FINMA2 FINANCIAL MANAGEMENT 2

INTEREST RATES

1. savers would like to earn as much interest as possible, and borrowers would like to pay
as little as possible.
2. The interest rate prevailing in the market at any given time reflects the equilibrium
between savers and borrowers.
3. Interest rate Usually applied to debt instruments such as bank loans or bonds; the
compensation paid by the borrower of funds to the lender; from the borrower’s point of
view, the cost of borrowing funds.
4. required return Usually applied to equity instruments such as common stock; the cost of
funds obtained by selling an ownership interest.
5. inflation A rising trend in the prices of most goods and services.
6. liquidity preference A general tendency for investors to prefer short-term (that is, more
liquid) securities.
7. savers demand higher returns (that is, higher interest rates) when inflation is high
because they want their investments to more than keep pace with rising prices
8. When people perceive that a particular investment is riskier, they will expect a higher
return on that investment as compensation for bearing the risk.
9. real rate of interest The rate that creates equilibrium between the supply of savings and
the demand for investment funds in a perfect world, without inflation, where suppliers
and demanders of funds have no liquidity preferences and there is no risk
10. RROI: no inflation, no liquidity preferences, no risk
11. Central bank increases supply of money  lower RROI  supply and demand at
equilibrium  lower cost of money  firms spend credit  economy expands again
12. nominal rate of interest The actual rate of interest charged by the supplier of funds and
paid by the demander
13. investors will demand a higher nominal rate of return if they expect inflation. The
additional return that investors require to compensate them for inflation is called the
expected inflation premium (IP).
14. The risk-free rate (as shown in Equation 6.3) embodies the real rate of interest plus the
expected inflation premium.
15. The inflation premium is driven by inves tors’ expectations about inflation: The more
inflation they expect, the higher will be the inflation premium, and the higher will be the
nominal interest rate.
16. The premium for expected inflation in Equation 6.3 represents the average rate of
inflation expected over the life of an investment.
17. term structure of interest rates The relationship between the maturity and rate of return
for bonds with similar levels of risk.
18. yield curve A graphic depiction of the term structure of interest rates.
19. yield to maturity (YTM) Compound annual rate of return earned on a debt security
purchased on a given day and held to maturity.
20. inverted yield curve A downward-sloping yield curve indicates that short-term interest
rates are generally higher than long-term interest rates.
21. normal yield curve An upward-sloping yield curve indicates that long-term interest rates
are generally higher than short-term interest rates
22. In a yield curve, the yield to maturity is plotted on the vertical axis and time to maturity
is plotted on the horizontal axis.
23. Historically, a downward-sloping yield curve, which is sometimes called an inverted yield
curve, occurs infrequently and is often a sign that the economy is weakening.
24. Usually, short-term interest rates are lower than long-term interest rates
25. flat yield curve A yield curve that indicates that interest rates do not vary much at
different maturities.
26. The shape of the yield curve may affect the firm’s financing decisions.
27. A fi nancial manager who faces a downward-sloping yield curve may be tempted to rely
more heavily on cheaper, long-term financing. However, a risk in following this strategy is
that interest rates may fall in the future, so long-term rates that seem cheap today may
be relatively expensive tomorrow.
28. Likewise, when the yield curve is upward sloping, the manager may believe that it is wise
to use cheaper, short-term financing.
29. Firms that borrow on a short-term basis may see their costs rise if interest rates go up.
Even more serious is the risk that a firm may not be able to refinance a short-term loan
when it comes due.
30. expectations theory The theory that the yield curve reflects investor expectations about
future interest rates;
31. an expectation of rising interest rates results in an upward sloping yield curve, and an
expectation of declining rates results in a downward-sloping yield curve.
32. if in vestors expect interest rates to rise, the 2-year rate today must be higher than the 1-
year rate today, and that in turn means that the yield curve must have an upward slope.
