IB - DCM

Which one has a higher Duration: A 10-year, zero-coupon bond, or a 15-year, 5% coupon bond? Assume prevailing interest rates are 5%.

Duration is the number of years it takes for the bond's cash flows to pay for the bond's upfront purchase price. For a zero-coupon bond, the Duration is always equal to the maturity of the bond since there are no interest payments. So, the 10-year bond has a Duration of 10. The 15-year bond's Duration will be less than 15 because it pays interest and, therefore, you won't need 15 entire years to earn back the upfront price (and the upfront price will be the bond's par value since the coupon rate = prevailing interest rates). However, the 15-year bond's Duration will be greater than 10 because after 10 years, the bond will have paid only 10 * 5% = 50% of its par value in interest. The remaining 5 years include 5 * 5% = 25% of the bond's par value in interest and then 100% of its par value at the end. So, the Duration is weighted toward the last 5 years since 125% of the bond's par value arrives then (vs. only 50% in the first 10 years). Therefore, the 15-year bond has a higher Duration.(The 15-year bond's Duration is 10.9 if you calculate it in Excel.)

Why do companies offer Pricing Discounts in IPOs?

Even if a company believes its shares are worth $100.00, it usually lets new investors in an IPO purchase them at a discount of ~15% (so, $85.00 here) because those investors assume significant risk by purchasing the shares before the company is a publicly traded entity. Anything could happen between pricing and the first few minutes of trading - the company's share price might plunge by 20%, for example. To compensate investors for that risk, companies offer this discount.

How might you determine the numbers for revenue growth, margins, and CapEx in Downside cases of a credit model?

First, you could look at the company's historical performance in recessions and see how its growth and margins have fallen and how its CapEx spending has changed when the economy has contracted. You could also look at peer companies that have not performed well and see how much their growth and margins have declined. Finally, you also have to consider the company's industry and maturity. A mature retailer with high fixed costs and inventory could easily crash and burn if demand falls, while a professional services company could adapt more smoothly by reducing its headcount.

What might a Shareholder Analysis tell you about an Equity deal?

For an existing public company, a Shareholder Analysis lets you compare current institutional investors to ones that the company might target in a new Equity offering. For example, if one of your client's investors has a low percentage of holdings in the transportation industry, and the company is transportation-related, then your team may want to target this investor in the offering since it may want more exposure to the industry. You could also use this analysis to find institutional investors with similar industry holdings that have not yet invested in your client and target them in the offering.

What would happen if prevailing interest rates were 10% instead? Why?

If prevailing interest rates were 10% instead, nothing about the zero-coupon bond would change: It would still take 10 years to pay for the upfront investment, so the Duration would still be 10. However, the 15-year bond would trade at a discount to par value, which would reduce the upfront price to buy the bond. We don't know what the bond's market price would be, but if interest rates double, the discount would be significant; we can guesstimate it as between 40% and 50% due to compounding (it's 38% in real life). At a 40-50% discount, you would recover the full purchase price before Year 10 because 10 * 5% = 50% of the bond's par value in interest. But you would pay only 50-60% of the bond's par value - so you'd recover almost that entire amount before Year 10. The Duration of the 15-year bond would be less than 10 in this case, making its Duration lower than that of the zero-coupon bond. If you calculate it in Excel, it's 9.6.

Which characteristics would make a Convertible Bond closer to Hedged Equity rather than Debt?

If the company's stock price at issuance and the Conversion Price of the Convertible Bond are very close, the bond is closer to "Hedged Equity" than traditional Debt. Also, the lower the coupon rate on the bond, the closer it is to "Hedged Equity"; traditional bond investors have little reason to invest if it's a zero-coupon bond, for example. A long Payback Period that exceeds the bond's maturity also makes it closer to Hedged Equity.

What happens to the YTM and Current Yield on a bond if prevailing interest rates move above the bond's coupon rate?

In this scenario, the bond will trade at a discount to par value, so its Current Yield will exceed its coupon rate. The bond's YTM will increase and exceed its Current Yield because the YTM of a bond should move to match prevailing interest rates. Intuitively, you can think of it as: "The investor gets a higher-than-expected yield because the bond trades at a discount, and he/she ALSO realizes an annual gain each year from the bond's discounted price. That annualized gain makes the YTM exceed the Current Yield."

How does a company decide on the amount of capital to raise in an IPO?

