Week 5: Valuation of Debt and Equity

Question 1

Debt finance.

Answer 1

Australian companies can borrow in two ways:

Loans from banks and financial institutions
•Indirect finance referred as intermediation where cash that are deposited or invested with a financial institutions is lent to a business.
•The financial intermediary acts as a principal and the investors and the ultimate borrowers do not know each other

Issue debt securities
•Direct finance refers to as disintermediation where the company raise funds by issuing debt securities such as commercial paper, bills of exchange and corporate bonds in the short term money market or the capital market.
•The financial institution act as agents to facilitate the capital raising process.

Question 2

Debt characteristics.

Answer 2

Key characteristics of debt holders:
•Debt holders are not the owners of the firms and therefore usually have no voting rights
•fixed and prior ranking contractual right to a return on capital
•fixed and prior ranking contractual right to a return of capital
•If the borrower is required to support its promise to repay the debt with a pledge of assets, the debt is classified as secured debt. If the debt is unsecured debt, the borrower has an obligation to repay the loan but this obligation is not supported by any pledge of assets.
•Debt holders can force the company into liquidation and take control of the company’s assets if the company fails to meet its obligations.

Question 3

What is debt?

Answer 3

Debt involves a contract whereby the borrower promises to pay future cash flows to the lender.

It is the temporary contribution of capital by investors for a specified time

Question 4

Short-term debt.

Answer 4

–Typically mature in less than a year
–The issuer (the company) promises to pay a sum of money (Face value) on a future date known as maturity date.
– Face (or par) value is the dollar amount paid at maturity
•Typically $100,000 or its multiple
- No other payments made to investors
•Return (or interest) earned by investors is based on the difference between the price paid (P0) and face value (FV).

Question 5

Commercial paper - short term debt instrument.

Answer 5

Commercial paper: also known as promissory notes.

–The issuer (the company-the borrower) promises to pay a sum of money known as face value (such as 500,000) on a stated future date(such as 90 day).
–Marketable in the secondary market so very liquid
–Unsecured
–In practice, only “blue chip” (large, reputable) companies with high credit ratings are able to raise funds by issuing commercial paper.
–Maturities range from 30 days to 180 days although some variations can be possible
–Treasury notes: similar to commercial papers but the issuer is government entities.

Question 6

Certificates of deposit - short term debt instruments.

Answer 6

Certificates of deposit
–Very similar to commercial paper but issued by banks
– less liquid than t-notes, but offer highly competitive returns

Question 7

Bills of exchange - short term debt instruments.

Answer 7

Bills of Exchange: very similar to commercial paper where the issuer (borrower) promises to pay the FV on a stated future date.

• Issued by companies that do not have a credit rating from a rating agency.
• In addition to the issuer (sometimes called the drawer of the bill) and the investor, there is also another party called the acceptor who receives a fee from the issuer and pays the face value to the investor at maturity. The acceptor then approaches the drawer for reimbursement.
• When the accepter of the bill is a bank, this bill is called bank accepted bills (BABs)
• Marketable short term securities
• Most common maturities are 90 and 180 days.

Question 8

Cash management trusts (CMT) - short term debt instruments.

Answer 8

Cash management trusts (CMT) –pool capital of many investors and invest it exclusively in high-yielding, short-term securities:
•T-notes
•large CDs
•commercial paper
–high-yielding securities often sold in denominations of $100,000, so CMT makes them available to individual investors

Question 9

Long term debt.

Answer 9

• Typically mature after several years
• Issuer has contractual obligation to make promised payments
• Face (or par) value is the dollar amount paid at maturity.
• Coupon rate is the interest rate promised by the issuer, expressed as a percentage of face value.
• Coupon payment is the periodic (usually semi-annual) payment made to debt holders
• Coupon payment=Coupon rate * Face value

Question 10

Debenture - long term debt instrument.

Answer 10

Debenture: Debt security that is secured by a charge over land or other tangible asset of the borrower.

–The term to maturity is fixed and range from 1 year to 5 years
–The coupon rate is fixed at the time the debentures are issued
–Some debentures are traded on the Australian Stock Exchange (ASX) while some are unlisted debentures.

Question 11

Corporate bonds - long term debt instruments.

