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Accounting 9313 Final > Ch. 11 Long-term Debt Financing > Flashcards

Ch. 11 Long-term Debt Financing Flashcards

1
Q

Capial:

  • Debt
    • Provided by creditors
  • Equity:
    • Capital provided by owners of invertor-owned businesses (i.e. Stock holders)
    • Fund Capital: Not-for-profit businesses (grants, contributions, retained earnings)
    • AKA: Nonliability capital
A
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2
Q

Interest Rate: Price to obtain debt capital

Dividends and Capital gains / losses: Price to obtain equity capital

4 Factors that affect the supply and demand of investment capital:

  1. Investment Opportunities
  2. Time preferences for consumption
  3. Risk
  4. Inflation
A
  1. Investment Opportunities: The higher the profitability of the business, the higher the interest rate that the borrower will agree to pay
  2. Time preferences for consumption: Low time preference lenders (don’t need the mony in the short term) will charge a low interest rate. High time preference lnders (can use the money in the short term) will charge a high interst rate
  3. Risk: The higher the risk, the higher the interst rate
  4. inflation: The higher the expected rate of inflation the higher the interest rate
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3
Q

Long term Loans

(Term loans): Borrower agrees to make a series of interest and principal payments on specified dates (amortized)

Advantages:

  • Speed
  • Flexibility
  • low administrative costs

Fixed Rate: The rate used will be close to the rate on equivalent maturity bonds issued by businesses of comparable risk

Variable Risk: Pegged at a few percentage points above an index rate such as prime rate

A

Potential disadvantages:

  1. Limit to the size of a term loan
  2. Lenders typically will not extend term loans to the maturity that businesses can attain in a bond financing.
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4
Q

Bond

Borrower agrees to make a series of interest payments on specified dates (amortized)

Entire amount of principal returned to lenders at maturity

Denominations of $1,000 or $5,000

Catagorized as either government (treasury), Corporate, or municipal

Fixed Interest rate

Zero Coupon bond: Do not pay any interest but are sold at a substantial discount from face vlue

A
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5
Q

Mortgage Bond:

The issuer pledges certain real assets as security for the bond. (i.e. mortgage on a hospital)

Debenture

  • Backed by the revenue producing power of the corporation
  • Carry a high interest rate

Municipal Bonds (muni)

Long-term (non federal) debt obligations issued by states and their political subdivisions to finance capital projects (buildings and equipment)

Short-term munis used to meet temporary cash needs

A

Types of Municipal Bonds

  • General Obligation bonds: secured by the taxing authority of the issuer
  • Special Tax bonds: Secured by specified tax (ex: Tax on utility services)
  • Revenue Bonds: Secured by revenue derived from projects (ex: roads / bridges)
    • Not-for-profit healthcare providers issue large amounts of municipal debt

Floating Rate: Riskier to the issuer / less risky for buyers

Call provision: Replace floating rate bonds with fixed rate bonds

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6
Q

Private Placement: The sale of newly issued securities to a single investor or a small group of investors

Indenture / Promissory note

Restrictive Covenants: Retricts the actions of managers: Ex: a designated current ratio (current assests / current liabilities) to 2.0 i.e. Current assets are twice as large as current liabilities

Call Provisions: The right of the issuer to call a bond for redemption prior to maturity:

  • The issuer must pay an amount greater (call premium) than the initial amount borrowed to redeem the bond.
A

Deferred Call: A period of call protection offered to investors of callable bonds

Refudnding: Should the issuer call the bonds and reissue in the event of a drop in interest rates? Have to consider administrative costs of reissuing as compared to benefits of lower future interest payments

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7
Q

Interest Rate

Investor’s Compensation for time vlaue, inflation, risk.

Rate of Return (Interest Rate) required by investors

**Real Risk Free Rate: **

The rate of interest on a riskless investment in the absence of infaltion.

  • Considers the time value of money only
  • Somewhere in the range of 2% - 4%

Inflation Premium

  • Built into the interest rate that is equal to the expected average rate of inflation over the life of the security
A

Real Risk Free Rate (RRF) + Inflation Premium (IP) =

Risk Free Rate (RF)

Default Risk Premium

Premium to take into account the posibility that a issuer will default on a payment

Liquidity Premium

Premium added to the base interest rate to compensate for lack of liquidity

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8
Q

Price Risk Premium

Price (Market value) of a long-term bond declines sharply when interest rates rise.

