1. Corp Financial Theory

2. Topics Covered: * Capital Budgeting (investing) * Financing (borrowing)

3. Corp Financial Theory Topics Covered: * Capital Budgeting (investing) * Financing (borrowing) Today: Revisit Financing Debt Financing, Risk & Interest Rates

4. Debt & Interest Rates Classical Theory of Interest Rates (Economics) developed by Irving Fisher

5. Debt & Interest Rates Classical Theory of Interest Rates (Economics) developed by Irving Fisher Nominal Interest Rate = The rate you actually pay when you borrow money

6. Debt & Interest Rates Classical Theory of Interest Rates (Economics) developed by Irving Fisher Nominal Interest Rate = The rate you actually pay when you borrow money Real Interest Rate = The theoretical rate you pay when you borrow money, as determined by supply and demand Supply Demand $ Qty r Real r

7. Debt & Interest Rates Nominal r = Real r + expected inflation Real r is theoretically somewhat stable Inflation is a large variable Q: Why do we care? A: This theory allows us to understand the Term Structure of Interest Rates. Q: So What? A: The Term Structure tells us the cost of debt.

8. Term Structure Spot Rate - The actual interest rate today (t=0) Forward Rate - The interest rate, fixed today, on a loan made in the future at a fixed time. Future Rate - The spot rate that is expected in the future Yield To Maturity (YTM) - The IRR on an interest bearing instrument YTM (r) Year 1981 1987 & present 1976 1 5 10 20 30

9. Term Structure 1987 is the normal Term Structure 1981 is abnormal & dangerous to the economy (becasue there is an incentive not to invest) YTM (r) Year 1981 1987 & present 1976 1 5 10 20 30

10. Term Structure 1987 is the normal Term Structure 1981 is abnormal & dangerous to the economy (becasue there is an incentive not to invest) YTM (r) Year 1981 1987 & present 1976 1 5 10 20 30 EG. 1981 Spot Rate (nominal) = Real r + Inflation.15 = (-.05) +.20

11. Term Structure 1987 is the normal Term Structure 1981 is abnormal & dangerous to the economy (becasue there is an incentive not to invest) YTM (r) Year 1981 1987 & present 1976 1 5 10 20 30 EG. 1981 Spot Rate (nominal) = Real r + Inflation.15 = (-.05) +.20

12. Term Structure YTM (r) Year 1981 1987 & present 1976 1 5 10 20 30 EG. 1981 Spot Rate (nominal) = Real r + Inflation.15 = (-.05) +.20

13. Term Structure YTM (r) Year 1981 1987 & present 1976 1 5 10 20 30 EG. 1981 Spot Rate (nominal) = Real r + Inflation.15 = (-.05) +.20 Forward Rate (nominal) = Real r + Inflation.10 =.01 +.09

14. Term Structure YTM (r) Year 1981 1987 & present 1976 1 5 10 20 30 EG. 1981 Spot Rate (nominal) = Real r + Inflation.15 = (-.05) +.20 Forward Rate (nominal) = Real r + Inflation.10 =.01 +.09 The economy feels that the future looks much better than the present.

15. Term Structure What Determines the Shape of the TS? 1 - Unbiased Expectations Theory 2 - Liquidity Premium Theory 3 - Market Segmentation Hypothesis Term Structure & Capital Budgeting CF should be discounted using Term Structure info Since the spot rate incorporates all forward rates, then you should use the spot rate that equals the term of your project. If you believe inother theories take advantage of the arbitrage.

16. Yield To Maturity All interest bearing instruments are priced to fit the term structure This is accomplished by modifying the asset price The modified price creates a New Yield, which fits the Term Structure The new yield is called the Yield To Maturity (YTM)

17. Yield to Maturity Example A $1000 treasury bond expires in 5 years. It pays a coupon rate of 10.5%. If the market price of this bond is 107-88, what is the YTM?

18. Yield to Maturity Example A $1000 treasury bond expires in 5 years. It pays a coupon rate of 10.5%. If the market price of this bond is 107-88, what is the YTM? C0C1C2C3C4C5 -1078.801051051051051105 Calculate IRR = 8.5%

19. Debt & Risk If you have two bonds, both providing a YTM of 8.5%, do you care which one you would prefer to buy? What additional information do you need to make your decision? Why do you need this information? Duration is the tool that tells us the difference in risk between two different bonds.

