FINANCE I

1
Lecture 5

• FINANCE I

2
Lecture Objectives

• 1. Long term and short term debt
• 2. Identify cashflows in a bond
• 3. Value bond
• 4. Yield curve

3
Debt as a Sourceof Funds

• Debt - Contractual claim on the firm
• Fixed periodic interest payment
• - Usually a fixed principal repayment to
  retire the loan

4
Short-Term Debt

• Bank overdraft
• Overdraw on current account
• Usually an upper limit on overdraft
• Inter-company Loans
• Direct lending between firms
• Commercial Bills
• Short-term loan than is usually endorsedby a
  third party
• Promissory Notes
• One-name paper that do not require thirdparty
  endorsement
• Trade credit
• Deferred payment for good and services

5
Long-Term Debt

• Term loans and mortgage loans
• Mortgage against property
• Fully drawn advances
• Like an overdraft facility but fora longer
  period, usually five years
• Leases
• Contract between lessor and lessee forperiodic
  payment for use of asset
• Debentures
• Entails a fixed interest payment and aprincipal
  payment to discharge the debt.
• Debt is secured against the issuers asset

6
How to Issue Debentures

• Public issue
• Issued to public through a prospectus
• Family issue
• Issued to equity, debenture and debtholders
• Private placement
• Issued to institutional investors

7
Bond/Debenture

• Long term loan
• Issued by government and corporation
• Cashflows provided by bonds
• Coupon fixed repayment on the loan based on a
  percentage of the face value

8
Bond/Debenture

• Face value
• Also called par value or maturity value. The
  principle value that is repaid when the bond is
  retired.
• Maturity date
• Date at which the bond expires

9
Bond/Debenture

• JANUARY 2005 - Maturity Date
• - A 5 yr Bond
• BHP - Organisation responsible for the
  interest and maturity payouts
• 100,000 - Amount to be received on
  Maturity - FACE VALUE
• Coupon _at_ 10 - Interest paid per year
• - ie 10,000

10
Bond/Debenture

• Cashflow provided by such a bond
• Bonds are discount instruments
• ie their value is the discounted value
• Value is determined by discounting all expected
  coupons and maturity payouts by an appropriate
  discount rate Rb(or i)

11
Bond/Debenture
12
Bond/Debenture

• The discount rate that we use is the market rate
  or yield. If the yield on the bond is 8 what is
  the price of the bond?
• Can you think of another wayof working out the
  answer?

13
Example 1

• A 10-year government bond offers a coupon rate of
  10 per annum. What is the price of the bond if
  the yield on the bond is 12 per annum and the
  face value is 1000.
• What happens as if the yield falls to 8?
• What happens if the yield rises to 14?

14
Bond/Debenture

• As observed from the above example
• There is an inverse relationship between the
  discount rate and the price.
• The discount rate is market driven
• it varies according to the supply and demand for
  bonds

15
Bond/Debenture

• Note - If the Coupon Rate and Kb are the same -
  ie 10
• Price of the Bond its Face Value 1000
• If C.R Kd If C.R gt Kd
• 10 10 10 gt 8
• Then PV FV Then PV gt FV
• 1134.2 gt 1000
• If C.R lt Kd
• 10 lt 14
• Then PV lt FV
• 791.4 lt 1000

16
Example 2

• What if the bond above is paying semi-annual
  coupons. What is the price if the yield is 12
  p.a.?

17
Bond/Debenture

• Yield to maturity Discount rate that equates
  the present value of the cashflows to its price.
• - the return one gets if holds the bond
  until the day it matures.
• - it is equivalent to IRR

18
Example 3

• A 100, 3-year bond is currently trading at
  108.5. If the coupon rate is 12 paid annually,
  what is the current yield, and what is the yield
  to maturity?

19
Example 4

• (Effective Nominal YTM)
• A 13, 100 bond that pays interest semi-annually
  is currently selling for 94. If the bond has 5
  years to mature, what is the nominal and
  effective yield to maturity?
• r 7.37 per half annum
• Nominalper year 7.37 x 2 14.78
• EffectivePer year (1.0737)2 - 1 15.32

20
Bond/Debenture

• The required return on bonds (Rb) depends on Risk
  / Inconvenience / Inflation
• Risk - is a function of time and who owes
  you the money.
• Government - Federal
• - State
• - Local
• - Private Cos - Blue Chip
• - Green Chip

21
Bond/Debenture

• Time - More time to default
• - Greater impact of inflation
• - Greater inconvenience
• When choosing a Kb to value a bond, take care to
  choose one indicative of the same MATURITY AND
  CLASS as the bond examined.
• "Get from The West Australian Australian
  Financial Review"

22
Inflation and the Time Value of Money

• If you determined your nominal YTM on a bond to
  be 14 p.a and inflation is currently running at
  7, what is your real return.
• R ( 1.14/1.07 ) - 1 6.54