Corporate Finance WT2024/25 PDF

M.Sc. Finance Corporate Finance WT 2024 / 25 Bamberger / Breitkreuz / Zweigardt ISM 2024 Bamberger 1 Imprint It is prohibited to use the script, even parts of it, without a prior approval by the university outside the ISM or in courses undertaken by the ISM....

M.Sc. Finance Corporate Finance WT 2024 / 25 Bamberger / Breitkreuz / Zweigardt ISM 2024 Bamberger 1 Imprint It is prohibited to use the script, even parts of it, without a prior approval by the university outside the ISM or in courses undertaken by the ISM. Responsible for the content of this script is the author or are the authors. Scripts are not quotable in scientific work. ISM International School of Management GmbH Otto-Hahn-Str. 19 44227 Dortmund www.ism.de ISM 2024 Bamberger 2 Course Content Students will take the issuer´s perspective and explore the fundamental principles of optimizing a corporation´s capital structure. The course sets out to introducing students to the fundamentals of financing decisions, the roles of financial managers, the overarching goals of corporations, agency problems and corporate governance principles. Next, different sources of capital are discussed: Debt starts with an explanation of the core concept of debt, then progresses to explore more complex debt instruments, including bank loans, syndicated loan facilities, private debt, and bonds. Key similarities and differences are presented, as well as the cost of capital implications. Hybrid Capital blends features of both debt and equity. Students will analyze instruments such as preferred stock, convertibles, warrants, mezzanine, leasing, and factoring. This section provides a comprehensive understanding of the trade-offs between different instruments and the resulting cost of each component of capital structure. ISM 2024 Bamberger 3 Course Content Continued Equity plays a fundamental role in corporate financing. This section introduces students to the key attributes of share capital and the strategies companies utilize to raise and distribute equity capital, including dividend and stock buy- back policies. The measurement of the cost of equity is exemplified through the application of two key approaches: the Capital Asset Pricing Model (CAPM) and dividend growth models. The optimization of capital structure aims to enhance shareholder value by minimizing the weighted average cost of capital. Students will gain the ability to differentiate between business and financial risks and implement a framework for determining optimal capital structure. Theoretical principles will be connected to practical contexts, providing guidance on making capital structure decisions in real-world situations. ISM 2024 Bamberger 4 Investing & Financing Module Corporate Finance Course: Type and duration of exam: Written exam (90 minutes) with intermediate exam (paper presentation) Weight of the mark in the final grade (4 semesters 120 ECTS): 5,56% ISM 2024 Bamberger 5 Examination and Grading Written Exam – 70% of total score – Only non-programmable calculators to be used in the exam – Preparation: make sure you fully understand the script. If you detect weaknesses, revert back to the original textbook (source provided at the lower left corner on each slide), train problem solving Paper Presentation – 30% of total score – You will prepare and present a Corporate Finance related topic in class and you also will prepare solutions to the exercises in this script. – After the first session, the lecturer will provide a schedule detailing assignment topics and dates. – Grading will be based on your presentation and how you solved the exercises. ISM 2024 Bamberger 6 Table of Content 01 Introduction 1.1 Corporate Investment and Financing Decisions 1.2 Financial Managers and Opportunity Cost of Capital 1.3 Goals of the Corporation 1.4 Agency Problems and Corporate Governance 02 Debt 2.1 Bank loans 2.2 Syndicated Loan Facilities 2.3 Private Debt 2.4 Bonds 2.5 Cost of Debt 2.6 Exercises 03 Hybrid Capital 3.1 Preferred Stock 3.2 Convertibles 3.3 Warrants 3.4 Mezzanine 3.5 Leasing 3.6 Factoring 3.7 Exercises ISM 2024 Bamberger 7 Table of Content 04 Equity 4.1 Stocks 4.2 Raising Equity Capital 4.3 Payout Policy 4.4 Cost of Equity 4.5 Exercises 05 Capital Structure 5.1 Target Structure 5.2 Business and Financial Risk 5.3 Optimal Structure 5.4 Theoretical Background 5.5 Empirical Evidence 5.6 Capital Structure in Practice 5.7 Exercises ISM 2024 Bamberger 8 Literature Compulsory reading: Berk, J. B. / DeMarzo, P. M., latest edition: Corporate Finance-Global Edition, Boston: Pearson. Supplementary reading: Brealey, R. A. / Myers, S. C. / Allen, F.., latest edition: Principles of Corporate Finance, latest edition, New York: McGraw-Hill. Berk, J. B. / DeMarzo, P. M.., latest edition: Fundamentals of Corporate Finance, latest edition, Boston: Pearson. Brigham, E. F. / Houston, J. F., latest edition: Fundamentals of Financial Management, latest edition, Thomson-ONE Business School Edition. Damodaran, A.: Debt and Value: Beyond Miller-Modigliani, New York; Stern School of Business. Miller, S. C. (2014): A Syndicated Loan Primer, S&P Capital IQ, New York. https://acc.aima.org/about-acc/about-private-credit.html ISM 2024 Bamberger 9 Corporate Finance 01 Introduction 1.1 Corporate Investment and Financing Decisions 1.2 Financial Managers and Opportunity Cost of Capital 1.3 Goals of the Corporation 1.4 Agency Problems and Corporate Governance ISM 2024 Bamberger 10 1.1 Corporate Investment and Financial Decisions Capital Budgeting / Capital Expenditure (CAPEX) - Investment decisions are often referred to as capital budgeting or capital expenditure (CAPEX) decisions, because most large corporations prepare an annual capital budget, listing the major projects approved for investment. Investments are recognized as assets in the Statement of Financial Position - Today’s capital investments generate future returns. Often the returns come in the distant future and are hard to project. Once the investment is made, it is recognized as an asset (resource controlled by the entity, as a result of past events, from which future economic benefits are expected to flow to the entity) on the company´s books. Assets need to be financed - A corporation needs an almost endless variety of assets. These assets need to be paid for. To pay for assets, a corporation can raise money from lenders or from shareholders. How does a Corporation raise money? Brealey: Chapter 1 ISM 2024 Bamberger 11 1.1 Corporate Investment and Financial Decisions Debt financing by lenders - If it borrows funds, the lenders contribute the cash and the corporation promises to pay back the debt plus a fixed rate of interest. Equity financing by investors - If (new or existing) shareholders put up the cash, they get no fixed return, but they hold shares of stock and therefore get a fraction of future profits and cash flow. Capital structure – mix of debt / equity financing - The choice between debt and equity financing is called the capital structure decision. It has major implications on company value and solvency and, therefore, will be thoroughly examined in the last chapter. How do “real life” Investment and Financing decisions look like? Brealey: Chapter 1 ISM 2024 Bamberger 12 1.1 Corporate Investment and Financial Decisions Companies raise and spend huge amounts of money. What is a “Corporation” after all? Brealey: Chapter 1 ISM 2024 Bamberger 13 1.1 Corporation Legal entity, owned by its shareholders. As a legal person, the corporation can make contracts, carry on a business, borrow or lend money, sue or be sued, and pays taxes. Formed under state law, based on articles of incorporation that set out the purpose of the business and how it is to be governed and operated. Board of Directors choose and advise top management and are required to sign off on some corporate actions, such as mergers and the payment of dividends. Corporations are owned by its shareholders but are legally distinct from them. Therefore, the shareholders have limited liability, which means that shareholders cannot be held personally responsible for the corporation’s debts. They can lose their entire investment in a corporation, but no more. When first established, its shares may be privately held by a small group of investors, perhaps the company’s managers and a few backers. In this case the shares are not publicly traded, and the company is closely held. Brealey: Chapter 1 ISM 2024 Bamberger 14 1.1 Corporation … continued Eventually, when the firm grows and new shares are issued to raise additional capital, its shares are traded in public markets such as the New York Stock Exchange. Such corporations are known as public companies. A large public corporation may have hundreds of thousands of shareholders, who own the business but cannot possibly manage or control it directly. This separation of ownership and control gives corporations permanence. Even if managers quit or are dismissed and replaced, the corporation survives. Today’s stockholders can sell all their shares to new investors without disrupting the operations of the business. Corporations can, in principle, live forever, and in practice they may survive many human lifetimes. How do Corporations deal with capital budgeting and financing decisions? Who is in charge? Brealey: Chapter 1 ISM 2024 Bamberger 15 1.2 Financial Managers (1) Cash raised by selling financial assets to investors; (2) cash invested in the firm’s operations and used to purchase real assets; (3) cash generated by the firm’s operations; (4a) cash reinvested; (4b) cash returned to investors. All of the investment and financing decisions are managed by the Chief Financial Officer (CFO). Assume that the financial manager is acting in the interests of the corporation’s owners. What do these stockholders want the financial manager to do? 4a) or 4b)? 4a): If the return offered by the investment project is higher than the rate of return that shareholders can get by investing on their own, then the shareholders would opt for reinvestment. 