FIN MAR

• Interest rate


  Compensation paid by the borrower of funds to the lender; from the borrower's point of view, the cost of borrowing funds
• Required return


  Cost of funds obtained by selling an ownership interest
• Factors that can influence the equilibrium interest rate


  • Inflation
  • Risk
  • Liquidity preference
• Near the height of the financial crisis in December 2008, interest rates on Treasury bills briefly turned negative, meaning that investors paid more to the Treasury than the Treasury promised to pay back
• Real rate of interest


  The rate that creates equilibrium between the supply of savings and the demand for investment funds in a perfect world, without inflation, where suppliers and demanders of funds have no liquidity preferences and there is no risk

  
• The real rate of interest changes

  With changing economic conditions, tastes, and preferences
• Nominal rate of interest

  The actual rate of interest charged by the supplier of funds and paid by the demander

  
• Risk-free rate, RF


  The real rate of interest plus the expected inflation premium

  
• The inflation premium is driven by investors' expectations about inflation—the more inflation they expect, the higher will be the inflation premium and the higher will be the nominal interest rate
• One of the disadvantages of bonds is that they usually offer a fixed interest rate. This presents a serious risk to bond investors, because if inflation rises while the nominal rate on the bond remains fixed, the real rate of return falls
• 1. bond


  An inflation-adjusted savings bond where the composite rate consists of a fixed rate that remains the same for the life of the bond and an adjustable rate equal to the actual rate of inflation
• Term structure of interest rates

  The relationship between the maturity and rate of return for bonds with similar levels of risk
• Yield to maturity (YTM)


  The compound annual rate of return earned on a debt security purchased on a given day and held to maturity

  
• Yield curves


  • Normal yield curve: upward-sloping, indicating long-term interest rates are generally higher than short-term
  • Inverted yield curve: downward-sloping, indicating short-term interest rates are generally higher than long-term
  • Flat yield curve: interest rates do not vary much at different maturities

  
• Theories of term structure

  • Expectations theory
  • Liquidity preference theory
  • Market segmentation theory
• Expectations theory


  The yield curve reflects investor expectations about future interest rates

  
• Liquidity preference theory


  Long-term rates are generally higher than short-term rates (yield curve is upward sloping) because investors perceive short-term investments to be more liquid and less risky than long-term investments

  
• Market segmentation theory


  The market for loans is segmented on the basis of maturity and the supply of and demand for loans within each segment determine its prevailing interest rate
• Risk premium


  The additional return required by investors to compensate for the risk associated with a particular security
• Corporate bond


  A long-term debt instrument indicating that a corporation has borrowed a certain amount of money and promises to repay
• Nominal rate of interest

  Equal to the risk-free rate (consisting of the real rate of interest plus the inflation expectation premium) plus the risk premium

  
• Risk premium


  Varies with specific issuer and issue characteristics
• The Treasury bond would represent the risk-free, long-term security, so we can calculate the risk premium of the other securities by subtracting the risk-free rate

  
• Corporate bond


  A long-term debt instrument indicating that a corporation has borrowed a certain amount of money and promises to repay it in the future under clearly defined terms
• Coupon interest rate


  The percentage of a bond's par value that will be paid annually, typically in two equal semiannual payments, as interest
• Bond's par value


  The amount borrowed by the company and the amount owed to the bond holder on the maturity date
• Bond's maturity date


  The time at which a bond becomes due and the principal must be repaid
• Bond indenture


  A legal document that specifies both the rights of the bondholders and the duties of the issuing corporation
• Standard debt provisions


  Provisions in a bond indenture specifying certain record-keeping and general business practices that the bond issuer must follow; normally, they do not place a burden on a financially sound business

  
• Restrictive covenants


  Provisions in a bond indenture that place operating and financial constraints on the borrower
• Most common restrictive covenants

  • Require a minimum level of liquidity
  • Prohibit the sale of accounts receivable to generate cash
  • Impose fixed-asset restrictions
  • Constrain subsequent borrowing
  • Limit the firm's annual cash dividend payments
• Sinking fund requirements


  A restrictive provision often included in a bond indenture, providing for the systematic retirement of bonds prior to their maturity
• Security interest


  A provision in the bond indenture that identifies any collateral pledged against the bond and how it is to be maintained

  
• Trustee


  A paid individual, corporation, or commercial bank trust department that acts as the third party to a bond indenture and can take specified actions on behalf of the bondholders if the terms of the indenture are violated
• The longer the bond's maturity


  The higher the interest rate (or cost) to the firm
• The larger the size of the bond offering

  The lower will be the cost (in % terms) of the bond
• The greater the default risk of the issuing firm

  The higher the cost of the bond issue
• Conversion feature for convertible bonds


  Allows bondholders to change each bond into a stated number of shares of common stock
• Call feature


  Gives the issuer the opportunity to repurchase bonds at a stated call price prior to maturity
• Call price


  The stated price at which a bond may be repurchased, by use of a call feature, prior to maturity