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Corporate Financial Theory. Lecture 8. Corp Financial Theory. Topics Covered: * Capital Budgeting (investing) * Financing (borrowing) Today: Revisit Financing Debt Financing, Risk & Interest Rates. Debt & Interest Rates. Classical Theory of Interest Rates (Economics)

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Corporate financial theory

Corporate FinancialTheory

Lecture 8


Corp financial theory
Corp Financial Theory

Topics Covered:

* Capital Budgeting (investing)

* Financing (borrowing)

Today:

Revisit Financing

Debt Financing, Risk & Interest Rates


Debt interest rates
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


Federal reserve policy
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


The federal reserve and the colts
The Federal Reserve and The Colts

Value of one Colts season ticket

Value of two Colts season tickets


Conclusions from example
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


  • Federal reserve monetary policy
    Federal Reserve Monetary Policy

    Fed Rate

    Banks Borrow

    Loan money to us


    The federal reserve dilemma
    The Federal Reserve Dilemma

    Monetary Policy

    Fed Discount Rate

    Inflation Rate


    The fed interest rates
    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



    Fed funds vs mortgage rates
    Fed Funds vs. Mortgage Rates

    Rates

    Fed Discount 30 Yr. Mortgage Inflation

    Feb ‘06 5.75 % 6.24 % 2.50 %

    Aug’08 2.25 % 6.67 % 5.83 %

    July 2008 CPI = 9.60 %

    Source: Bankrate.com 8/21/08 report, mortgage-x.com, & bls.gov July 2008 CPI report


    Fed funds vs mortgage rates1
    Fed Funds vs. Mortgage Rates

    1991

    2006

    Source: federal reserve board


    Fed funds vs mortgage rates2
    Fed Funds vs. Mortgage Rates

    1991

    2006

    Source: federal reserve board


    The fed interest rates1
    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


    Debt interest rates1
    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.


    Term structure of interest rates
    Term Structure of Interest Rates

    Maturity YTM

    1 3.0 %

    5 3.5%

    10 3.8%

    15 4.2%

    30 4.5%

    Listing of the hypothetical yields on U.S. Treasury Zero Coupon bonds

    = The Pure Term Structure


    Term structure of interest rates1
    Term Structure of Interest Rates

    Maturity YTM

    1 5.3 %

    5 5.9 %

    10 6.4 %

    15 6.7 %

    30 7.0 %

    AAA Corp Bond Term Structure


    Term structure of interest rates2
    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


    Yield curve
    Yield Curve

    • The graph of the term Structure of Interest Rates is called the “Yield Curve”

    YTM (r)

    Year

    1 5 10 20 30

    The Dynamic Yield Curve – Web Link



    Term structure
    Term Structure

    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

    YTM (r)

    1981

    1987

    1976

    Year

    1 5 10 20 30


    Term structure1
    Term Structure

    YTM (r)

    • 1987 is the normal Term Structure

    • 1981 is abnormal & dangerous to the economy (because there is an incentive not to invest)

    1981

    1987

    1976

    Year

    1 5 10 20 30

    EG. 1981

    Spot Rate (nominal) = Real r + Inflation

    .15 = (-.05) + .20


    Term structure2
    Term Structure

    YTM (r)

    1981

    1987

    1976

    Year

    1 5 10 20 30

    EG. 1981

    Spot Rate (nominal) = Real r + Inflation

    .15 = (-.05) + .20

    Forward Rate (nominal) = Real r + Inflation

    .10 = .01 + .09


    Term structure3
    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.



    Valuing a bond1
    Valuing a Bond

    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 1213141516

      115 115 115 115 1115


    Valuing a bond2
    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%)


    Valuing a bond3
    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?


    Valuing a bond4
    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?


    Valuing a bond5
    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?


    Valuing a bond6
    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?


    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)

    Yield To Maturity


    Yield to maturity1
    Yield to Maturity structure

    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 107.88, what is the YTM?


    Yield to maturity2
    Yield to Maturity structure

    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 107.88, what is the YTM?

    C0 C1 C2 C3 C4 C5

    -1078.80 105 105 105 105 1105

    Calculate IRR = 8.50%


    Bond prices and yields
    Bond Prices and Yields structure

    Bond Price, %

    Interest Rates, %


    Maturity and prices
    Maturity and Prices structure

    Bond Price, %

    Interest Rates, %


    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.

    Debt & Risk


    Debt risk1
    Debt & Risk care which one you would prefer to buy?

    Example (Bond 1)

    Given a 5 year, 10.5%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?

    Year CF [email protected] % of Total PV % x Year


    Debt risk2
    Debt & Risk care which one you would prefer to buy?

    Example (Bond 1)

    Given a 5 year, 10.5%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?

