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Profissional Documentos
Cultura Documentos
1. Bank loans
2. Leases
3. Commercial Paper
4. Corporate Bonds
Bank Loans
Line of credit
An arrangement between a bank and a firm that requires the bank to
quote an interest rate, typically for a short-term loan, when the firm
requests the loan. The bank authorizes the maximum loan amount when
setting up the line of credit.
Loan commitment
An arrangement that requires a bank to lend up to a maximum
prespecified loan amount at a prespecified interest rate at the firms
request as long as the firm meets the requirements established when
the commitment was drawn up. There are two types of loan
commitments:
Revolver, in which funds flow back and forth between the bank and the firm
without any predetermined schedule. Funds are drawn from the revolver
whenever the firm wants them, up to the maximum amount specified. They
may be subject to an annual cleanup in which the firm must retire all
borrowings.
Nonrevolving loan commitment in which the firm may not pay down the
loan and then subsequently increase the amount of borrowing.
Leases
A debt instrument in which the owner of an asset, the
lessor, gives the right to use the asset to another party,
the lessee, in return for a set of contractually fixed
payments.
Operating lease: An agreement, usually short term, allowing
the lessee to retain the right to cancel the lease and return the
asset to the lessor.
Financial lease (or capital lease): An agreement that generally
extends over the life of the asset and indicates that the lessee
cannot return the asset except with substantial penalties.
Leveraged lease (asset purchase financed by a third party),
Direct lease (asset purchase financed by the manufacturer of the
asset), and
Sale and leaseback (asset purchased from the lessee by the
lessor).
Commercial Paper
Commercial paper is a contract by which a
borrower promises to pay a prespecified amount
to the lender of the commercial paper at some
date in the future, usually one to six months.
This prespecified amount is generally paid off by
issuing new commercial paper (rollover).
Typically only available to very large companies
with very high credit ratings.
These contracts are typically traded in public
markets and carry very low interest rates.
Corporate Bonds
Bonds are tradable fixed-income securities.
Always have a face amount of $1,000.
Nearly always have semi-annual coupon payments.
Coupon rate equals the sum of the two semi-annual payments
divided by 1,000.
If the coupon rate is 6% the bond pays $30 every six months.
The 6% represents (30+30)/1000.
Bond Covenants
Equity holders who control the firm can
expropriate wealth from bondholders by
making assets more risky, reducing assets
through the payment of dividends, and
adding liabilities.
Virtually all debt contracts contain
covenants to restrict these kinds of
activities:
Asset Covenants
Seniority and collateral provisions ensure each
debt instruments position in line should
bankruptcy occur.
Senior debt must be paid in full prior to the junior debt
receiving funds. Junior debt must be paid in full prior
to the preferred shareholders.
Secured debt has a lien on a physical asset, the
collateral. (Think car loan or home mortgage.)
If the firm does not pay the secured debt on time the debt
holders can repossess the collateral. If selling the collateral
does not pay the claim in full the secured debt holders
become unsecured claimants for the remaining funds.
Their place on line, with the rest of the firms claimants,
depends on the set of contract provisions.
Dividend Covenants
Prevent the firm from effectively
liquidating, handing the funds to the
shareholders, and declaring bankruptcy.
Helps guarantee the bond holders receive
their funds prior to the equity holders.
Financing Covenants
Prevents the firm from issuing new debt
that has seniority over the currently issued
debt.
Not all debt has this protection!
On occasion investors have seen the value of
their bonds plummet when a firm issues new
debt that is either senior to or has parity with
(a.k.a. pari passu) their bonds.
2. AGENCY COSTS
Debt in the capital structure induces a distortion of
investment decisions (deviations from NPV rule).
3. BANKRUPTCY COSTS
What are the costs incurred in the process of
resolving financial distress?
Announcement Effects
Stock prices reaction to the announcement of a debt
issue is as follows:
Non-bank debt: no impact.
Implies that such debt issues are neutral in terms of the information
conveyed to the market.
