In this chapter, we start using the analysis tools that we developed in chapters 2 through 5 for real corporate finance problems. As you can imagine, the cost of borrowing money if you are a corporate manager is an important factor in determining whether a project will be profitable or not.
Selling bonds to the public is one way that corporations borrow money. Instead of borrowing from a bank, they sell bonds, which are really just corporate IOUs, to many individuals, banks, pension plans, etc. That way, they are not limited to what one bank can give them, and they give up less control over their enterprise — banks often set conditions that the firm may not like. It is often said that if you borrow too much from a bank, the bank owns your business.
If you have not had any experience with bonds, they can seem confusing. There are numerous new definitions and concepts in this chapter, so get out that pack of index cards! Once you learn the definitions, bonds will suddenly be simple and the calculations, given what you have learned in previous chapters, will be easy.
Since these bonds are negotiable — meaning that you can buy and sell them on the open market — buyers and sellers need to be able to figure out what they are worth. After studying this chapter, you will be able to do so as well.
When you finish your study of this chapter, you should know:
The following are terms that you should be able to define perfectly when you finish studying this chapter. Make your flash cards and take them with you, reviewing them whenever you have a chance. You will be a happy test taker!
Call protected bond
Default risk premium
Deferred Call provision
Interest rate risk
Interest rate risk premium
Over the Counter (OTC) market
Term structure of interest rates
Treasury yield curve
Yield to maturity
Yield to maturity
Zero coupon bond
Don’t forget! Homework is due by 6:30 PM on class day by e-mail to firstname.lastname@example.org! Don’t suffer a zero by being late.
Bonds are IOUs from companies or governments such as town and states. They are negotiable, meaning that you can buy and sell the bonds without the consent of the issuer. HOW MUCH they are worth depends on three things: the credit worthiness of the issuer, the interest rate they are paying compared to the market interest rate, AND the length of time to when they will be paid back. The market rate of interest demanded is directly related to inflation. When inflation is higher, interest rates go up. You can think of interest rates as the rent you pay to use money.