4b): If the investment project offers a lower return than shareholders can achieve on their own, the shareholders would vote to cancel the project and take the cash instead. How do shareholders make investments “on their own” (independently of the corporation)? Brealey: Chapter 1 ISM 2024 Bamberger 16 1.2 Opportunity Cost of Capital Whatever returns shareholders can achieve on their own is called a hurdle rate or cost of capital. It is really an opportunity cost of capital, because it depends on the investment opportunities available to investors in financial markets. Whenever a corporation invests cash in a new project, its shareholders lose the opportunity to invest the cash on their own. Corporations increase value by accepting all investment projects that earn more than the opportunity cost of capital. This is called maximizing shareholder value. Is maximizing value all shareholders care about? Brealey: Chapter 1 ISM 2024 Bamberger 17 1.3 Goals of the Corporation Each stockholder wants three things: – To be as rich as possible, that is, to Manage time Manage risk maximize his or her current wealth. L pattern of consumption charakteristics L – To transform that wealth into the plan Shareholders´ of investment most desirable time pattern of objectives consumption either by borrowing to spend now or investing to spend later. Maximze own – To manage the risk characteristics of that investment by leveraging or hedging. wealth position J As long as shareholders have free access to competitive financial markets, financial manager can only help the firm’s stockholders by increasing their wealth. That means increasing the market value of the firm / the current price of its shares. Maximizing corporate profits / maximizing shareholder value – same thing? Brealey: Chapter 1 ISM 2024 Bamberger 18 1.3 Goals of the Corporation Maximizing profits does not necessarily imply higher shareholder value: 1. Maximize which year’s profits? A corporation may be able to increase current profits by cutting back on maintenance or staff training, but those expenses may have added long-term value. Shareholders will not welcome higher short-term profits if long-term profits are damaged. 2. A company may be able to increase future profits by cutting this year’s dividend and investing the freed-up cash in the firm. That is not in the shareholders’ best interest if the company earns less than the opportunity cost of capital. 3. Decisions which are aimed at boosting profitability may result in a more severe risk profile of the corporation. This may destroy shareholder value, despite improved profitability. So it´s all about the shareholders? How about other stakeholders? Brealey: Chapter 1 ISM 2024 Bamberger 19 1.3 Goals of the Corporation In “Anglo-Saxon” economies, the idea of maximizing shareholder value is widely accepted as the chief financial goal of the firm. In other countries, workers’ interests are put forward much more strongly. Why is it that owners and managers interests are not always aligned? Brealey: Chapter 1 ISM 2024 Bamberger 20 1.4 Agency Problems Agency Problems result from the separation of ownership and control. The owners (shareholders) cannot directly control what the managers do. Managers may be tempted to pursue their own objectives. They may shy away from attractive but risky projects because they are worried more about the safety of their jobs than about maximizing shareholder value. They may work just to maximize their own bonuses: Conflicts between shareholders’ and managers’ objectives create agency problems. They arise when agents work for principals. The shareholders are the principals; the managers are their agents. What measures can be taken in order to align managers` and shareholders` objectives? Brealey: Chapter 1 ISM 2024 Bamberger 21 1.4 Corporate Governance Legal and Regulatory Requirements - Managers have a legal duty to act responsibly and in the interests of investors. For example, the U.S. Securities and Exchange Commission (SEC) sets accounting and reporting standards for public companies to ensure consistency and transparency. It also prohibits insider trading, that is, the purchase or sale of shares based on information that is not available to the general public. Compensation Plans - Managers are spurred on by incentive schemes that produce big returns if shareholders gain - but are worthless if they do not. Managers should have a huge personal stake in the success of the firm—and in increasing its market value – so the interests of shareholders and managers are aligned better. Monitoring - The company’s directors are not the only ones to be scrutinizing management’s actions. Managers are also monitored by security analysts, who advise investors to buy, hold, or sell the company’s shares, and by banks, which keep an eagle eye on the safety of their loans. Brealey: Chapter 1 ISM 2024 Bamberger 22 1.4 Corporate Governance Takeovers - Companies that consistently fail to maximize value are natural targets for takeovers by another company or by corporate raiders. “Raiders” are private investment funds that specialize in buying out and restructuring poorly performing companies. Shareholder Pressure - If shareholders believe that the corporation is underperforming and that the board of directors is not holding managers accountable, they can attempt to elect representatives to the board to make their voices heard. Stock Price - Disgruntled stockholders also send a message by selling out and moving on to other investments. If enough shareholders bail out, the stock price tumbles. This damages top management’s reputation and compensation. A large part of top managers’ paychecks comes from stock options. Thus, a falling stock price has a direct impact on managers’ personal wealth. A rising stock price, on the other hand, is good for managers as well as stockholders. Brealey: Chapter 1 ISM 2024 Bamberger 23 Corporate Finance 02 Debt 2.1 Bank loans 2.2 Syndicated Loan Facilities 2.3 Private Debt 2.4 Bonds 2.5 Cost of Debt 2.6 Exercises ISM 2024 Bamberger 24 2.0 Debt - Definitions If you owe the bank a hundred thousand dollars, the bank owns you. If you owe the bank a hundred million dollars, you own the bank. - American Proverb A debt is an obligation to repay an amount you owe. Debt securities, such as bonds or commercial paper, are forms of debt that bind the issuer, such as a corporation, bank, or government, to repay the security holder. Debts are also known as liabilities. Dictionary of Financial Terms, 2008, Lightbulb Press, Inc. A financial liability is any liability that is: a contractual obligation: – to deliver cash or another financial asset to another entity; or – to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity; or a contract that will or may be settled in the entity’s own equity instruments. International Financial Reporting Standards: IAS 32 ISM 2024 Bamberger 25 2.1 Bank Loan – Mini Case Loewe AG In 2003, Loewe AG, a listed Consumer Electronics Company based in Germany, was faced with a rapid decline of its core business (traditional TV sets) after flat TVs became increasingly popular. Financial Performance was deteriorating quickly and additional funding (fresh money) was needed to sustain operations. Loewe historically relied on its banking relationship with four financial institutions. Term loans and credit lines were based on bilateral agreements (short term, unsecured). What changes to Loewe´s financing structure were to be expected? Loewe AG: Annual Report 2003 ISM 2024 Bamberger 26 2.1 Bank Loan – Mini Case Loewe AG Banks stepped up their credit lines and gave funding commitments for a total term of two years. Loewe had to pledge all its assets as security and pay substantially higher fees and spreads which reflected its poor credit. Loewe AG: Annual Report 2003 ISM 2024 Bamberger 27 2.1 Bank Loans - Types Promissory Note primary sources of short-term financing, especially for small businesses loan typically initiated with a promissory note, which is a written statement that indicates the amount of the loan, the date payment is due, and the interest rate. Single, End-of-Period Payment Loan agreement requires that the firm pay interest on the loan and pay back the principal in one lump sum at the end of the loan. The interest rate may be fixed or variable With a variable interest rate, the terms of the loan may indicate that the rate will vary with some spread relative to a benchmark rate, such as the yield on one-year Treasury securities, the SOFR (Secured Overnight Financing Rate), or previously LIBOR. As it is a rate paid by banks with the highest credit quality, most firms will borrow at a rate that exceeds SOFR. Berk: Chapter 20 ISM 2024 Bamberger 28 2.1 Bank Loans - Types Line of Credit A bank agrees to lend a firm any amount up to a stated maximum. This flexible agreement allows the firm to draw upon the line of credit whenever it chooses. Firms frequently use lines of credit to finance seasonal needs. An uncommitted line of credit is an informal agreement that does not legally bind the bank to provide the funds. As long as the borrower is in good financial condition, the bank is happy to advance additional funds. A committed line of credit consists of a legally binding written agreement that obligates the bank to provide funds to a firm (up to a stated credit limit) regardless of the present financial condition of the firm (unless the firm is bankrupt) as long as the firm satisfies any restrictions in the agreement. The firm pays a commitment fee on the unused portion of the line of credit in addition to interest on the amount that the firm borrowed. A revolving line of credit is a committed line of credit, which a company can use as needed, that involves a solid commitment from the bank for a longer period of time, typically two to three years. Berk: Chapter 20 ISM 2024 Bamberger 29 2.1 Bank Loans – How to apply Prepare a business plan, backed by historical data (financial statements and most recent trading information) which clearly demonstrates that your business prospects are solid Provide detailed explanation on how the money will be used and your plan for paying off the loan Point out if you are having sufficient assets, financial reserves and personal collateral to endure business fluctuations (and still pay off your loan) In a start-up situation, provide evidence that key personnel have a track record of profitability and success in a similar business endeavor Explore alternative funding sources (equity