Chapter 9 Debt Valuation

1. Chapter 9Debt Valuation Updated 2-2015

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) Small firms choose to use bank loans due to high costs associated with issuing bonds. Large firms generally use bank loans for short-term needs and issue bonds for long-term financing needs.

3. Borrowing Money in Private Financial Market Financial Institutions are an important source of capital for corporations. Such loans are considered private market transactions since it only involves two parties to the loan. The loan might be used to finance firm’s day-to-day operations (working capital loans) or it might be used to purchase equipment or property (transaction loans). Loans may or may not be secured by a collateral.

4. Table 1

5. Borrowing Money in Public Financial Market Firms also raise money by selling debt securities (bonds) to individual investors and financial institutions i.e. mutual funds. In order to sell debt securities to public, issuing firm must meet legal requirements as specified by securities laws. Corporate bond is a debt security issued by corporation that has promised future payments and a maturity date. If firm fails to pay promised future payments of interest & principal, it will lead firm into bankruptcy.

6. Bond Features Basic features of a bond include the following: Bond Indenture Claims on Assets & Income Par / Face Value / Principal / Maturity Value Coupon Interest Rate Maturity & Repayment of Principal Call Provision and Conversion Features

7. Table 2

8. (1)

9. Bond Ratings & Default Risk Bond ratings indicate default risk i.e. probability that firm will make promised payments. Bond ratings affect rate of return that lenders require and firm’s cost of borrowing. Consistent with Principle 2 (There is a Risk-Return Tradeoff): The lower the bond rating, the higher the default risk and higher the rate of return required by investors Bond ratings are provided by rating agencies.

10. Table 3

11. Checkpoint 9.3 Valuing a Bond Issue Consider a $1,000 par value bond issued by AT&T (T) with a maturity date of 2032 and a stated coupon rate of 8.5%. On January 1, 2013, the bond had 20 years left to maturity. If market’s required yield to maturity on a comparable risk bond is 7.5%, what is the value of the bond? (2b)

12. Checkpoint 9.3 (2b)

13. Checkpoint 9.4 Valuing a Bond Issue That Pays Semiannual Interest Reconsider the bond issued by AT&T (T) with a maturity date of 2032 and a stated coupon rate of 8.5%. AT&T pays interest to bondholders on a semiannual basison January 15 and July 15. On January 1, 2013, 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?

14. Checkpoint 9.4 (2b)

15. Checkpoint 9.4 (2c)

16. Checkpoint 9.2 Calculating Yield to Maturity on a Corporate Bond Calculate yield to maturity for bond issued by Ford Motor Company (F) with a price of $744.80, where we assume that interest payments ($65) are made annually at the end of each year and the bond has a maturity of exactly 11 years. (2a)

17. Checkpoint 9.2 (2a) (2a)

18. Bond Valuation: Four Key Relationships First Relationship: Value of bond is inversely related to changes in yield to maturity. 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 investment will change is known as interest rate risk. Bond Value Rises Bond Value Drops

19. Bond Valuation: Four Key Relationships (cont.) Figure 1

20. Bond Valuation: Four Key Relationships (cont.) Second Relationship: Market value of a bond will be less than its par value if the yield to maturity is above coupon interest rate. This is a discount bond. Market value of bond will be above par value if the yield to maturity is below the coupon interest rate. This is a premium bond. There are two sources of return from bond investment: Periodic interest payments Capital gain or loss when the bond is sold

21. 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. Table 5

22. Figure 2

23. 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. Table 6

24. Types of Bonds Table 7 contains a listing of major types of long-term debt securities that are sold in public financial market. The differences among the various types of bond are based on the following bond attributes: Secured vs. Unsecured Priority of claim Initial offering market Abnormal risk Coupon level Amortizing vs. Non-amortizing Convertibility

25. Table 7

27. Types of Bonds (cont.) Secured vs. Unsecured Secured bonds have specific assets pledged to support repayment of the bond. Bonds secured by lien on real property is called a mortgage bond. Unsecured bond are referred to as debentures. 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 Debentures Subordinated debentures

28. Types of Bonds (cont.) Initial Offering Market Bonds are classified by where they were originally issued (in the domestic bond market or foreign bond market). For example, Eurobonds are issued in a foreign country but are denominated in domestic currency. An US corporation issuing bonds in Germany (but denominated in US dollars).

29. Types of Bonds (cont.) Abnormal Risk Junk or 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 facing severe financial problems. Coupon Level Bonds with a zero coupon are called zero coupon bonds. These bonds are issued at substantial discounts from their par value and do not pay coupon interest each year. The par value is repaid at the maturity of the bond.

30. 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. Convertibility Convertible bonds are debt securities that can be converted into a firm’s stock at a pre-specified price.

31. Personal Summary • Write down one thing you learned in this chapter that is interesting, new, or useful to you. • ____________________________________________________________________________________________________________________________________________

32. Exercises (End of Chapter) Q. 12: Hoyden Co.’s bonds mature in 15 years and pay 8 percent interest annually. If you purchase the bonds for $1,175, what is their yield to maturity? Q.19:

33. Exercises (End of Chapter) Q.22:

34. Exercises