Corporate finance class 3 ch 7
Examples of positive convenants include
the requirement to use proceeds of an issue for certain uses or to maintain certain amounts to meet future principal payments.
There is no ___ market for bonds. They are traded ---.
There is no centralized market for bonds. They are traded over the market (OTC).
Face value
(par value or principal value) is the amount repaid at maturity;
*bullet
*bullet: due at the end term for debt. Vs the bond form which is amortized
- Interest Expense: tax
- Interest Expense: tax deductible.
Nominal rate
1+R= (1+r) x (1+h) R nominal r real h inflation
• In case of liquidation, the procedure is as follows: (1) (2) (3)
1. Pledged assets: senior secured debt has priority over junior secured debt, which has priority over unsecured debt. 2. Unpledged asset: senior secured debt has priority over junior secured debt and unsecured debt, junior secured debt and unsecured debt share proceeds from remaining assets (pro- rata). 3. Subordinated debt gets whatever remains.
Stripped bond or zero coupon bond
A bond that makes no coupon payments, thus initially priced at a deep discount
Liquidation rights on Security A firm may issue secured ( _______ ) and unsecured debt ( _________ ).
A firm may issue secured (bond) and unsecured debt (debenture).
Sinking fund
Account managed by the bond trustee for early bond redemption
Why issue debt? Advanteges
Advantages to the firm: o Fixed claim leaving upside to shareholders o Interest deductibility o Fiscal transfer mechanism (intercompany loans, blocker corporation)
Call position
Agreement giving the corporation an option to re-purchase the barn at a specified price before maturity
Call provision
Agreement giving the corporation the option to re-purchase the bond at a specified price before maturity
Call premium
Amount by which the call price exceeds the par value of the bond
Liquidation rights on Security Asset(s) pledged by the firm to certain
Asset(s) pledged by the firm to certain debt issues or certain classes of debtholders.
Bankruptcy is a means to _____value based on the premise that a ____ is worth more than the liquidation value. In the case of businesses, the whole is often greater than the ____ .
Bankruptcy is a means to maximize value based on the premise that a going concern is worth more than the liquidation value. In the case of businesses, the whole is often greater than the sum of the parts
Call protected
Behind during period in which cannot be redeemed by the issuer
Bearer form
Bond issue without record of the owners name, payment is made to whoever holds the bond.
Differed call
Call provision prohibiting the company from redeeming the bond before a certain date
Canada plus call
Call provision that compensates barn investors for interest differential, making it an attractive for and if you were to call bond
Debt characteristics - principal rights Characteristics: (3)
Characteristics: • Liability: failure to pay triggers default. • Inflexible: pre-specified amount according to a repayment schedule. • Not an expense: not tax deductible.
What are the advantages of a private workout?
Default does not automatically imply liquidation: reorganization usually results in a loss for face value of debt for creditors
Bankruptcy - end game A: reorganization approved by creditors: and the Rights are reallocated amongst stakeholders with new securities issued:
Equity holders are nearly or totally wiped out; • Debtholders receive may see a portion of the debt cancelled and receive a mix of debt and equity; • Fulcrum security holders receive mix of repayment, new debt and post reorganization equity (post reorg equity).
Examples include restrictions on financial decisions
Examples include restrictions on financial decisions (debt issuance, dividend payments, asset pledges, asset sales), operational decisions (investments, acquisitions, dispositions) and the respect of financial metrics (respect of solvency ratios).
Bankruptcy - end game A: reorganization approved by creditors:
Firm emerges from bankruptcy and Rights are reallocated amongst stakeholders with new securities issued:
If debt A is senior to debt B and the firm defaults, This equivalent to saying that B-Debt.... or ... to Debt A.
If debt A is senior to debt B and the firm defaults, ---> holders of A- debt must be paid off (face value + accrued interest) from the proceeds of the liquidation before B-debt holders may be compensated. This equivalent to saying that B-Debt is subordinated or junior to A-Debt.
In the case of default, creditors may demand
In the case of default, creditors may demand full repayment (face value + accrued interest).
Liquidation rights on Security In the case of default, secured debtholders may ...
In the case of default, secured debtholders may seize the security in proceeds from liquidation up to current face value of debt + accrued interest.
Insolvency: • Stock-based Insolvency: • Flow-based Insolvency:
Insolvency: • Stock-based Insolvency: net asset value < face value of debt • Flow-based Insolvency: operating cash flow < debt service costs (interests payments + principal repayments).
