¡Descarga Comparing Bonds & Loans: Ownership, Rates, Repayment y más Apuntes en PDF de Administración de Empresas solo en Docsity!
CHAPTER 4 FINANCIAL MANAGEMENT
EXTERNAL FINANCIAL SOURCES
DEBT IS NOT BAD
“It takes money to make money”. Debt might help you generate more income
TAX-DEDUCTIBLE INTEREST
The tax deductibility of interest increases the total income that can be paid out to bondholders and
stockholders.
FIANCNIAL GEARING/LEVERAGE
Use of debt to increase the expected return on equity.
Firm U
- Debt = 2000
- Equity = 9.
- Firm U
- Increase of equiy = 1.
- Firm L
- Increase of debt = 1.
Firm L
• ROE=
$"#$
$%"$$
• ROE =
$#%&
$&$$$
The firm that uses debt as a source of financing presents a higher profitability (also a higher risk)
Advantages of Gearing
- Higher Return on Equity (ROE
= Net Income/Equity).
- Diversification of Investments Tax
Effective
- Can avoid equity dilution
Disadvantages & Risks of Gearing:
- Debts must be repaid
- Debts have some costs (fees, interest,
issue costs...)
- Risk of Interest, Risk of Currency
- Debts make the balance sheet to show a
worse situation
THE DEBT EFFECT: RISK-RETURN
Firm U
• ROE= 6,8%
Firm L
• ROE= 7,5%
Firm U presents a lower return (ROE) and a lower risk (lower debt ratio) than Firm L
ISSUE OF DEBTS: LOANS
Personal Loans:
- Unsecured loans: These loans don't require collateral such as your home, car or other personal
property. ...
Secured loans :Asecuredloanrequirescollateralthat“secures”theloan.
According to interest rates
- Fixed rate personal loans
Variable rate loans. ...
According to the repayment method
- Amortized loans
- Bullet loans
Lines of credit. ...
Credit cards, cash advances and balance transfers.
Þ Fixed interest rate loans – the interest rate of the loan remains the same either for the entire
term of the loan or for part of the term. This kind of loans are attractive for borrowers who don’t
want to be exposed to an increase of interest rates
Þ Floating interest rate loans – the interest rate on the loan fluctuates over time, because it is
based on an underlying benchmark interest rate or index that changes periodically. The obvious
advantage of a variable interest rate is that if the underlying interest rate or index declines, the
borrower's interest payments also fall. Conversely, if the underlying index rises, interest
payments increase.
Þ In Europe the benchmark is usually the euribor (euro interbank offer rate) while in USA is the
LIBOR (London interbank offer rate)
Þ Term loans – loans with a maturity higher than 1 year
Þ Business line of credit: provides flexibility that a regular business loan doesn’t. With a business
line of credit, you can borrow up to a certain limit and pay interest only on the portion of money
that you borrow. You then draw and repay funds as you wish, as long as you don’t exceed your
Since 2011, the total debt of S&P 500 companies have increased up to more than $8.000 billions,
although the leverage has decreased :
Issue of Debt:
In 2018, non-financial companies issued $5.700 billions of dollars a 3,6% than in the previous year. The
majority are rated BBB
Examples of bonds:
Microsoft issues biggest bond of the year in debt market boom: 10 - year bond with a 3,3% coupon to be
used for general corporate purposes, including the repayment of short-term debt used to help fund
Microsoft’s $26 billion acquisition of LinkedIn Corp
Walt Disney Co. sold $7 billion of bonds, leading one of the busiest days ever for investment-grade debt
issuance in the U.S. Disney offered the unsecured notes in six parts, the largest deal Tuesday, when a
total of about $27 billion priced. The longest portion of the offering, a 30-year security, will yield 0.
percentage points more than Treasuries, down from initial talk of around 1.15 percentage points,
according to a person with knowledge of the matter, asking not to be identified as the details are private
WHAT IS A BOND?
Bond: an aliquot (=equal) part of a debt.
