Chapter 3: Capital structure

contingent convertible bonds

(sometimes called CoCos) are also converted into shares of the issuer. However, the bonds are converted on a contingent basis: that is, if some predetermined event arises, the bonds are mandatorily converted into equity. The commonest example of this is in the banking sector, where banks are required to maintain core tier one capital (equity and retained profits) of at least 6% of their risk-weighted assets. A bank can issue a contingent convertible bond, which is convertible in the event of its tier one capital falling below (say) 5%. When tier capital falls below this threshold, the bond is converted into equity, immediately adding equity to the bank's capital base. These instruments were widely used during the banking crisis. CoCos can be highly complex and are more risky than conventional convertibles. Due to this, the Financial Conduct Authority (FCA) restricts their distribution to retail investors.

The market price is affected by a number of factors, including?

- the credit rating of the issuer; - the coupon (relative to market interest rates); - any security or guarantees attached to the bond; - and the bond's liquidity, which in turn is affected by the size of the issue, and the quality and condition of the markets it trades on.

What is considered unquoted debt?

1. bank loans 2. non-bank lenders

which type of debt instruments typically have variable interest rates?

1. bank loans (ST) 2. bank overdrafts (ST) 3. revolving credit facility (also has a commitment fee on undrawn amount)

two main sources of equity returns

1. distributions (holding investment) 2. capital gains (once sold)

limited companies can be what type of entities?

1. private limited company 2. public limited company

what fees are typically associated with an RCF?

1. variable interest rate and 2. Commitment fee on undrawn amount

how much higher is a conversion premium above the current share price for a convertible bond?

10-30% higher than the current share price

what is the nominal value of a bond?

100. Bonds are traded at a price which is linked to their nominal value per unit. For example, a bond with a nominal value of £100 could be priced at £101: in this case, it is trading at a premium to its par value. If its price is £98, it is trading at a discount to its par value.

fixed interest rate

A fixed rate is set at the time of issue, and generally remains unchanged for the term of the security. This is usually set in nominal terms.

Are bonds allowed to be traded?

Bonds can be traded through a stock exchange, like shares, or through an OTC dealing facility agreed by the issuer with a bank. Most bonds are transferable from one owner to another WITHOUT RESTRICTION by simple delivery of a physical certificate or by entering the new owner's details on a register.

Who may have a contingent convertible bond?

CoCos can be highly complex and are more risky than conventional convertibles. Due to this, the Financial Conduct Authority (FCA) restricts their distribution to retail investors.

quoted companies or traded companies.

Companies whose shares are traded on a stock exchange are referred to as _____, unless the company's shares are admitted to the Official List (ie, traded on the Main Market of the LSE) which allows the company to be described as "listed" companies. However, to be precise, a company whose shares are traded on the LSE's AIM market is described as quoted, AIM-listed or AIM-traded rather than listed.

convertible preference shares

Convertible bonds are, in many ways, very similar to _____ . Both carry the option of redemption or conversion and a fixed rate of dividend/coupon. The differences are that the dividend on a preference share is not tax-deductible and the preference share ranks lower in a liquidation than the convertible debt. Convertible preference shares will, therefore, generally offer a higher return than convertible loan stock from the same issuer due to the lower position in liquidation - eg, a higher coupon or lower conversion price.

how are coupons generally paid for bearer securities/bonds?

Coupons are paid electronically via the clearing systems to the holder of the eurobond (or their nominee account).

4. Why are debt issues attractive to companies?

Debt is attractive to companies because most tax regimes permit the issuer to deduct interest payments from their taxable profits, and so reduce their tax charge. This tax reduction (or tax shield) has the effect of reducing the effective cost of debt, which helps make it a relatively cheap form of capital.

notes, bills or commercial paper

Debt securities with a maturity of less than a year are referred to as _____

what are some examples of non-bank lenders?

Early-stage and start-up companies are commonly financed by the three Fs - founders, friends and family - and this capital can take the form of equity, debt or a combination of the two. Other sources of debt include peer-to-peer lending organisations, such as Funding Circle, where funds are provided by retail and other investors and made available via an online platform to businesses and individuals. Also, government funding.

