BF3201 Lecture 3 Cost of Debt Handout

BF 3215/3201
Corporate Finance & Strategy
Lecture 3
Cost of Debt
Dr. Siri Chutikamoltham

Intuition for Financing that Max Firm Value
E CF$,t 
n
◼ Firm Value: V =  (1 + k )
t =1
t
⚫ The discount rate is risk-adjusted WACC

⚫ The lower the discount rate, the higher Firm Value
◼ If so, should managers minimize k by using all debt for capital
since debt is the cheapest funding?
⚫ Too much debt increases the risk of financial distress and
bankruptcy
⚫ Thus, managers need to understand and decide on:
• the Cost of Debt
• the Capital Structure: the optimal D/E for your company
2
Lecture Objectives
◼ Understand interest rate and ◼ Estimate cost of debt in
discount rate determination practice
◼ Understand corporate debt ⚫ Mistakes to avoid
⚫ Bank loans
⚫ Corporate bonds
◼ Understand cost of debt
⚫ Bank loans
⚫ Corporate bonds
• Coupon
• YTM
• YTC
3
What is an interest rate?
◼ The cost or price of money
◼ What determine interest rates?
◼ k = k* (real risk-free)
◼ k = k*+IP = k RF (risk-free rate)
◼ k = k + DRP (default risk premium)
RF
◼ k = k + DRP+LP (liquidity risk premium)

RF
◼ k = k + DRP+LP +MRP (maturity risk premium)

RF

4
kd = k* + IP + DRP + LP + MRP.
kd = Required rate of return on a

debt security.
k* = Real risk-free rate.
IP = Inflation premium.
DRP = Default risk premium.
LP = Liquidity premium.
MRP = Maturity risk premium.

5
What factors affect the cost of money?
◼1.Production opportunities
K*
◼2.Time preferences for consumption
◼3.Expected inflation → IP
◼4.Risk → default risk (DRP),
liquidity risk (LP), maturity risk (MRP)
6
Corporate Debts
◼Most common forms:

⚫Bank loans
⚫Corporate bonds

7
Corporate Debts (cont)
◼ Bank loans
⚫ The most common and largest source of capital for business in many
countries
⚫ Often, the cheapest component of capital
• Interest rate on bank loan is lower than most other capital
• Interest tax-shield
⚫ Typical loan framework: The Five Cs of Credit
• Character: assess the borrower’s creditworthiness such as credit history
• Capacity: ability to service the loan such as interest coverage ratio,
forecasted revenues, cash inflows
• Capital: the amount of assets, equity the borrower has
• Collateral: assets that can be pledged as security for the loan
• Conditions: the purpose of the loan, terms and conditions of the loans

8
Corporate Debts (cont)
◼ Corporate bonds
⚫A debt instrument whereby the
borrower(issuer) agrees to pay principal and
interest to the bond holder (lender) on specific
dates.
⚫Usually the term “ bond” indicates a period
over one year.
⚫Types: treasury, municipal, corporate (high
grade and high yield), foreign (government and
corporate)
9
Compare Bond and Stock Markets
Comparison between Bond Comparison between Bond
Market and Stock Market Market and Stock Market
100 800
90
700
80
70 600
Trillion (USD)
60 500
Billion (USD)
50
400
40
300
30
20 200
10
100
0
Debt Outstanding vs Market 0
Capitalization Trading Volume
Bond Market Stock Market Bond Market Stock Market
Source: SIFMA
10
10
Key Features of a Bond
◼ 1. Par value: Face amount; paid at maturity.
Assume $1,000.
◼ 2. Coupon interest rate: Stated interest rate.
Multiply by par value to get dollars of interest.
Generally fixed.
◼ 3. Maturity: Years until bond must be fully repaid.
◼ 4. Issue date: Date when a bond is issued.
◼ 5. Yield to maturity: the rate of return on a bond
if held until the bond is mature.

