Principles of Managerial Finance 13th Edition Gitman SM

Principles of Managerial Finance 13th Edition Gitman SM

Part 3
Valuation of Securities
Chapters in this Part
Chapter 6 Interest Rates and Bond Valuation
Chapter 7 Stock Valuation
Integrative Case 3: Encore International

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 an approximate yield formula or calculator. Students learn how interest rates may affect their ability to borrow and expand business operations or assets under personal control.
 Suggested Answers to Opener in Review Questions
a. With short-term interest rates near 0 percent in 2010, suppose the Treasury decided to replace maturing notes and bonds by issuing new Treasury bills, thus shortening the average maturity of U.S. debt outstanding. Discuss the pros and cons of this strategy.
The U.S. Treasury would face many of the same considerations as those faced by a company that is considering revision of its average debt maturity. Short-term rates are normally lower, reducing total financing costs. However, if the U.S. Treasury relies on short-term rates and short-term rates rise, the cost of financing the federal debt could end up being higher. Even more serious is the risk that the U.S. Treasury may not be able to find buyers of new Treasury bills when old Treasury bills mature. According to market segmentation theory, there is a limited amount of demand for short-term securities. Excessive short-term demand might push up the cost of seasonal business loans higher, hindering business and tax revenues.
Another concern that the U.S. Treasury would have to face is whether the financing adjustment would diminish the high regard with which Treasury bills are held. Currently, Treasury bills are as close as we can get to a risk-free rate in the real world. If the amount of short-term financing becomes excessive, the ability of the federal government to make good on its short-term repayment promises may come into question, no longer make it a “risk-free” surrogate, and increase Treasury bill rates.
b. The average maturity of outstanding U.S. Treasury debt is about 5 years. Suppose a newly issued 5-year Treasury note has a coupon rate of 2 percent and sells for par. What happens to the value of this debt if the inflation rate rises 1 percentage point, causing the yield-to-maturity on the 5-year note to jump to 3 percent shortly after it is issued?

Debt priced at par provides a coupon payment sufficient to pay the required rate of return. Hence, if the required rate of return is 2%, it must be paying $20 annually. If the discount rate increases, the coupon payment is no longer sufficient. Hence, the price would drop to create a one percent capital gain per year, leading up to $1,000 at maturity. The price would be
N  5, I  3%, PMT  $20, FV  1,000
Solve for PV  954.20
The price of the Treasury would drop $45.80, or 4.58 percent, to $954.20.
c. Assume that the “average” Treasury security outstanding has the features described in part b. If total U.S. debt is $13 trillion and an increase in inflation causes yields on Treasury securities to increase by 1 percentage point, by how much would the market value of outstanding debt fall? What does this suggest about the incentives of government policy makers to pursue policies that could lead to higher inflation?
Based on the information provided in the Opener, a few calculations can lead us to an approximation for this complex and complicated question. We are informed that $383 billion is the 2009 interest expense and that the national debt was about $12 trillion in 2009 (i.e., $13 trillion less more than $1 trillion accrued in 2009). Division of the interest payment by the total debt results in an interest rate of 3.19 percent (i.e., $383 billion  $12 trillion). Assuming the Treasuries are priced at par, one ends up with $31.90 per thousand being the annual payment needed to result in Treasuries being priced at par.
If interest rates rise by 1% to 4.19 percent, the price of the federal debt would fall to $955.71,
as computed below.
N  5, I  4.19, PMT  31.9, and FV  $1,000
Solve for PV  $955.71
The drop in Treasury values would be about 4.4 percent. This would decrease the size of the federal debt by $572 billion (0.044  $13 trillion). Hence, if one considers the size of the current federal budget deficit in isolation, there is an incentive for the government to pursue policies which will lead
to higher inflation. However, higher prices will lead to higher future costs for goods and services purchased by the government and an increase in the cost of entitlements, making proper use of interest rates to properly manage the federal budget difficult, complicated, and, alas, political.
 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 3-month U.S. 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 U.S. 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 U.S. 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 stock issue defining the rights and restrictions of the issuer and the purchaser. These can increase or reduce the risk of a security.
• Tax risk: Certain securities issued by agencies of state and local governments are exempt from federal, and in some cases state and local taxes, thereby reducing the nominal rate of interest by an amount that brings the return into line with the after-tax return on a taxable issue of similar risk.
The risks that are debt specific are default, maturity, and contractual provisions.
6. Most corporate bonds are issued in denominations of $1,000 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 jeopardize 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 shares of stock 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. Stock purchase warrants, which are sometimes included as part of a bond issue, give the holder the right to purchase a certain number of shares of common stock at a specified price.
10. Current yields are calculated by dividing the annual interest payment by the current price. Bonds
are quoted in percentage of par terms, to the thousandths place. Hence, corporate bond prices are effectively quoted in dollars and cents. A quote of 98.621 means the bond is priced at 98.621% of par, or $986.21.
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 yield.
11. Eurobonds are bonds issued by an international borrower and sold to investors in countries with currencies other than that in which the bond is denominated. For example, a dollar-denominated Eurobond issued by an American corporation can be sold to French, German, Swiss, or Japanese investors. A foreign bond, on the other hand, is issued by a foreign borrower in a host country’s capital market and denominated in the host currency. An example is a French-franc denominated bond issued in France by an English company.
12. A financial manager must understand the valuation process in order to judge the value of benefits received from stocks, bonds, and other assets in view of their risk, return, and combined impact on share value.

13. Three key inputs to the valuation process are:
a. Cash flows—the cash generated from ownership of the asset;
b. Timing—the time period(s) in which cash flows are received; and
c. Required return—the interest rate used to discount the future cash flows to a PV. The selection of the required return allows the level of risk to be adjusted; the higher the risk, the higher the required return (discount rate).
14. The valuation process applies to assets that provide an intermittent cash flow or even a single cash flow over any time period.
15. The value of any asset is the PV of future cash flows expected from the asset over the relevant time period. The three key inputs in the valuation process are cash flows, the required rate of return, and the timing of cash flows. The equation for value is:

where:
V0  value of the asset at time zero
CF1  cash flow expected at the end of year t
r  appropriate required return (discount rate)
n  relevant time period
16. The basic bond valuation equation for a bond that pays annual interest is:

where:
V0  value of a bond that pays annual interest
I  interest
n  years to maturity
M  dollar par value
rd  required return on the bond
To find the value of bonds paying interest semiannually, the basic bond valuation equation is adjusted as follows to account for the more frequent payment of interest:
a. The annual interest must be converted to semiannual interest by dividing by two.
b. The number of years to maturity must be multiplied by two.
c. The required return must be converted to a semiannual rate by dividing it by two.