B40.2302 Class

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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

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• An Overview of Corporate Financing

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 14.4

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
3
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 doesnt usually have voting rights, but in
  case of default lender gets assets
• Asset administration handled by bankruptcy court

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Corporate Debt
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Corporate Debt
(Mobil continued (!))
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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• The Many Different Kinds of Debt

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 24

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
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

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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
• Trustees 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 firms 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 of
Straight bond
bond
100
Bond callable at 100
75
50
25
Value of
straight bond
25
50
75
100
125
150
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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, Marriotts 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. Marriotts 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
23
Project Finance
24
Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Warrants and Convertibles

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 22.1-22.3

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
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 Value
Example B.J. Services warrants, expire
April 2000 Exercise price 15
Warrant price at maturity
BJ Services share price
15
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United Glue Warrants

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

• 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

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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

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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
(d2) .304
N(d2) .620
N(d1) .865
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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 havent taken dilution into account

Warrant 12.865 - .62010/1.14
6.15
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United Glue Warrants

• Calculate warrant value including dilution
• When warrants are exercised, number of shares
  will increase by Nq100,000.
• Assets will increase by amount of exercise money
  NqEX100,000101 million
• Let V be value of Uniteds equity
• Warrant value at maturity maxP EX, 0
• (so with dilution) maxVNqEX/NNq-EX,
  0
• 1/(1q)maxV/N EX, 0
• So warrant price equals the price of 1/(1q) 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 Warrants

• Calculate 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
• Well assume volatility of undiluted firm is .41
  (use different sigma too)

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United Glue Warrants

• Calculate warrant value including dilution
• Note Lower value than if dont account for
  dilution, but still higher than the 5 the firm
  gets from the warrant issue

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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 dont 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
• Lets 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.

Straight bond value ( thousands)
bond repaid in full
default
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Convertible Bonds

• How conversion value at maturity varies with firm
  value.

Conversion value ( thousands)
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Convertible Bonds

• How value of convertible at maturity varies with
  firm value.

Value of convertible ( thousands)
convert
bond repaid in full
default
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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Leasing

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 25.1

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
41
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)

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Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Valuing Debt

• Slides by
• Matthew Will, Jeffrey Wurgler

Chapter 23

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
46
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
1981
1987 present
1976
Year
1 5 10 20 30
These are the interest rates you face today (t0)
to borrow 1 for t years
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Term structure theories

• Irving Fishers 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 (1r1)(1E1r2)
• If gt, nobody would hold one-year bonds
• If lt, 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

• 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

Year CF PV_at_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
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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.
• Moodys Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C
• Std. Poors 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 bonds
value? CF Prob 1090 .80
872.00 0 .20 0 .
872.00
expected CF
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Risk Default

• 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 thats
  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(ERm-9))