contribution, factoring, leasing, etc.) and pursue these projects as a back-up to the loan application Plan ahead, arrange for funding early – it is much harder to obtain financing if you urgently need cash! SME´s often rely on loans provided by banks on a bilateral basis. When should you go for a Syndicated Loan Facility instead? ISM 2024 Bamberger 30 2.2 Syndicated Loan Facility – Mini Case Douglas The Douglas Group was a European Specialty Retailer in the Perfumery, Books, Jewelry, Fashion and Confectionary Segment. Five retail divisions were managed and operated by a Holding Company, which also provided funding via inter-company loans and a centralized cash pooling system. Historically, Douglas Holding AG, the listed parent company, raised in total more than 300 mil Euro in long term loans with up to ten different banks on a bilateral basis, whenever market interest rates seemed to be favorable. Seasonal working capital patterns led to high cash balances (up to 500 mil. Euro) per end of December each year. Any ideas for improvement? Douglas Holding AG: Annual Report 2008/09 ISM 2024 Bamberger 31 2.2 Syndicated Loan Facility – Mini Case Douglas The new syndicated revolving credit facility, with a firm commitment for an initial five year term allowed flexible drawings with ample headroom at very low cost. Existing bilateral term loans were repaid and seasonal cash balances mostly eliminated. Douglas Holding AG: Annual Report 2008/09 ISM 2024 Bamberger 32 2.2 Syndicated Loan Facility - Overview A syndicated loan is a commercial loan provided by a group of lenders and structured, arranged, and administered by one or several commercial or investment banks known as arrangers. The syndicated loan market has become the dominant provider for loans because these are less expensive and more efficient to administer than traditional bilateral, or individual, credit lines. A loan is originally launched to market at a target spread. Banks then will make commitments that in many cases are tiered by the spread. The arranger will total up the commitments and then make a call on where to price the facility. Issuers use loan proceeds for four purposes: M&A-related transaction; recapitalization; refinancing debt; and general corporate purposes. Three types of syndications: an underwritten deal (arrangers guarantee the entire commitment), a “best-efforts” syndication (arranger group commits to underwrite less than the entire amount of the loan), and a “club deal” (smaller loan of up to $150 million that is pre-marketed to a group of relationship lenders). Miller: 2014 ISM 2024 Bamberger 33 2.2 Syndicated Loan Facility – Credit Risk Default risk is the likelihood of a borrower’s being unable to pay interest or principal on time. It is based on the issuer’s financial condition, industry segment, and conditions in that industry and economic variables and intangibles, such as company management. In most cases, it is most visibly expressed by a public rating. Where an instrument ranks in priority of payment is referred to as seniority. Based on this ranking, an issuer will direct payments with the senior-most creditors paid first and the most junior equity holders last. In a typical structure, senior secured and unsecured creditors will be first in right of payment—although in bankruptcy, secured instruments typically move to the front of the line—followed by subordinate bondholders, junior bondholders, preferred shareholders, and common shareholders. Loss-given-default risk measures the severity of loss the lender is likely to incur in the event of default. Investors assess this risk based on the collateral (if any) backing the loan and the amount of other debt and equity subordinated to the loan. Lenders will also look to covenants to provide a way of re-negotiating the terms of a loan if the issuer fails to meet financial targets. Miller: 2014 ISM 2024 Bamberger 34 2.2 Syndicated Loan Facility – Credit Risk Credit statistics help calibrate both default and loss-given-default risk. These statistics include credit ratios measuring leverage and coverage by industry. Then there are ratios that are suited for evaluating loss-given-default risk like collateral coverage, or the value of the collateral underlying the loan relative to the size of the loan. Industry sectors go in and out of favor. Loans to issuers in defensive sectors (like consumer products) can be more appealing in a time of economic uncertainty, whereas cyclical borrowers (like chemicals or autos) can be more appealing during an economic upswing. Many leveraged companies are owned by one or more private equity firms. To the extent that the sponsor group has a strong following among loan investors, a loan will be easier to syndicate and, therefore, can be priced lower. Among institutional investors, weight is given to an individual deal sponsor’s track record in fixing its own impaired deals by stepping up with additional equity or replacing a management team that is failing. Miller: 2014 ISM 2024 Bamberger 35 2.2 Syndicated Loan Facility – Types A revolving credit line allows borrowers to draw down, repay, and reborrow. Borrowers are charged an annual commitment fee on unused amounts (the facility fee). Revolving credits often run for 364 days and are generally limited to the investment-grade market since regulatory capital guidelines mandate that, after one year of extending credit under a revolving facility, banks must then in- crease their capital reserves to take into account the unused amounts. Therefore, banks can offer issuers 364-day facilities at a lower fee than a multi-year revolving credit. A term loan is simply an installment loan. The borrower may draw on the loan during a short commitment period (during which lenders usual share a ticking fee, akin to a commitment fee on a revolver) and repays it based on either a scheduled series of repayments or a one-time lump-sum payment at maturity (bullet payment). There are two principal types of term loans: An amortizing term loan (A-term loan or TLA) is a term loan with a progressive repayment schedule that typically runs six years or less. These loans are normally syndicated to banks along with revolving credits. An institutional term loan (B-term, C-term, or D-term loan) is a term loan facility carved out for nonbank accounts. Miller: 2014 ISM 2024 Bamberger 36 2.2 Syndicated Loan Facility – Types LOCs are guarantees provided by the bank group to pay off debt or obligations if the borrower cannot. A letter of credit facility specifically refers to a line of credit taken by a business entity primarily for the purpose of financing international trade Acquisition/equipment lines (delayed-draw term loans) are credits that may be drawn down for a given period to purchase specified assets or equipment or to make acquisitions. The issuer pays a fee during the commitment period (a ticking fee). The lines are then repaid over a specified period (the term-out period). Repaid amounts may not be re-borrowed. Bridge loans are loans that are intended to provide short-term financing to provide a “bridge” to an asset sale, bond offering, stock offering, divestiture, etc. Generally, bridge loans are provided by arrangers as part of an overall financing package. Typically, the issuer will agree to increasing interest rates if the loan is not repaid as expected. An equity bridge loan is a bridge loan provided by arrangers that is expected to be repaid by a secondary equity commitment to a leveraged buyout. Miller: 2014 ISM 2024 Bamberger 37 2.2 Syndicated Loan Facility – Roles In most syndications, there is one bookrunner/lead arranger. This institution is considered to be on the “left” (a reference to its position in a tombstone). The lead arranger or bookrunner title is a league table designation used to indicate the “top dog” in a syndication. The administrative agent is the bank that handles all interest and principal payments and monitors the loan. The syndication agent is the bank that handles, in purest form, the syndication of the loan. The documentation agent is the bank that handles the documents and chooses the law firm. The agent title is used to indicate the lead bank when there is no other conclusive title available, as is often the case for smaller loans. The co-agent or managing agent is largely a meaningless title used mostly as an award for large commitments. Miller: 2014 ISM 2024 Bamberger 38 2.2 Syndicated Loan Facility - Fees An upfront fee is a fee paid to the arranger by the issuer at close. Most often, fees are paid on a lender’s final allocation. For example, a loan has two fee tiers: 100 bps (or 1%) for $25 million commitments and 50 bps for $15 million commitments. A commitment fee is a fee paid to lenders on undrawn amounts under a revolving credit or a term loan prior to draw-down. On term loans, this fee is usually referred to as a “ticking” fee. A facility fee, which is paid on a facility’s entire committed amount, regardless of usage, is often charged instead of a commitment fee on revolving credits. A usage fee is a fee paid when the utilization of a revolving credit is above, or more often, below a certain minimum. A prepayment fee is a feature generally associated with institutional term loans. Typical prepayment fees will be set on a sliding scale; for instance, 2% in year one and 1% in year two. An administrative agent fee is the annual fee typically paid to administer the loan (including to distribute interest payments to the syndication group, to update lender lists, and to manage borrowings). For secured loans, the agent often collects a collateral monitoring fee, to ensure that the promised collateral is in place. Miller: 2014 ISM 2024 Bamberger 39 2.2 Syndicated Loan Facility - Covenants Loan agreements have a series of restrictions that dictate, how borrowers can operate and carry themselves financially. For instance, one covenant may prohibit it from taking on new debt. Most agreements also have financial compliance covenants, for example, that a borrower must maintain a prescribed level of performance, which, if not maintained, gives banks the right to terminate the agreement or push the borrower into default. The size of the covenant package increases in proportion to a borrower’s financial risk. The three primary types of loan