33. liquidity preference theory Theory suggesting that long term rates are generally higher
than short-term rates (hence, the yield curve is upward sloping) because investors
perceive short-term investments to be more liquid and less risky than long-term
investments. Borrowers must offer higher rates on long-term bonds to entice investors
away from their preferred short-term securities.
 34. market segmentation theory Theory suggesting that the market for loans is segmented
on the basis of maturity and that the supply of and demand for loans within each
segment determine its prevailing interest rate; the slope of the yield curve is determined
by the general relationship between the prevailing rates in each market segment.
35. the slope of the yield curve is affected by (1) interest rate expecta tions, (2) liquidity
preferences, and (3) the comparative equilibrium of supply and demand in the short-
and long-term market segments. Upward-sloping yield curves result from expectations
of rising interest rates, lender preferences for shorter-maturity loans, and greater supply
of short-term loans than of long-term loans relative to demand.
36. In general, the highest risk premiums and therefore the highest returns result from
securities issued by firms with a high risk of default and from long-term maturities that
have unfavorable contractual provisions
37. Default risk The possibility that the issuer of debt will not pay the contractual interest or
principal as scheduled. The greater the uncertainty as to the borrower’s ability to meet
these payments, the greater the risk premium. High bond ratings reflect low default risk,
and low bond ratings reflect high default risk.
38. Maturity risk That the longer the maturity, the more the value of a security will change
in response to a given change in interest rates. If interest rates on otherwise similar-risk
securities suddenly rise, the prices of long-term bonds will decline by more than the
prices of short-term bonds and vice versa.

BONDS
1. corporate bond A long-term debt instrument indicating that a corporation has borrowed
a certain amount of money and promises to repay it in the future under clearly defined
terms
2. coupon interest rate The percentage of a bond’s par value that will be paid annually,
typically in two equal semiannual payments, as interest.
3. The bondholders, who are the lenders, are promised the semiannual interest payments
and, at ma turity, repayment of the principal amount
4. Bond holders are protected primarily through the indenture and the trustee.
5. bond indenture A legal document that specifies both the rights of the bondholders and
the duties of the issuing corporation.
6. The borrower commonly must (1) maintain satisfactory accounting records in
accordance with generally accepted accounting principles (GAAP), (2) periodically supply
audited financial statements, (3) pay taxes and other liabilities when due, and (4)
maintain all facilities in good working order.
7. standard debt provisions Provisions in a bond indenture specifying certain record
keeping and general business practices that the bond issuer must follow; normally, they
do not place a burden on a financially sound business.
8. restrictive covenants Provisions in a bond indenture that place operating and financial
constraints on the borrower.
9. subordination In a bond indenture, the stipulation that subsequent creditors agree to
wait until all claims of the senior debt are satisfied.
10. Require a minimum level of liquidity, to ensure against loan default.
11. Prohibit the sale of accounts receivable to generate cash. Selling receivables could cause
a long-run cash shortage if proceeds were used to meet current obligations.
12. Impose fixed-asset restrictions. The borrower must maintain a specified level of fixed
assets to guarantee its ability to repay the bonds.
13. Constrain subsequent borrowing. Additional long-term debt may be prohib ited, or
additional borrowing may be subordinated to the original loan. Subordination means
that subsequent creditors agree to wait until all claims of the senior debt are satisfied.
14. Limit the firm’s annual cash dividend payments to a specified percentage or amount.
15. The violation of any standard or restrictive provision by the borrower gives the
bondholders the right to demand immediate repayment of the debt. Gener ally,
bondholders evaluate any violation to determine whether it jeopardizes the loan.
16. They may then decide to demand immediate repayment, continue the loan, or alter the
terms of the bond indenture.
