BUSI570 Managerial Finance
Prepared by: nansla
3 December 2012
What affect does inflation have on bond prices or interest rates for new or existing bonds? The price of bonds on the market can be either higher or lower than the face value of the bond depending on the current economic condition or the market condition, which can affect the price investors are willing to pay (Fidelity Investments, 2012). In regard to price, the bond prices are provided in terms of a percentage of par value. The price investors are willing to pay can be greatly affected by the current interest rates. For example, if interest rates inflate after the bonds are issued, the prices on the existing bonds will usually fall (Fidelity Investments, 2012). This happens because new bonds are often issued with higher coupon rates as interest rates increase, which makes the older outstanding bonds less attractive unless they can be purchased at a lower price resulting in lower prices for existing bonds (Fidelity Investments, 2012). The inverse is true when interest rates decline, which means investors can sometimes sell a bond for greater than the purchase price when interest rates go down since other investors are willing to pay a premium for a bond with a higher interest payment or coupon rate (Fidelity Investments, 2012). Inflation also leads to a higher interest rates, therefore inflation has the same effect as interest rates: when inflation rises, the price of a bond tends to drop (Fidelity Investments, 2012). A fixed-rate bond’s coupon rate normally remains unchanged for the life of the bond, so the bond may not be paying enough interest to stay ahead of inflation (Fidelity Investments, 2012). The longer a bond’s maturity, the greater the odds of inflation eventually lowering the bond price. For this reason, long term bonds often attract buyers by using higher interest rates to combat the fear of a rising inflation rate (Fidelity Investments, 2012).
Why is floatation cost included in computing the cost of capital for new stock issues? Floatation cost is defined as the cost associated with issuing new stocks or bonds (Barron's Finance & Investment Dictionary, 2012). As is the case with most everything in life, there is an associated cost – and so it is with the issuance of stocks as well. The amount of underwriting risk and the physical distribution associated with the issuance of the stock causes the floatation cost to vary (Barron's Finance & Investment Dictionary, 2012). Floatation cost comprises the following two elements: “(1) the compensation earned by the investment bankers (the underwriters) in the form of the spread between the price paid to the issuer (the corporation or government agency) and the offering price to the public, and (2) the expenses of the issuer (legal, accounting, printing, and other out-of-pocket expenses)” (Barron's Finance & Investment Dictionary, 2012). The key variable in floatation cost is the underwriting spread, which historically ranges from as low as 1.25% of the par value of high-grade bonds to 23.7% of the size of a small issue of common stock (Barron's Finance & Investment Dictionary, 2012). Both negotiation and competition in bidding are factors in determining the underwriting spread (Barron's Finance & Investment Dictionary, 2012). For these issuances to be profitable to the issuing companies, these floatation costs must be recovered through the issuing price of the stocks or bonds being sold. The Securities and Exchange Commission (SEC) reports that underwriter’s compensation (spread) is the largest component of floatation costs and that “floatation costs are higher for small business issuers for reasons unrelated to regulation” (Securities and Exchange Commission, 1996). The SEC also suggests that lower direct costs could produce lower costs of capital (Securities and Exchange Commission, 1996)....