B40.2302 Class #6

©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill

14- 1

B40.2302 Class #6

BM6 chapters 14.4, 24, 22.1-22.3, 25.1, 23 14.4, 24, 22.1-22.3, 25.1: debt varieties 23: debt valuation

Based on slides created by Matthew Will Modified 10/18/2001 by Jeffrey Wurgler

An Overview of Corporate Financing

Principles of Corporate FinanceBrealey and Myers Sixth Edition

Slides by

Matthew Will, Jeffrey Wurgler

Chapter 14.4



14- 3

Topics Covered

Debt At first glance, many different forms of debt But all share common features…


14- 4

Corporate Debt

General features of debt

Borrower (stockholder) promises a certain stream of interest and principal payments

But borrower may choose to default

Lender doesn’t usually have voting rights, but in case of default lender gets assets

• Asset administration handled by bankruptcy court


14- 5

Corporate Debt

TABLE 14-5 Large firms typically issue many different securities. This table

shows some of the debt securities on Mobil Corporation's balance sheet at the end

of 1996 and 1997 (figures in millions).

Debt Security 1996 19976 1/2% notes 1997 $1486 3/8% notes 1998 200 $2007 1/4% notes 1999 162 1488 3/8% notes 2001 200 1808 5/8% notes 2006 250 2508 5/8% debentures 2021 250 2507 5/8% debentures 2033 240 2168% debentures 2032 250 1648 1/8% Canadian dollar eurobonds 1998 a 1109 % ECU eurobonds 1997 b 148


14- 6

Corporate Debt

(Mobil continued (!))

Debt Security 1996 1997

9 5/8% sterling eurobonds 1999 187 182Variable rate notes 1999 110Japanese yen loans 2003-2005 388 347Variable rate project financing 1998 105 52Industrial revenue bonds 1998-2030 491 484Other foreign currencies due 1997-2030 1090 764Other long-term debt 660 716Capital leases 247 335Commercial paper 1634 1097Bank and other short 894 1168

The Many Different Kinds of Debt


Slides by


Chapter 24



14- 8

Topics Covered

Domestic Bonds and International Bonds The Bond Contract Interest, Security, Seniority Asset-Backed Securities Repayment/Retirement Provisions Covenants Private Placements and Project Finance


14- 9

Bond Terms: Markets

Foreign bonds - Bonds that are sold to local investors in another country's bond market (in local currency)

Yankee bond- a foreign bond sold in the United States. Samurai bond - a foreign bond sold in Japan.

Eurobond market – Bonds sold across several international markets (in a single major currency)

Note: nothing specific to Europe, nothing to do with “euro” currency! Just denotes bonds that are issued/distributed across many countries


14- 10

Bond Terms: The contract

Indenture or trust deed - the bond agreement between the borrower and a trust company.

Agreement lists main terms of the contract

Trustee’s role:

Agent for individual bondholders

Represents them in event of default


14- 11

Bond Terms: Who keeps track

Registered bond – company keeps track of bond owners, repays them directly Most common in US

Bearer bond – bondholder sends in “coupons” to claim interest payments and must send the certificate to claim principal repayment More common overseas


14- 12

Bond Terms: Interest

Fixed-rate debt keeps paying a constant interest rate over the life of the bond

Floating-rate debt pays an interest rate that fluctuates with the general level of interest rates Common benchmark rate is LIBOR (“London InterBank

Offered Rate”) Loan agreements negotiated with banks are commonly

floating rate.


14- 13

Bond Terms: Security

Unsecured debt obligations are most common for industrial and financial firms

Debentures - long-term unsecured issue Notes – short-term unsecured issue

Secured bonds have a claim to certain assets upon default Mortgage bonds - long-term secured debt that may contain a claim

against a specific building or property Collateral trust bonds – bonds issued by holding companies that use

common stock in other companies as collateral Equipment trust certificate – (not a bond) debt issued to finance

railroad equipment, trucks, aircraft, or ships


14- 14

Bond Terms: Seniority

Priority of claims on firm’s assets:

Senior secured debt

Senior unsecured debt

Junior/subordinated debt Junior (or subordinated) debt

Residual claimants are shareholders Preferred shareholders rank above common


14- 15

Asset-backed securities

Asset-backed securities: Rather than borrow directly, companies may bundle a group of assets and then sell the cash flows from these assets