It depends on the reason why the company is going public: If it needs capital for a specific purpose, such as making an acquisition or buying a factory, it will aim to raise that amount of capital. But if the company is going public to provide existing investors with an exit and liquidity, it often raises capital such that it sells a certain percentage of the company (often between 20% and 40%). The company wants to offer enough new shares to make investors committed to the company, but not so many that it gives up control. Some companies can get around these guidelines if they're "hot," and there's a huge amount of demand for their shares - they can often sell much smaller percentages of their Equity, such as 5-10%, in initial public offerings.

What does it mean if a company can't comply with maintenance covenants on Term Loans in the Downside or Extreme Downside cases?

It means that lenders won't fund the Term Loans, so you have to consider different loans with different covenants, or consider Equity financing (in whole or in part). Lenders focus on the Downside cases because they have limited upside but huge potential downside; it doesn't mean much if the company complies with the covenants in the Base case.

If a company's cash flow fluctuates greatly from year to year, which financing source is most appropriate for it?

"Anything that lacks maintenance covenants" is the best answer here. But, more specifically, it depends on how much the company's cash flow fluctuates. If the fluctuations are moderate, and the company never moves into crazy territory with its credit stats and ratios (e.g., nothing like 15x Debt / EBITDA), then it may be able to issue Senior Notes or Subordinated Notes, which have higher interest rates than Term Loans but which lack maintenance covenants. But if the company's cash flows are so unstable that it can't maintain reasonable leverage or coverage ratios, then it will have to use more Equity and possibly skip Debt altogether.

What's the significance of Primary vs. Secondary Shares in an IPO or FO?

"Primary Shares" are new ones issued by the company in an Equity offering. They dilute the company's existing investors by reducing their ownership stake, but they also allow the company to raise capital. "Secondary Shares" are existing shares sold to new investors in the offering. They do not dilute existing investors at all, but the company also receives no cash from them. The percentages of Primary and Secondary Shares should be within reasonable ranges in an Equity offering, or the market may not buy into it. For example, new investors may be skeptical if too many existing investors want to sell their shares.

What's the impact of a Greenshoe provision in an IPO or FO, and when might a bank and company offer it?

A "Greenshoe" lets a company sell more shares than originally planned in an Equity offering. A company might use it if there's higher-than-expected demand for its shares, and it believes it can raise additional capital easily, without completing a separate offering. For example, the company initially planned to offer 10 million shares at $10.00 each, but with a 15% Greenshoe, it can offer 11.5 million shares and raise $115 million instead of $100 million.

Why might a company issue a Convertible Bond rather than traditional Debt or Equity?

A Convertible Bond is a compromise solution that lets companies borrow more cheaply than they could with traditional Debt - but with possible share dilution in the future if the bonds convert into shares. A company might issue a Convertible Bond if Debt is cheaper than Equity for the company, but it has trouble meeting its targeted credit stats and ratios with a normal Debt issuance. Also, the company must be in an appropriate industry and at the right growth stage. High-risk, high-growth companies in industries such as technology and biotech tend to issue Convertible Bonds more often than those in other industries.

Which factors might make a Convertible Bond *less* valuable?

A Convertible Bond is less valuable if its Conversion Price and the company's stock price are further apart, so any decline in the company's share price will also reduce the Convertible Bond's value. A lower risk-free rate or lower volatility also reduce the chances of the company's stock price exceeding the Conversion Price, making the bond less valuable. Finally, less time to expiration (i.e., a lower maturity) also makes the bond less valuable because it reduces the probability of the company's stock price exceeding the Conversion Price.

How could a company reduce dilution from a Convertible Bond?

A company could use a "call spread," where it buys call options on its own stock and sells warrants on its stock at a higher exercise price to offset the cost of the call options. The net effect is that the company experiences no dilution from the Convertible Bonds until its stock price exceeds the exercise price of the warrants. Past that level, there is dilution, but it is reduced significantly from the levels under a normal Convertible Bond. The downside is that this strategy costs extra, and it may not be worth it depending on the company's share price and Cost of Equity.

Why would a company issue Debt rather than Equity?

A company would issue Debt if it is cheaper than Equity, as it normally is, and the company is capable of issuing additional Debt because its leverage ratio, interest coverage ratio, and other credit stats and ratios are in acceptable ranges. Most companies have a "maximum" Debt / EBITDA or Net Debt / EBITDA that they do not want to exceed, so you would check that figure with this new Debt included.