covenants are: Affirmative covenants state what action the borrower must take to be in compliance with the loan, i.e. pay the bank interest and fees, provide audited financial statements, maintain insurance, pay taxes, and so forth. Negative covenants limit the borrower’s activities in some way. Negative covenants, can limit the type and amount of acquisitions and investments, new debt issuance, liens, asset sales, and guarantees. Financial covenants enforce minimum financial performance measures against the borrower. If an issuer fails to achieve these levels, lenders have the right to accelerate the loan. In most cases, though, lenders will instead grant a waiver in return for some combination of a fee and/or spread increase; a repayment or additional collateral or seniority. Miller: 2014 ISM 2024 Bamberger 40 2.2 Syndicated Loan Facility – Financial Covenants A coverage covenant requires the borrower to maintain a minimum level of cash flow or earnings, relative to specified expenses, most often interest, debt service (interest and repayments), fixed charges (debt service, capital expenditures, and/or rent). A leverage covenant sets a maximum level of debt, relative to either equity or cash flow, with total-debt-to-EBITDA level being the most common. A current-ratio covenant requires that the borrower maintain a minimum ratio of current assets (cash, marketable securities, accounts receivable, and inventories) to current liabilities (accounts payable, short-term debt of less than one year). A tangible-net-worth (TNW) covenant requires that the borrower have a minimum level of TNW (net worth less intangible assets, such as goodwill, intellectual assets, excess value paid for acquired companies). A maximum-capital-expenditures covenant requires that the borrower limit capital expenditures (purchases of property, plant, and equipment) to a certain amount. Miller: 2014 ISM 2024 Bamberger 41 2.2 Syndicated Loan Facility – Protective Provisions Virtually all leveraged loans and some of the shakier investment-grade credits are backed by pledges of collateral. In the asset-based market, for instance, that typically takes the form of inventories and receivables, with the maximum amount of the loan that the issuer may draw down capped by a formula based off of these assets. The common rule is that an issuer can borrow against 50% of inventory and 80% of receivables. In the leveraged market, some loans are backed by capital stock of operating units. In this structure, the assets of the issuer tend to be at the operating- company level and are unencumbered by liens, but the holding company pledges the stock of the operating companies to the lenders. This effectively gives lenders control of these subsidiaries and their assets if the company de- faults. The risk to lenders in this situation, is that a bankruptcy court collapses the holding company with the operating companies and effectively renders the stock worthless. Most leveraged loans are backed by subsidiary guarantees so that if an issuer goes into bankruptcy all of its units are on the hook to repay the loan. This is often the case, too, for unsecured investment-grade loans. Miller: 2014 ISM 2024 Bamberger 42 2.2 Syndicated Loan Facility – Protective Provisions Most issuers agree not to pledge any assets to new lenders (negative pledge) to ensure that the interest of the loanholders are protected. Some loans have Springing liens/collateral release provisions that borrowers on the cusp of investment-grade and speculative-grade must either attach collateral or release it if the issuer’s rating changes. One of the events of default in a credit agreement is a change of issuer control. It will be triggered by a merger, an acquisition of the issuer, some substantial purchase of the issuer’s equity by a third party, or a change in the majority of the board of directors. Equity cures allow issuers to fix a covenant violation—exceeding the maximum leverage test for instance—by making an equity contribution. These provisions are generally found in private-equity backed deals. The equity cure is a right, not an obligation. Therefore, a private equity firm will want these provisions, which, if they think it’s worth it, allows them to cure a violation without going through an amendment process, through which lenders will often ask for wider spreads and/or fees in exchange for waiving the violation even with an infusion of new equity. Miller: 2014 ISM 2024 Bamberger 43 2.2 Syndicated Loan Facility – Default When technical defaults occur, because the issuer violates a provision of the loan agreement, the lenders can accelerate the loan and force the issuer into bankruptcy. In most cases, however, the issuer and lenders can agree on an amendment that waives the violation in exchange for a fee, spread increase, and/or tighter terms. A payment default is a more serious matter. This type of default occurs when a company misses either an interest or principal payment. There is often a pre-set period of time, say 30 days, during which an issuer can cure a default. After that, the lenders can accelerate, or call, the loan. If the lenders accelerate, the company will generally declare bankruptcy and restructure its debt. If the company is not worth saving, then the issuer and lenders may agree to a liquidation, in which the assets of the business are sold and the proceeds dispensed to the creditors. Syndicated Loan Facilities are often used in LBO Transactions. Who are the main players in this field? Miller: 2014 ISM 2024 Bamberger 44 2.2 LBO Financing – Mini Case Douglas CVC and Advent are among the top ten global private equity groups: In 2013, Advent International completed a public tender offer of Douglas Holding AG and initiated a squeeze-out of the remaining shareholders. In 2015, CVC Capital Partners acquired Douglas AG (Perfumeries Division) from Advent International in a secondary leveraged buyout (LBO). Suppose the 2015 Douglas transaction was around 3 billion Euro, what funding structure would you expect? ISM 2024 Bamberger 45 2.2 LBO Financing – Mini Case Douglas Press Release on June1, 2015: From the Offering Circular on „Sources and Uses of Funds“: Sources of Funds Amount (mil.) Uses of Funds Amount (mil.) Term Loan B Facility 1.220 € Total Cash Consideration for the Revolving Credit Facility 15 € Acquisition and repayment of Senior Secured Notes offered hereby 300 € Existing Facilities 2.869 € Senior Notes offered hereby 335 € Equity Contribtions 1.113 € Estimated Transaction Costs 114 € Total Sources 2.983 € Total Uses 2.983 € What if even more debt is needed – maybe raise some private debt? ISM 2024 Bamberger 46 2.3 Private Debt - Definition ´Private debt´ is an umbrella term used to describe the provision of credit to businesses by lenders other than banks. Most commonly, these lenders are regulated asset management firms pooling investor money into funds that are then used to finance respective businesses. The term private debt is also often used interchangeably with phrases such as ‘private credit’, 'direct lending', 'alternative lending' or 'non-bank lending'. It can be differentiated from other types of lending activity and investment strategies in various ways, including: Bilateral relationships: private credit lenders will often have a direct rather than an intermediated relationship with the businesses they are lending to Buy and hold: private credit assets – usually loans - are generally not intended to be traded and will be held to maturity by the original lender. A flexible/tailored approach: Core features of a credit agreement such as repayment terms or covenants will typically be structured to match the unique needs of the borrower. What is the motivation of borrowers and lenders? Recent examples? AIMA: 2024 ISM 2024 Bamberger 47 2.3 Private Debt – Borrower and Lender Motivation Private debt can offer business some advantages compared to traditional bank financing. This may include greater flexibility over the structure of the loan, for example repayment schedules and operational covenants. The ability to act quickly and value of a long-term partnership with a private credit manager are two other advantages commonly cited by borrowers. Regulatory measures introduced by policymakers to promote financial stability and support responsible lending practices as well as the simplification of banking business models mean that it is often no longer viable for banks to lend to certain businesses on realistic terms. This may not necessarily be due to the business posing a bad credit risk, but rather them not being a good fit for a bank’s risk appetite or existing exposure. In such circumstances, private debt may be a more appropriate source of finance than a bank. Private credit is an increasingly important market component for investors and is now a permanent fixture of the capital allocation models employed by investors all over the world. Private credit is predominantly an institutional asset class with majority of capital allocated to private credit strategies coming from pension funds, insurers or sovereign wealth funds. Family offices, HNWIs and private banks also invest in private credit but make up a smaller proportion of the investor base overall. Outside of the US there is extremely little retail investor participation in private credit although policymakers are introducing reforms which may improve retail access to private credit. AIMA: 2024 ISM 2024 Bamberger 48 2.3 Private Debt – Case Studies AIG Investments provided a total of €140m in financing over the past two years to a European- based real estate developer and asset manager. Through two private placement issuances, the company was able to diversify its funding sources and access fixed-rate, long-term financing, a key feature of the private placement market. The company was able to efficiently match their long- term real estate assets with long-term debt by locking in 12-year financing at a fixed rate. This incremental financing will support the company’s growth strategy, including further geographic diversification in Europe. CVC Credit provided a first lien loan to fund the acquisition of World of Books (“WoB”) by Livingbridge, as well as an acquisition facility to support growth. CVC Credit is offering an ESG- criteria linked margin