Differences Between Debt and Equity

• Equity
• Debt – Ownership interest
– Not an ownership interest
– Common stockholders
– Creditors do not have vote for the board of
voting rights directors and other issues
– Interest is considered a cost – Dividends are not
of doing business and is tax considered a cost of doing
deductible business and are not tax
– Creditors have legal deductible
recourse if interest or – Dividends are not a
principal payments are liability of the firm and
missed stockholders have no
– Excess debt can lead to legal recourse if
financial distress and dividends are not paid
bankruptcy – An all equity firm can not
go bankrupt
 The Bond Indenture
• Contract between the company and the
bondholders and includes
– The basic terms of the bonds
– The total amount of bonds issued
– A description of property used as security, if applicable
– Sinking fund provisions
– Call provisions
– Details of protective covenants
 Bond Classifications
• Registered vs. Bearer Forms
• Security
– Collateral – secured by financial securities
– Mortgage – secured by real property, normally land or
buildings
– Debentures – unsecured
– Notes – unsecured debt with original maturity less than
10 years
• Seniority
Bond Characteristics and Required
Returns
• The coupon rate depends on the risk
characteristics of the bond when issued
• Which bonds will have the higher coupon,
all else equal?
– Secured debt versus a debenture
– Subordinated debenture versus senior debt
– A bond with a sinking fund versus one without
– A callable bond versus a non-callable bond
 How does adding a “call
provision” affect a bond?
• Issuer can refund if rates decline. That
helps the issuer but hurts the investor.
• Therefore, borrowers are willing to pay
more, and lenders require more, on callable
bonds.
• Most bonds have a deferred call and a
declining call premium.
 When would bonds be called?
• In general, if a bond sells at a premium,
then (1) coupon > kd, so (2) a call is likely.
• So, expect to earn:
– YTC on premium bonds.
– YTM on par & discount bonds.
 What’s a sinking fund?
• Provision to pay off a loan over its life
rather than all at maturity.
• Similar to amortization on a term loan.
• Reduces risk to investor, shortens average
maturity.
• But not good for investors if rates decline
after issuance.
Sinking funds are generally handled in
2 ways

1. Call x% at par per year for sinking

fund purposes.
2. Buy bonds on open market.
Company would call if kd is below the
coupon rate and bond sells at a
premium. Use open market purchase
if kd is above coupon rate and bond
sells at a discount.
 Protective Covenants
• Agreements to protect bondholders
• Negative covenant: Thou shalt not:
– pay dividends beyond specified amount
– sell more senior debt & amount of new debt is limited
– refund existing bond issue with new bonds paying lower interest
rate
– buy another company’s bonds
• Positive covenant: Thou shalt:
– use proceeds from sale of assets for other assets
– allow redemption in event of merger or spinoff
– maintain good condition of assets
– provide audited financial information
 Bond Ratings – Investment
Quality
• High Grade
– Moody’s Aaa and S&P AAA – capacity to pay is
extremely strong
– Moody’s Aa and S&P AA – capacity to pay is very
strong
• Medium Grade
– Moody’s A and S&P A – capacity to pay is strong,
but more susceptible to changes in circumstances
– 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
 Bond Ratings - Speculative
• Low Grade
– Moody’s Ba, B, Caa and Ca
– S&P BB, B, CCC, CC
– Considered speculative with respect to capacity to
pay. The “B” ratings are the lowest degree of
speculation.
• Very Low Grade
– Moody’s C and S&P C – income bonds with no
interest being paid
– Moody’s D and S&P D – in default with principal
and interest in arrears
What factors affect default risk
and bond ratings?
• Financial performance
– Debt ratio
– TIE, FCC ratios
– Current ratios
• Provisions in the bond contract
– Secured vs. unsecured debt
– Senior vs. subordinated debt
– Guarantee provisions
– Sinking fund provisions
– Debt maturity
• Other factors
– Earnings stability
– Regulatory environment
– Potential product liability
– Accounting policies
Importance of bond ratings

• Bond interest rate, cost of debt

capital
• Clientele
 Key Features of a Bond
• Bond
– Contract under which a borrower agrees to
make payments of principal and interest on
specific dates to the holders of the bond
• Bonds are the most common form of
financing
 Key Features of a Bond

1. Par value: Face amount; paid

at maturity. Assume $1,000.

2. Coupon interest rate: Stated

interest rate. Multiply by par
to get $ of interest. Generally
fixed.
3. Maturity: Years until bond
must be repaid. Declines.

