Lecture 3: Raising Capital: Debt, Hybrid Securities and Leasing Flashcards
1.) Characteristics of Debt 2.) Effects of Financial Leverage 3.) Debt and Equity within an Options Framework 4.) Hybrid Securities 5.) Operating leases and Financial leases 6.) Financial evaluation of leases 7.) Advantages and Disadvantages of leasing
Define ‘debt’
Contribution of capital by lenders for a LIMITED period of time
What are key differences between debt and equity
Debt:
- Non-Voting
- Limited period
- Fixed and Superior contractual right to return of capital and return ON capital (interest)
What is an investment grade bond
Low Probability of Default
S&P: >BBB-
Moody: >Baa3
What are debt covenants
Restrictions placed on the borrower of the debt (i.e. firms)
What are 3 properties of debt covenants
- ) Pledge assets to be maintained in good order
- ) Restrict additional borrowing & incursion of additional liabilities
- ) Restrict dividend payments
Why do we need debt covenants
To prevent wealth transfer from debt holders to shareholders
What are debts in Australia mostly consist of
Bank lending
What are the 2 key features that distinguishes bank and non-bank lending
- ) Monitoring
2. ) Concentration of Bank Lending
Discuss monitoring in relation to bank lending
+ve
1.) Constrains managers from conducting -NPV actions
- ve
1. ) Constrains managers from conducting +NPV actions
Discuss Concentration of Bank Lending in relation to bank lending
-ve:
- ) Monopoly
- ) Reduce financial flexibility of firms
What is business risk
Inherent risk that cannot and will never be eliminated. Faced by shareholders only if it is 100% equity financed.
What is financial risk
As long as the firm has debt, it has financial risk (even if 1% equity). Shareholders will face this if any debt financing.
What are the effects of financial leverage with a simple definition
Trade-off between risk and expected returns
If the company is failing, what are the effects of financial leverage on shareholders and explain
Since debtholders have to be paid first, less wealth is shared among shareholders.
If the company is doing well, what are the effects of financial leverage on shareholders and explain
Since debtholders have to be paid first, additional wealth is shared among shareholders.
If a company is failing but is going to conduct a high-risk action, what will happen to the share price? Explain.
It will rise. Volatility increase > Long call become more valued > Shareholders invest more
Under an options framework, what do shareholders hold
Long call (With X as debt)
Under an options framework, what do debtholders hold
Short Put (With X as debt)
What are hybrid securities
Securities with both debt and equity characteristics
How many kinds of hybrid securities are there?
- ) Convertibles. Notes (short-term) & Bonds (long-term)
- ) Preference Shares
What are convertibles
Initially issued as a debt (i.e. fixed-term at fixed-interest rate), with an option to convert into shares at a specified date
If I have a 10-year, 10% convertible with a FV of $20 at a 1-for-1 ratio, when should I convert?
Convert if the share price of the stock is >FV (i.e. $20).
What is the advantage of convertibles
Advantage:
It overcomes the negative signals associated with issuing ordinary shares
What is the disadvantage of convertibles
Disadvantage:
The interest rate of convertibles is less than that of debt
What are Preference Shares
Holders of Preference Shares have priority over ordinary share holders in dividends, & especially in the event of liquidation.
What are the 4 characteristics of MOST preference shares
- ) Cumulative
- ) Irredeemable
- ) Non-Participating
- ) Non-Voting
CINN
Cumulative vs Non-cumulative
Cumulative: must be paid any accumulated dividends over ordinary shareholders
Irredeemable vs Redeemable
Irredeemable: No maturity date
Non-Participating vs Participating
Non-Participating: Not entitled to return in excess of stated dividend rate
Non-Voting vs Voting
Non-Voting: Not entitled to vote
What are 3 other preferences shares out there discussed in lecture
- ) Converting preference shares
- ) Reset preference shares
- ) Step-up preference shares
What are Converting preference shares
Automatic conversion to ordinary shares after typically 5-10 years
What are Reset preference shares
Dividend rate resets after a specified period
What are Step-up preference shares
Variable dividend rate (idk)
What is leasing
A form of finance ALTERNATIVE to borrowing funds from the market.
It is a contract where the lessor receives fixed payments from a lessee in return for asset use.
Lessor vs Lessee
lessOr: o wner
lessee: user
What are the 2 broad kinds of leases
- ) Operating lease
2. ) Finance lease
What are differences between operating and finance lease
- ) Time: Operating (short-term) vs Finance (long-term i.e. most of life)
- ) Cancellability: Operating (Cancellable) vs Finance (Not Cancellable)
- ) Risks: Operating (with lessor) vs Finance (with lessee)
- ) Identity: Operating (Supplier) vs Finance (financial institutions)
1 key idea to distinguish Operating and Finance leases
Operating: Rental Agreement; Finance: Loan Agreement
What are the 3 types of finance leases
- ) Sale and Lease-back Agreements
- ) Leverged Lease
- ) Cross-border Lease
What are Sale and Lease-back Agreements
The owner of the asset sells it to a financial institution and immediately leases it back.
