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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