Corporate Financial Policy 1.) Discuss Briefly: a. Firm value will be higher with callable debt because the firm is protected against falling interest rates. Callable bond may be issued for several reasons: (1) tax advantage if bondholders’ tax rates are less than the company’s tax rate, (2) future interest rate prediction through asymmetric information, (3) the firm can call a bond if there are future investment opportunities since there are no restrictive bond covenants, (4) decrease interest rate risk by correctly pricing bond at the market rate while at the same time not benefiting the shareholders. Callable bond’s yield to maturity is equal to or higher than a comparable straight bond (Value of call bond = straight bond value - call value). Advantage of callable bond is the reduced risk from a fall in interest rates. However, in an efficient market the call provision should be correctly priced and firms should not have a preference for using calls. Firms should call the bond when the bond price exceeds the call price. While the advantages of callable bonds are useful to firms in certain situations it does not provide a higher firm value through their use. Protective bond covenants “protect” the firm or power the probability of bankruptcy and in turn increase the value of the firm. b. In Europe, bonds contain fewer covenants than in the U. S. Bonds in Europe impose less restrictive covenants on borrowers, which in turn gives lenders less influence when problems arise. Consequently, borrowers in Europe (ex. France, Germany) were funded largely through bank loans, which in turn owned shares in the company and the company owned shares in the bank giving the loan. Since the financial institutions control both debt and equity of a company, they will act in their own best interest making covenants less useful. European corporate bond agreements are much more “loose” than agreements in Britain or the US which offer less restrictive covenants and less creditor protection. The bankruptcy laws in Europe (especially France) are also more geared toward the borrower which leaves the investor at a loss in the event of default. In the event of a bankruptcy by a European bond issuer results in far less recovery for the investor. Although there has been strong growth in the corporate bond market in Europe, there has not been a strong push for corporations to adopt US style bond covenants. This is in part that European investors have not demanded the same type of protection offered in the US. Also, bankruptcy laws vary across the Europe. For example, the French bankruptcy law focuses on the preservation of employees and the debtor, with the repayment of debt is last on the list. In Germany, Holland and southern Europe bankruptcy codes are less slanted towards borrowers in France, they still offer less protection to lenders than Britain and the US. The issue is not the reform existing laws but rather the market is not doing an adequate job of forcing the borrowers to pay adequately to compensate the investors for the higher risk that they are taking. 2. (a) Project A: PV costs = $650 PV payback = $1500 NPV = $850 (average payback) Project B: PV costs: = $750 PV payback = $1500 NPV = $750 (average payback) The firm offers debt with face value of $1000, market value of debt is? The market value of the debt is the present value of the future cash flows. The market value of the debt would be the PV of the projects the company chooses to invest in. However bondholders are going to require some restrictions and (risk adverse investors) will value the bonds with a worst case scenario. Project A: Bond: = $1000 Costs: = $650 Equity: = $350 NPV (worst case): = $150

Market Value of Debt: = $1150 = $350equity + $800 payback (worst case) Project B: Bond: = $1000 Costs: = $750 Equity: = $250 NPV (worst case): = -$250 Market Value of Debt: = $750 = $250eqity + $500 payback (worst case) Bond holders will force the corporation to fund worst case scenario a positive NPV project, Project A only. They would expect $1150 market value for a bond selling at $1000 face value in this case. There is no risk to the bondholder with project A, because worst case scenario the firm has the equity to fund repayment. The bondholders will formulate the covenant to restrict the payout of dividend to share holders prior to bond maturity. In addition they may require a sinking fund to reduce the risk of default on the bond. 2(b) Suppose the firm offers convertible debt where they can exchange the bonds for ½ the equity in the corporations at the bond holder’s option. What is the market value of the firm’s debt? For project A: this is essentially a risk less investment so the value of conversion is significantly less. For project B: There is an expectation to convert due to the higher variance / volatility in the investment. In the event of substantial growth the bond holder will choose to exercise the conversion option. Project A: Cost: $650 Payback best case: $2200 NPV: $1550 Bond Market Value (convertible): $1900 = $350equity + $1550project NPV (best case) Project B: Cost: $750 Payback best case: $2500 NPV with best case: $1750 Bond Market Value (convertible): $2000 = $250equity + $1750project NPV (best case) This Scenario assumes covenant controls payout to shareholders prior to bond maturity. Convertible bond investors will prefer project B due to its higher volatility and higher potential firm value growth. Bond holders for project B would pay more because the volatility inherent within project B gives them a higher payoff later. 