Chapter 15

A Eurobond

is a bond issued in multiple countries but denominated in a single currency, usually the issuer's home currency.

A put bond

allows the holder to force the issuer to buy the bond back at a stated price.

Preemptive right

- The right to purchase new stock issued, so as to maintain proportionate ownership - Pre Existing stockholders have the first right to purchase the stock before public

Why would someone buy or see zero coupon rates attractive?

The buyer of the bond receives a return by the gradual appreciation of the security, which is redeemed at face value on a specified maturity date.

Information needed for valuing pure discount bonds:

Time to maturity (T) = Maturity date - today's date Face value (F) Discount rate (r)

Cumulative and Noncumulative Dividends

Usually, both the accumulated (past) preferred dividends and the current preferred dividends must be paid before the common shareholders can receive anything.

A call provision allows the company...

to repurchase, or "call," part or all of the bond issue at stated prices over a specific period. Corporate bonds are usually callable.

YTM

A bond's yield to maturity (YTM) is the estimated rate of return based on the assumption that it will be held until its maturity date and not called.

Collateral

Collateral is a general term that frequently means securities (e.g., bonds and stocks) that are pledged as security for payment of debt. For example, collateral trust bonds often involve a pledge of common stock held by the corporation. However, the term collateral is commonly used to refer to any asset pledged on a debt.

A debenture is

an unsecured bond for which no specific pledge of property is made. (In the United Kingdom, a debenture is a secured obligation.)

Foreign bonds

are issued in a single country and are usually denominated in that country's currency.

The coupon rate depends on ...

The risk characteristics of the bond when issued.

What is an indenture?

The written agreement between the corporation (the borrower) and its creditors. It is sometimes referred to as the deed of trust. **The bond indenture is a legal document. It can run several hundred pages and generally makes for very tedious reading. It is an important document, however, because it generally includes the following provisions: 1. The basic terms of the bonds. 2. A description of property used as security. 3. Seniority. 4. The repayment arrangements. 5. The call provisions. 6. Details of the protective covenants.

Zero Coupon Bonds Features

- Make no periodic interest payments (coupon rate = 0%) - In bond markets, rational bond buyers will not pay more than the present discounted value of the cash stream of the bond ***** - The entire yield to maturity comes from the difference between the purchase price and the par value - Cannot sell for more than par value - Sometimes called zeroes, deep discount bonds, or original issue discount bonds (OIDs) - Treasury Bills and principal-only Treasury strips are good examples of zeroes

Features of preferred stock (dividends):

- Stated dividend must be paid before dividends can be paid to common stockholders. - Dividends are not a liability of the firm, and preferred dividends can be deferred indefinitely. - Most preferred dividends are cumulative - any missed preferred dividends have to be paid before common dividends can be paid.

Voting Rights (Cumulative vs. Straight)

Cumulative: All votes on one share & increases the likelihood of minority shareholders getting a seat on the board (allow minority participation) Straight: Directors are elected one at a time, one share = one vote

The term note is generally used for such instruments if the maturity of the unsecured bond is

less than 10 or so years from the date when the bond was originally issued.

What is the role of a trust company in an indenture?

(1) make sure the terms of the indenture are obeyed, (2) manage the sinking fund (described in the following pages), and (3) represent the bondholders in default, that is, if the company defaults on its payments to them

Protective covenants can be classified into two types: negative covenants and positive (or affirmative) covenants.

- A negative covenant is a "thou shalt not" type of covenant. It limits or prohibits actions that the company might take. For example, the firm must limit the amount of divi- dends it pays according to some formula. - A positive covenant is a "thou shalt" type of covenant. It specifies an action that the company must take or a condition that the company must abide by. For example, the com- pany must maintain its working capital at or above some specified minimum level.

Terms of a Bond: Registered Forms

- Corporate bonds are usually in registered form. - This means that the company has a registrar who will record the initial ownership of each bond, as well as any changes in ownership. - The company will pay the interest and principal by check mailed directly to the address of the owner of record. - A corporate bond may be registered and have attached "coupons." - To obtain an interest payment, the owner must separate a coupon from the bond certificate and send it to the company registrar (the paying agent).

Patterns of Financing

- Internally generated cash flow dominates as a source of financing: This preference has increased through time - Net stock buybacks accelerated in 2002-2007: Declined in 2008, likely as a result of the financial crisis

Sinking fund provisions

- The issuer of the bond, will create a fund during the life of a bond, to contribute money for the purpose of redeeming the bond overtime - Retirement of a bond is its maturity date - Corpations uses money to buy bonds on the market, debt is then extinguished

Warrant feature

A warrant gives the buyer of a bond the right to purchase shares of stock in the company at a fixed price. Such a right would be very valuable if the stock price climbed substantially.

