Starting a new business? You need capital! Expanding your existing business? You need capital! Starting a new family? You need capital too (in case nobody told you)!
Firms need capital for various reasons; expanding scale of existing operations, new projects, corporate acquisitions, the list goes on….
There are two main ways firms can finance their balance sheet; debt and/or equity. In this article, let’s explore debt financing from the investors’ perspective.
As the name suggests, debt is an obligation to another party to which the debt is owed to. Companies using debt financing usually raise capital through the issuance of corporate bonds. These bonds tend to yield higher returns compared to government bonds where the risk-premium fairly reflects the higher default risk. With that being said, corporate bonds with higher credit ratings will have lower interest rates, vice versa.
Bonds usually pay out interest semi-annually. These interest payments are called coupons. A bond with a face value of $1,000 and 6% interest will pay out $300 (1000*0.06*½) semi-annually for the remaining periods until maturity. However, investors would not pay $1000 for the bond if the general market yield is higher than 6%. In this situation, companies will need to reduce the issuing price of the bond (priced below face value) such that it matches the yield of the market. These bonds are called discounted bonds.
Below is an example of how the bond will be priced if the market yield is higher than the bond’s interest rate at face value.
|
Jargons |
Definition |
Value |
|
Market yield (yield-to-maturity) |
The return investors can earn on similar securities offered on the market. |
8% |
|
Par value (Face value) |
The amount an investor expects to receive at maturity. |
$1000 |
|
Interest rate |
Interest rate x Par value of the bond. |
6% |
|
Maturity |
Tenure of the bond. |
3 years |
|
Coupon |
Periodic interest payments. |
6 periods (semi-annually) |
To calculate the price of the bond today where market yield (8%) > interest rate of bond (6%), we need to discount the future periodic coupon payments and face value at maturity to present value. I used Excel to calculate the price of the bond today. The PV formula and parameters are stated below.
Hence, an investor would only be willing to pay $947.58 for a 3 year-bond with a $1,000 face value, 6% interest and maturity of 5 years from now if the market yield is currently 8%
There are bonds that don’t pay out any periodic coupons. These zero-coupon bonds have their interests payments factored into the maturity value.
The formula to calculate the a zero coupon bond is the same as the rate of return formula:
Yield to Maturity = (Face Value / Current Price of Bond) ^ (1 / Years to Maturity) – 1
For example, an investor that purchases a zero-coupon bond for $800 with a 4.56% yield and 5 years till maturity will expect to receive $1000 at maturity (receiving no interest during the loan tenure).
You would realize by now that market yield and bond prices have an inverse relationship.
In the event of liquidation, bond investors (creditors) would be pleased to know that they will be paid first, before preference and common shareholders.
Apart from the issuance of bonds, Small & Medium Enterprises (SMEs) might source for debt via alternative financing methods such as crowdfunding which we talked about in our previous article.
It is paramount for investors to understand risks associated with potentially higher returns before making an investment. Please do your due diligence before making a purchase in any fixed-income security.
In another post, we will look into raising capital through equity; preference and common shares.
Like our content? Remember to subscribe to our mailing list and like us on Facebook. More importantly, share this article with someone who may benefit from it!
Till next week, have a good weekend!
Cheers,
Nigel Fernandez
CapitalistLAD 