Transcript CHAPTER 11

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Long-Term Debt Sources of
Financing
Interest rate levels
Types of long-term debt
Risks of long-term debt
Debt valuation
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Capital Financing Basics
Businesses need capital to acquire the
assets needed to provide services.
Capital comes in two basic forms:
Debt capital (loans, bonds, debentures) -liability sources of capital
Equity capital (stock, retained earnings) -non-liability sources of capital
HSO utilization of debt and equity capital
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Common Long-Term Debt Instruments
Term loans (3-15 year maturities)
Amortized interest/principal payments
Lender as financial intermediary (bank)
Advantages: speed, flexibility, low cost
Bonds (10-30 year maturities)
Bond issues
Multiple creditors/investors per issue
Public vs. private placement of bond issues
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Common Long-Term Debt Instruments
Types of Bonds
Corporate Bonds
•
•
•
•
Investor-owned organizational debt issue
Longer maturity debt (10-30 years)
Fixed vs. variable interest rates
Payment of interest and principal
Mortgage Bonds
• Corporate debt issues backed by pledge of
organizational assets
• Primary vs. secondary mortgage issues
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Common Long-Term Debt Instruments
Types of Bonds
Corporate Debentures
• Corporate debt backed by revenue-generating
capacity of organization (no fixed assets)
• Higher cost form of corporate debt than MB’s
• Rationale for use
Subordinated Debentures
• “Junk” or below investment grade debt issues
• High-risk, high-cost corporate debt
• Rationale for use
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Common Long-Term Debt Instruments
Types of Bonds
Municipal Bonds (“Munis”)
• Debt issues from non-federal governmental
entities and/or their representative organizations
• Types of munis -- general obligation munis,
special tax bonds, revenue bonds (NFP’s)
• Fixed interest, longer-term maturities
• “Serial issue” municipal bonds
• Tax exemption of municipal bond interest
• Public vs. private placement of munis
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Debt Contract Provisions
Bond indentures
General provisions
• Maturity of bonds
• Interest rate (coupon rate)
Restrictive covenants (creditor
obligations of borrower)
Trustee (bond fiduciary)
Call provisions -- advantages and
disadvantages to issuer/borrowers
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Bond Ratings
Rating agencies assign bond ratings
that reflect the probability of default:
Investment Grade
Junk Bonds
Moody’s Aaa
Aa
A
Baa
Ba
B
S&P
AA
A
BBB
BB
B CCC D
AAA
Caa
C
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Bond Rating Concepts
Bond rating criteria
Issuer’s financial condition
Competitive situation
Quality of management
Importance of ratings
To investors/creditors
To issuers (cost of capital)
Changes in ratings (factors
affecting)
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Credit Enhancement
Credit enhancement (bond insurance)
is available on municipal bonds.
Insured bonds have the rating of the
insurer (AAA), not the issuer.
Issuers must pay an up-front fee to
obtain bond insurance. (50-75 basis
points based on total debt service)
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Interest Rate Components
Interest as opportunity cost of debt
The interest rate on any debt security
can be thought of a base rate plus
one or more components.
Here is the model:
Rate = RRF + IP + DRP + LP + PRP + CRP.
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Here:
RRF = Real risk-free rate.
IP = Inflation premium.
DRP = Default risk premium.
LP = Liquidity premium.
PRP = Price risk premium.
CRP = Call risk premium.
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Interest Rate Example 1
1-Year Treasury Security
RRF = 2%; IP = 3%:
Rate = RRF + IP + DRP + LP + PRP + CRP
= 2% + 3% + 0 + 0 + 0 + 0
= 5%.
 Why are there zeros for DRP, LP, PRP,
and CRP?
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Interest Rate Example 2
30-Year Columbia/HCA Callable Bond
RRF = 2%; IP = 4%; DRP, LP, PRP = 1%;
CRP = 0.4%:
Rate = RRF + IP + DRP + LP + PRP + CRP
= 2% + 4% + 1% + 1% + 1% + 0.4%
= 9.4%.
