Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
14- 1 B40.2302 Class #6 BM6 chapters 14.4, 24, 22.1-22.3, 25.1, 23 14.4, 24, 22.1-22.3, 25.1: debt varieties 23: debt valuation Based on slides created by Matthew Will Modified 10/18/2001 by Jeffrey Wurgler Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 Principles of Corporate Finance Brealey and Myers Sixth Edition An Overview of Corporate Financing Slides by Matthew Will, Jeffrey Wurgler Irwin/McGraw Hill Chapter 14.4 ©The McGraw-Hill Companies, Inc., 2000 14- 3 Topics Covered Debt At first glance, many different forms of debt But all share common features… Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 4 Corporate Debt General features of debt Borrower (stockholder) promises a certain stream of interest and principal payments But borrower may choose to default Lender doesn’t usually have voting rights, but in case of default lender gets assets • Asset administration handled by bankruptcy court Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 5 Corporate Debt TABLE 14-5 Large firms typically issue many different securities. This table shows some of the debt securities on Mobil Corporation's balance sheet at the end of 1996 and 1997 (figures in millions). Debt Security 6 1/2% notes 1997 6 3/8% notes 1998 7 1/4% notes 1999 8 3/8% notes 2001 8 5/8% notes 2006 8 5/8% debentures 2021 7 5/8% debentures 2033 8% debentures 2032 8 1/8% Canadian dollar eurobonds 1998 a 9 % ECU eurobonds 1997 b Irwin/McGraw Hill 1996 $148 200 162 200 250 250 240 250 110 148 1997 $200 148 180 250 250 216 164 ©The McGraw-Hill Companies, Inc., 2000 14- 6 Corporate Debt (Mobil continued (!)) Debt Security 9 5/8% sterling eurobonds 1999 Variable rate notes 1999 Japanese yen loans 2003-2005 Variable rate project financing 1998 Industrial revenue bonds 1998-2030 Other foreign currencies due 1997-2030 Other long-term debt Capital leases Commercial paper Bank and other short Irwin/McGraw Hill 1996 187 110 388 105 491 1090 660 247 1634 894 1997 182 347 52 484 764 716 335 1097 1168 ©The McGraw-Hill Companies, Inc., 2000 Principles of Corporate Finance Brealey and Myers Sixth Edition The Many Different Kinds of Debt Slides by Matthew Will, Jeffrey Wurgler Irwin/McGraw Hill Chapter 24 ©The McGraw-Hill Companies, Inc., 2000 14- 8 Topics Covered Domestic Bonds and International Bonds The Bond Contract Interest, Security, Seniority Asset-Backed Securities Repayment/Retirement Provisions Covenants Private Placements and Project Finance Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 9 Bond Terms: Markets Foreign bonds - Bonds that are sold to local investors in another country's bond market (in local currency) Yankee bond- a foreign bond sold in the United States. Samurai bond - a foreign bond sold in Japan. Eurobond market – Bonds sold across several international markets (in a single major currency) Note: nothing specific to Europe, nothing to do with “euro” currency! Just denotes bonds that are issued/distributed across many countries Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 10 Bond Terms: The contract Indenture or trust deed - the bond agreement between the borrower and a trust company. Agreement lists main terms of the contract Trustee’s role: Agent for individual bondholders Represents them in event of default Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 11 Bond Terms: Who keeps track Registered bond – company keeps track of bond owners, repays them directly Most common in US Bearer bond – bondholder sends in “coupons” to claim interest payments and must send the certificate to claim principal repayment More common overseas Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 12 Bond Terms: Interest Fixed-rate debt keeps paying a constant interest rate over the life of the bond Floating-rate debt pays an interest rate that fluctuates with the general level of interest rates Common benchmark rate is LIBOR (“London InterBank Offered Rate”) Loan agreements negotiated with banks are commonly floating rate. Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 13 Bond Terms: Security Unsecured debt obligations are most common for industrial and financial firms Debentures - long-term unsecured issue Notes – short-term unsecured issue Secured bonds have a claim to certain assets upon default Mortgage bonds - long-term secured debt that may contain a claim against a specific building or property Collateral trust bonds – bonds issued by holding companies that use common stock in other companies as collateral Equipment trust certificate – (not a bond) debt issued to finance railroad equipment, trucks, aircraft, or ships Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 14 Bond Terms: Seniority Priority of claims on firm’s assets: Senior secured debt Senior unsecured debt Junior/subordinated debt Junior (or subordinated) debt Residual claimants are shareholders Preferred shareholders rank above common Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 15 Asset-backed securities Asset-backed securities: Rather than borrow directly, companies may bundle a