Chapter 11: Long-Term Debt Financing

The Cost of Money

  • The Cost of Money The interest rate on a debt security is the cost of

    that capital:

    • Interest rates influence the cost of all capital


  • Four primary factors influence the general level of interest rates:

    • Investment opportunities.

    • Time preferences for consumption.

    • Risk.

    • Inflation expectations.


Common Long-Term Debt Instruments

  • Term loans

  • Bonds:

    • Treasury

    • Corporate

    • Municipal

  • Corporate bond types:

    • Mortgage bonds.

    • Debentures.

  • Public sale versus private placement


Debt Contracts

  • Debt contracts have several different names:

    • Bond indenture.

    • Loan agreement.

    • Promissory note.


  • They usually contain:

    • General provisions:

      • Maturity (when the principal must be repaid).

      • Type of debt.

      • Interest rate and type.

    • Restrictive covenants

    • Trustee designation (bond issues only)


  • Call provisions:

    • Permit the borrower to redeem (pay back) the debt prior to maturity.

    • Typically a call premium is specified.



Bond Ratings

  • Rating agencies assign debt ratings that reflect the probability of default. Here are some typical bond ratings:



Bond Rating Concepts

  • Bond rating criteria:

    • Includes both objective and subjective factors:

      • Issuer’s financial condition.

      • Competitive situation.

      • Quality of management.


  • Importance of ratings:

    • To investors.

    • To issuing businesses.


  • Changes in ratings


Interest Rate Components

  • The interest rate (required rate of return) on any debt security can be thought of a base rate plus one or more components to compensate for inflation and risk.


  • Next is the model:

    • RRF = Real risk-free (base) rate.

    • IP = Inflation premium.

    • DRP = Default risk premium.

    • LP = Liquidity premium.

    • PRP = Price risk premium.

    • CRP = Call risk premium.

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


A price risk premium would be needed.


The 4.0% wouldn’t be counted.


Bond Definitions

  • Par value - Stated face value of the bond. Generally the amount borrowed and repaid at maturity. Often $1,000 or $5,000.


  • Coupon rate - Stated interest rate on the bond. Multiply by par value to get dollar coupon payment. Usually fixed


  • Maturity date - Date when the par value will be repaid to investors. Note that the effective maturity of a bond declines each year after issue.


  • New versus seasoned bonds - When a bond is issued, its coupon rate reflects current conditions. When conditions change, the values of outstanding bonds change.


Debt Valuation

  • Why should healthcare managers worry about debt valuation?:

    • Managers must understand how investors make resource allocation decisions.


    • Cost of financing is important to good capital investment decisions.


    • Debt valuation concepts can be applied to other investments.


General Valuation Model

  • The financial value of any asset (investment) stems from the asset’s expected cash flows.

    • Thus, all assets are valued in the same way:

      • Estimate the expected cash flows.

      • Assess their riskiness.

      • Set the required rate of return.

      • Discount the cash flows and sum the present values.


Different Types of Bonds

  • At maturity, a bond’s value must equal its par value (plus final interest payment).

  • The value of a premium bond will decrease to par value at maturity

  • The value of a discount bond will increase to par value at maturity.

  • A par bond value will remain at par if interest rates remain constant.

  • The return in each year consists of an interest payment (yield) and a price change (capital gains yield).

Yield to Maturity

  • Yield to Maturity (YTM) - The expected rate of return assuming the bond is held to maturity and no default occurs.


  • Mathematically, it is the discount rate that forces the present value of the cash flows from the bond to equal the bond’s price.


Bonds Actually Have Semiannual Coupons

  • Twice as many interest payments as annual coupon payments.


  • But the interest payment is only half of the annual amount.


  • And the required rate of return is only half of the annual rate.


  • Otherwise, the valuation process is the same as for annual coupons.


Interest Rate Risk

  • Interest rates change constantly, which gives rise to two types of interest rate risk:

    • Price risk arises because bond values decline when interest rates rise.


    • Reinvestment rate risk arises because reinvested coupon (and principal) payments earn less when interest rates fall


The 10-year bond. The 10-year bond's price changes are +38.6% when rates drop to 5% and –25.1% when rates rise to 15%.

  • Longer-term bonds have more price risk (interest rate risk) because their fixed cash flows are locked in for longer, making their prices more sensitive to interest rate changes.


Does a one-year or ten-year bond have more reinvestment rate risk?:

  • Reinvestment rate risk depends both on the bond’s maturity and on the investor’s holding period (investment horizon).


  • In general, the shorter the maturity relative to the investment horizon, the greater the reinvestment rate risk.


How can interest rate risk be minimized?:

  • Long-term bonds have high price risk but low reinvestment rate risk.


  • Short-term bonds have low price risk but high reinvestment rate risk.