FIN2601 fin interest rate.

Chapter 6 Interest rates and bond valuation  Instructor’s resources Overview This chapter begins with a thorough discussion of interest rates, yield curves and their relationship to required returns. Features of the major types of bond issues are presented along with their legal issues, risk characteristics and indenture convents. The chapter then introduces students to the important concept of valuation and demonstrates the impact of cash flows, timing, and risk on value. It explains models for valuing bonds and the calculation of yield-to-maturity using either the trial-and-error approach or the approximate yield formula. Students learn how interest rates may affect their ability to borrow and expand business operations or assets under personal control. Study Guide Suggested Study Guide examples for classroom presentation: Example Topic 1 Valuation of any asset 4 Bond valuation 9 Yield to call  Suggested answer to chapter opening critical thinking question How might the issuance of large amounts of public debt affect the corporate debt market? Because corporate bonds are related to the risk-free interest rate as denoted by T-bills, as T-bill rates rise, so do newly issued corporate bonds. As the government’s demand for funds increases, the Treasury will need to issue more debt unless tax revenues increase to meet that demand. Issuing more public debt can have a negative effect on all debt instruments because the increased supply may require higher interest rates to attract buyers with sufficient capital to buy up all of the new debt. However, potential buyers can come from all over the world, and S.A. debt instruments are an attractive investment for many foreign investors because of their relatively high yields. Chapter 6 Interest rates and bond valuation 141  Answers to Review Questions 1. The real rate of interest is the rate that creates an equilibrium between the supply of savings and demand for investment funds. The nominal rate of interest is the actual rate of interest charged by the supplier and paid by the demander. The nominal rate of interest differs from the real rate of interest due to two factors: (1) a premium due to inflationary expectations (IP) and (2) a premium due to issuer and issue characteristic risks (RP). The nominal rate of interest for a security can be defined as r1  r *  IP  RP. For a three-month Treasury bill, the nominal rate of interest can be stated as r1  r *  IP. The default risk premium, RP, is assumed to be zero since the security is backed by the government; this security is commonly considered the risk-free asset. 2. The term structure of interest rates is the relationship of the rate of return to the time to maturity for any class of similar-risk securities. The graphic presentation of this relationship is the yield curve. 3. For a given class of securities, the slope of the curve reflects an expectation about the movement of interest rates over time. The most commonly used class of securities is government Treasury securities. a. Downward sloping: long-term borrowing costs are lower than short-term borrowing costs. b. Upward sloping: Short-term borrowing costs are lower than long-term borrowing costs. c. Flat: Borrowing costs are relatively similar for short- and long-term loans. The upward-sloping yield curve has been the most prevalent historically. 4. a. According to the expectations theory, the yield curve reflects investor expectations about future interest rates, with the differences based on inflation expectations. The curve can take any of the three forms. An upward-sloping curve is the result of increasing inflationary expectations, and vice versa. b. The liquidity preference theory is an explanation for the upward-sloping yield curve. This theory states that long-term rates are generally higher than short-term rates due to the desire of investors for greater liquidity, and thus a premium must be offered to attract adequate long-term investment. c. The market segmentation theory is another theory that can explain any of the three curve shapes. Since the market for loans can be segmented based on maturity, sources of supply and demand for loans within each segment determine the prevailing interest rate. If supply is greater than demand for short-term funds at a time when demand for long-term loans is higher than the supply of funding, the yield curve would be upward sloping. Obviously, the reverse also holds true. 5. In the Fisher equation, r  r *  IP  RP, the risk premium, RP, consists of the following issuer- and issue-related components:  Default risk: The possibility that the issuer will not pay the contractual interest or principal as scheduled.  Maturity (interest rate) risk: The possibility that changes in the interest rates on similar securities will cause the value of the security to change by a greater amount the longer its maturity, and vice versa.  Liquidity risk: The ease with which securities can be converted to cash without a loss in value.  Contractual provisions: Covenants included in a debt agreement or share issue defining the rights and restrictions of the issuer and the purchaser. These can increase or reduce the risk of a security. 142 Gitman • Principles of Managerial Finance, Twelfth Edition The risks that are debt specific are default, maturity and contractual provisions. 6. Most corporate bonds are issued in denominations of R1,000 with maturities of 10 to 30 years. The stated interest rate on a bond represents the percentage of the bond’s par value that will be paid out annually, although the actual payments may be divided up and made quarterly or semiannually. Both bond indentures and trustees are means of protecting the bondholders. The bond indenture is a complex and lengthy legal document stating the conditions under which a bond is issued. The trustee may be a paid individual, corporation, or commercial bank trust department that acts as a third-party ‘watch dog’ on behalf of the bondholders to ensure that the issuer does not default on its contractual commitment to the bondholders. 7. Long-term lenders include restrictive covenants in loan agreements in order to place certain operating and/or financial constraints on the borrower. These constraints are intended to assure the lender that the borrowing firm will maintain a specified financial condition and managerial structure during the term of the loan. Since the lender is committing funds for a long period of time, he seeks to protect himself against adverse financial developments that may affect the borrower. The restrictive provisions (also called negative covenants) differ from the so-called standard debt provisions in that they place certain constraints on the firm’s operations, whereas the standard provisions (also called affirmative covenants) require the firm to operate in a respectable and businesslike manner. Standard provisions include such requirements as providing audited financial statements on a regular schedule, paying taxes and liabilities when due, maintaining all facilities in good working order, and keeping accounting records in accordance with generally accepted accounting procedures (GAAP). Violation of any of the standard or restrictive loan provisions gives the lender the right to demand immediate repayment of both accrued interest and principal of the loan. However, the lender does not normally demand immediate repayment but instead evaluates the situation in order to determine if the violation is serious enough to jeopardise the loan. The lender’s options are: Waive the violation, waive the violation and renegotiate terms of the original agreement, or demand repayment. 8. Short-term borrowing is normally less expensive than long-term borrowing due to the greater uncertainty associated with longer maturity loans. The major factors affecting the cost of long-term debt (or the interest rate), in addition to loan maturity, are loan size, borrower risk and the basic cost of money. 9. If a bond has a conversion feature, the bondholders have the option of converting the bond into a certain number of ordinary shares within a certain period of time. A call feature gives the issuer the opportunity to repurchase, or call, bonds at a stated price prior to maturity. It provides extra compensation to bondholders for the potential opportunity losses that would result if the bond were called due to declining interest rates. This feature allows the issuer to retire outstanding debt prior to maturity and, in the case of convertibles, to force conversion. Share purchase warrants, which are sometimes included as part of a bond issue, give the holder the right to purchase a certain number of ordinary shares at a specified price. Bonds are rated by independent rating agencies such as Moody’s and Standard & Poor’s with respect to their overall quality, as measured by the safety of repayment of principal and interest. Ratings are the result of detailed financial ratio and cash flow analyses of the issuing firm. The bond rating affects the rate of return on the bond. The higher the rating, the less risk and the lower the rate