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Financing Options
Loans & Bonds
Equity
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Loans and Bonds
Creditors supply capital
No ownership interest
Legal claim on assets
75% of funding
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Equity
Investors supply capital
Preferred stock: 5% of funding
Common stock: 20% of funding
Claim on assets AFTER creditors
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Why corporations prefer DEBT
Tax system favors debt because of deductibility of interest
After-tax cost of debt is lower than stocks
Larger population of potential investors due to less risk
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Characteristics of Bonds
A bond is a legally binding agreement between a borrower and a lender
Par (face) value
Coupon rate
Current, or coupon yield
Maturity Date
Bond Ratings
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Bond
- legally binding agreement between a borrower and a lender
- Interest-only loan
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Par value
= Face value.
Amount that is repaid to bondholder at maturity
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Coupon rate
Percentage of the par value of the bond that will be paid out annually in the form of interest.
Coupon payment.
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Current yield
= Coupon yield.
Ratio of annual coupon payment to bond's current market price.
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Maturity Date
Date on which the bond issuer repays the par value to the bondholder, as well as the final coupon payment.
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Bond Ratings
Assessment of the creditworthiness of the firm.
- High grade.
- Medium grade.
- Very low grade.
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High grade bonds
Moody's Aaa and S&P AAA - capacity to pay is extremely strong
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Medium grade bonds
Moody's Baa and S&P BBB - capacity to pay is adequate, adverse conditions will have more impact on the firm's ability to pay.
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Very low grade bonds
Moody's C and S&P C & D - capacity to pay is uncertain, and, in many cases, already in default with principal and interest in arrears.
D rating means company is already in default on some of its payments.
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Bond Valuation
Valuation Principle
Amount of expected cash flows
Timing of expected cash flows
Riskiness of expected cash flows
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Valuation Principle
Value of financial securities = PV of expected future cash flows
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Riskiness of expected cash flows
reflected in the investors' required rate of return for undertaking the risk compared to the next best investment alternative
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Bond value is determined by
the present value of the coupon payments and par value using the market interest rate for bonds with similar risks.
Current Value = Present Value
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Par Value always understood to be
$1000
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Interest rates are _______ related to bond values
inversely
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Yield to Maturity
the rate implied by the current bond price.
Expected rate of return investors earn if they buy the bond at Psub0 and hold it until maturity.
Discount rate that equates the PV of a bond's cash flows with its current selling price.
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The YTM on a bond selling at par will always
equal the coupon rate.
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Investors' Selection Criteria
Select if PV > Selling Price, or if YTM > required rate of return. Both will indicate same decision.
Reject if PV < Selling Price, or if YTM < required rate of return.
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If PV > Selling Price
Select.
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If YTM > required rate of return
Select.
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If PV < Selling Price
Reject
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If YTM < required rate of return
Reject
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Bond prices and market interest rates move in _______ directions.
opposite
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When coupon rate = YTM,
price = par value
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When coupon rate > YTM,
price > par value
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When coupon rate < YTM,
price < par value
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Premium bond
When coupon rate > YTM...price > par value
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Discount bond
When coupon rate < YTM...price < par value
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Interest Rate Risk definition
Change in PRICE due to changes in interest rates
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_____-term bonds have more price than ______-term bonds.
Long; short
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Low coupon rate bonds have _____ price risk than high coupon rate bonds
more
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Zero Coupon Bonds:
Pure Discount Bond.
NO periodic interest payments (coupon rate = 0%)
Sold for LESS than par value
The entire yield to maturity comes from the difference between the purchase price and the par value
Value is calculated using SEMIANNUAL periods
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Government Bonds:
Treasury Securities
Municipal Securities
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Treasury Securities:
Federal government DEBT
T-bills
T-notes
T-bonds
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T-bills definition
pure discount bonds with original maturity LESS than one year
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T-notes definition
coupon debt with original maturity between one and ten years
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T-bonds definition
coupon debt with original maturity greater than ten years
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Municipal Securities:
DEBT of state and local governments
Varying degrees of default risk, rated similar to corporate debt
Interest received is TAX-EXEMPT at the federal level
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Corporate Bonds:
Coupon payments with varying maturities
Greater default risk relative to government bonds
Higher required yield (YTM) due to this added default risk
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Bond Markets
Primarily over-the-counter transactions with dealers connected electronically
Makes getting up-to-date prices difficult, particularly on a small company or municipal issues
National Assoc. of Security Dealers Automated Quotation System (NASDAQ)
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Factors affecting Required Return
Nominal rate of interest
Real rate of interest
Inflation premium
Interest rate risk premium
Default risk premium
Taxability premium
Liquidity premium
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Nominal rate of interest
quoted rate of interest
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Real rate of interest
change in purchasing power
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Inflation premium
change in inflation
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Interest rate risk premium
change in interest rates
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Default risk premium
remember bond ratings
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Taxability premium
remember municipal versus taxable
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Liquidity premium
remember demand and frequency of trading
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