Convertible bond

When a bond can be converted into common stock

A company might be prohibited from calling its bonds for the first 10 years. This is a ______________. During the period of prohibition, the bond is said to be _______________.

deferred call provision call protected

Floating Rate Bonds Features

- Coupon rate floats depending on some index value - Usually published by Consumer Price Index (CPI) - Examples - adjustable rate mortgages and inflation-linked Treasuries - There is less price risk with floating rate bonds. - The coupon floats, so it is less likely to differ substantially from the yield to maturity. - Coupons may have a "collar" - the rate cannot go above a specified "ceiling" or below a specified "floor."

Details of protective covenants

- Covenant means a promise made by issuer to the buyers - A part of an indenture or loan agreement that limits certain actions a company may take during the term of the loan to protect the lender's interests. - Positive issuer promises to do something: Maintain working capital at a minimum level - Negative issuer promises he will refrain: Will not pledge the security to anyone else; Protects security interest bought - Bond buyers are protected

Proxy Voting

- Grant of authority by a shareholder to someone else to vote her shares ** Proxy fights occur if an outside group of shareholders try to obtain proxies in an attempt to replace management by electing enough directors.

Early repayment in some form of a bond is more typical and is often handled through a sinking fund.

A sinking fund is an account managed by the bond trustee for the purpose of repay- ing the bonds. The company makes annual payments to the trustee, who then uses the funds to retire a portion of the debt. The trustee does this by either buying up some of the bonds in the market or calling in a fraction of the outstanding bonds.

Mortgage securities

Mortgage securities are secured by a mortgage on the real property of the borrower. The property involved is usually real estate, such as land or buildings. The legal document that describes the mortgage is called a mortgage trust indenture or trust deed. **Secured by real property, normally land or buildings

Income bonds

are similar to conventional bonds, except that coupon payments are dependent on company income. Specifically, coupons are paid to bondholders only if the firm's income is sufficient. This would appear to be an attractive feature, but income bonds are not very common.

Features of Preferred Stock

- Pays a cash dividend expressed in terms of dollars per share. - Preferred stock has a preference over common stock in the payment of dividends and in the distribution of corporation assets in the event of liquidation. Preference means only that holders of preferred shares must receive a dividend (in the case of an ongoing firm) before holders of common shares are entitled to anything. - Preferred stock typically has no maturity date. - Preferred stock is a form of equity from a legal and tax standpoint. - It is important to note, however, that holders of preferred stock usually have no voting privileges.

Is Preferred Stock Really Debt?

- Preferred shareholders receive a stated dividend only, and, if the corporation is liquidated, preferred shareholders get a stated value. - Often, preferred stocks carry credit ratings much like those of bonds. - Preferred stock is sometimes convertible into common stock. - In addition, preferred stocks are often callable, which allows the issuer to repurchase, or "call," part or all of the issue at a stated price. - Though preferred stock typically has no maturity date, many issues have obligatory sinking funds. A sinking fund requires a company to retire a portion of its preferred stock each year. A sinking fund effectively creates a final maturity, since the entire issue will ultimately be retired. - For these reasons, preferred stock seems to be a lot like debt. However, for tax purposes, preferred dividends are treated like common stock dividends.

Which bonds will have the higher coupon, all else equal? (Which is riskier from the point of view of the bondholder?) - Secured debt versus a debenture - Subordinated debenture versus senior debt - A bond with a sinking fund versus one without - A callable bond versus a non-callable bond

- Secured debt versus a debenture: Secured debt is less risky because the income from the security is used to pay it off first. Therefore, a debenture would have a higher coupon rate to encourage bond buyers to buy. Secured Debt is more secure. - Subordinated debenture versus senior debt: Subordinated debenture is riskier because they will be paid after the senior debt. Subordinated debenture's owners are creditors and they get paid after the other creditors. Senior debt holders have a legal right to get paid before. - A bond with a sinking fund versus one without: Bond without sinking fund has to come up with substantial cash at maturity to retire debt, and this is riskier than systematic retirement of debt through time. Without, has a higher coupon rate because more risky. - A callable bond versus a non-callable bond: Callable - bondholders bear the risk of the bond being called early, usually when rates are lower. They don't receive all of the expected coupons, and they have to reinvest at lower rates. Callable bond gives to the issuer, the right, not the obligation, to compel redemption of the bond before maturity. The issuer does not have the right to call a bond if its not said in the trust indenture. Risk increase the coupon rate also increases to compensate. (You want a callable bond - when there are high interest rates).

