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Interest Rates based onRiskiness of firm's ability to make payments

Time of maturityaRisk-free rateLiquidity premium

Major Rating AgenciesReview company's financial positionEvaluate risk of

Company not making paymentsBankruptcy

Company may sell bonds with different priorities

SeniorSubordinate

Investment GradesAAA

Smallest degree of riskLowest interest rates required by investors

AAABBBBBBCCCCCCD - Highest degree of default

Highest interest rates required by investors

Difference between (spread)Required Rate of return (called yield)

Treasury (risk free rate)

Bond Rate (YTM) = Yield to MaturityInvestor's Required Rate of Return (RROR) =Risk free + premiums for risk:

Default Premium +Maturity Premium +Liquidity Premium

Pro's of Debt:For startups - doesn't give up control of running co., compared to sellingownership, but may have some restrictions.Interest pd. On loan reduces taxable income

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Unlike dividends - dividends are seen by IRS as profits to ownerIe) without interest, taxable income = 100k, tax rate = 35% so taxes = 35kWith interest, if taxable inc = 100k and interest = 20k, taxable inc = 80k x 35%= 35% tax rate is 28k dollars which saves a lot of money and makes a hugedifference.

CONS:Have to repay by specified dateHave to pay interest on loan

-must make periodic payments for use of borrowed moneyMissed payment - can be forced to file for bankruptcyAnd means company may be forced out of businessCan be high risk if cash flows not enough to make paymentsBased on riskiness of borrower:

Higher risk that borrower may not be able to repay = higher interest ratethat lender charges

Start-ups => higher risk than company like IBM so higher rates

Can be restrictive covenantsTo maintain a certain amount of cashRestrictions on paying dividends

These are to protect the lender.Lender/Investor ProsBy taking risk, investors require higher rate of interest, receive steady stream ofcash, interested payments, and may place some restrictions on company toprotect loan.In case of default, lenders get $ before equity investors, even if pennies on $

To Take no risk:Invest in borrowing by US govtCalled treasury securities

How government finances debt - no risk, zero chance of default onpayments

Types of Debt: PrivateNot sold to public, fees charged100k loan with 5% fee is only 95k actual cash and you owe 100k\

Term Loan - Revolving Line of Credit - Asset-Backed LoanPrivate Placements - loans that meet SEC rule 144a - and are not under SEC

jurisdiction****See berk ch 14, pg 461Small Business Administration Loans

SBA, help business's and stuff

Types of Debt: PublicMust register with SEC like stockMust include form contract

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Specifying corporation obligation to bondholder-indentureCorp Bond

Corp borrows money from investorPromises to pay maturity (1000$)And coupon payments every 6 months

Corporate Bond:

Covenants in indenture - limitations on corp to protect bond holdersPrimary market -> corp gets $Notes

Unsecured loanLess than 10 years til maturity

DebenturesUnsecuredLonger than 10 years till maturity

Mortgage BondsSecured by Real Estate

Collateral in case of default

Asset Backed BondsSecured by asset other than Real Estate