Answer 11

Corporate bonds

–Very similar to debentures but unsecured.
–Long-term debt security issued by non-government entities
–Coupon payments may be made quarterly or semi-annually
–Minimum face value of $5,000.
–Corporate bonds can be listed or non-listed

Question 12

Off-shore bonds - long term debt instruments.

Answer 12

Off-shore bonds: Bonds issued by Australian companies in market outside Australia to foreign investors.

–The volume of bonds issued offshore by Australian borrowers is considerably larger than the volume issued onshore. Main reason is offshore markets particularly the US market have greater capacity to absorb securities of lower credit quality
–Foreign bonds: bonds issued by Australian borrowers in a foreign country and denominated in the currency of that country
–Australian dollar Euro bonds: debt security in Australian dollars but issued outside Australia to non-Australian investors.

Question 13

Valuing (pricing) debt security.

Answer 13

The valuation principle: The price of a security today equals the present value of all future expected cash flows discounted at the “appropriate” discount rate.

•pThe valuation variables are
–Current price
–Future expected cash flows.

For debt security, these cash flows are face value and/or coupon payments
–The discount rate
•Yield or Required rate of return.

Question 14

Relating coupon rates to the YTM (discount rate is often called Yield To Maturity).

Answer 14

1. When YTM Face Value
   –Bond is selling at a premium
2. When YTM = coupon rate; Price=Face Value
   –Bond is selling at par
3. When YTM>coupon rate; Price< Face Value
   –Bond is selling at a discount

Question 15

What is equity (ordinary shares)?

Answer 15

Unlike Debt, Equity represents “permanent” capital contribution by the owners to establish, operate and expand the business.

Question 16

Characteristics of equity.

Answer 16

•Key characteristics
–Full voting rights
–Subordinated right to a return on capital e.g. dividends
–Residual claim on return of capital upon liquidation
–Riskier than debt investment

Question 17

How do shareholders get a return on ordinary shares?

Answer 17

• Dividends
• Capital gains
• Tax credits – unique in imputation taxation system (AU)

Question 18

Equity finance.

Answer 18

•In Australia, there are several ways for a company to raise equity capital depending whether the company is a private or public company.

For a private company, the options to raise equity capital include:
–Angel investors
–Private Equity Funds
–Going public via IPO

For a public company, the options to raise equity capital include:
–Rights Issue
–Private Placement
–Dividend reinvestment plan

Question 19

Angel investors - funding for a private firm.

Answer 19

Angel investors: Wealthy individuals who are prepared to invest in a company that is at an early stage of development.

–The company issues equity to these investors in exchange for a lump sum of money which ranges from tens of thousands to hundreds of thousands of dollars.

Question 20

Private equity - funding for a private firm.

Answer 20

Private equity: a company that specialises in raising money to invest in young firms.

–Amount invested ranges from 500,000 to 20 million.
–Also provide network and expertise to the private firms.

Question 21

IPO - funding for a private firm.

Answer 21

IPO: the process where a private company goes public by inviting the general public to subscribe for their shares.

–Companies that conduct an IPO also applies for a stock exchange listing.
–After the IPO, the company’s shares are traded on the stock exchange.
–The amount that a company raise can be very substantial. E.g: Facebook raised $16 billion via IPO, Alibaba raised $25 billion.

Question 22

Rights issue - funding for a public company.

Answer 22

Rights Issue: An issue of new shares to existing shareholders.

–Existing shareholders have the right to buy for additional shares in the company at a price that is at a discount compared to the market price.
–The number of shares investors can buy based on the number of shares already held. A 5:1 rights offering means for every 5 existing shares, shareholders can buy one extra share at a discount compared to the market price.

Question 23

What are public companies?

Answer 23

Public companies are those that are already listed and have their shares traded on the stock exchange. These companies can raise equity capital via:
. Rights issue
. Private placement
. Dividend reinvestment plan

Question 24

Private placement - funding of public companies.

Answer 24

Private placement: Shares are sold to a restricted number of large investors, usually institutional investors at a price that is discount compared to the market price.

–Quick way of raising capital.

Question 25

Dividend reinvestment plan - funding for a public firm.

Answer 25

Dividend reinvestment plan: Instead of receiving the cash dividend, shareholders can choose to use these dividends to buy more shares in the company.