11
Bond Coupon

12
Call Provision
◼ A call provision gives the issuer the right, but not
obligation, to call the bonds for redemption.
◼ Issuer can retire a certain bond if the current interest
rate declines to lower than when the bond was first
issued.
◼ The calling provision benefits the issuer but hurts
the investors.
◼ Thus investors require more (a call premium).
◼ Most bonds have a deferred call and a call premium.

13
Sinking Fund
◼ Provision to pay off a loan over its life rather than all at maturity.
◼ Similar to amortization on a term loan.
◼ How it works:
⚫ Call a certain % of the issue when interest rate falls below
coupon rate
⚫ Buy back bonds in the open market when interest rate rises
above coupon rate.
◼ It reduces risk to investors.
◼ Lenders (investors) require less return with sinking fund.

14
Some Other Bond Features
◼ 1. Warrant: an option for bond holders to buy a

predetermined number of stock at a fixed price.
◼ 2. Convertible bond: exchangeable for common stock of
the firm if certain conditions are met.
◼ 3. Indexed bond: interest rate is adjusted to inflation.
◼ 4. Putable bond: bond holders can sell bond back to the
issuer before maturity.

15
Risks of Investment in Bonds
◼1. Inflation risk

◼2. Liquidity risk
◼3. Maturity risk
⚫Reinvestment risk
⚫Interest rate risk (price risk)
◼4. Default risk

16
Inflation Risk
◼ The purchasing power of the principal and coupon
payments is eroded by inflation.
◼ Investors can be protected with an inflation premium(IP)
◼ Treasury Inflation-Protected Securities (TIPS) are indexed
to inflation.
◼ The IP for a particular length maturity can be
approximated by the difference between the yield on a
non-indexed Treasury security minus the yield on a TIPS
of the same maturity.

17
Liquidity Risk
◼Concerns with the ability to sell a bond

quickly at a low transaction cost.
◼US Treasury has negligible liquidity risk.
◼High quality corporate bonds have small
liquidity risk, in general.
◼Some small corporate issues, foreign issues
may have larger liquidity risk.

18
Maturity Risk
◼Risk caused by the length of time to maturity

⚫Reinvestment risk: if interest rate level falls,
future investment will receives a lower rate
of return.
⚫Interest rate ( price) risk: if interest rate
level increases, the price of bond in your
holding will fall.

19
Interest rate and Reinvestment risk
Trade off
Risk Short Maturity Long Maturity

High Coupon Low Coupon Rate
Rate Bonds Bonds
Reinvestment risk High Low
Interest Rate risk Low High

20
Which one wins?
The Maturity Risk Premium
◼ Yields on longer term bonds are usually greater

than on shorter term bonds, reflecting MRP that
compensates for interest rate risk.

21
Default Risk
◼The issuer cannot pay back investors as

promised.
◼Example: the issuer goes bankrupt

22
Bond Ratings Provide Indications
of Default Risk
Investment Grade Junk Bonds
Moody’s Aaa Aa A Baa Ba B Caa C
S&P AAA AA A BBB BB B CCC D

23
Factors affecting default risk and bond rating
◼ Financial performance
◼ Other factors
⚫ Debt ratio
⚫ TIE, FCC ratios ⚫ Earnings stability
⚫ Current ratios ⚫ Regulatory
environment
◼ Provisions in the bond
contract ⚫ Potential product
⚫ Secured versus liability, anti-trust
unsecured debt
⚫ Potential labor
⚫ Senior versus problems
subordinated debt
⚫ Guarantee provisions ⚫ Accounting policies
⚫ Sinking fund
provisions
⚫ Debt maturity
24
Payment Priority at Liquidation
◼ Past due property taxes
◼ Secured creditors from sales of secured assets.
◼ Trustee’s costs
◼ Expenses incurred after bankruptcy filing
◼ Wages and unpaid benefit contributions, subject to limits
◼ Unsecured customer deposits, subject to limits
◼ Taxes
◼ Unfunded pension liabilities
◼ Unsecured creditors
◼ Preferred stock
◼ Common stock
25
Typical Rates
(US Markets)
Instrument Rate %( Aug 22)
U.S. T-bills (3 month) 2.61

U.S. T-note( 10 year) 2.98
U.S. T-bond( 30 year) 3.22
Corporate bonds(BBB, 10 year) 4.86**

Prime rate 5.50***
Mortgages 30 years fixed 5.79***
New car loan 60 months 14.76***
Credit card (median) 19.62****
Source:* Bloomberg.com, ** Moody’s, ***CNBC,****businessinsider.com
26
Analyzing Returns on Bonds
What is the nominal risk-free rate?
◼No risk, no inflation: kRF= k*
◼No risk, with inflation:
kRF = k*+ IP
In practice: kRF is approximated by T-
bill or T-bond rate.

