Fundamentals of Corporate Finance/3e,ch16


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Fundamentals of Corporate Finance/3e,ch16

  1. 1. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-1Chapter SixteenLong-term Financing: AnIntroduction
  2. 2. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-216.1 Corporate Long-term Debt16.2 Debt Ratings16.3 Some Different Types of Debenture16.4 Callable Debentures and Debenture Refunding16.5 Preference Shares16.6 Ordinary Shares16.7 Size of the Capital Market16.8 Summary and ConclusionsChapter Organisation
  3. 3. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-3Chapter Objectives• Explain the characteristics of debt.• Identify the various sources of long-term debt.• Outline the provisions of a debenture trust deed.• Understand debt ratings.• Identify the different types of debentures.• Calculate the cost, value and NPV of callable debentures.• Discuss the different features of both preference shares andordinary shares.• Understand the various definitions of financial distress.
  4. 4. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-4What is Debt?• An obligation to pay a specific amount of money to anotherparty.• Characteristics of debt:– short-term vs long-term– fixed vs floating interest rate loans– secured vs unsecured– domestic vs foreign
  5. 5. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-5Types of Long-term Debt• Debentures• Secured and unsecurednotes• Convertible notes• Fixed deposit loans• Mortgages• Eurobonds• Eurocurrency term loans• Leasing• Project finance• Transferable loancertificates• Derivative debt products
  6. 6. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-6Sources of Long-term Financing• Debentures—secure, fixed-term loan instruments issued bycompanies.• Secured notes—same as debentures with lower security.• Unsecured notes—shorter-term loans to a company offeringno assets as security.• Convertible notes—debt that provides an option to convert toequity at maturity.• Fixed deposits—unsecured loans at fixed rates for definiteterms.
  7. 7. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-7Sources of Long-term Financing• Mortgages—the conveyance of property for the security ofdebt.• Eurobonds—unsecured fixed-interest borrowingsdenominated in a currency of a country other than its countryof issue.• Eurocurrency FRNs—a foreign currency borrowing whoserates adjust to reflect market interest rates.• Leasing—purchaser of equipment leases the asset toanother party.• Project financing—syndicate financing of very large (andexpensive) projects.
  8. 8. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-8Sources of Long-term Financing• Transferable loan certificates—marketable evidence of theexistence of a debt.• Derivative debt products—instruments used to manageinterest rate risk:– interest rate swaps– forward rate agreements (FRAs)– interest rate futures– options on futures contracts.
  9. 9. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-9Debt versus Equity• Corporations try to create debt securities that are really equityto get the tax benefits of debt and the bankruptcy benefits ofequity.• Interest on debt is fully tax deductible, so the distinction isimportant for tax purposes.• Hybrid securities have characteristics of both debt and equity:– convertible notes– subordinated debt– preference shares.
  10. 10. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-10The Debenture Trust Deed• Legal document binding the corporation and its creditors.• Provisions in a trust deed include:– the basic terms of the issue– the amount of the debentures issued– property used as security– repayment arrangements– call provisions– any protective covenants.
  11. 11. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-11Debt Ratings• Letter grades that designate investment quality.• Assigned to a debt issue by independent rating agenciessuch as Moody’s and Standard & Poor’s.• Long-term ratings range from Aaa to C; short-term ratingsrange from Prime-1 to Prime-3.• Ratings relieve individual investors of the task of evaluatingthe investment quality of an issue.
  12. 12. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-12Different Types of Debentures• Zero coupon debentures—initially priced at a deep discountas they make no coupon payments.• Floating-rate debentures—coupon payments are tied to aninterest rate index and are therefore adjustable. Usuallycontain a put provision, together with coupon ceilings andfloors.• Income debentures—coupons dependent on companyincome.• Put debentures—holder can force the buy back of debt at astated price.
  13. 13. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-13Securitisation• The process of transforming financial institutions’ assets suchas mortgages, into marketable securities, by pooling andselling the rights to the income streams.• Advantages:– Investor—negotiable security provides both regularincome and final payout.– Mortgage agency—conversion of an illiquid asset into amarketable security.