 Callable vs. non-callable rates of interest
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The Term Structure of Interest Rates
Term structure is the relationship
between interest rates and debt
maturities. (years to maturity)
Thus, term structure tells us the
relationship between short-term
and long-term rates.
A graph of the term structure is
called the yield curve.
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Treasury Yield Curve (July 1998)
Interest
Rate (%)
7
6




10
20

1 yr.
5 yr.
10 yr.
20 yr.
30 yr.
5.3%
5.4
5.5
5.6
5.7
5
0
30
Years to Maturity
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Bond Yield Curves
What does a bond yield represent?
YTM (bond yield to maturity) -- (1)
coupon rate/yield for bonds that sell at
par value (new issues, mature issues);
(2) coupon rate/yield for bonds plus or
minus capital gain/loss for bonds that
sell below or above par value
(outstanding bond issues)
Normal vs. inverted yield curves
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Debt Valuation
Why should healthcare managers
worry about debt valuation?
Managers must understand how
investors make resource allocation
decisions.
Cost of financing is important to good
capital investment decisions.
Debt valuation concepts are used to
value other assets.
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General Valuation Model
The financial value of any asset
stems from the cash flows that the
asset is expected to produce.
Thus, all assets are valued in the
same way:
Estimate the expected cash flows.
Set the required rate of return/discount
rate
Discount the cash flows.
Sum the present values.
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General Valuation Model (Cont.)
0
1
2
R(R)
N
...
CF1
CF2
CFN
PV CF1
PV CF2
PV CFN
Value
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Bond Definitions
1. Par value: Stated face value of
the bond. Generally the amount
borrowed and repaid at maturity.
Often $1,000 or $5,000.
2. Coupon rate: Stated interest
rate on the bond. Multiply by par
value to get dollar coupon
payment. Usually fixed.
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3. Maturity date: Date when the
bond will be repaid. Note that
the effective maturity of a bond
declines each year after issue.
4. New versus outstanding bonds:
When a bond is issued, its
coupon rate reflects current
conditions. When conditions
change, bond values change.
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5. Debt service requirements:
Issuers are concerned with their
total debt service payments,
including both interest expense
and repayment of principal. Many
municipal bond issues (serial
issues) are structured so that debt
service requirements are roughly
constant over time.
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What’s the value of a 15-year, 10%
coupon bond if R(R) = 10%?
0
1
2
10%
15
...
100
100
100 + 1,000
$ 760.61
239.39
$1,000.00
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The bond consists of a 15-year, 10%
annuity of $100 per year plus a $1,000
lump sum at t = 15:
PV annuity
= $ 760.61
PV maturity value =
239.39
PV annuity
= $1,000.00
INPUTS
OUTPUT
15
N
10
I/YR
PV
1000
-100
PMT
-1000
FV
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What’s the value after one year if
interest rates remain constant?
INPUTS
OUTPUT
14
N
10
I/YR
PV
1000
-100
PMT
-1000
FV
If interest rates (the required rate of
return on the bond) stay constant, the
bond’s value remains at $1,000.
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Now suppose interest rates fell, so
that R(R) is now only 5 percent.
INPUTS
OUTPUT
14
N
5
I/YR
PV
1494.93
-100
PMT
-1000
FV
When R(R) falls, a bond’s value
increases. Now the bond sells above
its par value, or at a premium. (logic?)
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What would happen if interest rates
rise, and R(R) is now 15 percent?
INPUTS
OUTPUT
14
N
15
I/YR
PV
713.78
-100
PMT
-1000
FV
When R(R) rises, a bond’s value
decreases. Now the bond sells below
its par value, or at a discount. (logic?)
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Assume the bond has 14 years to
maturity. What would happen to
bond values over time if interest
rates remained at the levels given:
5 percent, 10 percent, and 15
percent?
Remember that the bond has a 10
percent coupon rate.
