Investment valuation models in perspective

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By Ebenezer M. ASHLEY (PhD.)

Valuation involves an estimation of the intrinsic value of an organisation or its stock. The present value theory forms the basis of valuation. Generally, the worth of an organisation can be determined using two major valuation methods. These include debt valuation and equity valuation. An effective measurement of the value of a security requires information on its discount rate, expected future payoffs over the security’s life, among others. Discussions in this chapter will lay strong emphasis on the debt valuation method. It is hoped a higher understanding of the debt valuation method will ease our understanding of the equity valuation method.

Definition of Bond

A bond is an investment debt in which an institution, government or corporate borrows financial resources (usually money) from individuals or groups of investors at a predetermined premium (coupon or interest rate) over a stated period of time. A completed bond agreement indicates the coupon or premium rate and the principal amount to be returned to the investor at the maturity date.



Further, it states when premium or coupon payments (monthly, semi-annually or annually) will be made to the investor. A bondholder is an investor who has loaned funds to an issuer, commonly called bond issuer. A bond may be negotiated at a later date. That is, the bondholder may decide to transfer ownership of his or her bond to a third party in the secondary market.

Types of Bond

A bond may be issued in different forms to meet varying financial needs of government and various corporate institutions. Examples include Government or Treasury bonds, municipal bonds, corporate bonds, savings bonds, zero-coupon bonds, convertible bonds, callable bonds, term bonds, amortised bonds, adjustment bonds, junk or high yield bonds, emerging market bonds, and angel bonds. The following section presents a discussion on each of the aforementioned bond types.

Government or Treasury Bonds: This is one of the safest investments in the bond market. It is safe in that it assures the holder of ‘prompt’ payment at the maturity date; it assures the holder of payment prior to maturity date, often at a penalty  – the holder forfeits part of the accumulated premium should he or she decide to redeem the bond prior to the agreed maturity date. Premium payments on the bond can be fixed or variable; payments can be effected semi-annually or annually. Treasury bonds can be issued for medium- (three to four years) or long-term (five years and above) or both. Treasury Notes are securities issued by Government to raise funds for durations of one and two years.

Treasury bonds are often issued by Governments to raise funds for socio-economic development; funds raised through debt-aid in the provision of good schools and hospitals; provision of potable water and extended electrification projects; and construction of highways and overpasses. Strategically, Government may issue a long-term bond and use the proceeds to settle current debts. Thus, it enables Government to transform a current liability into a long-term liability. This provides Government with some economic respite in terms of early debt settlement. Generally, Treasury bonds attract a lower coupon rate than corporate bonds due to lack of default risk in holding the former.

Municipal Bonds: Depending on the jurisdiction and type of governance system, municipal bonds may be issued by local government bodies (district assemblies), cities (metropolitan or municipal) and states (regions) to raise funds for specific socio-economic development activities. Risk associated with a municipal bond is higher than a Government bond, but less than a corporate bond. A municipal bond is sometimes called ‘munis’. Premium accumulated on municipal bonds is tax-free; that is, it is not taxable at the national and local levels.

Generally, municipal bonds offer lower pre-tax yields than taxable securities. This renders municipal bonds a safe investment ‘haven’ for individuals in higher income brackets than those in lower income brackets. All else held constant, individuals with higher incomes can invest more in municipal bonds to earn, cumulatively, higher pre-tax yields than individuals with lower incomes.

Corporate Bonds: Sometimes, commercial banks may be reluctant to lend money to corporate bodies due to myriad of factors, including high non-performing loan amounts on the banks’ books. Such a decision can have strong negative implications for the development and growth of corporate bodies in a given jurisdiction. For instance, in 2016 the non-performing loans amount recorded by banks in Ghana was estimated at GH¢6.2billion. This was an increase over the GH¢4.2billion recorded in 2015; but GH¢2.33billion short of the amount recorded during May 2018 (GH¢8.53billion).

In percentage terms, the increase (GH¢2billion) in 2016 over the preceding year translates into about 47.6191%. The non-performing loans value recorded at the end of July 2019 (GH¢6.83billion) was an improvement of GH¢1.7billion over the value recorded earlier in May 2018 (GH¢8.53billion). The foregoing notwithstanding, the relatively high NPL value (GH¢6.83billion) implied further room for improvement by lending institutions, especially banks. To avert such negative tendencies and assure a stream of cash flows for its operations and expansionary projects, a corporate body may issue corporate bonds in the bond market. Corporate bonds serve as an alternative source of funding to equity and commercial banks’ lending.

