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# 196.capital structure intro lecture 1

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• &amp;lt;number&amp;gt;
• The exchange feature of a convertible bond gives the right for the holder to convert the par amount of the bond for common shares a specified price or &amp;quot;conversion ratio&amp;quot;. For example, a conversion ratio might give the holder the right to convert \$100 par amount of the convertible bonds of Ensolvint Corporation into its common shares at \$25 per share. This conversion ratio would be said to be &amp;quot; 4:1&amp;quot; or &amp;quot;four to one&amp;quot;.
The share price affects the value of a convertible substantially. Taking our example, if the shares of the Ensolvint were trading at \$10, and the convertible was at a market price of \$100, there would be no economic reason for an investor to convert the convertible bonds. For \$100 par amount of the bond the investor would only get 4 shares of Ensolvint with a market value of \$40. You might ask why the convertible was trading at \$100 in this case. The answer would be that the yield of the bond justified this price. If the normal bonds of Ensolvint were trading at 10% yields and the yield of the convertible was 10%, bond investors would buy the bond and keep it at \$100. A convertible bond with an &amp;quot;exercise price&amp;quot; far higher than the market price of the stock is called a &amp;quot;busted convertible&amp;quot; and generally trades at its bond value, although the yield is usually a little higher due to its lower or &amp;quot;subordinate&amp;quot; credit status.
Think of the opposite. When the share price attached to the bond is sufficiently high or &amp;quot;in the money&amp;quot;, the convertible begins to trade more like an equity. If the exercise price is much lower than the market price of the common shares, the holder of the convertible can convert into the stock attractively. If the exercise price is \$25 and the stock is trading at \$50, the holder can get 4 shares for \$100 par amount that have a market value of \$200. This would force the price of the convertible above the bond value and its market price should be above \$200 since it would have a higher yield than the common shares.
Issuers sell convertible bonds to provide a higher current yield to investors and equity capital upon conversion. Investors buy convertible bonds to gain a higher current yield and less downside, since the convertible should trade to it bond value in the case of a steep drop in the common share price.
Investors traditionally use &amp;quot;breakeven&amp;quot; analysis to compare the coupon payment of the convertible to the dividend yield of the common shares. Modern techniques of option analysis examine the convertible as a bond with an equity option attached and value it in this manner.
• From Grinblatt and Titman
• Signaling theory is based on asymettric information and gives rise to a pecking order.
• PÓŹNIEJ;  POTEM = adverb for later
• ### 196.capital structure intro lecture 1

1. 1. Kevin Campbell, University of Stirling, October 2006 Capital structure Issues:  What is capital structure?  Why is it important?  What are the sources of capital available to a company?  What is business risk and financial risk?  What are the relative costs of debt and equity?  What are the main theories of capital structure?  Is there an optimal capital structure?
2. 2. Kevin Campbell, University of Stirling, October 2006 What is “Capital Structure”?  Definition The capital structure of a firm is the mix of different securities issued by the firm to finance its operations. Securities  Bonds, bank loans  Ordinary shares (common stock), Preference shares (preferred stock)  Hybrids, eg warrants, convertible bonds
3. 3. Kevin Campbell, University of Stirling, October 2006 Financial Structure What is “Capital Structure”? Balance Sheet Current Current Assets Liabilities Debt Fixed Preference Assets shares Ordinary shares
4. 4. Kevin Campbell, University of Stirling, October 2006 Capital Structure What is “Capital Structure”? Balance Sheet Current Current Assets Liabilities Debt Fixed Preference Assets shares Ordinary shares
5. 5. Kevin Campbell, University of Stirling, October 2006 Sources of capital  Ordinary shares (common stock)  Preference shares (preferred stock)  Hybrid securities  Warrants  Convertible bonds  Loan capital  Bank loans  Corporate bonds
6. 6. Kevin Campbell, University of Stirling, October 2006 Ordinary shares (common stock)  Risk finance  Dividends are only paid if profits are made and only after other claimants have been paid e.g. lenders and preference shareholders  A high rate of return is required  Provide voting rights – the power to hire and fire directors  No tax benefit, unlike borrowing
7. 7. Kevin Campbell, University of Stirling, October 2006 Preference shares (preferred stock)  Lower risk than ordinary shares – and a lower dividend  Fixed dividend - payment before ordinary shareholders and in a liquidation situation  No voting rights - unless dividend payments are in arrears  Cumulative - dividends accrue in the event that the issuer does not make timely dividend payments  Participating - an extra dividend is possible  Redeemable - company may buy back at a fixed future date
8. 8. Kevin Campbell, University of Stirling, October 2006 Loan capital  Financial instruments that pay a certain rate of interest until the maturity date of the loan and then return the principal (capital sum borrowed)  Bank loans or corporate bonds  Interest on debt is allowed against tax
9. 9. Kevin Campbell, University of Stirling, October 2006 Seniority of debt  Seniority indicates preference in position over other lenders.  Some debt is subordinated.  In the event of default, holders of subordinated debt must give preference to other specified creditors who are paid first.
