Corporate Fin Mgt NDLM.PDF

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21. Liquidity preference Theory

21.1 Investors have a preference for liquidity. So they ask for a higher yield as an

inducement to hold bonds of longer maturity.

22. Default Premium

22.1 Because of the possibility that corporate bonds may default on interest and/or

principal payment, investors will ask for a default premium, in addition, of course,

to the maturity premium. The default premium is a direct function of default risk.

The credit rating agencies considers:

a) Volatility of its operating income.

b) Ratio of outside liabilities to shareholders funds

c) Assets offered as security

22.2 Default premium tend to increase during economic recession and decrease during

economic expansion.

23. The effect of special features on interest rates is expected to be as follows:
    
    
    • A 'call' feature raises the interest rate because the investors are exposed to
      call risk.
    
    
    • A 'put' feature lowers the interest rate because the investors enjoy the put
      option.
    
    
    • A 'conversion' feature lowers the interest rate because the investors enjoy
      the option to convert.
    
    
    • A 'floating interest rate' feature may lower the interest rate as investors are
      protected against inflation risk.
    
    
    • A 'zero coupons' feature may lower the interest rate as investors are
      protected against reinvestment risk.
    
    
    
    


24. Determinants of interest Rate
    
    
    • Inflation rate
    
    
    • Real growth rate
    
    
    • Time preference
      Short term risk free rate
    
    
    
    

Maturity Premium

• Future
  expectation


• Liquidity
  preference


• Preferred habitat

Default Premium

• Business Risk


• Financial Risk


• Collateral

Interest rate

Special Features

• Call/put feature


• Conversion feature


• Other features