ratchet on the loan such that the company will be granted a margin reduction if it obtains third party ESG accreditation. Founded in 2008, WoB is a UK-based online re-commerce business primarily focussed on the global resale of used books. Hayfin provides €410mn unitranche loan to German TV home shopping player HSE24 to refinance existing debt and fund a dividend when the sponsor, Providence, transferred the asset into a new vehicle. Hayfin structured a comprehensive financing solution in a short timeframe for a bespoke transaction. Hayfin is a lender with the firepower to lead-arrange, underwrite and retain such a large facility, offering Providence the convenience of dealing with its lender on a bilateral basis. AIMA: 2024 ISM 2024 Bamberger 49 2.4 Bonds Read the fine print! What is a bond? ISM 2024 Bamberger 50 2.4 Bonds – Terminology Companies can raise debt using different sources. Typical kinds of debt are public debt, which trades in a public market, and private debt, which is negotiated directly with a bank or a small group of investors. The securities that companies issue when raising debt are called corporate bonds. What if there are no coupon payments? Berk: Chapter 6 ISM 2024 Bamberger 51 2.4 Zero Bonds Zero-coupon bonds make no coupon payments, so investors receive only the bond’s face value. The rate of return of a bond is called its yield to maturity (or yield). The yield to maturity of a bond is the discount rate that sets the present value of the promised bond payments equal to the current market price of the bond. The yield to maturity for a zero-coupon bond is given by: The risk-free interest rate for an investment until date n equals the yield to maturity of a risk-free zero-coupon bond that matures on date n. A plot of these rates against maturity is called the zero-coupon yield curve. Back to Coupon Bonds: Berk: Chapter 6 ISM 2024 Bamberger 52 2.4 Coupon Bonds The yield to maturity (YTM) for a coupon bond is the discount rate, that equates the present value of the bond’s future cash flows with its price: What is the impact of YTM fluctuations on bond prices? Berk: Chapter 6 ISM 2024 Bamberger 53 2.4 Coupon Bond Prices A bond will trade at a premium if its coupon rate exceeds its yield to maturity. It will trade at a discount if its coupon rate is less than its yield to maturity. If a bond’s coupon rate equals its yield to maturity, it trades at par. Berk: Chapter 6 ISM 2024 Bamberger 54 2.4 Coupon Bond Price Changes As a bond approaches maturity, the price of the bond approaches its face value. Bond prices change as interest rates change. When interest rates rise, bond prices fall, and vice versa. Long-term zero-coupon bonds are more sensitive to changes in interest rates than short-term zero coupon bonds. What is the impact on zero coupon bond prices if YTM fluctuates over time? Berk: Chapter 6 ISM 2024 Bamberger 55 2.4 Zero Bond Price Changes The graphs illustrate changes in price and yield for a 30-year zero-coupon bond over its life. Panel (a) illustrates the changes in the bond’s yield to maturity (YTM) over its life. In Panel (b), the actual bond price is shown in blue. Because the YTM does not remain constant over the bond’s life, the bond’s price fluctuates as it converges to the face value over time. Also shown is the price if the YTM remained fixed at 4%, 5%, or 6%. Panel (a) shows that the bond’s YTM mostly remained between 4% and 6%. The broken lines in Panel (b) show the price of the bond if its YTM had remained constant at those levels. Berk: Chapter 6 ISM 2024 Bamberger 56 2.4 Corporate Bonds When a bond issuer does not make a bond payment in full, the issuer has defaulted. The risk that default can occur is called default or credit risk. United States Treasury securities are deemed to be free of default risk. The expected return of a corporate bond, which is the firm’s debt cost of capital, equals the risk-free rate of interest plus a risk premium. The expected return is less than the bond’s yield to maturity because the yield to maturity of a bond is calculated using the promised cash flows, not the expected cash flows. Berk: Chapter 6 ISM 2024 Bamberger 57 2.4 Bond Rating System Berk: Chapter 6 ISM 2024 Bamberger 58 2.4 Bonds – Yield Spreads The difference between yields on Treasury securities and yields on corporate bonds is called the credit spread or default spread. The credit spread compensates investors for the difference between promised and expected cash flows and for the risk of default. Not just interest rates fluctuate over time, also spreads narrow and widen as investor´s “appetite for risk” is in constant flux. Berk: Chapter 6 ISM 2024 Bamberger 59 2.4 Corporate Bonds – Mini Case Hertz In mid-2005, Ford Motor Company decided to put one of its subsidiaries, Hertz Corporation, up for competitive bid. A group of private investors led by Clayton, Dubilier & Rice (CDR), a private equity firm, had reached a deal with Ford to purchase Hertz’s outstanding equity for $5.6 billion. In addition, Hertz had $9.1 billion in existing debt that it needed to refinance as part of the deal. CDR planned to finance the transaction in part by raising over $11 billion in new debt. Because almost all of the purchase would be financed with debt (leverage), the transaction is called a leveraged buyout. Funding included a syndicated term loan with Deutsche Bank and asset backed loans via a private placement transaction: Berk: Chapter 15 ISM 2024 Bamberger 60 2.4 Corporate Bonds – Mini Case Hertz Finally, three tranches of Junk Bonds and CDR´s equity contribution completed funding of the LBO transaction: Berk: Chapter 15 ISM 2024 Bamberger 61 2.4 Corporate Bonds – Mini Case Hertz Berk: Chapter 15 ISM 2024 Bamberger 62 2.4 Corporate Bonds – Mini Case Hertz Berk: Chapter 15 ISM 2024 Bamberger 63 2.4 Corporate Bonds - Types For public offerings, the bond agreement takes the form of an indenture, a formal contract between the bond issuer and a trust company. The indenture lays out the terms of the bond issue. Four types of corporate bonds are typically issued: notes, debentures, mortgage bonds, and asset-backed bonds. Notes and debentures are unsecured. Mortgage bonds and asset-backed bonds are secured. Corporate bonds differ in their level of seniority. In case of bankruptcy, senior debt is paid in full before subordinated debt is paid. International bonds are classified into four broadly defined categories: domestic bonds that trade in foreign markets; foreign bonds that are issued in a local market by a foreign entity; Eurobonds that are not denominated in the local currency of the country in which they are issued; and global bonds that trade in several markets simultaneously. What assurances can issuers give to investors? Berk: Chapter 15 ISM 2024 Bamberger 64 2.4 Corporate Bonds - Covenants Covenants are restrictive clauses in the bond contract that help investors by limiting the issuer’s ability to take actions that will increase its default risk and reduce the value of the bonds: Berk: Chapter 15 ISM 2024 Bamberger 65 2.4 Corporate Bonds – Repayment Provisions A call provision gives the issuer of the bond the right (but not the obligation) to retire the bond after a specific date (but before maturity). A callable bond will generally trade at a lower price than an otherwise equivalent non-callable bond. The yield to call is the yield of a callable bond assuming that the bond is called at the earliest opportunity. Another way in which a bond is repaid before maturity is by periodically repurchasing part of the debt through a sinking fund. Some corporate bonds, known as convertible bonds, have a provision that allows the holder to convert them into equity. Convertible debt carries a lower interest rate than other comparable non-convertible debt. How do financial managers of a bond issuer know, whether they should exercise a call provision? Berk: Chapter 15 ISM 2024 Bamberger 66 2.4 Corporate Bonds – Call Provision A financial manager will choose to exercise the firm’s right to call the bond only if the market price of the bond exceeds the call price. Naturally, investors view this possibility negatively and pay less for callable bonds than for otherwise identical non-callable bonds. Call Provisions in real life can be fairly sophisticated: What is the difference between a bond investor´s return and the issuer´s cost of debt? Berk: Chapter 15 ISM 2024 Bamberger 67 2.5 Cost of Debt Corporations have limited liability. If companies are unable to pay their debts, they can file for bankruptcy. Lenders are aware that they may receive less than they are owed, and that the expected yield on a corporate bond is less than the promised yield. Because of the possibility of default, the promised yield on a corporate bond is higher than on a government bond. This extra yield is the amount that you would need to pay to insure the bond against default. These policies are called credit default swaps. Cost of default swaps on the 10-year senior debt of four companies. Brealey: Chapter 23 ISM 2024 Bamberger 68 2.5 Cost of Debt There are no free lunches in financial markets. So the extra yield you get for buying a corporate bond is eaten up by the cost of insuring against default. The company’s option to default is equivalent to a put option. If the value of the firm’s assets is less than the amount of the debt, it will pay for the company to default and to allow the lenders to take over the assets in settlement of the debt. The spread between the yield on a corporate bond and the yield on a comparable government issue compensates for the possibility of default. End-year yield spreads between corporate and 10-year Treasury bonds Brealey: Chapter 23 ISM 2024 Bamberger 69 2.5 Cost of Debt Spreads can change rapidly as investors reassess the chances of default or become more or less risk-averse. When investors want a measure of the risk of a company’s bonds, they usually look at the rating that has been assigned by Moody’s, Standard & Poor’s, or Fitch. If the quality of the bonds deteriorates due to higher default risk, investors will demand a higher yield and the bond price will fall. Default rates of corporate bonds 1981–2008, by Standard & Poor’s rating at time of issue. Brealey: Chapter 23 ISM 2024 Bamberger 70 2.6 Exercise 1 What is