The bond entitles the holder to receive cash payments, generally annually, according to a specific coupon
rate and the nominal value of the bond at the maturity date
Terminology
- Bond - Security that obligates the issuer to make specified payments to the bondholder
- Face value (par value or principal value) - Payment at the maturity of the bond.
- Maturity date – the date when the bond makes its last payment
- Coupon - The interest payments made to the bondholder.
Coupon rate
- Annual interest rate, as a percentage of face value.
CHARACTERISTICS OF A BOND
Coupon Payment = Coupon rate * Face Value
ISSUE OF DEBT:
The main difference between debt issuance and a loan is:
Issue of debt: owing money to many lenders.
Getting a loan: owing money to one bank*
*or to a banks’ syndicate – a large loan provided by a group of banks
Banks and loans – both are methods for governments or firms to borrow money. The government/firm
will pay annual interest rate payments on both loans and bonds.
DEBT VS EQUITY FINANCING
DEBT EQUITY
Not an ownership interest in the firm
Not dilute ownership power
No voting power
Interest payments are tax deductible
Unpaid debt is a liability for the firm
Bankruptcy risk
Less cash: debt amortization and interest payments
Less expensive: Kd < Ke
Ownership interest in the firm
Produces dilution to old shareholders
Voting power
Dividens are not tax deductible
Equity is not a liability. You don't have to pay it back
No brankruptcy risk
More cash
More expensive: Ke > Kd
All bonds of an issuance must:
- Be equal.
- Inform about company’s features and place of payment
- Show date and number of the Public Deed, and name of Notary
- Number of bonds, face value, interest, maturity, premium (if there is a premium), redeemability
(if there are redeemable bonds).
- Guarantees of the issuance
- Signature of a director of the company
External funding sources – Different kinds of debt (bonds)
- Perpetuities
- Convertible bonds
- Callable bonds
- Bonds with warrants
- Senior and subordinated bonds
- Unsecured and secured bonds
- Bonds with tax rebate
- Zero-coupon bonds
- Strippable bonds
- Indexed and participating bonds
- Nominal and bearer bonds
TYPES OF BONDS:
the amortization will be at the maturity date § Short-term–Treasury-bills
o Medium – term – Treasury Notes (2, 3, 5, 7 and 10 years)
o Long-term bonds (debentures) have a maturity above 10 years
are also often called perpetuities or 'Perps'. They have no maturity date. The most famous of these are
the UK Consols, which are also known as Treasury Annuities or Undated Treasuries. Some of these were
issued back in 1888 and still trade today, although the amounts are now insignificant. Some ultra-long-
term bonds (sometimes a bond can last centuries: West Shore Railroad issued a bond which matures in
2361 (i.e. 24th century) are virtually perpetuities
(Known or by drawing lots).
bonds that may be converted into a fixed number of shares at the holder’s option. Usually, there is a
minimum and maximum term to execute the conversion. (Usually: non compulsory conversion)
In 2014 Tesla Motors Inc. issued $2 billion convertible bonds to finance the construction of the Tesla
Gigafactory in Nevada.
Raising capital for this project using standard nominal bonds was prohibitively expensive as the interest
rates demanded by investors were very steep. However, with the conversion option, the interest rates on
Tesla's convertible bonds ranged between 0,25% and 1,25%.
Example:
Issuance of Bonds with a Face Value of 1000€ (no premium nor discount: at par value) convertible in
shares at a price of 50€. (The present market value of a share is: 40€).
Conversion Coefficient = 1.000€ /50€ = 20
Conversion Value = 20 * 40€ = 800€
Conversion Premium = 1.000€ - 800€ = 200€
Should the convertible bondholder exercise his option to convert? NO
Conversion coefficient = Bond Issue Price / Conversion Price.
Conversion value = Conversion coefficient * Share Market Value
Conversion Premium = Bond Issue Price – Conversion Value
Which will be the criteria of the bondholder to convert or not the convertible bond into shares?
