Chapter 7 Define debt capital Debt capital is the capital that a business raises by taking out a loan It is a loan made to a company that is normally repaid at some future date What are characteristics of debt Interest Principal Debtor Repayment What is a syndicated loan Define revolving credit and term loan Why are they used by companies What are characteristics of a bond A syndicated loan is one that is provided by a group of lenders and is structured arranged and administered by one or several commercial banks Revolving credit is a system where there is no monthly payment instead payments are only made on the funds withdrawn from the credit account Term loans have payments and set dates Bonds have the following Face or Par Value Coupon Payment Maturity and an Issuer Compare and contrast public bonds and private placement bonds Private placement bond is a bond issued where some of the revenue would go to a private investor e g a bond to finance a sport stadium Public bonds incomes are tax free Define the following indenture secured vs unsecured seniority sinking fund call provision coupon par value Indenture a formal or legal agreement Secured loans have collateral e g a car or home loan unsecured loans have no collateral like student loans or credit cards Seniority ranks the order of repayment in case of bankruptcy Sinking fund is a fund that sets aside revenues to fund a future capital expense Call provisions is a contract provision that allows either party to call the bond and receive payment up front Coupon is the interest payment on a bond Par value is the face value of a bond typically paid at maturity How are ratings used with respect to bonds What is the common base rate What is a credit risk spread Ratings express the overall riskiness of the bond AAA is the highest rating Credit spread is the difference between Treasury securities and non treasury securities If a company s must offer a higher return because their credit is worse than the governments What is unique about US Treasury securities Municipal bonds Treasury notes are backed by the Fed Municipal bonds are issued by local governments What are sovereign bonds Sovereign bonds are bonds issued in a country but use a foreign currency They are generally more risky and more likely to default What is a zero coupon bond a floating rate bond a convertible bond Zero coupon bond a bond sold at a considerable discount but offers no coupon payments Floating Rate Bond a bond whose interest rate is tied to a benchmark rate such as the Treasury bill rate Convertible Bond can be converted into a predetermined amount of the company s equity at certain times during its life usually at the discretion of the bondholder Be able to calculate the following for a bond current yield yield to maturity bond value accrued interest and the dirty price yield to first call if appropriate See Formula Sheet What is interest rate risk Price risk Reinvestment risk How do each vary with coupon level and time to maturity Interest rate risk risk that the investment will lose value because as time passes and interest rates rise your money would be better spent invested in another bond This risk goes down with higher coupon payments but increase with longer time to maturity In this scenario market conditions are better than the bond so you want your return as quickly as possible Reinvestment Risk risk that coupons from a bond won t be reinvested at the prevailing interest rate when the bond was purchased e g interest rates are declining so the money you get in coupon payments won t be invested as efficiently This risk decreases with lower coupon payments and increases with a shorter yield to maturity In this scenario you want your money tied up in the bond as long as possible because the current market conditions are not as favorable Define nominal rate real rate and inflation premium Be able to calculate each given others Fisher effect Nominal Rate Interest rate before taking inflation into account Real Rate rate adjusted to remove the effects of inflation Inflation Premium the higher return an investor receives for investing in a long term security where inflation has a greater potential to reduce the real return What is the term structure of interest rates the yield curve Term Structure of Interest Rates relationship between interest rates and different terms of maturity Yield Curve upward sloping curve results from investors demanding a higher rate of return for longer term loans Explain the conditions that would need to exist for the Treasury yield curve to be downward sloping Short term treasury notes would have to have a higher rate of return then long term notes This is an indicator of an impending economic recession Describe the relationships that exist between the coupon rate the yield to maturity and the current yield for a bond trading at both a discount and a premium If a bond is trading at a discount the current yield is higher than if it was selling at a premium The coupon rate would stay the same in either scenario because the coupon rate is stipulated when the bond is formed Yield to maturity decreases when a bond is sold at a premium but increases when bought at a discount Define liquidity risk default risk and taxability risk and explain how these risks relate to bond yields Liquidity risk the risk that an assets cannot be sold quick enough during a decline A specialized piece of machinery is illiquid while shares of a popular stock would be considered liquid If an investor invests in an illiquid stock that he may watch helplessly as the stock price falls Default risk the risk that the company or establishment will declare bankruptcy or default on their commitments If the default risk is high the investor may lose all of their projected return Taxability risks risk that a municipal bond will lose is tax exempt status Since municipal bonds sells at a lower rate than taxable bonds bond holders would end up with a lower yield than planned Chapter 8 Define equity capital Equity Capital Invested money that is not repaid through the normal course of business but instead is repaid with ownership of stock in a company What are characteristics of equity Right to Income Claim on Assets Right to Control Voting rights Limited Liability Discuss the structure of a corporation shareholders board of directors management Shareholders elect board members who collectively make decisions on how to operate the company Managers report to the board
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