EXAM 2 STUDY GUIDE FINANCIAL MANAGEMENT OF THE FIRM CHAPTERS 7, 8, 9 CHAPTER 7:BONDS-Bonds : -When a corporation or government wishes to borrow money from the public on a long-term basis, it usually does so by issuing or selling debt securities those are called bonds. -Bonds are a debt instrument in which a company or government borrows money from investors and according to the conditions of the bond will repay the face value at maturity while making interest payments (coupons) o the bondholders at specified dates. -Long-term debt securities that generally provide for fixed payments at designated times. -Who issues bonds and why? -Government agencies, U.S treasury (large volume of debt in bonds), states, cites, corporations, FSU…Different Types of Bonds: -Corporate Bonds: Bonds that re issued by corporation. Since the corporation must make interest payments on their bonds corporations have the potential on their bonds corporations have the potential to go bankrupt or be in default -Default risk: Bond with a lot of default risk will have higher rates of return than treasury bonds of similar maturity *One large benefit to a corporation issuing debt though is that interest payments made on debt are considered tax deductible -Details about Bonds: -normally an interest-only loan, meaning that her borrower will pay the interest every period, but none of the principal will be repaid until the end of the loan the -Bondholders do not have ownership rights (they cannot vote). They are creditors- Interest payments to bondholders are tax DEDUCTIBLE to the issuing corporation (Dividends are NOT tax deductible)-Bondholders can force a firm into reorganization and/or liquidation (bankruptcy) if payments are not made as promised. Thus bondholders have a higher priority claim as compared to both common and preferred stockholders.-Face value: the principal amount of a bond that is repaid at the end of the term (also called par value)*Initial amount of money that is being borrowed and the amount that the lenders will receive upon maturity -Maturity Date: allows both issuer and investor to know that the bond expires on a certain date at which time the issuer of the bond will repay the investor the par value o the bond. *The number of years until the face value is paid is called the bonds maturity -Coupon: the stated interest payment made on the bond -Coupon Rate: How much interest paid on the bond (coupon rate)(face value)= annual interest paid on the bond (COUPOON RATE DETERMINES THE PAYMENT (PMT). *Coupon Rates is a fixed value through the maturity date*Interest rate may change in the marketplace, but the cash flows from a bond will stay the same.*When interest rates rise, the present value of the bonds remaining cash flows declines and the bond is worth less. When interest rates fall, the bond is worth more *Coupon payments are Interest expenses and the interest paid by the firm is tax deductible- interest expense lowers the firms taxable income and therefor lowers the firms tax liability, interest paid on bonds creates a tax shield and is an advantage to debt financing vs. Equity (stock financing)-Indenture: Bond CONTRACT that specifies the obligations of the issuer, the rights of the bondholders, various bond features, protective covenants etc..*Contract will include: Number of bonds issued, Collateral (are they secured by any of the firm’s assets?), Secured bonds (Specific assets pledged as collateral), Debenture (Unsecured, riskier and pay a higher rate) -Secured vs. Unsecured Bonds (debentures): is specific collateral pledged or is the bond just backed by the issuer in general? *A senior Debenture has higher seniority than a subordinated debenture. A subordinated debenture is paid last -Call Provision: enables the firm to retire the bonds prior to maturity by “calling” the bonds, which means that the issuer must pay the “call price” for each bond.*Call price = face value + one year’s interest typical to start*Companies usually call bonds only when interest rate are declining because when interest rates are declining a company can issue a new bonds at a lower interest rate and then use the new debt to pay off the debt that that was at the higher interest rate -“Make whole” call price becoming more popular now means: is aimed at having a company pay a “call price” that more closely reflects current interest rates. FAIR price to bondholders -Deferred call feature (call protection): bonds may not be callable for some period after they are issued, e.g. five year, bonds cannot be called immediately, only after an amount of time specified in the bond contract *Bonds are most likely to be called if interest rates have fallen since the bonds were originally issued. (Like refinancing a home mortgage) *Inverse relationship between bond prices and interest rates -Call Premium: is intended to compensate investor for some of the lost interest and is paid when the bond is called *When a bond is called the company will repay the face value but also one year’s coupon payment and that extra amount is the premium -Sinking funds: various arrangements that help provide for the orderly retirement of the bond issue. Prevents chaos when a lot of money comes due *If there is a sinking fund provision then the bonds are less risky *Examples: Bond Ratings: Moody’s, S & P, and Fitch are the primary bond rating agencies. They rate bond issues according to the likelihood of default *Investors want bonds that don’t have a callable feature How can investors have the ability to know a corporations financial strength? -Investors can turn to agencies/ companies that dedicate themselves to the evaluation of bond issuers and of the issuer’s financial strength. *Such as: Moody’s Investors Services, Fitch IBCA, and Standard & Poor’s Rating service are all companies that concentrate in appointing rating to bonds that determine the ability of their issuers to repay those bonds. *RATINGS: are alphabetical (AAA= highest) (C=lowest) Yield-To-Maturity: “Current Market Price”-YTM on the bond is the rate of return that investors require in order to buy the bond-Based upon the risk and maturity of the bond, the yield is the return that investors expect to receive for their investment based upon the interest payments of the bond and also whether or not the bond is selling at a discount or a premium.-To determine the value of a bond at a particular point n time, we need to know the number of
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