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  • 8/3/2019 Bonds Valuation Etc.



    One of the fundamental and systemic problems of our modern economy is theintervention and interference that occurs concerning the valuation of Capital.Our financial markets are controlled in manners that reinforce capital value andthis abnormality imposes a burden on the remainder of the economy.

    Capital is always value retained [or in a sense transferred] from workcompleted. This work can entail the creation of a "product" or simply labor; it isirrelevant to the production of capital. Capital represents a completedexchange; one has exchanged "value" for what was perceived as valuable.

    At that moment in which the exchange transpires, a value is agreed upon.What tends to present difficulties is the belief that this value should persist intothe future. There is no assurance that this will be the case. It is not a constantvalue and should never be controlled as if it were. The value of Capital shouldbe freely allowed to change as the economy reinterprets its worth.

    The greatest obstruction to honestly valuating Capital is the monopolization ofmoney creation. If money cannot be freely created, valued and exchanged byall, Capital can never be certain of its true value. Neither, due to the restraintincorrect value imposes, can it travel to where it is most demanded.

    Today, the Federal Reserve is responsible for this monopoly. The rabid creationof money with little or no backing wreaks havoc on the perceived value ofCapital. If money is created at will by any agency and the economy is coercedinto utilizing this currency, Capital, the remaining value of what has been doneand produced, is at the mercy of this errant money production. Rather thanseeking its natural value, it will fluctuate dependent upon how much newcurrency is created and where the new currency happens to be at the time.

    Initially, the work and product of the past will devalue, while the new currencywill capitalize. This is due to value being transferred from the real to theimagined. At some point further along, the economy recognizes that the valueof the currency is imagined and people try to retain real value by purchasing asmuch as they can of what they perceive as "real" in comparison to the createdcurrency. This process causes price inflation and overvaluation of Capital.When the "price" of real product gets out of hand, it consumes too great aportion of the actual productive output and recession follows with thenecessary price deflation.

    Due to the meddling of unbacked produced money and the correspondinginconsistent valuation of Capital, the swings between the two extremes aregreatly exaggerated and the loss and gains reach dizzying levels. While timesof prosperity are great, the downturns are as equally violent.

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    The second and equally important aspect of the problem is the "guaranteeing"of Capital value. Again, this practice relies on the erroneous belief that thevalue of Capital should be maintained or increase through time.

    The production of Capital is a straightforward process. Although, we commonlyrefer to Capital as all the value that is extracted from exchange that isn't

    consumed, this is a bit deceptive. Much of the "new" Capital has been passedthrough the exchange process and can be better termed "principal Capital".Look at in this way, the growth of Capital does not appear as phenomenal as itis often made out to be.

    For example, the farmer's entire grain harvest that isn't directly consumed maybe considered Capital, but really only that which is above and beyond what heoriginally put into the field is new Capital. Nevertheless, both his originalinvestment of grain and the resultant "excess" grain represent his futureCapital.

    At any moment in time, this grain has a value, but we certainly don't expect itto have the same value. There could be less or greater demand for grain in theeconomy or the grain itself could be considered in "better or worse" conditionthan when it was harvested. Or grain production itself could dynamicallychange affecting the "completed" grain's value. Many things can influence thevalue of grain. We cannot expect value or anything for that matter, to remainconstant or to increase. Value is always fluctuating. Capital value is nodifferent.

    For this reason, to "insure" that Capital value will retain or grow through time,is against the natural laws of economics. Because of this, there will always be a"market" for this insurance. There will always be those individuals or firms whowill put their own security up for grabs, in order to profit on other's insecurity.They will make a living or become insolvent, betting on the risk thataccompanies the value of Capital. This is human nature and free marketexpression of this is a normal part of the advanced economy.

    But to "guarantee" [in contrast to insure] that Capital will retain its value isdefiant of the principles of a natural economy. And, it is particularly maliciouswhen it is done with other people's Capital. The future value of Capital shouldnever be guaranteed with someone else's property! Although this seemsobvious, it is common practice.

    Any loan, any investment, anytime the future repayment of Capital isguaranteed or "backed" by money that doesn't belong to the backer, thisoccurs. The FDIC, bailouts and court backed loan contracts all fall under thisumbrella. It doesn't matter what it is, if the money that guarantees andreinforces the value of Capital does not come from the "insurer", then we have"socialized" the risk. Any subsidy or payment for investment also qualifies, such

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    as "oil exploration" subsidies or drug research funding. It is ALL THE SAME. Weare socializing the risk that occurs from natural risk and valuation of Capital.

    Courts have mistakenly taken it upon themselves to guarantee Capital value.Contracts involving the loaning of Capital without security are evidence of this.The courts have no reason to provide recourse for the investor who has

    received a "promise" of repayment if there is no security or "promise" ofsecurity to back the debt, as long as the debtor has not engaged in anydeception or fraud.

    Continuing economic and financial volatility has cemented in investors' minds

    the importance of diversification across asset classes. As interest rates have

    been driven down, and government gilt yields have fallen, investors seeking

    income or a higher rate of interest are increasingly turning to corporate bonds.What is the bond market?

    The bond market, also known as the debt, credit, or fixed income market, is a

    financial market where

    participants buy and sell debt, usually in the form of bonds (1). As of 2006, the

    size of the global bond market was an estimated $45 trillion with Corporate

    bonds accounting for $15 trillion in issue (source: Merrill Lynch Bond Index

    Almanac). Since the mid-1990s, corporate bond markets have become an

    increasingly important source of financing for companies, even more so with

    the recent credit and liquidity crunches (2) which have caused banks to reduce

    their lending.

