Chapter: 06

1. Chapter: 06 Interest Rates & Bond Valuation

2. Interest Rate Fundamentals • Interest Rate: The compensation paid by the borrower of funds to the lender; from the borrower points of view, the cost of borrowing funds. • Required Return: The cost of funds obtained by selling an ownership interest; it reflects the funds supplier’s level of expected return. • Real Rate of Interest: The rate that creates an equilibrium between the supply of savings & the demand for investment funds in a perfect world, without inflation, where funds suppliers & demanders are indifferent to the term of loans or investments & have no liquidity preference, where all outcomes are certain.

3. Interest Rate Fundamentals…contd. • Nominal Rate of Interest: The actual rate of interest charged by the suppliers of funds & paid by the demander. • Nominal rate of interest = real rate of interest + inflation premium + risk premium. • Risk free rate of interest = real rate of interest + inflation premium • Term Structure of Interest Rates = The relationship between interest rate or rate of return & the time to maturity. • Yield to Maturity (YTM): Annual rate of return earned on a debt security purchased on a given day & held to maturity.

4. Interest Rate Fundamentals…contd. • Yield Curve: A graph of the relationship between the debt’s remaining time to maturity & its YTM. • Inverted Yield Curve: A downward slopping yield curve that indicates generally cheaper long term borrowing costs than short-term borrowing costs. • Normal Yield Curve: An up-ward slopping yield curve that indicates generally cheaper short-term borrowing costs than long-term borrowing costs. • Flat Yield Curve: A yield curve that reflects relatively similar borrowing costs for both short-term & long-term loans.

5. Theories of Term Structure • Expectations Theory: The theory that the yield curve reflects investor expectations about future interest rates; an increasing inflation expectation results in an upward-slopping yield curve & a decreasing inflation expectations results in a downward-slopping yield curve. • Liquidity Preference Theory: Theory suggesting that for any given issuer, long-term interest rates tend to be higher than short-term rates because: • Lower liquidity & higher responsiveness to general interest rate movements of longer-term securities exists, & • Borrower willingness to pay a higher interest rate for long-term financing; causes the yield curve to be upward slopping.

6. Theories of Term Structure…contd. • Market Segmentation Theory:Theory suggesting that the market for loans is segmented on the basis of maturity & that the supply of & demand for loans within each segment determine its prevailing interest rate; the slope of the yield curve is determined by the general relationship between the prevailing rates in each segment.

7. Debt-specific issuer & issue-related Risk • Default Risk: The possibility that the issuer will not pay the contractual interest or principal as scheduled. • Maturity Risk: The fact that the longer the maturity, the more the value of security will change in response to a given change in interest rates. • Contractual Provision Risk: Conditions that are often included in a debt agreement or a stock issue.

8. Corporate Bond • A bond is a long-term debt instruments/obligations that promises to pay the bondholder a predetermined, fixed amount of interest each year until maturity. At maturity, the principal will be paid to the bondholder. • In the case of a firm's insolvency, a bondholder has a priority of claim to the firm's assets before the preferred and common stockholders. Also, bondholders must be paid interest due them before dividends can be distributed to the stockholders.

9. Bond Indenture • An indenture (or trust deed) is the legal agreement between the firm issuing the bonds and the bond trustee who represents the bondholders. It provides the specific terms of the bond agreement such as the rights and responsibilities of both parties. The bond indenture includes: • Descriptions of the amount & timing of all interest & principal payments, • Standard provisions, • Restrictive covenants, • Sinking-fund requirements, • Security interest provisions.

10. 1) Standard Provisions • Maintain satisfactory accounting record in accordance with GAAP. • Periodically supply audited financial statements. • Pay taxes & other liabilities when due, & • Maintain all facilities in good working order.

11. 2) Restrictive Covenants • Require a minimum level of liquidity, to ensure against loan default. • Prohibit the sale of accounts receivable to generate cash. • Impose fixed-asset restrictions. • Constrain subsequent borrowing. • limit the firm’s annual cash dividend payments to a specified percentage or amount.

