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Corporate Financial Strategy
4th edition
Dr Ruth Bender
Chapter 12
Types of financial instrument
Corporate Financial Strategy
Types of financial instrument: contents
 Learning objectives
 Options terminology
 Factors affecting the value of an option
 Black–Scholes options valuation model
 Payoffs on options
 Public (market) debt and private (bank) debt
 Continuum of financial instruments
 Credit ratings (long-term debt)
 Securitization cash flows
 Mezzanine and convertibles give return in two ways
 Mezzanine and convertibles, from lender’s point of view
 Positioning the convertible
 Why use a convertible?
 Features of convertibles
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Learning objectives
1. Distinguish different types of financial instrument, assess the broad
categories into which they fall, and contrast their fundamental
characteristics.
2. Discuss the continuum of financial instruments, and explain why the
terms of a particular instrument will affect its position on the
continuum.
3. Describe how credit rating agencies work.
4. Understand in broad terms the accounting treatment of financial
instruments.
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Options terminology
 A call option is the right to buy
 A put option is the right to sell
 A European option can be exercised at a particular date
 An American option can be exercised during a period
 If price of underlying asset > exercise price the option is in-the-money
 If price of underlying asset = exercise price the option is at-the-money
 If price of underlying asset < exercise price the option is out of-themoney (underwater)
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Factors affecting the value of an option
CALL
PUT
Price of underlying asset
Exercise price of option
Time to exercise
Volatility of price of underlying asset
Risk-free rate
?? Option value increases with time to expiry, but today’s value of the sum received decreases
with time, so the net end result is uncertain. (In principle, same should apply to the direction of
value for volatility, but it doesn’t.)
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??
Black–Scholes options valuation model
C  PN (d1) 
EN (d 2)
e
rt
C = price of call option
P = current price of the shares
E = exercise price
t = time remaining until expiry of option
r = risk-free rate
N(d1) = hedge ratio
Measures of volatility
N(d2) = probability of exercise
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Payoffs on options
Payoffs to buyers
Value to
option
owner
CALL
Value of share at expiry
PUT AND BUY THE
SHARE
PUT
Value of share at expiry
Value of share at expiry
Payoffs to sellers
CALL
PUT
Value of share at expiry
Corporate Financial Strategy
Value of share at expiry
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Public (market) debt and private (bank) debt
Public debt
−
−
−
−
−
Issued using a prospectus
Probably underwritten
Can be cheaper, with fewer covenants
Not suitable for small amounts of finance
Face value is generally denominated in units of 100 or 1,000 of currency. But it may not
be issued at 1,000 and probably won’t trade at that amount. Trading price is shown as a
% of the face value. Interest will be based on this face value.
− Difficult to resolve if the company faces problems
Private debt
−
−
−
−
Advanced by a bank
May be syndicated to a group of banks
Flexible and quick
E.g. Term loans, overdrafts, revolvers (a revolving line of credit is a credit commitment of
up to an agreed amount for a specified time, to be drawn and repaid as needed)
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Continuum of financial instruments
Required
return
Preference
shares
Convertibles
Mezzanine
High yield debt
Ordinary
shares
Unsecured
Secured debt
debt
Perceived risk
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Credit ratings (long-term debt)
AAA
AA+
AA
AA–
A+
A
A–
BBB+
BBB
BBB–
BB+
BB
BB–
B+ … D
Corporate Financial Strategy
Based on opinion of overall
financial capacity to pay. Uses
qualitative and quantitative
analysis. Information supplied
by the company, or from other
sources. May relate to a
company, or to a particular debt
obligation. Short-term debt is
also rated, using a different
system.
There are other ratings
agencies
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Aaa
Aa1
Aa2
Aa3
A1
A2
A3
Baa1
Baa2
Baa3
Ba1
Ba2
Ba3
B1 … C
Investment
grade
junk
Securitization cash flows
Credit
enhancement
Servicing fees
Originating
company
Issuer
Proceeds of
asset sale
(Special
Purpose
Vehicle)
Payment of principal &
interest
Asset pool
(principal and
interest from
borrowers)
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Subscription
proceeds
Investors
Principal &
interest
Mezzanine and convertibles give return in two ways
Required
return
Return from capital gain
Return from yield
Perceived risk
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Mezzanine and convertibles, from lender’s point of view
MEZZANINE
CONVERTIBLES
 Initial investment in Year 0
 Interest received in years 1 to n
 In Year n, two things happen
 Initial investment in Year 0
 Interest received in years 1 to n
 In Year n, one of two things will
happen
1. The loan is repaid
And
2. Warrant is exercised to receive
shares
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Either
1. The loan is repaid
Or
2. Loan is converted into shares
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Positioning the convertible
Debt
Yield
Interest
Upside
potential: None
based on
conversion price
Convertible
Equity
Interest on
convertible
Dividend
Capital gain on
conversion price
Capital gain on
today’s price
Repayment
option
None
Downside
protection:
based on
security, terms
and time to
repayment/
conversion
Corporate Financial Strategy
Repayment
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Why use a convertible
Can’t use
debt
Cash restrictions
– can’t afford interest
– can’t afford repayments
Profit restrictions
– can’t afford interest
Covenant restrictions from existing lenders
Can’t use
equity
Dilutes eps
Loss of control by block-holder
Convertibles are used to delay equity or sweeten debt
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Features of convertibles
For issuer
For holder






Gearing effect
Attracts investors
Tax advantages
Self-liquidating
Cheaper yield
Less eps dilution




Higher yield than equity
Upside of capital gain
Can decide if/when to
convert


Advantages
Corporate Financial Strategy

If under-priced, dilutes
eps more than
necessary
If over-priced, have to
repay at inopportune
time
Possibility of nonrepayment
If share price doesn’t
rise – lost out by
allowing cheap debt
Disadvantages
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