Equity Payoff
Debt Payoff
Amount Promised
Bond Holders
Profits
Risk Preferences
Notice that the equity holders like risk and
the bond holders dislike risk.
Encourages management to select riskier
projects, even if they have lower or
perhaps negative present values.
Example
Firm owes the bond holders $100.
The firm can invest in project Green or Gold.
Each project costs $100 in PV to implement.
Project Green pays $101 in PV for sure.
This is a positive PV project with an expected profit of
PV = $101-$100 = $1.
Project Gold
If the firm earns $25, it is bankrupt and the equity
holders get zero.
If the firm earns $125, the bondholders collect the
$100 due them. The equity holders get $125-$100 =
$25.
Expected equity payoff equals .5($0) + .5($25) =
$12.5.
Equity Payoff
Debt Payoff
Expected Gold
Payoffs
High Gold
Payoffs
$100
Low Gold
Payoffs
$100
Profits
Intuition
For the equity holders:
Heads equity wins, tails debt loses.
If the firm does well the profits go to equity.
If the firm does poorly, the losses go to the
bond holders.
For a given expected payoff, the more risk the
better.
Empirical evidence
Only seems to be a problem when firms are
close to or in bankruptcy.
Look for this in firms with low quality high yield
debt or distressed debt.
Bankruptcy Costs
If a firm is in financial distress, it may not
be able to meet its debt obligations.
This may lead to default.
Bankruptcy
Formal reorganization (Chapter 11), or
liquidation (Chapter 7).
Bankruptcy Costs
Direct costs:
Legal and administrative costs; losses for forced
liquidations
Indirect costs:
Lost business opportunities due to financial distress:
Lost customers
Suppliers want cash
Managers may leave
Firm
Value
Vmax
D
V
High ACD
Low ACE
Low Tax Benefits
optimal
D/V
Low ACD
High ACE
High Tax Benefits
Shelf Registration
Convertible Debt
A convertible bond gives the holder the right to exchange
it for a given number of shares of stock anytime up to
and including the maturity date of the bond.
If the holder chooses to convert, bondholders surrender
their bonds in exchange for a given fraction of equity.
Example: Bond with $1000 face value
Convertible into equity @ $20 per share (conversion price)
Conversion ratio: 50 shares per bond
Includes:
The value of a Straight Bond
Option value
Max A,,ST
A
Max 0,ST -
Value of
Value of the
the bond.
call option.
Firm Options
Callable Bond
Firm has the option to call the bonds prior to
maturity.
This is a call option for the firm.
Firms call bonds when:
Interest rates decline.
Their business fortunes improve.
Quoting Convention
When bond traders quote yields, they typically
quote yield to worst.
Assumption is that the firm in trying to minimize its
cost of capital will end up calling the bond at the date
that minimizes the bonds yield.
Call Price
106
105
104
103
Price
Call Date
7
8
10
100
12.70%
12.47%
12.31%
12.19%
12.00%
105
11.54%
11.43%
11.35%
11.30%
11.16%
110
10.46%
10.45%
10.46%
10.47%
10.37%
115
9.44%
9.53%
9.61%
9.68%
9.63%
YFC
YTW
Key:
YTM
Price
Call Date
7
8
10
100
17.75%
14.25%
13.13%
12.60%
12.00%
105
12.35%
11.43%
11.15%
11.04%
10.68%
110
7.34%
8.78%
9.29%
9.57%
9.44%
115
2.66%
6.29%
7.53%
8.18%
8.28%
YFC
YTW
Key:
YTM
Price
Call Date
8
9
10
100
15.85%
13.36%
12.00%
105
10.50%
10.55%
10.03%
110
5.53%
7.91%
8.17%
115
0.89%
5.42%
6.42%
Key:
YFC
YTW
YTM
Summary
OUTSIDE EQUITY
Costly because of its negative announcement effect.
Project financing may avoid such a negative impact.
DEBT FINANCING
Has positive effects:
Tax Advantages
No announcement effect
Reduces free cash-flow
RETAINED EARNINGS
Good: avoid costs of external financing
Bad: costs of free cash-flow