4th Group Chapter 9

Chapter 9
Debt Valuation
and Interest
Rates
Copyright © 2011 Pearson Prentice Hall. All rights reserved.

9.1 Overview of
Corporate Debt

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)

9-3
Corporate Borrowings (cont.)
• 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.

9-4
Borrowing Money in the Private
Financial Market
• Financial Institutions are an important

source of capital for corporations. The loan
might be used to finance firm’s 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.

9-5
Financial Market (cont.)
• 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)

9-6
• 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.

9-7
• 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.
– A maximum and a minimum annual rate, to
which the rate can adjust, called the ceiling and
floor.
– A maturity date
– Collateral

9-8
• For example, a corporation may get a 1-

year loan with a rate of 300 basis points
(or 3%) over LIBOR with a ceiling of 11%
and a floor of 4%.

9-9
9-10
Checkpoint 9.1
Calculating the Rate of Interest on a Floating Rate Loan
The Slinger Metal Fabricating Company entered into a loan agreement
with its bank to finance the firm’s working capital. The loan called for a
floating rate that was 25 basis points (.25%) over an index based on
LIBOR. In addition, the loan adjusted weekly based on the closing
value of the index for the previous week within the bounds of a
maximum annual rate of 2.5% and a minimum of 1.75%. Calculate
the rate of interest for the weeks 2 through 10.

9-11
Checkpoint 9.1

9-12
Checkpoint 9.1

9-13
Checkpoint 9.1

9-14
Checkpoint 9.1

9-15
Checkpoint 9.1: Check Yourself
Consider the same loan period as above but

change the spread over LIBOR from .25% to .75%.
Is the ceiling rate or floor rate violated during the
loan period?

9-16
Step 1: Picture the Problem
• The graph on the next slide shows the

LIBOR index (series 1), LIBOR plus the
spread of 75 basis points (series 2) the
ceiling rate (series 3), and the floor rate
(series 4).

9-17
Step 1: Picture the Problem (cont.)

9-18
Step 2: Decide on a Solution
Strategy
• We have to determine the floating rate for

every week and see if it exceeds the
ceiling or falls below the floor.
• Floating rate on Loan

= LIBOR for the previous week + spread of .75%

9-19
Strategy
• The floating rate on loan cannot exceed

the ceiling rate of 2.5% or drop below the
floor rate of 1.75%.
– If the floating rate falls below the floor, the rate

will be reset at the floor rate.
– If the floating rate exceeds the ceiling, the rate
will be reset at the ceiling rate.

9-20
Step 3: Solve
LIBOR LIBOR + Loan Rate
Spread
(.75%)
2/29/2008 1.98%
3/7/2008 1.66% 2.73% 2.50%
3/14/2008 1.52% 2.44% 2.41%
3/21/2008 1.35% 2.27% 2.27%
3/28/2008 1.60% 2.10% 2.10%
Ceiling
4/4/2008 1.63% 2.35% 2.35% Violated
4/11/2008 1.67% 2.38% 2.38%

4/18/2008 1.88% 2.42% 2.42%
4/25/2008 1.93% 2.63% 2.50%
5/2/2008 2.68% 2.50%

9-21
Step 3: Solve (cont.)
• The table shows the ceiling is violated

during the first week and last two weeks of
the loan period. The floor rate is never
violated.

9-22
Step 4: Analyze
• The ceiling is the maximum rate charged on the
loan while floor is the minimum rate charged on
the loan. If the ceiling or floor rates are violated,
the loan rate is reset to the ceiling rate or the
floor rate.
• If there were no ceiling, the loan rate would have

been 2.73% during the first week of the loan, and
2.63% and 2.68% during the last two weeks of
the loan.

9-23
Borrowing Money in the Public
Financial Market
• Firms also raise money by selling debt

securities to individual investors and
financial institutions such as mutual funds.
• In order to sell debt securities to the

public, the issuing firm must meet the
legal requirements as specified by the
securities laws.

