Ch. 11 Long-term debt financing

What is the “price” of debt capital

interest rate

What four factors affect the cost of money

• Investment opportunities

• Time preferences

• Risk

• Inflation

Describe term loan

contract where the borrower agrees to make a series of interest payments on specific dates to a lender typically obtained through commercial banks

Describe bonds

long term debt issued by businesses or government agencies that is generally sold to a large # of individuals

Describe first mortgage bond

bond issued by a business that pledges real property (lands & buildings) as collateral

Describe junior mortgage

second mortgage taken out using house as collateral while you still have another loan secured by house

Describe debenture

unsecured bond, no assets are pledged as security or collateral

Describe muncipal bond

tax-exempt bond issued by governmental agencies other than the federal gov

What is private placement?

company shares bond to only pre-selected investors and institutions

What is public placement?

company issues bonds to public at large

What are the key differences between private placement and public placement?

• private: higher interest rate, not open to review

• public: higher administrative costs, open to review

What is the purpose of a bond pool?

• raise funds for smaller companies/hospitals by issuing municipal bonds that are loaned to NFPs, gives smaller hospitals a chance at issuing bonds

• only have to pay administrative cost 1x

Describe bond indenture

legal contract spells out the rights and obligations of both bondholders

• typically include restrictive covenants

Describe restrictive covenant

provisions designed to protect bondholders against detrimental managerial actions

Describe trustee

represents bondholders and ensures the terms of the indenture are being carried out

Call provision

gives issues the right to call off a bond prior to maturity and pay it in full to redeem the issue for a better interest rate

What is a technical default?

if any party violates any of the restrictive covenants

What is a regular default?

When interest or principal payments are not made on time

What impact does a call provision have on an issuers interest rate?

bonds are called off when interest rate decreases, because issuer can replace the old rate with a new one that pays out less to bondholders

What are the 3 major bond rating agencies

• fitch ratings

• Moody’s

• Standard & Poor’s ratings

What are some criteria that rating agencies use when assigning ratings?

based on quality management and quantitative factors (businesses financial strength)

What is the grading scale on bond ratings?

• Prime (AAA)

• Excellent (AA)

• Upper Medium (A)

• Lower medium (BBB)

• Speculative (BB)

• Very speculative (B)

• Default (D)

How do bond ratings affect the cost of debt to the issuing firm?

the higher the bond rating, the greater the probability of recovering bondholder capital if default should occur, the lower its interest rate

What does RRF stand for?

real risk free rate

What does IP stand for?

inflation premium

What does DRP stand for?

default risk premium

What does LP stand for?

Liquidity premium

What does PRP stand for?

Price risk premium

What does CRP stand for?

call risk premium

What is the difference between RRF and RF rate?

• RRF: rate investors demand that is totally riskless with no inflation

• RF: a combo of RRF & inflation premium, but does not incorporate risk factors

Do the interest rates on treasury securities include a default risk premium? A liquidity premium? A price risk premium?

• Default risk- NO

• Liquidity premium- added to base interest rate

• Price-Risk Premium- added to base rate

Why are callable bonds riskier for investors than similar bonds without a call provision?

callable bonds have uncertain maturities, so a call risk premium is added to compensate for bearing a call risk

What is price risk? What type of debt securities would have the largest price-risk premium?

• Price risk = risk that rising interest rates will lower values of outstanding debt

• Debt securities with higher or uncertain interest rates have the largest price risk premium.

What is the general valuation model?

Model that

• (1) Estimates expected cash flow streams

• (2) Assesses riskiness of streams’

• (3) Sets required rate of return

• (4) Discounts and sums cash flows

How are bonds valued?

net present value of all coupons obtained over the bond holding time

What is meant by a bond’s yield to maturity?

its expected rate of return on a bond, assuming its held to maturity

What is meant by a bonds yield to call?

Expected rate of return on bond assuming it will be called and assuming the probability of default will be 0

Differentiate between price risk + investment rate risk

Price risk: interest rates can increase at any time, where bondholders face the risk of losses on their holdings

Reinvestment rate risk: If interest rates drop, bondholders will earn lower rates on reinvestment CF, which will negatively impact the future value of the holdings

what two forms does capital come in?

• debt capital

• equity (fund) capital

what four fundamental factors affect the cost of money?

• investment opportunities

• time preferences for consumption

• risk

• inflation

what are term loans and bonds?

long-term debt contracts under which a borrower agrees to make a series of interest and principal payments on specific dates to the lender

What is the difference between whom term loans and bonds are sold to?

term loans- sold to one or few investors

bonds- offered to the public and sold to many

What categories can debt fall into?

• Treasury

• Corporate

• Municipal

What is treasury debt?

debt issued by the federal government

What is corporate debt?

debt issued by taxable businesses

What is municipal debt?

debt issued by nonfederal government entities, including debt issued on behalf of NFP healthcare providers

What are revenue bonds

municipal bonds in which the revenues derived from such projects as roads or bridges, airports, water and sewage systems, and NFP healthcare facilities are pledged as security for bonds

What does bond default mean?

occurs when the bond issuer fails to make interest or principal payments within the specified period. A bond issuer may default when it has run out of cash to pay bondholders.

What is a bonds value?

PV oof expected cash flow stream