Chapter 6 Finance

Control of the Firm (Voting Rights) (pg.91)-

-Debt holders do not own the company; thus, they have no voting rights -Debt contracts can be written to allow for other types of control

Common Long-Term Debt Instruments (pg.93-95)

-Term Loan: A loan, generally obtained from a bank or insurance company, on which the borrower agrees to make a series of payments consisting of interest and principal. ~They are often referred to as *private debt* ~Although term loans' maturities vary from two years to 30 years, most maturities are in the three---to 15-year range. ~Term loans have 3 major advantages over public debt offerings such as corporate bonds: Speed Flexibility Low Issuance Costs -Bonds: A long-term (debt instrument) contract under which a borrower (issuer) agrees to make payments of interest and principal on specific dates to the bondholder (investor). (pg.93) ~The interest laments are determined by the **coupon rate,**which represents the oral interest paid each year, stated as the bond's face (maturity) value. -Coupon Rate: Interest paid on abound or other debt instrument stated as a percentage of its face (maturity) value. -Typically, interest is paid semiannually, although bonds that pay interest annually, quarterly, and monthly also exist, and the principal amount is generally paid in lump-sum amount at the end of the bond's life (maturity date).

Common Short-Term Debt Instruments (pg.91-93)

-Treasury Bills (T-Bills): Discounted debt instruments issued by the U.S. government to finance its operations and programs. ~Maturities that range from a few days to 52 weeks at the time of issue. ~T-bills are issued electrically with face values ranging from $1,000 to $5 million. -Repurchase Agreements (Repos): (pg.92) An arrangement where one firm sells some its financial assets to another firm with a promise to *repurchase* the securities at a later date. ~Although some repos last for days or even weeks, most repos last only a few hours, which means they are essentially overnight agreements. -Federal Funds (Fed Funds): (pg.92) Overnight loans from one bank to another. -Banker's Acceptance: (pg.92) An instrument issued by a bank that obligates the bank to pay a specified amount at some future date. -Commercial Paper: (pg.92) A discounted instrument that is a type of promissory note, or "legal" IOU, issued by large, financially sound firms. ~The maturity on commercial paper varies from one to nine months, with an average of about five months. ~Generally, commercial paper is issued in denominations of $100,000 or more, so few individuals can afford to directly invest in the commercial paper market. -Certificates of Deposit (CDs): (pg.92) An interest-earning time deposit at a bank or other financial intermediary. ~Wheres with a savings account you can deposit and withdraw funds relatively freely, with a CD you agree to keep the money there for a set period of time, called the "term length." ~To liquidate a traditional CD prior to maturity, the owner must return it to the issuing institution, which normally applies an interest penalty (lower interest) to the amount paid out. ~*Negotiable CDs,* however, can be traded to other investors prior to maturity b/c they can be redeemed by whoever owns them at maturity. ~*Jumbo CDs,* these investments typically are issued in denominations of $1 million to $5 million, they have maturities that range from a fees months to a few years. -Eurodollar Deposits: Is a deposit i a bank outside the United States that is not converted into the currency of the foreign country, instead, it is denominated in U.S. Dollars (pg.92) -Money Market Mutual Funds: Pools of funds managed by investment companies that are primarily invested in shirt-term financial assets (pg.92). ~These funds offer individual investors the ability to indirectly invest in such short-term securities as T-bills, commercial paper, and Eurodollars, which they otherwise would not be able to purchase because such investments either are sold in denominations that are too large or are not available to individual investors (pg.92-93).

How do bonds work? (slide show 1.1-9)

-When a firm borrows money by issuing bonds, the firm is borrowing relatively smaller amounts of money from each of many investors/lenders -This makes bond issues much more complex and expensive than term loans, but allows for greater sums to be borrowed -Typically, interest is paid twice yearly and the principal is repaid in a lump sum at maturity

How do loans work? (slide show 1.1-8)

-When a firm borrows money via a term loan, the firm is borrowing directly from one or a few banks -This makes term loans quick, flexible and inexpensive (relative to bonds) -Typically, interest and principal are paid monthly

Common Bonds Issued By Both Government's and Corporations (pg.93-95)

