Corporate Finance (BUSI2151)

Nottingham University Business School Malaysia Campus

Chapter 1
Financial Decision Making and the Law of One Price
Debt Financing
Valuing Bonds (Time Value of Money)

Objectives: To discuss
 Advantages and disadvantages of debt financing
 Basic of bond valuation – calculate bond price and
bond yield (return)
 The law of one price & Arbitrage profit

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I. The advantages & disadvantages of
using debt financing
(from the viewpoint of issuing firms as
borrowers)

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 Advantages of debt financing

• (1) Interest expenses are tax deductible, whereas

common and preferred stock dividends are paid out of
after-tax earnings (not tax deductible).

• Since the interest expenses are paid before taxes, we

thus have the before-tax cost of debt and after-tax
cost of debt.

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 Advantages of debt financing
• General income statement format

expenses The higher the amount of interest expenses

the lower the amount of taxes to be paid by
the firm.

Part of the earnings is paid as dividends to

common stock shareholders and they are
paid after taxes.
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 Reference Advantages of debt financing
 Example 1: debt financing could provide interest tax
shield
Debt to total asset ratio 0% 60% 80%
Debt (8% interest) 0 60,000 80,000
Equity 100,000 40,000 20,000
Debt/Equity=D/E 0 1.2 4
Total Capital=Total Asset 100,000 100,000 100,000
Outstanding Share 5,000 2,000 1,000
($20 per share)

Net sales 150,000 150,000 150,000

COGS 90,000 90,000 90,000
Fixed Costs 40,000 40,000 40,000
Interest Expense 0 4,800 6,400
Pretax Income 20,000 15,200 13,600
Income tax (25%) 5,000 3,800 3,400
Net Income 15,000 11,400 10,200
Earnings per share $3 $5.7 $10.20

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 Advantages of debt financing

• The two slides above show that the higher the

amount of debts, the lower the tax payments.

• Allowing companies to deduct interest expenses

when computing taxable income lowers the amount
of corporate taxes.

• Therefore, debt financing could provide tax savings

to the issuing firm.

• This in turn increases firm cash flows and makes

more cash available to investors.

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 Advantages of debt financing
• (2) Bondholders do not share in the value created by
growth opportunities; their payments are limited to
interest and principal (e.g. D/E = 0.25, D = $20,000,
i=8%).

• The slide below shows that even the earnings of a firm

increase, the amount of interest expenses is still fixed.
Income statement Scenario #1: poor Scenario #2: good
earnings earnings

Sales 150,000 250,000

Cost of goods sold (90,000) (120,000)
Gross profit 60,000 130,000
Operating expenses (40,000) (60,000)
Operating profit (EBIT) 20,000 70,000
Interest Expenses (1,600) (1,600)
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 Advantages of debt financing

– (3) Bondholders do not vote, enabling the owners to

maintain greater control over the firm. Therefore,
bondholders could not interrupt the operation of a
firm and its managers still have the flexibility in
running the firm.

– (4) When issuing new securities, the issuing firm

must pay the floatation costs (e.g printing fees,
legal fees, underwriting fees, stamp fee, etc). Debt
financing has lower floatation costs than common
stock financing (to be discussed in Session 2).

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 Advantages of debt financing

• (5) In the value of the firm drops significantly, the

common stockholders will have the option of
defaulting on their debts and turning over the firm to
the bondholders.

• Period 0:
Assets Liabilities and Equity
Assets RM50,000 Debts RM40,000
Equity RM10,000

• Period 1:
Assets Liabilities and Equity
Assets RM35,000 Debts RM40,000
Equity - RM5,000

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 Advantages of debt financing

• Shareholders have limited liabilities and they do not

need to raise additional funds to repay bondholders
and creditors in the liquidation of the firm.

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 Disadvantages of debt financing

• 1. Higher Probability of Bankruptcy. Greater use of

debt financing increases the firm’s financial risk,
possibly leading to bankruptcy and eventual
liquidation.

• The higher the amount of debts, the higher the

obligation to the issuing firm. The firm cannot skip
Coupon payment
the interest
Face value
expenses and the repayment of
principals.

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 Disadvantages of debt financing
• 2. Agency Costs of debts. When a firm borrows
funds by issuing debt, the interest rate charged by
lenders is based on the lender’s assessment of the
risk of the firm’s investments.

• The suppliers (e.g. lenders, investors, etc) of debt

financing are aware of two things:
(a) Management is in control of their money, and
(b) There are high chances of principal-agent
problems in any company.

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 Disadvantages of debt financing
• An example for principal-agent problems:
– After obtaining the loan, the firm’s stockholders
and/or managers could use the funds to invest
in riskier assets.

– If these high risk investments raise the profits of

investments, the benefits of bondholders are
locked in and are unable to share in this
success. It is unfair to bondholders as the
amount of the interest expenses made to them
is fixed (might refer to Slide 7).

