Chapter 25 Principles PrinciplesofCorporateFinance Ninth Edition The Many Different Kinds of Debt Slides by Matthew Will Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin

25- 2 Topics Covered  Domestic Bonds, Foreign Bonds and Euro Bonds  The Bond Contract  Security and Seniority  Repayment Provisions  Debt Covenants  Convertible Bonds and Warrants  Private Placements and Project Finance  Innovation in the Bond Market

25- 3 Bond Terminology  Foreign bonds - bonds that are sold to local investors in another country's bond market  Yankee bond- a bond sold publicly by a foreign company in the United States  Samurai - a bond sold by a foreign firm in Japan  Eurobond market - when European and American multinationals are forced to tap into international markets for capital

25- 4 Bond Terminology  Indenture or trust deed - the bond agreement between the borrower and a trust company  Registered bond - a bond in which the Company's records show ownership and interest and principal are paid directly to each owner  Bearer bonds - the bond holder must send in coupons to claim interest and must send a certificate to claim the final payment of principal  Accrued interest - the amount of accumulated interest since the last coupon payment

25- 5 Bond Contract Summary of terms of 8.25% sinking fund debenture 2022 issued by J.C. Penney

25- 6 Bond Terminology  Debentures - long-term unsecured issues on debt  Mortgage bonds - long-term secured debt often containing a claim against a specific building or property  Asset-backed securities - the sale of cash flows derived directly from a specific set of bundled assets

25- 7 Recovery Rates Ultimate Percentage Recovery Rates on Defaulting Debt (1987 – 2005) Recovery Percentage

25- 8 Bond Terminology  Sinking fund - a fund established to retired debt before maturity  Callable bond - a bond that may be repurchased by a the firm before maturity at a specified call price  Defeasance - a method of retiring corporate debt involving the creation of a trust funded with treasury bonds

25- 9 Bond Terminology  Restrictive covenants - Limitations set by bondholders on the actions of the Corporation  Negative Pledge Clause - the processing of giving unsecured debentures equal protection and when assets are mortgaged  Poison Put - a clause that obliges the borrower to repay the bond if a large quantity of stock is bought by single investor, which causes the firms bonds to beat down rated

Bond Terminology  Pay in kind (PIK) - a bond that makes regular interest payments, but in the early years of the bonds life the issuer can choose to pay interest in the form of either cash or more bonds with an equivalent face value  Puttable bond – A provision that allows the bondholder to demand immediate payment. This is the central feature in loan guarantees issued by the government.

Straight Bond vs. Callable Bond Value of straight bond bond Value of Straight bond bond callable at 100

Covenants  Debt ratios: –Senior debt limits senior borrowing –Junior debt limits senior & junior borrowing  Security: –Negative pledge  Dividends  Event risk  Positive covenants: –Working capital –Net worth

Event Risk: An Example October 1993 Marriott spun off its hotel management business worth 80% of its value. Before the spin-off, Marriott’s long-term book debt ratio was 2891/3644 = 79%. Almost all the debt remained with the parent (renamed Host Marriott), whose debt ratio therefore rose to 93%. Marriott’s stock price rose 13.8% and its bond prices declined by up to 30%. Bondholders sued and Marriott modified its spinoff plan.

What is a Convertible Bond?  Ford –4.25% Convertible 2036 –Convertible into shares –Conversion ratio –Conversion price = 1000/108.7 = $9.20 –Market price of shares = $12.00  Lower bound of value –Bond value –Conversion value = x 12 = $1,304

What is a Convertible Bond?  How bond value varies with firm value at maturity default bond repaid in full Bond value ($ thousands)

What is a Convertible Bond?  How conversion value at maturity varies with firm value Conversion value ($ thousands)

What is a Convertible Bond?  How value of convertible at maturity varies with firm value default bond repaid in full convert Value of convertible ($ thousands)

Bond Warrant Package  Bond and Option –Warrants are usually issued privately –Warrants can be detached –Warrants are exercised for cash –A package of bonds and warrants may be taxed differently –Warrants may be issued on their own

Project Finance 1. Project is set up as a separate company. 2. A major proportion of equity is held by project manager or contractor, so provision of finance and management are linked. 3. The company is highly levered.

Parties In Project Finance

Risk Allocation

Bond Innovations

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