Corporate bonds ease pressure on the costs of funding in organisations. Corporate bonds may be issued for a short-term (from one to four years), medium-term (five to twelve years) and long-term (thirteen years and beyond). Some organisations have the tendency to default in payment to corporate bondholders. As a result, corporate bonds often attract a higher coupon rate than Treasury and municipal bonds. Organisations with strong financial performance and effective bond repayment records often negotiate for a lower coupon rate.

The implication is organisations are making the necessary efforts to reduce costs associated with funding their operations and expansionary projects through corporate bonds. Small and medium-scale enterprises (SMEs) constitute about 90% of the world’s corporate establishments. Companies willing to expand and having a financial reputation as well as strong operational performance are able to borrow from both domestic and international bond markets.

Savings Bonds: The principal investment amount in Savings bonds has Government backing. That is, the principal is often guaranteed not to lose value. To this end, Savings bonds are described as the safest investment in the bonds market. These bonds are commonly issued in the bonds market in the United States of America. Coupon interests accumulated on savings bonds do not attract taxes at the local and state levels. At the federal level, proceeds from Savings bonds used to finance education do not attract taxes.

In spite of its attractive ‘package’, buying and selling Savings bond are not easy compared with other investment types. Stated differently, liquidity of Savings bonds is quite challenging; it is equally challenging to cash Savings bonds within one year of contract signing, while a three-month interest penalty is charged when the holder decides to cash within the first five years of contract signing.

Zero-Coupon Bonds: In some cases, a bond may be issued at a discounted rate or below its par value. However, the bondholder is assured collecting an amount at least equivalent to the bond’s par value at the maturity date. Thus, at maturity, a zero-coupon bondholder receives the principal investment plus imputed interest. Zero-coupon bonds allow investors to set aside a relatively small investment and derive higher returns in addition to the principal at the maturity date. Issuers of other types of bonds may effect semi-annual or annual coupon payments to bondholders.

However, issuers of zero-coupon bonds do not pay cash coupons as holders of zero-coupon bonds are expected to receive one-time payment at the maturity date; this one-time payment comprises the principal investment plus imputed interest. The imputed interest usually includes predetermined yield compounded semi-annually. The implication is issuers of zero-coupon bonds credit holders, regularly, with premium; but this premium credit is not paid until the bond matures.

A zero-coupon bond may be issued for a minimum of ten years. This enables the investor to engage in long-term investment planning. To illustrate, Mensean Corporation issues a 15-year bond with a face value of US$15,000, and a yield of 5%. An investor pays US$5,520 for the bond. At the maturity date, the investor would receive US$15,000. The difference (US$9,480) between US$15,000 and US$5,520 is the premium that compounds semi-annually until the maturity date.

Zero-coupon bonds may be issued by Governments, corporate bodies, and government agencies. Investment in zero-coupon bonds allows corporate bodies to release their excess capital requirements into other productive sectors of the economy over a considerable period of time.

Convertible Bonds: These bonds are often referred to as ‘CVs’. They are bonds with an underlying clause permitting holders to exchange them for stock or shares in the issuing corporation at a later date. Convertible bonds allow investors or creditors to transform their original investment status into shareholders. Convertible bonds enable holders to have voting rights in the issuing company when the holder decides to convert the value into shares.

Generally, the underlying clause of the bond agreement gives the holder the exclusive right to decide on the conversion. Convertible bonds may be issued to boost investor confidence in the issuing organisation; and to minimise any negative perception investors might have formed about the organisation and its operations.

Callable Bonds: Certain bond agreements allow the bond issuer to call the bond prior to its maturity date. Bonds in this category are described as callable or redeemable bonds. Coupon payments on callable bonds are computed and paid to the holder when the bond is called. The underpinning objective of the issuing organisation is to raise capital at the least cost; the issuing firm may be interested in paying lower coupon rate on the bonds.

Due to the foregoing, the issuer may call the bonds when there is a general decline in interest rates in the financial market. Suppose Amishadai Corporation issued a 10-year bond with a face value of US$30,000, and a yield-to-maturity of 10%. Reports obtained from the financial market reveal a decline in the interest rate from 10% to 6% over a 2-year period. Since Amishadai is interested in minimising its cost of capital, the 10% bond will be called and reissued at the prevailing lower market rate of 6%.

