Lecture 11 Flashcards
Debt finance advantages (3)
- Lower cost than equity finance (lower transaction costs/ rate of return)
- Debt holders don’t generally have votes
- Interest is tax deductible
Debt finance disadvantage (3)
- Committed to repayments and interest can be risky
- Use of secured assets for borrowing can be onerous constraint on management
- Covenants may restrict managerial action
Bonds =
Debt
Indenture =
Contract between issuer and bondholder. Includes coupon rate, maturity date and par value.
Face/ par value =
Principle repaid at maturity
Coupon rate =
Interest repayment, usually paid semi-annually
Zero-coupon bonds =
No coupon payment, sold at large discount to par value
Floating/ variable bond =
Pay variable coupon rate depending on short term interest/ inflation rates
Bonds are issued by
Governments (risk free) / companies (more risky)
Bond Interest rate =
Government interest rate for same maturity + Default risk premium
Risk premium of bond depends on
Company’s credit rating
US Treasury bonds (2)
- Purchased directly from the treasury
- Common denomination = $1000
Quoted price (flat price) doesn’t include
Interest that accrues between coupon payment dates
Invoice price =
Flat price + accrued interest
If a bond is purchased between coupon payment dates
Buyer must pay seller for accrued interest
Accrued interest calculation =
(Annual coupon payment / 2) x (Days since last coupon payment / Days separating coupon payments)
Corporate bond types (4)
- Callable
- Convertible
- Puttable
- Floating rate
Callable bonds =
Can be repurchased before maturity date
Convertible bonds =
Can be exchanged for shares in a firm’s common stock
Puttable bonds =
Gives bondholder the option to retire/ extend bond
Floating rate bond =
Adjustable coupon rate
Preferred stock > equity and fixed income characteristics (4)
- Dividends are paid in perpetuity
- Non-payment of dividends does not result in bankruptcy
- Preferred dividends are paid before common
- Non tax break (not tax deductible)
Foreign bonds =
Issued by borrower from different country to where sold
Yankee bonds =
US
Samurai bonds =
Japan
Bulldog bonds =
UK
Eurobonds =
Bonds which are denominated in one currency but sold in other national markets
Eurodollar bonds =
Dollar-denominated bonds sold outside the US
Inverse floaters =
Coupon rate falls when general interest rates rise
Double effect for inverse floaters in
Present value of money and the level of cash flows
Asset-backed bonds =
Coupon rate is tied to assets eg Walt Disney - performance of films
Catastrophe bonds =
Transfer ‘catastrophe risk’ from firm to capital markets, increased coupon rates due to increased risk
Indexed bonds =
Make payments tied to the general price index/ commodity
Price and yields have
Inverse relationship
Bond price curve is
Convex
Longer the maturity
More sensitive bond’s price is to changes in market interest rates
Yield to maturity =
Interest rate that makes the present value of a bond’s payment = price
Yield to maturity commonly interpreted as
The interest rate that measures the average rate of return earned on a bond if bought now and held until maturity (bond’s internal rate of return).
Current yield =
Annual coupon payment / Bond Price
For bonds selling at a premium
Coupon rate > Current yield > YTM
