Chapter 9

Debt Valuation and Interest Rates

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Overview of Corporate Debt

Copyright 2011 Pearson Prentice Hall. All rights reserved.

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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Corporate Borrowings
Smaller firms choose to raise money from banks in the form of loans because of the high costs associated with issuing bonds.

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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Borrowing Money in the Private Financial Market

Financial Institutions are an important source of capital for corporations. The loan might be used to finance firms day-to-day operations or it might be used for the purchase of equipment or property. Such loans are considered private market transactions since it only involves the two parties to the loan.

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Borrowing Money in the Private Financial Market

In the private financial market, loans are typically floating rate loans i.e. the interest rate is periodically adjusted based on a specific benchmark rate. The most popular benchmark rate is the London Interbank Offered Rate (LIBOR)

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Borrowing Money in the Private Financial Market

LIBOR is the daily interest rate that is based on the interest rates at which banks offer to lend in the London wholesale or interbank market.
Interbank market is the market where banks loan each other money.

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Borrowing Money in the Private Financial Market

A typical floating rate loan will specify the following:
The spread or margin between the loan rate and the benchmark rate expressed as basis points (100 basis points = 1%). A maximum and a minimum annual rate, to which the rate can adjust, called the ceiling and floor. A maturity date Collateral
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Borrowing Money in the Public Financial Market

Firms also raise money by selling debt securities to individual investors and financial institutions.

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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Borrowing Money in the Public Financial Market

Corporate bond is a debt security issued by corporation that has promised future payments and a maturity date. The basic features of a bond include:
Bond Indenture 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 Features
A call feature, which is included in most corporate issues, gives the issuer the opportunity to repurchase the bond prior to maturity at the call price. Issuers will exercise the call feature when interest rates fall and the issuer can reissue at a lower cost. Issuers typically must pay a higher rate to investors for the call feature compared to issues without the feature.

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Bond Features
Bonds also are occasionally issued with stock purchase warrants attached to them to make them more attractive to investors. Warrants give the bondholder the right to purchase a certain number of shares of the same firms common stock at a specified price during a specified period of time. Including warrants typically allows the firm to raise debt capital at a lower cost than would be possible in their absence.

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Bond Features
The bonds yield-to-maturity is the 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. A yield curve graphically shows the relationship between the time to maturity and yields for debt in a given risk class.

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Legal Aspects of Corporate Bonds

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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Legal Aspects of Corporate Bonds

Common restrictive covenants include provisions that specify:
Minimum equity levels Prohibition against factoring receivables Fixed asset restrictions Constraints on subsequent borrowing Limitations on cash dividends.

In general, violations of restrictive covenants give bondholders the right to demand immediate repayment.

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Legal Aspects of Corporate Bonds

Sinking fund requirements are restrictive provisions often included in bond indentures that provide for the systematic retirement of bonds prior to their maturity. The bond indenture identifies any collateral (security) pledged against the bond and specifies how it is to be maintained. A trustee is a paid individual, corporation, or commercial bank trust department that acts as the third party to a bond indenture.

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Corporate Bonds: Cost of Bonds to the Issuer

In general, the longer the bonds 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 since the flotation and administrative costs per peso borrowed are likely to decrease with increasing offering size (although larger offerings result in greater risk of default).

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Corporate Bonds: Cost of Bonds to the Issuer 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 for determining a bonds coupon interest rate.

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Bond Ratings and Default Risk

A credit rating serves as an unbiased, independent evaluation of the creditworthiness of a borrower. It is a grading system which provides an objective measure of credit quality, particularly the ability to pay the financial obligations upon maturity. A credit rating considers both the business and the financial risks. Credit ratings affect the rate of return that lenders require of the firm and the firms cost of borrowing.
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Bond Ratings and Default Risk

Consistent with Principle 2 (There is a Risk-Return Tradeoff), the lower the bond rating, the higher the risk of default and higher the rate of return demanded in the capital market. Bond ratings are provided by rating agencies like Moodys, Standard & Poors, and Fitch Investor Services. In the Philippines, we have the Philippine Rating Services Corporation (PhilRatings). 9-23

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Philippine Ratings Services (PhilRatings) Symbols The highest ratings assigned by PhilRatings for short-term and long-term issues are PRS 1 and PRS Aaa, respectively, while the lowest are PRS 6 and PRS C.

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Valuing Corporate Debt

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Valuation Fundamentals
The value of any investment asset is its intrinsic value, or the present value of expected future cash flows, discounted back to the present using the investors required rate of return. The required return is a function of the expected rate of inflation and the perceived risk of the asset. Higher perceived risk results in a higher required return and lower asset market values.

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Basic Valuation Model

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Four Basic Formulas: Future Value and Present Value FVn PV0 = = PV0(1+i)n FVn[1/(1+i)n] A (1+i)n - 1 i PVA0 = A 1 - [1/(1+i)n] = A x (PVIFAi,n) i
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= PV x (FVIFi,n) = FV x (PVIFi,n) = A x (FVIFAi,n)

FVAn =

Present Value of an Annuity Due

FVn (annuity due) = A (1+i)n1 (1 + i)

i
PVn (annuity due) = A 1- [1/(1+i)n] (1 + i) i

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Present Value of a Perpetuity

PV of Perpetuity = A i

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Basic Valuation Model (cont.)

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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.

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Bond Valuation: Basic Bond Valuation

On January 1, 2006, Mills Company, a large building contractor, issued a 10% coupon interest rate, 10-year bond with a P1,000 par value that pays interest annually. Assume that the required rate of return is also 10%.

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Bond Valuation: Basic Bond Valuation

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Bond Valuation: Bond Fundamentals

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Bond Valuation: Bond Fundamentals

Calculate the value of the bond if the required rate of return is:
12% 8%

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Bond Valuation: Bond Fundamentals (cont.)

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Checkpoint 9.3 (Textbook example)

Valuing a Bond Issue
Consider a $1,000 par value bond issued by AT&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
Calculate the present value of the AT&T bond should the yield to maturity for comparable risk bonds rise to 9% (holding all other things equal).

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Solution:
Using Mathematical Equation

Bond Value
= $ 85{ 1-(1/(1.09)20] $1,000/(1.09)20

(.20)} +

= $85 (9.128) + $178.43 = $954.36

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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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Checkpoint 9.4 (Textbook example)

Valuing a Bond Issue That Pays Semiannual Interest
Reconsider the bond issued by AT&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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Solution:

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Checkpoint 9.4
Calculate the present value of the AT&T bond should the yield to maturity on comparable bonds rise to 9% (holding all other things equal).

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Solution:
Using Mathematical Equation

Bond Value
= $ 42.5{ 1-(1/(1.045)40]

(.20)} + $1,000/(1.045)40

= $42.5 (18.40) + $171.93 = $954

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