Introduction to LongTerm Financing

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Introduction to Long-Term Financing

• CORF Lecture 3
• Saeid Samiei
• Portsmouth Business School

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Overview

• Types of Long term Finance
• Valuing equity
• Valuing debt

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Types of Long term Finance

• Equity
• Debt
• Hybrid securities

4
Examples of Different Finance Vehicles
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The Distinction between Debt and Equity

• Cash Flows Contractual versus Residual
• Cash Flows Priority
• The Tax Code
• Maturity
• Control

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Debt vs. Equity
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Equity

• Owner's Equity
• Venture Capital
• Common Stock
• Warrants
• Contingent Value Rights

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Warrants

• Def The right to buy a share of stock in the
  company at a fixed price during the life of the
  warrant
• Why might a firm use warrants rather than common
  stock to raise equity?
• Volatility estimates
• Raise finds
• Best of both worlds

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Contingent Value Rights

• Def the right to sell a share of stock in the
  underlying company at a fixed price during the
  life of the right
• Why a firm may choose to issue contingent value
  rights.
• Under-valuation
• Over-estimating Volatility
• Attract New Investors

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The Present Value of Common Stocks

• Dividends versus Capital Gains
• Valuation of Different Types of Stocks
• Zero Growth
• Constant Growth
• (Differential Growth)

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Case 1 Zero Growth

• Assume that dividends will remain at the same
  level forever

• Since future cash flows are constant, the value
  of a zero growth stock is the present value of a
  perpetuity

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Case 2 Constant Growth
Assume that dividends will grow at a constant
rate, g, forever. i.e.
.
.
.
Since future cash flows grow at a constant rate
forever, the value of a constant growth stock is
the present value of a growing perpetuity
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Estimates of Parameters in the Dividend-Discount
Model

• The value of a firm depends upon its growth rate,
  g, and its discount rate, r.
• Where does g come from?
• Where does r come from?

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Formula for Firms Growth Rate

• g Retention ratio Return on retained earnings

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Where does r come from?

• The discount rate can be broken into two parts.
• The dividend yield
• The growth rate (in dividends)
• In practice, there is a great deal of estimation
  error involved in estimating r.

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Debt

• Types of Debt
• Valuing debt

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Types of Debt

• Bank Debt
• Advantages
• Bonds
• Advantages

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Bonds

• Def A bond is a legally binding agreement
  between a borrower and a lender
• Specifies the principal amount of the loan (Plain
  Vanilla Bonds - Face value of 100)
• Specifies the size and timing of the cash flows
• Market value of debt PV of expected future cash
  flows
• Future cash flows interest (coupon)
  redemption value

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Valuing a bond Zero Coupon

• Zero coupon bond
• Information needed for valuing zero coupon bonds
• Time to maturity (T) Maturity date - todays
  date
• Face value (F)
• Discount rate (r)

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Zero coupon bond Example

• Find the value of a 30-year zero-coupon bond with
  a 1,000 par value and a YTM of 6.

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Redeemable bond

• Value of a Level-coupon bond
• PV of coupon payment annuity PV of face value
• Information needed to value level-coupon bonds
• Coupon payment dates and time to maturity (T)
• Coupon payment (C) per period and Face value (F)
• Discount rate

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Level-Coupon Bonds Example

• Find the present value (as of January 1, 2002),
  of a 6-3/8 coupon T-bond with semi-annual
  payments, and a maturity date of December 2009 if
  the YTM is 5-percent, Face Value 1000
• On January 1, 2002 the size and timing of cash
  flows are

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Yield to Maturity

• Def The percentage rate of return paid on a
  bond, note, or other fixed income security if the
  investor buys and holds it to its maturity date.
• When coupon rate YTM, price par value.
• When coupon rate gt YTM, price gt par value
  (premium bond)
• When coupon rate lt YTM, price lt par value
  (discount bond)

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Bond Yields and Prices

• Bond prices and market interest rates move in
  opposite directions.
• Once a bond has been issued and it's trading in
  the bond market, all of its future payouts are
  determined, and the only thing that varies is its
  asking price.
• Therefore, the price is driven by market forces,
  which will vary depending on the difference
  between the current market interest rates (for
  same risk level of bond) and the coupon rate.
• For example

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Example of price determination

• Irredeemable bond with coupon rate of 5. Suppose
  current mkt interest rates are 8. What will be
  the price of the bond?
• Discount future cash flows (i.e. 5 annual cash
  flows as a perpetuity)

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The cost of irredeemable debt

• More likely scenario irredeemable bond with
  coupon rate of 5, currently trading at 62.75,
  what is the YTM (or cost of debt capital)?

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Cost of redeemable bonds

• A little more complicated..YTM (or cost of debt)
  has to be found by estimating the IRR of the
  bonds cash flows
• Example
• Lagoa plc issued 10m worth of 5 bonds 7 years
  ago. They are due to be redeemed _at_ par in 3 years
  time. The bond has current mkt price of 101 (cum
  interest). What is the YTM?

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Solution

• Step 1 calculate ex-interest price of bond
• 101 - 5 96
• Step 2 Map cash flows of identical bond issued
  today
• Year 0 1 2 3
• 96 -5 -5 -105
• Step 3 Calculate cash flows at two discount
  rates
• _at_ 5 discount rate gt -4.0 NPV
• _at_ 15 discount rate gt 18.83 NPV
• Step 4 Use linear interpolation to find KD, the
  IRR

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Hybrid Securities

• Convertible Debt
• Preferred Stock
• Option-Linked Bonds
• Commodity Bonds

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Convertible debt

• Def This is debt that can be converted into
  equity at a rate that is specified as part of the
  debt agreement (conversion rate).
• conversion becomes a more attractive option as
  stock prices increase
• Firms generally add conversion options to bonds
  to lower the interest rate paid

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Preferred stock

• Preferred Stock Equity where the holders are
  given priority over common stockholders in the
  payment of dividend
• Characteristics
• fixed dollar dividend
• no voting rights
• payments are not tax-deductible
• no maturity.

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Summary

• Types of long-term financing
• Distinction between debt and equity
• Valuing equity
• Valuing debt