the price today of a two-year, default-free security with a face value of $1000 and an annual coupon rate of 6%? Does this bond trade at a discount, at par, or at a premium? Assume zero-coupon yields on default-free securities are as summarized in the following table: This bond trades at a premium since the coupon is greater than each of the zero coupon yields. ISM 2024 Bamberger 71 2.6 Exercise 2 Which of the following features would change the price and yields of a corporate bond? a) The bond is callable b) The bond is convertible into shares c) The bond is secured by a mortgage on real estate d) The bond is subordinated Price Yield Callable Decrease Increase Convertible Increase Decrease Mortgage bond Increase Decrease Subordinated bond Decrease Increase ISM 2024 Bamberger 72 2.6 Exercise 3 Your firm has a credit rating of AA. You notice that the credit spread for 10-year maturity AA debt is 90 basis points (0.90%). Your firm’s ten-year debt has a coupon rate of 5%. You see that new ten-year Treasury notes are being issued at par with a coupon rate of 4.5%. What should the price of your outstanding ten-year bonds be (semiannual interest payments)? If the credit spread is 90 basis points, then the yield to maturity (YTM) on your debt should be the YTM on similar Treasuries plus 0.9%. The fact that new ten-year Treasuries are being issued at par with coupons of 4.5% means that with a coupon rate of 4.5%, these notes are selling for $100 per $100 face value. Thus, their YTM is 4.5% and your debt’s YTM should be 5.4%. The cash flows on your bonds are $5 per year for every $100 face value, paid as $2.50 every six months. The six-month rate corresponding to a 5.4% yield is 2.7%. Your bonds offer a higher coupon (5% vs. 4.5%) than Treasuries of the same maturity, but sell for a lower price ($96.94 vs. $100). The reason is the credit spread. Your firm’s higher probability of default leads investors to demand a higher YTM on your debt. To provide a higher YTM, the purchase price for the debt must be lower. ISM 2024 Bamberger 73 2.6 Exercise 4 Consider a four-year, default-free security with annual coupon payments and a face value of $1000 that is issued at par. What is the coupon rate of this bond? Assume zero-coupon yields on default-free securities are as summarized in the following table: Solve Solvethe thefollowing followingequation: equation:  1 1 1 1  1000 1000  CPN        (1 .04) (1 .043) (1 .045) (1 .047)  (1 .047) 2 3 4 4 CPN  $46.76. Therefore, the par coupon rate is 4.676%. Therefore, the par coupon rate is 4.676%. ISM 2024 Bamberger 74 2.6 Exercise 5 HMK Enterprises would like to raise $10 million. The company plans to issue five-year bonds with a face value of $1000 and a coupon rate of 6.5% (annual payments). a) Assuming the bonds will be rated AA, what will the price of the bonds be? b) How much total principal amount of these bonds must HMK issue to raise $10 million today, assuming the bonds are AA rated? c) What must the rating of the bonds be for them to sell at par? The following table summarizes the yield to maturity for five-year (annual-pay) coupon corporate bonds of various ratings: ISM 2024 Bamberger 75 2.6 Exercise 6 IBM has just issued a callable (at par) five-year, 8% coupon bond with annual coupon payments. The bond can be called at par in one year or anytime thereafter on a coupon payment date. It has a price of $103 per $100 face value, implying a yield to maturity of 7.26%. What is the bond’s yield to call? The yield to maturity is higher than the yield to call because it assumes that you will continue receiving your coupon payments for five years, even though interest rates have dropped below 8%. Under the yield to call assumptions, since you are repaid the face value sooner, you are deprived of the extra four years of coupon payments resulting in a lower total return. ISM 2024 Bamberger 76 2.6 Exercise 7 An 8%, five-year bond yields 6%. If the yield remains unchanged, what will be its price one year hence? Assume annual coupon payments. What is the total return to an investor who held the bond over this year and what can you deduce about the relationship between the bond return over a particular period and the yield to maturity at the start and the end of the period? End of Year 0 1 2 3 4 5 Cash flow 8 8 8 8 108 Discount Factor (@6%) 0,943 0,890 0,840 0,792 0,747 Present Values (PVs) 7,5 7,1 6,7 6,3 80,7 Total PVs (year 1-5) 108,4 = Bond Price at the beginning of year 1 Cash flow 8 8 8 108 Discount Factor (@6%) 0,943 0,890 0,840 0,792 Present Values (PVs) 7,5 7,1 6,7 85,5 Total PVs (year 2-4) 106,9 = Bond Price at the beginning of year 2 Purchase Bond -108,4 Coupon Payment 8,0 Sell Bond 106,9 Total return 6,5 Return (%) 6,0% ISM 2024 Bamberger 77 Corporate Finance 03 Hybrid Capital 3.1 Preferred Stock 3.2 Convertibles 3.3 Warrants 3.4 Mezzanine 3.5 Leasing 3.6 Factoring 3.7 Exercises ISM 2024 Bamberger 78 3.1 Preferred Stock Preferred stock is a hybrid - similar to bonds in some respects and to common stock in other ways. Accountants classify perpetual preferred stock as equity, however, it imposes a fixed charge and thus increases the firm’s financial leverage, yet omitting the preferred dividend does not force a company into bankruptcy. The dividend was set when the stock was issued; it will not be changed in the future. If the preferred dividend is not earned, the company does not have to pay it. However, most preferred issues are cumulative, meaning that the cumulative total of all unpaid preferred dividends must be paid before dividends can be paid on the common stock. Unpaid preferred dividends are called arrearages. Preferred stock normally has no voting rights. For investors preferred stock is riskier than bonds: (1) Preferred stockholders’ claims are subordinated to those of bondholders in the event of liquidation, and (2) bondholders are more likely to continue receiving income during hard times than are preferred stockholders. Accordingly, investors require a higher after-tax rate of return on a given firm’s preferred stock than on its bonds. Brigham: Chapter 20 ISM 2024 Bamberger 79 3.1 Preferred Stock Advantages: The obligation to pay preferred dividends is not contractual, and passing a preferred dividend cannot force a firm into bankruptcy. By issuing preferred stock, the firm avoids the dilution of common equity that occurs when common stock is sold. Because preferred stock sometimes has no maturity, and because preferred sinking fund payments, if present, are typically spread over a long period, preferred issues reduce the cash flow drain from repayment of principal that occurs with debt issues. Disadvantages: Preferred stock dividends are not deductible to the issuer, hence the after-tax cost of preferred is typically higher than the after-tax cost of debt. Although preferred dividends can be passed, investors expect them to be paid, and firms intend to pay the dividends if conditions permit. Thus, preferred dividends are considered to be a fixed cost. Therefore, their use, like that of debt, increases financial risk and thus the cost of common equity. Brigham: Chapter 20 ISM 2024 Bamberger 80 3.2 Convertibles A security, usually a bond or preferred stock, that is exchangeable at the option of the holder for the common stock of the issuing firm. Conversion Ratio, CR, is the number of shares of common stock that are obtained by converting a convertible bond or share of convertible preferred stock. Conversion Price, Pc is the effective price paid for common stock obtained by converting a convertible security. Like a warrant’s exercise price, the conversion price is typically set at from 20 to 30 percent above the prevailing market price of the common stock at the time the convertible issue is sold. Generally, the conversion price and conversion ratio are fixed for the life of the bond, although sometimes a stepped-up conversion price is used. A change may also result from a clause protecting the convertible against dilution from stock splits, stock dividends, and the sale of common stock below the conversion price. Brigham: Chapter 20 ISM 2024 Bamberger 81 3.2 Convertibles At maturity, the value of a convertible bond is the maximum of the value of a $1000 straight bond (a non- convertible, non-callable bond) and 20 shares of stock, and it will be converted if the stock is above the conversion price. Prior to maturity, the value of the convertible bond will depend upon the likelihood of conversion, and will be above that of a straight bond or 20 shares of stock. This explains a convertible´s value relative to the stock price. But why issue convertibles? Berk: Chapter 15 ISM 2024 Bamberger 82 3.2 Convertibles - Conclusion Convertibles, like bonds with warrants, offer a company the chance to sell debt with a low interest rate in exchange for a chance to participate in the company’s success if it does well. However, the advantage of this low-cost debt will be lost when conversion occurs. In a sense, convertibles provide a way to sell common stock at prices higher than those currently prevailing. But if the stock greatly increases in price, the firm would probably find that it would have been better off, if it had used straight debt in spite of its higher cost and then later sold common stock and refunded the debt. If the company truly wants to raise equity capital, and if the price of the stock does not rise sufficiently after the bond is issued, then the company will be stuck with debt. A potential conflict of interest between bondholders and stockholders lies in an “option-related” incentive to take on projects with high upside potential and high risk. However, when convertible debt is issued some of the gains to shareholders have to be shared with convertible bondholders which reduces conflicts of interest. Brigham: Chapter 20 ISM 2024 Bamberger 83 3.3 Warrants A warrant is a certificate issued by a company that gives the holder the right to buy a stated number of shares of the company’s stock at a specified price for some specified length of time. Generally, warrants are distributed with debt, and they are used to induce investors to buy long-term debt with a lower coupon rate than would otherwise be required. There is a major difference between call options and warrants: When call options are