Advanced Financial Modeling. Unit 4

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1 Advanced Financial Modeling Unit 4

2 Financial Modeling for Debt and Bonds Models for Debt Repayment Modeling Amortizing Loans EMIs Financial Modeling for Bonds Bond Pricing

3 Models for Debt Repayment Companies that take debt, need to create a schedule to repay it. The repayment has to be modelled in financial models. There can be various ways this debt can be repaid 1. The debt could be repaid in equal monthly installments 2. The Principal could be repaid in equal amounts over a tenure 3. There could be a specific customized schedule for a certain loan 4. The loan repayment could be to manage a certain debt service coverage ratio

4 Equated Installments Under this method, similar to home loans repayment, an equal amount will be paid every year. This would be a combination of interest and principal, with principal being lower in initial periods, and interest being higher. At the end of the tenure, by making equal payments, we would reach a debt level of Zero We can use the PMT and PPMT function to find out the instalment and the principal repaid.

5 Equated Installments Let us take an example to understand this Assume a 150 crore loan taken by a company, for a period of 9 years, with an interest rate of 8%. Assuming annual payments being made for interest and principal repayment, find out the amortization schedule

6 Equal Principal Repayments Under this method, we just divide the principal over the loan tenure, and repay equal amounts of principal every year. This way, the sum of interest and principal payment keeps reducing every year.

7 Equal Principal Repayments Let us take an example to understand this Assume a 150 crore loan taken by a company, for a period of 9 years, with an interest rate of 8%. Assuming annual payments being made for interest and principal repayment, find out the amortization schedule

8 Questions Assume a 320 crore loan taken by a company, for a period of 12 years, with an interest rate of 10%. Calculate the amortization schedule, assuming 1. Equated Annual Installments 2. Equal Principal Repayment

9 Advanced Financial Modeling Unit 4

10 Customized Payment Schedule Under this method, usually the company and the bank agree on a specific customized payment schedule. This may be higher in initial years, and lower later, or vice versa

11 Customized Payment Schedule Let us take an example to understand this Assume a 150 crore loan taken by a company, for a period of 9 years, with an interest rate of 8%. The bank has asked the repayment for the first 4 years to be 5% each, while the next 5 years to be 16% each.

12 Debt Sculpting Under this method, the company now incorporates how cash flows could define how much money is being repaid. In the earlier methods, whether the company was making money or not, we were creating a repayment schedule. In real life, that may not be practical. So here, we assume that debt payment would depend on how much cash the company has to service this debt. This can be captured by Debt Service Coverage Ratio

13 Debt Sculpting DSCR = (EBITDA Tax) / (Principal + Interest) If the company has given its EBITDA for the next 9 years, then we can create the debt profile based on that. Assume the EBITDA and tax to be as given below Year EBITDA Tax

14 Debt Sculpting DSCR = (EBITDA Tax) / (Principal + Interest) Calculate the amortization schedule, assuming a DSCR of 2 to be maintained throughout by the company Year EBITDA Tax

15 Questions 1. Explain the concept of Debt Sculpting 2. Which debt repayment method looks the most practical from a real life perspective?

16 Advanced Financial Modeling Unit 4

17 Financial Modeling for Debt and Bonds Models for Debt Repayment Modeling Amortizing Loans EMIs Financial Modeling for Bonds Bond Pricing

18 Bond Basics Recap

19 Clean Price and Dirty Price Mr. A holds a straight bond of face value Rs. 1 lakh that pays coupon of Rs. 10,000 on 31 st December of every year from Interest Earned by A (Seller) Interest Earned by B (Buyer) 1 st Jan th June 31 st December Mr. A sells bond to Mr. B Mr. B receives (Settlement Date) coupon of Rs. 10,000