12. 3) Sinking-Fund Requirements • A restrictive provision often included in a bond indenture, providing for the systematic retirement of bonds prior to their maturity. To carry out this requirement, the corporation makes semiannual or annual payments that are used to retire bonds by purchasing them in the market place.

13. 4) Security Interest • The bond indenture identifies any collateral pledged against the bond & specifies how it is to be maintained. The protection of bond collateral is crucial to guarantee the safety of a bond issue.

14. Trustee • A paid individual, corporation or commercial bank trust department that acts as the third party to a bond indenture & can take specified actions on behalf of the indenture are violated.

15. Factors Affecting the Cost of Bonds to Issuer • Rate of interest paid by the bond issuer, • Bond’s Maturity, • Size of the offering, • Issuer’s Risk, & • Basic cost of money.

16. Bond Ratings • Bond ratings are simply judgments about the future risk potential of the bond in question. Bond ratings are extremely important in that a firm’s bond rating tells much about the cost of funds and the firm’s access to the debt market.Three primary rating agencies exist—Moody’s, Standard & Poor’s, and Fitch Investor Services in the United States.

17. Bond Ratings…contd.

18. Types of Bonds

19. Contemporary Types of Bonds • Zero-Coupon Bonds. • Junk Bonds. • Floating-rate bonds. • Extendible notes. • Putable bonds.

20. Valuation of Bonds Bond value • kd = required rate of return on a debt instrument • N = number of years before the bond matures • INT = dollars of interest paid each year (Coupon rate  Par value) • M = par or face, value of the bond to be paid off at maturity

21. Valuation of Bonds • Genesco 15%, 15year, $1,000 bonds valued at 15% required rated of return

22. Bond value Valuation of Financial Assets - Bonds • Numerical solution: Vd = $150 (5.8474) + $1,000 (0.1229) = $877.11 + $122.89 = $1,000

23. Changes in Bond Values over Time • If the market rate associated with a bond (kd) equals the coupon rate of interest, the bond will sell at its par value • If interest rates in the economy fall after the bonds are issued, kd is below the coupon rate. The interest payments and maturity payoff stay the same, causing the bond’s value to increase (investors demand lower returns, so they are willing to pay higher prices for bonds).

24. Changes in Bond Values over Time..contd. • Current yield is the annual interest payment on a bond divided by its current market value Current yield Capital gains yield

25. Changes in Bond Values over Time…contd. • Discount bond A bond that sells below its par value, which occurs whenever the going rate of interest rises above the coupon rate • Premium bond A bond that sells above its par value, which occurs whenever the going rate of interest falls below the coupon rate

26. Changes in Bond Values over Time…contd. • An increase in interest rates will cause the price of an outstanding bond to fall • A decrease in interest rates will cause the price to rise • The market value of a bond will always approach its par value as its maturity date approaches, provided the firm does not go bankrupt

27. Bond Value Kd < Coupon Rate Kd = Coupon Rate Kd > Coupon Rate Years Changes in Bond Values over Time..contd. • Time path of value of a 15% Coupon, $1000 par value bond when interest rates are 10%, 15%, and 20%

28. Approximate yield to maturity Yield to Maturity • YTM is the average rate of return earned on a bond if it is held to maturity

29. Bond Values with Semiannual Compounding

30. Interest Rate Risk on a Bond • Interest Rate Price Risk - the risk of changes in bond prices to which investors are exposed due to changing interest rates • Interest Rate Reinvestment Rate Risk - the risk that income from a bond portfolio will vary because cash flows have to be reinvested at current market rates

31. Value of Long and Short-Term15% Annual Coupon Rate Bonds

32. Value of Long and Short-Term15% Annual Coupon Rate Bonds 2,000 1,500 1,000 500 14-Year Bond 1-Year Bond 0 5 10 15 20 25

33. When is Bond Financing more appropriate? • Stability in revenue & earnings exists. • There is a satisfactory profit margin. • There is a good liquidity & cash flow position. • The debt-equity ratio is low. • Stock prices are currently depressed. • Control considerations are a primary factor. • Inflation is expected. • Bond indenture restrictions are not burdensome.