exercised, the stock provided to the option holder comes from the secondary market, but when warrants are exercised, the stock provided to the warrant holders are newly issued shares. This means that the exercise of warrants dilutes the value of the original equity, which could cause the value of the original warrant to differ from the value of a similar call option. Therefore, investment bankers cannot use the Black-Scholes model to determine the value of warrants. Brigham: Chapter 20 ISM 2024 Bamberger 84 3.3 Warrants A second difference involves flexibility. Most convertible issues contain a call provision that allows the issuer either to refund the debt or to force conversion, depending on the relationship between the conversion value and call price. However, most warrants are not callable, so firms generally must wait until maturity for the warrants to generate new equity capital. Generally, maturities also differ between warrants and convertibles. Warrants typically have much shorter maturities than convertibles, and warrants typically expire before their accompanying debt matures. With convertibles, all of the debt is converted to common stock, whereas debt remains outstanding when warrants are exercised. Together, these facts suggest that debt-plus-warrant issuers are actually more interested in selling debt than in selling equity. In general, firms that issue debt with warrants are smaller and riskier than those that issue convertibles. One possible rationale is the difficulty investors have assessing the risk of small companies. Brigham: Chapter 20 ISM 2024 Bamberger 85 3.4 Mezzanine Capital Mezzanine financing is a hybrid of debt and equity financing that gives the lender the rights to convert to an ownership or equity interest in the company in case of default. It usually is completed with little due diligence on the part of the lender and little or no collateral on the part of the borrower, and treated like equity on a company's balance sheet. A typical interest rate for mezzanine financing is 12 to 20%, making it a high-risk, potentially high-return debt form. Mezzanine financing typically replaces part of the capital that equity investors would otherwise have to provide a company. Mezzanine financing may result in lenders gaining equity in a business or warrants for purchasing equity at a later date. This may significantly increase an investor's rate of return. In addition, mezzanine financing providers receive contractually obligated interest payments. Borrowers prefer mezzanine debt because the interest is tax-deductible. It is more manageable than other debt structures because some or all of the interest may be deferred. However, owners sacrifice control and upside potential and also pay more in interest the longer mezzanine financing is in effect. Investopedia.com ISM 2024 Bamberger 86  3.5 Leasing Leasing is a form of asset based lending, often seen as substitute for medium to long term credit. The owner of an asset provides the right to use of the asset (like motor vehicles, equipment or real estate) for a specified period of time in exchange for a series of payments. The lessors retain ownership of the assets they lease throughout the life of the contract, these leased assets are therefore an inherent form of collateral in such contracts. Leasing separates the legal ownership of an asset from its economic use. Ownership of the asset may or may not pass to the customer at the end of the lease contract. In “finance leases”, typically substantially all the risks and rewards of ownership of the asset are transferred to the lessee (while the lessor remains owner) “Operating leases” essentially are rental contracts for the temporary use of an asset by the lessee. Typically, the risks associated with the ownership of the asset (e.g. maintenance and insurance responsibilities) remain with the lessor. Note: IFRS 16 replaces the typical straight-line operating lease expense for those leases applying IAS 17 with a depreciation charge for lease assets (included within operating costs) and an interest expense on lease liabilities (included within finance costs). This change aligns the lease expense treatment for both operating and finance leases. European Investment Fund ISM 2024 Bamberger 87  3.5 Leasing “Hire purchase” involves the transfer of ownership of the asset at the end of the contract, either automatically or through the exercise of a purchase option. These types of hire purchase contracts are therefore leases (i.e. in the UK, Germany, Poland and the Netherlands). However, in cases where ownership transfers at the beginning of the contract, these types of contracts are closer to an installment credit contract than a lease. Leasing is a very important source of financing for SMEs. The overall leasing market (new lease totals, all enterprise sizes) showed a continuous increase in recent years. European Investment Fund ISM 2024 Bamberger 88  3.6 Factoring Factoring is a financial transaction and a type of debtor finance in which a business sells its accounts receivable to a third party (called a factor) at a discount. It is commonly referred to as accounts receivable factoring, invoice factoring, and sometimes accounts receivable financing. From a user’s perspective, one of the main advantages of factoring is that users do not need to have other assets or be in business for a long time to access credit. The relative ease of attracting funding from factors and the “lightness” of their contracts has attracted more users in the aftermath of the financial crisis, as lending standards of commercial banks tightened in many countries. The factoring facility naturally grows with sales and is revolving and renewable without renegotiations. The factor can also provide ledger management, collection services and credit advice (and insurance, if required) as an integral, holistic approach to their cash flow management. Factoring allows for a partial diversification of a company´s funding sources. OECD ISM 2024 Bamberger 89  3.6 Factoring The vast majority of global users of factoring are small and medium sized enterprises. Factoring has been growing relatively fast in recent years in contrast to other sources of finance (such as bank debt, venture capital, leasing). SMEs usually display diverse customer bases. Since the factor advances funds against the security of debts from them and not the SME itself, factoring therefore takes advantage of a better distributed spread of risk than loans. In case of default, recovery is made from the debtors, not the SME, so the factor is well placed to advance (and recover) securely. Factoring includes a value added service beyond the provision of funding. It therefore attracts a premium price over traditional lending and consequently has higher potential returns on equity and assets. OECD ISM 2024 Bamberger 90 3.7 Exercise 8 Piglet Pies has issued a zero-coupon 10-year bond that can be converted into 10 Piglet shares. Comparable straight bonds are yielding 8%. Piglet stock is priced at $50 a share. a. Suppose that you had to make a now-or-never decision on whether to convert or to stay with the bond. Which would you do? b. If the convertible bond is priced at $550, how much are investors paying for the option to buy Piglet shares? c. If after one year the value of the conversion option is unchanged, what is the value of the convertible bond? a. If the fair rate of return on a 10-year zero-coupon non-convertible bond is 8%, then the price would be: $1,000/1.0810 = $463.19 The conversion value is: 10 * $50 = $500 By converting, you would gain: $500 – $463.19 = $36.81 That is, you could convert, sell the ten shares for $500, and then buy a comparable straight bond for $463.19. Otherwise, if you do not convert, and the bond is no longer convertible in the future, you will own a non-convertible Piglet bond worth $463.19 b. Investors are paying ($550.00 – $463.19) = $86.81 for the option to buy ten shares. c. In one year, bond value = $1,000/1.089 = $500.25 (i.e., the value of a comparable non-convertible bond) Then the value of the convertible bond is: $500.25 + $86.81 = $587.06 ISM 2024 Bamberger 91 3.7 Exercise 9 A company recently introduced two types of bonds. The first issue consisted of 10- year straight debt with a 6% annual coupon. The second issue consisted of 10-year bonds with a 4.5% annual coupon and attached warrants. Both issues sold at their $1,000 par values. What is the implied value of the warrants attached to the second bond? Straight Warrant Debt Attached Warrant Coupon: 6% 4,5% Par: 1000 1000 maturity in yrs 10 10 YTM 6% 6% PV of Coupons: $ 441,61 $ 331,20 PV of Face Value $ 558,39 $ 558,39 Total $1.000,00 $ 889,60 $ 110,40 ISM 2024 Bamberger 92 3.7 Exercise 10 Fill in the blanks, using the following terms: floating rate, common stock, convertible, subordinated, preferred stock, senior, warrant. If a lender ranks behind the firm’s general creditors in the event of default, his or her loan is said to be _______. Interest on many bank loans is based on a _______ of interest. A(n) _______ bond can be exchanged for shares of the issuing corporation. A(n) _______ gives its owner the right to buy shares in the issuing company at a predetermined price. Dividends on _______ cannot be paid unless the firm has also paid any dividends on its _______. If a lender ranks behind the firm’s general creditors in the event of default, his or her loan is said to be subordinated. Interest on many bank loans is based on a floating rate of interest. A convertible bond can be exchanged for shares of the issuing corporation. A warrant gives its owner the right to buy shares in the issuing company at a predetermined price. Dividends on common stock cannot be paid unless the firm has also paid any dividends on its preferred stock. ISM 2024 Bamberger 93 3.7 Exercise 11 What is the difference between pledging accounts receivable to secure a loan and factoring accounts receivable? When accounts receivable are pledged, the borrowing firm is simply using its accounts receivable as collateral for a loan. The lender reviews the invoices for the credit sales of the borrower and determines which accounts are acceptable collateral. The lender will then lend some percentage of the dollar amount of the accepted invoices. If one or