    What is a Corporate Bond?

    A 'corporate bond' is an 'IOU' issued by a company (corporation) rather than a

    government, typically with a maturity of greater than one year; anything less

    than that is often referred to as commercial paper . They are a way to raise

    money for projects and investment and are also known as credit. The issuance

    of a bond will often provide low cost finance, especially the case in recent years

    with low inflation, interest rates and good corporate stability. The low cost of

    the interest or coupon payments can be further reduced by the fact the

    payments are generally tax deductible. By issuing bonds, rather than equity, a

    company will also avoid diluting the equity in the company.

    A company seeking to raise money issues corporate bonds. These will typically

    be bought by investors at what is known as "par". Like equities, bonds can be

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    bought and sold until maturity and values can fluctuate depending on supply

    and demand. Other external factors, such as interest rates, can also impact the

    price. The company commits to pay a coupon or rate of interest to the investor.

    This will generally be a fixed amount and is paid annually or semi-annually.

    After a defined period, set at outset, the bond is repaid by the company. Bonds

    will typically redeem at par irrespective of how the market price has fluctuatedbefore maturity.

    How are Corporate Bonds rated and by whom?

    Independent ratings agencies are responsible for researching companies and

    supplying 'grades' or 'ratings' to companies' debt (bond issues).

    There are two main subdivisions of corporate bonds depending on their 'credit

    rating', which indicates to investors the level of risk associated with the bond.

    Investment Grade Bonds - With investment grade bonds it is assumed that the

    chance of non-repayment or default is low due to the issuing company having a

    comparatively stable financial position. As a result of the increased stability,

    the income or coupons offered are usually lower than those from sub or

    noninvestment grade.

    Sub-Investment Grade Bonds - High yielding, sub-investment grade bonds arehigher risk investments. They are sometimes referred to as junk bonds. These

    tend to be issued by less financially secure companies or those without a

    proven track record. The default rate of these bonds is expected to be higher

    than investment grade corporate bonds.

    What are the ratings?

    The ratings depend on how the credit rating agencies view the financial

    standing of the company issuing the bond, its ability to continue to makepayments to its bond holders in the future and what protection the bondholder

    has should the company face financial difficulties.

    Bond Credit Quality Ratings

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    How are returns measured?

    The income generated from a bond is referred to as the yield. There aretypically two yields to indicate the return the bond provides to an investor

    Income Yield - also called the interest yield or running yield, is a simplemeasure of how much annual income a bond will provide to the investor. Thediagram below shows the relationship between yield and the price of a bond.

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    In this example, the bond yields 4.00% based on its par value of 100p, i.e. 4p. Ifthe market value of the bond drops to 90p it still pays out 4p. This means anypurchaser at this price will receive a yield of 4.44%. If the price of the bonddrops further the yield will increase. Conversely, as the price of a bondincreases the yield decreases.

    Redemption Yield - takes account of both the income received until maturityand the capital gain or loss when the bond is redeemed. If a bond has been

    purchased at a market price higher than the par value at redemption thenthere will be a capital loss. This would mean the redemption yield will be lessthan the income yield. Depending on market conditions, there can be asubstantial difference between the redemption yield and the income yield.

    What impacts bond valuations?

    Interest rates the relationship between interest rates and corporate bondprices is usually negative, i.e. corporate bond prices fall when interest ratesrise. A rising interest rate makes the present value of the future couponpayments less attractive in comparison and investors may sell bonds, in order

    to move their monies. Any new issues of bonds must raise their yields in orderto attract investors so older issues with lower yields become less popular.Conversely, declining interest rates cause investors to seek higher yields frombonds, increasing the price.

    Inflation Similar to interest rates, the relationship between inflation andcorporate bond prices is usually negative. A high rate of inflation reduces the

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    value of future coupons or redemption value causing investors to seekalternative investments. Inflation and interest rates are often linked;predominantly because interest rates are commonly used by central banks as away of moderating inflation.

    Like all asset classes, valuations can be impacted by a wide range of factors,

    both general economic and financial, as well as specific to the issuingcompany. The performance of other asset classes can also impact valuations asthey attract investors away from or to bonds.

    What are yield curves and spreads?

    A yield curve illustrates the yield to maturity of a range of similarly ratedbonds with different periods to maturity. In the yield curve chart below bondsissued with longer maturity will typically offer higher yields to compensate forthe additional risk of time.

    The illustrated yield curves also demonstrate that credit spreads (yield on thetype of bond illustrated minus the yield on government gilts of an equivalentmaturity) are typically higher for riskier debt.

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    Why do investors buy Corporate Bonds?

    Companies typically offer higher yields than comparable maturity governmentbonds, bearing in mind the higher level of risk. Since corporate bonds can bebought and sold, supply and demand can also generate capital appreciation in

    addition to income payments.

    Similar to equities corporate bonds provide the opportunity to choose from avariety of sectors, structures and credit-quality characteristics to meetinvestment objectives. At the same time should an investor need to sell a bondbefore it reaches maturity, in most instances it can be easily and quickly soldbecause of the size and liquidity of the market. Most importantly for thoseseeking an income coupon payments and final redemption payments areusually fixed; this means there is a certainty about both the amount and timingof the income an investor will receive.