What are the elements of capital structure and the ranking of the various different instruments (levels of seniority for equity and debt)

FP FU SIPO 1. Fixed-charge holders are paid first (after the costs of realisation up to the value of the proceeds from the sale of the assets, subject to the fixed charge). 2. Preferential creditors: these are primarily employees' arrears of pay and holiday pay, up to specified limits. 3. Floating charge holders (after a prescribed part of any assets left at this stage, which are reserved for unsecured creditors). 4. Unsecured creditors, such as HM Revenue & Customs (HMRC), unsecured lenders or trade creditors, and any shortfall to secured creditors after realising the proceeds of the assets subject to the charge(s). 5. Subordinated creditors, if any (those who have agreed to be subordinated to unsecured creditors). 6. Interest on unsecured debt incurred post-liquidation. 7. Preference shareholders, if any. 8. Ordinary shareholders receive any surplus.

The cost of capital is an important issue for two reasons.

First, it makes economic sense to keep the cost of financing down. Second, the company's cost of capital is the discount rate which is used in a cashflow- based valuation of the company and has a significant impact on the value of the company.

(1) convertible (2) reverse (3) mandatory

In a _____(1)_____ bond, the INVESTOR has the right to decide whether to convert or redeem the bond. In a _____(2)_____ convertible, the ISSUER has the right to decide whether the bond is converted or redeemed. In a _____(3)_____ convertible, the bond MUST be converted in specified circumstances.

In a liquidation, at which level is payment not expected in full or at all?

In a liquidation, it is unusual for unsecured creditors to be paid in full, and it is common for shareholders of an insolvent company to receive no payment at all.

floating (or variable) interest rate

LIBOR + x% is set at the time of issue at a margin over some agreed threshold. In the UK, variable rate debt is usually set at a specified number of basis points over the London Interbank Offered Rate (LIBOR)

quoted debt

Larger borrowers can issue debt securities which are bought mainly by institutional investors and traded in the debt capital markets (DCMs, also referred to as bond markets or fixed-income markets).

bonds or loan stock

Long-term debt securities (with a maturity of greater than one year) are commonly issued by larger companies, governments, local governments and financial institutions. These are known as ____, and account for the largest proportion of the markets for these securities.

(1) negotiable certificated form ("negotiable instruments") (2) bearer securities or bearer bonds

More rarely, a bond can be issued in _____(1)_____ (ie, using physical paper certificates). In this case, the legal owner of the bond is the bearer or holder of the physical certificate and, therefore, the bonds are referred to as _____(2)_____. The eurobond market normally uses a hybrid of the two, with the bonds being legally issued in bearer form but held, recorded and traded within one of the clearing and depository systems (Euroclear and Clearstream being the most common).

in which cases is a bond not redeemed at par?

Most bonds are redeemed at par (ie, for their nominal value) but some may be redeemed at a premium to par value, particularly if they bear low coupons, or no coupon at all, or are index-linked.

cumulative preference shares

Most preference shares in issue are cumulative, which means that preference shareholders are entitled to receive all dividend arrears from prior years as soon as the company has sufficient distributable reserves to pay them. Until these arrears have been paid, the company must not pay a dividend to its ordinary shareholders. If the preference shares are not cumulative, holders cannot claim unpaid dividends from earlier years; they are lost.

do preference shareholders have voting rights, like ordinary shareholders?

Normally, preference shares do NOT carry voting rights (this is the trade off of having preference, I suppose). However, preference shareholders may have the right to vote in certain circumstances, such as on a change to the rights of the preference shares, or when their dividends are in arrears, but only if this is provided for in the company's articles of association.

do ordinary shareholders have contractual entitlement to dividends?

Ordinary shareholders do NOT have any statutory or contractual entitlement to dividends. However, they have the right to approve or reject a final dividend by voting on the subject at the company's annual general meeting (AGM).

What type of shares represent the primary risk of the company?

Ordinary shares represent the primary risk capital of a company

Over the long-term and short-term, what are the trade-offs of an equity investment?

