Docstoc

CH08-bond valuation

Document Sample
CH08-bond valuation Powered By Docstoc
					                                                                                 Chapter Objectives

                            Bond Valuation                                   •        Demonstrate how bond market prices are established
                                                                                      and influenced by interest rate movements
                              and Risk                                       •        Identify the factors that affect bond prices
        8                                                                    •        Explain how the sensitivity of bond prices to interest
                                                                                      rates is dependent on particular bond characteristics
                                                                             •        Explain the benefits of diversifying the bond portfolio
                                                                                      internationally




                                                     ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                                    ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




        Bond Valuation Process                                                   Bond Valuation Process

    •       Bonds are debt obligations with long-term maturities             •    Impact of the Discount Rate on Bond Valuation
            issued by governments or corporations to obtain long-                     •    Discount rate = market-determined yield that could
            term funds                                                                     be earned on alternative investments of similar risk
    •       Commonly purchased by financial institutions that wish                         and maturity
            to invest funds for long-term periods                                     •    Bond prices vary inversely with changes in market
    •       Bond price (value) = present value of cash flows to be                         interest rates
            generated by the bond                                                           •   Cash flows are contractual and remain the same each
                                                                                                period
                                                                                            •   Bond prices vary to provide the new owner the market rate
                                                                                                of return



                                                     ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                                    ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




        Bond Risks and Prices
                                                                                          Interest Rate Risk

        •    Higher risk                •   Lower risk                   •       Bond Prices fluctuate over Time
                                                                                  •       As interest rates in the economy change, required rates on bonds
        •    Higher discount rates      •   Lower discount rates                          will also change resulting in changing market prices.
        •    Lower bond prices          •   Higher bond prices

                       Note Inverse Relationship
                                                                                                Interest
                      Between Risk, required returns                                             Rates                             VB
                            and Bond Prices

                                                     ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                                    ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




1
                                                                                         Bond Valuation Process
                   Interest Rate Risk
    •       Bond Prices fluctuate over Time                                                  •   Bond Price = present value of cash flows
             •   As interest rates in the economy change, required rates on bonds                discounted at the market required rate of return
                 will also change resulting in changing market prices.                           •   C = Coupon per period (PMT)
                                                                                                 •   Par = Face or maturity value (FV)
                                                                                                 •   i = Discount rate (i)
                                                                                                 •   n = Compounding periods to maturity
                     Interest
                      Rates                            VB
                        Interest
                         Rates
                                                     VB                                              PV =
                                                                                                               C
                                                                                                                     +
                                                                                                                             C
                                                                                                                                    +…
                                                                                                                                       C + Par
                                                                                                             (1+ i)1       (1+ i) 2     (1+ i)n
                                                                 ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                         ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




            Bond Valuation Process                                                       Bond Valuation Process
        •    Consider a $1000, 10% coupon (paid annually) bond that                      PV = $100/(1+.12)1 + $100/(1+.12)2 + $1100/(1+.12)3
             has three years remaining to maturity. Assume the
             prevailing annualized yield on other bonds with similar                             = $951.97
             risk is 12 percent. Calculate the bond’s value.
              • The expected cash flows of a coupon bond includes
                periodic interest payments, and…
              • A final $1000 payoff at maturity                                                        N         I        PV       PMT     FV
              • Discounted at the market rate of return of 12%
                                                                                                        3        12          ?       100   1000


                                                                 ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                         ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




            Bond Valuation Process                                                       Bond Valuation Process

                                                                                     •   Valuation of Bonds with Semiannual Payments
        PV = $100/(1+.12)1 + $100/(1+.12)2 + $1100/(1+.12)3
                                                                                         •   Most bonds pay interest semiannually
                 = $951.97
                                                                                         •   Double the number of compounding periods (N) and
                                                                                             halve the annual coupon amount (PMT) and the
                                                                                             discount rate (I)
                        N          I        PV       PMT       FV

                         3         12    –951.97 100 1000


                                                                 ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                         ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




2
                                                                                                       Determining the Price of a Bond—Example
                                                                                                                   Q: The AYD Corporation issued an 8%, 25-year bond 15 years ago. At
     •        Re-work the above problem assuming                                                                      the time of issue it sold for its par (face) value of $1,000.