Investors will not convert:
If the price of the bond is > its conversion value
Investors will convert:
If the conversion value is > the price of the bond
Example of an issue of convertible bonds:
May 2017 – Banco Sabadell issues CoCos (contingent convertible bonds)
Amount =750 million of euros
Interest rate = 6,5%, revised every 5 years
Investment Banks that underwrite and sell the issue – Deutsche Bank, lead manager of the syndicate of
Banks
Should firms issue callable bonds?
Call provisions have value because a call works to the advantage of the issuer. If interest rates fall and
bond prices go up, the issuer has an option to buy back the bonds at a call price that may be below the
“true” market value. This is a valuable option. In bond refunding, firms will replace the called bonds with a
new bond issue. The new bonds will have a lower coupon rate than the callable bonds.
Callable bond value = Noncallable bond value – call provision option value
Bondholders will take the call provision into account when they buy the bond, and they will require
compensation in the form of higher interest rates.
Instead of issuing a convertible bond, companies may sell a package of:
Straight bonds + Warrants
What is a Warrant?
Warrants are long-term call options that give the investor the right to buy the firm’s common stock
Bonds with warrants give the bondholder the right (not the obligation) to buy a certain number of shares
at a fixed price for a specified period of time.
A $1,000 bond, for example, could come with a warrant to buy 500 shares at $20 each.
The bondholder can exercise the warrant any time during its life span, which could be a few years, or
extend indefinitely into the future. Usually the warrant runs at least five years.
In most cases, warrants are "detachable,”: the bondholder can sell the bond and keep the warrants or sell
the warrants and keep the bonds. This makes it possible to trade and invest in warrants independently
from the bond market. It also makes warrants different from call options, another arrangement for
buying stocks at a fixed price, because options can't be traded.
Warrants are not the same as call options
- Warrants are delivered by the issuing company and the option by the investor holding the shares
- In most cases, warrants are "detachable,” and options no
- Call options have a shorter shelf life than warrants do (usually less than a year versus five or
more for warrants)
Bonds with warrants are not the same as convertible bonds
1.In the convertible, the bond and the option are bundled together. They couldn’t be sold separately.
Warrants are sometimes non-detachable but usually you can keep the bond and sell the warrant.
2.When you convert a bond, you exchange the bond for shares. When the investor exercises warrants, he
generally puts up extra cash
3.They have different tax treatment
4.Warrants do not have to be issued in conjunction with other securities
Some bond issuances can offer tax rebates, with permission of the tax administration.
- Only bonds issued by tolled motorways companies, spanish law of 1972
- Reduction on withholding tax on interest (95%)
Example:
We invested 10.000€ in Audasa bonds (6%), we get the coupon of 600€; withholding tax on interest: 6,
€ (95% reduction on 21%).
Withholding tax of 21%: 600€ x 0,21 = 126€
Reduction of 95%: 0,05 x 126€ = 6,3€
(Note: There are different income bands: up to 6.000€ - tax at 19%; between 6.000€ and 50.000€ at 21%
and higher than 50.000€ - at 23%)
So, in our income tax declaration, we’re allowed to declare that the withholding tax on interest was of
21%, so 126 euros. We save almost 120 euros.
You pay 6,3€ but in your tax declaration will figure the amount of 126€
- senior and subordinated bonds
According with the priority in which the debt claims are paid by a firm in bankruptcy or liquidation, we
distinguish between: Senior Bonds and Subordinated bonds
If a company has both subordinated debt and senior debt and has to file for bankruptcy or faces
liquidation, the senior debt is paid back first before the subordinated debt. Once the senior debt is
completely paid back, the company then repays the subordinated debt.
There is risk, however, that a company is not able to pay back its subordinated debt due to the fact it
probably does not have much money and is obligated to pay back the senior debt first. Therefore, it is
more advantageous for a lender to own a claim on a company's senior debt than on subordinated debt.