Example: Mortgage lenders• They get cash now• They “pass-through” the mortgage repayments they receive to the

AB securityholders

Example: Rock star David Bowie• Got $55 million in 1997• “passed-through” the royalties to his albums to the “Bowie

bondholders”


14- 16

Bond Terms: Retirement

Sinking fund - a fund established to retired debt before maturity. Low-quality issues: strict sinking fund requirement High-quality issues: light requirement, so large “balloon”

payment of principal left at maturity

Callable bond - a bond for which the firm has the option to repay early for a specified call price.

Putable (or retractable) bond – a bond for which investors have the option to demand early repayment


14- 17

Straight Bond vs. Callable Bond

Value ofstraight bond

25 50 75 100 125 150

25

50

75

100

bondValue of

Straight bond

Bond callableat 100


14- 18

Bond Terms: Covenants

Restrictive (negative) covenants - “must not” limits set by bondholders Limits on debt ratios Limits on dividends Limits on leasing Negative pledge clause (“me too” clause)

• Gives (unsecured) debentures equal protection if and when assets are mortgaged

Positive covenants – “must” limits Minimum net working capital


14- 19

Value of covenants: An example

1992 - 1993 Marriott spun off its hotel management business worth 80% of its value.

Before the spin-off, Marriott’s long-term book debt ratio was 79%. Almost all the debt was kept with the parent (renamed Host Marriott), whose debt ratio therefore rose to 93%.

Marriott’s stock price rose 13.8% and its bond prices declined by up to 30%.

Bondholders sued and Marriott modified its spinoff plan.

… hence the value of covenants


14- 20

Public versus private debt Public debt

Must be registered with SEC Standardized contract, wide investor base Costly to issue More common for large firms

Privately placed debt Less registration requirements Can be custom contract, narrow investor base Cheaper to issue, but may be higher interest rate Maybe more restrictive covenants More common for small and medium-sized firms


14- 21

Project Finance

1. Project is set up as a separate company.

2. A major proportion of equity is held by project manager or contractor, so finance and management are linked.

3. The project is highly levered.


14- 22

Project Finance

Contractor Supplier(s)

Equity investors

Government Projectcompany

Equity sponsor

Lenders

Purchaser(s)


14- 23

Project FinanceRisk Shifted to: Contract

Completion/ continuing management

Sponsor Management contract/ completion gtees / working capital maintenance

Construction cost Contractor Turnkey contract/ fixed price/ delay penalties

Raw materials Supplier(s) Long-term contract/ indexed prices/ supply or pay

Revenues Purchaser(s) Long-term contract/ indexed to costs/ take or pay/ throughput agreements/ rolling contract

Concession/regulation Government Concession agreement/ provision of supporting infrastructure

Currency convertibility

Government Gtees or comfort letters

Warrants and Convertibles


Slides by


Chapter 22.1-22.3



14- 25

Topics Covered

What is a warrant? How to value a warrant under dilution? What is a convertible bond?


14- 26

Warrants

Warrant - Right to buy a security (usually shares) from a company at a stipulated price, on or before a stipulated date.

- A call option!


14- 27

Warrant ValueExample:

B.J. Services warrants, expire April 2000

Exercise price = $ 15

BJ Services share price

15

Warrant price at maturity


14- 28

United Glue Warrants

# shares outstanding (N) = 1 mil Current stock price (P) = $12 Number of shares to be issued per share outstanding (q) = .10 Total number of warrants issued (Nq) = 100,000 Exercise price of warrants (EX) = $10 Time to expiration of warrants (t) = 4 years Annualized standard deviation of stock returns (sigma) = .40 Annually-compounded riskless interest rate (r) = 10 percent No dividends

United Glue has just issued $2 million package of debt and warrants. Using the following data, calculate the warrant value.


14- 29


United glue has just issued $2 million package of debt and warrants. Calculate the warrant value.

Suppose without the warrants, debt is worth $1.5 million

tper warrancost 100,000

500,000$5

1,500,000-2,000,000500,000

warrantsdebt w/o of value- financing total warrantsofCost


14- 30


United glue has just issued $2 million package of debt and warrants. Calculate the warrant value.