4. Issue date: Date when bond

was issued.
 What’s “yield to maturity”?
• YTM is the rate of return earned on a bond held
to maturity.
• We will use the symbol rd or YTM to refer to
yield to maturity
• YTM is the appropriate discount rate for the
bond. It represents the opportunity cost that
could be earned on bonds of similar risk.
 What’s the value of a 10-year,
10% coupon bond if rd = 10%?
0 1 2 10
10% ...
V=? 100 100 100 + 1,000

$100 $100 $1, 000

VB = + . . . + +
(1 + r d ) (1 + r d ) (1+ d )
1 10 10
r

= $90.91 + . . . + $38.55 + $385.54

= $1,000.
The bond consists of a 10-year, 10%
annuity of $100/year plus a $1,000 lump
sum at t = 10:
PV annuity = $ 614.46
PV maturity value = 385.54
PV annuity = $1,000.00

INPUTS 10 10 100 1000

N I/YR PV PMT FV
OUTPUT -1,000
 The Bond-Pricing Equation
 1 
1 -
 (1 + r ) t  PAR
Bond Value = C  d
+
 (1 + rd )
t
 rd
 
What would happen if expected inflation
rose by 3%, causing rd = 13%?

INPUTS 10 13 100 1000

N I/YR PV PMT FV
OUTPUT -837.21

When rd rises, above the coupon rate,

the bond’s value falls below par, so it
sells at a discount.
 What would happen if inflation
fell, and rd declined to 7%?

INPUTS 10 7 100 1000

N I/YR PV PMT FV
OUTPUT -1,210.71

Price rises above par, and bond sells

at a premium, if coupon > rd.
The bond was issued 20 years ago and now has
10 years to maturity. What would happen to its
value over time if the yield to maturity remained
at 10%, or at 13%, or at 7%?
Bond Value ($)
1,372 rd = 7%.
1,211

rd = 10%. M
1,000

837
rd = 13%.
775

30 25 20 15 10 5 0

Years remaining to Maturity

• At maturity, the value of any bond must
equal its par value.
• The value of a premium bond would
decrease to $1,000.
• The value of a discount bond would
increase to $1,000.
• A par bond stays at $1,000 if rd remains
constant.
 Valuing a Discount Bond with
Annual Coupons
• Consider a bond with a coupon rate of 10% and
coupons paid annually. The par value is $1000 and the
bond has 5 years to maturity. The yield to maturity is
11%. What is the value of the bond?
– Using the formula:
• B = PV of annuity + PV of lump sum
• B = 100[1 – 1/(1.11)5] / .11 + 1000 / (1.11)5
• B = 369.59 + 593.45 = 963.04
– Using the calculator:
• N = 5; I/Y = 11; PMT = 100; FV = 1000
• CPT PV = -963.04
 Valuing a Premium Bond with
Annual Coupons
• Suppose you are looking at a bond that has a 10%
annual coupon and a face value of $1000. There
are 20 years to maturity and the yield to maturity
is 8%. What is the price of this bond?
– Using the formula:
• B = PV of annuity + PV of lump sum
• B = 100[1 – 1/(1.08)20] / .08 + 1000 / (1.08)20
• B = 981.81 + 214.55 = 1196.36
– Using the calculator:
• N = 20; I/Y = 8; PMT = 100; FV = 1000
• CPT PV = -1196.36
• If coupon rate < rd, discount.

• If coupon rate = rd, par bond.

• If coupon rate > rd, premium.

• If rd rises, price falls.

• Price = par at maturity.

 What’s the YTM on a 10-year, 9%
annual coupon, $1,000 par value bond
that sells for $887?
0 1 9 10
rd=?
...
90 90 90
PV1 1,000
.
.
.
PV10
PVM
887 Find rd that “works”!
INPUTS 10 -887 90 1000
N I/YR PV PMT FV
OUTPUT 10.91
 Semiannual Bonds
1.Multiply years by 2 to get periods = 2n.
2.Divide nominal rate by 2 to get periodic
rate = rd/2.
3.Divide annual INT by 2 to get PMT =
INT/2.

INPUTS 2n rd/2 OK INT/2 OK

N I/YR PV PMT FV
OUTPUT
Find the value of 10-year, 10% coupon,
semiannual bond if rd = 13%.

