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Corporate Financial Theory. Lecture 8. Corp Financial Theory. Topics Covered: * Capital Budgeting (investing) * Financing (borrowing) Today: Revisit Financing Debt Financing, Risk & Interest Rates. Debt & Interest Rates. Classical Theory of Interest Rates (Economics)

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Corporate FinancialTheoryLecture 8Corp Financial TheoryTopics Covered:* Capital Budgeting (investing)* Financing (borrowing)Today:Revisit Financing Debt Financing, Risk & Interest RatesDebt & Interest RatesClassical Theory of Interest Rates (Economics)developed by Irving Fisher Nominal Interest Rate = The rate you actually pay when you borrow moneyReal Interest Rate = The theoretical rate you pay when you borrow money, as determined by supply and demandrSupplyReal rDemand$ QtyFederal Reserve Policy Conventional wisdomThe Federal Reserve sets interest rates. Whenever they raise or lower interest rates, the amount I pay on my credit card increases or decreases accordingly. FALSEThe Federal Reserve and The Colts Value of one Colts season ticket Value of two Colts season ticketsConclusions from ExampleToo much cash = Inflation Growth in cash = Growth in goods Who controls Cash ? The Federal Reserve They DO NOT control interest rates They INFLUENCE inflation Why do we care? Inflation determines YOUR Interest Rates Federal Reserve Monetary PolicyFed RateBanks BorrowLoan money to usThe Federal Reserve DilemmaMonetary PolicyFed Discount RateInflation RateThe Fed & Interest RatesMyth: The Federal Reserve Board controls the interest rates WE PAYFact: The Fed controls the rate BANKS PAYFact: The rate we pay is set by the BanksFact: Banks rates are determined by the Fed Rate AND INFLATIONMortgage rate = Fed Rate + expected inflationInterest Rates and InflationFed Funds vs. Mortgage Rates Rates Fed Discount 30 Yr. Mortgage InflationFeb ‘06 5.75 % 6.24 % 2.50 %Aug’08 2.25 % 6.67 % 5.83 %July 2008 CPI = 9.60 %Source: Bankrate.com 8/21/08 report, mortgage-x.com, & bls.gov July 2008 CPI reportFed Funds vs. Mortgage Rates19912006Source: federal reserve boardFed Funds vs. Mortgage Rates19912006Source: federal reserve boardThe Fed & Interest RatesQ: How does this link to mortgage rates?A: Mortgage rates are the combination of inflation and the Fed Funds rate.Nominal rate = Real rate + expected inflationMortgage rate = Fed Funds + expected inflationReal rate is a theoretical number… KIND OFNominal rate is what we pay Inflation is the real dangerDebt & Interest RatesNominal r = Real r + expected inflationReal r is theoretically somewhat stableInflation is a large variableQ: Why do we care?A: This theory allows us to understand the Term Structure of Interest Rates.Q: So What?A: The Term Structure tells us the cost of debt.Term Structure of Interest RatesMaturity YTM 1 3.0 % 5 3.5% 10 3.8% 15 4.2% 30 4.5% Listing of the hypothetical yields on U.S. Treasury Zero Coupon bonds = The Pure Term StructureTerm Structure of Interest RatesMaturity YTM 1 5.3 % 5 5.9 % 10 6.4 % 15 6.7 % 30 7.0 % AAA Corp Bond Term StructureTerm Structure of Interest RatesExpectations Theory Term Structure and Capital Budgeting CF should be discounted using term structure info When rate incorporates all forward rates, use spot rate that equals project term Take advantage of arbitrage Yield CurveThe graph of the term Structure of Interest Rates is called the “Yield Curve” YTM (r)Year1 5 10 20 30The Dynamic Yield Curve – Web LinkUS Treasury Strips (2012)Term StructureSpot Rate - The actual interest rate today (t=0)Forward Rate - The interest rate, fixed today, on a loan made in the future at a fixed time.Future Rate - The spot rate that is expected in the futureYield To Maturity (YTM) - The IRR on an interest bearing instrument YTM (r)198119871976Year1 5 10 20 30Term StructureYTM (r)1987 is the normal Term Structure 1981 is abnormal & dangerous to the economy (because there is an incentive not to invest) 198119871976Year1 5 10 20 30EG. 1981 Spot Rate (nominal) = Real r + Inflation .15 = (-.05) + .20 Term StructureYTM (r)198119871976Year1 5 10 20 30EG. 1981 Spot Rate (nominal) = Real r + Inflation .15 = (-.05) + .20 Forward Rate (nominal) = Real r + Inflation .10 = .01 + .09 Term StructureWhat Determines the Shape of the TS?1 - Unbiased Expectations Theory2 - Liquidity Premium Theory3 - Market Segmentation HypothesisTerm Structure & Capital BudgetingCF should be discounted using Term Structure info Since the spot rate incorporates all forward rates, then you should use the spot rate that equals the term of your project. If you believe in other theories take advantage of the arbitrage. Valuing a BondValuing a BondExampleIf today is October 1, 2012, what is the value of the following bond? An IBM Bond pays $115 every September 30 for 5 years. In September 2016 it pays an additional $1000 and retires the bond. The bond is rated AAA (WSJ AAA YTM is 7.5%) Cash FlowsSept 1213141516115 115 115 115 1115Valuing a BondExample continuedIf today is October 1, 2012, what is the value of the following bond? An IBM Bond pays $115 every September 30 for 5 years. In September 2016 it pays an additional $1000 and retires the bond. The bond is rated AAA (WSJ AAA YTM is 7.5%) Valuing a BondExample - GermanyIn July 2012 you purchase 100 Euros of bonds in Germany which pay a 5% coupon every year. If the bond matures in 