American call option on stock with no dividends = never exercise early = same value as European call option = Black-Scholes

(d1) = 1.104

N(d1) = .865

(d2) = .304N(d2) = .620


14- 31

United Glue Warrants United glue has just issued $2 million package of debt and warrants. Calculate the warrant value.

But we haven’t taken dilution into account

Warrant = 12[.865] - [.620][10/1.14]

= $6.15


14- 32

United Glue WarrantsCalculate warrant value including dilution When warrants are exercised, number of shares will increase by Nq=100,000. Assets will increase by amount of exercise money Nq*EX=100,000*10=$1 million Let V be value of United’s equity Warrant value at maturity = max{P – EX, 0}

(so with dilution) = max{[V+NqEX]/[N+Nq]-EX, 0}

=1/(1+q)*max{V/N – EX, 0} So warrant price equals the price of 1/(1+q) call options on the stock of an “alternative firm” with same total equity value V but no outstanding warrants


14- 33

United Glue WarrantsCalculate warrant value including dilution Suppose (given) total value of debt is $5.5 million (includes $1.5 million associated with warrant issue), total assets $18 million

Or $12.50 per share. This is the share price you want to use in Black-Scholes to account for dilution We’ll assume volatility of undiluted firm is .41 (use different sigma too)

debts of value-assets total

s United'of Value

firm ealternativ

of ueequity valCurrent V

million 5.12$5.518 V


14- 34

United Glue WarrantsCalculate warrant value including dilution

Note: Lower value than if don’t account for dilution, but still higher than the $5 the firm gets from the warrant issue

03.6$64.610.1

1

firm ealternativon call of value1

1

q


14- 35

Convertible Bonds

Convertible Bond - Bond that the holder may exchange for a specified amount of another security (usually shares).

Convertibles are thus a combined security, combining a straight bond and a call option

Like bond-warrant combo, except in bond-warrant combo you don’t have to surrender one to get the other: you have both

Example to understand terms: ALZA 5% Convertible 2006, face value $1000 Convertible into 26.2 shares Conversion ratio 26.2 Conversion price = 1000/26.2 = $38.17 Market price of shares = $28


14- 36

Convertible Bonds Example to understand payoffs: Eastman Kodak

Suppose Eastman Kodak has issued convertibles with $1 million face value

Suppose these can be converted at any time to 1 million common shares

Suppose there are already 1 million shares outstanding

Let’s plot the value of the convertible bond as a function of the underlying total firm asset value


14- 37

Convertible Bonds How bond value varies with firm value at maturity.

0

1

2

3

0 1 2 3 4 5

Value of firm ($ million)

default

bond repaid in full

Straight bond value ($ thousands)


14- 38

Convertible Bonds How conversion value at maturity varies with firm value.

0

1

2

3

0 0.5 1 1.5 2 2.5 3 3.5 4


Conversion value ($ thousands)


14- 39

Convertible Bonds How value of convertible at maturity varies with firm value.

0

1

2

3

0 1 2 3 4


default

bond repaid in full

convert

Value of convertible ($ thousands)

Leasing


Slides by


Chapter 25.1



14- 41

Topics Covered

Lease terminology


14- 42

Lease Terms

Lessee (user of asset) promises to make a series of payments to the lessor (owner of asset)

Lease contract sets out the terms

When lease is terminated, asset goes back to owner but contract may give lessee option to buy or renew lease


14- 43

Lease Terms

Operating Leases Short-term, cancelable at option of lessee

Capital/Financial/Full-payout Leases Long-term, cover life of asset These are a source of financing


14- 44

Lease Terms

Other lease terms: Rental/full-service lease: owner services, pays

property taxes, insures Net lease: lessee services, pays property taxes,

insures Sale-and-lease-back arrangements

• To raise cash, firm sells an asset it already owns, then leases it back (e.g. sell factory, lease it back)

Valuing Debt


Slides by


Chapter 23



14- 46

Topics Covered

The Term Structure Term Structure Theories Risk: Duration and Volatility Risk: Default


14- 47

Term Structure

We know the mechanics of how to value a straight bond: Discount each coupon at the relevant opportunity cost of capital Usually, the term structure is not flat (as we have assumed so far) Not a problem: discount first coupon C at r1 , discount second coupon at r2 , discount third coupon at r3 etc.

rt is the cost of borrowing for a term of t periods. Add them all up to get present value

But what determines the discount rates r1 and r2 and r3 ?