    If a bonds market price increases

    then its yield must decrease

    conversely if a bonds market price decreases

    then its yield must increase


    If a bonds yield doesnt change over its life,

    then the size of the discount or premium will decrease as itslife shortens


    If a bonds yield does not change over its life

    then the size of its discount or premium will decrease

    at an increasing rate as its life shortens

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    A decrease in a bonds yield will raise the bonds price by anamount that is greater in size than the corresponding fall inthe bonds price that would occur if there were an equal-sized

    increase in the bonds yield

    the price-yield relationship is convex


    the percentage change in a bonds price owing to a change inits yield will be smaller if the coupon rate is higher

    Bonds are long-term debt securities that are issued by corporations andgovernment entities. Purchasers of bonds receive periodic interest payments,

    called coupon payments, until maturity at which time they receive the facevalue of the bond and the last coupon payment. Most bonds pay interestsemiannually. The Bond Indenture or Loan Contractspecifies the features ofthe bond issue. The following terms are used to describe bonds.

    Par or Face ValueThe par or face value of a bond is the amount of money that is paidto the bondholders at maturity. For most bonds the amount is$1000. It also generally represents the amount of money borrowedby the bond issuer.

    Coupon RateThe coupon rate, which is generally fixed, determines the periodiccoupon or interest payments. It is expressed as a percentage of thebond's face value. It also represents the interest cost of the bondissue to the issuer.

    Coupon PaymentsThe coupon payments represent the periodic interest paymentsfrom the bond issuer to the bondholder. The annual couponpayment is calculated be multiplying the coupon rate by the bond'sface value. Since most bonds pay interest semiannually, generallyone half of the annual coupon is paid to the bondholders every sixmonths.

    Maturity DateThe maturity date represents the date on which the bond matures,i.e., the date on which the face value is repaid. The last couponpayment is also paid on the maturity date.

    Original MaturityThe time remaining until the maturity date when the bond wasissued.

    Remaining Maturity

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    The time currently remaining until the maturity date.Call Date

    For bonds which are callable, i.e., bonds which can be redeemed bythe issuer prior to maturity, the call date represents the date atwhich the bond can be called.

    Call PriceThe amount of money the issuer has to pay to call a callable bond.When a bond first becomes callable, i.e., on the call date, the callprice is often set to equal the face value plus one year's interest.

    Required ReturnThe rate of return that investors currently require on a bond.

    Yield to MaturityThe rate of return that an investor would earn if he bought thebond at its current market price and held it until maturity.Alternatively, it represents the discount rate which equates thediscounted value of a bond's future cash flows to its current market

    price.Yield to Call

    The rate of return that an investor would earn if he bought acallable bond at its current market price and held it until the calldate given that the bond was called on the call date.

    The box below illustrates the cash flows for a semiannual coupon bond with aface value of $1000, a 10% coupon rate, and 15 years remaining until maturity.(Note that the annual coupon is $100 which is calculated by multiplying the10% coupon rate times the $1000 face value. Thus, the periodic coupounpayments equal $50 every six months.)

    Bond Cash Flows

    Because most bonds pay interest semianually, the discussion of Bond Valuationpresented here focuses on semiannual coupon bonds.

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    Yield to Maturity

    The yield to maturity on a bond is the rate of return that an investor would earnif he bought the bond at its current market price and held it until maturity. It

    represents the discount rate which equates the discounted value of a bond'sfuture cash flows to its current market price. This is illustrated by the followingequation:


    B0 = the bond price, C = the annual coupon payment, F = the face value of the bond, YTM = the yield to maturity on the bond, and t = the number of years remaining until maturity.

    The yield to maturity usually cannot be solved for directly. It generally must bedetermined using trial and error or an iterative technique. Fortunately, financialcalculators make the task of solving for the yield to maturity quite simple.

    Yield to Maturity Example

    Find the yield to maturity on a semiannual coupon bond with a face value of$1000, a 10% coupon rate, and 15 years remaining until maturity given that thebond price is $862.35.


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    Bond Valuation Equations

    Semiannual Coupon Bonds

    Bond Price:

    Yield to


    Yield to Call:

    Annual Coupon Bonds

    Bond Price:

    Yield to


    Yield to Call:

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    Bond Price

    The price or value of a bond is determined by discounting the bond's expectedcash flows to the present using the appropriate discount rate. This relationship

    is expressed for a semiannual coupon bond by the following formula:


    B0 = the bond value,

    C = the annual coupon payment, F = the face value of the bond, r = the required return on the bond, and t = the number of years remaining until maturity.

    Bond Valuation Example

    Find the price of a semiannual coupon bond with a face value of $1000, a 10%coupon rate, and 15 years remaining until maturity given that the requiredreturn is 12%.


    Par, Premium, and Discount Bonds

    Par BondsA bond is considered to be a par bond when its price equals its facevalue. This will occur when the coupon rate equals the required return onthe bond.

    Premium Bonds

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    A bond is considered to be a premium bond when its price is greater thanits face value. This will occur when the coupon rate is greater than therequired return on the bond.

    Discount BondsA bond is considered to be a discount bond when its price is less than its

    face value. This will occur when the coupon rate is less than the requiredreturn on the bond.

    A corporate bond is a bond issued by a Corporation. It is a bond that acorporation issues to raise money in order to expand its business. The term isusually applied to longer-term debt instruments, generally with a maturity datefalling at least a year after their issue date. (The term "commercial paper" issometimes used for instruments with a shorter maturity.)

