Corporate Debt

Chapter 9: Coverage

Valuing Corporate Debt

Bond/ Debt Valuation

(Ch 9 Titman, Ch 7 Keown)
VYE Summary & Notes

Bond Valuation- 4 Key

Relationships Types of Bonds Inflation and rates of return

Corporate Debt
Firms can borrow
A. Private financial markets thru various types of financial institutions 1. Floating rate or fixed rate loans (LIBOR rate, pdex) 2. Funds for working capital or transactions 3. Debt unsecured or unsecured
2

Corporate Debt
Firms can borrow B. Public financial markets by issuing corporate bonds which differ on a variety of features. 1. Bond indenture 2. Claim on assets 3. Par value 4. Coupon rate of interest 5. Maturity 6. Call provision or conversion feature 7. Bond ratings default risk

Corporate Debt

Valuing Corporate Debt

Required/ expected rate of return = YTM Interest rate = coupon rate Par value = maturity value $1,000; date Bond value Vb = market value = intrinsic value = present value of coupon interest payments and the principal amount (par value) Purpose: higher returns, higher risk, but cheaper than common stock
4 5

Valuing Corporate Debt

Bond Valuation: Four Key Relationships

1. Value inversely related to changes in YTM

Vb = PV of interest payments as an annuity + PV of maturity value Vb = Interest pmt x PVIFA i, n + $1000 x PVIF i,n

2. MV < $1,000 if YTM> i (discount) MV > $1,000 if YTM< i (premium) 3. As n maturity, MV $1,000 par value 4. LT bonds have > interest risk than ST bonds
6 7

Types of Bonds
There are a variety of types of bonds depending on their characteristics, usually a function of the following bond attributes:
1. Secured vs unsecured 5. Coupon level 2. Priority of claim 3. Initial offering market 4. Abnormal risk 6. Amortizing or

Types of Bonds

non-amortizing
7. Convertibility

Determinants of Interest Rates

Interest rates are affected by the real rate
of interest and the inflation premium

Determinants of Interest Rates

As n (bonds maturity) becomes longer,
the more the bond price fluctuates when interest rates change.

Risk of default = possibility that bond

issuer will fail to repay the borrowed amount

A maturity premium reflects this risk Term Structure of interest rates

reflects relationship between time to maturity and interest rates (all other variables constant)
10 11

Add a premium to interest rates to

reflect risk of default

Inflation, Rates of Return, and the Fisher Effect

Interest Rates

Interest Rates
Conceptually:

Nominal risk-free Interest Rate

Real risk-free Interest Rate

Inflationrisk premium

rnominal
Mathematically:

rreal

rinflation

(1 + rnominal) = (1 + rreal) (1 + rinflation)

12

This relationship is known as the Fisher Effect

13

Interest Rates
Suppose the real rate is 3%, and the nominal rate is 8%. What is the inflation rate premium?

Interest Rates
To simplify:

(1 + rnominal) = (1 + rreal) (1 + rinflation) (1.08) = (1.03) (1 + rinflation) (1 + rinflation) = (1.0485), so rinflation = 4.85%
14

rnominal = rreal + rinflation + rreal x rinflation r=R+i+Ri

15

REFERENCES:
Titman, S., Keown, A.j, Martin, J.D., (2011). Financial Management: Principles and Applications. (11th Ed.). Pearson Education, Pearson/Prentice Hall Keown, A.J., Martin, J.D., Petty, J.W., Scott Jr, D.F., Financial Management: Principles and Applications, 10th Edition, Pearson Prentice Hall 2005 Gitman, L. J. Principles of Managerial Finance, (11th ed.) Massachusetts: Addison Wesley Longman

16