Finance Chapter: Debt Valuation and Bonds

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Questions and Answers

What does the return that the bank should receive from lending money to a firm represent?

The total amount repaid by the firm including principal and interest.

The bank's profit margin on the loan.

The opportunity cost associated with lending the money. (correct)

The sum of deposits held in the bank.

How is the interest rate applied by the bank to the firm related to opportunity cost?

It is calculated based on the inflation rate.

It determines the economic stability of the firm.

It represents the bank's operational costs.

It indicates the potential return the bank misses out on by not investing elsewhere. (correct)

In what way does the bank's decision to lend money entail opportunity cost?

The bank has to lower interest rates for all customers.

The bank incurs additional fees for processing the loan.

The bank sacrifices customer transactions.

The bank loses out on future investments. (correct)

Which of the following best describes the opportunity cost for a bank when lending money?

The potential interest income from other lending options. Signup and view all the answers

What is the significance of understanding opportunity cost in banking?

It enables banks to make informed decisions regarding loan approvals. Signup and view all the answers

What is the cost of debt capital (Kd) when considering the risk-free interest rate (irf) and expected inflation rate (π)?

3.74% Signup and view all the answers

If the risk-free interest rate (irf) increases to 3%, what would be the new Kd given the same expected inflation rate (π) of 1.74%?

4.74% Signup and view all the answers

Which of the following is NOT a consequence of entering a state of bankruptcy for a corporation?

Increased investor confidence Signup and view all the answers

What effect does entering bankruptcy have on the overall costs of debt capital?

Increases due to higher risk perceptions Signup and view all the answers

What is one of the components used to calculate the cost of debt capital (Kd)?

Expected inflation rate (π) Signup and view all the answers

What factor is primarily responsible for differences in the slope of the function discussed?

The need for higher financial interests to recover losses Signup and view all the answers

What does the identical point of default indicate about the function's shape?

The shape of the function remains substantially similar Signup and view all the answers

Why is the market value of financial debt considered relevant?

It is a critical element for understanding financial losses Signup and view all the answers

What implication does the same probability of default have for debt holders?

It implies higher financial interests to cover losses Signup and view all the answers

Which of the following statements is true regarding the comparison of functions with respect to default?

The slope difference reflects financial interests related to losses Signup and view all the answers

What are additional costs that occur only because an activity did not continue referred to as?

Opportunity costs Signup and view all the answers

Which of the following best describes the term 'liquidated in bonis'?

Liquidation that considers only recoverable assets Signup and view all the answers

Which type of costs are likely to be incurred specifically when an activity halts?

Additional costs Signup and view all the answers

What is one consequence of an activity being liquidated 'in bonis'?

Incurring costs that would not have happened otherwise Signup and view all the answers

When assessing potential losses, which aspect is primarily affected by ceasing an activity?

Additional costs incurred Signup and view all the answers

What primarily determines the value of a bond?

The present value of expected cash flows, discounted at an appropriate interest rate Signup and view all the answers

Which factor does NOT influence the interest rate applicable to the valuation of bonds?

The current stock market trends Signup and view all the answers

What is the formula to find the periodic interest rate when payments occur more frequently than annually?

$Kd{sem} = (1 + Kd{year})^{1/2} - 1$ Signup and view all the answers

Which ratio is commonly used to determine the probability of bankruptcy?

Interest coverage ratio Signup and view all the answers

What interest coverage ratio is typically considered to indicate a financial debt at very high risk?

Lower than 1 Signup and view all the answers

If a company's interest coverage ratio is consistently above 1, what does this imply?

The company can perpetually pay interest regardless of its ability to repay the principal Signup and view all the answers

What is the relationship between bond value and the interest rate demanded by investors?

Inversely related; as interest rates rise, bond value falls Signup and view all the answers

In the formula for bond valuation, what does the term 'Pmkt' refer to?

The market price of the bond Signup and view all the answers

What does high interest coverage ratios indicate about a company's financial debt?

It is at low risk Signup and view all the answers

To calculate the yield to maturity of a bond, which value is needed?

Market price and present value of cash flows Signup and view all the answers

Which of the following best describes the 'maturity premium'?

The added risk associated with long-term bonds Signup and view all the answers

What must be true for the market data to estimate the cost of debt capital accurately?

Data should reflect the company's operational cash flows Signup and view all the answers

What does the formula $PVbond = ext{Pmkt} = rac{Coupon}{(1+k)^t} + rac{N om Val}{(1+K_d)^N}$ represent?

Present value of bond cash flows Signup and view all the answers

Study Notes

Opportunity Cost of Debt

Bank's opportunity cost of lending to a firm is equal to the interest rate applied to the firm.

Shape of Debt Function

The point of default is identical, but the slope varies.
Higher probability of default implies higher losses for debt holders, requiring higher financial interest to recover the losses.

Market value of Debt

Bank debt valuation is implicit.
Traded debt has an explicit price determination process that defines market price.
Bonds are used to demonstrate the relationship between market value and valuation parameters.

Value of Bond

Value of a bond is the present value of the expected cash flows discounted at the appropriate risk interest rate.
Bond value is inversely related to the interest rate investors demand.

Interest Rate Variables

Short-term risk-free interest rate: reflects overall interest rate levels in the economy.
Maturity premium: difference between long-term and short-term risk-free interest rates (generally positive).
Bond-specific default risk.

Periodic Interest Rate

Interest rate is usually determined annually.
For non-annual interest payments, adjust the discounting mechanism accordingly.
Calculate semi-annual capitalization by: Val1 = Val0 * (1 + Kdsem)^2 = Val0 * (1 + Kdyear)
Formula to calculate periodic interest rate Kdp: Kdp = (1 + Kdyear)^(12/p) - 1

Bond Price Calculation

Bond price (Pmkt) can be calculated as the sum of the discounted coupon payments and the discounted nominal value.
Formula: Pmkt = Bnom * [i/(1+k) * ( 1 - (1+k)^-n) + (1+k)^-n]
The formula applies to all coupon periodicities, provided that the coupon rate and cost of capital are expressed on the same basis.

Yield to Maturity

Bond's IRR (Internal Rate of Return) is the discount rate when the present value of coupons and nominal value equals the market price.
Yield to maturity is the same as the IRR.

Estimating Cost of Debt Using Market Data

Market data can be used to estimate the cost of debt capital.
Instead of directly analyzing operational cash flow risk, the market is used to estimate financing risk.
This involves calculating the Expected Loss (π), which is the product of the probability of default and the loss given default.

Costs of Bankruptcy and the Impact on Cost of Debt

Bankruptcy incurs costs that reduce enterprise value:
- Additional costs that wouldn't have occurred if the company had continued normal operations or been liquidated "in bonis".
- Costs related to legal, administrative, and restructuring processes.
Costs of bankruptcy need to be accounted for in estimating the cost of debt.

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Description

Explore the fundamental concepts of debt valuation, including the opportunity cost of debt, market value, and bond pricing. This quiz covers the impact of interest rates, default probabilities, and present value calculations related to bonds. Test your understanding of these key financial principles.