Interest In the United States, interest is typically paid twice a year at six month
Interest In the United States, interest is typically paid twice a year at six month
intervals. For example, a bond may pay interest on January 1 and July 1. Bonds issued in many other countries pay interest annually. A bond can
be designed to pay interest quarterly, monthly, or even daily, any way the
FINANCING DECISIONS
corporation desires. The objective is to design the interest payments to
be attractive to the investors, but, at the same time minimize the costs of administering the bonds—writing and mailing interest payments. Interest is also referred to as a coupon. The reference to coupons originates with bearer bonds. If you owned a bearer bond, you received the interest by clipping coupons off the side of the bond and redeeming them for cash. But over time, the interest received on both registered and bearer debt has come to be referred to as the coupon payment.
Interest is generally stated as a percentage of the par value of the bond and the rate or interest is referred to as the interest rate or the cou- pon rate. The coupon rate can be either a fixed coupon rate (fixed rate) or a floating coupon rate (floating rate). Most bonds have a fixed cou- pon rate and such issues are said to have a straight coupon.
In the past 25 years, there have been many innovations in the type of debt interest payments, so there is no longer any “typical” bond. These innovations include zero-coupon, deferred interest, floating rate, and dual coupon debt. Below we discuss the various types of coupon payments.
Zero-Coupon Zero-coupon bonds do not have a coupon. Since there are no coupons, the only return an investor gets by holding the bond until it matures is the difference between what was paid for the bond and its maturity value. This is why zero-coupon bonds are issued and trade at a discount from their maturity value. That is, they are issued and trade at
a price below 100. Effectively, the investor in a zero-coupon bond earns interest, but the investor does not receive it until the maturity date—the interest is part of the maturity value. Consider The Walt Disney Co. Zero-coupon Subordi- nated Notes, due 2005. These notes were issued in June 1990 at 41.199 (41.199% of their maturity value). An investor buying a $1,000 maturity value note in June 1990 would pay $411.99. If that investor held on to the bond until the maturity date, she would not receive interest during the life of the bond, but she would receive $1,000 in June 2005.
Zero-coupon bonds were first issued by corporations in 1981 and rapidly became popular. As with interest paid on any kind of debt, the issuer may deduct the implicit interest to determine taxable income. Investors are taxed on the bond’s interest income—the implicit inter- est—even though they receive no cash.
Consider the Disney notes. If you bought a note for $411.99 in June 1990 and hold it until maturity, you earn an annual return of 6.09%:
Present value of the investment = $411.99 Future value of the investment = $1,000.00 Number of periods
Intermediate and Long-Term Debt
Return = -------------------------- $1,000.00 – 1 = 6.09%
Implied interest for the first year is 6.09% multiplied by $411.99, or $25.09. Implied interest for the second year is 6.09% multiplied by $411.99 + $25.09 = $437.08, or $26.62. As time passes, the value of the note increases and the implicit interest on the note in any period is the 6.09% multiplied by the increased value. Implicit interest on the Disney note over its life is shown for each year in Exhibit 15.3.
EXHIBIT 15.3 Implied Interest on Disney Zero-Coupon Subordinated Notes, Due
2005, that were Issued June 1990 at 41.199 or $411.99 per Bond Beginning
End of Year Value = For the year
Implied Interest =
Beginning Value + ended June …
of the
Yield ××××
Year Value
Beginning Value
Implied Interest
57.40 1,000.00 Total implied interest
$588.01 Note:
Yield calculation:
$1,000.00 -------------------------- – 1 = 6.0899% Present value
Yield = ---------------------------------- Future value – 1 =
Check on the calculations:
Total implied interest + price when issued = Face value
FINANCING DECISIONS
Floating Rate In the 1970s, when bond issuers were reluctant to be locked into paying the high interest rates that prevailed in the United States, corporations began to issue bonds whose coupon rate changed as inter- est rates changed. Corporations thus ended up paying the “market rate” instead of a fixed rate.
Different interest rate benchmarks for floating rates include: ■ The London Interbank Offered Rate (LIBOR)
■ The rate on a money market instrument such a Treasury bill (T-bill) or the rate on commercial paper 2
A rate fixed by an auction process (specifically, a Dutch auction) As explained earlier when we discussed the floating rate for term
loans, there is an interest rate reset formula (called a coupon reset for- mula) that is used to determine the coupon rate for the reset period. The floating rate changes periodically, such as annually, semiannually, or quarterly, as specified. Many bonds with a floating rate will have a cap, the maximum coupon rate that the issuer pays. Some issues may have a floor, the minimum coupon rate.
By using derivatives and other types of derivative instruments, differ- ent types of coupon bonds can be created. Consider for example bonds that are issued in which the interest rate changes in the opposite direction from the benchmark rates. These bonds are referred to as inverse floaters. For example, in 1996 BMW issued 10-year bonds denominated in deut- schemarks. The bonds pay interest of 9% in the first year, reverting there- after to a semiannual interest payment that floats at 12% minus the prevailing six-month LIBOR for deutschemark. If the LIBOR falls, the coupon rate on these bonds rises. By issuing such a bond it would seem that BMW is accepting the risk that if interest rates fall, it will have to pay
a higher interest rate. While not demonstrated here, this risk may be elim- inated by using an interest rate swap. Later in this chapter, we will see how swaps are used to create a bond whose coupon payment depends on the performance of a stock market index.
Deferred Interest Somewhere between a zero-coupon bond and a straight bond lies a deferred interest bond—a bond whose interest payments do not start until some time after it is issued. Most deferred interest bonds have no interest for the first three to seven years and sell at a discount from their face value.
2 Money market instruments are debt obligations that mature in one year or less. We describe these instruments in Chapter 19.
Intermediate and Long-Term Debt
Deferred interest debt is usually used where cash flow problems are anticipated. For example, if a firm borrows heavily to restructure its oper- ations, deferred interest debt offers time to turn its operations around.
Income Bonds An income bond pays interest only when there are sufficient earnings to pay it. If earnings are not sufficient, the firm need not pay the interest to its income bondholders. Unlike other types of debt, failure to pay interest on an income bond is not necessarily an act of default.
Income bonds and notes are seldom issued, for two reasons. First, since they do not carry a fixed interest obligation, they are issued by companies that foresee financial difficulties—so this stigma is attached to income bonds. Second, since paying interest depends on accounting earnings, which can be manipulated, there is a potential problem—a possible conflict of interests between management, who represent share- holders, and the bondholders, who are the creditors.
Moreover, the Internal Revenue Service (IRS) is not naive. It recog- nizes that a firm may attempt to disguise preferred stock by packaging it as an income bond. If the IRS believes that an income bond has all of the characteristics of preferred stock, it will seek to reclassify the interest rate payments that were deducted by the firm so that they are treated as divi- dend payments which are not tax deductible.
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
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