    Sometimes, the term "corporate bonds" is used to include all bonds except

    those issued by Governments in their own currencies. Strictly speaking,however, it only applies to those issued by corporations. The bonds of localauthorities and supranational organizations do not fit in either category]

    Corporate bonds are often listed on major exchanges (bonds there are called"listed" bonds) and ECNs like and MarketAxess, and the coupon(i.e.interest payment) is usually taxable. Sometimes this coupon can be zerowith a high redemption value. However, despite being listed on exchanges, thevast majority of trading volume in corporate bonds in most developed marketstakes place in decentralized, dealer-based, over-the-counter markets.

    Some corporate bonds have an embedded call option that allows the issuer toredeem the debt before its maturity date. Other bonds, known as convertiblebonds allow investors to convert the bond into equity.

    Corporate Credit spreads may alternatively be earned in exchange for defaultrisk through the mechanism of Credit Default Swaps which give an unfundedsynthetic exposure to similar risks on the same 'Reference Entities'. However,owing to quite volatile CDS 'basis' the spreads on CDS and the credit spreadson corporate bonds can be significantly different.


    Corporate debt falls into several broad categories:

    Secured debt vs unsecured debt Senior debt vs subordinate debt

    Generally, the higher one's position in the company's capital structure thestronger one's claims to the company's assets in the event of a default.

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    A secured loan is a loan in which the borrower pledges some asset (e.g. a caror property) as collateral for the loan, which then becomes a secured debtowed to the creditor who gives the loan. The debt is thus secured against thecollateral in the event that the borrower defaults, the creditor takespossession of the asset used as collateral and may sell it to regain some or allof the amount originally lent to the borrower, for example, foreclosure of a


    In Finance, unsecured debt refers to any type of debt or general obligationthat is not collaterised by a lien on specific assets of the borrower in the case ofa bankruptcy or loquidation

    In the event of the bankruptcy of the borrower, the unsecured creditors willhave a general claim on the assets of the borrower after the specific pledgedassets have been assigned to the secured creditors, although the unsecuredcreditors will usually realize a smaller proportion of their claims than thesecured creditors.

    In some legal systems, unsecured creditors who are also indebted to theinsolvent debtor are able (and in some jurisdictions, required) to set- off thedebts, which actually puts the unsecured creditor with a matured liability to thedebtor in a pre-preferential position.


    Unsecured Loans

    Also called signature loans orpersonal loans. These loans are often usedby borrowers for small purchases such as computers, homeimprovements, vacations or unexpected expenses.

    An unsecured loan means the lender relies on your promise to pay itback. They're taking a bigger risk than with a secured loan, so interestrates for unsecured loans tend to be higher. You normally have setpayments over an agreed period and penalties may apply if you want torepay the loan early. Unsecured loans are often more expensive and lessflexible than secured loans, but suitable if you want a short-term loan(one to five years).

    In the UK there are hundreds of different unsecured loans to choose from,so comparison tables have become a popular way of finding out aboutthe different options available. In 2006, according to the Bank of England,22% of UK households had some unsecured debt with a further 21%having both secured and unsecured debt.

    Credit Cards Medical Bill

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    In finance, senior debt, frequently issued in the form ofsenior notes orreferred to as senior loans, is debt that takes priority over otherunsecured or otherwise more "junior" debt owed by the issuer. Seniordebt has greater seniority in the issuer's capital structure thansubordinated debt. In the event the issuer goes bankrupt, senior debttheoretically must be repaid before other creditors receive any payment.

    Senior debt is often secured by collateral on which the lender has put inplace a first lien. Usually this covers all the assets of a corporation and isoften used for revolving credit lines. It is the debt that has priority forrepayment in a liquidation.

    It is a class of corporate debt that has priority with respect to interest andprincipal over other classes of debt and over all classes of equity by thesame issuer.

    Limitations to seniority

    Secured parties may receive preference to unsecured senior lenders

    Notwithstanding the senior status of a loan or other debt instrument, anotherdebt instrument (whether senior or otherwise) may benefit from security thateffectively renders that other instrument more likely to be repaid in aninsolvency than unsecured senior debt. Lenders of a secured debt instrument(regardless of ranking) receive the benefit of the security for that instrumentuntil they are repaid in full, without having to share the benefit of that securitywith any other lenders. If the value of the security is insufficient to repay thesecured debt, the residual unpaid claim will rank according to itsdocumentation (whether senior or otherwise), and will receivepro rata

    treatment with other unsecured debts of such rank.

    Super-senior status

    Senior lenders are theoretically (and usually) in the best position because theyhave first claim to unsecured assets.

    However, in various jurisdictions and circumstances, nominally "senior" debtmay not rankpari passu with all other senior obligations. For example, in the2008 washingtom seizure, all assets and most (including deposits, coveredbonds, and other secured debt) of Washington Mutual Bank's liabilities were

    assumed by JPMorgan Chase. However other debt claims, including unsecuredsenior debt, were not. By doing this, the FDIC effectively subordinated theunsecured senior debt to depositors, thereby fully protecting depositors whilealso eliminating any potential deposit insurance liability to the FDIC itself. Inthis and similar cases, specific regulatory and oversight powers can lead tosenior lenders being subordinated in potentially unexpected ways.