group of assets and then sell the cash flows from these assets Example: Mortgage lenders • They get cash now • They “pass-through” the mortgage repayments they receive to the AB securityholders Example: Rock star David Bowie • Got $55 million in 1997 • “passed-through” the royalties to his albums to the “Bowie bondholders” Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 16 Bond Terms: Retirement Sinking fund - a fund established to retired debt before maturity. Low-quality issues: strict sinking fund requirement High-quality issues: light requirement, so large “balloon” payment of principal left at maturity Callable bond - a bond for which the firm has the option to repay early for a specified call price. Putable (or retractable) bond – a bond for which investors have the option to demand early repayment Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 17 Straight Bond vs. Callable Bond Value of bond Straight bond 100 Bond callable at 100 75 50 25 Value of straight bond 25 Irwin/McGraw Hill 50 75 100 125 150 ©The McGraw-Hill Companies, Inc., 2000 14- 18 Bond Terms: Covenants Restrictive (negative) covenants - “must not” limits set by bondholders Limits on debt ratios Limits on dividends Limits on leasing Negative pledge clause (“me too” clause) • Gives (unsecured) debentures equal protection if and when assets are mortgaged Positive covenants – “must” limits Minimum net working capital Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 19 Value of covenants: An example 1992 - 1993 Marriott spun off its hotel management business worth 80% of its value. Before the spin-off, Marriott’s long-term book debt ratio was 79%. Almost all the debt was kept with the parent (renamed Host Marriott), whose debt ratio therefore rose to 93%. Marriott’s stock price rose 13.8% and its bond prices declined by up to 30%. Bondholders sued and Marriott modified its spinoff plan. … hence the value of covenants Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 20 Public versus private debt Public debt Must be registered with SEC Standardized contract, wide investor base Costly to issue More common for large firms Privately placed debt Less registration requirements Can be custom contract, narrow investor base Cheaper to issue, but may be higher interest rate Maybe more restrictive covenants More common for small and medium-sized firms Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 21 Project Finance 1. Project is set up as a separate company. 2. A major proportion of equity is held by project manager or contractor, so finance and management are linked. 3. The project is highly levered. Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 22 Project Finance Contractor Supplier(s) Equity investors Government Project company Equity sponsor Lenders Purchaser(s) Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 23 Project Finance Risk Completion/ continuing management Construction cost Shifted to: Contract Management contract/ completion gtees / working capital maintenance Contractor Turnkey contract/ fixed price/ delay penalties Raw materials Supplier(s) Long-term contract/ indexed prices/ supply or pay Revenues Purchaser(s) Long-term contract/ indexed to costs/ take or pay/ throughput agreements/ rolling contract Concession/regulation Government Concession agreement/ provision of supporting infrastructure Currency Government Gtees or comfort letters convertibility Irwin/McGraw Hill Sponsor ©The McGraw-Hill Companies, Inc., 2000 Principles of Corporate Finance Brealey and Myers Sixth Edition Warrants and Convertibles Slides by Matthew Will, Jeffrey Wurgler Irwin/McGraw Hill Chapter 22.1-22.3 ©The McGraw-Hill Companies, Inc., 2000 14- 25 Topics Covered What is a warrant? How to value a warrant under dilution? What is a convertible bond? Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 26 Warrants Warrant - Right to buy a security (usually shares) from a company at a stipulated price, on or before a stipulated date. - A call option! Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 27 Warrant Value Example: B.J. Services warrants, expire April 2000 Exercise price = $ 15 Warrant price at maturity BJ Services share price Irwin/McGraw Hill 15 ©The McGraw-Hill Companies, Inc., 2000 14- 28 United Glue Warrants United Glue has just issued $2 million package of debt and warrants. Using the following data, calculate the warrant value. # shares outstanding (N) = 1 mil Current stock price (P) = $12 Number of shares to be issued per share outstanding (q) = .10 Total number of warrants issued (Nq) = 100,000 Exercise price of warrants (EX) = $10 Time to expiration of warrants (t) = 4 years Annualized standard deviation of stock returns (sigma) = .40 Annually-compounded riskless interest rate (r) = 10 percent No dividends Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 29 United Glue Warrants United glue has just issued $2 million package of debt and warrants. Calculate the warrant value. Suppose without the warrants, debt is worth $1.5 million Cost of warrants total financing - value of debt w/o warrants 500,000 