Chapter 12 Types of financial instrument Corporate Financial Strategy 4th edition Dr Ruth Bender Chapter 12 Types of financial instrument

Types of financial instrument: contents Learning objectives Options terminology Factors affecting the value of an option Black–Scholes options valuation model Payoffs on options Public (market) debt and private (bank) debt Continuum of financial instruments Credit ratings (long-term debt) Securitization cash flows Mezzanine and convertibles give return in two ways Mezzanine and convertibles, from lender’s point of view Positioning the convertible Why use a convertible? Features of convertibles

Learning objectives Distinguish different types of financial instrument, assess the broad categories into which they fall, and contrast their fundamental characteristics. Discuss the continuum of financial instruments, and explain why the terms of a particular instrument will affect its position on the continuum. Describe how credit rating agencies work. Understand in broad terms the accounting treatment of financial instruments.

Options terminology A call option is the right to buy A put option is the right to sell A European option can be exercised at a particular date An American option can be exercised during a period If price of underlying asset > exercise price the option is in-the-money If price of underlying asset = exercise price the option is at-the-money If price of underlying asset < exercise price the option is out of-the-money (underwater)

Factors affecting the value of an option CALL PUT Price of underlying asset Exercise price of option Time to exercise ?? Volatility of price of underlying asset Risk-free rate ?? Option value increases with time to expiry, but today’s value of the sum received decreases with time, so the net end result is uncertain. (In principle, same should apply to the direction of value for volatility, but it doesn’t.)

Black–Scholes options valuation model C = price of call option P = current price of the shares E = exercise price t = time remaining until expiry of option r = risk-free rate N(d1) = hedge ratio N(d2) = probability of exercise Measures of volatility

Payoffs on options Payoffs to buyers Payoffs to sellers PUT AND BUY THE SHARE Value to option owner CALL PUT Value of share at expiry Value of share at expiry Value of share at expiry Payoffs to sellers CALL PUT Value of share at expiry Value of share at expiry

Public (market) debt and private (bank) debt Public debt Issued using a prospectus Probably underwritten Can be cheaper, with fewer covenants Not suitable for small amounts of finance Face value is generally denominated in units of 100 or 1,000 of currency. But it may not be issued at 1,000 and probably won’t trade at that amount. Trading price is shown as a % of the face value. Interest will be based on this face value. Difficult to resolve if the company faces problems Private debt Advanced by a bank May be syndicated to a group of banks Flexible and quick E.g. Term loans, overdrafts, revolvers (a revolving line of credit is a credit commitment of up to an agreed amount for a specified time, to be drawn and repaid as needed)

Continuum of financial instruments Financial Instruments and Raising Equity Dr Ruth Bender Continuum of financial instruments Ordinary shares Required return Preference shares Convertibles Mezzanine High yield debt Unsecured debt Secured debt Perceived risk

Credit ratings (long-term debt) AAA AA+ AA AA– A+ A A– BBB+ BBB BBB– BB+ BB BB– B+ … D Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 … C Based on opinion of overall financial capacity to pay. Uses qualitative and quantitative analysis. Information supplied by the company, or from other sources. May relate to a company, or to a particular debt obligation. Short-term debt is also rated, using a different system. There are other ratings agencies Investment grade junk

Securitization cash flows Credit enhancement Originating company Servicing fees Subscription proceeds Investors Issuer (Special Purpose Vehicle) Proceeds of asset sale Principal & interest Payment of principal & interest Asset pool (principal and interest from borrowers)

Mezzanine and convertibles give return in two ways Required return Return from capital gain Return from yield Perceived risk

Mezzanine and convertibles, from lender’s point of view Initial investment in Year 0 Interest received in years 1 to n In Year n, two things happen The loan is repaid And Warrant is exercised to receive shares Initial investment in Year 0 Interest received in years 1 to n In Year n, one of two things will happen Either The loan is repaid Or Loan is converted into shares

Positioning the convertible

Convertibles are used to delay equity or sweeten debt Why use a convertible Can’t use debt Cash restrictions – can’t afford interest – can’t afford repayments Profit restrictions Covenant restrictions from existing lenders Can’t use equity Dilutes eps Loss of control by block-holder Convertibles are used to delay equity or sweeten debt

Features of convertibles Gearing effect Attracts investors Tax advantages Self-liquidating Cheaper yield Less eps dilution If under-priced, dilutes eps more than necessary If over-priced, have to repay at inopportune time For issuer Higher yield than equity Upside of capital gain Can decide if/when to convert Possibility of non-repayment If share price doesn’t rise – lost out by allowing cheap debt For holder Advantages Disadvantages