Fundamentals of Corporate Finance/3e,ch16
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Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 16-1 Chapter Sixteen Long-term Financing: An Introduction
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Transcript of Fundamentals of Corporate Finance/3e,ch16
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-1
Chapter Sixteen
Long-term Financing: An
Introduction
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-2
16.1 Corporate Long-term Debt
16.2 Debt Ratings
16.3 Some Different Types of Debenture
16.4 Callable Debentures and Debenture Refunding
16.5 Preference Shares
16.6 Ordinary Shares
16.7 Size of the Capital Market
16.8 Summary and Conclusions
Chapter Organisation
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-3
Chapter Objectives• Explain the characteristics of debt.• Identify the various sources of long-term debt.• Outline the provisions of a debenture trust deed.• Understand debt ratings.• Identify the different types of debentures.• Calculate the cost, value and NPV of callable debentures.• Discuss the different features of both preference shares and
ordinary shares.• Understand the various definitions of financial distress.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-4
What is Debt?
• An obligation to pay a specific amount of money to another party.
• Characteristics of debt:– short-term vs long-term– fixed vs floating interest rate loans– secured vs unsecured– domestic vs foreign
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-5
Types of Long-term Debt
• Debentures• Secured and unsecured
notes• Convertible notes• Fixed deposit loans• Mortgages• Eurobonds • Eurocurrency term loans
• Leasing• Project finance• Transferable loan
certificates• Derivative debt products
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-6
Sources of Long-term Financing
• Debentures—secure, fixed-term loan instruments issued by companies.
• Secured notes—same as debentures with lower security.• Unsecured notes—shorter-term loans to a company offering
no assets as security.• Convertible notes—debt that provides an option to convert to
equity at maturity.• Fixed deposits—unsecured loans at fixed rates for definite
terms.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-7
Sources of Long-term Financing
• Mortgages—the conveyance of property for the security of debt.
• Eurobonds—unsecured fixed-interest borrowings denominated in a currency of a country other than its country of issue.
• Eurocurrency FRNs—a foreign currency borrowing whose rates adjust to reflect market interest rates.
• Leasing—purchaser of equipment leases the asset to another party.
• Project financing—syndicate financing of very large (and expensive) projects.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-8
Sources of Long-term Financing
• Transferable loan certificates—marketable evidence of the existence of a debt.
• Derivative debt products—instruments used to manage interest rate risk:
– interest rate swaps– forward rate agreements (FRAs)– interest rate futures– options on futures contracts.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-9
Debt versus Equity
• Corporations try to create debt securities that are really equity to get the tax benefits of debt and the bankruptcy benefits of equity.
• Interest on debt is fully tax deductible, so the distinction is important for tax purposes.
• Hybrid securities have characteristics of both debt and equity:– convertible notes– subordinated debt– preference shares.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-10
The Debenture Trust Deed
• Legal document binding the corporation and its creditors.
• Provisions in a trust deed include:– the basic terms of the issue– the amount of the debentures issued– property used as security– repayment arrangements– call provisions– any protective covenants.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-11
Debt Ratings
• Letter grades that designate investment quality.
• Assigned to a debt issue by independent rating agencies such as Moody’s and Standard & Poor’s.
• Long-term ratings range from Aaa to C; short-term ratings range from Prime-1 to Prime-3.
• Ratings relieve individual investors of the task of evaluating the investment quality of an issue.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-12
Different Types of Debentures
• Zero coupon debentures—initially priced at a deep discount as they make no coupon payments.
• Floating-rate debentures—coupon payments are tied to an interest rate index and are therefore adjustable. Usually contain a put provision, together with coupon ceilings and floors.
• Income debentures—coupons dependent on company income.
• Put debentures—holder can force the buy back of debt at a stated price.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-13
Securitisation
• The process of transforming financial institutions’ assets such as mortgages, into marketable securities, by pooling and selling the rights to the income streams.
• Advantages:– Investor—negotiable security provides both regular
income and final payout.– Mortgage agency—conversion of an illiquid asset into a
marketable security.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-14
Debenture Refunding
• Process of replacing all or part of an issue of outstanding debentures.