What would cause a company's credit rating to change?

A company's credit rating might change if its credit stats and ratios, such as Debt / EBITDA or EBITDA / Interest, improve or worsen significantly, or its qualitative risk factors change. For example, if peer companies with "BB+" credit ratings have Debt / EBITDA between 4x and 5x, and the Debt / EBITDA of the company you're analyzing suddenly jumps to 6x, rating agencies will be likely to downgrade the company. But even if a company's financial stats stay the same, its credit rating might decline if its industry experiences a downturn, a major new competitor enters, or the growth outlook falls.

What are the advantages and disadvantages of driving an IPO model off of valuation multiples vs. # shares issued?

A model driven by valuation multiples - the description above - is closer to reality because companies price based on the multiples of comparable public companies and the capital they want to raise. However, such a model is also harder to explain to clients because you have to "back into" many of the figures in it. You could also drive the model based on the Offering Price and # Shares Issued. This one is easier to explain to clients because the deal size changes at different Offering Prices, as you would expect, but the % Company Sold stays the same. The downside is that it's not linked to peer companies' valuation multiples in the same way, and the capital raised varies at different Offering Prices - which isn't necessarily what companies want.

Why might a company consider Mezzanine or Preferred Stock financing rather than Subordinated Notes?

All these forms of Debt lack maintenance covenants, and the interest rates on Mezzanine and Preferred Stock are almost always higher than the rates on Subordinated Notes, so it can't be an issue of cost. The most likely reason is that the company already has too much Debt, so Subordinated Note investors won't invest, and the company must consider higher-cost financing. Another reason might be that the company cannot afford cash interest on the Subordinated Notes, but the Mezzanine and Preferred Stock provide a "Payment-in-Kind" (PIK) option where the interest accrues to the loan principal, reducing the company's cash expenses.

How is the Follow-On Offering process different from the Initial Public Offering process?

It's much faster and easier to issue Equity in a Follow-On Offering because the company is already public and doesn't need to go through regulatory approvals once again. Also, investors already know the company's name and reputation, and it doesn't take as much marketing to sell the offering. As a result, banks tend to earn lower fees in FOs - often less than 50% of what they earn in IPOs - and the legal and accounting fees are also lower. Since the company is already public, there's no question over the appropriate valuation - the main issue is how much of a discount to offer to new investors.

If a company wants to extend the maturity of its bonds by refinancing, how might you advise it?

At a high level, you want to ensure that the bond investors receive a similar yield with a similar risk profile when the company refinances its bonds. You can measure these attributes with the YTM, YTW, and Duration of the bonds and the company's credit rating before and after the issuance. You would aim to issue new bonds that offer a similar yield and Duration and which do not negatively impact the company's credit rating. For example, if the new bonds mature 2-3 years later than the old bonds, then the company might have to offer better terms to win over investors, such as a higher coupon rate or higher call premiums (since the interest-rate risk is higher with a longer maturity).

Why are ratios such as Debt / EBITDA and EBITDA / Interest important even if a company's Debt has no maintenance covenants?

Because lenders and rating agencies still judge a company based on these metrics, even if the company is not "required" to keep them above or below certain levels. For example, rating agencies often establish credit rating "bands" of Debt / EBITDA ratios (e.g., investment-grade companies might have Debt / EBITDA below 2x) and use them as guidelines to determine the ratings. Also, some Debt investors become unwilling to invest in a company's Debt beyond certain thresholds. For example, Term Loan investors might go up to 2x Debt / EBITDA, and Senior Note investors might go up to 3-4x Debt / EBITDA. But if the company wants to raise Debt beyond those levels, it will have to consider sources like Subordinated Notes or Mezzanine.

How do you set up a Follow-On Offering model differently from an IPO model?

It's similar to an IPO model driven by Shares Issued and Offering Prices, but the Offering Prices are framed in terms of a discount to the company's share price (such as 5%, 10%, or 15%). You determine the Shares Issued based on the amount of capital the company wants to raise and the discount it is offering; a higher discount means more shares, and a lower discount means fewer shares. Then, you factor in the Overallotment (Greenshoe) and the Primary vs. Secondary Share split and determine the Net Proceeds to the Issuer based on the proceeds from Primary Shares minus fees. You can then calculate the % of the company sold in the offering (based on Primary Shares issued and post-FO shares outstanding), the valuation multiples at pricing and trading, and the cost of issuing Equity based on the pricing discount.

