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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
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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
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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
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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
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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
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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
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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
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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.

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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
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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
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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”
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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
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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
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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
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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

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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.
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Project Finance
Contractor
Supplier(s)
Equity investors
Government
Project
company
Equity sponsor
Lenders
Purchaser(s)
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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
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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?
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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!
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Warrant Value
Example:
B.J. Services warrants, expire April 2000
Exercise price = $ 15
Warrant price at maturity
BJ Services share price
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15
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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
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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
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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
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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
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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
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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)
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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
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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
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Convertible Bonds
 Example to understand payoffs: Eastman Kodak

Suppose Eastman Kodak has issued convertibles with $1 million
face value

Suppose these can be converted at any time to 1 million common
shares

Suppose there are already 1 million shares outstanding
 Let’s plot the value of the convertible bond as a function
of the underlying total firm asset value
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Convertible Bonds
 How bond value varies with firm value at maturity.
Straight bond value ($ thousands)
3
2
bond repaid in full
default
1
0
0
1
2
3
4
5
Value of firm ($ million)
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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)
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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
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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
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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

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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
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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
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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
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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?
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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

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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.

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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
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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
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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”

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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
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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
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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