Classes of Stock

- The Class A shares are held by the public, and each share has one vote. - The Class B shares are held by company insiders, and each Class B share has 10 votes. - Class C have no vote

Terms of a Bond: Bearer Forms

- This means that the certificate is the basic evidence of ownership, and the corporation will "pay the bearer." - Ownership is not otherwise recorded, and, as with a registered bond with attached coupons, the holder of the bond certificate detaches the coupons and sends them to the company to receive payment. ** Draw backs: First, they are difficult to recover if they are lost or stolen. Second, because the company does not know who owns its bonds, it cannot notify bondholders of important events.

From the financial point of view, what are the main differences between Debt & Equity?

1. Debt is not an ownership interest in the firm. Creditors generally do not have voting power. 2. The corporation's payment of interest on debt is considered a cost of doing business and is fully tax deductible. Dividends paid to stockholders are not tax deductible. 3. Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of the firm. This action can result in liquidation or reorganization, two of the possible consequences of bankruptcy. Thus, one of the costs of issuing debt is the possibility of financial failure. This possibility does not arise when equity is issued.

There are many different kinds of sinking fund arrangements, and the details are spelled out in the indenture. For example:

1. Some sinking funds start about 10 years after the initial issuance. 2. Some sinking funds establish equal payments over the life of the bond. 3. Some high-quality bond issues establish payments to the sinking fund that are not sufficient to redeem the entire issue. As a consequence, there may be a large "balloon payment" at maturity.

Syndicated Loans

Large companies cannot generate enough good loans with the funds they have available. As a result, a very large bank may arrange a syndicated loan with a firm or country and then sell portions of it to a syndicate of other banks. With a syndicated loan, each bank has a separate loan agreement with the borrowers.

Two important features of bank loans are...

Lines of credit and syndication.

The majority of floaters have the following features:

1. The holder has the right to redeem his note at par on the coupon payment date after some specified amount of time. This is called a put provision, and it is discussed in the following section. 2. The coupon rate has a floor and a ceiling, meaning that the coupon is subject to a minimum and a maximum. In this case, the coupon rate is said to be "capped," and the upper and lower rates are sometimes called the collar. **the coupon payments are adjustable.

In addition to the right to vote for directors, shareholders usually have the following rights:

1. The right to share proportionally in dividends. 2. The right to share proportionally in assets remaining after liabilities have been paid in a liquidation. 3. The right to vote on stockholder matters of great importance, such as a merger. Voting usually occurs at the annual meeting or a special meeting.

Corporations are legally authorized to pay dividends to their shareholders. The payment of dividends is at the discretion of the board of directors. Some important characteristics of dividends include the following:

1. Unless a dividend is declared by the board of directors of a corporation, it is not a liability of the corporation. A corporation cannot default on an undeclared dividend. As a consequence, corporations cannot become bankrupt because of nonpayment of dividends. The amount of the dividend and even whether it is paid are decisions based on the business judgment of the board of directors. 2. Dividends are paid out of the corporation's aftertax cash flow. They are not business expenses and are not deductible for corporate tax purposes. 3. Dividends received by individual shareholders are taxable. However, corporations that own stock in other corporations are permitted to exclude 70 percent of the dividend amounts they receive and are taxed on only the remaining 30 percent.

Which are best: book or market values?

In general, financial economists prefer market values (when calculating debt ratios). However, many corporate treasurers may find book values more appealing due to the volatility of market values. **Whether we use book or market values, debt ratios for U.S. non-financial firms have been below 50 percent of total financing.

Present value of a pure discount bond at time 0:

PV = F / (1+r)^T

Seniority indicates...

Preference in position over other lenders, and debts are sometimes labeled as senior or junior to indicate seniority. Some debt is subordinated, as in, for example, a subordinated debenture.

What is the stated value of preferred shares?

Preferred shares have a stated liquidating value, usually $100 per share.

Call provisions

The issuer has the legal right to repurchase before maturity, pay to the holder of record the face value of the bond and the interest payments for the time being

Lines of credit

anks often provide a business customer with a line of credit, set- ting the maximum amount that the bank is willing to lend to the business. The business can then borrow the money according to its need for funds. If the bank is legally obligated, the credit line is generally referred to as a revolving line of credit or a revolver.

A convertible bond

can be swapped for a fixed number of shares of stock anytime before maturity at the holder's option. Convertibles are relatively common, but the number has been decreasing in recent years.

The dif- ference between the call price and the stated value is...

the call premium