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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 Corporate Financial Strategy 2 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. Corporate Financial Strategy 3 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) Corporate Financial Strategy 4 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.) Corporate Financial Strategy 5 ?? 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 Corporate Financial Strategy 6 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 7 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) Corporate Financial Strategy 8 Continuum of financial instruments Required return Preference shares Convertibles Mezzanine High yield debt Ordinary shares Unsecured Secured debt debt Perceived risk Corporate Financial Strategy 9 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 10 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) Corporate Financial Strategy 11 Subscription proceeds Investors Principal & interest Mezzanine and convertibles give return in two ways Required return Return from capital gain Return from yield Perceived risk Corporate Financial Strategy 12 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 Corporate Financial Strategy Either 1. The loan is repaid Or 2. Loan is converted into shares 13 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 14 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 Corporate Financial Strategy 15 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 16