20. Debt & Risk Example (Bond 1) Calculate the duration of our 10.5% bond @ 8.5% YTM YearCFPV@YTM% of Total PV% x Year

21. Debt & Risk Example (Bond 1) Calculate the duration of our 10.5% bond @ 8.5% YTM YearCFPV@YTM% of Total PV% x Year 1105 2105 3105 4105 5 1105

22. Debt & Risk Example (Bond 1) Calculate the duration of our 10.5% bond @ 8.5% YTM YearCFPV@YTM% of Total PV% x Year 110596.77 210589.19 310582.21 410575.77 5 1105734.88 1078.82

23. Debt & Risk Example (Bond 1) Calculate the duration of our 10.5% bond @ 8.5% YTM YearCFPV@YTM% of Total PV% x Year 110596.77.090 210589.19.083 310582.21.076 410575.77.070 5 1105734.88.681 1078.821.00

24. Debt & Risk Example (Bond 1) Calculate the duration of our 10.5% bond @ 8.5% YTM YearCFPV@YTM% of Total PV% x Year 110596.77.0900.090 210589.19.0830.164 310582.21.0760.227 410575.77.0700.279 5 1105734.88.6813.406 1078.821.004.166 Duration

25. Debt & Risk Example (Bond 2) Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is this bond’s duration? YearCFPV@YTM% of Total PV% x Year

26. Debt & Risk Example (Bond 2) Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is this bond’s duration? YearCFPV@YTM% of Total PV% x Year 1 90 2 90 3 90 4 90 5 1090

27. Debt & Risk Example (Bond 2) Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is this bond’s duration? YearCFPV@YTM% of Total PV% x Year 1 9082.95 2 9076.45 3 9070.46 4 9064.94 5 1090724.90 1019.70

28. Debt & Risk Example (Bond 2) Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is this bond’s duration? YearCFPV@YTM% of Total PV% x Year 1 9082.95.081 2 9076.45.075 3 9070.46.069 4 9064.94.064 5 1090724.90.711 1019.701.00

29. Debt & Risk Example (Bond 2) Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is this bond’s duration? YearCFPV@YTM% of Total PV% x Year 1 9082.95.0810.081 2 9076.45.0750.150 3 9070.46.0690.207 4 9064.94.0640.256 5 1090724.90.7113.555 1019.701.004.249 Duration

30. Debt & Risk Using the two previous examples, which bond whould you buy and why?

31. Debt & Risk Example (Bond 3) Given a 5 year, 9.0%, $1000 bond, with a 8.75% YTM, what is this bond’s duration? YearCFPV@YTM% of Total PV% x Year

32. Debt & Risk Example (Bond 3) Given a 5 year, 9.0%, $1000 bond, with a 8.75% YTM, what is this bond’s duration? YearCFPV@YTM% of Total PV% x Year 1 9082.76.0820.082 2 9076.10.0750.150 3 9069.98.0690.207 4 9064.35.0640.256 5 1090716.61.7103.550 1009.801.004.245 Duration

33. Debt & Risk Q: Given Bond 1 and its YTM of 8.5% Given Bond 3 and its YTM of 8.75% Which bond should you buy and why? A: You should purchase Bond 1 becasue it has a shorter duration.

34. Valuing Risky Bonds The risk of default changes the price of a bond and the YTM. Example We have a 5% 1 year bond. The bond is priced at par of $1000. But, there is a 20% chance the company will go into bankruptcy and only pay $500. What is the bond’s value? A:

35. Valuing Risky Bonds Example We have a 5% 1 year bond. The bond is priced at par of $1000. But, there is a 20% chance the company will go into bankruptcy and only pay $500. What is the bond’s value? A: Bond ValueProb 1,500.80= 840.00 500.20= 100.00. 940.00 = expected CF

36. Valuing Risky Bonds Example – Continued Conversely - If on top of default risk, investors require an additional 3 percent market risk premium, the price and YTM is as follows:

37. Key to Bond Ratings The highest quality bonds are rated triple-A. Investment grade bonds have to be equivalent of Baa or higher. Bonds that don’t make this cut are called “high-yield” or “junk” bonds.