Debt
Valuation
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Learning Objectives
1. Describe interest rate fundamentals, the
term structure of interest rates, and risk
premiums.
2. Identify the key features of bonds and
describe the difference between private and
public debt markets.
3. Calculate the value of a bond and relate it
to the yield to maturity on the bond.
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1
Interest Rates & Required Returns
• represent the price of money.
• represent the compensation that a demander
of funds must pay a supplier.
• When funds are lent, the cost of borrowing is
the interest rate.
• When funds are raised by issuing stocks or
bonds, the cost the company must pay is
called the required return, which reflects the
suppliers expected level of return.
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Interest Rates & Required Returns:
Interest Rate Fundamentals
• Interest rates -the compensation that a
demander of funds must pay a supplier.
• When funds are lent, the cost of borrowing
is the interest rate.
• When funds are raised by issuing stocks or
bonds, the cost the company must pay is
called the required return, which reflects
the suppliers expected level of return.
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6-4
2
Interest Rates & Required Returns: The
Real Rate of Interest
• Real interest rate - rate that creates an equilibrium
between the supply of savings and the demand for
investment funds in a perfect world (suppliers and
demanders have no liquidity preference).
• Risk-free rate of interest (RF) -compensates
investors only for the real rate of return and for the
expected rate of inflation.
• Nominal Rate of Interest -actual rate of interest
charged by the supplier of funds and paid by the
demander.
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6-5
Interest Rates & Required Returns:
Nominal (Actual Rate of Interest/Return)
• Nominal rate versus real rate of interest (
k*)
– Inflationary expectations reflected in an
inflation premium (IP), and
– Issuer and issue characteristics such as default
risks and contractual provisions as reflected in a
risk premium (RP).
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3
Interest Rates & Required Returns:
Nominal (Actual Rate of Interest/Return)
• Using this notation, the nominal rate of
interest for security 1, k1 is given in
equation 6.1, and is further defined in
equations 6.2 and 6.3.
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9-7
Theories of Term Structure:
Expectations Theory
• suggest that the shape of the yield curve
reflects investors expectations about the
future direction of inflation and interest
rates.
• Therefore, an upward-sloping yield curve
reflects expectations of higher future
inflation and interest rates.
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4
Theories of Term Structure:
Liquidity Preference Theory
• long term interest rates tend to be higher
than short term rates for two reasons:
– borrowers are generally willing to pay more for
long-term funds because they can lock in at a
rate for a longer period of time and avoid the
need to roll over the debt.
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9-9
Theories of Term Structure:
Market Segmentation Theory
• suggests that the market for debt at any
point in time is segmented on the basis of
its maturity.
• The shape of the yield curve will depend
on the supply and demand for a given
maturity at a given point in time.
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5
Term Structure of Interest Rates
• relates the interest rate to the time to
maturity for securities with a common
default risk profile.
• Treasury securities are used to construct
yield curves since all have zero risk of
default.
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Overview of
Corporate Debt
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Corporate Bonds
• A bond is a long-term debt instrument that pays
the bondholder a specified amount of periodic
interest rate over a specified period of time.
• The bond’s principal is the amount borrowed by
the company and the amount owed to the bond
holder on the maturity date.
• The bond’s maturity date is the time at which a
bond becomes due and the principal must be
repaid.
• The bond’s coupon rate is the specified interest
rate (or $ amount) that must be periodically paid.
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Corporate Bonds:
Cost of Bonds to the Issuer
• In general, the longer the bond’s maturity, the
higher the interest rate (or cost) to the firm.
• In addition, the larger the size of the offering,
the lower will be the cost (in % terms) of
the bond.
• Also, the greater the risk of the issuing firm, the
higher the cost of the issue.
• Finally, the cost of money in the capital market is
the basis form determining a bond’s coupon
interest rate.
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Corporate Bonds (cont.)
• Current Yield - annual interest (income) divided
by the current price of
the security.
• Yield-to-Maturity -yield (expressed as a
compound rate of return) earned on a bond from
the time it is acquired until the maturity date of
the bond.
• Yield Curve -graphically shows the relationship
between the time to maturity and yields for debt
in a given risk class.
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Corporate Borrowings
• There are two main sources of borrowing
for a corporation:
1. Private Debt
2. Public Debt
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Corporate Borrowings (cont.)
• Smaller firms choose to raise money from
banks.
• Larger firms raise money from banks for
short-term needs and use bond market for
long-term financing needs.
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Borrowing Money in the Private
Financial Market
• Financial Institutions -important source
of capital for corporations.
– private market transactions since it only
involves the two parties to the loan.
– loans are typically floating rate loans 91
days, 182 days or 364 days
• LIBOR - daily interest rate based on the
interest rates at which banks offer to lend
in the London wholesale or interbank
market. Liquid Banks – lend; illiquid banks- borrow
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9
Borrowing Money in the Private
Financial Market (cont.)
• Features of Floating rate loan:
– The spread or margin between loan rate and
benchmark rate: expressed as basis points.
100 BP = 1%
Tbill rate = 1.24% +3% = 4.24%
BSP O/N = 3.25% + Risk premium/(s)
– Ceiling and Floor rates
– A maturity date
– Collateral
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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=
3% over LIBOR with a ceiling of 11% and
a floor of 4%.
LIBOR RATE + RISK PREMIUM
4.54% + 3% = 7.54%
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10
Borrowing Money in the Public
Financial Market
• Debt securities – sold to individual
investors and financial institutions.