27
Bond Spreads, the DRP, and the LP
◼ A “bond spread” is often calculated as the

difference between a corporate bond yield and a
Treasury bond yield of the same maturity.
Therefore:
⚫Spread = DRP + LP.
◼ Bonds of large, strong companies often have very
small LPs. Bonds of small companies often have
LPs as high as 2%.

28
Sovereign Default Spread
Moody's Sovereign Rating Typical Sovereign Default Spread

Aaa 0.00%
Aa1 0.59%
Aa2 0.74%
Aa3 0.90%
A1 1.04%
A2 1.26%
A3 1.78%
Baa1 2.37%
Baa2 2.82%
Baa3 3.26%
Ba1 3.71%
Ba2 4.45%
Ba3 5.34%
B1 6.68%
B2 8.16%
B3 9.65%
Caa1 11.12%
Caa2 13.35%
Caa3 14.82%
Ca 17.79%
C 21.00%
Source: Moodys.com Dr. Siri Chutikamoltham
29
Premiums for Different Types of Debt
IP DRP LP MRP
ST Treasury K*
LT Treasury K*
ST Corporate K*
LT Corporate K*
30
Term Structure of Interest and Yield Curve
◼Term structure: the relationship between
interest rates (or yields) and maturities.
◼A graph of the term structure is called the

yield curve.

31
Hypothetical Treasury Yield Curve
Interest
Rate (%) 1 yr 8.0%
15 Maturity risk premium 10 yr 11.4%
20 yr 12.65%
10 Inflation premium
Real risk-free rate

0 Years to Maturity
1 10 20
32
Hypothetical Treasury and
Corporate Yield Curves
What factors contribute to different yield curves?
Interest
Rate (%)
15
BB-Rated
10
AAA-Rated
Treasury
6.0%
5 5.9% yield curve
5.2%
Years to
0
maturity
0 1 5 10 15 20
33
Principle: Risk-Return Tradeoff
Don’t take additional risk unless you

expect additional return
Thus, lenders or debt holders who take
more risk require higher interest rate

Bond Valuation
0 1 2 n
k ...
(PV) PMT1 PMT22 PMTn
+ FV
PMT1 PMT2 PMTn +FV
PV = + + ... +
(1+ k) 1
(1+ k) 2
(1+ k)n

35
What’s the value of a 10-year, 10% coupon bond
if kd = 10%?
0 1 2 10
10% ...
V=? 100 100 100 + 1,000
$100 $100 $1,000

VB = + . . . + + Formula
(1 + k d ) (1 + k d ) (1+ k d )
1 10 10
= $90.91 + . . . + $38.55 + $385.54

= $1,000.
36
The bond consists of a 10-year, 10% annuity of
$100/year plus a $1,000 lump sum at t = 10:
PV annuity = $ 614.46 Table IV
PV maturity value = 385.54 Table II
Value of bond = $1,000.00

Financial Calculator
INPUTS 10 10 100 1000
N I/YR PV PMT FV
OUTPUT -1,000
Dr. Siri Chutikamoltham Solution 37
The bond consists of a 10-year, 10% annuity of
$100/year plus a $1,000 lump sum at t = 10:
Excel Calculation

38
What would happen if expected inflation
rose by 3%, causing kd to rise to 13%?
INPUTS 10 13 100 1000

N I/YR PV PMT FV
OUTPUT -837.21
When kd rises, above the coupon rate, the bond’s

value falls below par, so it sells at a discount.

