Financing Decisions and the Enterprise Value - Debt and Hybrid Instruments

Question 1

What are the different debt instruments?

Answer 1

-Bank loans
-Bonds
-Leasing

Question 2

What are the main advantages of bank loans?

Answer 2

-Less costs regarding the operation in itself, even though it has higher interest rates than bonds
-Due to less costs, might be good for financing small accounts
-Companies can provide information to the banks so they assess the company credit with no risk of that information being revealed to competitors due to bilateral contract
-Doesn’t require company rating, but the banks may establish a credit scoring

Question 3

Regarding the debt service of a bank loan, when do companies have to repay principal?

Answer 3

They can pay in a single payment - bullet - or across the maturity period.

Question 4

Regarding the debt service of a bank loan, how can the coupon rate be?

Answer 4

It can be fixed or a floating rate

Question 4

Regarding a bank loan, what type of garantees can a bank ask for?

Answer 4

It can ask for general garantees, like cashflows, specific like collaterals or mortgage, or corporate and/or personal, when the company declares itself as a garantee

Question 5

Regarding bank loans and its financing contractual terms, what kind od covenants can a bank ask for?

Answer 5

It can ask for minimum or maximum values for certain indicators/financial ratios; periodoc reporting; limits to financial leverage, M&A; event triggering

Question 5

What are the main advantages in bonds as a debt instrument?

Answer 5

-Advantages in terms of interest due to risk sharing by a number of underwriting investors
-Permit more specific characteristics to the financing contract like conversion option and anticipated repayment

Question 5

In a bond with floating rate loans, what characteristics may they have?

Answer 5

-Caps - the floating rate may never be higher than that;
-Floors - the floating rate may never be lower than a given amount;
-Variable spread - increases or reduces across the bond maturity ->step-up or step-down

Question 6

Bonds may have different priority levels like the ones with specific guarantees (secure bonds) vs no specific guarantees- what kind is what?

Answer 6

With specific guarantees: mortgage bonds and collateral bonds (guaranteed by shares, bonds and other tradable securities)
With no specific guarantees: unsecured bonds and subordinate bonds (lower priority of claim over company cashflows in case of liquidity)

Question 6

What type and main difference, regarding to an extension/anticipation of maturity dates, in bonds?

Answer 6

-Callable bonds - possible to extinguish the bonds with anticipation paying back principal
-Puttable bonds - investor/creditor has the option to claim from the company anticipated payment of the principal

Question 6

What types of bonds can we find?

Answer 6

-Callable bonds
-Puttable bonds
-Income bonds - interest linked to the income of the company
-Option linked bonds - Face value linked to an index
-High-yield bonds - high credit risk / high return
-Perpetual bonds
-Convertible bonds
-Warrant bonds

Question 6

What are the main characteristics of financial leasing?

Answer 6

-Present value is lower than the actual value of the equipment
-price of buying option at the end of the contract is very small
-Period of the contract = economic life of the equipment
-Maintenance, insurance and taxes paid by the lessee

Question 7

What are the main characteristics of an operational leasing?

Answer 7

-Present value is higher or equal to the actual value of the equipment
-Exercise price of buying option at the end of the contract is very signifficant
-Time of the contract shorter than economic life of the equipment
-Cancelling option before the end of the contract
-Maintenance, insurance and taxes paid by the lesser
-Lessee runs no risk
-Rents treated as operational costs (rights of use)

Question 7

What are the advantages of an operational leasing?

Answer 7

-Allows the use of the equipment during a shorter period than its economic life
-Cancelling option
-Maintenance included
-Tax benefits

Question 7

What is the all-in cost?

Answer 7

Is the implicit rate of cost of capital plus all taxes and transaction costs incurred by the company in the financing transaction costs. Cost of capital is the most relevant criteria to choose amongst alternative debt financing solutions and the all.in cost is good when there is inefficiency in the market.

Question 7

What is the yield-to-maturity?

Answer 7

Is the implicit rate of return for which the present value of cash-flows of the bond equals its price. We assume the bond is kept until maturity and that the periodic cash-flows re reinvested and generate a return. This is not necessarily equal to the nominal rate or coupon rate

Question 8

What are hybrid financing instruments and why may companies use them?

Answer 8

They are part equity and part debt, combinating rights and risks, and since the markets aren’t fully efficient, companies may take some benefits from it. If they are efficient and there are no agency costs, companies won’t need them.

Question 8

What do hybrid financing instruments allow?

Answer 8

-A programmed implementation of the company’s capital structure
-Bond and equity holders to share value created
-Better conditions for the acceptance of the debt securities by debt market investors
-mitigation of liquidity and interest rate risks by the issuing company

Question 9

When do companies tend to offer these securities?

Answer 9

When there is a strong perspective of an increasing phase of the value of the company, reflected in an increasing trend of its shares market price

Question 9

What are the types of hybrid securities (6)

Answer 9

-Warrant bonds
-Convertible bonds
-Preferred shares
-Participating bonds
-Convertible preferred stock
-Floating dividend preferred stock

Question 10

What are the main characteristics of warrant bonds?

Answer 10

Warrant bonds are actually two assets, a bond and a warrant-> Value of a warrent bond = value of the basic bond + value of warrant. With the warrant we have a call option on the shares of the company, which means we can buy them at a certain exercise price at a certain time. Exercising the warrant doesn’t affect the bond (the investor who was already a bond holder becomes a shareholder) and the investor can trade the two securities independently

Question 11

What are the main differences between warrants and call options?

Answer 11

Warrants are sold by the company, who receives a premium. When a warrant is exercised, the company issues new shares receiving the exercise price. This means the total number of shares will increase and there is dilution of share capital, decreasing the market share price. In a call there is no dilution. A warrant bond has a lower coupon than a common bond, in orther to compensate for the conversion option

Question 12

What are the ain characteristics of convertible bonds?

Answer 12

Investors have an option of conversion into shares at a certain time. The convertible bart is the equity part; the debt part is the straight value. It has a floating exercise price, dependent on the bond market price at exercise date, unless it coincides with maturity, and the exercise price is paid with bonds. If they don’t decide to convert, they’ll receive the interest and reimbursement.

Question 12

What must be defined when issuing convertible bonds?

Answer 12

-Reimbersement date and periodic coupon
-Conversion period - exercise date
-Conversion ratio - number of shares in which it can convert
-Conversion price = FV/Conversion ratio

Question 12

How do we get the conversion value of convertible bonds?

Answer 12

Market share price * conversion ratio

Question 13

How do we get the value of a convertible bond?

Answer 13

Straight value + value of the conversion option
= PV of the debt cash-flows at maturity + value of the call option -> none of these can take a negative value

Question 13

What are the main characteristics of preferred stock?

Answer 13

Investors get a fixed revenue dependent on the company’s net earnings; don’t have voting power; the revenues are not tax deductible;
Rgarding capital structure and cost of capital, they are often seen as a third capital component