If a bond is trading at a premium to par value, and it has a 10-year maturity, how does its market price change as it approaches maturity?

Its market price will approach par value as the bond approaches maturity. The intuition is that there will be fewer and fewer terms in the Present Value formula that determines the bond's market price and, therefore, less and less of an effect from compounding. Put differently: Investors have less to gain from a discounted bond and less to lose from a premium bond as each bond approaches maturity.

Why might a company issue Equity even when Debt is cheaper for the company?

Not all companies can issue additional Debt because of restrictions on ratios such as Debt / EBITDA and EBITDA / Interest. For example, if a company already has 5x Debt / EBITDA, and lenders have said they're unwilling to lend the company anything beyond that, the company must issue Equity.

If a company can't comply with a Debt Service Coverage Ratio (DSCR) ratio covenant on its Term Loans, should it consider junior Debt instead?

Not necessarily. The Debt Service Coverage Ratio measures the cash flow available for required principal repayments + interest payments on Debt. "Junior Debt" such as Unsecured Senior Notes and Subordinated Notes has higher interest rates but no principal repayments, so the company may be able to service that Debt more easily. However, there is another option as well: Use Term Loans that lack significant principal repayments (such as Term Loans B or C rather than A) or ones that lack maintenance covenants ("covenant-lite" loans).

If a company has trouble meeting its covenants on a Debt issuance, when should it start to consider Equity instead?

Only after the company has already explored other forms of Debt, such as Senior Notes and Subordinated Notes, which are more expensive than Term Loans but which lack maintenance covenants. If those more expensive forms of Debt still don't work, then the company should consider Convertible Bonds if it is an ideal candidate for issuing them. And if all those cheaper financing sources still don't work, then the company should consider Equity as a last resort since it is almost always the most expensive financing method.

In a credit model, how should the Downside cases differ from the Base and Upside cases?

Revenue growth and operating margins should be lower in the Downside cases, CapEx spending should be higher, and metrics like EBITDA and Free Cash Flow should be lower and more "unstable" than in the other cases. To determine how much lower these metrics should be, you look at data from past downturns and data from poorly-performing companies in this industry.

True or False: If Prevailing Interest Rates are below the bond's coupon rate, then the bond must trade at a premium to par value.

Technically, this is false. For creditworthy companies with almost no chance of default, this statement is correct: Bond prices are affected mostly by coupon rates and prevailing interest rates. But if the company is distressed or has some chance of defaulting, the bond might trade at par value or a discount to par value, even if interest rates are below the bond's coupon rate. That price reflects the additional risk investors are assuming by investing in a company that might default on its Debt obligations.

You're analyzing two 5-year Convertible Bonds. The first one has a Payback Period of 3 years, and the second one has a Payback Period of 25 years. Which type of investor would each bond appeal to?

The "Payback Period" refers to the number of years it takes to earn back the premium you pay for purchasing a Convertible Bond rather than the underlying shares. A longer Payback Period means that there's more risk in purchasing the Convertible Bond because you may never earn back the premium. A bond with a Payback Period that's less than its maturity would appeal more to traditional fixed-income investors, while one with a longer Payback Period would appeal more to equity investors looking for a way to hedge their downside risk.

Will a 10% or 5% coupon rate bond be more sensitive to changes in prevailing interest rates?

The 5% coupon rate bond will be more sensitive to changes in prevailing interest rates because bondholders receive less money early in the holding period when there's less of a discount. A greater percentage of the cash flow from a 10% bond comes from interest paid on the bond, so the bond's market price will be less sensitive to changes in rates.

A company issues $100 million of Convertible Bonds with a Par Value of $1,000 and a Conversion Premium of 50%. Its current stock price is $66.67. How many new shares will be created if the company's stock price increases to the Conversion Price, and the bond investors convert their bonds into shares?

The Conversion Price is $100.00, or $66.67 * (1 + 50%), and the Conversion Ratio = Par Value / Conversion Price = $1,000 / $100.00 = 10.0, so each bond converts into 10 shares. There are 100,000 individual bonds because $100 million / $1,000 = 100,000. One million new shares will be created since 10 shares per bond * 100,000 bonds = 1 million shares.

What does the "Yield to Maturity" (YTM) on a bond mean?

