risk premium is the premium that follows because of the risk of default (refusal or appears in payment) on this security. The more unstable financial situation the company has, the higher the default risk premium will be. In order to measure the level of this risk, there exist several credit ratings (namely Fitch, S&P, Moody’s). In our paper we use the Fitch’s credit ratings system in order to measure credit rating for bonds.

Since the maturity risk (MR) and default risk grow across time, their premiums, the maturity risk premium (MRP) and default risk premium grow across time to maturity correspondingly. It is essential not to confuse the time to maturity of a bond with the life length of a bond (bond period), which is calculated as a period between the date of issue and the date of maturity. Given that, YTM is (at least theoretically) a growing function of the time to maturity parameter.

As we have already mentioned, the credit rating is another factor affecting YTM. Therefore, there are two parameters that YTM depends on: time to maturity and financial situation of the firm. The second one is partly described by the credit rating systems, but as it doesn’t change frequently, the current state of the firm is another force affecting YTM and price.

In this paper we performed the analysis of fair value based on the YTM estimation. Two approaches we applied:

Estimation of YTM of competitors in the media industry (in the sequel referred to as Industry)

Estimation of YTM via composite bond rate for the market as whole (in the sequel referred to as Composite)

Further we describe both approaches thoroughly.