Sources of Corporate Finance (LECTURE 3)

Question 1

What is DEBT and what are advantages of it?

Answer 1

In simple terms: something that has to be paid back. In form of interest and principle amount.

Cheaper than equity: lower transaction fee- cost of raising funds.

Tax deductibility of interest payments.

Less risky- lower required rate of return.

Increased EPS through financial leverage if debt issued instead of equity.

Greater control- do not have to give voting rights.

Question 2

What are the disadvantages of debt?

Answer 2

• Increased Financial Risk- can result in liquidation.
• Restriction placed by lenders.
• Secure assets against debt.

Question 3

BANK BORROWINGS

Answer 3

• Without incorporating capital markets
• No tradable securities issued.
• Attractive to company for the following reasons:
• Quicker than some other types of borrowings.
• Lower administrative and legal costs.
• Flexibility and negotiation.
• Access to all sizes of firms.

Question 4

What are the costs involved in bank borrowing?

Answer 4

• Arrangement fee (0.5% or 1% of loan it is negotiable)
• Interest rate:
• Fixed Rate
• Floating Rate: certain rate above LIBOR, if LIBOR is used as a base rate, higher the risk higher would be the % above LIBOR.

Question 5

What is LIBOR?

Answer 5

• A benchmark rate that banks charge each other for their short term loans.

Question 6

SYNDICATED LOANS

Answer 6

• For a large amount of loan, there can be more than one financial institution involved.
• Lower spread over LIBOR.
• Carries low risk/ ranked above bonds in case of liquidation.
• Useful when firm needs funds quickly and discreetly- such in case of merger or acquisition.

Question 7

CORPORATE BONDS

Answer 7

• A long term contract; bond holders lend money to firm (or government in case of government bonds.
• Investor typically gets:
• predetermined regular interest.
• a capital sum or principle at the end of the bonds life. (also known as face value, redemption value or maturity value).

Maturity can be any number of years.

• Most are liquid and have a secondary market.
• Redemption date or maturity- firm agrees to pay back the principle amount of the bond.

Question 8

PAR VALUE OF A BOND

Answer 8

Usually £100 in UK and $1,000 in US.

Question 9

CALLABLE BONDS

Answer 9

Which can be called back before maturity.

Question 10

COUPON RATE

Answer 10

Interest expressed as a percentage of the principal amount.

Question 11

STRAIGHT BONDS

Answer 11

Fixed coupon bonds.
Called straight bonds, plain vanilla bonds, bullet bonds.

-Usually annual or semi annual coupon payments.

Question 12

ZERO COUPON BONDS

Answer 12

(also called pure discount bonds, strip bonds, or just zeros)

-Issued at a discount and redeemed at par.

Question 13

FLOATING RATE BONDS

Answer 13

(variable rate bonds)

-Pay coupon but coupon linked to various factors to adjust their interest expense accordingly.

• LIBOR
• Rate of inflation
• Oil prices
• Exchange rate movements
• Price of silver/gold/other precious metal
• Stock market movements
• Earthquakes/other natural disaster

Question 14

SECURED BONDS

Answer 14

• Fixed charge and floating charge on assets
• Debenture and loan stock (secured bonds against assets)
• Mortgage bonds (secured against property)

Question 15

UNSECURED BONDS

Answer 15

Though not secured, bondholders have prior right on earnings and assets (in case of liquidation), as compared with shareholders.

Question 16

JUNK BONDS

Answer 16

• Offer higher returns, but also a greater risk.

- Offers yields 4-5% above government bonds.

Question 17

PERPETUAL BONDS

Answer 17

-Bonds with no maturity date and carry interest payments for perpetuity.

Question 18

CONVERTIBLE BONDS

Answer 18

• Carry a coupon like straight bonds but usually lower (due to convertibility feature).
• Gives right to exchange the bonds into ordinary shares in future according to some prearranged formula.
• Normally conversion price is 10-30% higher than the existing share price.

Question 19

COMMERCIAL PAPERS

Answer 19

• Unsecured short-term instrument of debt, issued primarily by corporations (issued by high credit quality firms).
• Promises to the holder a sum of money to be paid in a set number of days.
• Buyers include: other corporations, insurance companies, pensions funds, government and bank.
• Average maturity of about 40 days, normal range is 30-90 days.
• Normally issued at discount.

Question 20

What is the fundamental valuation model?