Term Bonds: Bonds in this category are usually not callable, they are held until maturity by investors. Term bonds are several bonds with the same maturity date. Stated differently, term bonds are two or more bonds issued simultaneously with the same maturity date. Term bonds may be registered or non-registered. They are registered term bonds when the issuing organisation takes the necessary steps to have detailed documentation on the sold bonds to ease traceability of the holder, should the need arise. Inversely, the issuer may not deem it necessary to register the bondholder. In such situations, it may be difficult for the issuer to contact the bondholder should the need arise. Bonds issued in this category are called unregistered term bonds.

Due to their uniqueness, term bonds are sometimes called bullet bonds or bullet-maturity bonds (Investopedia.com, 2017, para. 7). Assume Perlisto Corporation issued 3-year bonds worth US$520,000 on 4th January, 2018. All the bonds issued are expected to mature on the same date. This suggests on 4th January 2021, Perlisto Corporation would make payments to the bondholders or investors. If the bond sale and purchase agreement were to extend to say, 12 years, the same repayment method would apply.

Coupon rates associated with term bonds are usually low. Term bonds are usually risk-free and exempt from tax; they may be held for a shorter or longer period. For instance, investors may purchase and hold term bonds with a 3-year (short period) maturity or 12-year (long period) maturity. The term bullet portfolios (Investopedia.com, 2017, para. 7) is used to describe portfolios that hold bullet or term bonds.

Financial commitments of an investor to some term bonds may be very high. In such cases, the investor may require the issuer to establish a fund into which period or annual deposits will be made to ease repayment of the debt at the maturity date. Such a fund, when established, is called a sinking fund.

To allay investor fears and facilitate fund mobilisation in the bond markets, an issuing firm may back its term bonds with a collateral security. The collateral security guarantees the bond issuer’s repayment to the holder at maturity; collateral security assures the bondholder of the issuer’s commitment to repay at maturity. This category of bonds is referred to as secured term bonds.

Conversely, an organisation may issue term bonds without the need for collateral security; the issuing organisation’s historical records in terms of operations and financial performance are an ample evidence of its debt repayment capabilities. Term bonds issued without the need for a collateral security are called unsecured term bonds.

Term bonds are the inverse of serial bonds, which are called at varying maturity dates until they are retired fully by the issuer. Because repayments on these bonds are serialised and involve varying dates, different coupon rates may be applied.

Amortised Bonds: It is likely for a bond issuing institution to issue a bond below its face or par value. When this occurs, we say the bond is discounted. For accounting purposes, amortised bonds are recorded in the assets section of the balance sheet; the difference between the par value and the issued value, which is the discount, is amortised to expense over the life of the bond. Like depreciation, the amortised value is matched against the revenues it helps the organisation to generate over the life of the bonds. Depending on the jurisdiction and acceptable accounting practices, the bond discount may be treated, after the transaction, as an expense; or amortised and reduced to expense over the life of the asset (amortised bond).

Adjustment Bonds: An organisation saddled with bankruptcy usually requires financial ingenuity that will ensure its operational turnaround. An organisation stirred with bankruptcy will require restructuring. Prior to the restructuring stage, the firm might have issued outstanding bonds to bondholders. At the restructuring stage of its existence, the firm may issue adjustment bonds to these bondholders. The issuing organisation will take the necessary steps to recapitalise its debt obligations; it will consolidate and transfer the outstanding bond issue to the adjustment bond.

Recapitalisation is intended to provide the organisation with a financial ‘life-line’ to assure its continuous operation and existence. Through recapitalisation, varying maturity terms and premium rates are reviewed to emerge with a common maturity term and premium rate. This eases the firm’s financial burden and enhances its chances of repaying the debt. Continuous operations are likely to enhance an organisation’s performance, financial reputation and value.

Discontinued operations or liquidation may result in partial payment to the bondholder by the liquidated organisation. However, profit-oriented investors will not be interested in this development. The organisation issuing adjustment bonds is likely to receive the cooperation of its outstanding bondholders since operational failure of the former will have dire financial implications for investments of the latter.

Junk Bonds: These bonds are usually issued by organisations with questionable operational performance; junk bonds may be issued by firms with questionable business strategy, model or earnings. Due to the uncertainty surrounding the firm’s operations and earnings, it is believed to rate high in terms of default risk. This affects negatively the organisation’s credit rating. A lower credit rating affects the interest of existing and potential investors in the issuing organisation.