The YTM represents the internal rate of return (IRR) on a bond, with its current market price used as the upfront purchase price. The YTM assumes that you hold the bond until maturity, the company makes all interest and principal payments in full on the scheduled dates, and that you reinvest the cash flows you earn from the bond at the same YTM. The YTM is a useful way to compare bonds, but as with IRR, it rarely represents the real-life outcome because of all those assumptions.

How does a bank add value for a client in an IPO or Follow-On Offering?

The bank adds value for the client by guiding it through the entire process, recommending the terms in an offering (such as the appropriate Offering Price and Pricing Discount), and selling the offering to the right set of investors. Investment bankers focus on getting the company's "story" right, while the sales team uses its relationships with institutional investors to sell the offering. In ancient times, banks also used to assume risk in IPOs by buying the company's shares before the company went public and then re-selling them to new investors, but this practice is far less common today.

What happens to the YTM and Current Yield on a bond if the company's credit rating falls dramatically, but prevailing interest rates and the bond's coupon rate stay the same?

The bond will start to trade at a discount to par value if the company's credit rating falls dramatically, so the bond's Current Yield will increase above the coupon rate. The bond's YTM should also increase because it's based on the assumption of full repayment upon maturity - even if that's no longer realistic. The bond's YTM should increase to a figure above the Current Yield because investors now earn interest plus an annualized gain from buying the bond at a discount and earning back its par value upon maturity.

What are the main factors that influence a bond's market price?

The bond's coupon rate, prevailing interest rates on similar bonds in the market, and the company's creditworthiness make the biggest impact on the bond's market price. All of them appear in the pricing formula for a bond, but the company's creditworthiness makes a more indirect impact since it affects the "Redemption" term (lower creditworthiness means that the expected repayment percentage may be below 100%).

Should the coupon rate of a bond with call protection be higher or lower than one without call protection?

The coupon rate should be lower because call protection reduces the risk for the bond investors. Lower risk means a lower potential return, so the coupon rate should be lower to compensate. Call protection reduces the risk for investors by ensuring that the company cannot repay bonds early ("calling the bonds") for several years, and then allowing early repayment, but only at a premium to par value.

You are completing credit models for a furniture retailer, a luxury hotel chain, and a real estate company that owns multifamily units (i.e., rental apartments). Which of these companies is most likely to have the MOST EXTREME Downside case?

The luxury hotel chain will have the most extreme Downside case because hotel spending, especially in the luxury segment, declines far more than furniture spending or apartment rent in a downturn. There might be a modest decline in apartment rents (e.g., 3-5%) during a recession as landlords try to attract new tenants, and furniture sales might also decline modestly (e.g., 5-10%) as fewer people buy homes and redecorate. But luxury hotel spending falls off a cliff in a downturn - declines of 20-30% would not be unusual.

How might the market interpret an IPO with 100% Secondary Shares?

The market would interpret this deal negatively since the company is not issuing any new shares, which implies that growth expectations are low. Also, if so many existing investors sell their shares in the company, they're sending a signal to the market that they don't believe in the company's long-term prospects. In most market environments, it would be difficult-to-impossible to conduct an IPO with no Primary Shares.

A mature manufacturing company is already levered at 5x Debt / EBITDA, and lenders have been unwilling to fund additional Term Loans, Senior Notes, or Subordinated Notes because of concerns over the company's leverage and credit rating. The company wants to issue Convertible Bonds instead to get around this problem. Why might it NOT be able to issue them?

The problem is that this is a mature company in an established industry, so there are little growth potential and little upside in the company's stock price. Convertible Bonds are closer to Equity than Debt because they're a "hedged" way to invest in a company's shares, so Convertible Bond investors almost always favor speculative, higher- growth companies. This company might be able to issue Convertible Bonds if it were in a higher-growth segment of the manufacturing industry, or its stock price had significant perceived upside (e.g., many investors felt the company was significantly undervalued).

Interest rates have fallen, and a company wants to refinance an 8%, 7-year bond with a 6%, 10-year bond. Why might it not be able to do that?

The problem is the Duration - even if interest rates fall, bond investors want to maintain their interest-rate risk exposure. The longer the maturity of the bond, the more interest-rate risk it has. The Duration of the first bond is just under 6 years, but it's closer to 8 years for the proposed 10-year bond. That's a significant difference in interest-rate risk, so the company may have to offer investors an improved yield to compensate.