Answer 20

P0= Σ CFt/(1+k)t

OR

P0= CF1/(1+k)1 + CF2/(1+K)2 + … + CFn/ (1+K)n

P0= Price of asset at time (today)
CFt= Cash flow expected at time t
k= Discount rate
n= Number of discounting periods

Question 21

TIME TO MATURITY (n years)

Answer 21

P0= Σ It/(1+kd)t + Mn/(1+kd)n

Question 22

NO TIME TO MATURITY

Answer 22

P0= It/kd

Question 23

ZERO COUPON BONDS

Answer 23

M/(1+kd)n = M(PVIFkd,n)

Question 24

What is the difference between coupon rate and discount rate?

Answer 24

The coupon rate merely tells us what cash flow the bond will produce.
Discount rate is the required rate of return by a bond holder.

Question 25

STRAIGHT BOND VALUATION EXAMPLE: Suppose on Dec 2013, Vodaphone raised money by selling bond with 6% coupon rate and 2019 time to maturity. Each bond had a face value of £100. The 5% discount rate would be comparable with other investment opportunities at the time. What would you have been willing to pay for this bond in Dec 2013?

Answer 25

P0 = Σ It/(1+kd)t + Mn/(1+kd)n ``` I = Annuity kd = discount rate ``` PV bond = £6 (PVIFA6,5%) + £100 (PVIF6,5%) = £6 x 5.076 + £100 x 0.746 =£30.456 + £74.6 =£105.056

Question 26

PERPETUAL BOND EXAMPLE: British government issued a perpetual bond with par value of £100 and a coupon rate of 2.5%. A discount rate would be comparable with other investment opportunities at the time.

Answer 26

P0 = It/kd = 2.5/0.05 =£50

Question 27

ZERO COUPON BOND EXAMPLE: ABC Plc issued a 2 year zero-coupon bond with a face value of £100. A 5% discount rate would be comparable with other investment opportunities at the time.

Answer 27

P0= M/(1+kd)n = M(PVIFkd,n) =£100 (PVIF5%,2) = £100 x 0.907 =£90.7

Question 28

What is the relationship between interest rates and bond prices?

Answer 28

If interest rates go up (higher than the coupon rate) then bond prices go down because bonds become less attractive to investors.

Question 29

YIELD TO MATURITY

Answer 29

An estimate of return investors earn if they buy the bond at P0 and hold it until maturity. The YTM on a bond selling at par will always equal the coupon rate. YTM is the discount rate that equates the PV of a bond's cash flows with its price.

Question 30

Relationship between bond prices and yields.

Answer 30

When first issued the price will reflect the future anticipated discount rate (YTM) and be be valued at £100. Any time after this, until the maturity date a bond price could be less or greater than £100 if yield (YTM) different from coupon rate. There is an inverse relationship between bond prices and interest rates (discount rate).

Question 31

What happens to bond values if the required return is not equal to the coupon rate?

Answer 31

The bond price will differ from its par value. | Kd>Coupon interest rate -> P0 P0>par value = premium

Question 32

YTM EXAMPLE: Kelly Corp. has issued 12% bonds maturing in 20 years. If you purchase a bond for £868 and hold it to maturity what is the yield to maturity on this investment? Par value is £1,000. What is your implied required rate of return, Kd?

Answer 32

P0 = Σ It/(1+kd)t + Mn/(1+kd)n YTM is kd. What is it? PVbond= I x PVIFA(kd,n) + M x PVIF(kd,n) PVbond= £120PVIFA(kd,20) + £1,000PVIF(kd,20) PVcoupon rate TRY 13% =£930 Because £930>£868, the YTM is greater than 13%. TRY 14% = £868 If PV=current market price, the YTM on the bond is 14%

Question 33

YTM EXAMPLE 2: Suppose ABC plc's 7% debentures of par value £1,000 maturing in 2019 are selling at the end of 2012 for £877.50. Determine the bond's YTM?

Answer 33

P0

Question 34

YTM of PERPETUAL BONDS EXAMPLE: What is the YTM of a 6% annual coupon bond, with a £1,000 face value with no maturity currently selling at £1,100?

Answer 34

PV= 65/kd PV=£1,100 Yield, kd=65/1,100 = 5.91%

Question 35

YTM of ZERO-COUPON BONDS EXAMPLE: What is the yield of a 5 year zero-coupon bond, with a £1,000 face value which is currently selling at £713?

Answer 35

P0= M/(1+kd)^n = M(PVIFkd,n) ``` £713 = £1,000(PVIFytm,5) £0.713 = (PVIFytm,5) YTM/kd = 7%. ```