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Debt Valuation and Interest Rates

Debt Valuation and Interest Rates. Chapter 9. Corporate Borrowings. There are two main sources of borrowing for a corporation: Loan from a financial institution (known as private debt) Bonds (known as public debt since they can be traded in public financial markets).

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Debt Valuation and Interest Rates

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  1. Debt Valuation and Interest Rates Chapter 9

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

  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. 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 transactionssince it only involves the two parties to the loan.

  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. 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. 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. 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%.

  9. 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.

  10. 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.

  11. 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

  12. 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.

  13. 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.

  14. 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).

  15. 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).

  16. 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).

  17. 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.

  18. 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.

  19. 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.

  20. Checkpoint 9.2:Check Yourself Calculate the YTM on the Ford bond where the bond price rises to $900 (holding all other things equal).

  21. 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

  22. 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.

  23. 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.

  24. Step 3: Solve (cont.) Using an Excel Spreadsheet YTM = RATE(nper, pmt,pv,fv) = RATE (11,65,-900,1000) = 7.89%

  25. 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.

  26. 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%.

  27. 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.

  28. 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?

  29. 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).

  30. 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

  31. 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.

  32. Step 3: Solve (cont.) Using an Excel Spreadsheet Bond Value = PV (rate, nper, pmt, fv) = PV (.09,20,85,1000) = $954.36

  33. 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%.

  34. Semiannual Interest Payments Corporate bonds typically pay interest to bondholders semiannually. We can adapt Equation (9-2a) from annual to semiannual payments as follows:

  35. 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?

  36. 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).

  37. Step 1: Picture the Problem i= 9% Periods Cash flow $42.5 $42.5 $42.5 $1,042.50 40 6-month periods 0 1 2 3 … 40 PV=? $42.50 Semiannual interest $42.5 interest + $1,000 Principal

  38. 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.

  39. 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

  40. Step 3: Solve (cont.) Using an Excel Spreadsheet Bond Value = PV (rate, nper, pmt, fv) = PV (.045,40,42.5,1000) = $954

  41. Bond Valuation: Four Key Relationships First Relationship The value of bond is inversely related to changes in the yield to maturity. Bond Value Drops

  42. Bond Valuation: Four Key Relationships (cont.)

  43. 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.

  44. 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.

  45. 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.

  46. 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.

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