b40.2302 class #6
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©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
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Topics Covered
Debt At first glance, many different forms of debt But all share common features…
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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
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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
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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
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Slides by
Matthew Will, Jeffrey Wurgler
Chapter 24
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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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
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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
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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
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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
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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.
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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
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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
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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”
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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
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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
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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
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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
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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
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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.
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Project Finance
Contractor Supplier(s)
Equity investors
Government Projectcompany
Equity sponsor
Lenders
Purchaser(s)
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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
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Slides by
Matthew Will, Jeffrey Wurgler
Chapter 22.1-22.3
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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14- 25
Topics Covered
What is a warrant? How to value a warrant under dilution? What is a convertible bond?
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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!
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Warrant ValueExample:
B.J. Services warrants, expire April 2000
Exercise price = $ 15
BJ Services share price
15
Warrant price at maturity
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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.
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United Glue Warrants
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
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United Glue Warrants
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
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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
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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
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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
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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
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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
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Convertible Bonds Example to understand payoffs: Eastman Kodak
Suppose Eastman Kodak has issued convertibles with $1 million face value
Suppose these can be converted at any time to 1 million common shares
Suppose there are already 1 million shares outstanding
Let’s plot the value of the convertible bond as a function of the underlying total firm asset value
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Convertible Bonds How bond value varies with firm value at maturity.
0
1
2
3
0 1 2 3 4 5
Value of firm ($ million)
default
bond repaid in full
Straight bond value ($ thousands)
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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
Value of firm ($ million)
Conversion value ($ thousands)
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Convertible Bonds How value of convertible at maturity varies with firm value.
0
1
2
3
0 1 2 3 4
Value of firm ($ million)
default
bond repaid in full
convert
Value of convertible ($ thousands)
Leasing
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Slides by
Matthew Will, Jeffrey Wurgler
Chapter 25.1
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Topics Covered
Lease terminology
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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
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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
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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
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Slides by
Matthew Will, Jeffrey Wurgler
Chapter 23
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Topics Covered
The Term Structure Term Structure Theories Risk: Duration and Volatility Risk: Default
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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
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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
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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?
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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
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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.
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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
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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
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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”
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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
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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%)
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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.
..
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