17. sinking-fund requirement A restrictive provision often included in a bond indenture,
providing for the systematic retirement of bonds prior to their maturity
18. To carry out this requirement, the corporation makes semiannual or annual payments
that are used to retire bonds by purchas ing them in the marketplace
19. Security Interest The bond indenture identifies any collateral pledged against the bond
and specifies how it is to be maintained. The protection of bond collateral is crucial to
guarantee the safety of a bond issue
20. trustee A paid individual, corporation, or commercial bank trust department that acts as
the third party to a bond indenture and can take specified actions on behalf of the
bondholders if the terms of the indenture are violated
21. The cost of bond financing is generally greater than the issuer would have to pay for
short-term borrowing.
22. Impact of bond maturity. long-term debt pays higher interest rates than short-term debt.
In a practical sense, the longer the maturity of a bond, the less accuracy there is in
predicting future interest rates and therefore the greater the bondholders’ risk of giving
up an opportunity to lend money at a higher rate. In addition, the longer the term, the
greater the chance that the issuer might default
23. Impact of Offering Size The size of the bond offering also affects the interest cost of
borrowing but in an inverse manner: Bond flotation and administration costs per dollar
borrowed are likely to decrease with increasing offering size. On the other hand, the risk
to the bondholders may increase, because larger offerings result in greater risk of
default.
24. Impact of Issuer’s Risk The greater the issuer’s default risk, the higher the interest rate.
Some of this risk can be reduced through inclusion of appropriate restrictive provisions
in the bond indenture. Clearly, bondholders must be compensated with higher returns
for taking greater risk. Frequently, bond buyers rely on bond ratings (discussed later) to
determine the issuer’s overall risk.
25. Impact of the Cost of Money The cost of money in the capital market is the basis for
determining a bond’s coupon interest rate. Generally, the rate on U.S. Treasury securities
of equal ma turity is used as the lowest-risk cost of money. To that basic rate is added a
risk premium (as described earlier in this chapter) that reflects the factors mentioned
above (maturity, offering size, and issuer’s risk).
26. Three features sometimes included in a corporate bond issue are a conversion feature, a
call feature, and stock purchase warrants.
27. conversion feature A feature of convertible bonds that allows bondholders to change
each bond into a stated number of shares of common stock.
28. Bondholders convert their bonds into stock only when the market price of the stock is
such that conversion will provide a profit for the bondholder. Inclusion of the conver sion
feature by the issuer lowers the interest cost and provides for automatic conversion of
the bonds to stock if future stock prices appreciate noticeably.
29. call feature A feature included in nearly all corporate bond issues that gives the issuer
the opportunity to repurchase bonds at a stated call price prior to maturity.
30. call price The stated price at which a bond may be repurchased, by use of a call feature,
prior to maturity.
31. the call price exceeds the par value of a bond by an amount equal to 1 year’s interest.
32. $1,000 bond with a 10 percent coupon interest rate would be callable for around $1,100
[$1,000 + (10, * $1,000)]
33. call premium The amount by which a bond’s call price exceeds its par value.
34. The call feature enables an issuer to call an outstanding bond when interest rates fall
and issue a new bond at a lower interest rate.
35. When interest rates rise, the call privilege will not be exercised, except possibly to meet
sinking-fund re quirements.
36. Of course, to sell a callable bond in the first place, the issuer must pay a higher interest
rate than on noncallable bonds of equal risk, to compensate bondholders for the risk of
having the bonds called away from them.
37. stock purchase warrants Instruments that give their holders the right to purchase a
certain number of shares of the issuer’s common stock at a specified price over a certain
period of time.
38. The yield, or rate of return, on a bond is frequently used to assess a bond’s performance
over a given period of time, typically 1 year.
39. The three most widely cited bond yields are (1) current yield, (2) yield to maturity (YTM),
and (3) yield to call (YTC)
40. current yield A measure of a bond’s cash return for the year; calculated by dividing the
bond’s annual interest payment by its current price
41. $1,000 par value bond with an 8 per cent coupon interest rate that currently sells for
$970 would have a current yield of 8.25, [(0.08 * $1,000) , $970]
42. current yield ignores any change in bond value, it does not measure the total return
43. High-quality (high-rated) bonds provide lower returns than lower-quality (low-rated)
bonds, reflecting the lender’s risk–return trade-off.
