Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionIII. Valuation of Future
Cash Flows- Interest Rates and Bond
Valuation
(^242) © The McGraw−Hill
Companies, 2002
- The corporation’s payment of interest on debt is considered a cost of doing business
and is fully tax deductible. Dividends paid to stockholders are nottax deductible. - Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim
the assets of the firm. This action can result in liquidation or reorganization, two of
the possible consequences of bankruptcy. Thus, one of the costs of issuing debt is the
possibility of financial failure. This possibility does not arise when equity is issued.
Is It Debt or Equity?
Sometimes it is not clear if a particular security is debt or equity. For example, suppose a
corporation issues a perpetual bond with interest payable solely from corporate income if
and only if earned. Whether or not this is really a debt is hard to say and is primarily a
legal and semantic issue. Courts and taxing authorities would have the final say.
Corporations are very adept at creating exotic, hybrid securities that have many fea-
tures of equity but are treated as debt. Obviously, the distinction between debt and eq-
uity is very important for tax purposes. So, one reason that corporations try to create a
debt security that is really equity is to obtain the tax benefits of debt and the bankruptcy
benefits of equity.
As a general rule, equity represents an ownership interest, and it is a residual claim.
This means that equity holders are paid after debt holders. As a result of this, the risks
and benefits associated with owning debt and equity are different. To give just one ex-
ample, note that the maximum reward for owning a debt security is ultimately fixed by
the amount of the loan, whereas there is no upper limit to the potential reward from
owning an equity interest.Long-Term Debt: The Basics
Ultimately, all long-term debt securities are promises made by the issuing firm to pay
principal when due and to make timely interest payments on the unpaid balance. Be-
yond this, there are a number of features that distinguish these securities from one an-
other. We discuss some of these features next.
The maturity of a long-term debt instrument is the length of time the debt remains
outstanding with some unpaid balance. Debt securities can be short-term (with maturi-
ties of one year or less) or long-term (with maturities of more than one year).^1 Short-
term debt is sometimes referred to as unfunded debt.^2
Debt securities are typically called notes, debentures,or bonds.Strictly speaking, a
bond is a secured debt. However, in common usage, the word bondrefers to all kinds of
secured and unsecured debt. We will therefore continue to use the term generically to re-
fer to long-term debt.
The two major forms of long-term debt are public issue and privately placed. We
concentrate on public-issue bonds. Most of what we say about them holds true for
private-issue, long-term debt as well. The main difference between public-issue and pri-
vately placed debt is that the latter is directly placed with a lender and not offered to the
public. Because this is a private transaction, the specific terms are up to the parties
involved.212 PART THREE Valuation of Future Cash Flows
(^1) There is no universally agreed-upon distinction between short-term and long-term debt. In addition, people
often refer to intermediate-term debt, which has a maturity of more than 1 year and less than 3 to 5, or even
10, years.
(^2) The word fundingis part of the jargon of finance. It generally refers to the long term. Thus, a firm planning
to “fund” its debt requirements may be replacing short-term debt with long-term debt.
Information for bond
investors can be found at
http://www.investinginbonds.com.