39
What would happen if expected inflation
rose by 3%, causing kd to rise to 13%?
Face value = 1,000,
Coupon rate = 10%
Time to maturity = 10 years
Frequency of dividend pmnt =
1/year
Discount rate = 13%
When kd rises, above the

coupon rate, the bond’s
value falls below par, so it
sells at a discount.
Select the cell you will place the calculated result at, type the formula =PV(discount
rate,time, dividend amount, face value) into it, and press the Enter key.
Note the formula for PV in excel which corresponds to the cells
40
What would happen if inflation fell, and
kd declines to 7%?
INPUTS 10 7 100 1000

N I/YR PV PMT FV
OUTPUT -1,210.71
If coupon rate > kd, price rises above par, and bond
sells at a premium.
41
What would happen if inflation fell, and
kd declines to 7%?
Face value = 1,000,
Coupon rate = 10%
Time to maturity = 10 years
Frequency of dividend pmnt
= 1/year
Discount rate = 7%
If coupon rate > kd,

price rises above par,
and bond sells at a
premium.
Select the cell you will place the calculated result at, type the formula =PV(discount
rate,time, dividend amount, face value) into it, and press the Enter key.
Note the formula for PV in excel which corresponds to the cells
42
Summary: Bond Price and Interest Rate
Relationship
◼ If coupon rate < kd, bond sells at a …………
◼ If coupon rate = kd, bond sells at ………..
◼ If coupon rate > kd, bond sells at ………..
◼ Bond price = …………..at maturity.
◼ If kd rises, price ………..
◼ …………… relationship between bond price
and interest rate.

43
Bond Value and Time to Maturity
◼ At maturity, the value of any bond must equal its

par value.
◼ The value of a premium bond would decrease to
$1,000.
◼ The value of a discount bond would increase to
$1,000.
◼ A par bond stays at $1,000 if kd remains constant.

44
Bond Value ($)
1,372 kd = 7%.
1,211
kd = 10%. M
1,000
837
kd = 13%.
775
30 25 20 15 10 5 0
Years remaining to Maturity

45
Yield to Maturity
◼ YTM is the rate of return earned on a bond held to maturity.

Also called “promised yield.”
◼ When interest rate environment changes from the time a bond
is newly issued, YTM differs from the coupon rate.
◼ Investment in existing bonds earn YTM, not coupon rate.
◼ Thus, cost of debt (corporate bonds) is the YTM, not the
coupon rate.
◼ Reminder: cost of debt to the company is after-tax.
◼ Kd = YTM (1-T)

46
What’s the YTM on a bond that has 10 years to
maturity, 9% annual coupon, $1,000 par value that
is now selling for $887?
0 1 9 10
kd=?
...
90 90 90
PV1 1,000
.
.
.
PV10
PVM
887 Find kd that “works”!
47
Calculate YTM using Formula
INT ... + INT M

VB = 1 + +
(1 + k d ) (1 + k d ) (1 + k d )
N N
90 ... + 90 1,000
887 = 1 + 10 +
(1 + k d ) (1+ k d ) (1 + k d )
10
Kd = 10.91%

48
Calculate YTM on Financial Calculator
INPUTS 10 ? -887 90 1000

N I/YR PV PMT FV
OUTPUT
Solve for i/YR = 10.91%

49
Calculate YTM in Excel

50
Find YTM if price were $1,134.20.
INPUTS 10 -1134.2 90 1000

N I/YR PV PMT FV
OUTPUT 7.08
Sells at a premium. Because coupon =

9% > kd = 7.08%, bond’s value > par.

51
Bond Yields
Current yield = Annual coupon pmt

Current price
Capital gains yield = Change in price

Beginning price
Exp total Exp Exp cap

= YTM = +
return Curr yld gains yld

52
Find current yield and capital gains yield
for a 9%, 10-year bond when the bond sells
for $887 and YTM = 10.91%.
$90
Current yield = $887
= 0.1015 = 10.15%.

53
YTM = Current yield + Capital gains yield
Cap gains yield = YTM - Current yield

= 10.91% - 10.15%
= 0.76%.