                                                                                                         Example
                                                                                                                      Comparable bonds are yielding 10% today. What must AYD’s bond
              semiannual compounding                                                                                  sell for in today’s market to yield 10% (YTM) to the buyer? Assume
                                                                                                                      the bond pays interest semiannually. Also calculate the bond’s
                                                                                                                      current yield.
                                                                                                                   A: We need to solve for the present value of the bond’s expected cash
                                                                                                                      flows at today’s interest rate.
                                                                                                                        PB = PMT [PVFAk, n] + FV [PVFk, n]
                                                                                                                                                                       K represents the periodic
                            N              I              PV         PMT        FV                                                                                      current market interest
                                                                                                                       N represents the                                    rate, or 10% ÷ 2.
                                                                                                                           number of        The payment is 8% x
                                                                                                                        interest-paying    $1,000 or $80 annually.
                             6             6              ?          50         1000                                      periods until   However, it is received in
                                                                                                                                                                         The future value is the
                                                                                                                        maturity, or 10   the form of $40 every six
                                                                                                                                                                         principal repayment of
                                                                                                                        years x 2 = 20.           months.                        $1,000.




                                                                                  ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                                           ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




             Determining the Price of a Bond—Example
                                        Bond—                                                         Relationships Between Coupon Rate,
                                                                                                      Required Return, and Bond Price
                   A: Substituting the correct values into the equation gives us:
                      PB =    $40 [PVFAk, n] + $1,000 [PVFk, n]                                                                    Zero-Coupon Bonds
                         =    $40 [12.4622] + $1,000 [ 0.3769]
                         =    $498.49 + $376.90
                         =    $875.39                     This could also be calculated
         Example




                                                            via a financial calculator:

                                                               N      20
                                                                                                                   •   No periodic coupon
                          This is the price at which
                    the bond must sell to yield 10%.
                                                               PV     -875.39    Answer                            •   Pays face value at maturity
                    It is selling at a discount because
                     the current interest rate is above
                                                               FV     1000                                         •   Trade at discount from face value
                                                               PMT    40
                        the coupon rate. The bond’s
                      current yield is $80 ÷ $875.39,
                                                                                                                   •   No reinvestment risk
                                   or 9.14%.                   I/Y    5
                                                                                                                   •   Considerable price risk

                                                                                  ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                                           ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




    Bond Pricing
    Bond Pricing
                                                                                                         Characteristics of Bonds
     •      Since a bond’s yield to maturity is a market                                                                                   Market Rate                  Bond Sold at
            interest rate:
               •    As rates rise and fall                                                                                                          8%                     Premium
                      •   The yield rises and falls                                                      Bond
                      •   The bond price rises and falls                                                 Stated
                                                                                                        Interest                                  10%                    Face Value
                                                                                                          Rate
                                                                                                          10%
                                                                                                                                                  12%                      Discount
                                                                                  ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                                           ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




3
    Relationships Between Coupon Rate,                                                                                                  Relationships Between Coupon Rate,
    Required Return, and Bond Price                                                                                                     Required Return, and Bond Price

       •     Discount bonds are bonds priced below face                                                                                    •     Premium bond
             value; premium bonds above face value                                                                                                •    Coupon > Market
       •     Discounted bond                                                                                                                      •    Rates decreased since issuance
             •   Coupon < Market rates                                                                                                            •    Favorable risk experience
             •   Rates have increased since issuance                                                                                                   •   Price risk—depends on maturity
                                                                                                                                                       •   Default risk might have decreased as economic activity
             •   Adverse risks factors that may have occurred
                                                                                                                                                           has increased
                     •   Price risk—depends on maturity
                                                                                                                                                       •   Low inflation expectations
                     •   Default risk may have increased
                     •   Fisher effect of higher expected inflation

                                                                                                                    ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                                         ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