    Additionally, in US Chapter 11 bankruptcies, new lenders can come in to fundthe continuing operation of companies and be granted status super-senior to

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    other (even senior secured) lenders, so-called "debtor in possession" status.Similar regimes exist in other jurisdictions.

    "Senior" debt at holding company is structurally subordinated to all

    debt at the subsidiary

    A senior lender to a holding company is in fact subordinated to any lenders(senior or otherwise) at a subsidiary with respect to access to the subsidiary'sassets in a bankruptcy. The collapse of Washington Mutual bank in 2008highlighted this priority of claim, as lenders to Washington Mutual, Inc. receivedno benefit from the assets of that entity's bank subsidiaries.[2]

    In finance, subordinated debt (also known as subordinated loan,subordinated bond, subordinated debenture orjunior debt) is debtwhich ranks after other debts should a company fall into receivership or beclosed.

    Such debt is referred to as subordinate, because the debt providers (thelenders) have subordinate status in relationship to the normal debt. A typicalexample for this would be when a promoter of a company invests money in theform of debt, rather than in the form of stock. In the case of liquidation (e.g.the company winds up its affairs and dissolves) the promoter would be paidjust before stockholdersassuming there are assets to distribute after all otherliabilities and debts have been paid.

    Subordinated debt has a lower priority than other bonds of the issuer in case ofliquidation during bankruptcy, below the liquidator, government tax authorities

    and senior debt holders in the hierarchy of creditors. Because subordinateddebt is repayable after other debts have been paid, they are more risky for thelender of the money. It is unsecured and has lesser priority than that of anadditional debt claim on the same asset.

    Subordinated loans typically have a higher rate of return than senior debt dueto the increased inherent risk. Accordingly, major shareholders and parentcompanies are most likely to provide subordinated loans, as an outside partyproviding such a loan would normally want compensation for the extra risk.Subordinated bonds usually have a lower credit rating than senior bonds.

    A particularly important example of subordinated bonds can be found in bondsissued by banks. Subordinated debt is issued periodically by most largebanking corporations in the U.S. Subordinated debt can be expected to beespecially risk-sensitive, because subordinated debt holders have claims onbank assets after senior debt holders and they lack the upside gain enjoyed byshareholders. This status of subordinated debt makes it perfect forexperimenting with the significance of market discipline, via the signallingeffect of secondary market prices of subordinated debt (and, where relevant,the issue price of these bonds initially in the primary markets). From the
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    perspective of policy-makers and regulators, the potential benefit from havingbanks issue subordinated debt is that the markets and their information-generating capabilities are enrolled in the "supervision" of the financialcondition of the banks. This hopefully creates both an early-warning system,like the so-called "canary in the mine," and also an incentive for bankmanagement to act prudently, thus helping to offset the moral hazard that can

    otherwise exist, especially if banks have limited equity and deposits areinsured. This role of subordinated debt has attracted increasing attention frompolicy analysts in recent years.

    For a second example of subordinated debt, consider asset-backed securities.These are often issued in tranches. The senior tranches get paid back first, thesubordinated tranches later. Finally, mezzanine debt is another example ofsubordinated debt.

    Subordinated bonds are regularly issued (as mentioned earlier) as part of thesecuritization of debt, such as asset-backed securities, collateralized mortgage

    obligations or collateralized debt obligations. Corporate issuers tend to prefernot to issue subordinated bonds because of the higher interest rate required tocompensate for the higher risk, but may be forced to do so if indentures onearlier issues mandate their status as senior bonds. Also, subordinated debtmay be combined with preferred stock to create so called monthly incomepreferred stock, a hybrid security paying dividends for the lender and fundedas interest expense by the issuer.

    Bond CovenantAn agreement between the issuer and holder of a bond, requiring or forbiddingcertain actions of the issuer. Positive covenants require actions while negativecovenants forbid them. The exact terms of a bond covenant must be written inthe bond indenture.

    Types of Bond

    Bond certificate for the state of South Carolina issued in 1873 under the state'sConsolidation Act.

    The following descriptions are not mutually exclusive, and more than one ofthem may apply to a particular bond.
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    Fiexed rate bonds have a coupon that remains constant throughout thelife of the bond.

    Floating rate notes : have a variable coupon that is linked to a referencerate of interest, such as LIBOR or Euribor. For example the coupon maybe defined as three month USD LIBOR + 0.20%. The coupon rate is

    recalculated periodically, typically every one or three months.

    Zero coupon bonds pay no regular interest. They are issued at asubstantial discount to par value, so that the interest is effectively rolledup to maturity (and usually taxed as such). The bondholder receives thefull principal amount on the redemption date. An example of zero couponbonds is Series E savings bonds issued by the U.S. government. Zerocoupon bonds may be created from fixed rate bonds by a financialinstitution separating ("stripping off") the coupons from the principal. Inother words, the separated coupons and the final principal payment ofthe bond may be traded separately. See IO (Interest Only) and PO

    (Principal Only).

    Inflation linked bonds, in which the principal amount and the interestpayments are indexed to inflation. The interest rate is normally lowerthan for fixed rate bonds with a comparable maturity (this position brieflyreversed itself for short-term UK bonds in December 2008). However, asthe principal amount grows, the payments increase with inflation. The UKwas the first sovereign issuer to issue inflation linked Gilts in the 1980s.Treasury inflation protected secutrities. (TIPS) and I bonds are examplesof inflation linked bonds issued by the U.S. government.