3. (a) Finance companies, trying to save money on interest payments, are rushing to market offerings of “put bonds”. Since August, when the first such corporate offering was made, 12 companies have issued $1.4 billion of put bonds, which are so named because investors can “put”, or sell back, the securities at a specified date before the bonds mature. Corporations issuing put bonds are taking a risk, investment bankers note, because they can’t force investors to sell the bonds back to them if market rates drop. If rates are higher when the put date comes, the investors will redeem the bonds at face value and the company will have to refinance at a higher rate. But if rates are lower, the investors will keep them, preventing the issuers from refinancing the debt at a lower rate. He says that our investment banker is trying to talk him into issuing put bonds, but he’s not sure how they’re priced, and he’s not sure why finance companies are issuing them but steel companies are not. He asks what you think. The put bond provides the bondholder with a hedge instrument against the fluctuations in interest rate. By definition, the put bond becomes more valuable to the bondholder as the interest rates increase because the owner of the option has the right but not the obligation to exercise the option when the exercise rate is higher than the market interest rate. In essence, with a put bond (and increased interest rates), the bondholder has the flexibility to redeem the bond at face value and invest the proceeds at the prevailing (higher) interest rate. On the other hand, if the rates drop, the bondholder may hold the bond or extend it for higher future interest rates. For example, if a bondholder invested in a bond at 5% interest rate and the rates

move up to 8%, the bondholder has the option to redeem at the face value (5%) and invest at the 8% rate. Since a steel firm would usually have more assets in place, they would also typically choose a higher-leveraged position than a financial firm would. Simply said, highly leveraged companies would not desire investors to redeem their bonds during periods of increasing interest rates as this results in the steel firm having to restructure their debt at a high rate. Instead, steel companies would prefer to have a feature that allows them to re-structure their debt when interest rates decrease (e.g., callable debt). The put bond acts like a restrictive covenant because it gives more rights to the investor instead of the firm. Highly leveraged companies are sensitive to these restrictions due to detrimental effects that these covenants impose on the firm resulting from the large amount of assets financed by debt. As such, they would be less inclined to offer this type of contract since the resulting debt obligation could potentially wipe them out and lead to default of current debt holders in the event of rising interest rates (investors cash in their put bonds at the higher rate). It would thus follow that the current debt holders would not allow for such transactions because of the resulting weakening value to them. Steel firms also are mature and probably less volatile firms. This suggests that they would offer only a poor return as a result, since volatility is what the investors hope to capture with the option feature. Thus, investors would be unwilling a pay a sufficient premium to the issuer. All of these factors must be taken into consideration in pricing the put bond. (b) Your boss thinks this sound interesting and thinks we should issue them. He asks what you think. Issuing put bonds depends on several important variables. The company should evaluate their current investment opportunity set and the degree of flexibility the firm needs to maximize reduction of taxes and agency costs. As the issuer of debt, our company would not benefit by issuing a put bond because the debt does not provide the hedge and flexibility to the firm. While put bonds are attractive to the investors, they deprive the issuer with the flexibility to refinance, for example, in the event of dropping interest rates. As mentioned earlier, to the holder of the put bond, higher interest rates would lead them to redeem the bonds at face value (and invest in the higher interest rate instrument) while when interest rates drop, the investors will keep them for redemption in the future. As the issuing firm, we have to pay the bond at face value thereby causing us to refinance at a higher rate while with interest rates dropping, we would be unable to “call” the bond and refinance at a lower rate. the issuing firm, we have to pay the bond at face value thereby causing us to refinance at a higher rate while with interest rates dropping, we would be unable to “call” the bond and refinance at a lower rate.