      Bond Value                          As the maturity date approaches, the price of
         ($)                                                                                                                            Relationships Between Coupon Rate,
                                          a bond approaches its face value.
                                                                                                                                        Required Return, and Bond Price
      1368                                Time Path of Bond Value When kd < Coupon Rate
                                                        (Premium Bond)                                                                                      Bond Maturity and Price Variability
                 Time Path of Bond Value When kd = Coupon Rate
    M=1000                                                                                                                      M
                                   (Par Bond)
                                                                                                                                                  •    Long-term bond prices are more sensitive to given
       769                                 Time Path of Bond Value When kd > Coupon Rate
                                                                                                                                                       changes in market rates than short-term bonds
                                                         (Discount Bond)                                                                          •    Changes in rates compounded many times for later
                                                                                                                                                       coupon and maturity value, impacting price (PV)
                                                                                                                                                       significantly
                                                                                                                                                  •    Short-term securities have smaller price
                 0       1        2 3           4     5    6    7    8            9 10 11 12 13 14 15                                                  movements
                                                                                                                     Years
                                                                                                                    ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                                         ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




     Long versus Short Maturity Bonds                                                                                                      Interest Rate Risk

             Suppose YTMs decrease to 8%:
                                                                                                                                                                                             Interest rate     1 year    30 years
                                                                                                                                         Bond values ($)                                        5%           $1,047.62   $1,768.62
                                            100         1       1,000
                 Price       2
                                          =       1 -          +         2                     2
                                                                                                         = 1,035.67
                                            0 08 
                                                     (1 08) 
                                                                (1 08)                                                                                                                         10            1,000.00    1,000.00
                                                                                                                                               2,000                                            15             956.52     671.70
                                               100          1                            1,000                                                       $1,768.62                                20             916.67     502.11
                     Price       15        =          1-                               + (1 08)                 = 1,171.19
                                               0 08 
                                                                             15                         15

                                                        (1 08)                                                                               1,500        30-year bond
           Suppose YTMs increase to 12%:
                                                                                                                                                       $1,047.62           1-year bond
                                                                                                                                               1,000
                                                                                                                                                                                   $916.67
                                               100                 1                     1,000
                     Price            2    =               1 - (1 12)            2
                                                                                       + (1 12)             2   = 966.20
                                               0 08                                                                                           500                               $502.11
                                               100         1       1,000
                     Price       15
                                          =          1 -          +      15                        15
                                                                                                             = 863.78
                                                    
                                               0 12     (1 12)    (1 12)
                                                                                                                                                             5      10     15       20
                                                                                                                                                                                 Interest rates (%)
     Price Change: 2 Year ($70/1000 =7%)
                  15 Year ($307/1000 =30.7%)                                                                                             Value of a Bond with a 10% Coupon Rate for Different
                                                                                                                                         Interest Rates and Maturities
                                                                                                                    ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                                         ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




4
    Exhibit 8.4                                                                          Relationships Between Coupon Rate,
                                                                                         Required Return, and Bond Price
            1,800                                                                                            Coupon Rates and Price Variability
            1,600

            1,400

            1,200

            1,000                                                                               •   Low coupon bond prices more sensitive to change
                                                                     5-Year Bond
             800
                                                                     10-Year Bond
                                                                                                    in interest rates
                                                                     20-Year Bond
             600                                                                                •   PV of face value at maturity a major proportion of
             400                                                                                    the price
             200

                  0
                      0             5          8    10   12         15              20
                                        Required Return (Percent)
                                                                     ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                                  ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




    Explaining Bond Price Movements                                                         Explaining Bond Price Movements


    •   The price of a bond should reflect the present                                      •   Factors that affect the risk-free rate
        value of future cash flows discounted at a                                              •   Changes in returns on real investment
        required rate of return                                                                       •   Financial investment an alternative to real investment
    •   The required return on a bond is primarily                                                    •   Opportunity cost of financial investment is the returns
                                                                                                          available from real investment
        determined by                                                                                 •   Federal Government deficits/surplus position
        •    Prevailing risk-free rate                                                          •   Inflationary expectations
        •    Risk premium                                                                             •   Consumer price index
                                                                                                      •   Federal Reserve monetary policy position
                                                                                                      •   Oil prices and other commodity prices
                                                                     ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                •   Exchange rate movements                 ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




    Explaining Bond Price Movements                                                         Exhibit 8.8