9-24
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.
• If the firm fails to pay the promised future

payments of interest and principal, the
bond trustee can classify the firm as
insolvent and force the firm into
bankruptcy.

9-25
Basic Bond Features
• The basic features of a bond include the

following:
– Bond Indenture
– Claims on Assets and Income
– Par or Face Value
– Coupon Interest Rate
– Maturity and Repayment of Principal
– Call Provision and Conversion Features

9-26
9-27
Bond Ratings and Default Risk
• Bond ratings indicate the default risk i.e.

the probability that the firm will make the
promised payments.
• Bond ratings affect the rate of return that

lenders require of the firm and the firm’s
cost of borrowing.

9-28
Bond Ratings and Default Risk
(cont.)
• 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 three rating

agencies – Moody’s, Standard & Poor’s,
and Fitch Investor Services.

9-29
9-30
9.2 Valuing
Corporate Debt

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.

9-32
Valuing Corporate Debt (cont.)
• The valuation of corporate debt relies on

the first three basic principles of finance:
– Principle 1: Money Has a Time Value.

– Principle 2: There is a Risk-Return Tradeoff.
– Principle 3: Cash Flows are the Source of
Value.

9-33
Step-by-Step: Valuing Bonds by
Discounting Future Cash Flows
• Step 1: Determine the amount and timing of
bondholder cash flows. The total cash flows equal
the promised interest payments and principal
payment.
• Annual Interest = Par value × coupon rate
• Example 9.1: The annual interest for a bond with

coupon interest rate of 7% and a par value of
$1,000 is equal to $70, (.07 × $1,000 = $70).

9-34
Discounting Future Cash Flows (cont.)
• Step 2: Estimate the appropriate discount

rate on a similar risk bond. Discount rate is
the return the bond will yield if it is held to
maturity and all bond payments are made.
• Discount rate can be either calculated or

obtained from various sources (such as
Yahoo! Finance).

9-35
Discounting Future Cash Flows (cont.)
• 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.

9-36
Calculating a Bond’s Yield to
Maturity (YTM)
• We can think of YTM as the discount rate

that makes the present value of the bond’s
promised interest and principal equal to
the bond’s observed market price.

9-37
Checkpoint 9.2
Calculating the Yield to Maturity on a Corporate

Bond
Calculate the yield to maturity for the following bond issued by Ford Motor
Company (F) with a price of $744.80, where we assume that interest payments
are made annually at the end of each year and the bond has a maturity of exactly
11 years.

9-38
Checkpoint 9.2

9-39
Checkpoint 9.2

9-40
Checkpoint 9.2

9-41
Checkpoint 9.2: Check Yourself
Calculate the YTM on the Ford bond where

the bond price rises to $900 (holding all
other things equal).

9-42
Step 1: Picture the Problem
YTM=?
0 1 2 3… 11
Years
Cash flow -$900 $65 $65 $65 $1,065
• Purchase price = $900

• Interest payments = $65 per year for years 1-11
• Final payment = $1,000 in year 11 of principal.

9-43
Strategy
• We can use equation 9-2a to find YTM.

YTM is the rate that makes the present
value of all future expected cash flows
equal to the current market price.
• We can also solve for YTM using a

calculator and a spreadsheet.

9-44
Step 3: Solve
• Using Mathematical Equation
• It is cumbersome to solve for YTM by hand

using the equation. It is more practical to
use the financial calculator or the spread
sheet.

9-45
• Using Financial Calculator

Enter:
N = 11
I/Y = 7.89
PV = -900
PMT = 65
FV = 1,000

9-46
• Using an Excel Spreadsheet
• YTM = RATE(nper, pmt,pv,fv)

= RATE (11,65,-900,1000)
= 7.89%

9-47
Step 4: Analyze
• The yield to maturity on the bond is

7.89%. The yield is higher than the coupon
rate of interest of 6.5%. Since the coupon
rate is lower than the yield to maturity, the
bond is trading at a price below $1,000.
We call this a discount bond.