20 Clean Price and Dirty Price Mr. A holds a straight bond of face value Rs. 1 lakh that pays coupon of Rs. 10,000 on 31 st December of every year from Interest Earned by A (Seller) Interest Earned by B (Buyer) 1 st Jan th June 31 st December Mr. A sells bond to Mr. B Mr. B receives (Settlement Date) coupon of Rs. 10,000 Accrued Interest = (days since last coupon/days between coupons) x coupon payment = (182/365) x 10,000 = 5,000

21 Clean Price and Dirty Price Mr. A holds a straight bond of face value Rs. 1 lakh that pays coupon of Rs. 10,000 on 31 st December of every year from Interest Earned by A (Seller) Interest Earned by B (Buyer) 1 st Jan th June 31 st December Mr. A sells bond to Mr. B Mr. B receives (Settlement Date) coupon of Rs. 10,000 Accrued Interest = (days since last coupon/days between coupons) x coupon payment = (182/365) x 10,000 = 5,000 Clean Price (Flat Price) = 1 lakh

22 Clean Price and Dirty Price Mr. A holds a straight bond of face value Rs. 1 lakh that pays coupon of Rs. 10,000 on 31 st December of every year from Interest Earned by A (Seller) Interest Earned by B (Buyer) 1 st Jan th June 31 st December Mr. A sells bond to Mr. B Mr. B receives (Settlement Date) coupon of Rs. 10,000 Accrued Interest = (days since last coupon/days between coupons) x coupon payment = (182/365) x 10,000 = 5,000 Clean Price (Flat Price) = 1 lakh Full Price (Dirty Price) = Clean Price + Accrued Interest = 1 lakh + 5,000

23 Clean Price and Dirty Price In Excel, the PRICE function gives us the clean price of the bond. Syntax PRICE(settlement, maturity, rate, yield, redemption, frequency, [basis])

24 Question 1. What do we mean by Yield for a Bond? 2. Explain the concept of Clean Price and Dirty Price in Bonds.

25 Advanced Financial Modeling Unit 4

26 Financial Modeling for Debt and Bonds Models for Debt Repayment Modeling Amortizing Loans EMIs Financial Modeling for Bonds Bond Pricing

27 Interest Rate Risk Interest Rate 1 Price of Bond Interest Rate Increases Yield required by Investor Increases Price of Bond Decreases Example: Consider a 6% 20-year bond. This is offering a 1% premium to the market interest rate Year Interest Rate in Market Required Yield by Investors Price of Bond Year 1 5% 6% $100 Year 2 5.5% 6.5% $94.45 (Sell at Discount) Year 3 4.5% 5.5% $106 (Sell at Premium)

28 Measuring Interest Rate Risk - Duration We can also quickly solve to find approximate modified duration using this formula. Price if yield declines (Price if yield rises) 2 Initial Price (Change in Yield In Decimal) or V decline V increase 2 V 0 ( y) Approximate Macaulay Duration = Approximate Modified Duration X (1+r)

29 Measuring Interest Rate Risk - Duration Duration is the measure of the price sensitivity to the changes in yield for a bond Duration of a bond gives us a measure of how much the bond will move for a 100 basis point (1%) movement in yields. An approximate measure can be found by just changing the YTM of a bond slightly and seeing how much difference does the change make to the price. Let us look at an example. Assume a bond with coupon rate of 8%, tenure of 5 years, face value of Rs 100 and YTM (expected return) of 7.2%. The current price can be calculated using the NPV formula, or manually on excel.

30 Measuring Interest Rate Risk - Duration We can also use the function MDURATION in Excel to find Modified Duration of a Bond. Syntax MDURATION(settlement, maturity, coupon, yld, frequency, [basis])

31 Question 1. What do we mean Modified Duration? 2. If duration of a bond is 5, what does this mean?

Solutions For the benchmark maturity sectors in the United States Treasury bill markets,

Solutions For the benchmark maturity sectors in the United States Treasury bill markets, FIN 684 Professor Robert Hauswald Fixed-Income Analysis Kogod School of Business, AU Solutions 1 1. For the benchmark maturity sectors in the United States Treasury bill markets, Bloomberg reported the