Over the longer term, ordinary shareholders have historically been handsomely rewarded for assuming this equity risk. In the short term, however, they have generally experienced a greater volatility in their returns than is experienced in connection with any of the other main asset types.

convertible preference shares

Preference shares can also be convertible, which means that they can be converted by the shareholder into new ordinary shares at a pre-specified price or rate, on predetermined dates. In some cases, the conversion is mandatory, while in others, it is optional. If the preference shares are not converted, the shareholder is still entitled to the same fixed rate of dividend until the stated redemption date

redeemable preference shares

Preference shares can be either redeemable or non-redeemable. Redeemable shares will be bought back by the company at some future date. They are issued with a predetermined redemption price (usually face value, but sometimes at a premium or discount) and date or series of dates. Redemption may be at the option of the company, or of the preference shareholder, depending on the terms of the shares.

what are "participating" preference shares?

Preference shares can be participating, meaning that they carry a right to a participation in the company's profits (for example, 5% of profit after tax). This might be either instead of, or as well as, the fixed dividend

3. When a company declares a dividend, which shares have priority?

Preference shares have priority over ordinary shares when a company declares a dividend or is placed in liquidation (also called winding-up)

What is the typical structure of a venture capital firm for an investment?

Private equity and venture capital firms frequently structure a funding package to include a debt element. If the borrower can meet a bank's strict lending criteria, it will seek external bank debt; otherwise, the private equity firm may provide some of the finance in the form of debt, rather than equity. This usually takes the form of a CONVERTIBLE LOAN NOTE, so that the lender has the advantages of priority (for interest and repayment) over other finance providers, as well as the option of sharing in possible high equity returns

is a floating rate not more or less volatile than that of a fixed-interest bond?

Since the coupon of a floating interest rate is reset frequently, interest rates broadly track market rate, and so the price of a floating rate note is less volatile than that of a fixed-interest bond. (try to look at this from a market-rate standpoint)

what are the advantages and disadvantages of a sale and leaseback?

The advantage of sale and leaseback for a company is that it is a means of raising cash for operational purposes, debt reduction or investments, releasing the capital tied up in the company's non-current assets. Ratios, such as return on capital employed, may be improved, as the company's capital employed is reduced. There may also be tax advantages to sale and leaseback financing. The disadvantage is that the company may be perceived as having a weaker banking covenant, now that it has disposed of assets which could have been used as collateral, and may be perceived as having sold off the family silver. It may also lose some of its operational flexibility, as it gives up the freedom to use the property as it wishes. Note that this is an example of off-balance-sheet financing as the assets used by the company are no longer visible in its balance sheet.

convertibles

The convertible bond pays interest in the same way as straight bonds. Additionally it offers the holder an option to convert the bond into a specified number of ordinary shares in the issuing company at a specified future date. The conversion price is set at the time of issue and is typically 10-30% above the underlying share price at that time.

required yield and market value

The cost of debt is calculated by reference to _____ , not on coupon and nominal value. This is partly because bonds are often issued or redeemed at a discount or premium to nominal value, and partly because investors are, after all, more interested in total yield to maturity than in coupons alone.

Capital asset pricing model

The model is based on the risk/reward payoff: that is, the relationship between the risk of investing in company shares, and the expected reward required for that level of risk.

6. What is the most common form of hybrid security?

The most common hybrid is the convertible bond (sometimes referred to as a convertible loan stock or debenture).

what is the difference between a fixed and a floating charge

The nature of the security charge may be fixed or floating. "Fixed to specific assets" - • A fixed charge works exactly like the domestic mortgage. Here, the loan agreement CLEARLY IDENTIFIES SPECIFIC ASSETS which are pledged as security. They tend to be non-current assets, such as properties and machinery. In the event of default, these specific assets will be seized and sold to repay the company's creditors, with any shortfall forming part of the unsecured liabilities of the company. "Floating above a class of assets" - • A floating charge is a charge over a PARTICULAR CLASS OF ASSETS, such as inventory or trade receivables. It is not possible to identify specific individual assets of this type, as they change day by day as the company runs its business. However, at the date of default, the charge attaches to all assets of that class which exist at that date; they will then be seized and sold. Frequently, both a fixed and floating charge will be granted on the same loan.

difference between par and premium redemption

The principal amount of a bond is its nominal value. The bond issuer is obliged to repay the principal to the person who is the holder of the bond at maturity. Most bonds are redeemed at par (ie, for their nominal value) but some may be redeemed at a premium to par value, particularly if they bear low coupons, or no coupon at all, or are index-linked. The terms of redemption are set out at the time that the bond is issued and include provisions on the timing of redemption. This may provide for the whole of the bond to be redeemed on a specific date or for the bondholders to have the option for redemption on a series of dates.