An investor’s decision to purchase and hold bonds in such an organisation implies assuming higher risk. To compensate for the high investment risk, junk bondholders often demand higher premium rate as a meaningful return on their investment; investors demand higher coupon rate on junk bonds than they do in the case of Government bonds, which are believed to be safe in the bonds market. Junk bonds are also called speculative bonds or high-yield bonds.

Emerging Market Bonds: Emerging economies across the globe and their corporate bodies require additional funds to finance their development projects – and to meet other pressing social and economic needs of the citizenry. However, most countries in this category are often characterised by weaker socio-economic development structures. Some emerging economies suffer political unrest and unstable economic performance. This reduces the countries’ credit ratings and increases their cost of borrowing; investors in emerging market bonds often demand higher coupon rates to compensate for the higher risk they assume.

Angel Bonds: These bonds may be described as the inverse of junk bonds. As the name implies, an angel bond is very limited in investment blemish; issuers of angel bonds are believed to have a higher credit rating in the investment market. Therefore, issuers of this bond category often offer a lower premium rate to holders.

Bonds may be described as new issues; outstanding or seasoned issues. Generally, bonds issued within a month, actively traded in the bonds market, and sold close to their par value are known as new issues. Bonds issued into the bonds market over a month and may be sold below the par value are called outstanding or seasoned issues.

Key Features of a Bond

The financial needs of economies and corporate bodies vary from one to another. This implies the contractual provisions of bond agreements may not be the same across economies and corporate bodies; they may differ considerably. These differences notwithstanding, all bonds have some identical features. Notable among these are: par value, minimum bid, maximum bid, premium or coupon rate, maturity date, and call provisions. The following section presents a brief explanation on each of these features.

 

Par Value: This refers to the stated face value of the bond issued. It is the amount the bond issuer promises to pay the bondholder at the maturity date. Bonds may be issued in different currency denominations. For instance, in Ghana, Government normally issues bonds with a face value of One Ghana Cedi (GH¢1.00). Corporate bodies in Ghana may issue bonds with a face value of One Thousand Ghana Cedis (GH¢1,000.00). In the United States, bonds are issued in dollar denominations; they may be issued from One Thousand Dollars (US$1,000.00) to One Million Dollars (US$1,000,000.00); they may be issued in denominations less than US$1,000.00.

In other countries, bonds may be issued in similar or different denominations using the issuing country’s currency or the accepted legal tender for the transaction, which may be a foreign currency. As an example, recent Eurobonds issued by the Ghanaian Government were traded in the international bond market and sold in euro or its dollar equivalent, although the country’s (Ghana’s) official currency is the cedi.

Minimum Bid: This relates to the least amount an investor could invest in a bond transaction. This minimum investment amount is often determined by the bond issuer. For instance, the Government of Ghana recently issued 3-year and 5-year Treasury bonds to raise funds for development projects and partial retirement of some debts due for payment, among other expenditures. The stated minimum bid in either of the bonds issued was Fifty Thousand Ghana Cedis (GH¢50,000.00). In addition, investors had the opportunity to purchase additional bonds in multiples of One Thousand Ghana Cedis (GH¢1,000.00) after the initial investment of GH¢50,000.00.

Maximum Bid: Akin to minimum bid is maximum bid for bonds issued by a government or corporate body. Generally, the maximum bid may be tied to the bond issuer’s initial targetted amount; that is, the amount expected to be raised from the bond sales to meet a given expenditure. Suppose Ghana Government’s 5-year Treasury bond was issued to raise One Billion Ghana Cedis (GH¢1,000,000,000.00). In monetary terms, the highest amount an investor could invest in the bonds is GH¢1,000,000,000.00. This is known as the maximum bid.

In some cases, the maximum bid is not applied, especially when the bond’s coupon rate is attractive and results in over subscription by investors. The Government of Ghana’s GH¢1billion, 5-year Treasury bond may be over- subscribed by say, Five Hundred Thousand Ghana Cedis (GH¢500,000.00), resulting in total bonds proceeds of One Billion and Five Hundred Thousand Ghana Cedis (GH¢1,000,500,000.00). Conversely, the GH¢1billion, 5-year Treasury bond issued by the Government of Ghana may be under subscribed by, say, Five Hundred Thousand Ghana Cedis (GH¢500,000.00). In this case, total earnings from the bond sales would be Nine Hundred Million and Five Hundred Thousand Ghana Cedis (GH¢900,500,000.00).

