DEBT: BANK TERM LOANS

• Bank term loans

– Easy & cheap to raise
– Accessible for smaller firms
– Large amounts can be raised through loan syndication
• Term Loan Repayment: the method used has cash
flow implications for the borrower:
– Lump sum repayment: principal and interest are both
paid in one lump sum at end of term
– ‘Balloon’ or ‘Bullet’ repayment: Only interest is paid
until end of term, when the entire principal is repaid
– Periodic repayment of principal, with interest paid on
the reducing balance
– Amortised payments: Principal and interest are repaid
in equated annual instalments.
 COST OF BORROWING
o Lender’s required rate of return (or yield) depends
on:
• Base lending rate
• Credit risk (reflected in credit rating of larger borrowers)
• Security available to lender
• Liquidity: the longer the maturity the greater the liquidity
premium expected by lenders
• Timing of cash flows from borrower to lender

o Lender’s required yield is reflected in:

• Rate and periodicity of interest charged
• Difference, if any, between amount borrowed and amount
repaid
The yield is another term for the internal rate of return.
 YIELD = IRR
Suppose a bank lends a company £950 million today and
asks the firm to repay £1.2 billion after four years. What
is the implied interest rate being charged by the bank?
Calculation: 950 x (1 + k)4 = 1200
\(1 + k)4 = 1200/950  1 + k = 4(1200/950)
\k = 4(1200/950) – 1 = 0.06014 or 6.014%
According to the terms of this loan the lender requires a
return of 6.014% - this is the lender’s yield, or internal rate
of return (IRR).
[Note: The lender, whose required rate of return is 6.014%,
makes an investment of £950 and gets a return cash flow
of 1200 after 4 years. So the lender’s Net Present Value is:
(1200 ÷ 1.060144) – 950 = 0; i.e. 6.014% is the IRR]
The yield earned by the lender is the cost paid by the
borrower for the loan – it represents the cost of
borrowing. (Cost of debt capital)
Debt: Loan Stock (Bonds and Debentures)
• Debt securities issued by borrowers, entitling
the holder to regular interest payments
(coupons) and payment of face value of bond at
maturity.
• Very large amounts can be raised
• Long maturities are possible
• Source of funding is diversified (but
relationship with banker may be weakened)
• Cost of borrowing may be lower than for term
loans (but issue costs have to be incurred)
• Fewer restrictive covenants than term loans
A wide variety of bonds can be issued, e.g.:
1. Vanilla bond (coupon payments fixed for life of bond and at maturity,
principal is repaid and bonds are retired)

2. Zero coupon bonds (only one payment at maturity)

3. Callable. Gives the issuer the right to prepay a bond at a fixed price prior
to the stated maturity date, The company will gain by being able to refinance
at a lower interest rate. Holders of the bond will lose out as current market
yields will be lower./ Puttable: allows the bondholder to get the company
to repay the bond prior to the stated maturity date. A bondholder will seek
repayment if interest rates rise. The company will lose as it will have to
refinance at a higher interest rate. Holders of the bond will benefit from
being able to reinvest their money as current market yields will be higher

4. Convertible bonds (can be converted into ordinary

shares at a pre-determined ratio)
Others:
Irredeemable bonds (consols)
Foreign bonds issue by a foreign entity in domestic currency
/Eurobonds denominated in foreign currency
 BOND VALUATION
* A bond (i.e. ‘loan stock’) is a security issued
by a borrower promising to pay the face
value (or ‘redemption value’) of the bond to
the lender (i.e. the buyer of the bond) at a
future date, with interest (called ‘coupon’) at
a specified rate and periodicity.
* The price that investors pay for the bond
today is the present value of this stream of
cash flows, discounted at the appropriate
rate of return required by investors.
 YIELD ON BONDS
Yield to the lender - i.e. the cost of borrowing - is
determined not only by the coupon interest rate paid on
the face value of the bond, but also by the issue price or
market price of the bond
Rate of coupon interest paid on bond is not the same as
the yield. E.g. a zero coupon bond pays no coupon
interest at all - the entire return to the lender lies in
the difference between the amount paid for the bond
and the redemption value of the bond at maturity.
A zero with a redemption value of £100 after 5 years is
sold at an issue price of £78:
78 x (1 + k)5 = 100
\the yield k = 5.095%
Similarly, a coupon-paying bond may have a yield that is
quite different from the coupon rate of interest.
 COUPON-PAYING
COUPON-PAYING BOND
BOND
Coupon rate of interest : fixed by bond-
issuer, taking into account profitability of
operations, projected cash flows, etc.
Required rate of return of lenders : This is
the discount rate applied by the market. It
fluctuates, depending on:
• Supply and demand for capital
• Inflation
• Risk of the bond
• Years to maturity
 YIELD
YIELD ON
ON COUPON-PAYING
COUPON-PAYING BOND
BOND
 Stream of cash flows to holder of bond:
periodic coupon interest payments
face value of bond on maturity
 The market price of the bond today is the
present value of this stream of cash flows,
discounted at the appropriate rate of return
expected by investors for an investment of this
level of risk.
 This rate of return is referred to as the yield to
maturity (i.e. the lender’s internal rate of return
or IRR).
PV of Bond (Vb) = PV of Coupon Interest (C)
+
PV of Maturity Value (M)

