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Finance 1 > Sources of Corporate Finance (LECTURE 3) > Flashcards

Sources of Corporate Finance (LECTURE 3) Flashcards

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1
Q

What is DEBT and what are advantages of it?

A

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.

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2
Q

What are the disadvantages of debt?

A
  • Increased Financial Risk- can result in liquidation.
  • Restriction placed by lenders.
  • Secure assets against debt.
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3
Q

BANK BORROWINGS

A
  • 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.
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4
Q

What are the costs involved in bank borrowing?

A
  • 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.
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5
Q

What is LIBOR?

A
  • A benchmark rate that banks charge each other for their short term loans.
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6
Q

SYNDICATED LOANS

A
  • 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.
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7
Q

CORPORATE BONDS

A
  • 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.
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8
Q

PAR VALUE OF A BOND

A

Usually £100 in UK and $1,000 in US.

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9
Q

CALLABLE BONDS

A

Which can be called back before maturity.

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10
Q

COUPON RATE

A

Interest expressed as a percentage of the principal amount.

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11
Q

STRAIGHT BONDS

A

Fixed coupon bonds.
Called straight bonds, plain vanilla bonds, bullet bonds.

-Usually annual or semi annual coupon payments.

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12
Q

ZERO COUPON BONDS

A

(also called pure discount bonds, strip bonds, or just zeros)

-Issued at a discount and redeemed at par.

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13
Q

FLOATING RATE BONDS

A

(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
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14
Q

SECURED BONDS

A
  • Fixed charge and floating charge on assets
  • Debenture and loan stock (secured bonds against assets)
  • Mortgage bonds (secured against property)
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15
Q

UNSECURED BONDS

A

Though not secured, bondholders have prior right on earnings and assets (in case of liquidation), as compared with shareholders.

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16
Q

JUNK BONDS

A
  • Offer higher returns, but also a greater risk.

- Offers yields 4-5% above government bonds.

17
Q

PERPETUAL BONDS

A

-Bonds with no maturity date and carry interest payments for perpetuity.

18
Q

CONVERTIBLE BONDS

A
  • 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.
19
Q

COMMERCIAL PAPERS

A
  • 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.
20
Q

What is the fundamental valuation model?

A

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
21
Q

TIME TO MATURITY (n years)

A

P0= Σ It/(1+kd)t + Mn/(1+kd)n

22
Q

NO TIME TO MATURITY

A

P0= It/kd

23
Q

ZERO COUPON BONDS

A

M/(1+kd)n = M(PVIFkd,n)

24
Q

What is the difference between coupon rate and discount rate?

A

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.

25
Q

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?

A

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

26
Q

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.

A

P0 = It/kd

= 2.5/0.05
=£50

27
Q

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.

A

P0= M/(1+kd)n = M(PVIFkd,n)

=£100 (PVIF5%,2)
= £100 x 0.907
=£90.7

28
Q

What is the relationship between interest rates and bond prices?

A

If interest rates go up (higher than the coupon rate) then bond prices go down because bonds become less attractive to investors.

29
Q

YIELD TO MATURITY

A

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.

30
Q

Relationship between bond prices and yields.

A

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).

31
Q

What happens to bond values if the required return is not equal to the coupon rate?

A

The bond price will differ from its par value.

Kd>Coupon interest rate -> P0 P0>par value = premium

32
Q

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?

A

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%

33
Q

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?

A

P0

34
Q

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?

A

PV= 65/kd
PV=£1,100
Yield, kd=65/1,100 = 5.91%

35
Q

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?

A

P0= M/(1+kd)^n = M(PVIFkd,n)

£713 = £1,000(PVIFytm,5)
£0.713 = (PVIFytm,5)
YTM/kd = 7%.

Finance 1 (7 decks)

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