1. Corporate Financial Theory
Lecture 8

2. Corp Financial Theory
Topics Covered: * Capital Budgeting (investing) * Financing (borrowing) Today: Revisit Financing Debt Financing, Risk & Interest Rates

3. Debt & Interest Rates Classical Theory of Interest Rates (Economics)
developed by Irving Fisher
Nominal Interest Rate = The rate you actually pay when you borrow money
Real Interest Rate = The theoretical rate you pay when you borrow money, as determined by supply and demand r
Supply
Real r
Demand
$ Qty

4. Federal Reserve Policy
Conventional wisdom
The Federal Reserve sets interest rates. Whenever they raise or lower interest rates, the amount I pay on my credit card increases or decreases accordingly.
FALSE

5. The Federal Reserve and The Colts
Value of one Colts season ticket
Value of two Colts season tickets

6. Conclusions from Example
Too much cash = Inflation
Growth in cash = Growth in goods
Who controls Cash ?
The Federal Reserve
They DO NOT control interest rates
They INFLUENCE inflation
Why do we care?
Inflation determines YOUR Interest Rates

7. Federal Reserve Monetary Policy
Fed Rate
Banks Borrow
Loan money to us

8. The Federal Reserve Dilemma
Monetary Policy
Fed Discount Rate
Inflation Rate

9. The Fed & Interest Rates
Myth: The Federal Reserve Board controls the interest rates WE PAY
Fact: The Fed controls the rate BANKS PAY
Fact: The rate we pay is set by the Banks
Fact: Banks rates are determined by the Fed Rate AND INFLATION
Mortgage rate = Fed Rate + expected inflation

10. Interest Rates and Inflation

11. Fed Funds vs. Mortgage Rates
Fed Discount 30 Yr. Mortgage Inflation
Feb ‘ % % %
Aug’ % % %
July 2008 CPI = 9.60 %
Source: Bankrate.com 8/21/08 report, mortgage-x.com, & bls.gov July 2008 CPI report 3 3 3 3 4 3

12. Fed Funds vs. Mortgage Rates
1991
2006
Source: federal reserve board

13. Fed Funds vs. Mortgage Rates
1991
2006
Source: federal reserve board

14. The Fed & Interest Rates
Q: How does this link to mortgage rates?
A: Mortgage rates are the combination of inflation and the Fed Funds rate.
Nominal rate = Real rate + expected inflation
Mortgage rate = Fed Funds + expected inflation
Real rate is a theoretical number… KIND OF
Nominal rate is what we pay
Inflation is the real danger

15. Debt & Interest Rates
Nominal r = Real r + expected inflation Real r is theoretically somewhat stable Inflation is a large variable Q: Why do we care? A: This theory allows us to understand the Term Structure of Interest Rates. Q: So What? A: The Term Structure tells us the cost of debt.

16. Term Structure of Interest Rates
Maturity YTM % % % % %
Listing of the hypothetical yields on U.S. Treasury Zero Coupon bonds
= The Pure Term Structure

17. Term Structure of Interest Rates
Maturity YTM % % % % %
AAA Corp Bond Term Structure

18. Term Structure of Interest Rates
Expectations Theory
Term Structure and Capital Budgeting
CF should be discounted using term structure info
When rate incorporates all forward rates, use spot rate that equals project term
Take advantage of arbitrage

19. Yield Curve
The graph of the term Structure of Interest Rates is called the “Yield Curve”
YTM (r)
Year
The Dynamic Yield Curve – Web Link

20. US Treasury Strips (2012)

21. Term Structure Year YTM (r) 1 5 10 20 30
1981
1987
1976
Year
Spot Rate - The actual interest rate today (t=0)
Forward Rate - The interest rate, fixed today, on a loan made in the future at a fixed time.
Future Rate - The spot rate that is expected in the future
Yield To Maturity (YTM) - The IRR on an interest bearing instrument

22. Term Structure Year YTM (r) 1 5 10 20 30
1981
1987
1976
Year
1987 is the normal Term Structure
1981 is abnormal & dangerous to the economy (because there is an incentive not to invest)
EG. 1981
Spot Rate (nominal) = Real r Inflation
.15 = (-.05)

23. Term Structure Year EG. 1981 Spot Rate (nominal) = Real r + Inflation
YTM (r)
1981
1987
1976
Year
EG. 1981
Spot Rate (nominal) = Real r Inflation
.15 = (-.05)
Forward Rate (nominal) = Real r Inflation
.10 =

24. Term Structure What Determines the Shape of the TS?
1 - Unbiased Expectations Theory
2 - Liquidity Premium Theory
3 - Market Segmentation Hypothesis
Term Structure & Capital Budgeting
CF should be discounted using Term Structure info
Since the spot rate incorporates all forward rates, then you should use the spot rate that equals the term of your project.
If you believe in other theories take advantage of the arbitrage.

25. Valuing a Bond

26. Valuing a Bond Cash Flows Sept 12 13 14 15 16 115 115 115 115 1115
Example
If today is October 1, 2012, what is the value of the following bond? An IBM Bond pays $115 every September 30 for 5 years. In September 2016 it pays an additional $1000 and retires the bond. The bond is rated AAA (WSJ AAA YTM is 7.5%)
Cash Flows
Sept

27. Valuing a Bond Example continued
If today is October 1, 2012, what is the value of the following bond? An IBM Bond pays $115 every September 30 for 5 years. In September 2016 it pays an additional $1000 and retires the bond. The bond is rated AAA (WSJ AAA YTM is 7.5%)

28. Valuing a Bond Example - Germany
In July 2012 you purchase 100 Euros of bonds in Germany which pay a 5% coupon every year. If the bond matures in 2018 and the YTM is 3.8%, what is the value of the bond?