  14. 14. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-14Debenture Refunding• Process of replacing all or part of an issue of outstandingdebentures.• Used to refinance a higher-interest loan with a lower-interestone.• Call provision allows a company to repurchase or ‘call’ part orall of the debt issue at stated prices over a specified period.• Debtholders demand a coupon that exactly compensatesthem for the possibility of a call.• Cost of call provision = Value of call position
  15. 15. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-15Example—DebenturesAssume:• Current interest rate on debentures is 10 per cent• Probability of interest rate changes by the end ofthe year:— fall to 5 per cent (50 per cent probability)— rise to 15 per cent (50 per cent probability)• Call premium = $20• Call period = by the end of the year• Face value of debenture = $100• Debentures are perpetual
  16. 16. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-16Solution—Debentures( )paratsells$1001.10$100$101.10endyearatpriceExpectedcouponyear-First=+=+=NCPMarket price of debenture (if not callable):
  17. 17. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-17Solution—Debentures( ){ }$11.54$1.10$1200.50/0.15$0.50$$1001.10endyearatpriceExpectedcouponyear-First=×+×+=+=CCCPCIf issue is callable, what coupon (C) must beoffered?This is higher than the non-callable coupon.
  18. 18. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-18Solution—Debentures( ) ( ){ }$150.001.105$11.54/0.00.505$11.54/0.10.50$11.541.10endyearatpriceExpectedcouponyear-First=×+×+=+=NCPWhat is the cost of the call provision?The call provision effectively costs $50.
  19. 19. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-19Solution—Debentures( )( )[ ][ ]$110$20$1001.308$20$100/$100/NPV=−×=−×−=−×−= pNNo CCCCWhat is the NPV per debenture of the refunding ifinterest rates fall to 5 per cent?As NPV is positive, refunding should commence.
  20. 20. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-20Reasons for Issuing CallableDebentures• Superior interest rate forecasting—company insiders maythink they know more about interest rate decreases thandebtholders.• Taxes—call provisions provide tax advantages to bothdebtholders and the company.• Future investment opportunities—allows the company to buyback debentures to take advantage of superior investmentopportunities.
  21. 21. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-21Preference Shares• Shares with dividend priority over ordinary shares, normallywith a fixed dividend rate, sometimes without voting rights.• Cumulative vs non-cumulative dividends.• Irredeemable vs redeemable shares.• Non-participating vs participating shares.Most preference shares issued are cumulative, irredeemableand non-participating.
  22. 22. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-22Reasons for Issuing PreferenceShares• Redeemable preference shares can be used to enhance thebalance sheet by increasing the equity base.• As subordinate debt, they can be included in a bank’s capitalbase.• They can be used to avoid the threat of bankruptcy that existsfor debt.• Companies unable to take advantage of the tax deductibilityof debt favour preference shares.• A means of raising equity without surrendering control.
  23. 23. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-23Ordinary Shares• Equity without priority for dividends or in bankruptcy.• Types of companies:– companies limited by shares– companies limited by guarantee– companies limited by both shares and guarantee– unlimited companies– no liability companies.
  24. 24. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-24Shareholders’ Rights• The right to share proportionally in dividends paid.• The right to share proportionally in assets remaining afterliabilities have been paid in liquidation.• The right to elect the directors and to vote on importantshareholder matters (one share = one vote).• The right to share proportionally in any new shares sold (pre-emptive right).
  25. 25. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-25Dividends• Payment by a corporation to shareholders; made in eithercash or shares.• The return on capital to shareholders.• They are not a liability of the company unless declared by theboard of directors.• They are not a business expense and are therefore not taxdeductible.• They are fully taxable in the hands of the shareholder.However, an imputation credit may be allowed.
  26. 26. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-26Classes of Ordinary Shares• Different classes of ordinary shares may be distinguished by:– voting rights– dividend entitlement– priority to dividend payment– priority to capital repayment and surplus assetdistribution in the event of liquidation.• Reasons for different classes:– debt characteristics for some shares– retain control in small/newly listed firms– taxation issues– nature of company (e.g. home units).
  27. 27. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-27Size of the Capital Market
  28. 28. Copyright  2004 McGraw-Hill AustraliaPty Ltd16-28Financial DistressThe disadvantage of using debt is the possibility of financialdistress, which can be defined as:– business failure– legal bankruptcy– technical insolvency– accounting insolvency.