Chapter 14 Intro. to Corporate Financing PDF

Chapter 14 Overview of Corporate Finance  Common Shares: Issued Shares Outstanding Shares Authorized Share Capital Par Value Additional Paid-In Capital (Capital Surplus)  Some companies issue multiple classes of common shares – certain voting shares are...

Chapter 14 Overview of Corporate Finance  Common Shares: Issued Shares Outstanding Shares Authorized Share Capital Par Value Additional Paid-In Capital (Capital Surplus)  Some companies issue multiple classes of common shares – certain voting shares are concentrated with a small number of owners and not traded, and public held non- voting shares (eg: Magna) Special Share Class Votes per Major % of Total % of Total Share Shareholder Shares Votes Magna Internat. 500 Stronach 0.70% 56.50% Inc. Trust Executive Compensation Chair/CEO Total Revenue EPS Compens. $M $ $000 1 Magna Int 52,137 13,044 5.83 2 Alcan 17,456 12,553 1.15 3 CNR 12,261 6,173 2.87 4 EnCana 12,085 11,031 2.92 5 BCE 11,798 19,809 3.96  Common Shares: Because of the lack of direct organization of the small common shareholders, effective influence on the direction taken by the firm (through the board of directors) can be imposed by holder (or an organized group of holders) of a block representing much less than absolute controlling influence (ie: 50% + 1 share) Cumulative voting allows shareholders to direct all of their votes to elect one board member – favours rights of minority shareholders Non cumulative or majority voting distributes votes among all board members “Coattail” provision gives vote to non-voting shares in the event of a take-over bid Large shareholder groups may include another company (with a minority interest), mutual funds, pension funds (OMERS, Ontario Teachers)  Proxy Used by minority shareholders to exercise control Steps: Obtain list of all shareholders Contact (or advertise) to redirect proxies Use collective authority to influence decisions at the annual meeting  Warrants and Stock Options An investment instrument that represent a potential future commitment on the part of the issuer in that the buyer has the right, not the obligation, to acquire common shares at a given (exercise) price. The fluctuation in the value of warrants exceeds that of the underlying stock. Valuation of Common Shares and Warrants Period Change 1 2 $ % Stock Value $ 2.50 $ 2.75 $ 0.25 10% Warrant Exercise Price $ 2.00 $ 2.00 Warrant Value $ 0.50 $ 0.75 $ 0.25 50%  Preferred Shares Preferred shares have an entitlement to a fixed payment of dividends before any dividends are distributed to common shareholders. The entitlement is determined by the share’s par value and percentage entitlement Payments are made on the after-tax returns of the company Payments are made only if dividends are declared Usually two classes of preferred shares: Cumulative Preferred Shares Regular Preferred Shares  Preferred Shares In some cases, there is a further class of shares – Participating Preferred Shares. Income Statement Sales Less: Cost of Goods Sold Depreciation Equals: Earnings Before Interest and Taxes (EBIT) Less: Interest Expense Corporate Taxes Equals: Net Income Retained >> Dividends: Earnings Preferred: Cumulative Regular Common Participating Preferreds Preferred Share – call and retraction provisions – convertible feature (usually into common shares) – rarely have voting privileges Participating Preferred Shares In addition to fixed dividend, entitled to share as common, after common shares have received a fixed amount of dividend payment Floating Rate Preferred Shares Dividend rate is tied to the prime lending rate If interest rates increase (usually inflation-related), dividend is adjusted as a hedge.  Hierarchy of Entitlement to Income: Interest Expense (Coupon and Maturing Debt) Taxes Retained Earnings Cumulative Preferred Shares in arrears Preferred Shares Common Shares Participating portion of Preferred Shares  Bonds and Debentures Bonds and Debentures Covenants (positive and negative pledges) Bonds – Secured long-term loans Debentures – Unsecured long-term loans Subordinate Debt – Debt that ranks below other debt in the event of a claim on assets if default occurs Call Provisions: Most bonds are non-callable Some bonds contain call features, usually as a sole right of the issuer Call features are explicitly set out when the bond is issued “Extendible – Retractable” Strip Bonds – principal only, no coupons Residuals – coupon only, no principal Some Terms and Provisions Regarding Bonds: Private Placement: Sale of securities to a limited number of investors without being offered to the general investment community Convertible Bonds: Bonds offering the buyer the option to convert the bond into common shares at a future date at a specified price Methods of Interest Payment: Fully Registered: ▪ Interest paid to registered owner