How do you value a company in an IPO?

The same way you value a company in any other transaction: With comparable public companies, precedent transactions, and a DCF analysis. The main difference is that you focus on the forward multiples of the Public Comps because investors pay so much attention to them when a company goes public. A company's pricing in an IPO is based on these metrics as well. So, if the median 1-year forward P / E multiple for similar public companies is 20x, you might suggest a range of 1-year forward P / E multiples around 20x for your company as well.

How do you value a bond?

The same way you value any other asset: By discounting its future cash flows (interest + principal repayment) to their Present Values based on an appropriate discount rate, and then summing them up. With bonds, the "appropriate discount rate" is the prevailing coupon rate on similar bonds. So, if your company has issued a bond with a 5% coupon rate, but interest rates have risen, and similar bonds now have 6% coupon rates, you would discount the bond's cash flows to Present Value based on a 6% discount rate.

You're considering 3 companies that want to raise capital: A utility company, a railroad company, and a branded pharmaceutical company. Which company is most appropriate for 100% Equity, which one is most appropriate for 50% Debt / 50% Equity, and which one is most appropriate for 100% Debt?

Think about the potential upside and downside of each company and remember that, above all else, lenders want to avoid losing money. The least risky company is the utility firm since consumers always need electricity, water, etc., and many of these firms have local monopolies. Utility companies are also predictable and have less growth potential than others. Therefore, this company is the best candidate for 100% Debt. The railroad company is riskier than the utility company but less risky than the branded pharmaceutical company because it's subject to market forces, and its freight pricing and volume can shift dramatically based on the economy. However, it's still relatively predictable because you can look at past economic cycles to forecast downturns. So, the railroad company is the best candidate for 50% Debt / 50% Equity. The branded pharmaceutical company is incredibly risky because its products are protected by patents, which expire over time, and it's dependent on finding new drugs to replace older ones that have lost patent protection. On the other hand, there's also a huge amount of upside if the company discovers a drug that cures cancer. So, this company the best candidate for 100% Equity. Side Note: Many branded pharmaceutical companies also issue Convertible Bonds for the same reason, especially if they're already cash flow-positive.

Why is the relationship between bond prices and prevailing interest rates convex?

This relationship is convex because declining interest rates make more of an impact on a bond's market price than rising interest rates. So, if you plot them on a graph, the slope gets steeper as interest rates decline. As the prevailing interest rates decline, the discount factors in the Present Value formula decrease more and more quickly, which increases the bond's value non-linearly.

What conclusions can you draw if a company's EBITDA Cushion for its Interest Coverage Ratio covenant is 10% in the Downside case, but its Leverage Ratio covenant has a Cushion of 50%?

This result means that the company's Debt / EBITDA ratio is acceptable even if things go horribly wrong, but its EBITDA / Interest covenant is in danger of being breached if the company underperforms. The company could solve this issue by negotiating for Debt with lower interest rates but offering other terms that are more favorable to the lender, or by raising Debt with no maintenance covenants.

It seems straightforward to model and value a bond. Why is it more difficult than it appears?

When a company initially issues a bond to investors to raise capital, it is straightforward to model. But in the secondary markets - where investors buy and sell bonds from other investors - it gets more complicated. First off, the bond's market price can change over time. The timing also gets tricky because bonds pay interest at different intervals, and a new investor may have to pay for "Accrued Interest" if he/she purchases the bond in between interest payments. Also, bonds often have embedded call, put, and conversion options, all of which complicate the analysis. Finally, some bonds also have warrants or equity options attached, which make it trickier to calculate the yields.

Would lenders ever pay attention to scenarios other than the Downside cases in a credit model?

Yes, potentially. Lenders focus on the Downside cases because their upside is limited to the interest rate on the Debt, while their downside consists of losing everything. However, some forms of Debt, such as Mezzanine, may offer warrants or equity options, which could affect the numbers significantly. For example, if the Downside case numbers look bad (e.g., a decent chance of recovering only 80% of a loan's principal), the lender might do the deal anyway if the equity options make the IRR high enough in the Base or Upside cases.

How might you evaluate whether a company should raise capital via Equity, Term Loans, or Subordinated Notes?

