1. Copyright © 2011 Pearson Prentice Hall. All rights reserved. Debt Valuation and Interest Rates Chapter 9

2. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-2 Corporate Borrowings There are two main sources of borrowing for a corporation: 1.Loan from a financial institution (known as private debt) 2.Bonds (known as public debt since they can be traded in public financial markets)

3. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-3 Corporate Borrowings (cont.) Smaller firms choose to raise money from banks in the form of loans because of the high costs associated with issuing bonds. Larger firms generally raise money from banks for short-term needs and depend on the bond market for long-term financing needs.

4. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-4 Borrowing Money in the Private Financial Market Financial Institutions are an important source of capital for corporations. The loan might be used to –finance firm’s day-to-day operations, or –for the purchase of equipment or property. Such loans are considered private market transactions since it only involves the two parties to the loan.

5. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-5 Borrowing Money in the Private Financial Market (cont.) In the private financial market, loans are typically floating rate loans i.e. the interest rate is periodically adjusted based on a specific benchmark rate. The most popular benchmark rate is the London Interbank Offered Rate (LIBOR)

6. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-6 Borrowing Money in the Private Financial Market (cont.) LIBOR is the daily interest rate that is based on the interest rates at which banks offer to lend in the London wholesale or interbank market. –Interbank market is the market where banks loan each other money.

7. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-7 Borrowing Money in the Private Financial Market (cont.) A typical floating rate loan will specify the following: –The spread or margin between the loan rate and the benchmark rate expressed as basis points. –A maximum and a minimum annual rate, to which the rate can adjust, called the ceiling and floor. –A maturity date –Collateral

8. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-8 Borrowing Money in the Private Financial Market (cont.) For example, a corporation may get a 1- year loan with a rate of 300 basis points (or 3%) over LIBOR with a ceiling of 11% and a floor of 4%.

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10. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-10 Borrowing Money in the Public Financial Market Firms also raise money by selling debt securities to individual investors and financial institutions such as mutual funds. In order to sell debt securities to the public, the issuing firm must meet the legal requirements as specified by the securities laws.

11. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-11 Borrowing Money in the Public Financial Market Corporate bond is a debt security issued by corporation that has promised future interest payments and a principal payment at a maturity date. If the firm fails to pay the promised future payments of interest and principal, the bond trustee can classify the firm as insolvent and force the firm into bankruptcy.

12. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-12 Basic Bond Features The basic features of a bond include the following: –Bond Indenture –Claims on Assets and Income –Par or Face Value –Coupon Interest Rate –Maturity and Repayment of Principal –Call Provision and Conversion Features

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14. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-14 Bond Ratings and Default Risk Bond ratings indicate the default risk i.e. the probability that the firm will (not) make the promised payments. Bond ratings affect the rate of return that bondholders require of the firm and thus the firm’s cost of borrowing.

15. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-15 Bond Ratings and Default Risk (cont.) Risk-Return Tradeoff: –the lower the bond rating, the higher the risk of default and higher the rate of return demanded in the capital market. Bond ratings are provided by three rating agencies – Moody’s, Standard & Poor’s, and Fitch Investor Services.

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17. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-17 Valuing Corporate Debt The value of corporate debt is equal to the present value of the contractually promised principal and interest payments (the cash flows) discounted back to the present using the market’s required yield (YTM).

18. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-18 Step-by-Step: Valuing Bonds by Discounting Future Cash Flows Step 1: Determine the amount and timing of bondholder cash flows. The total cash flows equal the promised interest payments and principal payment. Annual Interest = Par value × coupon rate Example 9.1: The annual interest for a bond with coupon interest rate of 7% and a par value of $1,000 is equal to $70, (.07 × $1,000 = $70).

19. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-19 Step-by-Step: Valuing Bonds by Discounting Future Cash Flows (cont.) Step 2: Estimate the appropriate discount rate on a similar risk bond. Discount rate is the return the bond will yield if it is held to maturity and all bond payments are made. Discount rate can be either calculated or obtained from various sources (such as Yahoo! Finance).

20. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-20 Step-by-Step: Valuing Bonds by Discounting Future Cash Flows (cont.) Step 3: Calculate the present value of the bond’s interest and principal payments from Step 1 using the discount rate estimated in step 2.

21. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-21 Calculating a Bond’s Yield to Maturity (YTM) We can think of YTM as the discount rate that makes the present value of the bond’s promised interest and principal equal to the bond’s observed market price.

22. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-22 Checkpoint 9.2 Calculating the Yield to Maturity on a Corporate Bond Calculate the yield to maturity for the following bond issued by Ford Motor Company (F) with a price of $744.80, where we assume that interest payments are made annually at the end of each year and the bond has a maturity of exactly 11 years.

23. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-23 Checkpoint 9.2: Check Yourself Calculate the YTM on the Ford bond where the bond price rises to $900 (holding all other things equal).

24. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-24 Step 1: Picture the Problem YTM=? Years Cash flow -$900 $65 $65 $65 $1,065 Purchase price = $900 Interest payments = $65 per year for years 1-11 Final payment = $1,000 in year 11 of principal. 0123 …11

25. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-25 Step 2: Decide on a Solution Strategy We can use equation 9-2a to find YTM. YTM is the rate that makes the present value of all future expected cash flows equal to the current market price. We can also solve for YTM using a calculator and a spreadsheet.

26. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-26 Step 3: Solve Using Mathematical Equation It is cumbersome to solve for YTM by hand using the equation. It is more practical to use the financial calculator or the spread sheet.

27. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-27 Step 3: Solve (cont.) Using an Excel Spreadsheet YTM = RATE(nper, pmt,pv,fv) = RATE (11,65,-900,1000) = 7.89%

28. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-28 Using Market Yield to Maturity Data Market yield to maturity is regularly reported by a number of investor services and is quoted in terms of credit spreads or spreads to Treasury bonds. Table 9-4 contains some examples of yield spreads.

29. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-29 Using Market Yield to Maturity Data (cont.) The spread values in table 9-4 represent basis points over a US Treasury security (T-Bills or T- Bonds) of the same maturity as the corporate bond. For example, a 30-year Ba1/BB+ corporate bond has a spread of 275 basis points over a similar 30-year US Treasury bond. Thus this corporate bond should earn 2.75% over the 4.56% earned on treasury yield or 7.31%.

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31. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-31 Promised Returns versus Expected Yield to Maturity The yield to maturity calculation assumes that the bond performs according to the terms of the bond contract or indenture. Since corporate bonds are subject to risk of default, the promised yield to maturity may not be equal to the actual or expected yield to maturity.

32. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-32 Checkpoint 9.3 Valuing a Bond Issue Consider a $1,000 par value bond issued by AT&T (T) with a maturity date of 2026 and a stated coupon rate of 8.5%. On January 1, 2007, the bond had 20 years left to maturity, and the market ’ s required yield to maturity for similar rated debt was 7.5%. If the market ’ s required yield to maturity on a comparable risk bond is 7.5%, what is the value of the bond?

33. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-33 Checkpoint 9.3: Check Yourself Calculate the present value of the AT&T bond should the yield to maturity for comparable risk bonds rise to 9% (holding all other things equal).

34. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-34 Step 1: Picture the Problem i= 9% Years Cash flows $85 $85 $85 $1,085 0123 …20 PV of all Cash flows =? $85 annual interest $85 interest + $1,000 Principal

35. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-35 Step 2: Decide on a Solution Strategy Here we know the following: –Annual interest payments = $85 –Principal amount or par value = $1,000 –Time = 20 years –YTM or discount rate = 9% We can use the above information to determine the value of the bond by discounting future interest and principal payment to the present.

36. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-36 Step 3: Solve (cont.) Using an Excel Spreadsheet Bond Value = PV (rate, nper, pmt, fv) = PV (.09,20,85,1000) = $954.36

37. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-37 Step 4: Analyze (cont.) An investor who buys AT&T bonds at its current discounted price will earn a promised yield to maturity of 9%.

38. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-38 Semiannual Interest Payments Corporate bonds typically pay interest to bondholders semiannually. We can adapt Equation (9-2a) from annual to semiannual payments as follows:

39. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-39 Checkpoint 9.4 Valuing a Bond Issue That Pays Semiannual Interest Reconsider the bond issued by AT&T (T) with a maturity date of 2026 and a stated coupon rate of 8.5%. AT&T pays interest to bondholders on a semiannual basis on January 15 and July 15. On January 1, 2007, the bond had 20 years left to maturity. The market’s required yield to maturity for a similarly rated debt was 7.5% per year or 3.75% for six months. What is the value of the bond?

40. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-40 Checkpoint 9.4: Check Yourself Calculate the present value of the AT&T bond should the yield to maturity on comparable bonds rise to 9% (holding all other things equal).

41. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-41 Step 1: Picture the Problem i= 9% Periods Cash flow $42.5 $42.5 $42.5 $1,042.50 0123 …40 PV=? $42.50 Semiannual interest $42.5 interest + $1,000 Principal 40 6-month periods

42. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-42 Step 2: Decide on a Solution Strategy Here we know the following: –Semiannual interest payments = $42.50 –Principal amount or par value = $1,000 –Time = 20 years or 40 periods –YTM or discount rate = 9% or 4.5% for 6- months We can use the above information to determine the value of the bond by discounting future interest and principal payment to the present.

43. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-43 Step 3: Solve Using Mathematical Equation Bond Value = $ 42.5{ [ 1-(1/(1.045) 40 ] ÷ (.20)} + $1,000/(1.045) 40 = $42.5 (18.40) + $171.93 = $954

44. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-44 Step 3: Solve (cont.) Using an Excel Spreadsheet Bond Value = PV (rate, nper, pmt, fv) = PV (.045,40,42.5,1000) = $954

45. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-45 Bond Valuation: Four Key Relationships First Relationship The value of bond is inversely related to changes in the yield to maturity. YTM = 12%YTM rises to 15% Par value$1,000 Coupon rate12% Maturity date5 years Bond Value$1,000$899.44 Bond Value Drops

46. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-46 Bond Valuation: Four Key Relationships (cont.)

47. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-47 Bond Valuation: Four Key Relationships (cont.) Since future interest rates cannot be predicted, a bond investor is exposed to the risk of changing values of bonds as interest rates change. The risk to the investor that the value of his or her bond investment will change is known as interest rate risk.

48. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-48 Bond Valuation: Four Key Relationships (cont.) Second Relationship: The market value of a bond will be less (more) than its par value if the yield to maturity is above (below) the coupon interest rate.

49. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-49 Bond Valuation: Four Key Relationships (cont.) When a bond can be bought for less than its par value, it is called discount bond. For example, buying a $1,000 par value bond for $950. Bonds will trade at a discount when the yield to maturity on the bond exceeds the coupon rate.

50. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-50 Bond Valuation: Four Key Relationships (cont.) When a bond can be bought for more than its par value, it is called premium bond. For example, buying a $1,000 par value bond for $1,110. Bonds will trade at a premium when the yield to maturity on the bond is less than the coupon rate.

51. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-51 Bond Valuation: Four Key Relationships (cont.) Third Relationship: As the maturity date approaches, the market value of a bond approaches its par value. Regardless of whether the bond was trading at a discount or at a premium, the price of bond will converge towards par value as the maturity date approaches.

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53. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-53 Bond Valuation: Four Key Relationships (cont.) Fourth Relationship: Long term bonds have greater interest rate risk than short- term bonds. While all bonds are affected by a change in interest rates, long-term bonds are exposed to greater volatility as interest rates change. Why?

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55. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-55 Types of Bonds Table 9-7 contains a listing of major types of long-term debt securities that are sold in the public financial market. The differences among the various types of bond are based on the following bond attributes: Secured versus Unsecured, Priority of claim, Coupon level, Amortizing or Non-amortizing, and Convertibility.

56. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-56 Types of Bonds (cont.) Secured versus Unsecured –Secured bonds have specific assets pledged to support repayment of the bond. –Unsecured bond are referred to as debentures. –Bonds secured by a lien on real property are called mortgage bonds.

57. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-57 Types of Bonds (cont.) Priority of Claim –The priority of claim refers to the order of repayment when the firm’s assets are distributed, as in the case of liquidation. Secured bonds are paid first Un-subordinated debentures are paid next, Subordinated debentures are paid last.

58. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-58 Types of Bonds (cont.) Abnormal Risk –Junk (high-yield) bonds have a below- investment grade bond rating. These bonds have a high risk of default as the firms that issued these bonds are usually facing severe financial problems.

59. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-59 Types of Bonds (cont.) Coupon Level –Bonds with a zero or very low coupon are called zero coupon bonds. –These bonds are issued at deep discounts from their par value and promise to repay a zero or very low coupon rate each year. The par value is repaid at the maturity of the bond.

60. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-60 Types of Bonds (cont.) Amortizing or Non-Amortizing –The payments from amortizing bonds, like a home mortgage, include both the interest and principal. –The payments from a non-amortizing bonds include only interest. At maturity, the bonds repay the par value of bond.

61. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-61 Types of Bonds (cont.) Convertibility –Convertible bonds are debt securities that can be converted into a firm’s stock at a pre- specified price.

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63. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-63 Determinants of Interest Rates As we observed earlier, bond prices vary inversely with interest rates. Therefore in order to understand bond pricing we need to know the determinants of interest rates.

64. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-64 Real Rate of Interest and the Inflation Premium Quotes of interest rates in the financial press are commonly referred to as the nominal (or quoted) interest rates. Real rate of interest adjusts the nominal rate for the expected effects of inflation.

65. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-65 Determinants of the Nominal Rate of Interest

66. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-66 Fisher Effect The relationship between the nominal rate of interest, r nominal, the anticipated rate of inflation, r inflation, and the real rate of interest is known as the Fisher effect.

67. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-67 Fisher Effect (cont.) Example 9.3 What will be the real rate of interest if the nominal rate of interest is 10% and the anticipated rate of inflation is 3%?

68. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-68 Fisher Effect (cont.) r real = {(1+.10) ÷ (1+.03)} – 1 =.0679 or 6.79%

69. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-69 Fisher Effect (cont.) We can approximate the real rate of interest as follows: Real Rate of Interest ≈ Nominal interest rate – Inflation premium

70. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-70 Checkpoint 9.6: Check Yourself If you anticipate that the rate of inflation will now be 4% next year, holding all else the same, what rate of return will you need to earn on your savings in order to achieve a 2% increase in purchasing power?

71. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-71 Step 3: Solve r nominal =.02 +.04 + (.02 ×.04) =.0608 or 6.08%

72. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-72 Default Premium In addition to accounting for the time value of money and inflation, the interest rate that a firm’s bonds pay must also offer a default premium to compensate for the risk that the issuer will fail to repay interest and principal in a timely manner (or at all).

73. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-73 Maturity Premium – The Term Structure of Interest Rates Long-term bonds are more sensitive to interest rate changes. Maturity premium is the compensation that investors demand for bearing interest rate risk on long-term bonds.

74. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-74 Maturity Premium – The Term Structure of Interest Rates (cont.) The relationship between interest rates and time to maturity with risk held constant is known as the term structure of interest rates or the yield curve. Figure 9-3 illustrates a hypothetical yield curve of US Treasury Bonds.

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76. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-76 Shifts in the Yield Curve The term structure of interest rates changes over time as expectations regarding each of the three factors that underlie interest rates change. Figure 9-4 shows the yield curve one day before 9/11 and again two weeks later.

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78. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-78 Shifts in the Yield Curve (cont.) What happened? Investors shifted their funds to the safety of short-term Treasury securities, pushing up the prices and bringing down the yields on those securities.

79. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-79 Shifts in the Yield Curve (cont.) The yield curve is generally upward sloping but it can assume different shapes i.e. downward sloping or flat. Figure 9-5 illustrates different shapes of yield curves at different dates.

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