5. Financing Decisions and the Enterprise Value

Question 1

I. What are the main Debt Instruments?

Answer 1

• Bank loans
• Bonds
• Leasing

Question 2

I. Name some advantages of bank loans.

Answer 2

Advantages of bank loans:
- not so costly operation (when compared with bond issues), which can be used for small financing amounts
- since it is represented by a bilateral contract, it allows the company to provide all relevant information to the lending bank, so that it may evaluate the company credit
risk
- does not require company rating (although the bank may try to establish a
company credit scoring)

Question 3

I. Point and describe 2 financing contractual terms.

Answer 3

Financing contractual terms

1. Debt Service:
   - It includes the repayment of principal and the coupon (represents the full payment of a loan).
   - The coupon can be fixed or a floating rate. In the last case, the risk will be upon the company and the customers, not the bank. Since it can change according to the Index+spread.
2. Guarantees
   - It can be general or specific (mortgage, collateral).
   - Can also be Corporate (when one company will be responsible for the default of another company), or personal.
3. Restrictive clauses or covenants
   - Minimum or maximum values for certain financial ratios
   - Covenants are used in the case companies exceed the initial expected risk
   - Limits to: financial leverage; mergers and acquisitions; spin-offs; dividend
   payments

Question 4

I. Name some advantages of Bonds.

Answer 4

Advantages of Bonds
- They offer more advantageous conditions (in terms of interest) than bank
loans
- They permit adding some specific characteristics to the financing contract, such as conversion option (into equity), anticipated, repayment (call option).

Question 5

I. Describe specific characteristics about Bonds.

Answer 5

In floating rate loans
- Caps e Floors- the floating rate will never be higher than a determined amount
- Variable spread – in this case, spread increases or reduces across the bond
maturity

Different seniority/priority levels (Debtholders have higher priorities than shareholders,
within debtholders can be differences, the senior debt, the junior, and the subordinate bonds)
- With specific guarantees such as mortgage bonds and collateral bonds
- With no specific guarantees such as unsecured bonds and subordinate bonds

Question 6

I. What are Callable/Puttable bonds?

Answer 6

Callable bond- the company has the option to extinguish the bond with anticipation, paying back the principal. Basically, it helps the company when the interest rates decrease, because the value of the bond goes up
V. Callable bond < V. Bond

Puttable bond- The investor (the creditor) has the option to claim from the company the anticipated payment of the principal.

Question 7

I. Identify other types of bonds.

Answer 7

Other types of bonds
- Income bonds
- Option linked bonds
- High-yield bonds (junk bonds)

• Perpetual bonds
• Convertible bonds
• Warrant bonds.

Note: The last 3 are Hybrid instruments

Question 8

I. Name and describe 2 types of leasing.

Answer 8

Financial Leasing:
- present value of future leasing rents is lower than the value of the equipment
- the price of buying option at the end of the contract is very small
- period of the leasing contract is equal to the economic life of the equipment
- There is no cancelling option before the end of the contract

Operational Leasing:
- present value of future leasing rents is higher or equal to the value of the equipment
- the exercise price at the end of the contract (when it exists) is very
significant
- period of the leasing contract is shorter than the economic life of the equipment
- Cancelling option before the end of the contract
- Rents are treated as an operational cost
There is no certainty regarding the option to buy the equipment.

Question 9

I. Name the advantages of operational leasing.

Answer 9

• It allows the use of an equipment during a period shorter than its economic life
• Cancelling option is very valuable
• Maintenance included
• Tax benefits

Question 10

I. Describe some criteria to decide upon alternative debt financing solutions.

Answer 10

Criteria to choose among debt financing solutions:

1. All-in-cost
2. Yield-to-maturity Implicit rate of return for which the present value of cash-flows of the bond equals the price
   - Assumptions: The bond is kept until its maturity; periodic cash-flows are reinvested.

Question 11

II. Hybrid Financing Instruments characteristics are …

Answer 11

Combination of rights
Combination of risks
Arbitrage

• Allowing a programmed definition and implementation of the capital structure
• Offering bond holders the possibility to share in the value created to shareholders
• Creating better conditions for the acceptance of the debt securities
• Mitigating the liquidity and interest rate risks

Question 12

II. The offer of these Hybrid Financing Instruments …

Answer 12

Happens when there is a strong perspective of an increase in the value of the company, reflected in an increasing trend of its shares market price

Question 13

II. What are the types of hybrid securities?

Answer 13

• Warrant bonds
• Convertible bonds
• Preferred shares
• Participating bonds (coupon is indexed to company earnings)
• Convertible preferred stock
• Floating dividend preferred stock (The dividend is indexed to
  some variable, like EURIBOR)

Question 14

II. What is a warrant bond?

Answer 14

As the combined securities (bond and warrant) are autonomous:
- The exercise of the warrant does not imply the extinction of the bond
- After issuance, the two securities can be traded independently

Value of a warrant bond = Value of the basic bond + Value of warrants

-

Question 15

II. What is the difference between a warrant and a call option.

Answer 15

• The seller of the warrant is the company itself
• Any time a warrant is exercised, the company will issue new shares, increasing
  the total number of shares
• By issuing new shares, any time warrants are exercised,
  a dilution of share capital will happen

Question 16

II. Describe the characteristics of convertible bonds.

Answer 16

A convertible bond is an option of conversion into shares, that can be converted, by decision of the bondholder, into a pre-determined number of shares, at a given date, during a given time period.
- It is a floating exercise price (depending on the bond market price at the exercise date),
unless exercise date coincide with the maturity of the bond
- Exercise price is paid with bonds

• As in the case of a warrant bond, the coupons are lower than those of a corresponding common bond, in order to compensate the issuer for the conversion option.

Question 17

II. In the case of convertible bonds, at issuance it is necessary to define …

Answer 17

1. Reimbursement date(s) and periodic coupon
2. Conversion period (exercise date(s));
3. Conversion ratio (Nº of shares in which a bond is converted)
4. Conversion price (Face bond value / conversion ratio)

Question 18

II. Regarding convertible bonds, the conversion value is …

Answer 18

The value given to the bond when converted
Market share price * conversion ratio

Question 19

II. In terms of convertible bonds, the valuation…

Answer 19

Includes the valuation of two components:

1. Straight value- Present value of all debt service cash-flows to maturity.
2. Value of the conversion option- Value of the call option attached to the bond (similar to a warrant).

Question 20

II. What are preferred stocks (non-voting)?

Answer 20

• Fixed revenue, although dependent on company net earnings. When the
  company cannot pay the preferred dividend, this will accrue to following
  period.
• it does not grant voting power, they are neutral with respect to company control.

(In this case it is not possible to separate equity and debt clearly.)