Interest Rates based on

Riskiness of firm's ability to make payments

Time of maturitya
Risk-free rate
Liquidity premium

Major Rating Agencies

Review company's financial position
Evaluate risk of
Company not making payments
Bankruptcy

Company may sell bonds with different priorities

Senior
Subordinate

Investment Grades
AAA
Smallest degree of risk
Lowest interest rates required by investors
AA
A
BBB
BB
B
CCC
CC
C
D - 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 Maturity

Investor'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 selling
ownership, but may have some restrictions.
Interest pd. On loan reduces taxable income
Unlike dividends - dividends are seen by IRS as profits to owner
Ie) without interest, taxable income = 100k, tax rate = 35% so taxes = 35k
With 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 huge
difference.

CONS:
Have to repay by specified date
Have to pay interest on loan
-must make periodic payments for use of borrowed money
Missed payment - can be forced to file for bankruptcy
And means company may be forced out of business
Can be high risk if cash flows not enough to make payments

Based on riskiness of borrower:

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

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

Can be restrictive covenants

To maintain a certain amount of cash
Restrictions on paying dividends
These are to protect the lender.

Lender/Investor Pros
By taking risk, investors require higher rate of interest, receive steady stream of
cash, interested payments, and may place some restrictions on company to
protect loan.
In case of default, lenders get $ before equity investors, even if pennies on $
To Take no risk:
Invest in borrowing by US govt
Called treasury securities
How government finances debt - no risk, zero chance of default on
payments

Types of Debt: Private

Not sold to public, fees charged
100k loan with 5% fee is only 95k actual cash and you owe 100k\
Term Loan - Revolving Line of Credit - Asset-Backed Loan
Private Placements - loans that meet SEC rule 144a - and are not under SEC
jurisdiction****
See berk ch 14, pg 461

Small Business Administration Loans

SBA, help business's and stuff

Types of Debt: Public

Must register with SEC like stock
Must include form contract
 Specifying corporation obligation to bondholder-indenture
Corp Bond
Corp borrows money from investor
Promises to pay maturity (1000$)
And coupon payments every 6 months
Corporate Bond:
Covenants in indenture - limitations on corp to protect bond holders
Primary market -> corp gets $

Notes
Unsecured loan
Less than 10 years til maturity
Debentures
Unsecured
Longer than 10 years till maturity

Mortgage Bonds
Secured by Real Estate
Collateral in case of default

Asset Backed Bonds

Secured by asset other than Real Estate