Chapter 9

Debt Valuation
and Interest

Slide Contents
Learning Objectives
1.Overview of Corporate Debt
2.Valuing Corporate Debt
3.Types of Bonds
4.Determinants of Interest Rates

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9.1 OVERVIEW OF
CORPORATE DEBT

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9-3

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

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Borrowing Money in the

Private Financial Market
Financial Institutions provide loans to
finance firms 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.

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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 (Security Exchange
Commission) registration
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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.

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Table 9-1 Types of Bank Debt

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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

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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.

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Basic Bond Features

The basic features of a bond include the
following:

Bond contract
Claims on assets and income
Par or face value
Coupon interest rate
Maturity and repayment of principal
Call provision and conversion features

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Bond Ratings and Default

Risk
Bond ratings indicate the default risk i.e. the
probability that the firm will make the bonds
promised payments. Rating agencies use
borrowers financial statements, financing mix,
profitability, variability of past profits, and
make judgments about the quality of the
firms management in order to determine
ratings.

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Table 9.3 Interpreting Bond

Ratings

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9.2 VALUING CORPORATE

DEBT

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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 markets required yield to maturity on
similar risk.

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Table 9.2 Bond Terminology

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Valuing Bonds by Discounting

Future Cash Flows
Step 1: Determine bondholder cash flows,
which are the the amount and timing of the
bonds 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.

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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.

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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 in step 2.

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Calculating a Bonds Yield to

Maturity (YTM)
We can think of YTM as the discount rate that
makes the present value of the bonds
promised interest and principal equal to the
bonds observed market price.

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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.

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Promised versus Expected

Yield to Maturity (cont.)
Promised YTM
= {(Interest year 1 + Principal) (Bond Value)} 1

= {($80+$1,000)

($850)} 1

= 27.06%

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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?

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Promised versus Expected

Yield to Maturity (cont.)
YTMdefault
1

= {(Interest year 1 + Principal)} (Bond Value)}

= {($80+$1000) .60} ($850)} 1

= -23.76%

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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.

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

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9.4 TYPES OF BONDS

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Table 9-7 Types of

Corporate Bonds

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9.5 DETERMINANTS OF
INTEREST RATES

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Determinants of Interest
Rates
As we observed earlier, bond prices vary
inversely with interest rates. Therefore in
order to understand how bond prices
fluctuate, we need to know the determinants
of interest rates.

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Inflation and Real versus

Nominal Interest Rates
Quotes of interest rates in the financial press
are commonly referred to as the nominal
(or quoted) interest rates. Real rate of
interest adjusts for the effects of inflation.
Real Rate of Interest (approximation)
Nominal interest rate Inflation premium

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Fisher Effect: The Nominal

and Real Rate of Interest
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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Interest-Rate Determinants
Breaking It Down
The nominal return or interest rate on a note
or bond can be thought of including five basic
components:

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Interest Rate Determinants

(cont.)
The inflation premium
a premium for the expected rate of inflation

Defaultrisk premium
A premium reflecting the default risk of the note or bond

Maturity-risk premium
To reflect the added price volatility that accompanies bonds with
longer terms to maturity

Liquidity-risk premium
A compensates for the fact that some bonds cannot be converted
or sold at reasonably predictable prices

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