M
= (C x PVIFAk,n)+ ------
(1 + k)n
k is the “Yield to Maturity” or “Redemption Yield”
- it is the average rate of return which
investors require from the bond. Its value
determines whether a bond sells at par, at a
discount or at a premium.
It represents the cost of borrowed capital
for the firm.
 Example:
Face value (= maturity or par value), i.e. M = £100
Coupon rate = 4 percent, so I = £4
Maturity 4 years
Market value (Vb) = £89.84; i.e. investors are required to
pay £89.84 to purchase the following set of cash flows
Year: 1 2 3 4
Cash Flow: £4 £4 £4 £4 + £100
At a discount rate of 7%, the Net Present Value of this
investment will be exactly equal to the purchase price:
(£4 x PVIFA7%,4) + (£100/1.074)
= (£4 x 3.3872) + (£100/1.3108) = 89.84
In other words, the IRR of investment in the bond (i.e. its
‘yield to maturity’) is 7%.
This is the market’s expected rate of return on the bond -
it is the rate of discount applied by the market to the
bond’s cash flows, resulting in the market value of £89.84.
Another example: M = £100, I = £8, n = 4 years.

If k = 12%, Vb = (£8 x PVIFA12%, 4) + (£100/1.124)

= (£8 x 3.0373) + (£100 ÷ 1.5735) = £87.85
Bond will trade at a discount to face value of £100

If k = 8%, Vb = (£8 x PVIFA8%, 4) + (£100/1.084) =

(£8 x 3.3121) + (£100 ÷ 1.3605) = £100
Bond will trade at par

If k = 4%, Vb = (£8 x PVIFA4%, 4) + (£100/1.044) =

(£8 x 3.6299) + (£100 ÷ 1.1699) = £114.52
Bond will trade at a premium to face value of £100
 AN
AN IMPORTANT
IMPORTANT MAXIM
MAXIM
The market value of a bond is equal to the
value of the cash flows to the bond discounted
at the expected rate of return of lenders for
a bond of this level of risk.

Therefore when market interest rates

increase, the market values of bonds fall

and

when market interest rates decrease, the

market values of bonds rise
 INTEREST
INTEREST RATE
RATE RISK
RISK
Another important maxim: Long-term bonds are
more interest-sensitive than short-term bonds.
E.g.: Zero coupon bond with face value of £100:
Years to maturity
1 10 40
Bond value @ 3% 97.1 74.4 30.7
Bond value @ 9% 91.7 42.2 3.2
Percentage drop in 5.6% 43.3% 89.6%
Long-term bonds are more exposed to
value
interest rate risk than short-term bonds.
 Capital Market Efficiency
 In efficient capital market, security prices fully reflect
knowledge and expectations of all investors at
particular point in time.
 If markets are efficient, investors and financial
managers can believe securities are priced at or near
true value.
 A security’s true value is price reflecting investors’
estimates of value of expected future cash flows.
e.g. PV of Bond (Vb) = PV of Coupon Interest (I) +
+ PV of Maturity Value (M)
M
= (I x PVIFAk,n) + ------
(1 + k)n 15
 Capital Market Efficiency
 Informational efficiency:

 market prices reflect all relevant information about

securities at particular point in time.
 market prices adjust quickly to new information
about a security as it becomes available.
 Competition among investors is important driver of
informational efficiency.

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 Capital Market Efficiency
Efficient Market Hypotheses
 The efficient market hypothesis (EMH) is an
investment theory that states it is impossible to "beat
the market" because stock market efficiency causes
existing share prices to always incorporate and reflect
all relevant information.
 three form levels:
Strong form market efficiency
Price of security in market reflects all information –
public as well as private, insider information.

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 Capital Market Efficiency
Semi-strong market efficiency
 only public information is reflected in security’s market price.
 Investors with access to insider/ private information will be
able to earn abnormal returns.
 Example: Public stock markets in developed countries.

Weak-form market efficiency

 All information contained in security’s past prices is
reflected in current prices.
 It would not be possible to earn abnormally high returns by
looking for patterns in security prices, but it would be
possible to do so by trading on public or private information.

