The Risk Premium Market participants talk of interest rates on non-Treasury securities as
The Risk Premium Market participants talk of interest rates on non-Treasury securities as
“trading at a spread” to a particular on-the-run Treasury security (or a spread to any particular benchmark interest rate selected). For example, if the yield on a 10-year non-Treasury security is 7% and the yield on a 10- year Treasury security is 6%, the spread is 100 basis points. This spread reflects the additional risks the investor faces by acquiring a security that is not issued by the U.S. government and, therefore, can be called a risk pre- mium. Thus, we can express the interest rate offered on a non-Treasury security as:
Interest rate = Base interest rate + Spread
or equivalently,
Interest rate = Base interest rate + Risk premium We have discussed the factors that affect the base interest rate. One of
the factors is the expected rate of inflation. That is, the base interest rate can be expressed as:
Base interest rate = Real rate of interest + Expected rate of inflation
FOUNDATIONS
Turning to the spread, the factors that affect it are (1) the issuer’s per- ceived creditworthiness; (2) the term or maturity of the instrument; (3) provisions that grant either the issuer or the investor the option to do something; (4) the taxability of the interest received by investors; and (5) the expected liquidity of the issue.
It is important to note that yield spreads must be interpreted relative to the benchmark interest rate used. This is particularly important to keep in mind for the second and last factors that affect the spread when the benchmark interest rate is other than the yield on U.S. Treasury securities.
Perceived Creditworthiness of Issuer Credit risk refers to the risk that the issuer of a debt obligation may be unable to make timely payment of interest and/or the principal amount when it is due. Most market partic- ipants rely primarily on commercial rating companies to assess the default risk of an issuer. These companies perform credit analyses and express their conclusions by a system of ratings. The three commercial rating companies in the United States are (1) Moody’s Investors Service, (2) Standard & Poor’s Corporation, and (3) Fitch Ratings.
In all systems the term high grade means low credit risk, or con- versely, high probability of future payments. The highest-grade bonds are designated by Moody’s by the symbol Aaa, and by S&P and Fitch by the symbol AAA. The next highest grade is denoted by the symbol Aa (Moody’s) or AA (S&P and Fitch); for the third grade all rating systems use A. The next three grades are Baa or BBB, Ba or BB, and B, respec- tively. There are also C grades. Moody’s uses 1, 2, or 3 to provide a nar- rower credit quality breakdown within each class, and S&P and Fitch use plus and minus signs for the same purpose.
Bonds rated triple A (AAA or Aaa) are said to be prime; double A (AA or Aa) are of high quality; single A issues are called upper medium grade, and triple B are medium grade. Lower-rated bonds are said to have speculative elements or be distinctly speculative. Bond issues that are assigned a rating in the top four categories are referred to as investment- grade bonds. Issues that carry a rating below the top four categories are referred to as noninvestment-grade bonds, or more popularly as high- yield bonds or junk bonds. Thus, the bond market can be divided into two sectors: the investment-grade and noninvestment-grade markets. The spread between Treasury securities and non-Treasury securities that are identical in all respects except for quality is referred to as a quality spread or credit spread.
Term to Maturity The price of a financial asset will fluctuate over its life as yields in the market change. It can be demonstrated that the price volatility of a bond is dependent on its maturity. More specifically, with
Financial Institutions and the Cost of Money
all other factors being constant, the longer the maturity of a bond, the greater the price volatility resulting from a change in market yields. The spread between any two maturity sectors of the market is called a matu- rity spread or yield curve spread. The relationship between the yields on comparable securities but different maturities is called the term structure of interest rates. The term-to-maturity topic is of such impor- tance that we discuss in more detail later in this chapter.
Inclusion of Options It is not uncommon for a bond issue to include a pro- vision that gives either the bondholder and/or the issuer an option to take some action against the other party. An option that is included in a bond issue is referred to as an embedded option. The most common type of option in a bond issue is a call provision. This provision grants the issuer the right to retire the debt, fully or partially, before the sched- uled maturity date. The inclusion of a call feature benefits issuers by allowing them to replace an old bond issue with a lower interest cost issue should interest rates in the market decline. Effectively, a call provi- sion allows the issuer to alter the maturity of a bond. A call provision is detrimental to the bondholder because the bondholder will be uncertain about maturity and might have to reinvest the proceeds received at a lower interest rate if the bond is called and the bondholder wants to keep his or her funds in issues of similar risk of default.
An issue also may include a provision that allows the bondholder to change the maturity of a bond. An issue with a put provision grants the bondholder the right to sell the issue back to the issuer at par value on designated dates. Here, the advantage to the investor is that, if interest rates rise after the issue date and result in a price that is less than the par value, the investor can force the issuer to redeem the bond at par value.
A convertible bond is an issue giving the bondholder the right to exchange the bond for a specified number of shares of common stock. This feature allows the bondholder to take advantage of favorable move- ments in the price of the issuer’s common stock.
The presence of these embedded options has an effect on the spread of an issue relative to a Treasury security and the spread relative to other- wise comparable issues that do not have an embedded option. In general, market participants require a larger spread over a comparable Treasury security for an issue with an embedded option that is favorable to the issuer (e.g., a call option) than for an issue without such an option. In contrast, market participants require a smaller spread over a comparable Treasury security for an issue with an embedded option that is favorable to the investor (for example, put option and conversion option). In fact, for a bond with an option that is favorable to an investor, the interest rate on an issue may be less than that on a comparable Treasury security!
FOUNDATIONS
Taxability of Interest Unless exempted under the federal income tax code, interest income is taxable at the federal level. In addition to federal income taxes, there may be state and local taxes on interest income. The federal tax code specifically exempts the interest income from qualified municipal bond issues from taxation at the federal level. Municipal bonds are securities issued by state and local governments and by their cre- ations, such as “authorities” and special districts. The large majority of outstanding municipal bonds are tax-exempt securities. Because of the tax-exempt feature of municipal bonds, the yield on municipal bonds is less than that on Treasuries with the same maturity.
Expected Liquidity of an Issue Bonds trade with different degrees of liquidity. The greater the expected liquidity with which an issue trades, the lower the yield that investors require. As noted earlier, Treasury securities are the most liquid securities in the world. The lower yield offered on Trea- sury securities relative to non-Treasury securities reflects, to a significant extent, the difference in liquidity.
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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