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Chapter 9 Debt Valuation and Interest

Chapter 9 Debt Valuation and Interest. Slide Contents. Principles Applied in This Chapter Learning Objectives Overview of Corporate Debt Valuing Corporate Debt Bond Valuation: Four Key Relationships Types of Bonds Determinants of Interest Rates Key Terms. Learning Objectives.

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Chapter 9 Debt Valuation and Interest

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  1. Chapter 9Debt Valuation and Interest

  2. Slide Contents • Principles Applied in This Chapter • Learning Objectives • Overview of Corporate Debt • Valuing Corporate Debt • Bond Valuation: Four Key Relationships • Types of Bonds • Determinants of Interest Rates • Key Terms

  3. Learning Objectives • Identify the key features of bonds and describe the difference between private and public debt markets. • Calculate the value of a bond and relate it to the yield to maturity on the bond. • Describe the four key bond valuation relationships.

  4. Learning Objectives (cont.) • Identify the major types of corporate bonds. • Explain the effects of inflation on interest rates and describe the term structure of interest rates.

  5. Principles Applied in This Chapter • Principle 1: Money Has a Time Value. • Principle 2: There is a Risk-Return Tradeoff. • Principle 3: Cash Flows Are the Source of Value

  6. 9.1 OVERVIEW OF CORPORATE DEBT

  7. Corporate Borrowings • There are two main sources of borrowing for a corporation: • Loan from a financial institution (known as private debt since it involves only two parties) • Bonds (known as public debt since they can be traded in the public financial markets)

  8. Borrowing Money in the Private Financial Market Financial Institutions provide loans to finance firm’s day-to-day operations (working capital loans) or it might be used for the purchase of equipment or property (transaction loans). Loans may or may not be secured by a collateral.

  9. Borrowing Money in the Private Financial Market (cont.) • Advantages of Private Debt Placement • Speed • Reduced costs • Financing flexibility • Disadvantages of Private Debt Placement • Interest costs • Restrictive covenants • The possibility of future SEC registration

  10. Floating-Rate Loans In the private financial market, loans are typically floating rate loans i.e. the interest rate is adjusted based on a specific benchmark rate. The most popular benchmark rate is the London Interbank Offered Rate (LIBOR), rate at which banks offer to lend in the London wholesale or interbank market

  11. Floating-Rate Loans (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%.

  12. Table 9-1 Types of Bank Debt

  13. Calculating the Rate of Interest on a Floating-Rate Loan Consider the same loan period as above but change the spread over LIBOR from .25% to .75%. Is the ceiling rate or floor rate violated during the loan period? CHECKPOINT 9.1: CHECK YOURSELF

  14. Step 1: Picture the Problem • The graph on the next slide shows the LIBOR index (series 1), LIBOR plus the spread of 75 basis points (series 2), the ceiling rate (series 3), and the floor rate (series 4).

  15. Step 1: Picture the Problem (cont.)

  16. Step 2: Decide on a Solution Strategy • We have to determine the floating rate for every week and see if it exceeds the ceiling or falls below the floor. • Floating rate on Loan = LIBOR for the previous week + spread of .75%

  17. Step 2: Decide on a Solution Strategy The floating rate on loan cannot exceed the ceiling rate of 2.5% or drop below the floor rate of 1.75%. • If the floating rate falls below the floor, the rate will be reset at the floor rate. • If the floating rate exceeds the ceiling, the rate will be reset at the ceiling rate.

  18. Step 3: Solve Ceiling Violated

  19. Step 3: Solve (cont.) The table shows the ceiling is violated during the first week and last two weeks of the loan period. The floor rate is never violated.

  20. Step 4: Analyze • The ceiling is the maximum rate charged on the loan while floor is the minimum rate charged on the loan. If the ceiling or floor rates are violated, the loan rate is reset to the ceiling rate or the floor rate. • If there were no ceiling, the loan rate would have been 2.73% during the first week of the loan, and 2.63% and 2.68% during the last two weeks of the loan.