10. 10. Kevin Campbell, University of Stirling, October 2006 11 Security  Security is a form of attachment to the borrowing firm’s assets.  It provides that the assets can be sold in event of default to satisfy the debt for which the security is given.
11. 11. Kevin Campbell, University of Stirling, October 2006 11 Indenture  A written agreement between the corporate debt issuer and the lender.  Sets forth the terms of the loan:  Maturity  Interest rate  Protective covenants  e.g. financial reports, restriction on further loan issues, restriction on disposal of assets and level of dividends
12. 12. Kevin Campbell, University of Stirling, October 2006 11 Warrants  A warrant is a certificate entitling the holder to buy a specific amount of shares at a specific price (the exercise price) for a given period.  If the price of the share rises above the warrant's exercise price, then the investor can buy the security at the warrant's exercise price and resell it for a profit.  Otherwise, the warrant will simply expire or remain unused.
13. 13. Kevin Campbell, University of Stirling, October 2006 11 Convertible bonds  A convertible bond is a bond that gives the holder the right to "convert" or exchange the par amount of the bond for ordinary shares of the issuer at some fixed ratio during a particular period.  As bonds, they provide a coupon payment and are legally debt securities, which rank prior to equity securities in a default situation.  Their value, like all bonds, depends on the level of prevailing interest rates and the credit quality of the issuer.  Their conversion feature also gives them features of equity securities.
14. 14. Kevin Campbell, University of Stirling, October 2006 11 The Cost of Capital Expected Return Risk premium Risk-free rate Time value of money ________________________________________________________ ______ Risk Treasury Corporate Preference Hybrid Bonds Bonds Shares Securities Ordinary Shares
15. 15. Kevin Campbell, University of Stirling, October 2006 11 Measuring capital structure  Debt/(Debt + Market Value of Equity)  Debt/Total Book Value of Assets  Interest coverage: EBITDA/Interest
16. 16. Kevin Campbell, University of Stirling, October 2006 11 Selected leverage data for US corporations Company Debt/Debt +MVE Debt/Book Assets EBITDA / Interest Delta Air 53% 32% 1.1 Disney 9 20 14.1 GM 61 37 3.0 HP 13 17 21.7 McDon's 15 31 7.2 Safeway 55 53 3.1
17. 17. Kevin Campbell, University of Stirling, October 2006 11 Interpreting capital structures  The capital structures we observe are determined both by deliberate choices and by chance events  Safeway’s high leverage came from an LBO  HP’s low leverage is the HP way  Disney’s low leverage reflects past good performance  GM’s high leverage reflects the opposite
18. 18. Kevin Campbell, University of Stirling, October 2006 11  Capital structures can be changed  Leverage is reduced by  Cutting dividends or issuing stock  Reducing costs, especially fixed costs  Leverage increased by  Stock repurchases, special dividends, generous wages  Using debt rather than retained earnings Interpreting capital structures
19. 19. Kevin Campbell, University of Stirling, October 2006 11 Business risk and Financial risk  Firms have business risk generated by what they do  But firms adopt additional financial risk when they finance with debt
20. 20. Kevin Campbell, University of Stirling, October 2006 22 Risk and the Income Statement Sales Operating – Variable costs Leverage – Fixed costs EBIT – Interest expense Financial Earnings before taxes Leverage – Taxes Net Income EPS = Net Income No. of Shares
21. 21. Kevin Campbell, University of Stirling, October 2006 22 Business Risk  The basic risk inherent in the operations of a firm is called business risk  Business risk can be viewed as the variability of a firm’s Earnings Before Interest and Taxes (EBIT)
22. 22. Kevin Campbell, University of Stirling, October 2006 22 Financial Risk  Debt causes financial risk because it imposes a fixed cost in the form of interest payments.  The use of debt financing is referred to as financial leverage.  Financial leverage increases risk by increasing the variability of a firm’s return on equity or the variability of its earnings per share.