Price Risk Premium: The risk that rising interest rates will lower the values of outstanding debt

***Price Risk of any bond grows as the maturity of the bond lengthens. **

Price Risk Premium: Directly tied to the term to maturity

  • Raise Interest rates on long-term bonds relative to those on shrot-term bonds
A

Call Risk Premium

  • Carry an uncertain maturity
  • Reinvest Call proceeds at a lower interest rate
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9
Q

Combining the Components

Interest Rate = RRF + IP + DRP + LP + PRP + CRP

RRF = Real Risk Free Premium

IP = Inflation Premium

DRP = Default Risk Premium

LP = Liquidity Premium

PRP = Price Riks Premium

CRP = Call Risk Premium

A
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10
Q

Term Structure

  • The relationship between long and short term rates.
  • The relationship between yield to maturity and term to maturity for debt of a single risk class. Ex: Treasury securities

Yield Curve:

  • Upword sloping curve would be expected if the inflation premium is relatively constant across all maturities becuase price risk premium of long-term issues will push long-term rates above short-term rates
A
  • Use Yield curves to help make decisions regarding debt maturities.

Sound Financial Policy

  • Calls for a mix of long-term and short-term debt as well as equity.
  • Must try to match the maturities of assests with maturities of debt financing
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11
Q

The general Level of Interest rates is influenced by 3 factors:

  1. Federal Reserve Policy
  2. Federal Budgetary Policy
  3. The overall level of economic activity

Federal Reserve Policy

  • Money Supply:
  • Typically the impact of Fed’s actions on short-term rates is much greater than on long-term rates
A

Federal Budgetary Policy

  • If the Federal gov’t spends more than it receives in tax revenue, the deficit is covered by borrowing
  • Increases the demand for debt capital
  • Raises general level of interest rates

Level of Economic Activity

  • More impact on short term rates
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12
Q

Debt Valuation

General Valuation Model

  1. Estimate the expected Cash Flow Stream:
    * Estimate the expected cash flow in each period during the life of the asset.
  2. Assess the riskiness of the stream:
  • Cash flows of most assets are not known but are best represented by probability distributions
  • The more uncertain these distributions, the greater the riskiness of the cash flows
A
  1. Set the Required Rate of Return:
    * Based on the streams’s riskiness and the returns available on alternative investments of similar risk (Opportunity cost)
  2. Discount and Sum the expected cash flows:
    * Discounted at the assets riquired rate of return
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13
Q

Par Value: Stated (face) value of the bond. Often $1,000 or $5,000. Amount of money the business borrows per bond.

Maturity Date: The Date when the par value will be repaid

  • The effective maturity of a bond declines each year after it is issued

Coupon Rate: Rate used to calculate the specific amount of interest each period

  • Used to determine a bonds value. The higher the coupon payment the higher its vlaue
A

New Issue vs. Outstanding bond:

  • At the time a bond is issued, its coupon rate is generally set at a level that will cause the bond to sell at its par value

Debt Service requirements

  • Interest payments and repayment of principal
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14
Q

**Basic Bond Valuation **

Bond = An annuity + lump sum

Bond Value = Present value of its cash flow stream

Current Yield = Value of 1 PMT / Price

Capital Gains Yield = Ppurchased - Psold/ Ppurchased

Total Rate of Return = Current Yield - Capital gains yield

A

Rule of Thumb

  1. When the required rate of return on a bond = its coupon rate, the bond will sell at par
  2. When interest rates and required rates of return fall after a bond is issued, the bond’s value rises above par selling at a Premium
  3. When the interest rates and required rates of return rise after a bond is issued, the bond’t value falls below par selling at a discount
  4. The price of a bond will always approach par value as it approaches its maturity date
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15
Q

**Yield to Maturity **

  • Expected Rate of Return on a bond assuming it is held to maturity
  • For a bond that sells at Par: The YTM consists entirely of interest yield
  • For a bond that sells at a discount or a premium: YTM consists of the current yield + / - capital gains yields

Callable Bonds

  • Both a YTM / Yield to Call
  • Yield to Call (YTC): Expected rate of return on the bond assuming it will be called (N = the number of years until the bond will be called)
A

Semiannual Compounding

  1. PMT / 2
  2. N x 2
  3. Required Rate of return / 2
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16
Q

Interest Rate Risk: Two Components

Increase in interest rate leades to a decline in the value of outstanding bonds

  1. Price Risk: Risk related to an increase in interests rates leading to losses on holdings
  • Depends on the maturity of the Bonds
  • The longer the maturity the more susceptible the bond to price risk
A

Reinvestment Rate risk: If interest rates fall, bondholders will earn a lower rate on the reinvested cash flows

Interest Rare Risk can be mitigated by matching the investor’s investment horizon (holding period)

Accounting 9313 Final (10 decks)

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