CorporatefinanceEighthEditionChapter5Long-termfinance:debtfinance,hybridfinanceandleasingRisk,returnandsecurityDebtislessriskythanequity:StatutoryrighttointerestpaymentsPositionofdebtincreditorhierarchySecurityDebtisalwayscheaperthanequity:Lowerrisk,solowerreturnrequiredInterestpaymentsaretax-deductible

(taxefficiency)DebenturesandloanstockFixedorfloatinginterestrateNominalvalueofbondsis￡100Onmaturity,bondissuemustberedeemedDebenturesaresecuredbonds:FixedchargeFloatingchargeCovenantswrittentoprotectinvestorsOthertypesofdebtSubordinatedebtJunkbondsDeepdiscountbonds:issuedatdeepdiscounttonominalvaluesolowerinterestasrevenuereturntradedforcapitalgainZerocouponbonds:paynointerestso

returnisentirelycapitalgainEurobondsRedemptionandrefinancingAtmaturity,principalmustberepaidThiscallsforsubstantialcashsumRepaymentaffectscapitalstructureSinkingfundRefinancingRedemptionwindowInfluenceofcurrentvexpectedinterestratesBondratingsStandard&Poor’sratings:AAA MaximumSafetyAA HighGradeA Upper/mediumGradeBBB Lower/mediumGradeBB SpeculativeB HighlySpeculativeCCC SubstantialRiskD InDefaultS&Puse‘–’and‘+’toindicateweakness/strengthwithintheratingbandsInvestmentgradeBelowinvestmentgrade(‘junk’)BankandinstitutionaldebtBankloansarenottradedsonomarketvaluecanbeplacedonthedebtFixedorvariableinterestrateSecuredonassetsofthecompanyRepaymentschedulemeanscapitaloweddecreaseseachyearSmallbusinessesmaygetgovernmentassistancewhenseekingdebtfinanceBankandinstitutionaldebt(continued)Equalannualpaymentisloanamountdividedbypresentvaluefactorforloanperiodatloaninterestrate.Example:loanof￡100,000at10%over5years;whatisannualpayment?100,000/3.791=￡26,378peryear.Annualpaymentincludesbothcapitalandinterest.ConvertiblebondsConvertiblebondscanbeconvertedtoordinarysharesatoptionoftheholder.Optiontoconvertleadstointerestbeinglowerthanonstraightdebt.Companyhopesconvertibledebtwillnot

needtoberedeemed.Conversiontermswillbedesignedtomakeconversionattractive.Convertiblebonds(continued)Conversionmayoccuroveraperiodoftimeratherthanononlyonedate.Differentconversiontermsmayariseatdifferentdates.Conversiondateisoftendifferentfromtheredemptiondate.Ifconversionbecomesunlikely,issuermayhavedifficultyredeemingthebond.Convertiblebonds(continued)Floorvalueisthatofstraightdebt.Actualmarketvaluedependson:currentconversionvalue;timetoconversion;expectedconversionvalue;marketexpectationregardingconversion.Convertiblebonds(continued)Conversionratio:numberofsharesfrom

eachbondconverted.Conversionvalue:marketvalueofsharesintowhichonebondwillconvert.Conversionpremium:marketvalueofbondlessitsconversionvalue.Rightspremium:differencebetweenfloorvalueandmarketvalueofbond.Convertiblebonds(continued)Example:12%bondRedeemableatnominalin6yearsConvertibleinnext3yearsto30sharesCurrentexinterestbondprice:￡118.20Currentshareprice:￡3.20Priceofsimilarordinarybond:￡108.70Convertiblebonds(continued)Currentconversionvalue: 30×3.20=￡96.00Currentconversionpremium:

118.20

96=￡22.20(74p/share)Currentrightspremium:

118.20

108.70=￡9.50(32p/share)AdvantagesofconvertiblesSelf-liquidating,soavoidsredemptionSharepricesdonotfallonconversionInthelongterm,gearingisloweredConversionincreasesdebtcapacityLowerinterestthanstraightdebtInterestistaxdeductibleAttractivetothecautiousoptimistsWarrantsWarrantsgiveoptiontobuysharesonafuturedateatasetprice.Warrantsareattachedtobondissuetomakeitmoreattractivetoinvestors.Warrantscanbedetachedandsoldon.Exercisingwarrantshasnoeffectonthebond,whichcontinuestotradetoredemption.Warrants(continued)Warrantsofferadditionalincometoinitialinvestorortheopportunitytoparticipateinequitygrowth.Forasmalloutlay,warrantsofferalargereturninpercentageterms(gearingeffect).ValuationofwarrantsTimevalueandintrinsicvalueIntrinsicvaluedependson: marketpriceoftheshare = M warrantexerciseprice = O numberofsharesgained = NLinearequation:V=(M