    Receipt for temporary bonds for the state of Kansas issued in 1922

    Other indexed bonds, for example equiry lined notes and bonds indexedon a business indicator (income, added value) or on a country's GCP.

    Asset backed securities are bonds whose interest and principal paymentsare backed by underlying cash flows from other assets. Examples ofasset-backed securities are mortgage bakced securities (MBS's),collateralized mortgage obligations (CMOs) and collateralized debtobligations (CDOs).

    Subordinate bonds are those that have a lower priority than other bondsof the issuer in case of liquidation. In case of bankruptcy, there is ahierarchy of creditors. First the liquidator is paid, then government taxes,etc. The first bond holders in line to be paid are those holding what iscalled senior bonds. After they have been paid, the subordinated bondholders are paid. As a result, the risk is higher. Therefore, subordinated

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    bonds usually have a lower credit rating than senior bonds. The mainexamples of subordinated bonds can be found in bonds issued by banks,and asset-backed securities. The latter are often issued in tranches. Thesenior tranches get paid back first, the subordinated tranches later.

    Perpetual bonds are also often called perpetuties or 'Perps'. They have no

    maturity date. The most famous of these are the UK Consols, which arealso known as Treasury Annuities or Undated Treasuries. Some of thesewere issued back in 1888 and still trade today, although the amounts arenow insignificant. Some ultra-long-term bonds (sometimes a bond canlast centuries: West Shore Railroad issued a bond which matures in 2361(i.e. 24th century) are virtually perpetuities from a financial point of view,with the current value of principal near zero.

    Bearer bond is an official certificate issued without a named holder. Inother words, the person who has the paper certificate can claim the valueof the bond. Often they are registered by a number to prevent

    counterfeiting, but may be traded like cash. Bearer bonds are very riskybecause they can be lost or stolen. Especially after federal income taxbegan in the United States, bearer bonds were seen as an opportunity toconceal income or assets.[4] U.S. corporations stopped issuing bearerbonds in the 1960s, the U.S. Treasury stopped in 1982, and state andlocal tax-exempt bearer bonds were prohibited in 1983.[5]

    Registered bond is a bond whose ownership (and any subsequentpurchaser) is recorded by the issuer, or by a transfer agent. It is thealternative to a bearer bond. Interest payments, and the principal uponmaturity, are sent to the registered owner.

    Treasury bond, also called government bond, is issued by the Federalgovernment and is not exposed to default risk. It is characterized as thesafest bond, with the lowest interest rate. A treasury bond is backed bythe full faith and credit of the federal government. For that reason, thistype of bond is often referred to as risk-free.

    Pacific Railroad Bond issued by City and County of San Francisco, CA.May 1, 1865

    Municipal bond is a bond issued by a state, U.S. Territory, city, localgovernment, or their agencies. Interest income received by holders ofmunicipal bonds is often exempt from the federal income tax and fromthe income tax of the state in which they are issued, although municipalbonds issued for certain purposes may not be tax exempt.

    Build America Bonds (BABs) is a new form of municipal bond authorizedby the American Recovery and reinvestment Act of 2009. Unliketraditional municipal bonds, which are usually tax exempt, interest
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    received on BABs is subject to federal taxation. However, as withmunicipal bonds, the bond is tax-exempt within the state it is issued.Generally, BABs offer significantly higher yields (over 7 percent) thanstandard municipal bonds.

    Book-entry bond is a bond that does not have a paper certificate. As

    physically processing paper bonds and interest coupons became moreexpensive, issuers (and banks that used to collect coupon interest fordepositors) have tried to discourage their use. Some book-entry bondissues do not offer the option of a paper certificate, even to investorswho prefer them.

    Lottery bond is a bond issued by a state, usually a European state.Interest is paid like a traditional fixed rate bond, but the issuer willredeem randomly selected individual bonds within the issue according toa schedule. Some of these redemptions will be for a higher value than theface value of the bond.

    War bond is a bond issued by a country to fund a war.

    Serial bond is a bond that matures in installments over a period of time.In effect, a $100,000, 5-year serial bond would mature in a $20,000annuity over a 5-year interval.

    Revenue bond is a special type of municipal bond distinguished by itsguarantee of repayment solely from revenues generated by a specifiedrevenue-generating entity associated with the purpose of the bonds.Revenue bonds are typically "non-recourse," meaning that in the event ofdefault, the bond holder has no recourse to other governmental assets orrevenues.

    Climate bond is a bond issued by a government or corporate entity inorder to raise finance for climate change mitigation or adaptation relatedprojects or programs.


    PURCHASE OR LEASE OF A MACHINE, EQUIPMENT OR BUILDINGAn investment is a purchase or lease: of a machine, equipment or building(bookedin bookkeeping as Non-Current Assets). of tools. (booked in bookkeeping asNon- Current Assets).of intangible assets (e.g. IT-software) (booked in bookkeeping as Non-CurrentAssets)

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    IDEAInvestment under consideration

    STEP 1Investment simulation and profitability analysis

    STEP 2Investment proposal


    STEP 4Reporting of the investment

    STEP 5

    Follow-up of the investment

    Project Cost EstimationThe Problem

    The Program Managers (PMs) Job Plan the Project Estimate the Cost and Establish the Budget Identify and Acquire Necessary Resources (People, Equipment, etc.) Manage it (to the schedule, within budget)

    The PMs Dilemma Cost is Usually the Boundary that Cannot be Crossed Cost is a Determined by How Much (labor, materials, etc.) and How Long

    (Schedule) So How Do You Figure Out What it Will Take Before Youve Done It??