44. first three types—debentures, subordinated debentures, and income bonds—are
unsecured, whereas the last three—mortgage bonds, collateral trust bonds, and
equipment trust certificates—are secured.
45. Putable bonds Bonds that can be redeemed at par (typically, $1,000) at the option of
their holder either at specific dates after the date of issue and every 1 to 5 years
thereafter or when and if the firm takes specified actions, such as being acquired,
acquiring another company, or issuing a large amount of additional debt. In return for its
conferring the right to “put the bond” at specified times or when the firm takes certain
actions, the bond’s yield is lower than that of a non putable bond.
46. foreign bond A bond that is issued by a foreign corporation or government and is
denominated in the investor’s home currency and sold in the investor’s home market
47. Eurobond A bond issued by an international borrower and sold to investors in countries
with currencies other than the currency in which the bond is denominated
48. Valuation is the process that links risk and return to determine the worth of an asset. It
is a relatively simple process that can be applied to expected streams of benefits from
bonds, stocks, income properties, oil wells, and so on
49. Key inputs to the valuation process (1) cash flows (returns), (2) timing, and (3) a measure
of risk, which determines the required return
50. Cash flows (returns) The value of any asset depends on the cash flow(s) it is expected to
provide over the ownership period. To have value, an asset does not have to provide an
annual cash flow; it can provide an intermittent cash flow or even a single cash flow over
the period
51. Timing In addition to making cash flow estimates, we must know the timing of the cash
flows.2 For example, Celia expects the cash flows of $2,000, $4,000, and $10,000 for the
 oil well to occur at the ends of years 1, 2, and 4, respectively. The combination of the
cash flow and its timing fully defines the return ex pected from the asset.
52. Risk and Required Return The level of risk associated with a given cash flow can
significantly affect its value. In general, the greater the risk of (or the less certain) a cash
flow, the lower its value. Greater risk can be incorporated into a valuation analysis by
using a higher required return or discount rate. The higher the risk, the greater the re
quired return, and the lower the risk, the less the required return.
53. the value of any asset is the present value of all future cash flows it is expected to
provide over the relevant time period.
54. Most corporate bonds pay interest semiannually (every 6 months) at a stated coupon
interest rate, have an initial maturity of 10 to 30 years, and have a par value, or face
value, of $1,000 that must be repaid at maturity.
55. Whenever the required return on a bond differs from the bond’s coupon inter est rate,
the bond’s value will differ from its par value.
56. The required return is likely to differ from the coupon interest rate because either (1)
economic con ditions have changed since the bond was issued, causing a shift in the cost
of funds; or (2) the firm’s risk has changed.
57. Increases in the cost of funds or in risk will raise the required return; decreases in the
cost of funds or in risk will lower the required return.
58. discount The amount by which a bond sells below its par value.
59. premium The amount by which a bond sells above its par value.
60. Required return > coupon rate = discount
61. Coupon rate > required return = premium
62. When the required return is different from the coupon interest rate and is constant until
maturity, the value of the bond will ap proach its par value as the passage of time moves
the bond’s value closer to ma turity. (Of course, when the required return equals the
coupon interest rate, the bond’s value will remain at par until it matures.)
63. interest rate risk The chance that interest rates will change and thereby change the
required return and bond value. Rising rates, which result in decreasing bond values, are
of greatest concern.
64. short ma turities have less interest rate risk than long maturities when all other features
(cou pon interest rate, par value, and interest payment frequency) are the same.
65. Converting annual interest, I, to semiannual interest by dividing I by 2.
66. Converting the number of years to maturity, n, to the number of 6-month periods to
maturity by multiplying n by 2.
67. Converting the required stated (rather than effective)6 annual return for sim ilar-risk
bonds that also pay semiannual interest from an annual rate, rd, to a semiannual rate by
dividing rd by 2.
68.