29. Valuing a Bond Another Example - Japan
In July 2012 you purchase 200 Yen of bonds in Japan which pay a 8% coupon every year. If the bond matures in 2017 and the YTM is 4.5%, what is the value of the bond?

30. Valuing a Bond Example - USA
In July 2012 you purchase a 3 year US Government bond. The bond has an annual coupon rate of 4%, paid semi-annually. If investors demand a 2.48% return on 6 month investments, what is the price of the bond?

31. Valuing a Bond Example continued - USA
Take the same 3 year US Government bond. The bond has an annual coupon rate of 4%, paid semi-annually. If investors demand a 1.50% return on 6 month investments, what is the new price of the bond?

32. Yield To Maturity
All interest bearing instruments are priced to fit the term structure
This is accomplished by modifying the asset price
The modified price creates a New Yield, which fits the Term Structure
The new yield is called the Yield To Maturity (YTM)

33. Yield to Maturity Example
A $1000 treasury bond expires in 5 years. It pays a coupon rate of 10.5%. If the market price of this bond is , what is the YTM?

34. Yield to Maturity Example
A $1000 treasury bond expires in 5 years. It pays a coupon rate of 10.5%. If the market price of this bond is , what is the YTM?
C0 C1 C2 C3 C4 C5
Calculate IRR = 8.50%

35. Bond Prices and Yields
Bond Price, %
Interest Rates, %

36. Maturity and Prices
Bond Price, %
Interest Rates, %

37. Debt & Risk
If you have two bonds, both providing a YTM of 8.5%, do you care which one you would prefer to buy?
What additional information do you need to make your decision?
Why do you need this information?
Duration is the tool that tells us the difference in risk between two different bonds.

38. Debt & Risk Year CF PV@YTM % of Total PV % x Year Example (Bond 1)
Given a 5 year, 10.5%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?
Year CF % of Total PV % x Year

39. Debt & Risk Year CF PV@YTM % of Total PV % x Year 1 105 2 105 3 105
Example (Bond 1)
Given a 5 year, 10.5%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?
Year CF % of Total PV % x Year
1 105
2 105
3 105
4 105

40. Debt & Risk Year CF PV@YTM % of Total PV % x Year 1 105 96.77
Example (Bond 1)
Given a 5 year, 10.5%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?
Year CF % of Total PV % x Year

41. Debt & Risk Year CF PV@YTM % of Total PV % x Year 1 105 96.77 .090
Example (Bond 1)
Given a 5 year, 10.5%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?
Year CF % of Total PV % x Year

42. Debt & Risk Year CF PV@YTM % of Total PV % x Year
Example (Bond 1)
Given a 5 year, 10.5%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?
Year CF % of Total PV % x Year
Duration

43. Debt & Risk Year CF PV@YTM % of Total PV % x Year Example (Bond 2)
Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?
Year CF % of Total PV % x Year

44. Debt & Risk Year CF PV@YTM % of Total PV % x Year 1 90 2 90 3 90 4 90
Example (Bond 2)
Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?
Year CF % of Total PV % x Year
1 90
2 90
3 90
4 90

45. Debt & Risk Year CF PV@YTM % of Total PV % x Year 1 90 82.95
Example (Bond 2)
Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?
Year CF % of Total PV % x Year

46. Debt & Risk Year CF PV@YTM % of Total PV % x Year 1 90 82.95 .081
Example (Bond 2)
Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?
Year CF % of Total PV % x Year

47. Debt & Risk Year CF PV@YTM % of Total PV % x Year
Example (Bond 2)
Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?
Year CF % of Total PV % x Year
Duration

48. Debt & Risk
Using the two previous examples, which bond whould you buy and why?

49. Debt & Risk Year CF PV@YTM % of Total PV % x Year
Example (Bond 3)
Given a 5 year, 9.0%, $1000 bond, with a 8.75% YTM, what is this bond’s duration?
Year CF % of Total PV % x Year
Duration

50. Debt & Risk Q: Given Bond 1 and its YTM of 8.5%
Which bond should you buy and why?
A: It depends on your tolerance for risk.

51. Valuing Risky Bonds
The risk of default changes the price of a bond and the YTM.
Example
We have a 5% 1 year bond. The bond is priced at par of $1000. But, there is a 20% chance the company will go into bankruptcy and only pay $500. What is the bond’s value? A:

52. Valuing Risky Bonds Example A: Bond Value Prob 1,050 .80 = 840.00
We have a 5% 1 year bond. The bond is priced at par of $1000. But, there is a 20% chance the company will go into bankruptcy and only pay $500. What is the bond’s value?
A: Bond Value Prob
1, = =
= expected CF

53. Valuing Risky Bonds Example – Continued
Conversely - If on top of default risk, investors require an additional 3 percent market risk premium, the price and YTM is as follows:

54. Key to Bond Ratings
The highest quality bonds are rated AAA. Investment grade bonds have to be equivalent of Baa or higher. Bonds that don’t make this cut are called “high-yield” or “junk” bonds.

55. Key to Bond Ratings

56. Bond Terminology Read Chapter 24 for terminology Examples
Collateralized Debt Obligations
Asset Backed Securities
Mortgage Backed Securities
Loan Guarantees (Puttable bonds)