Introduction to Finance

Debt financing

1
Outline (NO COMPUTER, IPAD, SMARTPHONE, etc.)

Debt financing:
1-Debt
2-Amortization Table (or schedule)
3-Types of reimbursement
4-Bonds

Don’t forget: « What is a bond? » + Quizz (see Syllabus)

Vernimmen Pierre. (2011) Corporate finance: theory and practice, 3rd edition.
John Wiley & Sons. (Cyberlibris; ISBN: 9781119975588): chap. 21; SEE ALSO
Chap. 17 section 17.4
Schim Jaek. (2007). Schaum’s outline of financial management, 3rd edition.
McGraw Hill. (Cyberlibris; ISBN: 9780071481281): chap. 14

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1-Debt

Debt Capital:
– A contract between borrower/lender
– Bankruptcy/reorganization threat if contract is violated
– Priority claim on assets, cash flow
– Less return potential than equity
– Little/no voice in management

General terms associated with debt:

– Par value, face value or nominal value C0 = € 100
– Interest rate, coupon rate, nominal rate i = 5%
– Interest or coupon I1 = € 5
– Pay back, reimbursement, principal repaid R1 = € 20
– Annuity, periodical payment a1 = € 25
– Maturity date 5 years

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2-Amortization Table (or schedule): Cash-flows
Funds borrowed

C0

0 1 2 ………………….
T
time

General rules:
– Sum of principal repayments from period 1 to T (maturity date) =
amounts of funds borrowed (that is R0+R1+…+RT=C0).
– Interest payments are calculated based on the capital value owned at the
beginning of the period (Unpaid balance, that is Cn=Cn-1-Rn).
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2-Amortization Table (or schedule): Reimbursement

Consider a loan of C0 € with a i% interest rate, over T periods.

Period t Unpaid balance Interests paid Principal repaid Annuity paid at

(Principal due for the period: for the period: the end of
at each period): It Rt period:
Ct-1 at
1 C0 I1=C0 x i R1 a1=I1+R1
2 C1=C0-R1 I2=C1 x i R2 a2=I2+R2
… … … … …
T CT-1=CT-2-RT-1 IT=CT-1 x i RT aT=IT+RT
SUM C0

Properties: R1 + R2 + ... + RT = C0
CT −1 = RT
a1 a2 aT
C0 = + + ... +
(1 + i )1 (1 + i ) 2 (1 + i )T
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3-Types of reimbursement: In Fine (1)

« In Fine »:
– The whole principal amount of the loan is repaid once at the end.
– The Unpaid balance doesn’t change.
– Interests paid at each period are identical.

Period t Unpaid balance Interests paid Principal repaid Annuity paid at

(Principal due for the period: for the period: the end of
at each period): It Rt period:
Ct-1 at
1 C0 I1=C0 x i 0 a1=I1+0
2 C1=C0 I2=I1 0 a2=I2+0
… … … … …
T CT-1=C0 IT=I1 RT=C0 aT=IT+RT
SUM C0

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3-Types of reimbursement: In Fine (2)

Example 6.1: Consider a loan of 40,000 € with a 5% annual rate, over 4 years
(annual payments), reimbursed « in fine ».

Period t Unpaid balance Interests paid Principal repaid Annuity paid at

(Principal due for the period: for the period: the end of
at each period): It Rt period:
Ct-1 at
1 40,000
2
3
4
SUM

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3-Types of reimbursement: Constant amortization (1)

«constant amortization» or with equal slices (linear amortization) :

– The same portion of the whole principal is repaid at each period.
– The Unpaid balance decreases by the same amount at each period.
– Interests paid decrease at each period.

Period t Unpaid balance Interests paid Principal repaid Annuity paid at

(Principal due for the period: for the period: the end of
at each period): It Rt=C0/T period:
Ct-1 at
1 C0 I1=C0 x i R1=C0/T a1=I1+R1
2 C1=C0-R1 I2=C1 x i R2=C0/T a2=I2+R2
… … … … …
T CT-1=CT-2-RT-1 IT=CT-1 x i RT=C0/T aT=IT+RT
SUM C0

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3-Types of reimbursement: Constant amortization (2)

Example 6.2: Consider a loan of 40,000 € with a 5% annual rate, over 4 years
(annual payments), reimbursed with equal slices.