What are Leverged Leases
Lessor borrows most of the funds via equity and debt to acquire the asset and leases out to a lessee
What are Cross-Border Leases
Lessee and Lessor are in different countries
Are the companies in Australia typically lessors or lessees
Lessees
When do we use cross-border leases
It is usually motivated by tax regulations
In the financial evaluation of leases, which capacity does it take up?
Debt capacity. Use the cost of debt capital as an appropriate discount rate.
What are the 6 components for a lessee to consider leasing
a.) Advantages
1a. ) Avoided cost of buying asset
2a. ) Lease Payments
3a. ) Residual payment that must be paid under lease
b.) Disadvantages
1b. ) Depreciation tax shield forgone for not acquiring asset
2b. ) Tax savings obtained from lease payments
3b. ) Tax saved from gain or loss of sale of asset
Remember that the NPV calculations are only between LEASE vs PURCHASE, not ASSET SERVICES vs either
Just remember
If the lease payments are higher, is it better or worse for the lessees
It is often worse due to less tax savings
What are the advantages of leasing
TT
- ) Company Taxation
- ) Transaction Costs
What are the disadvantages of leasing
1.) Agency Costs
What are the invalid arguments regarding the pros and cons of leasing
- ) Conservation of Capital
- ) Off-balance sheet financing
- ) Cost of Capital
Elaborate on the advantage “Company Taxation”
Lessor’s tax rate > Lessee’s tax rate:
Lessor can share advantage of greater tax savings with lessee by reducing lease payments.
No loser in this situation
Elaborate on the advantage “Transaction Costs”
RCS
- ) Repossession of asset easier for Lessor than a secured lender
- ) Credit checks on standing of lessee not as thorough as a lender
- ) Simple, standardized contracts compared to borrowing
Elaborate on the disadvantage “Agency Costs”
Leasing = Separation of ownership and control
Higher agency costs when leased asset may be easily damaged.
Elaborate on the invalid argument “Conservation of Capital”
Leasing is often wrongly promoted as 100% debt financing but it is not.
Elaborate on the invalid argument “Off-balance sheet financing”
Leases finance is a substitute for debt and accounting standards make leasing hard to go off-balance
Elaborate on the invalid argument “Cost of Capital”
Discount rates are the same (Because there is no reason it should have different risk).
It is possible that i (lessor) < i (lessee) but that can only happen if the lessee assumes all risk of ownership and the differences should reflect this risk
What are the 4 factors in leasing policies
- ) Sensitivity to use and maintenance
- ) General Assets
- ) Transaction costs & Flexibility
- ) Comparative Advantage in Asset Disposal
Elaborate on the leasing policy “Sensitivity to use and maintenance”
Leasing: Separation of Ownership and Control
Lessee has less incentive to take care. Lessors will recognize (set higher payments).
The more sensitivity to use and maintenance, the less attractive leasing is.
Elaborate on the leasing policy “General assets”
The more general the asset is, the more active its second-hand market.
> Easier to forecast disposal values & agree on lease terms
More incentive to buy specialized company-specific assets as they are more valued within their own company
Elaborate on the leasing policy “Transaction costs + Flexibility”
Transaction Cost:
Lower transaction cost than buying and selling
Flexibility:
- Search costs
- Cost of assessing quality
Elaborate on the leasing policy “Comparative Advantage in Asset Disposal”
Similar to “General Assets”. Especially good if the lessor is a manufacturer/distributor
Used Assets:
Can operate a specialized market
To Reuse Assets:
Able to repair and maintain assets
What is a speculative grade
Not as good
S&P:
Who does debt covenants protect
Though it prevents wealth transfer from debt to shareholders, it protects ALL parties.
BONUS: When will the NPV of leasing = buying
- ) No transaction costs
- ) Information is freely available
3) All parties (lessor & lessee) has the same Tc
BONUS: When is leasing ESPECIALLY attractive
- ) Tax (Lessor) and Tax (Lessee) great difference
- ) High Depreciation Rate (Claim early tax savings)
- ) High Interest Rates (Lower PV)
rate of return on ASSETS > rate of return on DEBT in a leveraged firm, what will happen to the rate of return to shareholders
The rate of return on EQUITY is INCREASED
If the rate of return on ASSETS < rate of return on DEBT in a leveraged firm, what will happen to the rate of return to shareholders
The rate of return on EQUITY is DECREASED