You always start with the cheapest form of financing - Term Loans in this case. You would create different operational scenarios for the company, project its cash flow, and evaluate how well it can comply with the maintenance covenants and other restrictions on the Term Loans, particularly in the Downside cases. If it does well, great; go with the Term Loans. If not, consider Subordinated Notes next since they lack the same restrictions as Term Loans, and they're still cheaper than Equity. If the company's credit stats and ratios decline too much in the Downside cases (e.g., its EBITDA / Interest falls to 1.5x when the company doesn't want to go below 2x), then you have to consider Equity, the most expensive funding source. You might then try combinations of Debt and Equity to get the cheapest financing that also lets the company meet its targeted credit stats and ratios.

You purchase a $100 bond at a 5% discount to par value. The bond's coupon rate is 8%, and it matures in 5 years. What is the bond's approximate YTM?

You can approximate the YTM with: (Annual Interest + (Redemption Value - Bond Price) / # Years to Maturity) / ((Redemption Value + Bond Price) / 2) The annual interest is $8, the redemption value is 100 (since full repayment is assumed with YTM), the bond price is 95, and the # years to maturity is 5, so: YTM = (8 + (100 - 95) / 5) / ((100 + 95) / 2) YTM = (8 + 1) / 97.5 = 9.2% (You could say, "Between 9% and 10%" in an interview) The intuition is that we earn 8% interest per year and also 1% on the bond's principal per year since it increases from 95% to 100% over 5 years.

How do you build an IPO model for a company?

You start by assuming a range of forward multiples (often P / E multiples) and then applying them to the company's projected financial metrics. If you're using P / E multiples, that gets you the company's implied post-money Equity Value when it starts trading. But companies almost always offer new investors a pricing discount in IPOs, so you have to apply that discount (10-15%) to determine the post-money Equity Value at pricing. Then, you can determine the Offering Price per Share by taking the post-money Equity Value at pricing, subtracting the offering size, and dividing by the company's pre-IPO share count. Based on that, you can calculate the Primary Shares issued in the offering. For example, a post- money Equity Value of $10 billion / $50.00 Offering Price = 200 million shares, and if the company currently has 150 million shares, it must issue 50 million new ones. You can then determine the Secondary Shares and Overallotment Shares based on separate assumptions for those. Finally, you calculate the % of the company sold in the IPO and its valuation multiples at pricing and trading, reflecting the Net IPO Proceeds in its Equity Value and Enterprise Value.

What are the most important statistics in an analysis of Comparable Debt Issuances?

You typically screen the issuances by industry, geography, size, time, and credit rating; it doesn't make sense to compare Microsoft to a tech startup that just went public. You look at statistics such as the median coupon rate, offering amount, bond price, maturity, YTW, YTM, and interest and coverage ratios to determine if your proposed issuance has appropriate terms. For Convertible Bonds, you would also look at the median Conversion Ratio and Conversion Premium to ensure that your offering is in-line with similar, recent issuances.

How can you determine whether Equity or Debt is cheaper?

You use the same approach as in a WACC analysis: Calculate the Cost of Equity with Risk-Free Rate + Levered Beta * Equity Risk Premium, and calculate the Cost of Debt with Interest Rate on Debt or Similar Debt Issuances * (1 - Tax Rate). You could also use the YTM, Current Yield, or various other metrics instead of the Interest Rate on the company's current Debt. You could also calculate Cost of Equity by taking the reciprocal of the company's P / E multiple (e.g., 10x P / E means a 10% Cost of Equity since 1 / 10 = 10%). Both methods tend to produce results showing that Equity is more expensive, but the numbers may differ significantly.

How might you use Comparable Follow-On Issuances in an analysis for an Equity deal?

You'll often look at a set of "Follow-On Comps" to get a sense for the appropriate offering size (as a % of the company's current Market Cap), the Primary vs. Secondary split, the typical Pricing Discount, and the stock-price performance of recent offerings. For example, if the median Follow-On Offering represented 10% of the company's pre-deal Market Cap, Primary Shares were 35% of the total sold, and the median Pricing Discount was 5%, you might use those terms as well. You might use the stock-price performance (e.g., did the company's stock price increase by 30% after the offering?) to advise the company on whether or not it's a good time to issue Equity.

Which type of bond has the highest Convexity?

Zero-coupon bonds have the highest Convexity because they are the most sensitive to changes in interest rates. Since zero-coupon bonds pay no interest, their value depends ONLY on the discount rate AKA prevailing interest rates. That makes them the most sensitive to interest rates and, therefore, the most Convex bonds.