EXAMPLE:
For example, if a company has senior debt A that totals $100 and subordinated debt B that totals $
If the company needs to file for bankruptcy, it is required to liquidate all of its assets to repay the debt. If
the company's assets are liquidated for $125, it first needs to pay off the $100 amount of its senior debt
A. The remaining subordinated debt B is only half repaid due to the lack of money.
- unsecured and secured bonds
According to guarantees:
UNSECURED BONDS - DEBENTURE
A debenture is a type of debt instrument that is not secured by physical assets or collateral. Debentures
have no collateral, so they are backed only by the general creditworthiness and reputation of the issuer.
Bond buyers generally purchase debentures based on the belief that the bond issuer is unlikely to default
on the repayment.
An example of a government debenture would be any government- issued Treasury bond (T-bond) or
Treasury-bill (T-bill). T-bonds and T-bills are generally considered risk-free because governments, at
worst, can print more money or raise taxes to pay these types of debts.
“Strippable Bonds”: You break it in “n” parts: one for each coupon, and one for the face value. In our case
n is four.
Why are they issued? Market liquidity and tax advantages (no withholding tax-on- interest).
Example 2:
A 10-year bond with a $40,000 face value and a 5% annual interest rate can be stripped. Assuming it
originally pays coupons semi-annually 21 zero- coupon bonds can be created:
- Thisincludesthe20semi-annual coupon payments. Each stripped coupon has a $1,000 face value, which
is the amount of each coupon.
- There is also a bond created from the principal payment at maturity.
- All 21 securities are distinct and trade in the market.
- indexed bonds and participating bonds
- Indexed bonds – inflation-indexed bonds (US) or Index-linked bonds (UK), in which the principal amount
and the interest payments are indexed to inflation.
- Participating bonds - is a bond that pays the holder dividends as well as interest. Participating bonds are
frequently issued by financially weak corporations who must offer an extra inducement to attract
investors.
- nominal bonds and bearer bonds
- Nominal bonds – bond or debt security issued by a business entity such as a corporation or a
government and with the name of the holder registered
- Bearer bonds – bonds issued without a named holder. It is unregistered
AMORTIZATION (REDEMPTION) OF BONDS
It is the act of an issuer repurchasing a bond at or before maturity
Redemption is made at the face value of the bond unless it occurs before maturity in which case the bond
is bought back at a premium to compensate for lost interest
Causes of amortization:
- Agreement company & bondholders syndicate
- Purchase (secondary market) with this aim
- Conversion into shares (convertible bonds)
- At par – the market price of the bond is equal to nominal value 100%
- At Premium - the market price of the bond is above nominal value > 100%
- At a discount - the market price of the bond is under nominal value < 100%
Amortization (redemption) of Bonds - is the return of an investor's principal in a fixed income security.
The redemption of an investment may generate a capital gain or loss.
Amortization systems.
- Constant amortization method. (drawing lots).
- Sinking fund method.(combined with purchase) – money saved by a Company for the payment
of future debts.
“Early redemption clause”.
When companies need to raise new capital, they follow the traditional way of issuing securities:
Fixed income – bonds or Variable income – stocks
How companies issue securities?
When a company decided to raise capital by issuing stock, it must file a formal registration statement
with the Securities and Exchange Commission (SEC). This registration statement contains details such as
the financial history of the business, current financial situation and the proposed public issue and future
projections. Also, the company must also prepare a preliminary prospectus that contains information
similar to that of the registration statement for all potential investors.
There is a waiting period of twenty days, after which the registration statement is considered as
accepted. During this period, if there are any clarifications or changes sought, the SEC would send a letter
of comment seeking changes. After the conclusion of the waiting period, the securities can be sold, and a
financial prospectus can be issued.
An investment bank will act as an underwriter to effect the sale, and this is known as a primary offering.
Companies issuing stocks and bonds may use investment banks to facilitate the process. For example, if a
company decides to sell bonds, the investment bank determines the value and riskiness of the
corporation, and then determines the prices, and underwrites and sells the bonds to the public.
