FIN 3701- Chapter3 :Debt Valuation and Interest rate “This is time to unlock your true power” Assumption University of Thailand Hillary Clinton Debt Valuation and Chapter 3 FIN3701 Interest rate Corporate Debt Valuation Finance and Interest rate Dr. Chainarin Srinutchasart Source: http://www.prachachat.net/ 1 2 In this chapter, you will learn Principles Applied in This Chapter • The features of bonds • Principle 1: Money Has a Time Value. • Types of bond. • How to calculate intrinsic value of bonds. • Principle 2: There is a Risk-Return • Yield to Maturity, Yield to Call, Realized Tradeoff. Yield and Current Yield. • The risks of bond investing and issuing. • Principle 3: Cash Flows Are the Source of Value 3 4 Corporate Finance addresses the How to grow up a firm following 3 questions: Net DIV payout Income or 1. What long-term investments should the firm Share Repurchase engage in? Use retained earnings 2. How can the firm raise money for the Make tender offers Or Open market Or pay off some debt required investments? (Alternatives: Bonds, or doing nothing Stocks, Preferred Stocks=what is the Growth = increase the size of assets appropriate price?) Internal Growth vs. 3. How much short-term cash flow does a External growth company need to pay its bills? and how to Borrow money from banks (private debt), raise it Issue Bond(public debt), Issue Common/Preferred Stocks 5 6 1 FIN 3701- Chapter3 :Debt Valuation and Interest rate Corporate Borrowings Corporate Borrowings (cont.) • There are two main sources of borrowing • Smaller firms choose to raise money from for a corporation (External Growth): banks in the form of loans because of the high costs associated with issuing bonds (smaller firm higher risk). • Loan from a financial institution such as banks (known as private debt) • Larger firms generally raise money from banks for short-term needs and depend • Bonds (known as public debt since on the bond market for long-term they can be traded in public financial markets> bond markets) financing needs. 7 8 Borrowing Money in the Private Borrowing Money in the Private Financial Market Financial Market (Cont.) • Financial Institutions are an important • In the private financial market, loans are source of capital for corporations. The typically floating rate loans i.e. the loan might be used to finance firm’s day- interest rate is periodically adjusted based to-day operations or it might be used for on a specific benchmark rate. the purchase of equipment or property. • Such loans are considered private • The most popular benchmark rate is the market transactions since it only London Interbank Offered Rate involves the two parties to the loan. (LIBOR) 9 10 Borrowing Money in the Private Checkpoint Financial Market (Cont.) STEP 1: Picture the problem We can envision the problem solution by looking at a graph of the ceiling rate, the floor rate, and LIBOR plus the spread • A typical floating rate loan will specify the of 25 basis points. The rate of interest on the floating rate following: loan is based on LIBOR plus the spread but can never exceed the ceiling rate of 2.5%, nor can it ever drop below the floor • The spread or margin between the loan rate of 1.75%. rate and the benchmark rate expressed as basis points. • A maximum and a minimum annual rate, to which the rate can adjust, called the ceiling and floor. • A maturity date • Collateral 11 12 2 FIN 3701- Chapter3 :Debt Valuation and Interest rate The Balance-Sheet Model of the Firm The Capital Structure Decision (Ch. 12, 15, 18) (Financing Decision) Current Liabilities Current Assets How can the Features of bonds This firm raise Long-Term Debt ch. the money Fixed Assets for the required 1 Tangible investments? Shareholders’ 2 Intangible Equity 13 14 What is a bond? Characteristics of Bonds • A long-term contract under which a borrower • Bonds pay fixed coupon (interest) (issuer) agrees to make payments of interest payments at fixed intervals (usually every and principal, on specific dates, to the holders six months) and pay the par value at of the bond (investors) maturity $I $I $I $I $I $I+$M 0 1 2 . n Source: http://pds.exblog.jp/ 15 16 What is a bond? (cont.) The major constituents of a bond consists of: • The issuer is obligated to pay the lenders/investors periodic coupon payments 1. Issuer – the issuing organization can be until the stated maturity. Thus, bond investor either a government-related body or a has the claim of the future cash flows from private entity. Issuer is the one who needs holding the bond. the additional capital, and thus is the • The information regarding the periodic borrower of the proceeds. Issuer is interest rates, frequency of the coupon obligated to pay the future cash flows in payments, term to maturity, par term of interest payments and repay the value of