Overview of Corporate Debt

When a corporation borrows money to finance its operations, it can choose to either take out a loan
from a financial institution, such as a bank or an insurance company, or sell bonds. When debt is
incurred through a loan from a financial institution, it is often referred to as private debt because the
debt is not publicly traded. In contrast, bonds are referred to as public debt because they can be
traded in the public financial markets.
Because of the costs associated with issuing bonds, smaller firms raise debt capital almost
exclusively by borrowing from banks. Large firms also borrow from banks, and, in addition, they raise
debt capital by issuing bonds. These firms generally borrow from banks when they need capital for a
relatively short period of time and prefer raising capital in the bond markets when they need funds
for a long period of time and prefer to lock in a fixed rate of interest. This chapter will focus primarily
on bonds, but because all companies take out loans from time to time, let’s first examine the loan
alternative.

Par or face value

The par or face value of a bond is the amount that must be repaid to the bondholder at maturity.

Clean price and dirty price

Clean price refers to the price before considering any accrued interest that the current owner is old
Clean price are the quoted price plus a accrued interest is referred to as dirty price.

Coupon interest rate

 The coupon interest rate on a bond indicates the percentage of the power value of the bond
that will be paid out annually in the form of interest, that the interest rate is quoted as an
annual percentage rate (APR). Typically, corporate bonds have fixed coupon interest rate
that must be paid on the principle amount, or par value, of the debt, and this rate does not
change over the lifetime of the bond
 The coupon interest also determines the bonds current yield, the ratio of the annual interest
payment to the bonds current market price.

 Floating rate bonds, however have floating rate of interest just like floating rate bank loans
which means doctor read I just opened down in response to changing the market rate of
interest.

Maturity and repayment of principal

The maturity of bond indicates the length of time until the bond issuer is required to repay and
terminate the bond. It is common for bonds to be repaired and retired in part or in whole before
they mature will stop bones are retired early when they are either called (call a decision made by the
issuer) or converted (a decision made by the investor).

Call provision and conversion features

 A call provision is most valuable when the bond is sold during the period of abnormally high
rates of interest and there is a reasonable expectation that the rates will fall in the future
before the bond matures. Having the call feature allows the bond issuer to issue new bonds
if rates decline and then use the proceeds to retire the higher cost bond.
 Some bonds have conversion features that allow the bond holders to convert the bond into
a prescribed number of shares of the firms common stock.
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 market’s
Required yield to maturity on bonds of similar risk.

Valuing Bonds by Discounting Future Cash Flows

Step 1. Determine bondholder cash flows, which are the amount and timing of the bond’s
promised or contractual interest and principal payments to the bondholders.

Step 2. Estimate the appropriate discount rate on a bond of similar risk, where the discount rate is
the return the bond will yield if it is held to maturity and all bond payments are made.

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.
Step 1: Determine Bondholder Cash Flows
Defining the contractually promised bondholder cash flows is straightforward and can be done by
reviewing the bond indenture.

Step 2: Estimate the Appropriate Discount Rate

We find the present value of the bond’s promised or contractual interest and principal payments by
using the market’s required yield to maturity as our discount rate. We estimate the market’s
required yield to maturity by finding a bond of similar risk and maturity—that is, with the same
default risk classification. In general, the yield to maturity (YTM) on any bond is the discount rate
that equates the present value of the bond’s contractual or promised cash flows (interest and
principal at maturity) with the current market price of the bond. This is also the return the investor
will earn on the bond if the investor is paid everything that is contractually promised by the issuing
firm and the bond is held until maturity.

Calculating a Bond’s Yield to Maturity

We calculate the yield to maturity for a bond with annual interest payments and n years to maturity
using Equation (9–2a). You’ll notice that in the final year this bond pays the bondholder both the
interest and the principal.

Step 3: Calculate the Present Value Using the Discounted

Cash Flow
Bond Valuation: Four Key Relationships

Relationship 1
The value of a bond is inversely related to changes in the market’s required yield to maturity.

Relationship 2
The market value of a bond will be less than the par value if the market’s required yield to maturity is
above the coupon interest rate and will be more than the par value if the market’s required yield to
maturity is below the coupon interest rate.

Relationship 3
As the maturity date approaches, the market value of a bond approaches its par value.

Relationship 4
Long-term bonds have greater interest-rate risk than short-term bonds.
Fisher Effect: The Nominal and Real Rates of Interest
The relationship among the nominal rate of interest, rnominal; the anticipated rate of inflation,
rinflation; and the real rate of interest, rreal, is known as the Fisher effect. As we discuss the Fisher
effect, keep in mind that the real rate of interest is not a risk-free rate. The Fisher effect is captured
in Equation (9–3):
Macauly Duration

The weighted average maturity of the cashflows from a bond.

Macaulay duration is the weighted average of the time to receive the cash
flows from a bond. It is measured in units of years. Macaulay duration tells
the weighted average time that a bond needs to be held so that the total
present value of the cash flows received is equal to the current market price
paid for the bond.

If MacD is high the bond is more exposed to interest rate risk. The bond is
more volatility.

Modified duration
It measures the sensitivity of the bond’s price to yield

Mod D = MacD/1+(YTM/k)