9-48
Using Market Yield to Maturity Data
• Market yield to maturity is regularly

reported by a number of investor services
and is quoted in terms of credit spreads
or spreads to Treasury bonds.
• Table 9-4 contains some examples of yield

spreads.

9-49
Using Market Yield to Maturity Data
(cont.)
• The spread values in table 9-4 represent basis

points over a US Treasury security of the same
maturity as the corporate bond. For example, a
30-year Ba1/BB+ corporate bond has a spread of
275 basis points over a similar 30-year US
Treasury bond.
• Thus this corporate bond should earn 2.75% over

the 4.56% earned on treasury yield or 7.31%.

9-50
9-51
Promised Returns versus Expected
Yield to Maturity
• The yield to maturity calculation assumes

that the bond performs according to the
terms of the bond contract or indenture.
Since corporate bonds are subject to risk
of default, the promised yield to maturity
may not be equal to expected yield to
maturity.

9-52
Yield to Maturity (cont.)
• Example 9.2 Consider a one-year bond

that promises a coupon rate of 8% and
has a principal (par value) of $1,000.
Further assume the bond is currently
trading for $850. What is the promised
yield to maturity?

9-53
• Promised YTM
= {(Interest year 1 + Principal) ÷ (Bond Value)} – 1
= {($80+$1,000) ÷ ($850)} – 1
= 27.06%

9-54
• The yield of 27.06% is based on the

assumption of no default.
• Assume there is a 40% probability of

default on this bond and if the bond
defaults, the bondholders will receive only
60% of the principal and interest owed.
What is the expected YTM on this bond?

9-55
• YTMdefault
= {(Interest year 1 + Principal)} ÷ (Bond Value)} – 1
= {($80+$1000) × .60} ÷ ($850)} – 1
= -23.76%

9-56
= (27.06 × .60) + (-23.76 × .40)

= 6.73%
• The financial press quotes promised yield

and not expected YTM.

9-57
Bond Valuation: Four Key
Relationships
• First Relationship The value of bond is

inversely related to changes in the yield to
maturity.
YTM = 12% YTM rises to 15%
Par value $1,000 $1,000

Coupon rate 12% 12%
Maturity date 5 years 5 years
Bond Value $1,000 $899.44
Bond
Value
Drops

9-58
Relationships (cont.)

9-59
• Since future interest rates cannot be

predicted, a bond investor is exposed to
the risk of changing values of bonds as
interest rates change.
• The risk to the investor that the value of

his or her investment will change is known
as interest rate risk.

9-60
• Second Relationship: The market value of

a bond will be less than its par value if the
yield to maturity is above the coupon
interest rate and will be valued above par
value if the yield to maturity is below the
coupon interest rate.

9-61
• There are two sources of return from bond

investment:
– Periodic interest payments
– Capital gain or loss when the bond is sold

9-62
• When a bond can be bought for less than

its par value, it is called discount bond.
For example, buying a $1,000 par value
bond for $950.
• Bonds will trade at a discount when the

yield to maturity on the bond exceeds the
coupon rate.

9-63
• When a bond can be bought for more than

its par value, it is called premium bond.
For example, buying a $1,000 par value
bond for $1,110.
• Bonds will trade at a premium when the

yield to maturity on the bond is less than
the coupon rate.

9-64
• Third Relationship As the maturity date

approaches, the market value of a bond
approaches its par value.
• Regardless of whether the bond was

trading at a discount or at a premium, the
price of bond will converge towards par
value as the maturity date approaches.

9-65
9-66
9-67
• Fourth Relationship Long term bonds have

greater interest rate risk than short-term
bonds.
• While all bonds are affected by a change in

interest rates, long-term bonds are
exposed to greater volatility as interest
rates change.

9-68
9-69
9.4 Types of
Bonds

Types of Bonds
• Table 9-7 contains a listing of major types of

long-term debt securities that are sold in the
public financial market.
• The differences among the various types of bond

are based on the following bond attributes:
Secured versus Unsecured, Priority of claim,
Initial offering market, Abnormal risk, Coupon
level, Amortizing or non-amortizing, and
Convertibility.