Period t Unpaid balance Interests paid Principal repaid Annuity paid at

(Principal due for the period: for the period: the end of
at each period): It Rt period:
Ct-1 at
1 40,000
2
…
T
SUM

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3-Types of reimbursement: Constant annuity (1)

«constant annuity» or fixed instalments:

– The annuity is the same at each period. The principal repaid increases at
each period.
– The Unpaid balance decreases at each period.
– Interests paid decrease at each period.
Period t Unpaid balance Interests paid Principal repaid Annuity paid at
(Principal due for the period: for the period: the end of
at each period): It Rt period:
Ct-1 at
1 C0 I1=C0 x i R1=a-I1 a
2 C1=C0-R1 I2=C1 x i R2=a-I2 a
… … … … …
T CT-1=CT-2-RT-1 IT=CT-1 x i RT=a-IT a
SUM C0

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3-Types of reimbursement: Constant annuity (2)

How to find the constant annuity? The proof of the formula

a1 a2 aT a  1 1 
C0 = + + ... + = × 1 + + ... +
(1 + i )1 (1 + i ) 2 (1 + i )T (1 + i )1  (1 + i )1 (1 + i )T −1 
14444244443
sum of the first T terms of a geometric series

  1 T   
1 −   
⇔ C0 =
a
×  1 + i  = a 
×
1 − (1 + i )−T
 1 − (1 + i )−T 
+ −  = a× 
(1 + i )1
 1  1 + i 1 i 1  i 
 1− 1+ i  
 1+ i 

 
This formula gives the loan amount based on what you can pay at each period:
1 − (1 + i )−T 
C0 = a ×  
 i 
This formula is used to calculate the constant annuity:
 i 
a = C0 ×  −T 
1 − (1 + i ) 
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3-Types of reimbursement: Constant annuity (3)

Example 6.3: Consider a loan of 40,000 € with a 5% annual rate, over 4 years
(annual payments), reimbursed with a constant annuity.

Period t Unpaid balance Interests paid Principal repaid Annuity paid at

(Principal due for the period: for the period: the end of
at each period): It Rt period:
Ct-1 at
1 40,000
2
3
4
SUM

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3-Types of reimbursement:

Problem 6.1: You borrowed 50,000 euros on 3 years to buy a new car. You
repay by monthly equal payments (constant annuity), and the rate is 6.50 %
APR (Annual Proportional Rate). What is the unpaid balance after 4 months?

Problem 6.2: What is the principal repaid in the last monthly payment on a
4,000 euros loan, contracted over 5 years at 5.6 % APR (monthly equal
payments) ?

Problem 6.3: You have estimated that you can’t pay more than 2,800 € per
month to your bank. The (Annual Proportional Rate) interest rate is 4%. How
much could you borrow over 15 years?

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4-Bonds: A finite-life security and shares of a same loan

Loan’s characteristics (annual payment):

– Par value : 100,000€
– Interest rate: 5% Time 1 2 3 4
– Maturity: 4 years Annuity 5,000 5,000 5,000 105,000
– Repayment: « in fine »

Funds are raised by issuing 1,000 shares of a bond sold to a pool of investors
(bondholders).
Bond’s characteristics (annual payment):
– Par value: 100 €
– Coupon rate: 5% Time 1 2 3 4
– Maturity: 4 years Annuity 5 5 5 105
– Repayment: « in fine »
At the time of the issue, 5% is the return expected by bondholders; if the bond
is issued (sold) at par (selling price = par value):
5 5 5 105
100 = + + +
(1 + 5%)1 (1 + 5%) 2 (1 + 5%)3 (1 + 5%) 4

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4-Bonds: Yield To Maturity

The IRR is the return offered by the investment’s project.