zero-coupon bonds

The return to bondholders is provided entirely in the form of a capital gain on redemption. The bond price will increase as they approach maturity, but the value will tend to be very much more volatile than interest-bearing bonds. These bonds tend to be relatively long term, compared with other corporate bonds. ____ are most attractive to investors who are not seeking income but looking for long-term capital uplift, eg, for inheritance planning purposes. For tax purposes, part of the capital gain is treated as interest and so attracts tax relief.

limited company

Under the Companies Act 2006, the shareholders of these companies have no personal liability for the payment of the company's debts and their liability extends only to the extent of any outstanding payment on the nominal value of the company's shares held. This compares with the situation of partners in an unlimited liability partnership, who have full and unlimited liability for the debts of the partnership

at what price can shares be issued?

When a class of ordinary shares is first created it is assigned a nominal value or par value. This may be any amount but is commonly £1 (in comparison, for debt it is 100). The nominal value is fixed, and bears no relationship to the market value of the shares, which may be very volatile. Indeed, as the company grows and raises more equity capital, it may sell additional shares at a significant premium to the nominal value. However, all new issues of shares must be priced at or above the nominal value; under the Companies Act 2006, they cannot be issued at a discount to their nominal value (in comparison, debt can be issued at a discount or premium).

(1) finance lease (2) operating lease

With _____(1)_____ leasing, economic ownership of the asset - along with the accompanying risks and rewards - lies with the lessee, and the assets are leased for the greater part of their economic life. This means that the lessee is responsible for long-term repairs, maintenance and insurance, even though the legal title to the asset stays with the lessor. If these features are not part of the lease agreement, the lease is instead described as an _____(2)_____ lease.

(Documentation) Where are security charges found in a bank loan? where are they found in a bond?

With a bank loan, the charges are set out in the loan AGREEMENT. With a bond issue, the security terms are incorporated into a LEGAL TRUST DEED, and the borrower's compliance with it is overseen by an independent trustee appointed by the company. If any of these terms are breached, the trustee has the right to appoint a receiver to realise (ie, sell), the asset(s) subject to the charge.

Can preference shareholders combine the various features of preference shares?

Yes, for example: Finally, preference shares may have a combination of these features; for example, a £1 5% convertible redeemable cumulative preference share gives the holder the right to a 5p per annum dividend, rolled up in the event of any arrears, together with the option of either redemption (for £1) or conversion into a pre-agreed number of ordinary shares, in specified circumstances.

do preference shareholders have contractual entitlement to dividends?

Yes, preference shareholders carry an entitlement to a fixed dividend, expressed as a percentage of its face value. For example, a £1 5% preference share will pay a dividend of 5p per annum per share. This dividend must be paid before ordinary shareholders are entitled to receive a dividend. However, the company is not allowed to pay either preference or ordinary dividends unless it has sufficient distributable reserves to do so

is it possible for a lender of an bank overdraft to required repayment on demand?

Yes. However this is not the case for a RCF.

beta

_____ are calculated statistically from historic data and can be industry-, sector- or company-specific. A company with a beta of 1.0 is expected to move in line with overall market returns. A beta of 1.5 implies that if the index (overall market) moves by 1%, the target stock will move by 1.5% in the same direction as the market. It is more volatile than the market, and therefore deemed to be more risky; investors should seek an above-average return to compensate. A beta of 0.80 implies that if the overall index moves by 1%, the target stock will move only by 0.8%; it is therefore less volatile and (by implication) less risky; investors should be satisfied with a lower return than on a market portfolio.

floating (security) charge

_____ is a charge over a particular CLASS OF ASSETS, such as INVENTORY OR TRADE RECEIVABLES. It is not possible to identify specific individual assets of this type, as they change day by day as the company runs its business. However, at the date of default, the charge attaches to all assets of that class which exist at that date; they will then be seized and sold. Frequently, both a fixed and floating charge will be granted on the same loan.

