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Slide Contents
Learning Objectives Principles Used in This Chapter
1.Overview of Corporate Debt 2.Valuing Corporate Debt 3.Bond Valuation: Four Key Relationships 4.Types of Bonds 5.Determinants of Interest Rates
Key Terms
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Learning Objectives
1. Identify the key features of bonds and describe the difference between private and public debt markets. 2. Calculate the value of a bond and relate it to the yield to maturity on the bond. 3. Describe the four key bond valuation relationships.
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Corporate Borrowings
There are two main sources of borrowing for a corporation:
1. Loan from a financial institution (known as private debt) 2. Bonds (known as public debt since they can be traded in public financial markets)
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Larger firms generally raise money from banks for short-term needs and depend on the bond market for long-term financing needs.
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Checkpoint 9.1
Calculating the Rate of Interest on a Floating Rate Loan The Slinger Metal Fabricating Company entered into a loan agreement with its bank to finance the firms working capital. The loan called for a floating rate that was 25 basis points (.25%) over an index based on LIBOR. In addition, the loan adjusted weekly based on the closing value of the index for the previous week within the bounds of a maximum annual rate of 2.5% and a minimum of 1.75%. Calculate the rate of interest for the weeks 2 through 10.
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Checkpoint 9.1
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Checkpoint 9.1
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Checkpoint 9.1
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Checkpoint 9.1
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2.50%
0.50%
0.00% 1 2 3 4 5 6 7 8
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Step 3: Solve
LIBOR LIBOR + Spread (.75%) Loan Rate
2/29/2008
1.98%
3/7/2008
3/14/2008 3/21/2008 3/28/2008 4/4/2008 4/11/2008 4/18/2008
1.66%
1.52% 1.35% 1.60% 1.63% 1.67% 1.88%
2.73%
2.44% 2.27% 2.10% 2.35% 2.38% 2.42%
2.50%
2.41% 2.27% 2.10% 2.35% 2.38% 2.42%
Ceiling Violated
4/25/2008
5/2/2008
Copyright 2011 Pearson Prentice Hall. All rights reserved.
1.93%
2.63%
2.68%
2.50%
2.50%
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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.
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In order to sell debt securities to the public, the issuing firm must meet the legal requirements as specified by the securities laws.
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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.
Copyright 2011 Pearson Prentice Hall. All rights reserved.
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Bond ratings affect the rate of return that lenders require of the firm and the firms cost of borrowing.
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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).
Copyright 2011 Pearson Prentice Hall. All rights reserved.
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Step-by-Step: Valuing Bonds by Discounting Future Cash Flows (cont.) Step 3: Calculate the present value of the bonds interest and principal payments from Step 1 using the discount rate estimated in step 2.
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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.
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Checkpoint 9.2
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Checkpoint 9.2
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Checkpoint 9.2
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0
-$900
1
$65
2
$65
3
$65
11
$1,065
Purchase price = $900 Interest payments = $65 per year for years 1-11 Final payment = $1,000 in year 11 of principal.
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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.
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Enter:
N = 11 I/Y = 7.89 PV = -900 PMT = 65 FV = 1,000
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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.
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= {($80+$1,000) = 27.06%
($850)} 1
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= (27.06 .60) + (-23.76 .40) = 6.73% The financial press quotes promised yield and not expected YTM.
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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 markets required yield to maturity for similar rated debt was 7.5%. If the markets required yield to maturity on a comparable risk bond is 7.5%, what is the value of the bond?
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Checkpoint 9.3
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Checkpoint 9.3
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Checkpoint 9.3
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1
$85
2
$85
3
$85
20
$1,085
We can use the above information to determine the value of the bond by discounting future interest and principal payment to the present.
Copyright 2011 Pearson Prentice Hall. All rights reserved.
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Step 3: Solve
Using Mathematical Equation
Bond Value
= $ 85{ 1-(1/(1.09)20] $1,000/(1.09)20
(.20)} +
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Step 4: Analyze
The value of AT&T bond falls to $954.36 when the yield to maturity for comparable risk bond rises to 9%. The bonds are now trading at a discount as the coupon rate on AT&T bonds is lower than the market yield.
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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 markets 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?
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Checkpoint 9.4
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Checkpoint 9.4
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Checkpoint 9.4
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Checkpoint 9.4
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1
$42.5
2
$42.5
3
$42.5
40
$1,042.50
PV=?
We can use the above information to determine the value of the bond by discounting future interest and principal payment to the present.
Copyright 2011 Pearson Prentice Hall. All rights reserved.
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Step 3: Solve
Using Mathematical Equation
Bond Value
= $ 42.5{ 1-(1/(1.045)40]
(.20)} + $1,000/(1.045)40
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Step 4: Analyze
Using semi-annual compounding we get a value of $954 for AT&T bonds. This is very close to the value of $954.26 found using annual compounding.
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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.
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While all bonds are affected by a change in interest rates, long-term bonds are exposed to greater volatility as interest rates change.
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Types of Bonds
Table 9-7 contains a listing of major types of long-term debt securities that are sold in the public financial market. The differences among the various types of bond are based on the following bond attributes: Secured versus Unsecured, Priority of claim, Initial offering market, Abnormal risk, Coupon level, Amortizing or non-amortizing, and Convertibility.
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Real rate of interest adjusts the nominal rate for the expected effects of inflation.
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Fisher Effect
The relationship between the nominal rate of interest, rnominal , the anticipated rate of inflation, rinflation , and the real rate of interest is known as the Fisher effect.
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Checkpoint 9.5
Solving for the Real Rate of Interest
You have managed to build up your savings over the three years following your graduation from college to a respectable $10,000 and are wondering how to invest it. Your banker says they could pay you 5% on your account for the next year. However, you recently saw on the news that the expected rate of inflation for next year is 3.5%. If you are earning a 5% annual rate of return but the prices of goods and services are rising at a rate of 3.5%, just how much additional buying power would you gain each year? Stated somewhat differently, what real rate of interest would you earn if you made the investment?
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Checkpoint 9.5
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Step 3: Solve
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Step 4: Analyze
Here the nominal rate of interest is equal to the expected rate of inflation. Therefore, the real rate of return is equal to zero i.e. there is no increase in purchasing power from investing the savings at 5%.
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Checkpoint 9.6
Solving for the Nominal Rate of Interest
After considering a number of investment opportunities, you have decided that you should be able to earn a real return of 2% on your $10,000 in savings over the coming year. If the expected rate of inflation is expected to be 3.5% over the coming year, what nominal rate of return must you anticipate in order to earn the 2% real rate of return?
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Checkpoint 9.6
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Checkpoint 9.6
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Step 3: Solve
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Step 4: Analyze
In order to achieve a 2% increase in purchasing power in the face of a 4% rate of inflation, you must earn a 6.08% rate on your savings.
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Default Premium
In addition to accounting for the time value of money and inflation, the interest rate that a firms bonds pay must also offer a default premium i.e. risk that the issuer will fail to repay interest and principal in a timely manner.
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Investors shifted their funds to the safety of Treasury securities, pushing up the prices and bringing down the yields.
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Key Terms
Amortizing bond Bond rating Bond indenture Call provision Collateral Conversion feature
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