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11 - 1 Long-Term Debt Sources of Financing Interest rate levels Types of long-term debt Risks of long-term debt Debt valuation Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 2 Capital Financing Basics Businesses need capital to acquire the assets needed to provide services. Capital comes in two basic forms: Debt capital (loans, bonds, debentures) -liability sources of capital Equity capital (stock, retained earnings) -non-liability sources of capital HSO utilization of debt and equity capital Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 3 Common Long-Term Debt Instruments Term loans (3-15 year maturities) Amortized interest/principal payments Lender as financial intermediary (bank) Advantages: speed, flexibility, low cost Bonds (10-30 year maturities) Bond issues Multiple creditors/investors per issue Public vs. private placement of bond issues Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 4 Common Long-Term Debt Instruments Types of Bonds Corporate Bonds • • • • Investor-owned organizational debt issue Longer maturity debt (10-30 years) Fixed vs. variable interest rates Payment of interest and principal Mortgage Bonds • Corporate debt issues backed by pledge of organizational assets • Primary vs. secondary mortgage issues Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 5 Common Long-Term Debt Instruments Types of Bonds Corporate Debentures • Corporate debt backed by revenue-generating capacity of organization (no fixed assets) • Higher cost form of corporate debt than MB’s • Rationale for use Subordinated Debentures • “Junk” or below investment grade debt issues • High-risk, high-cost corporate debt • Rationale for use Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 6 Common Long-Term Debt Instruments Types of Bonds Municipal Bonds (“Munis”) • Debt issues from non-federal governmental entities and/or their representative organizations • Types of munis -- general obligation munis, special tax bonds, revenue bonds (NFP’s) • Fixed interest, longer-term maturities • “Serial issue” municipal bonds • Tax exemption of municipal bond interest • Public vs. private placement of munis Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 7 Debt Contract Provisions Bond indentures General provisions • Maturity of bonds • Interest rate (coupon rate) Restrictive covenants (creditor obligations of borrower) Trustee (bond fiduciary) Call provisions -- advantages and disadvantages to issuer/borrowers Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 8 Bond Ratings Rating agencies assign bond ratings that reflect the probability of default: Investment Grade Junk Bonds Moody’s Aaa Aa A Baa Ba B S&P AA A BBB BB B CCC D AAA Caa C Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 9 Bond Rating Concepts Bond rating criteria Issuer’s financial condition Competitive situation Quality of management Importance of ratings To investors/creditors To issuers (cost of capital) Changes in ratings (factors affecting) Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 10 Credit Enhancement Credit enhancement (bond insurance) is available on municipal bonds. Insured bonds have the rating of the insurer (AAA), not the issuer. Issuers must pay an up-front fee to obtain bond insurance. (50-75 basis points based on total debt service) Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 11 Interest Rate Components Interest as opportunity cost of debt The interest rate on any debt security can be thought of a base rate plus one or more components. Here is the model: Rate = RRF + IP + DRP + LP + PRP + CRP. Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 12 Here: RRF = Real risk-free rate. IP = Inflation premium. DRP = Default risk premium. LP = Liquidity premium. PRP = Price risk premium. CRP = Call risk premium. Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 13 Interest Rate Example 1 1-Year Treasury Security RRF = 2%; IP = 3%: Rate = RRF + IP + DRP + LP + PRP + CRP = 2% + 3% + 0 + 0 + 0 + 0 = 5%. Why are there zeros for DRP, LP, PRP, and CRP? Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 14 Interest Rate Example 2 30-Year Columbia/HCA Callable Bond RRF = 2%; IP = 4%; DRP, LP, PRP = 1%; CRP = 0.4%: Rate = RRF + IP + DRP + LP + PRP + CRP = 2% + 4% + 1% + 1% + 1% + 0.4% = 9.4%. Callable vs. non-callable rates of interest Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 15 The Term Structure of Interest Rates Term structure is the relationship between interest rates and debt maturities. (years to maturity) Thus, term structure tells us the relationship between short-term and long-term rates. A graph of the term structure is called the yield curve. Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 16 Treasury Yield Curve (July 1998) Interest Rate (%) 7 6 10 20 1 yr. 5 yr. 10 yr. 20 yr. 30 yr. 5.3% 5.4 5.5 5.6 5.7 5 0 30 Years to Maturity Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 17 Bond Yield Curves What does a bond yield represent? YTM (bond yield to maturity) -- (1) coupon rate/yield for bonds that sell at par value (new issues, mature issues); (2) coupon rate/yield for bonds plus or minus capital gain/loss for bonds that sell below or above par value (outstanding bond issues) Normal vs. inverted yield curves Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 18 Debt Valuation Why should healthcare managers worry about debt valuation? Managers must understand how investors make resource allocation decisions. Cost of financing is important to good capital investment decisions. Debt valuation concepts are used to value other assets. Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 19 General Valuation Model The financial value of any asset stems from the cash flows that the asset is expected to produce. Thus, all assets are valued in the same way: Estimate the expected cash flows. Set the required rate of return/discount rate Discount the cash flows. Sum the present values. Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 20 General Valuation Model (Cont.) 0 1 2 R(R) N ... CF1 CF2 CFN PV CF1 PV CF2 PV CFN Value Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 21 Bond Definitions 1. Par value: Stated face value of the bond. Generally the amount borrowed and repaid at maturity. Often $1,000 or $5,000. 2. Coupon rate: Stated interest rate on the bond. Multiply by par value to get dollar coupon payment. Usually fixed. Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 22 3. Maturity date: Date when the bond will be repaid. Note that the effective maturity of a bond declines each year after issue. 