    •   Factors that affect the credit or default risk                                               U.S.
                                                                                                    Fiscal
                                                                                                                     U.S.
                                                                                                                   Monetary
                                                                                                                                    U.S.
                                                                                                                                  Economic
                                                                                                                                                Issuer’s
                                                                                                                                                Industry
                                                                                                                                                               Issuer’s
                                                                                                                                                                Unique
                                                                                                    Policy          Policy        Conditions   Conditions     Conditions
        premium
        •    Strong economic growth
              •       High level of cash flows                                                                      Long-T erm
                                                                                                                    Risk-Free                     Risk
              •       Investors bid up bond prices; lower default premium                                         Interest Rate
                                                                                                                    (Treasury
                                                                                                                                                Premium
                                                                                                                                                of Issuer
                                                                                                                   Bond Rate)
        •    Weak economic growth
              •       Lower profits and cash flows                                                                                 Required
                                                                                                                                    Return
                                                                                                                                    on the
              •       Impact on specific industries varied                                                                           Bond

              •       Investors flee from risky bonds to Treasury bonds
              •       Bond prices fall; default premiums increase                                                                 Bond Price

                                                                     ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                                  ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




5
    Sensitivity of Bond Prices to Interest Rate Movements                       Sensitivity of Bond Prices to Interest Rate Movements


                                                                                 •   Calculate the price sensitivity of a zero-coupon
     •       Bond Price Elasticity = Bond price sensitivity for any                  bond with 10 years until maturity if interest rates
             % change in market interest rates
                                                                                     go from 10% to 8%.
     •       Bond Price Elasticity =
                                                                                     •   First, calculate the price of the bond for both rates
             (% Change In Price)/(% Change In Interest Rates)
                                                                                             •   When k = 10%, PV = ?
     •       Increased elasticity means greater price risk                                   •   When k = 8%, PV = ?
                                                                                             •   Hint: Remember zero-coupon or no PMT in this
                                                                                                 calculation
                                                                                             •   The price of a zero-coupon bond is the present value of a
                                                                                                 single future value cash flow.


                                                            ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                                ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




    Sensitivity of Bond Prices to Interest Rate Movements                       Sensitivity of Bond Prices to Interest Rate Movements


     •       Calculate the price sensitivity of a zero-coupon                        Calculate the bond elasticity:
             bond with 10 years until maturity if interest
             rates go from 10% to 8%.                                                                                    $ 463 − $ 386
              •   First, calculate the price of the bond for both rates                              percent ∆ P             $ 386
                                                                                                 P =
                                                                                                  e
                                                                                                                 =                     = − . 997
                  •   When k = 10%, PV = $386                                                        percent ∆ k          8 % − 10 %
                  •   When k = 8%, PV = $463
                                                                                                                             10 %

                                                                                             Bond elasticity or price sensitivity to changes in
                                                                                         interest rates approaches the limit at –1 for zero-coupon
                                                                                                bonds. Price sensitivity is lower for coupon
                                                                                             bonds. The inverse relationship between k and p
                                                                                                        causes the negative numbers
                                                            ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                                ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




    Sensitivity of Bond Prices to Interest Rate Movements                       Sensitivity of Bond Prices to Interest Rate Movements

         •    Price-Sensitive Bonds
              •   Longer maturity—more price variation for a change                                               Duration
                  in interest rates
              •   Lower coupon rate bonds are more price sensitive
                  (the PV is a greater % of current value)
              •   Zero-coupon bonds most sensitive, approaching –1                       •       Measure of bond price sensitivity
                  price elasticity                                                       •       Measures the life of bond on a PV basis
              •   Greater for declining rates than for increasing rates                  •       Duration = Sum of discounted, time-weighted cash
                                                                                                 flows divided by price


                                                            ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                                ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




6
    Sensitivity of Bond Prices to Interest Rate Movements                  Sensitivity of Bond Prices to Interest Rate Movements

                                                                            •   Modified duration is an easily calculated
                                 Duration                                       approximate of the duration measure


                                                                                                                                               DUR
               •   The longer a bond’s duration, the greater its                                                  DUR * =
                   sensitivity to interest rate changes                                                                                       (1 + k )
               •   The duration of a zero-coupon bond = bond’s term
                   to maturity
               •   The duration of any coupon bond is always less                      DUR* is a linear approximation of DUR which measures
                                                                                        the convex relationship between bond yields and prices
                   than the bond’s term to maturity

