Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
flows, not surprisingly called reinvestment rate risk. Suppose you buy a U.S. Treasury Bond that matures in five years. There is no default risk, since the U.S. government could simply print more money to pay the interest and principal. Does this mean there is no risk when you own a Treasury bond? No. You need to do something with the interest payments as you receive them and the principal amount when it matures. You could stuff them under your mattress, reinvest in another Treasury bond, or invest them otherwise. If yields have been falling, however, you cannot reinvest the interest payments from the bond and get the same return you are getting on the bond. When your Treasury bond matures, you face reinvestment risk.
If we look at an investment that produces cash flows before matu- rity or sale, such as a stock (with dividends) or a bond (with interest), we face a more complicated reinvestment problem. In this case we’re concerned with the reinvestment of the final proceeds (at maturity or sale), but also with the reinvestment of the intermediate dividend or interest cash flows (between purchase and maturity or sale).
Let’s look at the case of a five-year bond issued by Company Y, that pays 10% interest (at the end of each year, to keep things simple), and has a par value of $1,000. This bond is a coupon bond; that is, interest is paid at the coupon rate of 10% per year, or $100 per bond. If you buy the bond when it is issued at the beginning of Year 1 and hold it to maturity, you will have the following cash flows:
Company Y Bond Date
Cash Flow
January 1, Year 1 –$1,000.00 ← Purchase of bond December 31, Year 1 100.00
December 31, Year 2 100.00 December 31, Year 3 100.00 December 31, Year 4 100.00 December 31, Year 5 1,100.00 ← Proceeds of maturity and last interest payment
You face five reinvestment decisions along the life of this bond: the four intermediate flows at the end of each year, and the last and largest cash flow that consists of the last interest payment and the par value.
Risk and Expected Return
Suppose we wish to compare the investment in the Company Y bond with another five-year bond, issued by Company Z, that has a dif- ferent cash flow stream, but a yield that is nearly the same. Company Z’s bond is a zero-coupon bond; that is, it has no interest payments, so the only cash flow to the investor is the face value at maturity:
Company Z bond Date
Cash Flow
January 1, Year 1 –$1,000.00 ← Purchase of bond December 31, Year 5
+$1,610.51 ← Proceeds at maturity Both bonds have the same annual yield-to-maturity of 10%. If the
yield is the same for both bonds, does this mean that they have the same reinvestment rate risk? No. Just from looking at the cash flows from these bonds we see there are intermediate cash flows to reinvest from Company Y’s bond, but not from Company Z’s bond.
Let’s see just how sensitive the yield on the investment is to changes in the assumptions on the reinvestment of intermediate cash flows. Sup- pose we can reinvest the interest payments at 5%, not 10%. We calcu- late the yield on the bonds assuming reinvestment at 5%—a modified internal rate of return—by calculating the future value of the reinvested cash flows and determining the discount rate that equates the original investment of $1,000 to this future value:
Company Y Bond
Company Z Bond
Values as of Cash
Values as of
Cash December 31, Date
Flow Year 5
December 31, Year 1 $100.00
December 31, Year 2
December 31, Year 3
December 31, Year 4
December 31, Year 5 1,100.00
$1,610.50 $1,610.51 Future value, with cash flows
reinvested at 5%
$1,610.51 Using the value of the cash flow as of December 31, Year 5 as the
future value and the $1,000 investment as the present value, the modi- fied internal rates of return are 9.2% for Company Y’s bond and 10% for Company Z’s bond. You’ll notice that the modified internal rate of
THE FUNDAMENTALS OF VALUATION
return for Company Z’s bond is the same as its yield-to-maturity— because there are no intermediate cash flows.
If we compare two bonds with the same yield-to-maturity and the same coupon rate, the bond with the longer maturity has more reinvestment risk. That’s because it has more cash flows to reinvest throughout its life.
If we compare two bonds with the same yield-to-maturity and the same time to maturity, the bond with the greater coupon rate has more reinvestment rate risk. That’s because it has more of its value coming sooner in the form of cash flows.
Two types of risk closely related to reinvestment risk of debt securi- ties are prepayment risk and call risk. Prepayment risk is associated with certain asset-backed securities. These securities, which are discussed in Chapter 26, are created by pooling loans and using the pool as collateral for the securities. Examples of asset-backed securities issued by corpora- tions are those backed by residential mortgage loans, automobile loans, and equipment leases. The loans have a schedule for the repayment of principal. Typically the borrower has the right to prepay a loan without a penalty at any time prior to the scheduled principal prepayment date. A payment made in excess of the schedule principal repayment is referred to as a prepayment. A borrower may benefit from exercising the option to prepay if interest rates decline below the loan’s interest rate. A prepay- ment that occurs when interest rates decline below the loan’s interest rate is a disadvantage to the investor in an asset-backed security because it forces the investor to reinvest the proceeds received at a lower interest rate. This risk is referred to as prepayment risk.
Call risk is the risk that a callable security will be called by the issuer. If you invest in a callable security, there is a possibility that the issuer may call it in (buy it back). While you may receive a call premium (a specified amount above the par value), you have to reinvest the funds you receive.
There is reinvestment risk for assets other than stocks and bonds, as well. if you are investing in a new product—investing in assets to manufacture and distribute it—you expect to generate cash flows in future periods. You face a reinvestment problem with these cash flows: What can you earn by investing these cash flows? What are your future investment opportunities?
If we assume that investors do not like risk—a safe assumption— then they will want to be compensated if they take on more reinvest- ment rate risk. The greater the reinvestment rate risk, the greater the expected return demanded by investors.
Reinvestment rate risk is relevant to investment decisions no matter the asset and you must consider this risk in assessing the attractiveness of investments. The greater the cash flows during the life of an investment, the greater the reinvestment rate risk of the investment. And if an investment has a greater reinvestment rate risk, this must be factored into decisions.
Risk and Expected Return
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
Show more