54
Semiannual Bonds
1. Multiply years by 2 to get periods = 2n

2. Divide nominal rate by 2 to get periodic
rate = kd/2
3. Divide annual INT by 2 to get PMT =
INT/2
INPUTS 2n kd/2 OK INT/2 OK

N I/YR PV PMT FV
OUTPUT
55
Find the value of 10-year, 10% coupon,
semiannual bond if kd = 13%.
2(10) 13/2 100/2

INPUTS 20 6.5 50 1000
N I/YR PV PMT FV
OUTPUT -834.72

56
Example Bond Pricing
You could buy, for $1,000, either a 10%, 10-year,
annual payment bond or an equally risky 10%, 10-
year semiannual bond. Which would you prefer?
The semiannual bond’s EFF% is:

m 2

EFF% =  1 +
iNom   0.10
 − 1 =  1+  − 1 = 10.25%
.
 m   2 
10.25% > 10% EFF% on annual bond, so buy

semiannual bond.
57
Example Bond Pricing (cont)
If $1,000 is the proper price for the semiannual
bond, what is the proper price for the annual
payment bond?
◼ Semiannual bond has kNom = 10%, with EFF% = 10.25%.
Should earn same EFF% on annual payment bond
◼ At a price of $984.80, both bonds give investors the same
EFF% = 10.25%
INPUTS 10 10.25 100 1000

N I/YR PV PMT FV
OUTPUT -984.80
58
Yield to Call
◼ YTC = the return a bondholder receives if he holds the
bond until the call date that happens before it reaches
maturity.
◼ Example: A 10-year, 10% semiannual coupon, $1,000 par
value bond is selling for $1,135.90 with an 8% yield to
maturity. It can be called after 5 years at $1,050. What’s
the bond’s nominal yield to call (YTC)?
INPUTS 10 -1135.9 50 1050

N I/YR PV PMT FV
OUTPUT 3.765 x 2 = 7.53% = nominal YTC
EFF% = (1.03765)2 - 1 = 7.672%.
59
If you buy a bond with a call provision, would
you be more likely to earn YTM or YTC?
◼ Coupon rate = 10% vs. YTC = kd = 7.53%. Could raise
money by selling new bonds which pay 7.53%.
◼ Could thus replace bonds which pay $100/year with bonds
that pay only $75.30/year.
◼ Investors should expect a call, hence YTC = 7.5%, not
YTM = 8%.
◼ In general, if a bond sells at a premium, then (1) coupon >
kd, so (2) a call is likely.
◼ So, expect to earn:
⚫ ………….. on premium bonds.
⚫ ………….. on par & discount bonds

60
Avoid Common Mistakes About Cost of Debt
DO DON’T
◼ 1. If debt is in corporate ◼ Don’t use the firm’s current cost of debt
bonds, use YTM, not coupon (coupon rate, interest rate of outstanding
rate on the existing bonds bond issues or bank loans)
◼ 2. Use YTC, if the existing ◼ Don’t use the firm’s historical cost of
bond will likely be called debt
◼ 3. If finance with new bond ◼ Empirical evidence*
issue, use coupon rate of the ⚫ 37%, of managers used the average
new issue rate on current outstanding debts
◼ 4. If debt is in bank loans, ⚫ 29% used the average historical rate
use interest rates on new of the company’s borrowings
loans, not the existing loans
⚫ Only 34% used the forward-looking
cost of debt for new bond issuance or
* “Do You Know Your Cost of Capital?” HBR June-July 2012 bank loans
61
DO DON’T
◼ Use marginal corporate ◼ Don’t use the current effective corporate
tax rate to calculate after- tax rate
tax cost of debt ◼ Don’t’ use average historical tax rate
◼ Empirical evidence
⚫ 64% of managers used currently
effective tax rate
⚫ 7% used a future tax rate that they
wanted to be at (target rate)
⚫ Only 29% used the marginal tax rate
* “Do You Know Your Cost of Capital?” HBR June-July 2012