more of the borrowing firm’s customers fail to pay, the firm is still responsible to the lender for the money it has borrowed. In a factoring arrangement, the accounts receivable are sold to the lender (i.e., factor), and the firm’s customers typically make their payments directly to the lender. The lender agrees to pay the borrowing firm the amount due from the firm’s customers at the end of the firm’s payment period, but the firm may borrow a certain percentage of the face value of its receivables in order to receive the money in advance. The factoring arrangement may be “with recourse,” which means that if any of the borrowing firm’s customers defaults on its bills, the factor can require the borrowing firm to make the payment. It may also be “without recourse,” in which case the lender bears the risk that one or more customers will default on their bills. The borrowing firm is not responsible for the payments. ISM 2024 Bamberger 94 Corporate Finance 04 Equity 4.1 Stocks 4.2 Raising Equity Capital 4.3 Payout Policy 4.4 Cost of Equity 4.5 Exercises ISM 2024 Bamberger 95 4.0 Equity - Definitions The value of a company which is the property of its ordinary shareholders, or a company's capital which is invested by shareholders, who thus become owners of the company shareholders equity. BusinessDictionary.com. WebFinance, Inc. http://www.businessdictionary.com/definition/shareholders-equity.html (accessed: February 26, 2017). Ordinary shareholders' funds, that is, their ordinary share capital subscribed plus any reserves or ploughed-back profit. Alternatively, equity can be regarded as what would be left to the ordinary shareholders of a company after all the company's debts and liabilities have been met. Financial Glossary. S.v. "equity." Retrieved March 1 2017 from http://financial-dictionary.thefreedictionary.com/Equity. Equity is the residual of recognized assets minus recognized liabilities. It may be subclassified into funds contributed by shareholders, retained earning and gains and losses recognized directly in equity. International Financial Reporting Standards: IFRS for SMEs, Pervasive Principles ISM 2024 Bamberger 96 4.1 Stocks – Mini Case Standard Oil William and John D Rockefeller – What are their roles at Standard Oil? ISM 2024 Bamberger 97 4.1 Stocks – Mini Case Standard Oil What´s different here? ISM 2024 Bamberger 98 4.1 Stocks – Mini Case Standard Oil Suppose, this is how it all started, Johnny had a grand vision – we´re founding an oil company… ISM 2024 Bamberger 99 4.1 Stocks – Mini Case Standard Oil First year was tough, exploration and drilling is expensive. No oil so far, but at least Standard Oil hasn´t run out of money – yet. ISM 2024 Bamberger 100 4.1 Stocks – Mini Case Standard Oil thereof $1 mil. Bonus goes to Johnny! Second year: Great success, found oil! By year end, it has pumped and sold oil for $ 6.5 mil. Now Willy wants to sell his shares to Hardy, but what´s a fair price? ISM 2024 Bamberger 101 4.1 Stocks – Mini Case Standard Oil Value Indication based on Gordon Growth Formula: Value = Dividends / ( WACC – growth rate ) $129 / ( 25% - 5% ) = $643 / share $129 / ( 25% - 15% ) = $1.286 / share Willy wants at least $643 per share and Hardy istn´t going to pay more than $1.286. What´s a fair price? ISM 2024 Bamberger 102 4.1 Stocks – Mini Case Standard Oil Willy $100 $200 $300 $400 $500 $600 $700 $800 $900 $1.000 $1.100 $1.200 $1.300 $1.400 $1.500 $1.600 $1.700 $1.800 $1.900 $2.000 Hardy Willy and Hardy agree on $1.000 per share. This is the price at which the shares are exchanged and, therefore, its fair market value. Note: Hardy paid a substantial premium on SOC´s book equity per share ($200). Many years and several mergers later, Standard Oil evolved into Exxon Mobil, a publicly listed corporation. ISM 2024 Bamberger 103 4.1 Stocks – Mini Case Standard Oil Standard Ask Price Bid Oil Corp. Volume per Share Volume $500,00 300 Investor A $850,00 1.000 Investor B $975,00 100 Investor C Willy 250 $1.000,00 250 Hardy Shareholder X 3.000 $1.150,00 Shareholder Y 1.000 $1.500,00 Shareholder Z 3.500 $3.000,00 Trading in SOC stock was a tedious process. Nowadays, shares of listed companies are exchanged in organized markets and prices are set based on supply and demand. ISM 2024 Bamberger 104 4.1 Stocks – Mini Case Standard Oil Stock prices result from a great number of stock transactions which often are depicted in charts and tables. What do the numbers above tell you? https://finance.yahoo.com/quote/XOM/ ISM 2024 Bamberger 105 4.1 Stocks Ownership in a corporation is divided into shares of stock. These shares carry rights to share in the profits of the firm through future dividend payments. The shares also come with rights to vote to elect directors and decide on other important matters. Some firms issue preferred stock, which has preference over common stock in the payment of dividends and in liquidation, but typically carries no voting rights. The Valuation Principle states that the value of a stock is equal to the present value of the dividends and future sale price the investor will receive. The value of a stock is driven by dividends and future sale price? Always? Berk: Chapter 7 ISM 2024 Bamberger 106 4.1 Stock Price and Dividends Today´s share price is driven by dividends, expected returns and tomorrow´s share price. Tomorrow´s share price is driven by … Brealey: Chapter 4 ISM 2024 Bamberger 107 4.1 Stock Price and Dividends Price one year hence: General Stock Price Formula: Long-term investors almost exclusively care about dividends. Why? Brealey: Chapter 4 ISM 2024 Bamberger 108 4.1 Stock Price and Dividends What if dividends are growing at a constant rate? Remember Gordon Growth Formula? Brealey: Chapter 4 ISM 2024 Bamberger 109 4.1 Stock price and dividend growth The constant dividend growth model assumes that dividends grow at a constant expected rate, g. If all increases in future earnings result exclusively from new investments made with retained earnings (money plowed back into the business), then earnings growth can be found as plowback ratio multiplied by return on investment. The dividend-discount model is sensitive to the dividend growth rate, which is difficult to estimate accurately and it is not practical for valuing the majority of stocks not (yet) paying dividends. If the firm undertakes share repurchases, it is more reliable to use the total payout model (present value of future total dividends and repurchases) to value the firm. Note: The growth rate of the firm’s total payout is governed by the growth rate of earnings, not earnings per share. How do we calculate stock prices? Berk: Chapter 9 ISM 2024 Bamberger 110 4.1 Stock price and dividend growth Be careful, these formulae only work if the company has reached „steady state growth“. Brealey: Chapter 4 ISM 2024 Bamberger 111 4.1 Stock Price - Example Suppose steady state growth is reached in year 4. What is a fair price for one share of this company today (10% discount rate)? Brealey: Chapter 4 ISM 2024 Bamberger 112 4.2 Raising Equity Capital - Private Companies The initial capital that is required to start a business is usually provided by the entrepreneur and the immediate family. Other investors are: Angel Investors; Individual Investors who buy equity in small private firms Venture Capital Firms; A limited partnership that specializes in raising money to invest in the private equity of young firms Private Equity Firms; Organized very much like a venture capital firm, but it invests in the equity of existing privately held firms rather than start-up companies. Institutional investors; Such as pension funds, insurance companies, endowments, and foundations, may invest directly in private firms or they may invest indirectly by becoming limited partners in venture capital firms A corporation that invests in private companies; Also known as corporate partner, strategic partner, and strategic investor might invest for corporate strategic objectives, in addition to the financial returns. How do you take a company public? Berk: Chapter 14 ISM 2024 Bamberger 113 4.2 Raising Equity Capital - Public Markets An initial public offering (IPO) is the first time a company sells its stock to the public. The main advantages of going public are greater liquidity and better access to capital. Disadvantages include regulatory and financial reporting requirements and the undermining of the investors’ ability to monitor the company’s management. During an IPO, the shares sold may represent either a primary offering (if the shares are being sold to raise new capital) or a secondary offering (if the shares are sold by earlier investors). An underwriter is an investment bank that manages the IPO process and helps the company sell its stock. The SEC requires that a company file a registration statement prior to an IPO. The preliminary prospectus is part of the registration statement that circulates to investors before the stock is offered. Underwriters value a company before an IPO using valuation techniques and by book building. Stock may be sold during an IPO on a best-efforts basis, as a firm commitment IPO, or using an auction IPO. How does IPO pricing work? Berk: Chapter 14 ISM 2024 Bamberger 114 4.2 Raising Equity Capital - IPO Berk: Chapter 23 ISM 2024 Bamberger 115 4.2 Raising Equity Capital - IPO Next step: During the road show, when a company’s senior management and its underwriters travel around promoting the company and explaining their rationale for an offer price to the underwriters’ largest customers, mainly institutional investors such as mutual funds and pension funds. These investors subsequently express their interest in the IPO by placing orders at various prices. How do we get from this initial price range to the final IPO price? Berk: Chapter 23 ISM 2024 Bamberger 116 4.2 Raising Equity Capital - IPO Berk: Chapter 23 ISM 2024 Bamberger 117 4.2 Raising Equity Capital - IPO Berk: Chapter 23 ISM 2024 Bamberger 118 4.2 Raising Equity Capital – IPO Puzzles On average, IPOs appear to be underpriced: The price at the end of trading on the first day is often substantially higher than the IPO price. The number of IPOs is highly cyclical. When times are good, the market is flooded with IPOs; when times are bad, the number of IPOs dries up. The transac