Principles of Managerial Finance 9th Edition

1. Principles of Managerial Finance9th Edition Chapter 2 Institutions, Securities, Markets and Rates

2. Learning Objectives • Understand the relationship between financial institutions and markets, and the role of the money market. • Describe the key characteristics and types of corporate bonds. • Differentiate between debt and equity capital. • Discuss the rights, characteristics, and features of both common and preferred stock.

3. Learning Objectives • Review the operation of the capital market, particularly the securities exchanges and the role of the investment banker. • Describe the interest rate fundamentals and the basic relationship between risk and rates of return.

4. Financial Institutions & Markets • Firms that require funds from external sources can obtain them in three ways: • through a bank or other financial institution • through financial markets • through private placements • This chapter will focus on financial institutions and markets

5. Financial Institutions & Markets Financial Institutions • Financial institutions are intermediaries that channel the savings of individuals, businesses, and governments into loans or investments. • The key suppliers and demanders of funds are individuals, businesses, and governments. • In general, individuals are net suppliers of funds, while businesses and governments are net demanders of funds.

6. Financial Intermediaries in the U.S.

7. The Changing Role of Financial Institutions DIDMCA • A revolution in the financial services industry began with the passage of the Depository Institutions Deregulation and Monetary Control Act of 1980. • This legislation was crafted and passed as a result of the tumultuous conditions in the financial markets during the late 1970s which resulted in rapid disintermediation.

8. The Changing Role of Financial Institutions DIDMCA • DIDMCA (1980) actually consisted of two parts: Depository Institutions Deregulation and Monetary Control. • DID was designed to do a number of things: • curtail regulation Q (interest rate ceilings) • increase various sources of funding available to banks • expand the scope and activity of S&Ls by allowing them to invest in other than home mortgages

9. The Changing Role of Financial Institutions DIDMCA • The monetary control (MC) portion of DIDMCA was designed to extend the Fed’s control to thrifts and nonmember banks by extending reserve requirements and other controls to them. • This permitted both greater competition for deposits and more flexibility in terms of the types of investments various institutions could make.

10. Financial Markets • Financial markets provide a forum in which suppliers of funds and demanders of funds can transact business directly. • The two key financial markets are the money market and the capital market. • Transactions in short term marketable securities take place in the money market while transactions in long-term securities take place in the capital market.

11. Financial Markets • Whether subsequently traded in the money or capital market, securities are first issued through the primary market. • The primary market is the only one in which a corporation or government is directly involved in and receives the proceeds from the transaction. • Once issued, securities then trade on the secondary markets such as the New York Stock Exchange or NASDAQ.

12. Financial Markets

13. Claims to Wealth • While real assets include the direct ownership of tangible assets such as land or buildings, financial assets represent claims against the income and assets of those who issued the claims. • Types of financial assets include stocks, bonds, and bank deposits. • Some financial assets, such as stocks and bonds, can be traded in the secondary markets while others, such as bank deposits, cannot.

14. The Relationship between Financial Institutions and Financial Markets Indirect finance Direct finance

15. The Money Market • The money market exists as a result of the interaction between the suppliers and demanders of short-term funds (those having a maturity of a year or less). • Most money market transactions are made in marketable securities which are short-term debt instruments such as T-bills and commercial paper. • Money market transactions can be executed directly or through an intermediary.

16. Money market instrument • Treasury bill • Banker’s acceptance • Negotiable certificate of deposit • Commercial paper • Federal funds

17. The Money Market • The international equivalent of the domestic (U.S.) money market is the Eurocurrency market. • The Eurocurrency market is a market for short-term bank deposits denominated in U.S. dollars or other marketable currencies. • The Eurocurrency market has grown rapidly mainly because it is unregulated and because it meets the needs of international borrowers and lenders.

18. Corporate Bonds • Bonds are long-term debt instruments issued by corporations. • Corporate bonds typically pay interest semiannually, pay fixed coupon interest, have a par or face value of $1,000 and have an original maturity of 10 to 30 years. • Furthermore, they have a prior claim on the firm’s assets (in from of stockholders) but do not represent ownership in the firm.

19. Corporate Bonds Legal Aspects • The bond indenture specifies the conditions under which it has been issued. • It outlines both the rights of bondholders and duties of the issuing corporation. • It also specifies the timing of interest and principal payments, any restrictive covenants, and sinking fund requirements.