the bond, redemption value of the principal at the maturity of the issue. bond and any other provisions are all stated in the prospectus when a bond is issued. a.k.a. indenture 17 18 3 FIN 3701- Chapter3 :Debt Valuation and Interest rate The major constituents of a bond The major constituents of a bond consists of: (Cont.) consists of: (Cont.) 2. Type of bond – the specification of each 3. Term to maturity – the total amount of time bond is clearly identified in its prospectus between when a bond is issued and when when the bond is issued. There are many the same bond matures. varieties of bond that can be customized to the specific needs of the issuer. Some of the 4. Issue Date – the official issue date of the examples of bond that can be issued are bond. It is also the date in which the coupon straight bond, zero-coupon bond, step- interest starts to accumulate. up coupon bond, amortizing bond, convertible bond, bond issued with warrant, etc. 19 20 The major constituents of a bond The major constituents of a bond consists of: (Cont.) consists of: (Cont.) 5. Maturity Date – the date on which a debt 6. Par Value – par value is the promised becomes due for a completion of its interest amount repaid to investors by the issuer at payment and repayment of the principal. It maturity. Par value is sometimes referred to is simply the date in which the borrower as face value or redemption value of the must pay back the money they have bond. Bonds issued in Thailand generally borrowed through the issue of a bond. have a par value of 1,000 Baht. Investors don’t need to buy at PAR value 21 22 The major constituents of a bond The major constituents of a bond consists of: (Cont.) consists of: (Cont.) 7. Coupon Rate – the periodic interest 8. Payment Frequency – is the number of the payment on a bond is called “coupon”. It is coupon or interest payments, often on an the committed cash flow the issuer pays to annual basis. For example, a bond that is an investor. The coupon rate is then the quoted to have a frequency of 4 means the stated percentage rate of interest in which bond will pay interest payment on a the coupon payments will be determined. quarterly basis. (% of Par value) 23 24 4 FIN 3701- Chapter3 :Debt Valuation and Interest rate The major constituents of a bond AAA consists of: (Cont.) Highest rating. Issuer’s capacity to repay interest and principal is excellent. 9. Issue Rating – Securities and Exchange AA Commission, Thailand (SEC) sets the credit Very strong capacity to repay principal and interest. rating rules required for every bond issued and sold in Thailand. There are A two credit rating agencies in Thailand, Strong capacity to repay principal and interest. May Fitch and TRIS. The ratings are based on be susceptible to adverse changes in economic evaluation of an issuer’s financial strength conditions. to meet its payment obligations. Ratings BBB range between AAA to D, whereas any ratings above BBB are considered Adequate capacity to repay principal and interest. investment grade. Adverse economic conditions will likely lead to erosion in ability to pay. 25 26 Based on TIE ratio (EBIT/interest) BB BOND RATINGS2 Little near-term weakness but faces major ongoing Rating Agency uncertainties or exposure to adverse business, Moody’s Standard & Investment Quality Description financial, or economic conditions that could lead to Poor’s inadequate capacity to repay principal and interest. Aaa AAA Highest grade Very strong capacity to pay interest B and principal. Aa AA High grade Strong capacity to pay Currently has the ability to pay principal and interest. A A Medium Quality Bond is more susceptible to adverse changes. Poor economic or business conditions would likely Baa BBB impair the ability to repay principal and interest. Ba, B BB,B Low Quality Highly speculative in their ability to C meet interest and Ca, C CC,C Speculative principal obligations This rating is applied to debt that is subordinated to “Junk bonds”3 D D In default Interest and/or repayment are in senior debt that has been assigned a CCC rating. arrears. D Note: At times, both agencies use adjustments; S&P uses "+" or "-" to Debt is currently in default. indicated strength or weakness. Moody's uses 1,2, or 3, with 1 being the highest. 27 28 DEBT MARKET PRIMARY MARKET $ Issuer/Borrower Promised CFs Lender 1/ Buyer 1 “certificate” of ownership SECONDARY MARKET: Lender 1 sells bond to buyer 2 Issuer/Borrower Promised CFs Lender 2/ Buyer 2 market value of “certificate” bond ($) of ownership Lender 1/ Buyer 1 Source: http://slideplayer.es/ 29 30 5 FIN 3701- Chapter3 :Debt Valuation and Interest rate Secondary Market of Bonds Characteristics of Bonds • Bonds pay fixed coupon (interest) payments at fixed intervals (usually every six months) and pay the par value at maturity.