Invoice factoring (also called debt factoring)

_____ is a common source of short-term financing involving the sale or assignment of a company's sales invoices to a third party (the factor). The factor buys the company's trade receivables (in the form of the company sales invoices) for a sum which is typically 80-90% of the face value of the invoices, depending on the quality, terms and age of the company's receivables book. The factor takes on responsibility for collecting these debts and, once they have been collected, pays over the balance of the invoice amounts - less a fee. This means that the company can raise working capital finance from the factor, rather than waiting for its customers to pay their invoices.

A sale and leaseback

_____ is another means of financing non-current assets, and property in particular. In this case the company sells one or more of its properties to a bank or specialist financing house, in return for a cash payment at the property's market value. Simultaneously it enters into a lease agreement to rent the property from the bank so that it continues to have the use of the assets in its operations, in exchange for rental payments. These rental payments may be at market rates, index-linked, or based on the value of the transaction.

market risk premium

_____ is the difference between the expected return on a market portfolio (broadly the stock market as a whole) and the risk-free rate. Independent research organisations carry out research into the historical gap between returns on government bonds and returns on the equity markets over time, and this research is frequently used to assess the risk premium going forward. The premium over an extended period of time (20-50 years) is more reliable, as the long-term relationship between stock market returns and the risk-free return is relatively stable. Short-term data may show very wide variations and may not be reliable as an indication of investors' needs.

asset-based lending

_____ the lenders provide a secured term loan of up to (say) 80% of the value of the assets - depending on the type and quality of the asset. The term of the loan will depend on the life, quality and type of the assets used as security for the loan. Unlike a factoring company, an asset-based lender will not take ownership of the assets unless the borrower defaults on the loan, in which case it may enforce the security.

fixed (security) charge

_____ works exactly like the domestic mortgage. Here, the loan agreement clearly identifies SPECIFIC ASSETS which are pledged as security. They tend to be NON-CURRENT ASSETS, such as properties and machinery. In the event of default, these specific assets will be seized and sold to repay the company's creditors, with any shortfall forming part of the unsecured liabilities of the company.

(1) Bearer bonds (2) negotiable instruments

_____(1)_____ are certificated instruments. They can be transferred from one holder to another without formality or entry in a register, simply by physically handing over the certificates, as if they were banknotes. This means that bearer bonds qualify as _____(2)_____.

Exchangeable

______ bonds share all the characteristics of convertibles except one. Whereas convertible bonds may be converted into shares in the issuing company only, exchangeable bonds are converted into shares in another company. This is either a subsidiary of the issuer, or another company or companies in which the issuer has a substantial equity interest.

Contingent

______ convertible bonds (sometimes called CoCos) are also converted into shares of the issuer. However, the bonds are converted on a contingent basis: that is, if some predetermined event arises, the bonds are mandatorily converted into equity. The commonest example of this is in the banking sector, where banks are required to maintain core tier one capital (equity and retained profits) of at least 6% of their risk-weighted assets. A bank can issue a contingent convertible bond, which is convertible in the event of its tier one capital falling below (say) 5%. When tier capital falls below this threshold, the bond is converted into equity, immediately adding equity to the bank's capital base. These instruments were widely used during the banking crisis.

mezzanine debt

a method of obtaining additional leverage on top of a traditional first mortgage. This debt is secured by the pledge of an equity interest in the borrowers' partnership or business- it usually is not secured by a lean on a property (quizlet definition)

bank overdrafts

allows the company to borrow and repay up to a pre-agreed amount, without further discussion with its bankers, as and when required. It is usually used for short-term funding needs, such as short-term working capital shortfalls. Overdraft interest is typically variable rate, and the sums borrowed are usually repayable on demand.

which type of structure is predominately used by Non-For-Profits?

company limited by guarantee. - does not have a share capital or shareholders - Instead, it has guarantors who guarantee the obligations of the company, rather than contributing capital, and their liability extends only to the level of their guarantee.

when would it be a good time to issue a convertible bond?

convertible issue may be an attractive option when shares are underpriced, and this can make it an inexpensive way to issue shares, while earning interest in the meantime.

private limited company

designated 'limited' or 'ltd'. Private companies are not allowed to offer shares to the public and are subject to rather fewer regulatory restrictions than public companies

public limited company

designated 'plc'. These are allowed to offer shares to the public, and are subject to greater regulatory restriction. can apply for admission to listing on the London Stock Exchange (LSE) or another stock exchange, enabling it to raise capital by selling shares in the equity markets, and provide a trading venue for its investors. However, the majority of plcs do not have a stock market listing, perhaps choosing to avoid the cost and regulatory burden involved. Some of these may raise equity capital through other routes, such as private equity placements