20. Corporate Bonds Legal Aspects • Common standard debt provisions in the indenture typically include: • the maintenance of satisfactory accounting records • periodically furnishing audited financial statements • the payment of taxes and other liabilities when due • the maintenance of all facilities in good working order • identification of any collateral pledged against the bond

21. Corporate Bonds Legal Aspects • Common restrictive provisions (or covenants) in the indenture typically include: • the maintenance of a minimum level of liquidity • prohibiting the sale of accounts receivable • the imposition of certain fixed asset investments • constraints on subsequent borrowing • limits on annual cash dividend payments

22. Corporate Bonds Legal Aspects • An additional restrictive provision often included in the indenture is a sinking fund requirement, which specifies the manner in which a bond is systematically retired prior to maturity. • Sinking funds typically dictate that the firm make semi- annual or annual payments to a trustee who then purchases the bonds in the market.

23. Corporate Bonds Cost of Bonds • In general, the longer the bond’s maturity, the higher the interest rate (or cost) to the firm. • In addition, the larger the size of the offering, the lower will be the cost (in % terms) of the bond. • Finally, the greater the risk of the issuing firm, the higher the cost of the issue.

24. Corporate Bonds General Features • The conversion feature ofconvertible bonds allows bondholders to exchange their bonds for a specified number of shares of common stock. • Bondholders will exercise this option only when the market price of the stock is greater than the conversion price. • A call feature (callable bond), which is included in most corporate issues, gives the issuer the opportunity to repurchase the bond prior to maturity at the call price.

25. Corporate Bonds General Features • In general, the call premium is equal to one year of coupon interest and compensates the holder for having it called prior to maturity. • Furthermore, issuers will exercise the call feature when interest rates fall and the issuer can refund the issue at a lower cost. • Issuers typically must pay a higher rate to investors for the call feature compared to issues without the feature.

26. Corporate Bonds General Features • Bonds also are occasionally issued with stock purchase warrants attached to them to make them more attractive to investors. • Warrants give the bondholder the right to purchase a certain number of shares of the same firm’s common stock at a specified price during a specified period of time. • Including warrants typically allow the firm to raise debt capital at a lower cost than would be possible in their absence.

27. Variety of Corporate Debt Secured Bond Mortgage Bonds • Mortgage bonds are backed by real estate and/or the physical assets of the corporation. • The real assets pledged will have a market value greater than the bond issue. • If the company defaults on the bonds, the real assets are sold off to pay off the mortgage bond holders.

28. Variety of Corporate Debt Secured Bond Equipment Trust Certificates • Equipment trust certificates are very similar to automobile loans. • When you borrow money for your new car, you make a down payment. Then you make your monthly installment payments. • At no time throughout the life of the loan is your car worth less than the outstanding amount of the loan.

29. Variety of Corporate Debt Equipment Trust Certificates Secured Bond • Many railroad and transportation companies use equipment trust certificates to meet their financing needs. airline trustee investor • Usually, 20% of the purchase price is put down by the company in the form of a down payment. Then the balance is paid off over 15 years. lease fund ETC Serial payment fund buy Airplane manufacturer

30. Variety of Corporate Debt Equipment Trust Certificates • When the company is finished paying off the loan, it receives clear title from the trustee. • If the company defaults on its loan, the equipment is sold off and the bond holders are paid off.

31. Variety of Corporate Debt Equipment Trust Certificates • Equipment Trust Certificates are serial bonds. • That is, each time a payment is made, a portion of that payment is interest and a portion of that payment is principal. • In this way, as previously stated, the loan amount never exceeds the collateral value.

32. Variety of Corporate Debt Unsecured Bond Debentures • Debentures are unsecured promissory notes that are supported by the general creditworthiness of the issuing company. • Because no assets are pledged, these bonds are riskier than collateralized bonds. • As a result, they are often referred to as subordinatedebt and carry higher interest rates and/or other features to make them more desirable to investors.

33. Variety of Corporate Debt Unsecured Bond Income Bonds • Income bonds will only pay interest if income is earned by the issuing company and only to the extent that income is earned. • Income bonds are the only bonds issued where failure to pay the interest in a timely fashion does not lead to immediate default. • As a result, income bonds are considered to be extremely risky.

34. Variety of Corporate Debt Income Bonds • In general, income bonds are issued by a company in bankruptcy. • The company facing bankruptcy will meet with its creditors (usually bond holders) and agree to issue new income bonds in exchange for the old bonds. • Because failure to pay interest would land the company back into bankruptcy court, the creditors agree that interest will only be paid to the extent earned.