4. New versus outstanding bonds: When a bond is issued, its coupon rate reflects current conditions. When conditions change, bond values change. Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 23 5. Debt service requirements: Issuers are concerned with their total debt service payments, including both interest expense and repayment of principal. Many municipal bond issues (serial issues) are structured so that debt service requirements are roughly constant over time. Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 24 What’s the value of a 15-year, 10% coupon bond if R(R) = 10%? 0 1 2 10% 15 ... 100 100 100 + 1,000 $ 760.61 239.39 $1,000.00 Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 25 The bond consists of a 15-year, 10% annuity of $100 per year plus a $1,000 lump sum at t = 15: PV annuity = $ 760.61 PV maturity value = 239.39 PV annuity = $1,000.00 INPUTS OUTPUT 15 N 10 I/YR PV 1000 -100 PMT -1000 FV Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 26 What’s the value after one year if interest rates remain constant? INPUTS OUTPUT 14 N 10 I/YR PV 1000 -100 PMT -1000 FV If interest rates (the required rate of return on the bond) stay constant, the bond’s value remains at $1,000. Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 27 Now suppose interest rates fell, so that R(R) is now only 5 percent. INPUTS OUTPUT 14 N 5 I/YR PV 1494.93 -100 PMT -1000 FV When R(R) falls, a bond’s value increases. Now the bond sells above its par value, or at a premium. (logic?) Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 28 What would happen if interest rates rise, and R(R) is now 15 percent? INPUTS OUTPUT 14 N 15 I/YR PV 713.78 -100 PMT -1000 FV When R(R) rises, a bond’s value decreases. Now the bond sells below its par value, or at a discount. (logic?) Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 29 Assume the bond has 14 years to maturity. What would happen to bond values over time if interest rates remained at the levels given: 5 percent, 10 percent, and 15 percent? Remember that the bond has a 10 percent coupon rate. Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 30 Bond Value ($) 1,495 1,216 1,000 R(R) = 5%. R(R) = 10%. M 832 R(R) = 15%. 714 14 10 5 0 Years to Maturity Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 31 At maturity, the value of any bond must equal its par value. The value of a premium bond will decrease to par value at maturity. The value of a discount bond will increase to par value at maturity. A par bond value will remain at par if interest rates remain constant. The return in each year consists of an interest payment and a price change. Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 32 Definitions Current yield = Annual interest payment . price Capital gains yield = Change in price . Beginning price Total Current Capital = + . return yield gains yield Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 33 Find the current yield, capital gains yield, and total return during Year 1 when the interest rate falls to 5%. $100 Current yield = $1,000 = 0.100 = 10.00%. $495 Capital gains = $1,000 = 0.495 = 49.5%. Total return = 10.0% + 49.5% = 59.5%. Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 34 Repeat the calculation, but this time for Year 2. $100 Current yield = $1,495 = 0.670 = 6.70%. Capital gain -$25 = $1,495 = -0.170 = -1.70%. Total return = 6.7% - 1.7% = 5.0%. Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 35 Yield to Maturity The yield to maturity (YTM) on a bond is the expected rate of return assuming the bond is held to maturity. (reported bond yields) Mathematically, it is the discount rate that forces the present value of the cash flows from the bond to equal the bond’s price. Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 36 What’s the YTM on a 14-year, 10% annual coupon, $1,000 par value bond that sells for $1,494.93? 0 YTM = ? 1 $1,495 10 ... 100 PV1 . . PV9 PV10 PVM 9 100 100 1,000 Find the discount rate that “works”! Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 37 Using a Financial Calculator for YTM INPUTS OUTPUT 14 N 1494.93 -100 I/YR PV PMT 5.00 -1000 FV Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 38 Find YTM if price were $713.78. INPUTS 14 N OUTPUT 713.78 I/YR PV 15.0 -100 PMT -1000 FV Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 39 Bonds Actually Have Semiannual Coupons Therefore, there are twice as many interest payments compared to annual coupon payments. But, the interest payment is only half of the annual payment. And, the required rate of return (discount rate) is only half of the annual rate. Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 40 Find the value of a 14-year, 10% coupon, semiannual bond if the required rate of return is 5 percent. 2x14 INPUTS 28 N OUTPUT 5/2 2.5 I/YR 100 / 2 -50 PV PMT 1499.12 -1000 FV Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 41 Find the YTM of a 14-year, 10% coupon, semiannual bond if the bond is selling for $1,400. INPUTS OUTPUT 2x14 28 N 100 / 2 1400 -50 I/YR PV PMT 2.90 -1000 FV Thus, the annual YTM = 2 x 2.90% = 5.80%. Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 42 Interest Rate Risk Interest rates change constantly, which gives rise to two types of interest rate risk. Price risk arises because bond values decline when interest rates rise. Reinvestment rate risk arises because reinvested coupon (and principal) payments earn less when interest rates fall. Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 43 Does a 1-year or 10-year 10 percent bond have more price risk? R(R) 1-year Change 10-year Change 5% $1,048 10% 1,000 15% 956 $1,386 +4.8% -4.4% 1,000 749 +38.6% -25.1% Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 44 Value $1,500 $1,000 10-year . . . . . 5% 10% 15% 1-year $500 0 0% R(R) Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 45 Does a 1-year or 10-year bond have more reinvestment rate risk? Reinvestment rate risk depends both on the bond’s maturity and the investor’s holding period. In general, the shorter the maturity, the greater the reinvestment rate risk. Copyright © 1999 by the Foundation of the American College of Healthcare Executives 11 - 46 How can interest rate risk be minimized? Long-term bonds have high price risk but low reinvestment rate risk. Short-term bonds have low price risk but high reinvestment rate risk. Nothing is riskless! However, risk can be minimized by matching the maturity of the bond to the holding period. Copyright © 1999 by the Foundation of the American College of Healthcare Executives