FUNCTIONS OF INVESTMENT BANKS
The role of investment banks:
- Underwriters of stocks and bonds
- Handling mergers and acquisitions
- Financial advisors
The redemption and cancellation of the notes marks a significant milestone in the execution of the
company's business plan. The purpose of the transaction is to reduce gross debt and the average cost of
its long-term debt, while extending its average tenor.
Pursuant to the terms and conditions of the issuance, the cancellation will be completed pursuant the
voluntary early redemption process that allows NH to redeem the 2013 Notes as from 15 November 2017
at 103.438% of their nominal value, plus accrued and unpaid interest from the last interest payment date
to the redemption date.(to continue on next slide)
NH Hotels announced that on next, november 30, it will redeem its senior guaranteed bonds with
maturity in 2019 and an outstanding value of 100 million euros.
With this early redemption, NH will benefit from a saving of 9,6 million euros in interest over the
remaining period until maturity (november 30, 2019).
After the announced amortization, the average cost of the debt is reduced from 4,2% to 3,8%.
After the redemption announced today, and without considering the temporary use of short- term credit
facilities, the average cost of the company's debt will fall from 4.2% to 3.8%; its average tenor will
increase from 4.4 to 4.7 years, and the gross debt will stand at around €740 million. Also as a result of this
redemption, the syndicated revolving credit facility arranged in 2016 for €250 million will remain fully
undrawn and its maturity will be automatically extended to 2021.
Following the issuance of senior secured notes carried out in 2016 and 2017, which had already
significantly reduced the company's average borrowing cost and extended its maturity profile, NH Hotel
Group completes the refinancing of its long-term debt with this redemption. The only debt instrument
now due in the medium term are the €250 million convertible bonds due November 2018 with a
conversion price of €4.919/share (last close: €5.33).
ABOUT NH HOTEL GROUP
NH Hotel Group (www.nhhotelgroup.com) is a world-leading urban hotel operator and a consolidated
multinational player. It operates close to 400 hotels and almost 60,000 rooms in 31 markets across
Europe, the Americas and Africa, including top city destinations such as Amsterdam, Barcelona, Berlin,
Bogota, Brussels, Buenos Aires, Düsseldorf, Frankfurt, London, Madrid, Mexico City, Milan, Munich, New
York, Rome and Vienna.
BANK CREDIT ACCOUNTS & LOANS
Bank loans, for many smaller firms, are the only source of borrowing.
Term – Loans: they have typically a maturity of four to five years. They can be repaid in level amounts
over the period of the loan, though there is sometimes a large final balloon payment or just a single bullet
payment at maturity.
Term loans are often renegotiated before maturity.
Bank Loan covenants restrict companies from taking actions that would increase the risk of their debt. For
example:
- Set a maximum fraction of net income that can be paid out as dividends
- Sweeps state that all or part of the loan must be repaid if the borrower makes a large sale of
assets or a substantial issue of debt.
- Set conditions on key financial ratios (debt ratio, interest coverage ratio or current ratio
Bank loans, for many smaller firms, are the only source of borrowing. Different kinds (short-term):
Credit lines: the Company is allowed to borrow up to an established limit from the bank
- Evergreen credit: is a credit line with no fixed maturity
- Revolving credit: is a credit line with a fixed maturity
Cost: credit lines are expensive because in addition to paying interest on any borrowing, the Company
must pay a commitment fee of around 0,25% on the unused amount
Þ Fixed interest rate loan costs – is an interest rate on a loan that remains the same either for the
entire term of the loan or for part of the term. This kind of loans are attractive for borrowers
who don’t want to be exposed to an increase of interest rates
Þ
Floating interest rate loan costs
- is an interest rate on a loan that fluctuates over time, because
it is based on an underlying benchmark interest rate or index that changes periodically. The
obvious advantage of a variable interest rate is that if the underlying interest rate or index
declines, the borrower's interest payments also fall. Conversely, if the underlying index rises,
interest payments increase.
Þ In Europe the benchmark is usually the euribor while in USA is the LIBOR
EURIBOR IN THE BENCHMARK