CF1 CF2 CF3 CFt
0 = −CF0 + + + + ... +
(1 + IRR)1 (1 + IRR) 2 (1 + IRR) 3 (1 + IRR)t
The same concept is used to estimate the return offered to the lender/investor
by the borrower.

The return offered on a loan is the Yield To Maturity (YTM):

a1 a2 a3 aT
0 = − P0 + + + + ... +
(1 + YTM )1 (1 + YTM ) 2 (1 + YTM )3 (1 + YTM )T

P0 is the current market value of the debt (or the current bond’s price)
– Knowing the market value of debt, interest, time to maturity and par
value, it is possible to find the implicit discount rate, or Yield To Maturity,
by trial and error only. To do this, try different discount rates until the
calculated market value equals the given value (or let a financial calculator
do it for you!).
– Increasing the discount rate decreases the market value.

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4-Bonds: Bond ratings

Components of interest rate (for a same time to maturity):

interest rate = risk free rate + default risk premium
144424443
depends on debt rating
– Default risk premium is also called default spread.

Bond Ratings:
– Measure likelihood of default; influenced by level of issuer’s cash flow,
investor protection in the covenants
– Acts as a market signal
– Lower rating Higher risk Higher coupon rate on new issues

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4-Bonds: Bond rating examples

Standard &
Moody’s Fitch
Poor’s
Aaa AAA AAA Best quality, least credit risk.
Capacity to pay is extremely strong
Aa1 AA+ AA+ High quality, slightly more risk than
Aa2 AA AA a top-rated bond. Capacity to pay is
very strong
Aa3 AA- AA-
A1 A+ A+ Upper-medium grade, possible
A2 A A future credit quality difficulties.
Capacity to pay is strong, but more
A3 A- A- susceptible to changes in some
circumstances
Baa1 BBB+ BBB+ Medium quality bonds. Capacity to
Baa2 BBB BBB pay is adequate, adverse conditions
will have more impact on the firm’s
Baa3 BBB- BBB- ability to pay

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4-Bonds: High-Yield or Junk Bonds

Standard &
Moody’s Fitch
Poor’s
Ba1 BB+ BB+ Speculative Issues, greater credit
Ba2 BB BB risk. Considered speculative with
respect to capacity to pay.
Ba3 BB- BB-
B1 B+ B+ Very speculative, likelihood of future
B2 B B default. The “B” ratings are the
B3 B- B- lowest degree of speculation.

Caa CCC CCC Highly speculative, either in default

Ca CC CC or high likelihood of going into
default. income bonds with no
C C C interest being paid
D DDD
In default with principal and interest
DD
in arrears
D
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4-Bonds: Market value (1)

Simplifying assumptions (to set RT equal to par value):

– Pay back equals par value.
– Pay back is realized at the maturity date.

The return on such an investment is called Yield To Maturity (YTM):

I1 I2 IT + R T
P0 = + + ... +
(1 + YTM ) (1 + YTM )
1 2
(1 + YTM )T
In this particular case (because pay back occurs once at the end, interest are
constant, I is interest in €), the formula can be rewritten:
1 - (1 + YTM )− T  RT
P0 = I ×   +
 (1 + YTM )
T
 YTM
Bond Pricing Theorems:
– Debts of similar risk (and maturity) will be priced to yield about the same
return, regardless of the coupon rate.
– If you know the value of one debt, you can estimate its YTM and use that
to find the value of the second debt.
– This is a useful concept that can be transferred to valuing any security.
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4-Bonds: Market value (2)

