Module 5 - Interest Rates and Bond Valuation Flashcards
It is usually applied to debt instruments such as bank loans or bonds
Interest rate
it is the compensation paid by the borrower of funds to the lender
interest rate
it is usually applied to equity instruments such as common stock
required return
the cost of funds obtained by selling an ownership interest
required return
the cost of funds obtained by selling an ownershp interest
required return
a company that plans a plant expansion can obtain financing either through:
debt or equity
if the company issues bonds, they would have to pay the creditors the principal at a specified time
obtain financing through debt
some companies raise capital through the issuance of shares
cimpanies obtaining financing through equity
it is money lent at an interest rate for a certain period of time
Loan
Content of a Loan Agreement: part of legal documentation. intended to protect investors by providing assurance on what the borrower will do or won’t do over the life of the bond
Covenants
Content of a Loan Agreement: Pledge agreement, security agreement
Collateral
Content of a Loan Agreement: Lump sum, semi-annual, monthly, etc.
Term of loan
Content of a Loan Agreement: Provision in most loan and insurance contracts which allows payment to be received for a certain period of time after the actual due date
Grace Period
Content of a Loan Agreement: during this period, no late fees will be charged, and the late payment will not result in default or cancellation of the loan
Grace Period
also a form of loan but can be traded through PDEX
Bond
PDEX
Philippine Dealing and Exchange (PDEX) System
True or False: the cost of equity is generally higher than the cost of debt.
True
why is the cost of equity generally higher than the cost of debt
since equity investors take on more risk when purchasing a company’s stock as opposed to a company’s bond. therefore, an equity investor will demand higher returns
Factors that influence the Equilibrium interest rate (3)
- Inflation
- Risk
- Liquidity preference
Factor the influence EIR: rising trend in the prices of most goods and services, investors would demand higher returns to compensate for decreased purchasing power
Inflation
Factor the influence EIR: Higher __ lead investors to expect a higher return on investment.
Risk
Factor the influence EIR: General tendency of investors to prefer short-term securities because they are more liquid and involve relatively lower risk
Liquidity Preference
The rate that creates equilibrium between the supply of savings and the demand for investment funds in a perfect world
real rate of interest
represents the most basic cost of money, changes with changing economic conditions, tastes, and preferences
real rate of interest
the actual rate of interest charged by the supplier of funds and paid by the demander
nominal interest rate
also known as actual interest rate
nominal interest rate
the nominal rate differs from the real rate of interest as a result of two factors:
- inflation premium
2. risk premium
the ____ rate embodies the real rate of interest plus the expected inflation premium
risk-free rate
the relationship between the maturity and rate of return for bonds with similar levels of risk
term structure of interest rates
the term structure of interest rates is depicted graphically in a:
yield curve
tells analysts how rates vary between short, medium, and long-term bonds. also provides information on where interest rates and the economy are headed in the future
yield curve (term structure of interest rates)
determined by the equilibrium between supplier and demanders of short-term funds
short-term interest rates
determined by the equilibrium between supplier and demanders of long-term funds
long-term interest rate
an upward sloping yield curve that indicates that long-term interest rates are generally higher than short-term interest rates
normal yield curve
a downward sloping yield curve that indicates that short-term interest rates are generally higher than long-term interest rates.
inverted yield curve
a yield curve that indicates that interest rates do not vary much at different maturities
flat yield curve
three theories that are frequently cited to explain the general shape of the yield curve
- expectations theory
- liquidity preference theory
- market segmentation theory
theory that the yield curve reflects investor expectations about future interest rates
expectations theory
expectations theory: an expectation of rising interest rates results in ____ sloping yield curve; an expectation of declining rates result in ____ sloping yield curve
upward; downward
a theory that suggests that long term rates are generally higher than short-term rates because investors perceive short-term investments to be more liquid and less risky than long-term investments
Liquidity Preference Theory
this theory is n explanation for the upward-sloping yield curve
liquidity preference theory
in liquidity preference theory, Investors generally prefer to buy _____ securities, while issuers/borrowers prefer to sell _____ securities (longer time to pay for debt)
short-term, long-term securities
this theory suggests that the market for loans is totally segmented on the basis of maturity and that the supply of and demand for loans within each segment determine its prevailing interest rate
market segmentation theory
in market segmentation theory, this curve indicates greater borrowing demand relative to the supply of funds in the long-term segment of the debt market relative to the short-term segment
upward-sloping yield curve
to calculate the risk premium of other securities
subtract Treasury bond (risk-free rate) to other securities
the possibility that the issuer will not pay the contractual interest or principal as scheduled