That is, what determines the term structure of interest rates ? Especially the term structure of nominal interest rates?

Need this because the bond coupons are usually in nominal terms


14- 48

Term Structure

rt

Year

1981

1987 & present

1976

1 5 10 20 30

These are the interest rates you face today (t=0)

to borrow $1 for t years


14- 49

Term structure theories Irving Fisher’s theory:

Nominal rt = Real rt + expected inflationt(approximation)

Real rt is relatively stable, but expected inflation is highly variable

Maybe this helps to explain why nominal interest rates move so much? Or why the term structure has a certain shape?


14- 50

Term structure theories

More complete theories of TS: Expectations Theory

Posits that return to holding a two-year bond should be equal to the expected return to rolling over a one-year bond

I.e., (1+ r2) 2 = (1+r1)*(1+E[1r2]) If >, nobody would hold one-year bonds If <, nobody would hold two-year bonds Therefore must be = Implies: only reason for upward-sloping TS is that investors

expect spot rates (one-year rates) to rise, only reason for downward-sloping TS is that investors expect spot rates to fall


14- 51

Term structure theories

More complete theories of TS: Liquidity-Preference Theory

Expectations theory ignores risk If your horizon is 2 years, return to holding 2-year bond is riskless,

return to rollover strategy is risky If your horizon is 1 year, return to holding 2-year bond and selling

after 1 year is risky, return to holding 1-year bond is riskless Whether “long” or “short” investors dominate the market,

determines where the risk premium falls If “short” investors dominate the market, i.e. typical investor has a

“liquidity preference,” then 2-year bond yield will have to have a premium to get them to hold it. Hence TS usually slopes upward.


14- 52

Term Structure: Using it

Which TS theory is right?•No agreement•Probably all have elements of truth

How to integrate these theories with CAPM? •Sloppy but possible•CAPM is inherently a single-period model. TS is inherently multi-period. To use CAPM over multiple periods, could use multi-period risk-premium, multi-period beta, multi-period risk-free rate

How to proceed, in practice?•To value a bond, discount its coupons using the TS appropriate for bonds of that risk


14- 53

Risk: Duration & Volatility

Year CF PV@YTM % of Total PV % x Year

1 90 82.95 .081 0.081

2 90 76.45 .075 0.150

3 90 70.46 .069 0.207

4 90 64.94 .064 0.256

5 1090 724.90 .711 3.555

1019.70 1.00 4.249 Duration

Duration: Average time to each bond payment Longer duration means more sensitive to interest rate movements, higher

volatility Example: 5 year, 9.0%, $1000 bond, with a 8.5% YTM


14- 54

Risk: Default Default Risk is the risk that shareholders will

walk away from the debt obligation

Bond Ratings are issued by independent companies to help investors assess default risk of individual debt securities. Moody’s: Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C Std. & Poor’s: AAA, AA, A, BBB, BB, B, CCC, CC, C Top 4 ratings = “investment grade,” below = “junk”


14- 55

Risk: Default

Imagine a 1-year bond with face value $1000 and coupon of 9%. There is an 80% chance the bond pays off fully, but a 20% chance the company defaults and pays nothing. What is the bond’s value?

CF Prob

1090 .80 = 872.00

0 .20 = 0 .

872.00 = expected CF


14- 56

Risk: Default

Value

YTM

872

1091090

80036 3%

.$800

.

• Discount with CAPM

Case 1: If risk of default is purely idiosyncratic, then return has beta of 0.0, so discount at riskless one-year rate (say that’s 9%)


14- 57

Risk: Default

• Discount with CAPM

Case 2: If risk of default is partly systematic, so return has positive beta. Now need to discount at higher rate, say 11% (11% = 9% + beta*(E[Rm]-9%))

Value

YTM

872

11159

1090

7855938 8%

.$785.

..

B40.2302 Class #6

Documents

Transcript of B40.2302 Class #6