Chapter_11_Cost_of_Debt

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Click to edit Master subtitle style Chapter 11 The Opportunity Cost of Capital: The Cost of Debt Instructors: Please do not post raw PowerPoint files on public website. Thank you! 11

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Estimating the Cost of Debt 1. Search Bloomberg (or other financial databases) for the yield to maturity on the company’s long-dated, option-free debt. To determine price and yield accurately, use only large trades (> \$1 million). 1. If bonds do not trade, instead add a default premium to a benchmark rate. The benchmark rate should be a long-dated local Treasury bond rate. The default premium is based on the company’s debt rating. 2. If your company (or client) does not have a debt rating, then use a scoring model to estimate a rating. 22
33 Yield to Maturity of Debt When purchasing a bond, investors require compensation. The discount factor used to value a bond is known as its yield to maturity (YTM). Factor #1: the bond’s time to maturity (duration) Factor #2: the credit spread for default risk A bond’s yield to maturity (YTM) is dependent on two factors:

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Home Depot: Pricing Example To value a bond, use the annuity formula for coupon payments and present value for the face value. Alternatively, use a spreadsheet to compute the present value of individual cash flows. For U.S. bonds, coupons are paid twice a year. Therefore, the bond-equivalent yield must be divided by two for discounting semiannual cash flows. 44 Home Depot Coup on 5.8 75 5.875 Bond, maturing 12/16/2036 Yi el d 5.8 65 Semia nnual Disco unt Pres ent Peri od D at e Cou pon Yi el d Fac tor Val ue 1 12/16/20 10 2.93 75 2.93 25 1.02 93 2.8 54 2 6/16/20 11 2.93 75 2.93 25 1.05 95 2.7 73 3 12/16/20 11 2.93 75 2.93 25 1.09 06 2.6 94 4 6/16/20 12 2.93 75 2.93 25 1.12 26 2.6 17 5 12/16/20 12 2.93 75 2.93 25 1.15 55 2.5 42 6 6/16/20 13 2.93 75 2.93 25 1.18 94 2.4 70 7 12/16/20 13 2.93 75 2.93 25 1.22 42 2.3 99 8 6/16/20 14 2.93 75 2.93 25 1.26 01 2.3 31 9 12/16/20 14 2.93 75 2.93 25 1.29 71 2.2 65 1 0 6/16/20 15 2.93 75 2.93 25 1.33 51 2.2 00 5 0 6/16/20 35 2.93 75 2.93 25 4.24 25 0.6 92 5 1 12/16/20 35 2.93 75 2.93 25 4.36 70 0.6 73 5 2 6/16/20 36 2.93 75 2.93 25 4.49 50 0.6 54 5 3 12/16/20 36 102.93 75 2.93 25 4.62 68 22.2 48 Present value: 100.1 34
55 To find the yield to maturity for companies with liquid corporate debt , search for trading data on the company’s long-term bonds (greater than 10 years). In the United States, corporate bond trades are reported to the National Association of Securities Dealers, through its Trade Reporting and Compliance Engine (TRACE) system. Only trades greater than \$1 million dollars should be considered. Consider trade data on bonds from

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This note was uploaded on 06/06/2011 for the course FINA 4210 taught by Professor Staff during the Spring '08 term at UGA.

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Chapter_11_Cost_of_Debt - Instructors: Please do not post...

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