                                                       ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                                                            ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




    Bond Investment Strategies Used by Investors                           Bond Investment Strategies Used by Investors

                           Matching Strategy                                                                      Laddered Strategy

       •   Create bond portfolio that will generate income that                  •    Funds are allocated evenly to bonds in several
           will match their expected periodic expenses                                different maturity classes
       •   Used to provide retirement income from savings                        •    Example: ¼ funds invested in bonds with 5 years
           accumulation                                                               until maturity, ¼ in10-year bonds, ¼ in 15-year
       •   Estimate cash flow needs then select bond portfolio                        bonds, and ¼ in 20-year bonds
           that will generate needed income                                      •    Investor receives average return of yield curve over
                                                                                      time as maturing bonds are reinvested


                                                       ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                                                            ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




    Bond Investment Strategies Used by Investors                           Comparison of laddered and barbell
                                                                           maturity strategies
                                                                                     Percent of Portfolio
                                                                                       A dobe Sy stems




                                                                                                Maturing                       Laddered Maturity Strategy
                                                                                                      10
                           Barbell Strategy

           •   Allocated funds to short-term bonds and long-term
               bonds
                                                                                                                   1   2       3         4         5     6      7     8       9    10
                                                                                Percent of Portfolio
           •   Short-term bonds provide liquidity from maturity                            Maturing
                                                                                                                                                                    Maturity in Years

                                                                                                  40
                                                                                                                           Barbell Maturity Strategy
           •   Long-term bonds provide higher yield (assuming
               up-sloping yield curve)                                                                   30

                                                                                                         20

                                                                                                         10


                                                       ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                      1    2   3   4       ...       ...   10   11          ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬
                                                                                                                                                             12 13 14 15
                                                                                                                                                             Maturity in Years




7
    Bond Investment Strategies Used by Investors                                    Foreign Exchange Rates and Interest Rates

                                                                                    •   Country interest rate differences reflect expected future
                              Interest Rate Strategy                                    spot foreign exchange rates
                                                                                    •   Expected future spot foreign exchange rates (forward
           •   Funds are allocated in a manner that capitalizes on                      forex rates) reflect expected inflation differences
               interest rate forecasts                                                  between countries
           •   Example: if rates are expected to decline, move                      •   Expected return on foreign bond portfolio related to
               into longer-term bonds                                                   return on bonds adjusted for expected changes in forex
                                                                                        rates
           •   Problems:
                •   High transaction costs because of higher trading
                •   Difficulty in forecasting interest rates

                                                                ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                                       ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




       Diversifying Bonds Internationally                                               Bond Ratings
                                                                                                                                          Low Quality, speculative,
                                                                                                        Investment-Quality Bond Ratings            and/or “Junk”
       •       Investor may diversify by:                                                               High Grade      Medium Grade       Low Grade     Very Low Grade

               •    Credit risk                                                     Standard & Poor’s   AAA    AA       A       BBB        BB      B     CCC CC C         D
                                                                                    Moody’s             Aaa    Aa       A       Baa        Ba      B     Caa Ca C         C
               •    Country risk
                                                                                    Moody’s S&P
               •    Foreign exchange risk                                           Aaa     AAA         Debt rated Aaa and AAA has the highest rating. Capacity to pay
                                                                                                        interest and principal is extremely strong.
               •    Interest rate risk                                              Aa       AA         Debt rated Aa and AA has a very strong capacity to pay interest
                                                                                    and                 repay principal. Together with the highest rating, this group
       •       Seek lower total variability of returns per level                    A        A
                                                                                                        comprises the high-grade bond class.
                                                                                                        Debt rated A has a strong capacity to pay interest and repay
               of risk assumed                                                                          principal, although it is somewhat more susceptible to the
                                                                                                        adverse effects of changes in circumstances and economic
                                                                                                        conditions than debt in high rated categories.




