Bond Contract Features & Debt vs Equity

Features of Financial Instruments Bonds Preferred Stock Common Stock Derivatives Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1 BONDS Princ...

Features of Financial Instruments Bonds Preferred Stock Common Stock Derivatives Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1 BONDS Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2 Bond Contract Features  Bond Indenture  Trustee  Restrictive covenant  Call provision  Sinking fund  call for redemption by annual lottery  buy bonds on the open market  Convertible Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 3 Bond Ratings  Moody’s Investors Service (Moody’s)  Standard & Poor’s Corporation (S&P)  Investment grade bonds  Triple B or better  Criteria for rating bonds  Importance of bond ratings  Changes in ratings Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 4 Bond Indenture Bond Indenture: A formal agreement (contract) between the issuer of a bond and the bondholders. Trustee: An Official who ensures that the bondholder’s interests are protected and that the terms of the indenture are carried out Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 5 Bond Features Restrictive Covenant: A provision in a debt contract that constrains the actions of the borrower Call Provision: A provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal maturity date. Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 6 Bond Features cont’d Sinking Fund: A required annual payment designed to amortize a bond (or preferred stock) issue. Conversion: Permits bondholders to exchange their investments for a fixed number of shares of common stock Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 7 Bond Ratings Based on both Qualitative and Quantitative factors:  Financial strength - measured by various ratios  Collateral provisions  Seniority of the debt  Restrictive covenants  Provisions such as Sinking Fund & Deferred Call  Regulations Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 8 Investment-grade Bond A bond rated BBB or greater; many banks and other institutional investors are permitted by law to hold only bonds rated investment grade or better. Bond ratings serve as an indicator of its default risk and has a direct measurable influence on the bond’s interest rate and the firm’s cost of borrowing Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 9 PREFERRED STOCK Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10 Preferred Stock Often referred to as a Hybrid Security, because:  It is similar to bonds in some respects  It is similar to stocks in some respects Like Bonds: has Par or Face Value has Fixed Dividend payments (like interest) NB: Failure to pay preferred stock dividend will not lead to bankruptcy Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11 Preferred Stock Features Priority to Assets and Earnings Cumulative Dividends Gives Voting Rights if not paid for a period Convertibility Par Value (a) amount due under liquidation (b) dividend stated as a percentage of Par Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 12 Preferred Stock: Other Provisions Participating: Sharing in the company’s earnings (after dividends) Sinking Fund: Requires the repurchase and retirement of a given percentage of the preferred stock each year Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 13 Preferred Stock: Other Provisions cont’d Call Provision: Gives the right to call in the preferred stock for redemption – at an amount greater than the Par value. Maturity: Most preferred stock has a Sinking Fund – which results in an effective maturity date with call provisions. Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 14 Preferred Stock: Other Provisions cont’d Call Premium: The amount in excess of Par value that a company must pay when it calls a security Cumulative Dividends: A protective feature on preferred stock that requires preferred dividends previously not paid to be accumulated and disbursed before any common stock dividends can be paid. Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 15 COMMON STOCK Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 16 Common Stock Features Owners of the business with certain rights, obligations, and privileges:  Hold the LEAST Priority to Assets and Earnings  Have No obligation to receive dividends  Have No specified maturity – perpetual  Retain control of the company and Voting Rights Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 17 Investments in Common Stock Income Stocks: Stocks of firms that traditionally pay large, relatively constant dividends each year. Growth Stocks: Stocks that generally pay little or no dividends so the company can retain earnings to fund growth opportunities. Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 18 Features of Voting Rights Proxy: A document giving one person the authority to act for another, typically the power to vote – shares of common stock Proxy fight: An attempt by a person or group of people to gain control of a firm by getting its stockholders to grant that person or group the authority to vote using their shares, so as to change the management team. Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 19 Features of Voting Rights cont’d Takeover: An action whereby a person or group succeeds ibn ousting a firm’s management and taking control of the company. Preemptive right: A provision in the corporate charter or bylaws that gives common stockholders the right to purchase on a pro rata basis new issues of common stock (or convertible securities) to prevent dilution. Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 20 Types of Common Stock Classified Stock: Common stock that is given a special designation, such as Class A, Class B, and so forth, to meet special needs of the company or certain investors. Founders’ Shares: Stock owned by the company’s founders that have sole voting rights but generally pays out only restricted dividends for a specified number of years. Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 21 Types of Common Stock cont’d Closely held Corporation: A corporation that is owned by a few individuals who are typically associated with the company’s management. Publicly owned Corporation: A corporation that is owned by a relatively large number of individuals who are not actively involved in its management. Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 22 Derivatives  Value depends on some underlying asset such as a stock or bond  Option - contract that gives the right to buy or sell an asset at a set price within a specified period of time  Call: holder has the right to buy  Put: holder has the right to sell  Striking price: exercise price of the option Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 23 Derivatives  Convertibles - bonds or preferred stocks that can be exchanged for common stock at the option of the holder  Conversion ratio defines the number of shares of stock the convertible holder receives upon conversion  Futures - arrangement for delivery of an item at a set future date and at a set price Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 24 Derivatives Swaps - an agreement to exchange cash flows or assets at a set time in the future Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 25 Derivatives Hedge Funds- a private pool of funds constructed for the purpose of generating a specific range of returns, no matter what happens in the general stock market Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 26 Rationale for Using Different Types of Securities Differences in trade-off between risk and expected after tax return Appeal to broad market and different investment needs Different securities are popular during different economic conditions or at different times Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 27 Which Financial Instrument is Best? Issuer’s or investor’s viewpoint ? Bonds  fixed interest payments  does not represent ownership  may have restrictions on dividends  interest expense is deductible Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 28 Which Financial Instrument is Best? Preferred stock  fixed payment - but not obligated  no voting rights  higher after-tax cost since dividends are not deductible expenses Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 29 Which Financial Instrument is Best? Common Stock  no obligation of dividend payments  no maturity date for “repayment”  increases creditworthiness  prospects affect terms  gives control to stockholders  shares the income of the firm  higher costs of distribution than debt  dividends are not deductible Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 30 Risk & Returns on Different Classes of Financial Instruments Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 31 Financial Instruments in International Markets  American Depository Receipts (ADRs)  represent ownership in stocks of foreign countries that are held in trust by a bank located in the country the stock is traded  Foreign debt  sold by a foreign borrower but denominated in the currency of the country in which it is sold Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 32 Financial Instruments in International Markets  Eurodebt  debt sold in a country other than the one in whose currency the debt is denominated  Eurobonds  Eurocredits: usually tied to London InterBank Offer Rate (LIBOR)  Euro-commercial paper (Euro-CP)  Euronotes Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 33 Financial Instruments in International Markets Equity instruments  Euro stock is traded in countries other than the “home” country of the company, not including the United States  Yankee stock is stock issued by foreign companies that is traded in the United States Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 34 Chapter Principles Key Financial Assets Concepts  Why are there so many different types of financial institutions?  Different investors have different risk/return tradeoff preferences  Firms can raise funds more easily if they offer the types of securities that investors want  What is debt? What types of debt exist?  A debt is a loan  Two classifications of debt are short-term and long-term Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 35 Chapter Principles Key Financial Assets Concepts  What are bond ratings and why are they important?  Bond ratings are based on both quantitative and qualitative factors; give an indication of the default risk associated with a bond  What is equity?  The value of the assets owned minus the amount of debt that is owed Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 36 Chapter Principles Key Financial Assets Concepts  What are derivatives?  Financial assets that have values based on the values of other assets such as stocks and bonds  What are some of the more familiar types of derivatives?  Options, futures, convertibles and swaps Principles of Finance 5e, Ch. 2 Financial Assets © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 37