of the bond ▪ On maturity, principal paid to registered owner of the bond Bearer ▪ Interest paid to holder of bond ▪ On maturity, principal paid to holder of the bond  Investment Term Decision Years Investment Term Rate 1 2 3 4 5 6 7 8 9 10 $ 10,000,000 10 year * 6% $600,000 $ 600,000 $600,000 $ 600,000 $ 600,000 $600,000 $600,000 $600,000 $600,000 $600,000 5 years 5.75% $575,000 $ 575,000 $575,000 $ 575,000 $ 575,000 Difference $ 25,000 $ 25,000 $ 25,000 $ 25,000 $ 25,000 Accumulated Savings (@ 5.75%) $ 140,225 Balance to Finance (5 yr.) $ 9,859,775 Equivalent Interest Rate (5 yr. ) 6.09% $ 600,000 $ 600,000 $ 600,000 $ 600,000 $ 600,000 * Asset Life General Sinking Fund Bond Features: Annual payment based on an amount which, if invested at a conservative rate, would grow to equal the lump sum obligation at the end of the payment period (ie: the payments result in the final obligation reducing or “sinking” over time) Sinking fund payments are part of the bond contract (indenture) and are transferred to a trustee acting on behalf of the investor and charged with prudent investment of the funds Sinking fund assets are segregated from general assets of the firm, so if bankruptcy occurs, sinking fund bond holders are not just general creditors Sinking Fund Bonds carry lower risk and therefore a lower coupon rate  General Sinking Fund Bond Year 1 2 3 4 5 6 7 Principal Investor Interest Interest Issuer Principal Principal Trustee Foreign Borrowing Hedged and Unhedged (Naked) Contracts Hedge against movement in the currencies that will affect the pay-out of the cashflow in the foreign currency when it is due. Uses a forward contract Example of a Hedged Contract: A company needs to pay out 1 million Euros in 6 months and wishes to know today what will be the cost of this transaction. That is, the company wants to make a transaction today to cover the payment rather than risk having to pay a higher or lower amount if the Euro/Cdn exchange rate changes. The company is, therefore, “hedging” the transaction through the use of a forward contract. Foreign Borrowing Information Needed: Spot (current) exchange rate: 1 Euro = $1.494 Cdn Cost of borrowing in Canadian dollars for 6 months: 2.5% Investment rate for Euros for 6 months: 2.0% Calculations: 1. How many Euros today will grow to $1m Euros in 6 months? 1,000,000 / 1.02 = 980,392 Euros 2. How many Canadian dollars to buy 980,392 Euros today? 980,392 Euros x 1.494 = $1,464,706 Cdn. 3. What will it cost to borrow $1,464,706 Cdn. today and repay in 6 months? $1,464,706 x 1.025 = $1,501,324 Foreign Borrowing Transaction: 1. Company will borrow $1,464,706 today 2. Company will convert $1,464,706 into 980,392 Euros today 3. Company will invest 980,392 Euros for 6 months In 6 months: 1. The company will pay off the Canadian loan of $1,501,324 2. The company will complete the transaction by redeeming the $1,000,000 Euro loan. The six-month forward exchange rate is therefore: 1Euro = $1.501 Cdn. Securitization Securitization is a relatively new and popular way that companies can raise cash usually for the purchase of capital assets Securitization involves the “selling” of secure receivables Examples of candidate receivables are: - Credit card receipts - Rental income - Royalties - Instalment payment contracts The cash value of the cashflow from the receivables is the PV of the cashflow, adjusted for the risk of non-payment (allowance for bad debts)  Sources of Funds Summary Common Shares Voting Non-Voting Warrants Stock Options Preferred Shares Regular Cumulative Participating Bonds & Debentures Private Placement Fully Registered, Coupon, and Bearer Callable Sinking Fund Convertible Zero Coupon Foreign Borrowing Hedged and Unhedged Transactions Forward Exchange Rate Securitization  MD Management Mutual Funds One Three Five Ten Year Year Year Year Money Market 0.35 0.49 0.75 0.64 Bond Fund (8.66) (1.43) 0.77 1.45 Canadian Equity (4.57) 6.50 6.18 6.70 American Equity (10.17) 9.71 12.67 15.35 Internation Equity (18.12) 1.64 3.59 7.14 International Equity American Equity Intern. Equity 95.00 % U. S. Equity 91.87 % Cash/ Equivalents 3.49 Intern. Equity 5.78 Canadian Equity 1.51 Cash/ Equivalents 2.29 100.00 % Canadian Equity 0.05 Fixed Income 0.01 100.00 % Canadian Equity Bond Fund Canadian Equity 94.13 % Fixed Income 98.24 % Cash/ Equivalents 2.66 Cash/ Equivalents 1.22 Fixed Income 2.04 Canadian Equity 0.31 Intern. Equity 0.74 U. S. Equity 0.21 U. S. Equity 0.43 Intern. Equity 0.02 100.00 % 100.00 % Money Market Cash/ Equivalents 95.40 % Fixed Income 4.60 100.00 %  MD Management Mutual Funds One-Year Performance Ten-Year Performance Intern. Amer. Cda. Bond Money Intern. Amer. Cda. Bond Money Equity Equity Equity Fund Fund Equity Equity Equity Fund Fund 16% 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0% 1 2 3 4 5 6 7 8 9 0 11 12 13 14 15 16 17 18%