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 Disadvantages of debt financing
• 3. In order to mitigate any losses due to this agency
problem, the debt suppliers place some constraints
on the use of their money.
– Examples of these constraints:
include raising the rate on future debt issues,
denying future loan requests,
Not to have new loan in future

imposing restrictive bond provisions (e.g the

sales of fixed assets are not allowed).

• Bonds typically contain restrictive covenants that

limit the firm’s financial and operating
flexibility(impose the restriction on the operation of a
firm carried out by managers).
If the debt-equity ratio is not high, this
disadvantage is not significance
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At what could the issuer sell its bond(new
securities)?
II. Bond Valuation

Face
value(par
value)

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 The basic of bonds

• Long-term debt financial assets. Might be equal

to market value

Payment-annually or semi-annually or quarterly

• Typically offers fixed periodic interest in return, which is
semi-annual in most cases.

• Have a face value, which is also the maturity value or par

value the bond.

– Investors get periodical interest payments and the maturity value

at the end of the maturity.

– If they sell before maturity, investors receive interest payments

plus the selling price.

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 The basic of bonds
Key Terminologies
• Coupon rate (%) – is presented in percentage of face
value.
– Coupon payment ($) CP is the periodic interest payment

• i is the market interest rate that is required by

investors to hold a particular bond. The higher the
risk of a bond, the higher the i.
– Coupon rate and i are not same, unless the bond is selling at
par value

• Remaining maturity – only remaining maturity of the

bond is important in evaluating investment in bonds.
Also called Term.

• Bond indenture; bond certificate – bond contract

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 Bond valuation
CP: Coupon (=Coupon rate Par value)
CP + FV
CP CP

0 1 2 …… n

Bond Price (P0 )

CP CP CP Par value
   ...  
1  i  1  i 
1 2
1  i n
1  i n

n
CP Par value
 
t 1 (1  i) t
(1  i) n

 CP  PVIFA(i, n)  Par  PVIF(i, n)

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 Bond valuation
Example 3: A $1000 face value bond will be matured 3 years
from now. The coupon rate is 3% and it is paid annually.
(a). Calculate the bond price (market value) if the market
interest rate is 2%.
$30 $30 $30 +$1,000
0 1 2 3

(b). If the bond is selling at $980, calculate its arbitrage profit.

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 Bond valuation

Return on bonds
• Expected return per year
if we purchase the bond
and hold it until maturity. YTM
Two conditions

Yield to maturity
Meaning that we are not
selling the bond.

• (Average) Return per year

if we purchase the bond
and sell it after certain HPR
Holding period return
holding period date, say
for example, return after
1 year.
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 Bond valuation
Return on bonds
• YTM – average yearly return if the bond is purchased
today and held until maturity.
Par - P0
CP  CP= Periodic coupon payment
YTM  i  N Par = Par value (face value)
 Par  P0  P0 = Market price or selling price
  N = Remaining maturity
 2 

• HPR – average holding period return

 CP   P1  P0  CP= Periodic coupon payment

HPR       100 P1 = Selling price at period 1
 P0   P0  P0 = Purchase price at period 0
Current Capital
Yield Gain Yield 21
 Bond valuation
Example 4: Suppose a ten-year, $1,000 bond with an 8%
coupon rate and annual coupons is trading for a price of
$1,030.74. Calculate the yield to maturity of this bond.

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 Bond valuation
Example 5: A newly issued bond pays its coupons once
annually. Its coupon rate is 5%, its maturity is 20 years, and its
yield to maturity is 8%. Find the holding-period return for a
one-year investment period if the bond is selling at a yield to
maturity of 7% by the end of the year.
Time Period
t=0 t=1
Years left to maturity

Yield to maturity

Bond Price

Holding period return

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 Bond valuation
Example 5 (cont.):

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III. The Law of One Price
&
Arbitrage Profit

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 The law of one price & arbitrage profit
• The practice of buying and selling equivalent goods in different
markets to take advantage of a price difference is known as
arbitrage.

• Arbitrage opportunity: any situation in which it is possible to

make a profit without taking any risk or making any investment.

• We call a competitive market in which there are no arbitrage

opportunities a normal market. Once an arbitrage opportunity is
spotted, it will quickly disappear.

• Law of one price: if equivalent investment opportunities trade

simultaneously in different competitive markets, then they must
trade for the same price in both markets.

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 The law of one price & arbitrage profit
• Example 2: Consider two securities (or two projects) that pays risk-
free cash flows over the next two years and that have the current
markets shown here:
Security Price today Cash Flow in One Cash Flow in Two
Year Year
A $94 100 0
B $85 0 100

• (a). Determine the no-arbitrage price of a security that pays cash

flows of $100 in one year and $100 in two years.
The price of the security =

• (b). Determine the no-arbitrage price of a security that pays cash

flows of $100 in one year and $500 in two years.
The price of the security =

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 The law of one price & arbitrage profit
• (c). Suppose Security C with cash flows of $200 in one year and
$100 in two years is trading for a price of $260. Is an arbitrage
opportunity available? If yes, explain how to purchase it.
The no-arbitrage price of Security C
=

The availability of arbitrage opportunity:

The way to pursue the arbitrage profit:

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