2,000,000 - 1,500,000 500,000 $5 cost per warran t 100,000 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 30 United Glue Warrants United glue has just issued $2 million package of debt and warrants. Calculate the warrant value. American call option on stock with no dividends = never exercise early = same value as European call option = BlackScholes (d1) = 1.104 N(d1) = .865 Irwin/McGraw Hill (d2) = .304 N(d2) = .620 ©The McGraw-Hill Companies, Inc., 2000 14- 31 United Glue Warrants United glue has just issued $2 million package of debt and warrants. Calculate the warrant value. Warrant = 12[.865] - [.620][10/1.14] = $6.15 But we haven’t taken dilution into account Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 32 United Glue Warrants Calculate warrant value including dilution When warrants are exercised, number of shares will increase by Nq=100,000. Assets will increase by amount of exercise money Nq*EX=100,000*10=$1 million Let V be value of United’s equity Warrant value at maturity = max{P – EX, 0} (so with dilution) = max{[V+NqEX]/[N+Nq]-EX, 0} =1/(1+q)*max{V/N – EX, 0} So warrant price equals the price of 1/(1+q) call options on the stock of an “alternative firm” with same total equity value V but no outstanding warrants Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 33 United Glue Warrants Calculate warrant value including dilution Suppose (given) total value of debt is $5.5 million (includes $1.5 million associated with warrant issue), total assets $18 million Current equity val ue of alternativ e firm V Value of United' s total assets - value of debts V 18 5.5 $12.5 million Or $12.50 per share. This is the share price you want to use in Black-Scholes to account for dilution We’ll assume volatility of undiluted firm is .41 (use different sigma too) Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 34 United Glue Warrants Calculate warrant value including dilution 1 value of call on alternativ e firm 1 q 1 6.64 $6.03 1.10 Note: Lower value than if don’t account for dilution, but still higher than the $5 the firm gets from the warrant issue Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 35 Convertible Bonds Convertible Bond - Bond that the holder may exchange for a specified amount of another security (usually shares). Convertibles are thus a combined security, combining a straight bond and a call option Like bond-warrant combo, except in bond-warrant combo you don’t have to surrender one to get the other: you have both Example to understand terms: ALZA 5% Convertible 2006, face value $1000 Convertible into 26.2 shares Conversion ratio 26.2 Conversion price = 1000/26.2 = $38.17 Market price of shares = $28 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 36 Convertible Bonds Example to understand payoffs: Eastman Kodak Suppose Eastman Kodak has issued convertibles with $1 million face value Suppose these can be converted at any time to 1 million common shares Suppose there are already 1 million shares outstanding Let’s plot the value of the convertible bond as a function of the underlying total firm asset value Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 37 Convertible Bonds How bond value varies with firm value at maturity. Straight bond value ($ thousands) 3 2 bond repaid in full default 1 0 0 1 2 3 4 5 Value of firm ($ million) Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 38 Convertible Bonds How conversion value at maturity varies with firm value. Conversion value ($ thousands) 3 2 1 0 0 0.5 1 1.5 2 2.5 3 3.5 4 Value of firm ($ million) Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 39 Convertible Bonds How value of convertible at maturity varies with firm value. Value of convertible ($ thousands) 3 2 convert bond repaid in full 1 default 0 0 Irwin/McGraw Hill 1 2 Value of firm ($ million) 3 4 ©The McGraw-Hill Companies, Inc., 2000 Principles of Corporate Finance Brealey and Myers Sixth Edition Leasing Slides by Matthew Will, Jeffrey Wurgler Irwin/McGraw Hill Chapter 25.1 ©The McGraw-Hill Companies, Inc., 2000 14- 41 Topics Covered Lease terminology Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 42 Lease Terms Lessee (user of asset) promises to make a series of payments to the lessor (owner of asset) Lease contract sets out the terms When lease is terminated, asset goes back to owner but contract may give lessee option to buy or renew lease Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 43 Lease Terms Operating Leases Short-term, cancelable at option of lessee Capital/Financial/Full-payout Leases Long-term, cover life of asset These are a source of financing Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 44 Lease Terms Other lease terms: Rental/full-service lease: owner services, pays property taxes, insures Net lease: lessee services, pays property taxes, insures Sale-and-lease-back arrangements • To raise cash, firm sells an asset it already owns, then leases it back (e.g. sell factory, lease it back) Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 Principles of Corporate Finance Brealey and Myers Sixth Edition Valuing