• Used to refinance a higher-interest loan with a lower-interest one.
• Call provision allows a company to repurchase or ‘call’ part or all of the debt issue at stated prices over a specified period.
• Debtholders demand a coupon that exactly compensates them for the possibility of a call.
• Cost of call provision = Value of call position
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-15
Example—Debentures
Assume:• Current interest rate on debentures is 10 per cent• Probability of interest rate changes by the end of the year: — fall to 5 per cent (50 per cent probability) — rise to 15 per cent (50 per cent probability)• Call premium = $20• Call period = by the end of the year• Face value of debenture = $100• Debentures are perpetual
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-16
Solution—Debentures
parat sells $100 1.10
$100 $10
1.10
endyear at price Expected coupon year -First
NCP
Market price of debenture (if not callable):
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-17
Solution—Debentures
$11.54 $1.10
$120 0.50 /0.15$ 0.50 $ $100
1.10
endyear at price Expected coupon year -First
C
CC
PC
If issue is callable, what coupon (C) must be offered?
This is higher than the non-callable coupon.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-18
Solution—Debentures
$150.00 1.10
5$11.54/0.0 0.50 5$11.54/0.1 0.50 $11.54
1.10
endyear at price Expected coupon year -First
NCP
What is the cost of the call provision?
The call provision effectively costs $50.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-19
Solution—Debentures
$110
$20 $100 1.308
$20 $100 /0.050.05 0.1154
$100 / NPV
pNNo CCCC
What is the NPV per debenture of the refunding if interest rates fall to 5 per cent?
As NPV is positive, refunding should commence.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-20
Reasons for Issuing Callable Debentures
• Superior interest rate forecasting—company insiders may think they know more about interest rate decreases than debtholders.
• Taxes—call provisions provide tax advantages to both debtholders and the company.
• Future investment opportunities—allows the company to buy back debentures to take advantage of superior investment opportunities.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-21
Preference Shares
• Shares with dividend priority over ordinary shares, normally with a fixed dividend rate, sometimes without voting rights.
• Cumulative vs non-cumulative dividends.• Irredeemable vs redeemable shares.• Non-participating vs participating shares.
Most preference shares issued are cumulative, irredeemable and non-participating.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-22
Reasons for Issuing Preference Shares
• Redeemable preference shares can be used to enhance the balance sheet by increasing the equity base.
• As subordinate debt, they can be included in a bank’s capital base.
• They can be used to avoid the threat of bankruptcy that exists for debt.
• Companies unable to take advantage of the tax deductibility of debt favour preference shares.
• A means of raising equity without surrendering control.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-23
Ordinary Shares
• Equity without priority for dividends or in bankruptcy.
• Types of companies:– companies limited by shares– companies limited by guarantee– companies limited by both shares and guarantee– unlimited companies– no liability companies.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-24
Shareholders’ Rights
• The right to share proportionally in dividends paid.
• The right to share proportionally in assets remaining after liabilities have been paid in liquidation.
• The right to elect the directors and to vote on important shareholder matters (one share = one vote).
• The right to share proportionally in any new shares sold (pre-emptive right).
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-25
Dividends
• Payment by a corporation to shareholders; made in either cash or shares.
• The return on capital to shareholders.
• They are not a liability of the company unless declared by the board of directors.
• They are not a business expense and are therefore not tax deductible.
• They are fully taxable in the hands of the shareholder. However, an imputation credit may be allowed.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-26
Classes of Ordinary Shares
• Different classes of ordinary shares may be distinguished by:– voting rights– dividend entitlement– priority to dividend payment– priority to capital repayment and surplus asset
distribution in the event of liquidation.
• Reasons for different classes:– debt characteristics for some shares– retain control in small/newly listed firms– taxation issues– nature of company (e.g. home units).
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-27
Size of the Capital Market
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
16-28
Financial Distress
The disadvantage of using debt is the possibility of financial distress, which can be defined as:
– business failure– legal bankruptcy– technical insolvency– accounting insolvency.