1.) -Government Bonds: Debt issued by a federal, state, or local government (pg.93). ~U.S. government bonds are issued by the U.S. Treasury and are called either *Treasury Notes* or *Treasury Bonds.* Both types pay interest semiannually. -Treasury Bills: short-term [1.1-6] -Treasury Notes & Treasury Bonds: long-term [1.1-6] ~Federal Debt: Considered to be default-free [1.1-6] -Municipal Bonds: Bonds issued by a state or local (city) government (pg.93) ~The 2 Principal Types of munis are REVENUE BONDS and GENERAL OBLIGATION BONDS. -revenue-generating projects, or -General Obligations to the citizenry 2.) -Corporate Bonds: Long-term debt instruments issued by corporations (pg.94) ~Are generally advertised, offered to the public, and sold to many different investors. ~The interest rate typically remains fixed, although the popularity of floating-rate bonds has grown during the past couple of decades. 3.) -Mortgage Bonds: A bond backed by tangible assets. First-mortgage bonds are senior in priority to second-mortgage bonds. 4.) -Debenture: A long-term bond that is not secured by a mortgage on specific property (pg.94). ~An unsecured bond; as such, it provides no lien (a legal right granted by the owner of property--> serves to guarantee an underlying obligation), or claim, against specific property as security for the obligation. -Subordinated Debenture: A bond which, in the event of liquidation, has a claim on assets only after the senior debt has been paid off (pg.94) ~An unsecured bond that ranks low, or is inferior to, other debt with respect to claims on cash distributions made by a firm. 4b.) Several other types of corporate bonds are used sufficiently often to merit mention. -Income Bonds: A bond that pays interest to the holder only if the interest is earned by the firm. ~Pay interest only when the firm generates sufficient income to cover the interest payments. -As a consequence, when income is insufficient, missing interest payments on these securities cannot bankrupt a company. From an investor's standpoint, these bonds are riskier than bonds that require fixed interest payments. -Putable Bonds: A bond that can be redeemed at the bondholder's option when certain circumstances exist. ~Bonds that can be turned in to the firm prior to maturity in exchange for cash at the bondholder's option if the firm takes some specified action--- for example, if the firm is acquired by a weaker company or its outstanding debt increases substantially. -Indexed (Purchasing Power) Bonds: A bond that has interest payments based on an inflation index to protect the holder from loss of purchasing power (pg.94) ~Pay interest based on an inflation index, such as the consumer prices index (CPI). The interest paid rises automatically when the inflation rate rises, thereby protecting bondholders against inflation. -Floating-Rate Bonds: A bond whose interest rate fluctuates with shifts in the general level of interest rates (pg.94) ~Are similar to indexed bonds except the coupon rates on these bonds float with market interest rates rather than with the inflation rate. ~When interest rates rise, the coupon rates increase, and vice versa. ~In many cases, limits are imposed on how high and low rates on such debt can go (referred to as caps and collars, relatively). 5.) Zero Coupon Bonds (OIDs--> Original i\Issue Discount Bonds)(1980s): A bond that pays no annual interest but sells at a discount below par, thus providing compensation to investors in the form of capital appreciation (is an increase in the price or value of assets) (pg.94-95). ~For this reason, most OID bonds currently are held by institutional investors, such as pension funds and mutual funds, rather than by individual investors. 6.) Junk Bonds: A high-risk, high-yield bond; used to finance mergers, leveraged (management) buyouts, and troubled companies. ~In junk deals, firms generally have significant amounts of debt, so bondholders must bear as much risk as stockholders normally would. The high yield (the income return on an investment) on these bonds reflect this fact.

Indenture (pg.95)

A formal agreement (contract) between the issuer of abound and the bondholders. -A document that spells out the legalities of the bond issue, including any features or legal restrictions associated with the bond and the rights of the bondholders (lenders) and the corporation (bond issuer). ~A *trustee,* usually a bank, is assigned to represent the bondholders and to guarantee that the terms of the indenture are carried out. -The indenture, which could be several hundred pages long, includes *restrictive covenants* that cover such points as the conditions under which the issuer can off the bonds prior to maturity, the levels at which various financial measures (such as the ability to pay interest) must be maintained if the company is to sell additional bonds, and restrictions on the payment of dividends to stockholders when earnings do not meet certain specifications.

Call Provision (pg.95)

A provision (condition) in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal maturity date. -Most corporate bonds contain a call provision, which gives the issuing firm the right to "call in" the bonds for redemption (paying off) prior to maturity. ~A call provision generally states that the company must pay the bondholders an amount greater than the bond's par value when it is called. -This additional amount, which is termed a *call premium,* typically equals one year's interest if the bond is called during the first year in which a call is permitted; the premium declines at a constant rate each year thereafter. -Bonds usually are not callable until 7 years (generally 5 to 10) after they are issued; bonds with such *deferred calls* are said to have a *call protection.* Call provisions allo firms to refinance debt, much as individuals might refinance mortgage on their houses: when interest rates decline, firms can *recall* (refund) high-cost debt that is outstanding and replace it with new, lower-cost debt.