2(10) 13/2 100/2

INPUTS 20 6.5 50 1000
N I/YR PV PMT FV
OUTPUT -834.72
 YTM with Semiannual Coupons
• Suppose a bond with a 10% coupon rate and
semiannual coupons, has a face value of $1000, 20
years to maturity and is selling for $1197.93.
– Is the YTM more or less than 10%?
– What is the semiannual coupon payment?
– How many periods are there?
– N = 40; PV = -1197.93; PMT = 50; FV = 1000; CPT
I/Y = 4% (Is this the YTM?)
– YTM = 4%*2 = 8%
 What’s interest rate (or price) risk? Does a 1-
year or 10-year 10% bond have more risk?

Interest rate risk: Rising rd causes

bond’s price to fall.

kd 1-year Change 10-year Change

5% $1,048 $1,386
+4.8% +38.6%
10% 1,000 1,000
-4.4% -25.1%
15% 956 749
 Interest Rate Risk
• Price Risk
– Change in price due to changes in interest rates
– Long-term bonds have more price risk than
short-term bonds
• Reinvestment Rate Risk
– Uncertainty concerning rates at which cash
flows can be reinvested
– Short-term bonds have more reinvestment rate
risk than long-term bonds
 Government Bonds
• Treasury Securities
– Federal government debt
– T-bills – pure discount bonds with original maturity of one
year or less
– T-notes – coupon debt with original maturity between one
and ten years
– T-bonds coupon debt with original maturity greater than
ten years
• 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
 Example 7.3
• A taxable bond has a yield of 8% and a municipal
bond has a yield of 6%
– If you are in a 40% tax bracket, which bond do you
prefer?
• 8%(1 - .4) = 4.8%
• The after-tax return on the corporate bond is 4.8%, compared
to a 6% return on the municipal
– At what tax rate would you be indifferent between the
two bonds?
• 8%(1 – T) = 6%
• T = 25%
 Zero-Coupon Bonds
• Make no periodic interest payments (coupon rate
= 0%)
• The entire yield-to-maturity comes from the
difference between the purchase price and the par
value
• Cannot sell for more than par value
• Sometimes called zeroes, or deep discount bonds
• Treasury Bills and principal only Treasury strips
are good examples of zeroes
 Floating Rate Bonds
• Coupon rate floats depending on some index value
• Examples – adjustable rate mortgages and
inflation-linked Treasuries
• There is less price risk with floating rate bonds
– The coupon floats, so it is less likely to differ
substantially from the yield-to-maturity
• Coupons may have a “collar” – the rate cannot go
above a specified “ceiling” or below a specified
“floor”
 Convertible Bonds

• Conversion ratio:
– Number of shares of stock acquired by conversion
• Conversion price:
– Bond par value / Conversion ratio
• Conversion value:
– Price per share of stock x Conversion ratio
• In-the-money versus out-the-money
 More on Convertibles
• Exchangeable bonds
– Convertible into a set number of shares of a third
company’s common stock.
• Minimum (floor) value of convertible is the
greater of:
– Straight or “intrinsic” bond value
– Conversion value
• Conversion option value
– Bondholders pay for the conversion option by
accepting a lower coupon rate on convertible bonds
versus otherwise- identical nonconvertible bonds.
 Inflation and Interest Rates
• Real rate of interest – change in purchasing
power
• Nominal rate of interest – quoted rate of
interest, change in purchasing power and
inflation
• The ex ante nominal rate of interest
includes our desired real rate of return plus
an adjustment for expected inflation
 The Fisher Effect
• The Fisher Effect defines the relationship between
real rates, nominal rates and inflation
• (1 + R) = (1 + r)(1 + h), where
– R = nominal rate
– r = real rate
– h = expected inflation rate
• Approximation
– R=r+h
 Example 7.6
• If we require a 10% real return and we expect
inflation to be 8%, what is the nominal rate?
• R = (1.1)(1.08) – 1 = .188 = 18.8%
• Approximation: R = 10% + 8% = 18%
• Because the real return and expected inflation are
relatively high, there is significant difference
between the actual Fisher Effect and the
approximation.
 Term Structure of Interest Rates
• Term structure is the relationship between time to
maturity and yields, all else equal
• It is important to recognize that we pull out the
effect of default risk, different coupons, etc.
• Yield curve – graphical representation of the term
structure
– Normal – upward-sloping, long-term yields are higher
than short-term yields
– Inverted – downward-sloping, long-term yields are
lower than short-term yields