62
DO DON’T
◼ Don’t use book value of debt or other
◼ When calculate the
capital components
weight of debt, use
market value of debt ◼ Empirical evidence
and capital ⚫ 30% of managers used book value of
debt to book value of equity at the
current capital structure
⚫ 28% used book value of debt to book
value of equity at target capital
structure
⚫ 19% used book value of debt to market
value of equity
* “Do You Know Your Cost of Capital?” HBR June-July 2012 ⚫ 23% used market value of debt to
market value of equity
63
Estimate Cost of Debt in the Real World
Source: Brotherson, Eades, Harris, and Higgins (2013)

64
Lesson Learned
◼ Intrinsic value of financial security = PV of future cash flows
generated by the security.
◼ Must understand four major factors that determine the cost of debt
for your company
◼ The discount rate of a future cash flows reflects the risk of the
security
◼ Debt has the lowest risk to the lenders while stock has the highest
risk to investors
◼ Thus, cost of debt is lower than costs of other capital components
◼ One additional benefit of debt is interest tax shield, lowering the
cost of debt for the company even further
◼ However, the risk of financial distress must be considered when
use debt
65
Lessons Learned
◼ What can be used as debt rate in the real world
⚫ Coupon, YTM, YTC
◼ Inverse relationship between bond price and interest rate
◼ Relationship between bond yield and time to maturity
◼ Calculate the cost of debt for WACC calculation
◼ Opportunity cost concept
⚫ Interest rate on a new loan
⚫ Bond coupon rate for a newly issued bond
⚫ YTM or YTC on an existing bond
⚫ Cost to the company is on after-tax basis
66
Plan Ahead
◼ Read Ch. 5
◼ Individual assignment: Problem set cost of debt.
◼ Due before next class.

67

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BF 3215/3201

Corporate Finance & Strategy

Dr. Siri Chutikamoltham

⚫ The discount rate is risk-adjusted WACC

◼ k = k + DRP+LP (liquidity risk premium)

◼ k = k + DRP+LP +MRP (maturity risk premium)

Dr. Siri Chutikamoltham

kd = Required rate of return on a

Dr. Siri Chutikamoltham

◼Most common forms:

Dr. Siri Chutikamoltham

Dr. Siri Chutikamoltham

Dr. Siri Chutikamoltham

Dr. Siri Chutikamoltham

Dr. Siri Chutikamoltham

Dr. Siri Chutikamoltham

◼ 1. Warrant: an option for bond holders to buy a

Dr. Siri Chutikamoltham

◼1. Inflation risk

Dr. Siri Chutikamoltham

Dr. Siri Chutikamoltham

◼Concerns with the ability to sell a bond

Dr. Siri Chutikamoltham

◼Risk caused by the length of time to maturity

Dr. Siri Chutikamoltham

Risk Short Maturity Long Maturity

Interest Rate risk Low High

Dr. Siri Chutikamoltham

◼ Yields on longer term bonds are usually greater

Dr. Siri Chutikamoltham

◼The issuer cannot pay back investors as

Dr. Siri Chutikamoltham

Investment Grade Junk Bonds

Moody’s Aaa Aa A Baa Ba B Caa C

S&P AAA AA A BBB BB B CCC D

Dr. Siri Chutikamoltham

U.S. T-bills (3 month) 2.61

Corporate bonds(BBB, 10 year) 4.86**

Dr. Siri Chutikamoltham

◼ A “bond spread” is often calculated as the

Dr. Siri Chutikamoltham

Moody's Sovereign Rating Typical Sovereign Default Spread

◼A graph of the term structure is called the

Dr. Siri Chutikamoltham

Real risk-free rate

Don’t take additional risk unless you

Dr. Siri Chutikamoltham

Dr. Siri Chutikamoltham

$100 $100 $1,000

= $90.91 + . . . + $38.55 + $385.54

PV annuity = $ 614.46 Table IV

PV maturity value = 385.54 Table II

Value of bond = $1,000.00

Dr. Siri Chutikamoltham

INPUTS 10 13 100 1000

When kd rises, above the coupon rate, the bond’s

Dr. Siri Chutikamoltham

When kd rises, above the

INPUTS 10 7 100 1000

If coupon rate > kd,