Chapter # 03

Cost of Finance
LO 05: YIELD CURVES:
Each item of debt finance for a company has a different cost. This is because debt capital has differing risk, according to
whether the debt is secured, whether it is senior or subordinated debt, and the amount of time remaining to maturity.

Furthermore, the cost of debt differs for different periods of borrowing. This is because lenders might require compensation
for the risk of having their cash tied up for longer and/or there might be an expectation of future changes in interest rates.
The relationship between length of borrowing and interest rates is described by the yield curve. This session looks at the
derivation and use of yield curves.

Background:

An earlier section covered the relationship that exists between the market value of a bond, the cash flows that must be paid
to service that bond and the cost of debt inherent in that bond. The market value of a bond is the present value of the future
cash flows that must be paid to service the debt, discounted at the lender’s required rate of return (pre-tax cost of debt). The
lender’s required rate of return (the pre-tax cost of debt) is the IRR of the cash flows (pre-tax) that must be paid to service the
debt.
Example # 26:
Market value of bond A company has issued a bond that will be redeemed in 4 years. The bond has a nominal interest rate of
6%.
Required:

Calculate what the market value of the bond would be if the required rate of return was 5% or 6% or 7%.
Shape of the yield curve (Term structure of interest rates):

The cost of fixed-rate debt is commonly referred to as the ‘interest yield’. The interest yield on debt capital varies with the
remaining term to maturity of the debt.

 As a general rule, the interest yield on debt increases with the remaining term to maturity. For example, it should
normally be expected that the interest yield on a fixed-rate bond with one year to maturity/redemption will be
lower than the yield on a similar bond with ten years remaining to redemption. Interest rates are normally higher
for longer maturities to compensate the lender for tying up his funds for a longer time.

 When interest rates are expected to fall in the future, interest yields might vary inversely with the remaining time
to maturity. For example, the yield on a one-year bond might be higher than the yield on a ten-year bond when
rates are expected to fall in the next few months.

 When interest rates are expected to rise in the future, the opposite might happen, and yields on longer dated
bonds might be much higher than on shorter-dated bonds.

Interest yields on similar debt instruments can be plotted on a graph, with the x-axis representing the remaining term to
maturity, and the y-axis showing the interest yield. A graph which shows the ‘term structure of interest rates’, is called a yield
curve.
Normal Yield Curve:

Time to Maturity

As indicated above, a normal yield curve slopes upwards, because interest yields are normally higher for longer dated debt
instruments. Sometimes it might slope upwards, but with an unusually steep slope (steeply positive yield curve). However, on
occasions, the yield curve might slope downwards, when it is said to be ‘negative’ or ‘inverse’.
Inverse Yield Curve:

Time to Maturity
When the yield curve is inverse, this is usually an indication that the markets expect short-term interest rates to fall at some time in future.
When the yield curve has a steep upward slope, this indicates that the markets expect short-term interest rates to rise at some time in future.
Yield curves are widely used in the financial services industry. Two points should be noted about yield curve are:
 Yields are gross yields, ignoring taxation (pre-tax yields).
 A yield curve is constructed for ‘risk-free’ debt securities, such as government bonds. A yield curve therefore shows ‘risk-free yields’.
As the name implies, risk-free debt is debt where the investor has no credit risk whatsoever, because it is certain that the borrower will repay
the debt at maturity. Debt securities issued by governments with AAA credit ratings (see later) in their domestic currency by the government
should be risk-free.
Bond valuation using the yield curve:
Annual spot (valid on the day they are published) yield curves are published in the financial press. The cost of new debt can
be estimated by reference to a yield curve.

Example # 27:
A company wants to issue a bond that is redeemable at par in four years and pays interest at 6% of nominal value. The annual
spot yield curve for a bond of this class of risk is as follows:
Maturity Yield
One year 3.0%
Two years 3.5%
Three years 4.2%
Four years 5.0%
Required:
Calculate the price that the bond could be sold for (this is the amount that the company could raise) and then use this to
calculate the gross redemption yield (yield to maturity, cost of debt).
Estimating the yield curve:
A yield curve was provided in the previous section. The next issue to consider is how these are constructed. This technique is
called “bootstrapping”.

Example # 28:
Estimating the yield curve There are three bonds in issue for a given risk class. All three bonds pay interest annually in arrears
and are to be redeemed for par at maturity. Relevant information about the three bonds is as follows:

Bond Maturity Coupon rate Market value

A 1 year 6.0% 102
B 2 years 5.0% 101
C 3 years 4.0% 97

Required:
Construct the yield curve that is implied by this data.