The maximum bid also relates to highest proportion of the total bonds issued that an investor or group of investors can hold. Maximum bid may be used by the issuing governments or corporate bodies to diversify their investment portfolios; it may be used to effectively manage risks inherent in the investment. Over-concentrated or non-diversified portfolio may be economically ‘injurious to the bond issuer. An investment portfolio is over-concentrated when the fund manager does not ensure equitable distribution of the investment funds to ease repayment pressures on the bond issuer.

Premium or Coupon Rate: At the bond issuing date, the issuer promises to pay a certain amount on the principal investment to the bondholder. This ‘certain’ amount is often called premium or coupon rate. Others commonly refer to this certain amount as coupon interest or bond interest. A coupon rate is the return on the bondholder’s decision to invest in the bond issuer’s operations or investment projects. The bond’s contractual agreement spells out the payment terms; payments can be effected monthly, semi-annually, or annually.

Most coupon payments on bonds contracted in the United States and elsewhere are often computed on semi-annual or annual basis. Suppose the GH¢50,000.00, 5-year Treasury bond issued by the Government of Ghana promises an annual payment of GH¢12,000 to the holder. The GH¢12,000.00 represents coupon payment.

The premium or coupon rate is the coupon payment (GH¢12,000.00) expressed as a percentage of the face value (GH¢50,000.00). The premium or coupon rate is 24% [(GH¢12,000 ÷ GH¢50,000) x 100% = 0.24 x 100% = 24%]. The premium rate quoted by some corporate bodies is tied to the Treasury rate; others are tied to the London Interbank Offered Rate (LIBOR). Generally, corporate bodies have higher investment risk than governments. As a results, bond investors demand higher coupon rate from the former than from the latter.

Maturity Date: Generally, parties to a bond contract (bond issuer and bondholder) agree to a common date on which the principal investment and outstanding coupon payments, if any, will be paid to the bondholder. This is called the maturity date. Suppose the Government of Ghana’s 3-year Treasury bond was issued on 5th January, 2017. The maturity date would be 4th January, 2020. The 4th January, 2020 is known as the original maturity date. The original maturity date may be altered if the issued bond has a callable provision, and the bond is called prior to the initial maturity date. Bonds are issued from 3 years to 30 years; others are issued beyond 30 years.

Call Provisions: Clauses in some bond contractual agreements allow bond issuers and bond holders to call back the bonds at a later date, but prior to the maturity date. These clauses are called call provisions. Some bonds may not be eligible for calling within 2, 3, 4, 5, or more years from the date of issue. Such an arrangement is called deferred call. Bonds have call protection when their calling dates are predetermined or deferred.

Bonds called earlier than their maturity date by the bond issuer attract higher premium. This higher premium serves as compensation to the bondholder for an early surrender. Should the bondholder decide to redeem the bonds earlier than their maturity date, the bond issuer may charge an early redemption penalty to compensate for the former’s inability to hold on to the investment (bond) to the maturity date.

In April 2017, the Government of Ghana issued two separate bonds totalling Two Billion, Two Hundred and Twenty-Five Million United States Dollars (US$2,250,000,000). The first group of bonds issued with 7 and 15 years’ maturity fetched the government One Billion, One Hundred and Thirty Million United States Dollars (US$1,130,000,000). The second group of bonds issued with 5 and 10 years’ maturity earned the government One Billion, One Hundred and Twenty Million United States Dollars (US$1,120,000,000).

The underlying objectives of issuing these bonds are to pay off some domestic maturing debts, ease foreign currency shortage in the economy; and to repurchase some government debts issued earlier at relatively higher coupon rates. The latter objective is called refunding operation. A refunding operation helps bond issuers to reduce their cost of funds, considerably. This strategy, that is a refunding operation, is often implemented by governments and corporate bodies.

An organisation may engage in a merger or an acquisition after issuing bonds, but prior to the bonds’ maturity dates. However, a critical analysis of the firm’s financial statements by the investor prior to his or her investment decision may unearth the weakness inherent in the organisation’s current and long-term operations, and financial performance. In such a situation, the bondholder may call for the inclusion of the clause, super poison put, in the bond purchase agreement. In case of a merger or an acquisition, the foregoing clause will allow the bondholder to surrender the bond to the issuer at its face value.