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 Interest Rate Risk
Bond Theorems

1. Bond prices are inversely related to interest rate

movements. i.e. interest rates decline, prices of
bonds rise; as interest rates rise, prices of bonds
decline.
 M
 PV of Bond (Vb) = (I x PVIFAk,n) + ------
 (1 + k)n

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 Interest Rate Risk
Bond Theorems

2. All other things being equal, long term bonds have

more interest rate risk than short-term bonds.
 i.e. For a given change in interest rates, prices of
long-term bonds will change more than prices of
short-term bonds.

20
Exhibit 8.2: Relation Between Bond
Price Volatility and Maturity

21
 Interest Rate Risk
Bond Theorems
3. For a given change in interest rates, lower-Coupon Bonds
Have greater Interest Rate Risk than higher -coupon bonds.
 The lower the bond’s coupon rate, the greater the proportion
of the bond’s cash flow investors will receive at maturity.

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4. Interest rate risk increases as maturity increases, but at a
decreasing rate. (see Exhibit 8.2)
5. Capital Gains from an Interest Rate Decline Exceed the
Capital Loss from an Equivalent Interest Rate Increase

Theorem 5 can be seen by examining the 5% bond. A one

percent increase in the yield from 5% to 6% results in a loss of
euro 73.6 (euro 1,000 - euro902), but a one percent decrease in
the yield from 5% to 4% results in a gain of euro 81.11.
 Interest Rate Risk
Bond Theorem Applications
 If rates are expected to increase, a portfolio manager should
avoid investing in long term securities.
 Portfolio could see a significant decline in value.

 If you are an investor and you expect interest rates to

decline, you may want to invest in long-term zero coupon
bonds.
 As interest rates decline, price of long-term zero
coupon bonds will increase more than any other type of
bond.
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 Risk characteristics of debt instruments

Market analysts have identified four risk

characteristics of debt instruments (four
factors that are responsible for most of the
differences in corporate borrowing costs
-structure of interest rates)
1. A security’s marketability
2. Call feature
3. Default risk
4. Term to maturity

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 Marketability

 Refers to investor’s ability to sell a security quickly

at low transaction cost and at its fair market value.
 The interest rate, or yield, on a security varies
inversely with its degree of marketability.
(Treasury bills have the largest and most active
secondary market. They are considered the most
marketable of all securities.)

26
 Call Provision
 Gives the firm issuing bonds option to purchase the bond from
an investor at a predetermined price (the call price). i.e.
Investors must sell the bond at that price)
When bonds are called, investors suffer financial loss because
they are forced to surrender their high-yielding bonds and
reinvest their funds at lower prevailing market rate of interest.
 Bonds with call provisions sell at higher market yields than
comparable non-callable bonds
 Difference in interest rates between a callable bond and a
comparable non-callable bond call interest premium (CIP)
CIP = icall - incall > 0
Bonds issued during periods when interest rates are high
are likely to be called when interest rates decline; these bonds
have a high CIP 27
Default Risk

 Is the Risk that lender may not receive

payments as promised.
DRP = idr - irf
DRP=default risk premium
idr = default rate
irf= risk free rate
 No default risk in government securities; hence the
best proxy measure for the risk-free rate.

28
 Bond Ratings
 Individuals and small businesses must rely on outside
agencies for information on default potential of
bonds.
 The most prominent credit rating agencies
internationally are: Fitch IBCA, Moody’s Investors
Service (Moody’s) and Standard & Poor’s (S&P).
 Credit rating services rank bonds in order of
expected probability of default; and publish ratings
as letter grades.

29
Exhibit 8.4: Corporate Bond Rating Systems

30
Exhibit 8.5: Default Risk Premiums

31
 The Term Structure of Interest Rates
This is the relationship between yield and term to maturity. Three basic
shapes (slopes) of yield curves in the marketplace:
1. Ascending or normal yield curves are upward sloping yield curves
that occur when the economy is growing.
2. Descending or inverted yield curves are downward sloping yield
curves that occur when the economy is declining or heading into
recession.
3. Flat yield curves imply interest rates are unlikely to change in the
near future.
Three economic factors determine shape (slope) of yield curve:
4. Real rate of interest
5. Expected rate of inflation
6. Interest rate risk

32
1. The real rate of interest varies with the business cycle.
Highest rates are seen at end of a period of business
expansion, and vice versa, . Lowest rates at the bottom of a
recession. Changes in expected future real rate of interest can
affect the slope of the yield curve.

2. If investors believe inflation will be increasing in the future,

the yield curve will be upward sloping (and vice versa, since
long-term interest rates will contain a larger inflation
premium than short-term interest rates.

3. The longer the maturity of a security, the greater its interest

rate risk and the higher the interest rate. The interest risk
premium always adds an upward bias to the slope of the yield
curve.
Exhibit 8.6: Yield Curves for Eurozone
AAA Government Securities

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