Sources of Corporate Finance (LECTURE 3) Flashcards
What is DEBT and what are advantages of it?
In simple terms: something that has to be paid back. In form of interest and principle amount.
Cheaper than equity: lower transaction fee- cost of raising funds.
Tax deductibility of interest payments.
Less risky- lower required rate of return.
Increased EPS through financial leverage if debt issued instead of equity.
Greater control- do not have to give voting rights.
What are the disadvantages of debt?
- Increased Financial Risk- can result in liquidation.
- Restriction placed by lenders.
- Secure assets against debt.
BANK BORROWINGS
- Without incorporating capital markets
- No tradable securities issued.
- Attractive to company for the following reasons:
- Quicker than some other types of borrowings.
- Lower administrative and legal costs.
- Flexibility and negotiation.
- Access to all sizes of firms.
What are the costs involved in bank borrowing?
- Arrangement fee (0.5% or 1% of loan it is negotiable)
- Interest rate:
- Fixed Rate
- Floating Rate: certain rate above LIBOR, if LIBOR is used as a base rate, higher the risk higher would be the % above LIBOR.
What is LIBOR?
- A benchmark rate that banks charge each other for their short term loans.
SYNDICATED LOANS
- For a large amount of loan, there can be more than one financial institution involved.
- Lower spread over LIBOR.
- Carries low risk/ ranked above bonds in case of liquidation.
- Useful when firm needs funds quickly and discreetly- such in case of merger or acquisition.
CORPORATE BONDS
- A long term contract; bond holders lend money to firm (or government in case of government bonds.
- Investor typically gets:
- predetermined regular interest.
- a capital sum or principle at the end of the bonds life. (also known as face value, redemption value or maturity value).
Maturity can be any number of years.
- Most are liquid and have a secondary market.
- Redemption date or maturity- firm agrees to pay back the principle amount of the bond.
PAR VALUE OF A BOND
Usually £100 in UK and $1,000 in US.
CALLABLE BONDS
Which can be called back before maturity.
COUPON RATE
Interest expressed as a percentage of the principal amount.
STRAIGHT BONDS
Fixed coupon bonds.
Called straight bonds, plain vanilla bonds, bullet bonds.
-Usually annual or semi annual coupon payments.
ZERO COUPON BONDS
(also called pure discount bonds, strip bonds, or just zeros)
-Issued at a discount and redeemed at par.
FLOATING RATE BONDS
(variable rate bonds)
-Pay coupon but coupon linked to various factors to adjust their interest expense accordingly.
- LIBOR
- Rate of inflation
- Oil prices
- Exchange rate movements
- Price of silver/gold/other precious metal
- Stock market movements
- Earthquakes/other natural disaster
SECURED BONDS
- Fixed charge and floating charge on assets
- Debenture and loan stock (secured bonds against assets)
- Mortgage bonds (secured against property)
UNSECURED BONDS
Though not secured, bondholders have prior right on earnings and assets (in case of liquidation), as compared with shareholders.
JUNK BONDS
- Offer higher returns, but also a greater risk.
- Offers yields 4-5% above government bonds.
PERPETUAL BONDS
-Bonds with no maturity date and carry interest payments for perpetuity.
CONVERTIBLE BONDS
- Carry a coupon like straight bonds but usually lower (due to convertibility feature).
- Gives right to exchange the bonds into ordinary shares in future according to some prearranged formula.
- Normally conversion price is 10-30% higher than the existing share price.
COMMERCIAL PAPERS
- Unsecured short-term instrument of debt, issued primarily by corporations (issued by high credit quality firms).
- Promises to the holder a sum of money to be paid in a set number of days.
- Buyers include: other corporations, insurance companies, pensions funds, government and bank.
- Average maturity of about 40 days, normal range is 30-90 days.
- Normally issued at discount.
What is the fundamental valuation model?