Determinants of Market Interest Rates

The financial market is often inundated with different securities; that is, it does not have one security. All things being equal, the existence of different debt securities means the availability of different interest rates in the securities (financial) market. The fundamental determinants of interest rates in the securities market are the forces of demand and supply; interactions between sellers (securities issuers) and buyers (securities buyers) in the securities market influence, to a very great extent, the interest rate quoted. Stability in the interest rate is witnessed when supply of securities equals demand in the financial market.

However, the activities of a firm willenhance its reputation and increase its creditworthiness. Under this circumstance, demand for the firm’s debts by investors may exceed the quantity the firm may be willing to supply; this will lead to an excess demand over supply. All else held constant, an increase in demand over supply will result in downward review of the security’s interest rates.

Conversely, poor operational performance by the firm could impact negatively on its ratings and patronage of its securities by investors in the debt market. Loss of interest in the firm’s securities means investors may not be willing to pay a higher price for them; investors may ascribe a higher risk perception index to the company’s securities, and as a result may not be attracted to lower market interest rates. To encourage investors to purchase its debt, the company will have to offer a higher market interest rate for its securities. Thus, to compensate for the assumption of high risk in the company, the investor will be interested in earning a higher market interest rate on the securities or debts purchased.

It is worth emphasising the interactions between demand and supply are not the only determinants of interest rates in the securities market; there are other equally compelling and significant factors that contribute to the effective determination of return (interest rate) on the investments of investors in the securities market. These other significant factors are couched in the risk inherent in the debt-issuing firm.

Nominal Interest Rate: Generally, there is an interest rate that is commonly observed in the financial market. This is called a nominal interest rate. Inherent in a nominal interest rate is an expected inflation premium. Financial analysts make projections into the future; they determine prevailing economic conditions in the following year or several years. The projection often involves consideration for increased price of goods and services which may affect the value of an investment at the maturity date. To help maintain or increase the value of the investment at the maturity date, an inflation premium is factored into the final rate of interest that the debt issuer agrees to pay to the debtholder. Mathematically, the nominal interest rate with inflation premium is expressed as:

r = RR + IP…………(i).

Where:

r = Nominal interest rate

RR = Real interest rate

IP = Inflation premium

The nominal interest rate above is ideal for an organisation with no risk of payment default; that is, the organisation has the financial ability to pay debtholders at the maturity date. Debt issuers in this category are often governments. However, some debt issuers cannot be immune from payment default. In this case, the debtholder may call for the inclusion of a default risk premium in the nominal interest rate.

A default risk premium is the compensation a debt issuer provides to a debtholder for accepting to invest in the former’s organisation; it is the compensation to the debtholder for assuming the risk of non-payment of interest or non-payment of principal or both by the debt issuer at the maturity date. A nominal interest rate with a default risk premium is mathematically presented as:

r = RR + IP +DRP…………(ii).

Where:

r = Nominal interest rate

RR = Real interest rate

IP = Inflation premium

DRP = Default risk premium

A nominal interest rate with inflation premium and default risk premium may not fall under the purview of government debts; it may be common among corporate debt issuers. As noted earlier, the investor may be interested in a higher interest rate to compensate for the risk assumed in the firm issuing the debts. The risk assumed by the investor (debtholder) up to this stage is considered moderate. However, operational and management challenges may impact negatively on a firm’s ability to repay its debts to holders when they become due; this increases the level of risk assumed by debtholders. In this regard, the debtholder will require higher compensation in the form of a higher market interest rate from the debt issuer. Thus, to avert any investment contingency in the short- and long-term, investment analysts include maturity risk premium and liquidity risk premium in the computation of the nominal interest rate:

 r = RR + IP +DRP + MRP + LP…………(iii).

Where:

r = Nominal interest rate

RR = Real interest rate

IP = Inflation premium

DRP = Default risk premium

MRP = Maturity risk premium

LP = Liquidity premium

The inclusion of maturity risk premium and liquidity premium in the computation of the nominal interest rate helps to protect debtholders against market fluctuations in the short- and long-term; the inclusion insures investors against possible loss of investment value at the maturity date.

Author’s Note

The above write-up was extracted from a Chapter in ‘Principles of Corporate Finance: Theory with a Practical Dimension (Second Edition)’ by Ashley (In Press).

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