                                                                ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                                       ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




              Bonds-
      Trading Bonds-How Ratings Work                                                            Bonds-
                                                                                        Trading Bonds-How Ratings Work

      In general, higher ratings are associated with:                               It is important to note that
             more profitable companies                                                      *bond rating are given to issues not companies
             relying less on debt as a form of financing                                            same can have different rating assigned to different
             more liquid                                                                            issues
             stronger cash flows                                                            *bond rating can change with changes in conditions
             no trouble servicing their debt in a timely fashion                            *bond rating capture on default risk
                                                                                            *more highly rated issues are more interest sensitive
      AAA through BBB is considered “investment grade” indicating
            financially strong, well run companies
      Below BBB (i.e. BB or Ba) denotes junk bonds - default risk
            is considered to be high.



                                                                ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                                       ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




8
    DETERMINING COST OF DEBT CAPITAL                                                                 DETERMINING COST OF DEBT CAPITAL



            rdebt or rd = RR + IP + DRP +LP + MP                                                          rdebt or rd = RR + IP + DRP+LP + MP
    •   Determinants of Market Interest Rates
        • Nominal interest rate - observed or stated interest                                         •   Determinants of Market Interest Rates
          rate                                                                                            >Inflation premium (IP) – average expected
        • Real interest Rate (RR) – rate in addition to the                                               inflation rate over the life of a risk-free loan
          inflation rate expected on a risk-free loan                                                      Inflation – rising prices not offset by increasing
                    Risk-Free Rate or rf = RR + IP                                                         quality of the goods or services being purchased
        •   Risk-free interest rate – interest rate on debt capital
            that is virtually free of default risk
                                                                    ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                                                   ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




    DETERMINING COST OF DEBT CAPITAL                                                                 DETERMINING COST OF DEBT CAPITAL


            rdebt or rd = RR + IP + DRP +LP + MP                                                          rdebt or rd = RR + IP + DRP +LP + MP
        •   Determinants of Market Interest Rates                                                •   Determinants of Market Interest Rates
            >Default Risk Premium (DRP) – additional                                                 >Liquidity Premium (LP) – charged when a debt
            interest rate premium required to compensate the                                         instrument cannot be converted to cash quickly and at
            lender for the probability that a borrower will                                          its existing value
            default on a loan
                •   Prime rate – interest rate charged by banks to their highest                     >Maturity Premium (MP) – premium to reflect in-
                    quality (lowest default risk) business customers                                 creased uncertainty associated with long-term debt
                •   Bond rating – reflects the default risk of a firm’s bonds as judged
                                                                                                           •   Term structure of interest rates – relationship between nominal
                    by a bond rating agency
                                                                                                               interest rates and time to maturity when default risk is held constant
                •   Senior debt – debt secured by a venture’s assets
                                                                                                           •   Yield curve – graph of the term structure of interest rates
                •   Subordinated debt – debt with an inferior claim (relative to senior
                    debt) to venture assets                            ‫اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬     .‫د‬                                                                            ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




    DETERMINING MARKET INTEREST RATES                                                                The Term Structure of Interest Rates
                                                                                                      A. Upward-sloping term structure                 B. Downward-sloping term structure

                                                                                               Interest                                            Interest

            rdebt or rd = RR + IP + DRP+LP + MP                                                rate                                     Nominal    rate
                                                                                                                                        interest
                                                                                                                                        rate



                                                                                                                                                                                         Nominal
        •   Real interest rate = 3%                                                                                     Interest rate                                      Interest rate
                                                                                                                                                                                         interest
                                                                                                                                                                                              rate
                                                                                                                        risk premium                                       risk premium
        •   Inflation expectation = 3%
        •   Default risk = 5%                                                                                                                                               Inflation
                                                                                                                          Inflation                                         premium
        •   Liquidity premium = 3%                                                                                        premium

        •   Maturity premium = 2%
                                                                                                                         Real rate                                          Real rate


                                                                                                                                        Time to                                          Time to
        rd = 3% + 3% + 5% + 3% + 2% = 16%                                                                                               maturity                                         maturity

                                                                    ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬                                                                                   ‫د. اﺣﻤﺪ ﻳﻮﺳﻒ دﺷﺘﻲ‬




9

				
DOCUMENT INFO
Shared By:
Categories:
Tags:
Stats:
views:9
posted:7/12/2011
language:English
pages:9