Will the yield to maturity increase or decrease as a result of a bond issued a discount? at a premium?

discount --> capital gain if held to maturity --> YTM increases premium --> capital loss if held to maturity --> YTM decreases

is a traded debt short-term or long-term?

either

do bank loans have an amortising repayment schedule or bullet repayment schedule?

either are possible/

what is the main reason why debt is generally a cheap form of capital?

interest expense is deductible

loans

may be *bilateral agreements* (ie, an arrangement directly between a borrower and one bank) or they may be *syndicated agreements* (ie, a loan provided by a syndicate of banks, organised by a mandated lead arranger) Either way, there is no public trading facility in place for these loans. They may be referred to as unquoted, to distinguish them from quoted debt securities. Bank loans are the most common form of unquoted debt.

zero coupon bonds

no interest payable over the life of the bond

1. A company's share capital can be divided broadly into two distinct classes of share. What are they?

ordinary and preference shares

2. What is nominal value also known as?

par value

are preference shareholders paid before or after ordinary shareholders?

preference shareholders, as they have "preference". However, stating the obvious, on a winding-up, both preference and ordinary shareholders rank behind all debt holders and other creditors of the company

conversion ratio

refers to the number of shares which can be bought with £100 nominal value convertible bonds.

difference between fixed-rate and floating-rate interest

see p.87

How is the title to equities in the UK evidenced?

share register. In comparison, debt issuers maintain an electronic register or the register is maintained by intermediaries

- Short-term bonds typically have a maturity of _____; - medium-term bonds typically have a maturity of _____ ; and - long-term bonds typically have a maturity of _____.

short-term bonds: 1-3 years medium-term bonds: 3-10 years long-term bonds: 10+ years

revolving credit facilities

similar to an overdraft in that it allows the borrower to draw down and repay all or part of the loan as necessary throughout the life of the facility. The facility is available for a pre-agreed period and, providing that the borrower complies with the terms of their agreement, it is not repayable on demand

Where do DCMs make their trades?

stock exchanges, such as the LSE, and over-the counter (OTC) trading, ie, off-exchange

index-linked bonds

the coupon is expressed in real terms and the bondholder is entitled to this coupon plus an inflation-linked uplift. In a 3% index-linked bond after one year of issue where the retail prices index (RPI) inflation rate was 1.5%, the 3% coupon would be increased for the following year by 1.5%, ie, increased to 3.045%, while the redemption value would also be increased by the same percentage.

how does a transfer of ownership take place?

through a clearing organisation when a trade is settled

another term for liquidation?

winding-up

what rights do ordinary shareholders generally have?

• VOTING RIGHTS AT ANNUAL GENERAL MEETINGS, which allow them to appoint directors, adopt the company's accounts, approve the directors' remuneration report and pass other resolutions (private companies are not obliged to hold an AGM) • VOTING RIGHTS AT (AD HOC) GENERAL MEETINGS which are not AGMs; these meetings are held on an ad hoc basis during the year for some special purpose, such as a capital reorganisation or a significant transaction • INFORMATIONG RIGHTS, including the right to receive the annual report and accounts and interim financial statements, and to attend and speak at general meetings (private companies are not required to produce interim financial statements).

It will be clear that debt is always a less expensive source of capital than equity, because it:

• provides a tax shield, reducing the amount of tax a borrower pays • is less risky for the investor, as it ranks above equity for distributions and on a winding-up, such that a lender should require a lower return than an equity investor

what features do a straight / vanilla bond have?

• with index-linked coupon payments and redemption proceeds • without coupon payments; these are known as zero coupon bonds • with conversion rights; these convertible bonds normally confer a right on the holder to convert them into ordinary shares of the issuer, on pre-specified terms and on predetermined dates •with floating rather than fixed coupons. These are termed floating rate notes (FRNs) or variable rate notes (VRNs) • with provisions for early redemption; a CALLABLE BOND enables the issuer to enforce early repayment, whereas a bond with a PUT provision enables the holder to enforce early repayment.