Financial

1. Chapter 4 (Learning Area 2)

2. • Principle sources of LT capital available
to companies – debt and equity
• Consider risk and return aspects of each
type of finance from the viewpoint of the
company raising money
• Investors attitude towards risk to
different types of finance are critical in
determining whether or not a particular
method of finance could be used

3. INTEREST IS PAYMENTS BY A BORROWER TO A LENDER FOR THE USE
OF MONEY
INTEREST RATE IS:
 THE RETURN A LENDER ENJOYS OF DEFERING HIS/HER CONSUMPTION
OF LIQUIDITY
 THE PRICE A BORROWER HAS TO PAY TO ENJOY THE USE OF FUNDS
WHICH HE/SHE DOES NOT OWN
 COULD ALSO BE DEFINED AS THE PRICE OF MONEY
DIFFERENT TYPES OF INTEREST RATES:
 • MONEY MARKET RATES
 • REPO RATE
 • PRIME OVERDRAFT RATE
 • CALL MONEY RATES
 • CAPITAL MARKET RATES

4.  REPO RATE AS ADJUSTED BY THE MONETARY POLICY
COMMITTEE OF SARB
 IN SHORT, THE ANSWER TO THE QUESTION IS THAT
INTEREST RATES ARE SET BY THE SARB IN RESPONSE TO
WHAT IS HAPPENING AND EXPECTED TO HAPPEN IN THE
SA ECONOMY
 INFLATION RATE
 ECONOMIC GROWTH
 EXCHANGE RATES

5. Long-term interest tends to be higher than
short-term interest for two reasons:
 Long-term interest perceived to be riskier
 Borrowers willing to pay more for long-term
funds because they can lock in at a specific
rate for a longer period of time

6.  Long-term loan capital instruments are often referred to as
BONDS and short-term instruments as BILLS
 Issues of loan capital may be listed on a securities exchange
 Holders of loan capital are creditors of the company
 Characteristics of a bond:
 They will receive periodic interest payments
 Which is a cost to the company
 They will be paid back the principle (capital) amount at
maturity

7. Most bond prices are redeemed at par on a set date and
coupons are paid every six months. The following variations
may exist:
 Capital repayments may be made between two dates
 Interest payments may be set as at fixed margin over a bench
mark interest rate
 Interest rates may be increased in steps
 Call loan that allows the company to redeem the loan at any
time
 Capital payments may be made right through duration

8. RIGHTS OF BOND HOLDERS
 Set out in the agreement
 In most cases a trustee is appointed to act on behalf of bond
holders
 Trustee is a corporate body such as a bank
 Legal aspects:
1. Bond indenture that specifies the right of the bond holder and
the issuing company
2. Standard debt provision
3. Restrictive debt provision

9. FUNDAMENTALS OF PRICING AND YIELD ON BONDS
 Market value of any investment asset is the PV of expected cash
flows
 The interest rate that these cash flows are discounted is called the
required rate of return (yield to maturity)
 Discount rate (required rate of return) is a function of inflation and
the perceived risk of the asset
 Higher risk results in a higher required return (yield) and a lower
asset value
 Since bonds are tradable, the price varies with supply and demand

10. VALUATION OF CAPITAL MARKET INSTRUMENTS (BONDS)
 Clean price
n
d
n
n
1
t
t
d
t
0
)
k
1
(
m
I
)
k
1
(
I
P




 

Consists of the present value of coupon payment, plus
present value of nominal value (par value).

11. CHARACTERISTICS OF BONDS
 n - Time to maturity / expiration
 M - Par value at maturity date/expiration (FV)
 Po – Current market price (PV)
 I – Coupon rate (usually semi-annually) PMT
 Kd- Yield to maturity (i)

12. Homework:
Nominal value R1 000 000
Coupon (semi-annually) 14%
Interest dates 15 March & 15 September
Maturity date 15 March 2015
Settlement date 15 September 2005
Yield 11,2% per annum
Calculate the clean price?

13. YIELD TO MATURITY
Relationship between yield to maturity and market price
Market value
Yield

14. YIELD TO MATURITY
Required return Bond value, Bo Status
12% R 885,30 Discount
10% 1000,00 Par value
8% 1135,20 Premium

15. BONDS YIELD
 If a bond is bought at par value then the coupon rate is equal
to the yield
 When does an investment in bonds offer a capital gain?
Example:
 A bonds current yield is the annual interest (income) divided
by the current price
 Yield to maturity is the yield earned on a bond from the time
it is acquired until the maturity date
 Yield curve graphically shows the relationship between time
to maturity and yield in a given risk class

16. COST OF BONDS TO THE ISSUER
 The longer the bonds maturity, the higher the interest
rate to the firm
 The larger the size of the offering, the lower will be the
cost (% terms) of the bond
 The greater the risk of the issuing firm , the higher the
cost of the issue
 The cost of money in the capital market is the basis for
determining a bond’s coupon rate


17. PRICE VOLATILITY OF A BOND IS DETERMINED BY:
 Time to maturity (the longer the outstanding term,
the more sensitive the bond price for a given % ∆ in
the yield)
 Coupon rate (the lower the coupon rate the more
sensitive the bond’s price for a given % ∆ in the
yield)
 Yield (the lower the yield of a bond, the more volatile
the price of the bond for a given % ∆ in the maturity
or coupon rate of the bond)

18. RELATIONSHIP BETWEEN THE VALUE OF A BOND AND
THE COUPON RATE
 The amount of coupon interest also impacts a bond’s
price volatility
 The lower the coupon, the greater the bonds
volatility, because it will be longer before the investor
receives a significant portion of the cash flow from
the investment

19. The volatility in the value of a 10 year bond issued at
R1 000 par- value for different yields to maturity and
coupon rates
Coupon % Price @ 13,5% Price @ 14,5% % Change
15 1081.02 1025.95 5.09
10 810,95 766,20 5.52
5 540,87 506,42 6,37

20. YIELD TO MATURITY
 Yield to maturity measures the compound annual
return to an investor and considers all bond cash
flow (IRR)
 Yield to maturity will only be equal to coupon rate if
the bond is selling at par value
 Premium bonds, where Yield < coupon rate
 Discount bonds, where Yield > coupon rate