Nominal rates
Interest rates are rates of return that have not been adjusted for inflation
Real rates
Interest rates for rates of return that have been adjusted for inflation
Debt Markets are less ---(than equity). There is no ----.
Markets are less transparent. There is no global centralization of volume and prices.
Negative (restrictive) covenants are
Negative (restrictive) covenants are a requirement to prevent certain activities, unless agreed to by the bondholders.
Protective covenant
Part of the indenture limiting certain transactions that can be taken during the term of the loan, usually to protect the lenders interest
Positive covenants are a a promise to do
Positive covenants are a a promise to do something or to spend money.
Bankruptcy Procedures: (4)
Procedure: • Suspension of the firm financial obligations to creditors (automatic stay). • Interim financing provided to maintain operations: debtor-in- possession loan (DIP). • A trustee (most of the times the debtor) operates the business under court supervision. • The trustee proposes a reorganization plan to be approved by creditors.
How did the subprime crisis come about? What did the rating agencies get wrong?
Ratings are a crutch used by some investors and fiduciaries. Unfortunately, the crutch is not always foolproof.
Indenture Deed of trust
Reading agreement between the corporation and the lender detailing the terms of this debt issue.
Registered form
Register company reach records ownership of each bond. Payment is made directly to the owner of record
Debt Risks to the firm:
Risks to the firm: o Liability through interest payments and principal repayments o Potential end game if liability cannot be met ... failure to pay leads to default, which in turn can lead to restructuring or liquidation.
Seniority defines o Senior debt has ....
Seniority defines priority in case of default o Senior debt has priority over junior debt.
To the extent the debt indenture (contract) is respected, debtholders do not have any control over operational decisions. T/F
T
Fisher affect
The relationship between Nominal returns, real returns, and inflation
Unless otherwise specified, both classes ----- proceeds (---- of remaining face value) of unpledged assets.
Unless otherwise specified, both classes share proceeds (pro rata of remaining face value) of unpledged assets.
Note
Unsecured debt usually withmaturity under 10 years
Debentures
Unsecured debt, usually with maturity of 10 years or more
A debt issue represents a contract between______.
a creditor and a debtor
Liquidation rights protect debtholders should
a firm be incapable of meeting its liabilities.
debt security
debt securities are classified according to the collateral and mortgages used to protect the bondholder
Debt characteristics - principal rights Purpose: return of funds that
debtholders lent to the company for a an agreed amount of time.
- Liability: failure to pay triggers
default.
Should the issuer fail to meet its obligations listed in the indenture, (non payment of interest, principal, covenants), the issuer is said to be in
default.
Debt markets are much bigger than ---; a given company may have many separate bond issues with many issues not trading on a given day.
equity markets
Debt is a_____ claim on a firm.
fixed
Coupon
is the annual interest rate with payment contingent on the issue (usually annual or semiannual);
o Debtholders have a priority claim on ....
o Debtholders have a priority claim on assets ;
o Debtholders' claim is par (face value) +....
o Debtholders' claim is par (face value) + accrued interest;
o To the extent that assets are insufficient to meet total amounts owing, securities and seniorities ....
o To the extent that assets are insufficient to meet total amounts owing, securities and seniorities dictate how the proceeds of a restructuring or liquidation are split.
• Zero-coupon bonds accrue to
par over time.
Bankruptcy - advantages (4)
• Bankruptcy is a great innovation as it allows good companies with bad balance sheets to continue to operate. • It provides for the ability to contract new loans (DIP) by providing absolute seniority; • It provides temporary relief from obligations to creditors; • It provides a means to right-size a business by revisiting contracts (leases, union agreements, pension obligations);
• Covenants are a means to
• Covenants are a means to control a company.
Bankruptcy reorganization is not approved
• Firm enters liquidation (Chapter 7 in US and Bankruptcy and Insolvency Act in Canada). • Priority rules apply.
Term structure of interest rates (4)
• Real rate • Inflation premium • Interest rate risk premium • Credit risk premium
Resolutions to insolvency
• Voluntary restructuring: private workout between a debtor and creditors • Bankruptcy: petition that can be filed by the debtor or the creditors, which leads to one of two outcomes: o reorganization o liquidation
Bankruptcy: legal procedure that leads to
• reorganization, • or liquidation.