default risk
the longer the maturity, the more the value of a security will change in response to a given change in interest rates
Maturity (interest rate) risk
conditions that are often included in a debt agreement or a stock issue
contractual provisions
corporate bonds: amount borrowed by the company and amount owed to the bondholder on the maturity date
par (face) value
corporate bonds: time at which a bond becomes due and the principal mus be repaid
maturity date
corporate bonds: percentage of a bond’s par value that will be paid annually, typically in two equal semiannual payments, as interest
coupon rate
long-term debt instrument indicating that a corporation has borrowed a certain amount of money and promises to repay it n the future under clearly defined terms
corporate bond
two legal aspects of corporate bonds
standard debt provisions and restrictive covenants
legal aspect of corporate bonds: specify certain record-keeping and general business practice that the bond issuer must follow
Standard Debt Provisions
corporate bonds: normally include restrictive covenants, place operating and financial constraints on the borrower
Restrictive Covenants
a legal document that specifies both the rights of the bondholders and the duties of the issuing corporation
bond indenture
most common restrictive covenants: (6)
require minimum liquidity level
- prohibit sale of accounts receivable
- impose fixed-asset restrictions
- constrain subsequent borrowing
- limit annual cash dividend payments
cost of bonds to issuer: the longer the bond’s maturity, the ____ he interest rate to the firm
maturity
cost of bonds to issuer: the larger the size of the offering, the ___ will be the cost of the bond
lower
cost of bonds to issuer: the greater the default risk of the issuing firm, the ___ the cost of the issue
default risk
cost of bonds to issuer: the cost of money in the capital market is the basis for determining a bond’s __________ rate
coupon interest rate
the rate of interest paid by the bond issuer
cost of bonds to issuer
general features of a bond issue: (3)
- conversion feature
- call feature
- stock purchase warrants
general features of a bond issue: allows bondholders to change each bond into a stated number of shares of common stock
COnversion feture
general features of a bond issue: call feature
gives the issuer the opportunity to repurchase bonds prior to maturity
general features of a bond issue: gives holders the right to buy a certain number of shares of the issuer’s common stock
Stock purchase warrants
when the amount by which a bond’s call price exceeds its par value, it is equal to one-year coupon interest and compensates the holder for having it called prior to maturity.
call premium
three most widely cited yields: (3)
- current yield
- yieldto maturity
- yield to call
bond yields: a measure of a bond’s cash return for the year; interest payment divided by the current price
current yield
bond yields: compound annual rate of return earned on a debt security purchased on a given day and held to maturity
Yield to maturity
bond yields: yield of the bond if you were to buy and hold the security until call date
Yield to call
___ yield: typically involves equity market, dividend income, and stock price
Current yield
_____ typically involves the bond market, coupon payment, and price vs. face value
Yield to Maturity
assess the riskiness of publicly traded bond issues
Independent rating agencies
evaluate and attach ratings to credit instrumnts
Cret-rating agencies
Types of Bonds - Unsecured: (3)
- Debenture
- Subordinated debenture
- Income bonds
Types of Bonds - Unsecured: bonds that only creditworthy firms can issue; claims are the same as those of any general creditor
Debenture
Types of Bonds - Unsecured: claims are not paid until senior debts have been fully satisfied; claim is that of a general creditor but not as good as a senior debt claim
Subordinate debenture
Types of Bonds - Unsecured: payment of interest is required only when earnings are available; claim is that of a general creditor
Income bonds
Types of Bonds - Secured (3):
- mortgage bonds
- collateral trust bonds
- equipment trust certificates
Types of Bonds - Secured: secured by real estate or buildings; claim is on proceeds from sale of mortgaged assets
Mortgage bonds
Types of Bonds - Secured: secured by stock and/or bonds; claim is on proceeds from stock and/or bond collateral
collateral trust bonds
Types of Bonds - Secured: used to finance rolling stock”; claim is on proceeds from the sale of the asset
Equipment trust certificates
process that links risk and return to determine the worth of an asset
Bond valuation
three key inputs to the valuation process
- cash flows (returns)
- timing
- a measure of risk, which determines the required return
in general, the greater the risk of (or the less certain a cash flow, the _____ its value.
lower
the higher the risk, the ____the required return, and the lower the risk, the _____ the required return
higher, lower
the value of any asset is the _____ value of all future cash flows it is expected to provide over the relevant time period
present
it is equal to the cash flows (CF) expected at the end of year n
Future Value
true or false: the bond price would be the present value of cash flows, the payments the issuer is contractually obligated to make until maturity which would include the interest payments and the principal
true
contract rate > market rate
bond sells at a premium
contract rate = market rate
bond sells at par
contract rate < market rate
bond sells at discount
contract rate is sometimes called:
coupon rate, stated rate, and nominal rate
increase in the basic ost of long-term funds o in in risk will ____ the required return; decreases in cost of funds or in risk will _____ the required return
raise, lower
