B40.2302 Class #6

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

2. Principles of Corporate Finance Brealey and Myers Sixth Edition • An Overview of Corporate Financing Slides by Matthew Will, Jeffrey Wurgler Chapter 14.4 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

3. Topics Covered • Debt • At first glance, many different forms of debt • But all share common features…

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

5. Corporate Debt

6. Corporate Debt (Mobil continued (!))

7. Principles of Corporate Finance Brealey and Myers Sixth Edition • The Many Different Kinds of Debt Slides by Matthew Will, Jeffrey Wurgler Chapter 24 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

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

9. 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. • Samuraibond - 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

10. 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

11. 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

12. 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.

13. 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

14. 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

15. 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”

16. 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

17. Straight Bond vs. Callable Bond Value of Straight bond bond 100 Bond callable at 100 75 50 25 Value of straight bond 25 50 75 100 125 150

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

19. 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

20. 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

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.

22. Project Finance

23. Project Finance

24. Principles of Corporate Finance Brealey and Myers Sixth Edition • Warrants and Convertibles Slides by Matthew Will, Jeffrey Wurgler Chapter 22.1-22.3 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

25. Topics Covered • What is a warrant? • How to value a warrant under dilution? • What is a convertible bond?

26. 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!

27. Warrant Value Example: B.J. Services warrants, expire April 2000 Exercise price = $ 15 Warrant price at maturity BJ Services share price 15

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

29. 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

30. 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 = Black-Scholes (d1) = 1.104 (d2) = .304 N(d2) = .620 N(d1) = .865

31. United Glue Warrants • United glue has just issued $2 million package of debt and warrants. Calculate the warrant value. • But we haven’t taken dilution into account Warrant= 12[.865] - [.620][10/1.14] = $6.15

32. 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

33. 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 • 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)

34. United Glue Warrants Calculate warrant value including dilution Note: Lower value than if don’t account for dilution, but still higher than the $5 the firm gets from the warrant issue

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

36. 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

37. Convertible Bonds • How bond value varies with firm value at maturity. Straight bond value ($ thousands) bond repaid in full default

38. Convertible Bonds • How conversion value at maturity varies with firm value. Conversion value ($ thousands)

39. Convertible Bonds • How value of convertible at maturity varies with firm value. Value of convertible ($ thousands) convert bond repaid in full default

40. Principles of Corporate Finance Brealey and Myers Sixth Edition • Leasing Slides by Matthew Will, Jeffrey Wurgler Chapter 25.1 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

41. Topics Covered • Lease terminology

42. 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

43. 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

44. 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)

45. Principles of Corporate Finance Brealey and Myers Sixth Edition • Valuing Debt Slides by Matthew Will, Jeffrey Wurgler Chapter 23 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

46. Topics Covered • The Term Structure • Term Structure Theories • Risk: Duration and Volatility • Risk: Default

47. 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

48. 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

49. 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?

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