    Understanding "Whats in the Cost"

    Elements of Costs Direct Costs - Attributable to the Project:

    Salaries and Associated Benefits, Materials, Payments toSubcontractors or Consultants, Project Related Travel

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    Indirect (Overhead) Costs - Necessary Business Expenses:

    General Administrative Costs, Facility (Space, Utilities,Insurance), Marketing, Ongoing Research and Development

    Basic Equation: Cost = Labor$ x Time + Other Direct Costs + Indirect Costs

    Note: Indirect Costs are Usually Allocated on Some Proportional BasisEach project a Business is Executing

    The Process (Figuring Our What it Takes)

    Step 1 - Break the Project Down into a Set of Definable Tasks Iterative, Top Down Process

    o Identify Major Activities (Design, Development, Integration, Test,Production)

    o Break Down Further into "Self Contained" tasks (Design UserInterface, Develop Database Software, Develop Prototype xyzBoard)

    o Take it Down One or More Steps Depending on Size and Complexity(Layout All Display Formats, Determine Operator Action/EntrySequences, Define Limit Tests and Error Notifications)

    Too Little Breakdown is Bad, Too Much is Bad - it takes a Balance Tools - Logic, Analysis, Experience

    The Process - Estimating Each Task

    Determine What it Takes to Address Each Task in the WBS Usually Focused on Labor What Type (Programmer, Engineer, Network Administrator,

    Writer/Illustrator) Experience Mix

    o May Look Like Mini Project Teams (Some Guidance from a SeniorType + 2 Juniors doing details and a Writer)

    Estimate How Long the Task Should Take

    Very Subjectiveo Historical Performance Metrics and/or or Personal Experience Helpso Capabilities/Limitations of Candidate Project Team Members Must

    be Considered Cover the Gaps (the Team is usually Fixed and Finite)

    o Plan for Continuous Tasking for each member Until No Longerneeded

    The Process - Preparing The Schedule

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    Schedule the Tasks Assess Start Point for Each (Possibly Relative to Progress of Others) Assumes Some Sequence/Dependency Analysis Has Been Conducted Insert Milestones Key Review/Delivery/Test Points Evaluate the Result Staff Profile (is it Reasonable) Make Necessary Adjustments (Schedule, Resource Mix, etc.)

    The Process - Calculating the Cost

    Labor Schedule and Staff Profile Summarizes labor Types and How Much of

    Each (Total Hours, Days Weeks etc.) Labor Hour Costs Normally are Salary + Fringe Multiplier Materials Delivered or Consumed as Part of Project

    o Computers, Software Licenses, Peripherals, etc. Delivered toCustomer

    o Usually a "Firm Number" Supported by Vendor Quoteso Paper, Special Materials to be Used During Job for Books, Pictures,

    Etc.o Typically a "Best Estimate" and Minor Relative to Materials and

    Labor Consultants and Subcontractors Costs Consultants Costs Predicted Based on Hourly Quote and Usage Estimate Subcontractors Based on Firm Quote for Services Other (Travel, Etc.) Estimates Based on Job Requirements Add it Up: Cost =Labor (w/Fringe) + Materials +Consultants/Subs +Other + Indirect

    We Have a WBS (work breakdown structure), Schedule Cost - Now What..A Final Look

    Prepare to Track It Set Up a Total Cost Profile (How the Project Flows Financially) Set Up a Labor Profile (Either by Hours, Labor Cost - or Both) During Execution Account for Expenses Against WBS items Review "Progress" Against Cost Profile Regularly If behind Schedule, Ahead of Cost Profile, Must be problems Another Dilemma "If You Cant Measure It - You Cant Track It."

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    "If You Dont Know Where Youre Going - You Might End Up SomewhereElse"

    Project finance

    Project finance is the long term financing of infrastructure and industrialprojects based upon the projected cash flows of the project rather than thebalance sheets of the project sponsors. Usually, a project financing structureinvolves a number of equity investors, known as sponsors, as well as asyndicate of banks that provide loans to the operation. The loans are mostcommonly non-recourse loans, which are secured by the project assets andpaid entirely from project cash flow, rather than from the general assets orcreditworthiness of the project sponsors, a decision in part supported byfinancial modeling The financing is typically secured by all of the projectassets, including the revenue-producing contracts. Project lenders are given alien on all of these assets, and are able to assume control of a project if theproject company has difficulties complying with the loan terms.

    Generally, a special purpose entity is created for each project, therebyshielding other assets owned by a project sponsor from the detrimental effectsof a project failure. As a special purpose entity, the project company has noassets other than the project. Capital contribution commitments by the ownersof the project company are sometimes necessary to ensure that the project isfinancially sound. Project finance is often more complicated than alternativefinancing methods. Traditionally, project financing has been most commonlyused in the mining, transportation, telecommunication and public utilityindustries. More recently, particularly in Europe, project financing principles

    have been applied to public infrastructure under publicprivate partnerships(PPP) or, in the UK, Private Finance Initiative (PFI) transactions.