O)×NNointrinsicvalueifM<OValuationofwarrants(continued)ValueofwarrantSharepriceExercisepriceIntrinsicvalueTimevalueTotalvalueValuingfixed-interestbondsForirredeemabledebt,marketvalueis:Here: P0=currentex-interestmarketvalue I=interestpayment Kd=costofdebtP0IKd=Valuingfixed-interestbonds(continued)Redeemablebondhasseveralinterestpaymentsplusrepaymentofprincipal

where:

I=interestpayment

RV=redemptionvalueorprincipal

Kd=costofdebtcapital

n=numberofyearstomaturityP0I(1+Kd)=+I(1+Kd)2+I(1+Kd)3+I+RV(1+Kd)n+

Valuingfixed-interestbonds(continued)Example:12%bondredeemablein6years,investorsneedreturnof10%Ex-interestmarketvalueis￡108.66YearCashFlow￡10%DiscountFactorPV(￡)1–6Interest124.355 52.266Principal1000.56456.40108.66ValuingconvertibledebtTheconversionvaluedependson:theconversionratio Rthecurrentshareprice P0thesharepricegrowthrate gthetimetomaturity n

CV=P0

(1+

g)n

RExample:10%bond,convertibleafter4yearsinto25shares,redeemableatnominalafter5years.Currentsharepriceof￡3isexpectedtogrowby6%peryear.Conversionvalue: ￡3×(1+0.06)4×25=￡94.67Conversionisunlikely,somarketvaluewill

beasstraightdebtplussmallpremium.Valuingconvertibledebt(continued)Valuingconvertibledebt(continued)Nowassumeexpectedgrowthrateof10%andrequiredreturnof11%: Conversionvalue:3×1.14×25=￡109.81 MV=PV

(interest)

+

PV

(conversionvalue) =(10×3.102)+(109.81×0.659) =31.02+72.36=￡103.38Marketvalueasstraightdebt:MV=(10×3.696)+(100×0.593) =36.96+59.30=￡96.26Factorsinfluencingmarketvalueofconvertiblebonds: sizeandfrequencyofinterestpayments sharepriceandassociatedgrowthrate conversionratio numberofyearstoconversionandmaturity principalamount,anypremiumpayable requiredreturnofdebtinvestors.Valuingconvertibledebt(continued)CLMValueofordinarydebtincreasesovertimetoredemptionvalue(M)onmaturity￡TimeRValuingconvertibledebt(continued)￡CLMM’ConversionvaluerisesovertimeassharepricerisesTimeRValuingconvertibledebt(continued)￡CLMM’RMarket

valueisfloorvalueorconversionvalueplustimevalueTimeValuingconvertibledebt(continued)CLMM’R

Conversionpremium=marketvaluelessconversionvalue

Rightspremium=marketvaluelessfloorvalueTime￡Valuingconvertibledebt(continued)Valuingconvertibledebt(continued)

(conversionnotexpected)TimeCLMRValueofconvertiblefallstothevalueofstraightdebtfinanceandfollowsitsmarketvalueuntilmaturity￡LeasefinanceLessorownstheleasedassetLesseemakesregularpaymentstolessorforuseoftheleasedassetLeasefinanceisnotinstalmentfinanceWhyisleasingpopular?Howtotellifleasingisfinanciallyattractive?AccountingtreatmentExplainedbyInternationalFinancialReportingStandard(IFRS)16.Leasesmustbereportedasfinancialassetsandassociatedfinancialliabilities.Leasesof12monthsorlessandleasesforlow-valueitemsmaybeexempt.ReasonsforleasingAssetacquiredevenifshortofcashTaxadvantagesvialeasepaymentsLeasingcanavoidobsolescenceLessors’sizeadvantagesEasiertoleasethantoborrowEvaluationofleasingIfbothfinancingandinvestmentdecisions:Method1:Evaluateinvestmentdecision,thenmakefinancingdecision(preferred)Method2:Makefinancingdecision,thenevaluateinvestmentdecisionMethod3:EvaluatefinancingandinvestmentdecisionssimultaneouslyEvaluationofleasing(continued)Whatdiscountratedoesthelesseeuse?Forinvestmentdecisions,discountrelevantcashflowsatcostofcapital,e.g.WACC.Forfinancingdecisions,discountrelevantcashflowsatcompany’safter-taxcostofborrowing.Evaluationofleasing(continued)Whatarethelessee’srelevantcashflows?Forbuyingthroughborrowing: PurchasecostandscrapvalueCapitalallowancesBalancingchargesorallowancesMaintenancecosts,relatedtaxeffectsForleasing:LeaserentalsandrelatedtaxbenefitsCommonsavings