Corporate Fin: Chpt. 8

  1. Financing Options
    Loans & Bonds

  2. Loans and Bonds
    Creditors supply capital

    No ownership interest

    Legal claim on assets

    75% of funding
  3. Equity
    Investors supply capital

    Preferred stock: 5% of funding

    Common stock: 20% of funding

    Claim on assets AFTER creditors
  4. 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
  5. 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
  6. Bond
    • legally binding agreement between a borrower and a lender
    • Interest-only loan
  7. Par value
    = Face value.

    Amount that is repaid to bondholder at maturity
  8. Coupon rate
    Percentage of the par value of the bond that will be paid out annually in the form of interest.

    Coupon payment.
  9. Current yield
    = Coupon yield.

    Ratio of annual coupon payment to bond's current market price.
  10. Maturity Date
    Date on which the bond issuer repays the par value to the bondholder, as well as the final coupon payment.
  11. Bond Ratings
    Assessment of the creditworthiness of the firm.

    • High grade.
    • Medium grade.
    • Very low grade.
  12. High grade bonds
    Moody's Aaa and S&P AAA - capacity to pay is extremely strong
  13. 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.
  14. 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.
  15. Bond Valuation
    Valuation Principle

    Amount of expected cash flows

    Timing of expected cash flows

    Riskiness of expected cash flows
  16. Valuation Principle
    Value of financial securities = PV of expected future cash flows
  17. Riskiness of expected cash flows
    reflected in the investors' required rate of return for undertaking the risk compared to the next best investment alternative
  18. 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
  19. Par Value always understood to be
  20. Interest rates are _______ related to bond values
  21. 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.
  22. The YTM on a bond selling at par will always
    equal the coupon rate.
  23. 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.
  24. If PV > Selling Price
  25. If YTM > required rate of return
  26. If PV < Selling Price
  27. If YTM < required rate of return
  28. Bond prices and market interest rates move in _______ directions.
  29. When coupon rate = YTM,
    price = par value
  30. When coupon rate > YTM,
    price > par value
  31. When coupon rate < YTM,
    price < par value
  32. Premium bond
    When coupon rate > YTM...price > par value
  33. Discount bond
    When coupon rate < YTM...price < par value
  34. Interest Rate Risk definition
    Change in PRICE due to changes in interest rates
  35. _____-term bonds have more price than ______-term bonds.
    Long; short
  36. Low coupon rate bonds have _____ price risk than high coupon rate bonds
  37. 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
  38. Government Bonds:
    Treasury Securities

    Municipal Securities
  39. Treasury Securities:
    Federal government DEBT



  40. T-bills definition
    pure discount bonds with original maturity LESS than one year
  41. T-notes definition
    coupon debt with original maturity between one and ten years
  42. T-bonds definition
    coupon debt with original maturity greater than ten years
  43. 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
  44. Corporate Bonds:
    Coupon payments with varying maturities

    Greater default risk relative to government bonds

    Higher required yield (YTM) due to this added default risk
  45. 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)
  46. 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
  47. Nominal rate of interest
    quoted rate of interest
  48. Real rate of interest
    change in purchasing power
  49. Inflation premium
    change in inflation
  50. Interest rate risk premium
    change in interest rates
  51. Default risk premium
    remember bond ratings
  52. Taxability premium
    remember municipal versus taxable
  53. Liquidity premium
    remember demand and frequency of trading
Card Set
Corporate Fin: Chpt. 8
Exam 2: part 1