Debt Slides by Matthew Will, Jeffrey Wurgler Irwin/McGraw Hill Chapter 23 ©The McGraw-Hill Companies, Inc., 2000 14- 46 Topics Covered The Term Structure Term Structure Theories Risk: Duration and Volatility Risk: Default Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 47 Term Structure We know the mechanics of how to value a straight bond: Discount each coupon at the relevant opportunity cost of capital Usually, the term structure is not flat (as we have assumed so far) Not a problem: discount first coupon C at r1 , discount second coupon at r2 , discount third coupon at r3 etc. rt is the cost of borrowing for a term of t periods. Add them all up to get present value But what determines the discount rates r1 and r2 and r3 ? That is, what determines the term structure of interest rates ? Especially the term structure of nominal interest rates? Need this because the bond coupons are usually in nominal terms Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 48 Term Structure rt 1981 1987 & present 1976 Year 1 5 10 20 30 These are the interest rates you face today (t=0) to borrow $1 for t years Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 49 Term structure theories Irving Fisher’s theory: Nominal rt = Real rt + expected inflationt (approximation) Real rt is relatively stable, but expected inflation is highly variable Maybe this helps to explain why nominal interest rates move so much? Or why the term structure has a certain shape? Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 50 Term structure theories More complete theories of TS: Expectations Theory Posits that return to holding a two-year bond should be equal to the expected return to rolling over a one-year bond I.e., (1+ r2) 2 = (1+r1)*(1+E[1r2]) If >, nobody would hold one-year bonds If <, nobody would hold two-year bonds Therefore must be = Implies: only reason for upward-sloping TS is that investors expect spot rates (one-year rates) to rise, only reason for downward-sloping TS is that investors expect spot rates to fall Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 51 Term structure theories More complete theories of TS: Liquidity-Preference Theory Expectations theory ignores risk If your horizon is 2 years, return to holding 2-year bond is riskless, return to rollover strategy is risky If your horizon is 1 year, return to holding 2-year bond and selling after 1 year is risky, return to holding 1-year bond is riskless Whether “long” or “short” investors dominate the market, determines where the risk premium falls If “short” investors dominate the market, i.e. typical investor has a “liquidity preference,” then 2-year bond yield will have to have a premium to get them to hold it. Hence TS usually slopes upward. Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 52 Term Structure: Using it Which TS theory is right? •No agreement •Probably all have elements of truth How to integrate these theories with CAPM? •Sloppy but possible •CAPM is inherently a single-period model. TS is inherently multi-period. To use CAPM over multiple periods, could use multi-period risk-premium, multi-period beta, multi-period risk-free rate How to proceed, in practice? •To value a bond, discount its coupons using the TS appropriate for bonds of that risk Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 53 Risk: Duration & Volatility Duration: Average time to each bond payment Longer duration means more sensitive to interest rate movements, higher volatility Example: 5 year, 9.0%, $1000 bond, with a 8.5% YTM Year CF PV@YTM 1 90 82.95 .081 0.081 2 90 76.45 .075 0.150 3 90 70.46 .069 0.207 4 90 64.94 .064 0.256 5 1090 724.90 .711 3.555 1019.70 1.00 4.249 Duration Irwin/McGraw Hill % of Total PV% x Year ©The McGraw-Hill Companies, Inc., 2000 14- 54 Risk: Default Default Risk is the risk that shareholders will walk away from the debt obligation Bond Ratings are issued by independent companies to help investors assess default risk of individual debt securities. Moody’s: Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C Std. & Poor’s: AAA, AA, A, BBB, BB, B, CCC, CC, C Top 4 ratings = “investment grade,” below = “junk” Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 55 Risk: Default Imagine a 1-year bond with face value $1000 and coupon of 9%. There is an 80% chance the bond pays off fully, but a 20% chance the company defaults and pays nothing. What is the bond’s value? CF Prob 1090 .80 = 0 .20 = 872.00 0 . 872.00 = expected CF Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 56 Risk: Default • Discount with CAPM Case 1: If risk of default is purely idiosyncratic, then return has beta of 0.0, so discount at riskless one-year rate (say that’s 9%) 872 Value $800 109 . 1090 YTM 36.3% 800 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000 14- 57 Risk: Default • Discount with CAPM Case 2: If risk of default is partly systematic, so return has positive beta. Now need to discount at higher rate, say 11% (11% = 9% + beta*(E[Rm]-9%)) 872 Value $785.59 111 . 1090 YTM 38.8% 78559 . Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000