Example: A first debt has just been issued: 3 years to maturity, its par value is
1000 and its interest rate 5%. The second debt is older: still 3 years to
maturity, its par value is 1000 and its interest rate 8%.
Since the first one has just been issued, its YTM is 5% and its market value
1000. Assume they have both the same risk, the second debt market value has
not changed, for which debt would you prefer to be creditor?
What should occur if the two debts are represented by bonds listed on a
market? What is then the market value of the second debt?
For the second one, the market value should be different from its par value.
Since the two debt have the same risk, they must offer the same return (the
YTM expected by bondholders is the same). The first bond has been issued at
the current YTM of 5%, the current market value for the second one is the
discounted value of its future cash flows with 5% as the discount rate:
80 80 80 + 1,000
P0 = + + = 1,081.7
or
(1 + 5% ) (1 + 5% ) (1 + 5% )
1 2 3

1 - (1 + 5% )−3  1,000
P0 = 80 ×   + = 1,081.7
 (1 + 5%)
3
 5%

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4-Bonds:

Problem 6.4: Consider a debt with an interest rate of 10% and interests paid
annually. The par value is €1000 and the debt has 5 years to maturity. The yield
to maturity is 11%. What is the value of the debt ?
Interest annually paid : interest rate times par value = 10% × 1000 = 100

Problem 6.5: Now, suppose you are looking at a debt that has a 10% annual
interest and a face value of €1000. There are 20 years to maturity and the yield
to maturity is 8%. What is the market value of this debt ?

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4-Bonds:

Problem 6.6: Suppose you are looking at a debt that has a 10% annual
interest and a face value of €1000. There are 20 years to maturity and the yield
to maturity is 10%. What is the market value of this debt ?

If YTM = interest rate, then par value = debt’s market value

If YTM > interest rate, then par value > debt’s market value
If YTM < interest rate, then par value < debt’s market value

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4-Bonds: Market value and Yield To Maturity

The market value of debt is the present value of interests to be paid in the
future and the amount to be paid back.
If pay back occurs once at maturity :
1 - (1 + YTM )− T  RT
P0 = I ×   +
 YTM  (1 + YTM )T

The market value, one more time, is conditioned by the discount rate. Here, the
discount rate is the yield to maturity (YTM).

When YTM increases, the market value of the debt decreases.

YTM is the current interest rate expected by creditors on the market, it can
increase because:
– for a same default risk, creditors expect a higher default risk premium;
– with no change in the default risk premium, the firm’s default risk has
increased.

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5-Conlusion: Key Terms

Bond "In fine" reimbursement (Create)

Loan "constant amortization" or with equal
Lender slices (linear amortization)
Borrower reimbursement (Create)
Par value, face value, nominal value "constant annuity" or fixed instalments
Interest rate, coupon rate, nominal rate reimbursement (Create)
Interest, coupon Constant annuity (Formula)
Pay back, reimbursement, principal Maximum loan amount (Formula)
repaid Yield To Maturity (YTM)
Annuity, periodical payment Current market value of the debt, Current
Maturity date bond’s price (Formula)
Unpaid balance Default risk premium, Default spread
Bond rating
High-Yield bonds, Junk Bonds

Create: It is necessary to be able to create it.

Formula: It will be included in the formula sheet given at the exam.
Equation: It is necessary to know it since it will not be included in the formula
sheet given at the exam.
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5-Conclusion: MCQ (1)

1) The bonds of Ford Motor Company have received a rating of "B" by Moody's.
The "B" rating indicates
a) the bonds are insured.
b) the bonds are junk bonds.
c) the bonds are referred to as "high yield" bonds.
d) both that the bonds are junk bonds and the bonds are referred to as "high
yield" bonds.
2) Ceteris paribus, the price and yield on a bond are
a) positively related.
b) negatively related.
c) sometimes positively and sometimes negatively related.
d) not related.
3) The ______ is a measure of the average rate of return an investor will earn if
the investor buys the bond now and holds until maturity.
a) dividend yield
b) P/E ratio
c) yield to maturity
d) discount yield

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5-Conclusion: MCQ (1)

4) If yield to maturity is higher than the interest rate, then:

a) debt’s market value is lower than par value
b) debt’s market value is higher than par value
c) debt’s market value is equal to par value
d) debt’s market value is independent of par value

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5-Conclusion: MCQ Answers

1 – d
2 – b
3 – c
4 – a

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