  21. Borrowing Money in the Public Financial Market Corporations engage the services of an investment banker while raising long-term funds in the public financial market. The investment banker performs three basic functions: • Underwriting: assuming risk of selling a security issued. The client is given the money before the securities are sold to the public. • Distributing • Advising

  22. Corporate Bonds • Corporate bond is a debt security issued by corporation that has promised future payments and 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.

  23. 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

  24. Bond Ratings and Default Risk Bond ratings indicate the default risk i.e. the probability that the firm will make the bond’s promised payments. Rating agencies use borrower’s financial statements, financing mix, profitability, variability of past profits, and make judgments about the quality of the firm’s management in order to determine ratings.

  25. Table 9.3 Interpreting Bond Ratings

  26. 9.2 Valuing Corporate Debt

  27. 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 to maturity on similar risk.

  28. Table 9.2 Bond Terminology

  29. Valuing Bonds by Discounting Future Cash Flows Step 1: Determine bondholder cash flows, which are the the amount and timing of the bond’s promised interest and principal payments to the bondholders. • Annual Interest = Par value × coupon rate • Example 9.1: The annual interest for a 10-year bond with coupon interest rate of 7% and a par value of $1,000 is equal to $70, (.07 × $1,000 = $70). This bond will pay $70 every year and $1,000 at the end of 10-years.

  30. Valuing Bonds by Discounting Future Cash Flows (cont.) Step 2: Estimate the appropriate discount rate on a bond of similar risk. Discount rate is the return the bond will yield if it is held to maturity and all bond payments are made.

  31. 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 in step 2.

  32. 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.

  33. Calculating the Yield to Maturity on a Corporate Bond Calculate the YTM on the Ford bond where the bond price rises to $900 (holding all other things equal). CHECKPOINT 9.2: CHECK YOURSELF

  34. 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. 0 1 2 3 … 11

  35. 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.

  36. Step 3: Solve Using a 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.

  37. Step 3: Solve (cont.) Using a Financial Calculator N = 11 I/Y = 7.89 PV = -900 PMT = 65 FV = 1,000 Using an Excel Spreadsheet = RATE(nper, pmt,pv,fv) = RATE (11,65,-900,1000) = 7.89%

  38. Step 4: Analyze The yield to maturity on the bond is 7.89%. The yield is higher than the coupon rate of interest of 6.5%. Since the coupon rate is lower than the yield to maturity, the bond is trading at a price below $1,000. We call this a discount bond.

  39. Using Market-Yield-to-Maturity Data Market-yield-to-maturity data 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 spreads.

  40. Table 9-4 Corporate Bond Spread Tables

  41. Using Market Yield to Maturity Data (cont.) • The spread values reported in table 9-4 represent basis points over a US Treasury security 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%.

  42. Promised 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 expected yield to maturity.

  43. Promised versus Expected Yield to Maturity (cont.) • Example Consider a one-year bond that promises a coupon rate of 8% and has a principal (par value) of $1,000. Further assume the bond is currently trading for $850. What is the promised yield to maturity?

  44. Promised versus Expected Yield to Maturity (cont.) Promised YTM = {(Interest year 1 + Principal) ÷ (Bond Value)} – 1 = {($80+$1,000) ÷ ($850)} – 1 = 27.06%

  45. Promised versus Expected Yield to Maturity (cont.) The yield of 27.06% is based on the assumption of no default. Assume there is a 40% probability of default on this bond and if the bond defaults, the bondholders will receive only 60% of the principal and interest owed. What is the expected YTM on this bond?

  46. Promised versus Expected Yield to Maturity (cont.) YTMdefault = {(Interest year 1 + Principal)} ÷ (Bond Value)} – 1 = {($80+$1000) × .60} ÷ ($850)} – 1 = -23.76%

  47. Promised versus Expected Yield to Maturity (cont.) = (27.06 × .60) + (-23.76 × .40) = 6.73% The financial press quotes promised yield and not expected YTM.

  48. Valuing a Bond Issue 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). CHECKPOINT 9.3: CHECK YOURSELF

  49. Step 1: Picture the Problem i= 9% Years Cash flows $85 $85 $85 $1,085 0 1 2 3 … 20 PV of all Cash flows =? $85 annual interest $85 interest + $1,000 Principal

  50. 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.

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