    Risk identification and allocation is a key component of project finance. Aproject may be subject to a number of technical, environmental, economic andpolitical risks, particularly in developing countries and emerging markets.Financial institutions and project sponsors may conclude that the risks inherentin project development and operation are unacceptable (unfinanceable). Tocope with these risks, project sponsors in these industries (such as powerplants or railway lines) are generally completed by a number of specialistcompanies operating in a contractual network with each other that allocates

    risk in a way that allows financing to take place. "Several long-term contractssuch as construction, supply, off-take and concession agreements, along with avariety of joint-ownership structures, are used to align incentives and deteropportunistic behaviour by any party involved in the project." The variouspatterns of implementation are sometimes referred to as "project deliverymethods." The financing of these projects must also be distributed amongmultiple parties, so as to distribute the risk associated with the project whilesimultaneously ensuring profits for each party involved.

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    A riskier or more expensive project may require limited recourse financingsecured by a surety from sponsors. A complex project finance structure mayincorporate corporate finance, securitization, options, insurance provisions orother types of collateral enhancement to mitigate unallocated risk

    Project finance shares many characteristics with maritime finance and aircraft

    finance; however, the latter two are more specialized fields.

    Basic scheme

    Hypothetical project finance scheme

    Acme Coal Co. imports coal. Energen Inc. supplies energy to consumers. Thetwo companies agree to build a power plant to accomplish their respectivegoals. Typically, the first step would be to sign a MOU to set out the intentionsof the two parties. This would be followed by an agreement to form a jointventure

    Acme Coal and Energen form an SPC (Special Purpose Corporation) calledPower Holdings Inc. and divide the shares between them according to their

    contributions. Acme Coal, being more established, contributes more capital andtakes 70% of the shares. Energen is a smaller company and takes theremaining 30%. The new company has no assets.

    Power Holdings then signs a construction contract with Acme Construction tobuild a power plant. Acme Construction is an affiliate of Acme Coal and the onlycompany with the know-how to construct a power plant in accordance withAcme's delivery specification.
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    A power plant can cost hundreds of millions of dollars. To pay AcmeConstruction, Power Holdings receives financing from a development bank anda commercial bank. These banks provide a guarantee to Acme Construction'sfinancier that the company can pay for the completion of construction.Payment for construction is generally paid as such: 10% up front, 10% midwaythrough construction, 10% shortly before completion, and 70% upon transfer of

    title to Power Holdings, which becomes the owner of the power plant.

    Acme Coal and Energen form Power Manage Inc., another SPC, to manage thefacility. The ultimate purpose of the two SPCs (Power Holding and PowerManage) is primarily to protect Acme Coal and Energen. If a disaster happensat the plant, prospective plaintiffs cannot sue Acme Coal or Energen and targettheir assets because neither company owns or operates the plant.

    A Sale and Purchase Agreement (SPA) between Power Manage and Acme Coalsupplies raw materials to the power plant. Electricity is then delivered toEnergen using a wholesale delivery contract. The cashflow of both Acme Coal

    and Energen from this transaction will be used to repay the financiers.

    Complicating factors

    The above is a simple explanation which does not cover the mining, shipping,and delivery contracts involved in importing the coal (which in itself could bemore complex than the financing scheme), nor the contracts for delivering thepower to consumers. In developing countries, it is not unusual for one or moregovernment entities to be the primary consumers of the project, undertakingthe "last mile distribution" to the consuming population. The relevant purchaseagreements between the government agencies and the project may containclauses guaranteeing a minimum offtake and thereby guarantee a certain levelof revenues. In other sectors including road transportation, the governmentmay toll the roads and collect the revenues, while providing a guaranteedannual sum (along with clearly specified upside and downside conditions) tothe project. This serves to minimise or eliminate the risks associated withtraffic demand for the project investors and the lenders.

    Minority owners of a project may wish to use "off balance sheet" financing, inwhich they disclose their participation in the project as an investment, andexcludes the debt from financial statements by disclosing it as a footnoterelated to the investment. In the United States, this eligibility is determined bythe Financial accounting board. Many projects in developing countries mustalso be covered with war risk insurance which covers acts of hostile attack,derelict mines and torpedoes, and civil unrest which are not generally includedin "standard" insurance policies. Today, some altered policies that includeterrorism are called Terrorism Insurance or Political Risk Insurance. In manycases, an outside insurer will issue a performance bond to guarantee timelycompletion of the project by the contractor.
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    Publicly-funded projects may also use additional financing methods such as taxincrement financing or private finance institution (PFI). Such projects are oftengoverned by a capital improvement plan which adds certain auditingcapabilities and restrictions to the process.

    Profitability index (PI), also known as profit investment ratio (PIR) and

    value investment ratio (VIR), is the ratio of payoff to investment of aproposed project. It is a useful tool for ranking projects because it allows you toquantify the amount of value created per unit of investment.

    The ratio is calculated as follows:

    Assuming that the cash flow calculated does not include the investment made

    in the project, a profitability index of 1 indicates breakeven. Any value lowerthan one would indicate that the project's PV is less than the initial investment.As the value of the profitability index increases, so does the financialattractiveness of the proposed project.

    Rules for selection or rejection of a project:

    If PI > 1 then accept the project If PI < 1 then reject the project

    For example, given:

    Investment = 40,000 life of the Machine = 5 Years

    CFAT Year CFAT

    1 180002 120003 100004 90005 6000

    Calculate NPV at 10% and PI:

    Year CFAT PV@10% PV

    1 18000 0.909 163622 12000 0.827 99243 10000 0.752 7520
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    4 9000 0.683 61475 6000 0.621 3726

    Total present value 43679(-) Investment 40000

    NPV 3679

    PI = 43679 / 40000= 1.091= >1= Accept the project