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    Types of Financial Instrument: Corporate Financial Strategy 4th Edition DR Ruth Bender

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    Ain rose
    The chapter discusses different types of financial instruments that corporations can use. It defines options terminology, explores factors that affect option values, and describes models for valuing options. The chapter also examines the differences between public and private debt, outlines where various financial instruments fall on a risk/return continuum, and explains how credit ratings and securitization work. Mezzanine financing and convertible instruments are discussed as having dual potential returns through interest payments and equity appreciation.

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    Types of Financial Instrument: Corporate Financial Strategy 4th Edition DR Ruth Bender

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    Ain rose
    31 views16 pages
    The chapter discusses different types of financial instruments that corporations can use. It defines options terminology, explores factors that affect option values, and describes models for valuing options. The chapter also examines the differences between public and private debt, outlines where various financial instruments fall on a risk/return continuum, and explains how credit ratings and securitization work. Mezzanine financing and convertible instruments are discussed as having dual potential returns through interest payments and equity appreciation.

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    The chapter discusses different types of financial instruments that corporations can use. It defines options terminology, explores factors that affect option values, and describes models for valuing options. The chapter also examines the differences between public and private debt, outlines where various financial instruments fall on a risk/return continuum, and explains how credit ratings and securitization work. Mezzanine financing and convertible instruments are discussed as having dual potential returns through interest payments and equity appreciation.

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    Download as pptx, pdf, or txt
    31 views16 pages

    Types of Financial Instrument: Corporate Financial Strategy 4th Edition DR Ruth Bender

    Uploaded by

    Ain rose
    The chapter discusses different types of financial instruments that corporations can use. It defines options terminology, explores factors that affect option values, and describes models for valuing options. The chapter also examines the differences between public and private debt, outlines where various financial instruments fall on a risk/return continuum, and explains how credit ratings and securitization work. Mezzanine financing and convertible instruments are discussed as having dual potential returns through interest payments and equity appreciation.

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    Corporate Financial Strategy

    4th edition
    Dr Ruth Bender
    Chapter 12

    Types of financial instrument

    Corporate Financial Strategy


    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

    Corporate Financial Strategy 2


    Learning objectives

    1. Distinguish different types of financial instrument, assess the broad


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

    Corporate Financial Strategy 3


    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)

    Corporate Financial Strategy 4


    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.)

    Corporate Financial Strategy 5


    Black–Scholes options valuation model

    EN (d 2)
    C  PN (d1)  rt
    e
    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

    Corporate Financial Strategy 6


    Payoffs on options

    Payoffs to buyers
    PUT AND BUY THE
    SHARE
    Value to
    CALL PUT
    option
    owner

    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

    Corporate Financial Strategy 7


    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)

    Corporate Financial Strategy 8


    Continuum of financial instruments

    Ordinary
    Required shares
    return
    Preference
    shares
    Convertibles
    Mezzanine
    High yield debt
    Unsecured
    Secured debt
    debt

    Perceived risk

    Corporate Financial Strategy 9


    Credit ratings (long-term debt)

    AAA Based on opinion of overall Aaa


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

    Corporate Financial Strategy 10


    Securitization cash flows

    Credit
    enhancement

    Servicing fees Subscription


    Originating proceeds
    Issuer
    Investors
    company (Special
    Proceeds of Purpose
    asset sale Principal &
    Vehicle)
    interest
    Payment of principal &
    interest

    Asset pool
    (principal and
    interest from
    borrowers)

    Corporate Financial Strategy 11


    Mezzanine and convertibles give return in two ways

    Required
    return

    Return from capital gain

    Return from yield

    Perceived risk

    Corporate Financial Strategy 12


    Mezzanine and convertibles, from lender’s point of view

    MEZZANINE CONVERTIBLES
     Initial investment in Year 0  Initial investment in Year 0
     Interest received in years 1 to n  Interest received in years 1 to n
     In Year n, two things happen  In Year n, one of two things will
    1. The loan is repaid happen
    And Either
    2. Warrant is exercised to receive 1. The loan is repaid
    shares Or
    2. Loan is converted into shares

    Corporate Financial Strategy 13


    Positioning the convertible

    Debt Convertible Equity


    Yield
    Interest on
    Interest Dividend
    convertible
    Upside
    potential: None Capital gain on Capital gain on
    based on conversion price today’s price
    conversion price
    Downside
    protection:
    based on Repayment
    security, terms Repayment None
    option
    and time to
    repayment/
    conversion

    Corporate Financial Strategy 14


    Why use a convertible

    Cash restrictions
    – can’t afford interest
    – can’t afford repayments
    Can’t use Profit restrictions
    debt – can’t afford interest

    Covenant restrictions from existing lenders

    Dilutes eps
    Can’t use
    equity Loss of control by block-holder

    Convertibles are used to delay equity or sweeten debt

    Corporate Financial Strategy 15


    Features of convertibles

     Gearing effect  If under-priced, dilutes


     Attracts investors eps more than
     Tax advantages necessary
    For issuer  Self-liquidating  If over-priced, have to
     Cheaper yield repay at inopportune
     Less eps dilution time

     Higher yield than equity  Possibility of non-


     Upside of capital gain repayment
     Can decide if/when to  If share price doesn’t
    For holder
    convert rise – lost out by
    allowing cheap debt

    Advantages Disadvantages

    Corporate Financial Strategy 16

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