Lesson 4

Debt as a source of funds

Learning objectives
This topic introduces the evaluation of a fixed interest security. After completing
this module, you should be able to:
 distinguish between long term and short term debt
 identify cash flows for a long term bond
 find the value of a commercial or government bond
 calculate the yield to maturity of a bond
In understanding the above, you should be able to understand the difference in the
use of long term and short term debt as a source of funds.

Introduction
Firms borrow money to fund their operations and investments. The borrowing
can be long term or short term. It depends on what the fund is used for. Firms
have many means of sourcing debt. They can use short term sources like trade
credit or bank overdraft or they can use long term sources like a bond issue.
The feature of debt is that it:
- is a contractual claim on the firm
- has fixed periodic interest payment
- usually requires a fixed principal repayment to retire the loan
Long-term is usually classified as longer than a year.

Short term debt

The following are examples of short-term debt a firm can use. The textbook does
not describe some of them adequately. It will be helpful if you can read another
textbook or use the internet to find out more about the following:
Bank overdraft
 Overdraw on current account
 Usually an upper limit on overdraft
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Inter-company Loans
 Direct lending between firms
Commercial Bills
 Short term loan than is usually endorsed by a third party
Promissory Notes
 One-name paper that do not require third party endorsement
Trade credit
 Deferred payment for good and services

Long term debt

The following are examples of long term debt that the firm can issue. Again, it
would be helpful if you can use other resources to learn more about these sources.
Term loans and mortgage loans
 Mortgage against property
Fully drawn advances
 Like an overdraft facility but for a longer period, usually five years
Leases
 Contract between lessor and lessee for periodic payment for use of asset
Debentures
 Entails a fixed interest payment and a principal payment to discharge the debt.
 Debt is secured against the issuer’s asset

How to issue debentures

Public issue
 Issued to public through a prospectus
Family issue
 Issued to equity, debenture and debt holders
Private placement
 Issued to institutional investors

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Features of a bond/debenture
The following are some of the features of a bond or debenture. They are:
 Long term loan
 Issued by government and corporation

It is important that we identify the cash flows provided by the bond.

 Coupon – fixed repayment on the loan based on a percentage of the face value
 Face value:
Also called par value or maturity value. The principle value that is repaid
when the bond is retired.
 Maturity date:
Date at which the bond expires

The following is a crude example of a bond. Suppose today is the year 2000.

January, 2005 BHP

SYDNEY

$100,000

COUPON @ 10% PAID ANNUALLY

January 2005 - Maturity Date

If today is the year 2000, the bond has 5 years to
mature
BHP - Organisation responsible for the interest and maturity
payouts
$100,000 - Amount to be received on maturity - FACE VALUE
Coupon @ 10% - Interest paid per year - ie $10,000. The interest is
calculated on the face value. That is, 10% of
$100,000.

3 Module 5
The cash flow provided by such a bond is as follows:

0 1 2 3 4 5

10,000 10,000 10,000 10,000 10,000

100,000

The holder of this bond will receive the interest payment of $10,000 per year for
five years and than the face value of the bond which is $100,000.
Since a bond is a discount instrument, its value is the present value of the cash
flow it provides.
Value is determined by discounting all expected coupons and maturity payouts by
an appropriate discount rate – Rb(or i)
Coupon Coupon Coupon Coupon Coupon+ FV
PV = + + + +
(1+ Rb )1 (1+ R b )2 ( 1+ R b )3 (1+ R b )4 ( 1+ Rb )5

Or

PV = PV of coupon payments + PV of final payment

For the above example:

10 , 000 10 , 000 10 , 000 10 , 000 110 , 000

PV = + + + +
(1+ Rb )1 (1+ R b )2 (1+ R b )3 (1+ R b )4 (1+ R b )5

The discount rate that we use is the market rate or yield. The yield is also called
the yield to maturity of the bond. If the yield on the bond is 8% what is the price
of the bond?

10 , 000 10 , 000 10 ,000 10 , 000 110, 000

PV = + + + +
(1+. 08 )1 (1+.08 )2 (1+. 08)3 (1+. 08 )4 (1+. 08)5
¿ 107 , 985 . 42

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Can you think of another way of working out the answer?

Activity 5.1
A 10-year government bond offers a coupon rate of 10% per annum. What is the
price of the bond if the yield on the bond is 12% per annum and the face value is
$1000?
The time line for the above bond will be as follows:

0 1 2 … 9 10

100 100 100 100 100

1000

100 100 100 1100

PV = + +.. .+ +
(1+. 12)1 (1+. 12)2 (1+. 12)9 (1+. 12)10
¿ 887

What happens as if the yield falls to 8%?

Answer: PV = 1134.20

What happens if the yield rises to 14%?

Answer: 791.35

What happens if the yield is 10%?

Answer: 1000

5 Module 5
As observed from the above example:
 There is an inverse relationship between the discount rate and the price. This
relationship is mathematical. The discount rate is the divisor. If the divisor
increases in value, the answer to the fraction must decrease.
 The discount rate is market driven - it varies according to the supply and
demand for bonds
There are some other interesting observations you would have made:
- If: Coupon rate = Rb 10% = 10% Then PV=FV
- If: Coupon rate > Rb 10% > 8% Then: PV > FV
- If: Coupon rate < Rb 10% < 14% Then: PV < FV

Activity 5.2
What if the bond above is paying semi-annual coupons? What is the price if the
yield is 12% per annum?
For the above problem the following time line will apply:

0 1 2 … 19 20

50 50 50 50 50

1000

50 50 50 1050
PV = 1
+ 2
+.. .+ +
(1+. 06 ) (1+. 06) (1+. 06 ) (1+. 06 )20
19

¿ 885 . 30

Note that we had to half the coupon payments and double the number of periods.
Because we are working on a semi-annum basis, our discount rate has to be
halved as well.

Nominal and effective yield to maturity

The yield to maturity of a bond is the discount rate that equates the present value
of the cash flow to its price. It is the return you get when you buy the bond and
hold it till maturity. It is equivalent to the internal rate of return.

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The yield to maturity or the required rate of return on the bond (Rb) depends on
the risk, inconvenience and inflation.
The riskiness of a bond is a function of time and who owes you the money.
A bond can be issued the government
- Federal
- State
- Local
Or by a private company
- Blue Chip
- Green Chip
The riskiness of the bond also depends time, that is how long it has to mature.
The long the maturity:
- the more time to default
- the greater impact of inflation
- the greater the inconvenience
How do we decide what required rate of return (Rb) to use in evaluating a bond?
We can calculate the yield to maturity of an existing bond of a same risk class and
maturity. The information needed to work out the yield to maturity is readily
available from the financial press or through the internet. If I want to estimate the
rate of return of a 10 year bond that is to be issue by a mining company, I need to
pick an existing bond of a similar maturity date from another mining company to
estimate its rate of return.

Inflation and the value of a bond

Inflation erodes the value of a fixed interest security like a bond.

Activity 5.5
If you determined your nominal YTM on a bond to be 14% per annum and
inflation is currently running at 7% per annum, what is your real return?
Real rate = ( 1.14/1.07 ) - 1 = 6.54%

7 Module 5
Reflecting on what you have learned
Write a paragraph on the following:
What is the distinction between long-term and short-term debt?

Why is the value of a bond the present value of its cash flows?

What is the yield to maturity and how does it differ from the coupon rate?

How does the risk differ between a corporate bond and a government bond?