35. Variety of Corporate Debt Convertible Bonds • Convertible bonds are one type of hybrid security. • They are like bonds in that they pay a fixed rate of interest and have a maturity date. • They are also like stock because they give the investor an option to convert the bond into a specified number of shares of stock. • The market price of a convertible bond therefore depends both on the firm’s stock price and prevailing interest rates.

36. Variety of Corporate Debt Variable Interest Rate Bonds (floating-rate bonds) • Variable interest rate bonds are bonds with coupon rates that vary with changes in short-term interest rates (like adjustable rate mortgages). • Usually, the interest rate is pegged to another rate such as U.S. Treasury bills. • In general, the market price of a variable rate bond will be less volatile. • On most bonds, an increase in interest rates will result in a decrease in market price.

37. Variety of Corporate Debt Discount and Zero Coupon Bonds • A zero couponbond pays no coupon interest from year to year the way most bonds do. • Investors earn their returns by purchasing the bonds at deep discounts from the bond’s face value, and then receiving the full face value at maturity. • Since the return on a zero depends strictly on the issuing firm’s ability to pay the face value at maturity, only the most creditworthy firms are able to issue them.

38. Variety of Corporate Debt High-Yield (Junk) Bonds • High-yield bonds are not a different type of bond -- simply a bond of lower quality. • Bonds rated BB (S&P) or Ba (Moody’s) or lower are considered to be junk. • Junk bonds are usually debentures and are subordinated to the firm’s other debt. • In general, junk bonds pay around 3 to 4 percent higher yields to investors than higher-grade bonds.

39. Variety of Corporate Debt Extendible Notes • Extendible Notes: Short-tern ( 1-5 years) noterenewable at the option of holders in the new market rate.

40. Variety of Corporate Debt Putable Bonds • Putable bond: bonds redeemable at par value at the option of holder 在發行後的某個時間點，或者當公司被併購、併購別人、或大幅舉債時。

41. Retiring Debt Serial-Bonds • A serial bond is simply one in which some of the bonds in the issue mature or are retired each year rather than all at once. • Serial bonds are usually used by companies to finance costly equipment, or by municipalities to finance capital improvements. • Also, the assets financed are usually used as collateral to secure the bonds.

42. Retiring Debt Sinking Funds • A sinking fund is simply a series of periodic payments to retire part of a debt issue. • In most cases, the periodic payments plus the interest earned on those deposits retire the debt at maturity. • In some cases, the firm sets aside funds and randomly selects bonds to be called. • Strong sinking funds set aside a large amount to be retired (say 10% per year).

43. Retiring Debt Sinking Funds • Weak sinking funds will leave most of the issue outstanding until maturity. • This is sometimes referred to as a balloon payment. • Bonds with strong sinking funds are generally considered to be less risky than those with weak sinking funds.

44. Retiring Debt Repurchasing Debt • Firm’s that have outstanding bonds which have substantially declined in price and are selling at a discount are sometimes repurchased by the issuer in the open market. • Thus, a firm with bonds selling at $500 with a face value of $1000 can cut their financing costs in half. • However, this decision must be weighed against any alternative uses for the cash used to execute the repurchase. also the subsequent financing needs. When interest rate

45. Retiring Debt Eurobond Foreign bond Callable Bonds • A call feature gives the issuer the right (or option) to retire a debt issue prior to maturity. • Issuer’s tend to call bonds that were issued during a period of high interest rates because it gives them the opportunity to refund the debt at a lower rate. • To protect investors, callable bonds usually require the issuer to pay a call premium which amounts to one year of extra interest expense (but usually declines over time). • *putable bond: holders have the option to redeem it at par at every 1 to 5 years or when firms liquidate, M&A,…

46. Bond Risk Sources of Risk • Default Risk • Risk that the interest will not be paid • Risk that the principal will not be paid • Risk that the price of the bond will decline due to poor company prospects • Inflation Risk • Call Risk • Interest Rate Risk.

47. Corporate Bonds Bond Ratings Junk bond

48. The Nature of Equity Capital Contrasting Debt & Equity

49. The Nature of Equity Capital Voice in Management • Unlike bondholders and other credit holders, holders of equity capital are owners of the firm. • Common equity holders have voting rights that permit them to elect the firm’s board of directors and to vote on special issues. • Bondholders and preferred stockholders receive no such privileges.

50. The Nature of Equity Capital Claims on Income & Assets • Equity holders are have a residual claim on the firm’s income and assets. • Their claims can not be paid until the claims of all creditors, including both interest and principle payments on debt have been satisfied. • Because equity holders are the last to receive distributions, they expect greater returns to compensate them for the additional risk they bear.