P0= Σ CFt/(1+k)t
OR
P0= CF1/(1+k)1 + CF2/(1+K)2 + … + CFn/ (1+K)n
P0= Price of asset at time (today) CFt= Cash flow expected at time t k= Discount rate n= Number of discounting periods
TIME TO MATURITY (n years)
P0= Σ It/(1+kd)t + Mn/(1+kd)n
NO TIME TO MATURITY
P0= It/kd
ZERO COUPON BONDS
M/(1+kd)n = M(PVIFkd,n)
What is the difference between coupon rate and discount rate?
The coupon rate merely tells us what cash flow the bond will produce.
Discount rate is the required rate of return by a bond holder.
STRAIGHT BOND VALUATION EXAMPLE:
Suppose on Dec 2013, Vodaphone raised money by selling bond with 6% coupon rate and 2019 time to maturity.
Each bond had a face value of £100.
The 5% discount rate would be comparable with other investment opportunities at the time.
What would you have been willing to pay for this bond in Dec 2013?
P0 = Σ It/(1+kd)t + Mn/(1+kd)n
I = Annuity kd = discount rate
PV bond = £6 (PVIFA6,5%) + £100 (PVIF6,5%)
= £6 x 5.076 + £100 x 0.746
=£30.456 + £74.6
=£105.056
PERPETUAL BOND EXAMPLE:
British government issued a perpetual bond with par value of £100 and a coupon rate of 2.5%. A discount rate would be comparable with other investment opportunities at the time.
P0 = It/kd
= 2.5/0.05
=£50
ZERO COUPON BOND EXAMPLE:
ABC Plc issued a 2 year zero-coupon bond with a face value of £100. A 5% discount rate would be comparable with other investment opportunities at the time.
P0= M/(1+kd)n = M(PVIFkd,n)
=£100 (PVIF5%,2)
= £100 x 0.907
=£90.7
What is the relationship between interest rates and bond prices?
If interest rates go up (higher than the coupon rate) then bond prices go down because bonds become less attractive to investors.
YIELD TO MATURITY
An estimate of return investors earn if they buy the bond at P0 and hold it until maturity.
The YTM on a bond selling at par will always equal the coupon rate.
YTM is the discount rate that equates the PV of a bond’s cash flows with its price.
Relationship between bond prices and yields.
When first issued the price will reflect the future anticipated discount rate (YTM) and be be valued at £100.
Any time after this, until the maturity date a bond price could be less or greater than £100 if yield (YTM) different from coupon rate.
There is an inverse relationship between bond prices and interest rates (discount rate).
What happens to bond values if the required return is not equal to the coupon rate?
The bond price will differ from its par value.
Kd>Coupon interest rate -> P0 P0>par value = premium
YTM EXAMPLE:
Kelly Corp. has issued 12% bonds maturing in 20 years. If you purchase a bond for £868 and hold it to maturity what is the yield to maturity on this investment? Par value is £1,000.
What is your implied required rate of return, Kd?
P0 = Σ It/(1+kd)t + Mn/(1+kd)n
YTM is kd. What is it?
PVbond= I x PVIFA(kd,n) + M x PVIF(kd,n)
PVbond= £120PVIFA(kd,20) + £1,000PVIF(kd,20)
PVcoupon rate
TRY 13%
=£930
Because £930>£868, the YTM is greater than 13%.
TRY 14%
= £868
If PV=current market price, the YTM on the bond is 14%
YTM EXAMPLE 2:
Suppose ABC plc’s 7% debentures of par value £1,000 maturing in 2019 are selling at the end of 2012 for £877.50. Determine the bond’s YTM?
P0
YTM of PERPETUAL BONDS EXAMPLE:
What is the YTM of a 6% annual coupon bond, with a £1,000 face value with no maturity currently selling at £1,100?
PV= 65/kd
PV=£1,100
Yield, kd=65/1,100 = 5.91%
YTM of ZERO-COUPON BONDS EXAMPLE:
What is the yield of a 5 year zero-coupon bond, with a £1,000 face value which is currently selling at £713?
P0= M/(1+kd)^n = M(PVIFkd,n)
£713 = £1,000(PVIFytm,5) £0.713 = (PVIFytm,5) YTM/kd = 7%.