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Bond Value ($)
1,495
1,216
1,000
R(R) = 5%.
R(R) = 10%.
M
832
R(R) = 15%.
714
14
10
5
0
Years to Maturity
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At maturity, the value of any bond must
equal its par value.
The value of a premium bond will
decrease to par value at maturity.
The value of a discount bond will
increase to par value at maturity.
A par bond value will remain at par if
interest rates remain constant.
The return in each year consists of an
interest payment and a price change.
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Definitions
Current yield = Annual interest payment .
price
Capital gains yield = Change in price .
Beginning price
Total
Current
Capital
=
+
.
return
yield
gains yield
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Find the current yield, capital gains
yield, and total return during Year 1
when the interest rate falls to 5%.
$100
Current yield = $1,000 = 0.100 = 10.00%.
$495
Capital gains = $1,000 = 0.495 = 49.5%.
Total return = 10.0% + 49.5% = 59.5%.
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Repeat the calculation,
but this time for Year 2.
$100
Current yield = $1,495 = 0.670 = 6.70%.
Capital gain
-$25
= $1,495 = -0.170 = -1.70%.
Total return = 6.7% - 1.7% = 5.0%.
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Yield to Maturity
The yield to maturity (YTM) on a
bond is the expected rate of return
assuming the bond is held to
maturity. (reported bond yields)
Mathematically, it is the discount
rate that forces the present value of
the cash flows from the bond to
equal the bond’s price.
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What’s the YTM on a 14-year, 10%
annual coupon, $1,000 par value bond
that sells for $1,494.93?
0
YTM = ?
1
$1,495
10
...
100
PV1
.
.
PV9
PV10
PVM
9
100
100
1,000
Find the discount rate that “works”!
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Using a Financial Calculator for YTM
INPUTS
OUTPUT
14
N
1494.93 -100
I/YR PV PMT
5.00
-1000
FV
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Find YTM if price were $713.78.
INPUTS 14
N
OUTPUT
713.78
I/YR PV
15.0
-100
PMT
-1000
FV
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Bonds Actually Have
Semiannual Coupons
Therefore, there are twice as many
interest payments compared to annual
coupon payments.
But, the interest payment is only half of
the annual payment.
And, the required rate of return (discount
rate) is only half of the annual rate.
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Find the value of a 14-year, 10%
coupon, semiannual bond if the
required rate of return is 5 percent.
2x14
INPUTS 28
N
OUTPUT
5/2
2.5
I/YR
100 / 2
-50
PV PMT
1499.12
-1000
FV
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Find the YTM of a 14-year, 10%
coupon, semiannual bond if the
bond is selling for $1,400.
INPUTS
OUTPUT
2x14
28
N
100 / 2
1400 -50
I/YR PV PMT
2.90
-1000
FV
Thus, the annual YTM = 2 x 2.90% = 5.80%.
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Interest Rate Risk
Interest rates change constantly, which
gives rise to two types of interest rate
risk.
Price risk arises because bond values
decline when interest rates rise.
Reinvestment rate risk arises because
reinvested coupon (and principal)
payments earn less when interest rates
fall.
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Does a 1-year or 10-year 10 percent
bond have more price risk?
R(R)
1-year
Change 10-year Change
5% $1,048
10%
1,000
15%
956
$1,386
+4.8%
-4.4%
1,000
749
+38.6%
-25.1%
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Value
$1,500
$1,000
10-year
.
.
.
.
.
5%
10%
15%
1-year
$500
0
0%
R(R)
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Does a 1-year or 10-year bond have
more reinvestment rate risk?
Reinvestment rate risk depends both
on the bond’s maturity and the
investor’s holding period.
In general, the shorter the maturity, the
greater the reinvestment rate risk.
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How can interest rate risk
be minimized?
Long-term bonds have high price risk
but low reinvestment rate risk.
Short-term bonds have low price risk
but high reinvestment rate risk.
Nothing is riskless! However, risk can
be minimized by matching the maturity
of the bond to the holding period.
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