# Finance 6

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1. when a corporation (or govt) wishes to borrow money from the public on a longterm basis, it usually does soby issuing, or selling, debt securities that are generically called
Bonds
2. Bonds
normally an interest only loan
3. coupon
stated interest payment made on a bond

Ex: \$1,000 bond for 30 years 12% interest, 120 a year for 30 years, 120 is your coupon

- if level and constant, it can be called a level coupon bond
4. face value/par value
the amount that will be repaid at the end of the loan
5. coupon rate
the annual coupon divided by the fave value of the bond

(interest rate of the bond)

120 is coupon, 1000 is the face value, 120/1000= 12% coupon rate
6. maturity
date on which the principal amount of the bond is paid

- number of years until the face value is paid (i.e. 30 years)
7. as interest rates change, the cash flows from the bond stay the same, but the value of the bond will fluctuate
when interest rates rise, the PV of the bonds remaining cash flows declines, and the bond is worth less

when interest rates fall, the bond is worth more
8. determine value of a bond at a point in time
• number of periods remaining
• the face value
• the coupon
• market interest rate (YTM, yield to maturity)
9. discount bond
bond sells for less than face value
bond sells for more than face value
11. bond value
• = C*[1-1/(1+r)t]/r   +   F/(1+r)t
• = PMT * PV of coupons  +  PV of face amt
12. interest rate risk
- depends on how sensitive its price is to interest rate changes

• - time to maturity
• - coupon rate

• *All other things equal
• 1. the longer the time to maturity, the greater the interest rate risk
• 2. the lower the coupon rate, the greater the interest rate risk
13. current yield
bonds annual coupon divided by the price

*not to be confused with the yield to maturity
14. equity and debt securities
securities issues by corporations
15. differences between debt and equity
1. debt is not an ownership interest in the firm. Creditors do not have voting power

2. the corporations payment of interest on debt is considered a cost of doing business and it fully tax deductible. DIvidends paid to stockholders are NOT tax deductible

3. Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of the firm. This action can result in liquidation or reorganization, 2 of the possible conseqences of bankruptcy. Thus, one of the costs of issuing debt is the possibility of finaincial failure. (this does not arise when issing equity!)

*One reason that corporations try to create a debt security that is really equity is to obtain the tax benefits of debt and the bankruptcy benefits of equity.

*Equity represents an ownership interest, and it is a residual claim. Equity holders are paid after debt holders
16. Long Term Debt
• promises made by the issuing firm to pay principal when due and to make timely interest payments on the unpaid balance
• maturity is the length of time the debt remains outstanding with some unpaid balance
• debt securities can be short term
• also known as notes, debentures, or bonds
• A bond is a secured debt
• public issue and privately placed
17. unfunded debt
short term debt
18. indenture
• written agreement between the corporation (the borrower) and its creditors
• deed of trust
• usually a trustee is appointed to represent the bondholders
19. responsibility of the trust company in an indenture
• make sure the terms are obeyed
• manage the sinking fund
• represent the bondholders in default (if the company fails to pay them)
20. bond indenture includes
• basic terms of the bond
• total amount of the bonds issued
• description of property used as security
• repayment arrangements
• call provisions
• details of the protective covenants
21. principal value
• face value
• par value
• initial accounting value
22. registered form
the form of the bond issue in which the registrar of the company records ownership of each bond; payment is made directly to the owner of the record
23. bearer form
form of bond issue in which the bond is issued without record of the owner's name; payment is made to whomever holds the bond

• drawnback:
• difficult to recover if lost or stolen
• company cannot notify bondholders of important events

• benefit:
• mot traceable (taxes)
24. collateral
general term that frequently means securities that are pledged as security for payment of debt
25. debenture
unsecured debt, usually with a maturity of 10 years or more
26. note
unsecured debt, usually with a maturity under 10 years
27. gilts
bonds issued by the british government are called treasury "stock"

in the UK, a debenture is a secured obligation
28. sinking fund
account managed by the bond trustee for early bond redemption, purpose of repaying the bonds
29. Call provision
an agreement giving the corporation the option to repurchase the bond at a specific price prior to maturity

allows the company to repurchase or "call", part or all of the bond issue at stated prices over a specific period

corporate bonds are usually callable
difference between the call price and the stated value

becomes smaller over time
31. deferred call provision
a call provision prohibiting the company from redeeming the bond prior to a certain date

during this period, it is called call protected
32. make whole call
• very popular recently in the corp bond market
• bondholders receive exactly what the bonds are worth if they are called
• calculate the PV of the remaining interest and principal pmts at a rate specified in the indenture
• call price is higher when interest rates are lower (and vice versa)
33. protective covenants
part of the indenture limiting certain actions that might be taken during the term of the loan, usually to protect the lender

• Negative covenant - "thou shalt not", limits or prohibits actions the company might take
• OR
• Positive (affirmative) covenant - "thou shalt" specifies an action that the company agrees to take or a condition that company must abide by
34. bond ratings
• creditworthiness is based on how likely the firm is to default
• highest AAA (S&P) or Aaa (Moodys) best quality, lowest degree of default risk
• lowest rating is D debt in default
• investmen grade bonds are atleast BBB or Baa
• crossover, or split rating BBB or Baa and BB and Ba, rated differently by agencies
• bonds that drop into junk territory are called fallen angels
• NCAA no coupon at all
35. Types of bonds
• government bonds
• zero coupon bonds
• floating rate bonds
• income bonds
• convertible bonds
• put bonds
36. government bonds
• US treasury notes/bonds are issued when the govt wants to borrow money for more than 1 year with maturities ranging from 2-30 years
• older issues are callable
• no default risk because they can't default (hopefully) and they are exempt from state income taxes (not federal)
• when state and local govt borrow money its called a municipal bond
• munis are almost always callable
• coupons are exempt from federal income taxes (and state in some situations), attractive to high income, high tax bracket investors
• yields are lower then taxable bonds
37. compare aftertax yields
Mucis mond 4.8%
corp bond 6.3%
ignoring state and local taxes, the munis bond pays 4.8% both pretax and after tax

corp pays 6.3% aftertax, to calculate after tax .063*(1-.30)= .044 or 4.4%

munis is better
38. Zero coupon bond
• a bond that makes no coupon payments and thus is initially priced at a deep discount
• must be offered at a price that is much lower than its stated value
39. Floating Rate Bonds (floaters)