Different types of debt ( LT 8)

Question 1

Initial value of debt

Answer 1

This is the expected payoff that a debt holder is expected to receive

Question 2

Accrued Interest

Answer 2

The amount of accumulated interest since the last coupon payment

Question 3

dirty price of bond

Answer 3

• clean price + accrued interest
• The ACTUAL price you pay for a bond

Question 4

sinking fund

Answer 4

A facility which allows a firm to pay debt over time

Question 5

Payment in kind

Answer 5

This is when payments made by the firm are not in cash

Question 6

Positive covenants

Answer 6

When you specify the actions a firm must take

Question 7

Negative covenants

Answer 7

When you forbid the actions a firm takes

Question 8

callable bonds

Answer 8

Bonds that can be repurchased by a firm before maturity. These will be repurchased by a firm when the bond is above the exercise price

Question 9

Callable bonds formula

Answer 9

P (callable) = P(straight) - call option

Question 10

What is a puttable bond?

Answer 10

a bond that gives investors the right to demand early repayment. ( at date t bond holders sell the bond ot the firm at par)
Bond holders have a straight bond + (long) put option.

Question 11

Why are puttable bonds poisonous for the issuer?

Answer 11

Bond investors exercise the put option when bond price is low. this is also when the firm is introuble. Firms usually don’t have the money to redeem. Forced into default.

Question 12

Convertible bonds?

Answer 12

Give bondolders the irhgt to exchange the bond for a prespecified number of shares.

Question 13

Conversion ratio?

Answer 13

the number of shares in which each bond can be converted.

Question 14

What is conversation price?

Answer 14

value of the bond divided by the number of shares in which it may be exchanged.

Question 15

Market Conversion Price

Answer 15

= Market price of convertible bond/Conversion ratio

Question 16

Conservation value?

Answer 16

stock price times the conversion ratio

• This is the value the holder gets if they convert

Question 17

What is price of convertible?

Answer 17

Pt ( convertible) = Pt(straight) + ct ( CALL OPTION TO ACCQUIRE COMMON STOCK)

Question 18

The value of a convertible bond must be?

Answer 18

greater than or equal to the larger of: straight bond value and conversion value. So i will only convert if i get more from converting than a straight bond.

Question 19

If we know the market price of convertible bond, what can we calculate?

Answer 19

Option value = convertible price - straight bond price.

Question 20

Why issue convertible bonds?

Answer 20

• When it is costly to assess risk of debt
• Investors are worried managers won’t act in shareholders best interest

Question 21

What is share dilution?

Answer 21

When the number of outstanding shares increases without a corresponding increase in the company’s value, it dilutes the value of existing shares. Essentially, each share’s piece of the company’s earnings and assets becomes smaller.

This dilution can be detrimental to existing shareholders, as it can lead to a decrease in earnings per share (EPS) and potentially a decrease in the stock’s price

Question 22

What is the difference between market price of convertible bond and the conversion value?

Answer 22

The market price of a convertible bond is its current trading price, reflecting its value as both a bond and a conversion option. The conversion value is what the bond would be worth if converted into shares right now, calculated by multiplying the current stock price by the bond’s conversion ratio.

Question 23

Why is the market price of a convertible bond usually higher than its conversion value?

Answer 23

The market price of a convertible bond is usually higher than its conversion value as it accounts for both the value if converted and the income from interest payments until maturity, which the conversion value doesn’t consider.

Question 24

What would it mean if the market price of convertible was less than conversion value?

Answer 24

If the market price of a convertible bond is less than its conversion value, it presents an arbitrage opportunity. In theory, an investor could buy the convertible bond at its market price, immediately convert it into shares, and then sell the shares at their market price. This would generate an immediate risk-free profit equal to the difference between the conversion value and the market price of the convertible bond.

Question 25

When is it optimal to call back a callable bond?>

Answer 25

when call price = straight price. ( value of the bond = callable value)

Question 26

At maturity when is conversion justified?

Answer 26

it is justified when conversion value is at least as big as the final bond payment.