9-71
Types of Bonds (cont.)
• Secured versus Unsecured
– Secured bonds have specific assets pledged

to support repayment of the bond.
– Unsecured bond are referred to as
debentures.
– Bonds secured by lien on real property is called
a mortgage bond.

9-72
• Priority of Claim
– The priority of claim refers to the order of
repayment when the firm’s assets are
distributed, as in the case of liquidation.
– Secured bonds are paid first followed by
debentures; Among debentures, subordinated
debentures have lower priority than secured
debt and unsubordinated debentures.

9-73
• Initial Offering Market
– Bonds are classified by where they were

originally issued (in the domestic bond market
or not).
– For example, Eurobonds are issued in a
foreign country but are denominated in
domestic currency. For example, a US
corporation issuing bonds in Germany in US
dollars.

9-74
• Abnormal Risk
– Junk, or high-yield, bonds have a below-

investment grade bond rating. These bonds
have a high risk of default as the firms that
issued these bonds are facing severe financial
problems.

9-75
• Coupon Level
– Bonds with a zero or very low coupon are called

zero coupon bonds.
– These bonds are issued at substantial discounts
from their par value and promise to repay a
zero or very low coupon rate each year. The
par value is repaid at the maturity of the bond.

9-76
• Amortizing or Non-Amortizing
– The payments from amortizing bonds, like a

home mortgage, include both the interest and
principal.
– The payments from a non-amortizing bonds
include only interest. At maturity, the bonds
repay the par value of bond.

9-77
• Convertibility
– Convertible bonds are debt securities that can

be converted into a firm’s stock at a pre-
specified price.

9-78
9-79
Key Terms
• Amortizing bond • Convertible bond

• Bond rating • Corporate bond
• Bond indenture • Coupon interest rate
• Call provision • Credit spread
• Collateral • Current yield
• Conversion feature • Debenture
• Default premium

9-80
Key Terms (cont.)
• Interest rate risk
• Discount bond
• Junk (high-yield)
• Eurobonds
bonds
• Fisher effect
• LIBOR
• Fixed rate loan
• Maturity premium
• Floating rate bonds
• Mortgage bonds
• Floating rate
• Nominal (or quoted)
• Inflation premium rate of interest
• Non-amortizing bond

9-81
Key Terms (cont.)
• Par or face value of • Subordinated

debentures
a bond
• Term structure of
• Private market interest rates
transaction
• Transaction loans
• Premium bond
• Unsubordinated
• Real rate of interest debentures
• Recovery rate • Yield curve
• Secured debt • Yield to maturity
• Spread to Treasury • Zero coupon bond

9-82

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Chapter 9

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• There are two main sources of borrowing

1. Loan from a financial institution (known as

2. Bonds (known as public debt since they can

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Smaller firms choose to raise money from

• Larger firms generally raise money from

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Financial Institutions are an important

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• In the private financial market, loans are

• The most popular benchmark rate is the

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• LIBOR is the daily interest rate that is

– Interbank market is the market where banks

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• A typical floating rate loan will specify the

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• For example, a corporation may get a 1-

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Consider the same loan period as above but

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• The graph on the next slide shows the

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• We have to determine the floating rate for

• Floating rate on Loan

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• The floating rate on loan cannot exceed

– If the floating rate falls below the floor, the rate

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

4/11/2008 1.67% 2.38% 2.38%

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• The table shows the ceiling is violated

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• If there were no ceiling, the loan rate would have

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Firms also raise money by selling debt

• In order to sell debt securities to the

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Corporate bond is a debt security issued

• If the firm fails to pay the promised future

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• The basic features of a bond include the

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Bond ratings indicate the default risk i.e.

• Bond ratings affect the rate of return that

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Consistent with Principle 2 (There is a

• Bond ratings are provided by three rating

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.