    Year CF [email protected] % of Total PV % x Year

    1 105

    2 105

    3 105

    4 105

    5 1105


    Debt risk3
    Debt & Risk care which one you would prefer to buy?

    Example (Bond 1)

    Given a 5 year, 10.5%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?

    • Year CF [email protected] % of Total PV % x Year

    • 1 105 96.77

    • 2 105 89.19

    • 3 105 82.21

    • 4 105 75.77

    • 5 1105 734.88

      • 1078.82


    Debt risk4
    Debt & Risk care which one you would prefer to buy?

    Example (Bond 1)

    Given a 5 year, 10.5%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?

    • Year CF [email protected] % of Total PV % x Year

    • 1 105 96.77 .090

    • 2 105 89.19 .083

    • 3 105 82.21 .076

    • 4 105 75.77 .070

    • 5 1105 734.88 .681

      • 1078.82 1.00


    Debt risk5
    Debt & Risk care which one you would prefer to buy?

    Example (Bond 1)

    Given a 5 year, 10.5%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?

    • Year CF [email protected] % of Total PV % x Year

    • 1 105 96.77 .090 0.090

    • 2 105 89.19 .083 0.164

    • 3 105 82.21 .076 0.227

    • 4 105 75.77 .070 0.279

    • 5 1105 734.88 .681 3.406

      • 1078.82 1.00 4.166 Duration


    Debt risk6
    Debt & Risk care which one you would prefer to buy?

    Example (Bond 2)

    Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?

    Year CF [email protected] % of Total PV % x Year


    Debt risk7
    Debt & Risk care which one you would prefer to buy?

    Example (Bond 2)

    Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?

    Year CF [email protected] % of Total PV % x Year

    1 90

    2 90

    3 90

    4 90

    5 1090


    Debt risk8
    Debt & Risk care which one you would prefer to buy?

    Example (Bond 2)

    Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?

    • Year CF [email protected] % of Total PV % x Year

    • 1 90 82.95

    • 2 90 76.45

    • 3 90 70.46

    • 4 90 64.94

    • 5 1090 724.90

      • 1019.70


    Debt risk9
    Debt & Risk care which one you would prefer to buy?

    Example (Bond 2)

    Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?

    • Year CF [email protected] % of Total PV % x Year

    • 1 90 82.95 .081

    • 2 90 76.45 .075

    • 3 90 70.46 .069

    • 4 90 64.94 .064

    • 5 1090 724.90 .711

      • 1019.70 1.00


    Debt risk10
    Debt & Risk care which one you would prefer to buy?

    Example (Bond 2)

    Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?

    • Year CF [email protected] % of Total PV % x Year

    • 1 90 82.95 .081 0.081

    • 2 90 76.45 .075 0.150

    • 3 90 70.46 .069 0.207

    • 4 90 64.94 .064 0.256

    • 5 1090 724.90 .711 3.555

      • 1019.70 1.00 4.249 Duration


    Debt risk11
    Debt & Risk care which one you would prefer to buy?

    Using the two previous examples, which bond whould you buy and why?


    Debt risk12
    Debt & Risk care which one you would prefer to buy?

    Example (Bond 3)

    Given a 5 year, 9.0%, $1000 bond, with a 8.75% YTM, what is this bond’s duration?

    • Year CF [email protected] % of Total PV % x Year

    • 1 90 82.76 .082 0.082

    • 2 90 76.10 .075 0.150

    • 3 90 69.98 .069 0.207

    • 4 90 64.35 .064 0.256

    • 5 1090 716.61 .710 3.550

      • 1009.80 1.00 4.245 Duration


    Debt risk13
    Debt & Risk care which one you would prefer to buy?

    Q: Given Bond 1 and its YTM of 8.5%

    Given Bond 3 and its YTM of 8.75%

    Which bond should you buy and why?

    A: It depends on your tolerance for risk.


    Valuing risky bonds
    Valuing Risky Bonds care which one you would prefer to buy?

    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:


    Valuing risky bonds1
    Valuing Risky Bonds care which one you would prefer to buy?

    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: Bond Value Prob

    1,050 .80 = 840.00

    500 .20 = 100.00 .

    940.00 = expected CF


    Valuing risky bonds2
    Valuing Risky Bonds care which one you would prefer to buy?

    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:


    Key to bond ratings
    Key to Bond Ratings care which one you would prefer to buy?

    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.


    Key to bond ratings1
    Key to Bond Ratings care which one you would prefer to buy?


    Bond terminology
    Bond Terminology care which one you would prefer to buy?

    • Read Chapter 24 for terminology

      Examples

    • Collateralized Debt Obligations

    • Asset Backed Securities

    • Mortgage Backed Securities

    • Loan Guarantees (Puttable bonds)


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