– issuing firm must meet the legal requirements
as specified by the securities laws
1. Maintaining minimum level of liquidity.
Face Value = 1,000
Initial Investment = 854.10
Coupon Rate = 10% x 1,000 = 100
2 years after, pre-terminate investment
= 857.10
= 840.10
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Borrowing Money in the Public
Financial Market
• Corporate bond - debt security issued by corporation that has
promised future payments and a maturity date.
Treasury Bond
= r* + IP + MRP + DRP + LRP
y +y +y + 0 + 0
Corporate Bond
= r* + IP + MRP + DRP + LRP
2.75 + 1.0 + 0.75+ 1.0 = 5.5%
2.75 + 1.0 + 1.25 + 1.5 = 6.5%
• 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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11
Basic Bond Features
• The basic features of a bond include the following:
– Bond Indenture
– Claims on Assets and Income
– Par Value or Face Value or Maturity Value (M)
– Coupon Interest Rate (CR)
– Required Rate of Return (Yield-to-Maturity)
– Maturity(n) and Repayment of Principal (at the of the
term of the bond)
– Call Provision and Conversion Features
10-year bond = 7.5%
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Bond Ratings and Default Risk
• indicate the default risk
• affect the rate of return that lenders
require of the firm and the firm’s cost of
borrowing.
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13
Valuing
Corporate
Debt
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27
Valuation Formula
process that links risk and return to determine the
worth of an asset.
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14
Valuing Corporate Debt
• 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.
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Valuing Corporate Debt (cont.)
• The valuation of corporate debt relies on
the first three basic principles of finance:
– Principle 1: Money Has a Time Value.
– Principle 2: There is a Risk-Return Tradeoff.
– Principle 3: Cash Flows are the Source of
Value.
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Finance Principles Used
Money There is a Cash flows
has a risk-return are the
time value trade off source of
value
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Bond Value
• present value of the payments its issuer is
contractually obligated to make, from the current time
until it matures.
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Relationship Between Coupon Rate and
Yield to Maturity (Y) or Current
➢ When YTM = coupon rate, Bo = PVn
➢ When YTM < coupon rate, Bo >PVn
–(Bond sells at a premium)
➢ When YTM > coupon rate, Bo < PVn
–(Bond sells at a discount)
Also Note: If interest rates (Y) go up, bond prices
drop, and vice versa. Furthermore, the longer the
maturity of the bond, the greater the price change
for any given change in interest rates.
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Bond Valuation Example:
Jimmy Cordova wishes to determine the current value of
the Walmart 10-year bond. Assuming that interest on the
Walmart bond issue is paid annually and that the
required return is equal to the bond’s coupon interest
rate is 10%, par value of $1,000, and a yield to maturity
of 10%.
Interest Payment = Par Value x Coupon Interest rate
=1000x 10% = $100 x 1/1.10
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Bond Value
• present value of the payments its issuer is
contractually obligated to make, from the current time
until it matures.
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Present Value Formula
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Step-by-Step: Valuing Bonds by
Discounting Future Cash Flows
• Step 1: Determine the amount and timing of
bondholder cash flows.
Cash Flows =interest payments + principal payment.
Annual Interest = Par value × coupon rate
• Example: What is the annual interest for a bond
with coupon interest rate of 7% and a par value
of $1,000?
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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.
Yield to Maturity - Compound annual rate of
return earned on a debt security purchased on
a given day and held to maturity.
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Step-by-Step: Valuing Bonds by
Discounting Future Cash Flows (cont.)
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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.
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21
Bond Valuation: Basic Bond
Valuation
Mills Company, a large defense contractor, on January 1, 2014, issued
a 8% coupon interest rate, 10-year bond with a $1,000 par value that
pays interest annually.
Investors who buy this bond receive the contractual right to two cash
flows: (1) $100 annual interest (10% coupon interest rate * $1,000 par
value) distributed at the end of each year and (2) the $1,000 par value
at the end of the tenth year.
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Bond’s Cash Flows
90.91
82.64
75.13
68.30
62.09
56.45
51.32
46.65
42.41
38.55
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Changes in Bond Value over Time
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Problem Solving
Assume that the market’s required yield on a given bond is 12
percent. The bond has a par value of $1,000 and a 12% percent
coupon interest rate. Assuming a five-year maturity date, the bond
is worth $1,000, compute for the bond value:
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23
Using Excel Computation
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Bond Value with Interest
payment made semi-annually
or more frequently than
annually
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Bond with Interest Payments made
Semi-annually
1. Convert annual interest, I, to semiannual interest by dividing I by 2.
2. Convert number of years to maturity, n, to the number of 6-month
periods to maturity by multiplying n by 2.
3. Convert required stated (rather than effective)6 annual return for
similar-risk bonds that also pay semiannual interest from an annual
rate, rd, to a semiannual rate by dividing rd by 2.
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Bond Valuation Example with
Semi-Annual Interest
Let us assume that Crossroad Company bond pays
interest semiannually with annual coupon rate of
10% and that the required stated annual return, rd,
is 12% for similar-risk bonds that also pay
semiannual interest.
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Legal Aspects of Corporate Bonds
• The bond indenture is a legal document that
specifies both the rights of the bondholders and
the duties of the issuing corporation.
• Standard debt provisions in the indenture
specify certain record keeping and general
business procedures that the issuer must follow.
• Restrictive debt provisions are contractual
clauses in a bond indenture that place operating
and financial constraints on the borrower.
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Bond Indenture
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