Sinking Fund (pg.95)

A required annual lament designed to amortize (reduce) a bond issue. -A provision (condition) that facilitates the orderly retirement of a bond issue. Typically, the sinking fund provision requires the firm to retire a portion of the bond issue each year. ~Often the firm has the right to handle the sinking fund in two ways: by randomly calling for redemption (at par value) a certain percentage of the bonds in the open market. The firm will choose the lower-cost method. -A sinking fund call does not require the company to pay a call premium, but only a small percentage of the issue is normally callable in any one year.

6-2b Importance of Bond Ratings (pg.97-98)

Bond ratings are important to both issuers and investors for several reasons. ~First b/c a bond's rating serves as an indicator of its default risk, the rating has a direct, measurable influence on the bond's interest rate and the firm's cost of using such debt. -The greater a bond's default risk, the rester the *default risk premium (DRP)* associated with the bond. ~Second, most bonds are purchased by institutional investors rather than individuals, and many institutions are restricted to *investment-grade,* or high-quality, securities. As a result of their higher risk and more restricted market, lower-grade bonds offer higher returns then high-grade bond. Least amount of risk ----> High amount of risk: -U.S. Government Bonds -AAA-rated corporate bonds -BBB-rated corporate bonds

6-2c Changes in Ratings (pg.98)

Changes in a firm's bond rating affect both its ability to borrow long-term capital and the cost of such funds. ~Firms that had their credit ratings downgraded discovered that their costs of raising funds in the financial markets increased b/c their bankruptcy risks were perceived by investors to be higher than they were prior to to the downgrades.

Priority to Assets and Earnings (pg.91)-

Corporate debt holders have priority over stockholders with regard to distribution of earnings and liquidations of assets; that is, they must be paid before any stockholders can be paid. -To subordinate a debt means to place it further back in the priority line. ~Senior debt is required before junior debt ~Superior debt is required before subordinate debt

Debt (pg.91)

Is a loan to a firm, a government, or an individual. Examples of Debt Instruments: -home mortgages -commercial paper -bonds -unsecured notes Often, we identify debt by describing three of its features: the principal amount that must be paid, the interest payments, and the time to maturity.

Conversion Feature (pg.95)

Permits bondholders to exchanger their investments for a fixed number of shares of common stock. -Permits the bondholder (investor) to exchange, or *convert,* the bond into shares of the company's common stock at a fixed price. ~Investors have greater flexibility with a *convertible bond* then with a straight (regular) bond because they can choose whether to hold the company's bond or convert the bond into its stock. -Once the conversion is made,investors cannot convert back to bonds. *Conversion Ratio*--> which is defined as the number of shares of stock that the bondholder receives upon conversion. *Conversion Price*--> the price that is effectively paid for the common stock obtained by converting a bond into stock.

LONG-TERM DEBT (pg.93-95)

Refers to debt instruments with maturities greater than one year.

SHORT-TERM DEBT (pg.91)

Refers to debt instruments with original maturities of one year or less.

Maturity Date (pg.91)

Represents the date in which the principal amount of debt is due. As long as interest has been paid when due, once the total principal amount is repaid, the debt obligation has been satisfied. *Installment Loans*: (a debt instrument) require the principal amounts to be repaid in several payments during the lives of the loans. ~In such cases, the maturity date is the date the sat installment payment is due.

Discounted Securities (pg.91)

Securities selling for less than par value.

6-2a Bond Rating Criteria (pg.96-97)

The 2 Major rating agencies are Moody's Investors Service (Moody's) and Standard & Poor's Corporation (S&P)(pg.96). Bond ratings are based on both qualitative and quantitative factors. ~Factors considered by the bond rating agencies include the financial strength of the company -There is no precise formula that is used to set a firm's rating; all factors listed, plus others, are taken into account, but not in a mathematically precise manner.

Principal Value* (pg.91)

The amount owed to the lender, which must be repaid at some pint during the life of the debt. -For much of the debt issued by corporations, the principal amount is repaid at the maturity date. ~Consequently, we also refer to the principal value as the *maturity value.* (pg.91) ~In addition, the principal value generally is written on the face, or outside cover, of the debt contract, so it is sometimes called the *face value.* For most debt, therefore, the terms *par value,* *face value,* *maturity vale,*and *principal value* are interchangeably to designate the borrowed amount that must be repaid by the borrower.

TYPES OF DEBT (pg.91)

Whereas most long-term debt instruments pay interest, most short-term debt instruments do not; rather they are sold as discounted securities when issued, so that the difference between their purchases prices and maturity values represent the dollar returns earned by investors.