2018 and the YTM is 3.8%, what is the value of the bond? Valuing a BondAnother Example - JapanIn July 2012 you purchase 200 Yen of bonds in Japan which pay a 8% coupon every year. If the bond matures in 2017 and the YTM is 4.5%, what is the value of the bond? Valuing a BondExample - USAIn July 2012 you purchase a 3 year US Government bond. The bond has an annual coupon rate of 4%, paid semi-annually. If investors demand a 2.48% return on 6 month investments, what is the price of the bond? Valuing a BondExample continued - USATake the same 3 year US Government bond. The bond has an annual coupon rate of 4%, paid semi-annually. If investors demand a 1.50% return on 6 month investments, what is the new price of the bond? All interest bearing instruments are priced to fit the term structureThis is accomplished by modifying the asset priceThe modified price creates a New Yield, which fits the Term StructureThe new yield is called the Yield To Maturity (YTM)Yield To MaturityYield to MaturityExampleA $1000 treasury bond expires in 5 years. It pays a coupon rate of 10.5%. If the market price of this bond is 107.88, what is the YTM? Yield to MaturityExampleA $1000 treasury bond expires in 5 years. It pays a coupon rate of 10.5%. If the market price of this bond is 107.88, what is the YTM? C0 C1 C2 C3 C4 C5 -1078.80 105 105 105 105 1105Calculate IRR = 8.50%Bond Prices and YieldsBond Price, %Interest Rates, %Maturity and PricesBond Price, %Interest Rates, %If you have two bonds, both providing a YTM of 8.5%, do you care which one you would prefer to buy?What additional information do you need to make your decision?Why do you need this information?Duration is the tool that tells us the difference in risk between two different bonds.Debt & RiskDebt & RiskExample (Bond 1)Given a 5 year, 10.5%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?Year CF PV@YTM % of Total PV % x YearDebt & RiskExample (Bond 1)Given a 5 year, 10.5%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?Year CF PV@YTM % of Total PV % x Year1 105 2 105 3 105 4 105 5 1105 Debt & RiskExample (Bond 1)Given a 5 year, 10.5%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?Year CF PV@YTM % of Total PV % x Year 1 105 96.77 2 105 89.19 3 105 82.21 4 105 75.77 5 1105 734.88 1078.82 Debt & RiskExample (Bond 1)Given a 5 year, 10.5%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?Year CF PV@YTM % of Total PV % x Year 1 105 96.77 .090 2 105 89.19 .083 3 105 82.21 .076 4 105 75.77 .070 5 1105 734.88 .681 1078.82 1.00 Debt & RiskExample (Bond 1)Given a 5 year, 10.5%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?Year CF PV@YTM % of Total PV % x Year 1 105 96.77 .090 0.090 2 105 89.19 .083 0.164 3 105 82.21 .076 0.227 4 105 75.77 .070 0.279 5 1105 734.88 .681 3.406 1078.82 1.00 4.166 Duration Debt & RiskExample (Bond 2)Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?Year CF PV@YTM % of Total PV % x YearDebt & RiskExample (Bond 2)Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?Year CF PV@YTM % of Total PV % x Year1 90 2 90 3 90 4 90 5 1090 Debt & RiskExample (Bond 2)Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?Year CF PV@YTM % of Total PV % x Year 1 90 82.95 2 90 76.45 3 90 70.46 4 90 64.94 5 1090 724.90 1019.70 Debt & RiskExample (Bond 2)Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?Year CF PV@YTM % of Total PV % x Year 1 90 82.95 .081 2 90 76.45 .075 3 90 70.46 .069 4 90 64.94 .064 5 1090 724.90 .711 1019.70 1.00 Debt & RiskExample (Bond 2)Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is this bond’s duration?Year CF PV@YTM % of Total PV % x Year 1 90 82.95 .081 0.081 2 90 76.45 .075 0.150 3 90 70.46 .069 0.207 4 90 64.94 .064 0.256 5 1090 724.90 .711 3.555 1019.70 1.00 4.249 Duration Debt & RiskUsing the two previous examples, which bond whould you buy and why?Debt & RiskExample (Bond 3)Given a 5 year, 9.0%, $1000 bond, with a 8.75% YTM, what is this bond’s duration?Year CF PV@YTM % of Total PV % x Year 1 90 82.76 .082 0.082 2 90 76.10 .075 0.150 3 90 69.98 .069 0.207 4 90 64.35 .064 0.256 5 1090 716.61 .710 3.550 1009.80 1.00 4.245 Duration Debt & RiskQ: Given Bond 1 and its YTM of 8.5% Given Bond 3 and its YTM of 8.75% Which bond should you buy and why?A: It depends on your tolerance for risk.Valuing Risky BondsThe risk of default changes the price of a bond and the YTM.ExampleWe have a 5% 1 year bond. The bond is priced at par of $1000. But, there is a 20% chance the company will go into bankruptcy and only pay $500. What is the bond’s value?A: Valuing Risky BondsExampleWe have a 5% 1 year bond. The bond is priced at par of $1000. But, there is a 20% chance the company will go into bankruptcy and only pay $500. What is the bond’s value?A: Bond Value Prob 1,050 .80 = 840.00 500 .20 = 100.00 . 940.00 = expected CF Valuing Risky BondsExample – ContinuedConversely - If on top of default risk, investors require an additional 3 percent market risk premium, the price and YTM is as follows:Key to Bond RatingsThe highest quality bonds are rated AAA. Investment grade bonds have to be equivalent of Baa or higher. Bonds that don’t make this cut are called “high-yield” or “junk” bonds.Key to Bond RatingsBond TerminologyRead Chapter 24 for terminology ExamplesCollateralized Debt Obligations Asset Backed Securities Mortgage Backed Securities Loan Guarantees (Puttable bonds)

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