23. 23. Kevin Campbell, University of Stirling, October 2006 22 Financial Risk vs. Business Risk  There is a trade-off between financial risk and business risk.  A firm with high financial risk is using a fixed cost source of financing. This increases the level of EBIT a firm needs just to break even.  A firm will generally try to avoid financial risk - a high level of EBIT to break even - if its EBIT is very uncertain (due to high business risk).
24. 24. Kevin Campbell, University of Stirling, October 2006 22 Why should we care about capital structure?  By altering capital structure firms have the opportunity to change their cost of capital and – therefore – the market value of the firm
25. 25. Kevin Campbell, University of Stirling, October 2006 22 What is an optimal capital structure?  An optimal capital structure is one that minimizes the firm’s cost of capital and thus maximizes firm value  Cost of Capital:  Each source of financing has a different cost  The WACC is the “Weighted Average Cost of Capital”  Capital structure affects the WACC
26. 26. Kevin Campbell, University of Stirling, October 2006 22 Capital Structure Theory  Basic question  Is it possible for firms to create value by altering their capital structure?  Major theories  Modigliani and Miller theory  Trade-off Theory  Signaling Theory
27. 27. Kevin Campbell, University of Stirling, October 2006 22 Modigliani and Miller (MM)  Basic theory: Modigliani and Miller (MM) in 1958 and 1963  Old - so why do we still study them?  Before MM, no way to analyze debt financing  First to study capital structure and WACC together  Won the Nobel prize in 1990
28. 28. Kevin Campbell, University of Stirling, October 2006 22 Modigliani and Miller (MM)  Most influential papers ever published in finance  Very restrictive assumptions  First “no arbitrage” proof in finance  Basis for other theories
29. 29. Kevin Campbell, University of Stirling, October 2006 22  Debt versus Equity  A firm’s cost of debt is always less than its cost of equity  debt has seniority over equity  debt has a fixed return  the interest paid on debt is tax-deductible.  It may appear a firm should use as much debt and as little equity as possible due to the cost difference, but this ignores the potential problems associated with debt. A Basic Capital Structure Theory
30. 30. Kevin Campbell, University of Stirling, October 2006 33 A Basic Capital Structure Theory  There is a trade-off between the benefits of using debt and the costs of using debt.  The use of debt creates a tax shield benefit from the interest on debt.  The costs of using debt, besides the obvious interest cost, are the additional financial distress costs and agency costs arising from the use of debt financing.
31. 31. Kevin Campbell, University of Stirling, October 2006 33 Summary  A firm’s capital structure is the proportion of a firm’s long-term funding provided by long-term debt and equity.  Capital structure influences a firm’s cost of capital through the tax advantage to debt financing and the effect of capital structure on firm risk.  Because of the tradeoff between the tax advantage to debt financing and risk, each firm has an optimal capital structure that minimizes the WACC and maximises firm value.
32. 32. Kevin Campbell, University of Stirling, October 2006 33 Is there magic in financial leverage?  … can a company increase its value simply by altering its capital structure?  …yes and no  …we will see….