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From the issuers point of view this value is the cost

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Unformatted text preview: e internal rate of return (IRR) on the bond cash flows. From the issuer’s point of view, this value is the cost to maturity of the cash flows associated with the debt. The cost to 2. Generally, the yield to maturity of bonds with a similar “rating” is used. Bond ratings, which are published by independent agencies, were discussed in Chapter 6. 474 PART 4 Long-Term Financial Decisions FOCUS ON e-FINANCE In Practice Sold to the Lowest Bidder In August 2000, Dow Chemical became the first industrial corporation to price and distribute bonds online. WR Hambrecht Co., a pioneer in online equity IPOs, conducted the 2-hour Dutch auction at its OpenBook auction Web site. In a Dutch auction (long used to price and sell Treasury bonds), investors place bids to buy a particular amount of a security at a specific price within a spread set by the issuer before the auction. The underwriter accepts the lowest price at which there is enough demand to sell all the bonds offered (the clearing price). Investors who bid that price or higher get their requested allocations at the clearing price. Dow’s open bond auction of $300 million in 5-year bonds was well received, attracting a broader investor base that could reduce volatility in the secondary market. The interest rate on the issue was similar to what Dow would have paid using the traditional syndication process, but the underwriting fee was over 50 percent lower. “To me, it’s a no-brainer,” said Dow treasurer Geoffery Merszei. In the future, market watchers expect Internet auctions to lower issuance costs for debt capital through more efficient pricing that reflects market demand. All bidders have equal access to securities, and investors can see a real-time, fully visible demand curve for a bond issue as it unfolds, resulting in improved distribution and enhanced liquidity. Despite Dow’s success, few corporations have followed it online. Ford Motor Credit issued $750 million of 3-year notes in March 2001. In February 2001, government-sponsored residential mortgage agency Freddie Mac announced that it would use OpenBook for eight auctions. So far, most major investment bankers have resisted endorsing a method that would undercut their more lucrative traditional underwriting business. However, both proponents and opponents of online Dutch auctions of corporate debt believe that this method works best for large, standard-issue bonds from investment-grade issuers. Sources: Adapted from Shella Calamba, “Wall St. Ignores Online Bond Deals at Its Peril,” Dow Jones Newswires (August 18, 2000), downloaded from www. wrhambrecht.com/inst/openbook/media. html; Emily S. Plishner, “E-bonds: Will They Fly?” CFO (March 1, 2001); and “WR Hambrecht Co’s Core Technology to Support the First Dutch Auction of Freddie Mac Two- and Three-Year Reference Notes,” press release from WR Hambrecht Co. (February 8, 2001), downloaded from www.wrhambrecht.com/inst/ openbook/media.html. maturity can be calculated by using either a trial-and-error technique3 or a financial calculator. It represents the annual before-tax percentage cost of the debt. EXAMPLE In the preceding example, the net proceeds of a $1,000, 9% coupon interest rate, 20-year bond were found to be $960. The calculation of the annual cost is quite simple. The cash flow pattern is exactly the opposite of a conventional pattern; it consists of an initial inflow (the net proceeds) followed by a series of annual outlays (the interest payments). In the final year, when the debt is retired, an outlay representing the repayment of the principal also occurs. The cash flows associated with Duchess Corporation’s bond issue are as follows: End of year(s) 0 1–20 20 WW W Cash flow $ 960 $ 90 $1,000 3. The trial-and-error technique is presented at the book’s Web site, www.aw.com/gitman. CHAPTER 11 Input 20 Function N 960 PV 90 PMT 1000 The Cost of Capital 475 The initial $960 inflow is followed by annual interest outflows of $90 (9% coupon interest rate $1,000 par value) over the 20-year life of the bond. In year 20, an outflow of $1,000 (the repayment of the principal) occurs. We can determine the cost of debt by finding the IRR, which is the discount rate that equates the present value of the outflows to the initial inflow. FV CPT I Solution 9.452 Calculator Use [Note: Most calculators require either the present (net proceeds) or the future (annual interest payments and repayment of principal) values to be input as negative numbers when we calculate cost to maturity. That approach is used here.] Using the calculator and the inputs shown at the left, you should find the before-tax cost (cost to maturity) to be 9.452%. Approximating the Cost The before-tax cost of debt, kd, for a bond with a $1,000 par value can be approximated by using the following equation: I kd $1,000 Nd n Nd $1,000 2 (11.1) where I Nd n EXAMPLE annual interest in dollars net proceeds from the sale of debt (bond) number of years to the bond’s maturity Substituting the appropriate values from the Duche...
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