Long-term Financing

Ashok Banerjee
 Various long-term sources:
Domestic
• Bank Financing
• Debt Financing
– Long-term Bond- Fixed rate, floating rate, market-
linked
– Convertible Bond/Hybrids
– Perpetual Bond
– Zero-coupon Bond
• Equity
– IPO
– Seasoned Equity
– Rights
 Convertibles
• Assume the following convertible bond data:
– 20-year, 10.5% annual coupon, callable convertible bond will
sell at its Rs.1,000 par value; straight debt issue would
require a 12% coupon.
– Call protection = 5 years and call price = Rs.1,100. Call the
bonds when conversion value > Rs.1,200, but the call must
occur on the issue date anniversary.
– P0 = Rs.20; D0 = Rs.1.48; g = 8%.
– Conversion ratio = CR = 40 shares.
• What conversion price (Pc) is built into the bond?
• What is (1) the convertible’s straight debt value and
(2) the implied value of the convertibility feature?
 Still with Convertibles
• What is the formula for the bond’s
expected conversion value in any year?
Conversion value = CVt = CR(P0)(1 + g)t.
t=0
CV0 = 40(Rs.20)(1.08)0 = Rs.800.
t = 10
CV10 = 40(Rs.20)(1.08)10
= Rs.1,727.14.
 Still with Convertibles
• What is meant by the floor value of a
convertible? What is the floor value
at t = 0? At t = 10?
The floor value is the higher of the straight
debt value and the conversion value.
• Straight debt value0 = Rs.887.96.
• CV0 = Rs.800.
Floor value at Year 0 = $887.96.
 Still with Convertibles
• Straight debt value10 = $915.25.
• CV10 = $1,727.14.
Floor value10 = $1,727.14.
• A convertible will generally sell above its
floor value prior to maturity because
convertibility constitutes a call option that
has value.
 Still with Convertibles
• If the firm intends to force conversion
on the first anniversary date after CV >
Rs.1,200, when is the issue expected to
be called?

• What is the convertible’s expected cost

of capital to the firm?
Long-term Financing: Overseas
• External Commercial Borrowing
• Foreign Currency Convertible Bonds
(FCCB)
• Foreign Currency Exchangeable Bonds
(FCEB)
• Masala Bond
• ADR- Sponsored and Non-sponsored
• GDR
Examples of some FCCBs issued in India
 Taxation on FCCBs
• Until the conversion option is exercised, all the interest
payments on the bonds, is subject to deduction of tax at
source at the rate of 10% (20%) for NRIs (FIIs)
• Tax exercised on dividend on the converted portion of
the bond is subject to deduction of tax at source at the
rate of 10%(20%) for NRIs (FIIs)
• If Foreign Currency Convertible Bonds ( FCCB ) is
converted into shares it will not give rise to any capital
gains liable to income-tax in India
• If Foreign Currency Convertible Bonds (FCCB) is
transferred by a non-resident investor to another non-
resident investor it shall not give rise to any capital gains
liable to tax in India
RIL’s Overseas Borrowing: Recent Initiatives
Reliance Industries had an outstanding debt of Rs 2,87,505 crore (US$42 billion) and it
grew by Rs 69,000 crore in FY19 because of its investments in Reliance Jio. It had cash
reserves of Rs. 1,33,027 crore.
• RIL’s overseas borrowing crossed $10b during 2012-2014
• In January 2015, it raised $1b @4.25%, 10-year bond
• In February 2015, the company raised, $750m @4.875%, 30-year
bonds
• In May 2015, it raised $200m @5% 20-year Formosa bond issued
primarily to Taiwanese life insurance companies. The bonds will also
have an annual call option at par starting June 5, 2020
• It 2017 it raised $2.25b through ECB at a price of 90-100 bps over
LIBOR. The US 12-months LIBOR was 1.7%
• It raised around $1.2 billion in 2018 at LIBOR+175 bps to refinance a
five-year multicurrency facility.
• In mid-2019, it raised another $1.85 billion to use the proceeds to
fund business activities instead of any refinancing.
 Under what conditions would a firm
exercise a bond call provision?

• If interest rates have fallen since the bond

was issued, the firm can replace the
current issue with a new, lower coupon
rate bond.
• However, there are costs involved in
refunding a bond issue. For example,
– The call premium.
– Flotation costs on the new issue. (More...)
• The NPV of refunding compares the
interest savings benefit with the costs of
the refunding. A positive NPV indicates
that refunding today would increase the
value of the firm.
• However, it interest rates are expected
to fall further, it may be better to delay
refunding until some time in the future.
 Zero Coupon Bonds
• Bonds have no coupon, and pay no
interest.
• Only payment is face value at maturity.
• Bonds are sold at discount. If market
rates are 9% and firm issues zero
coupon bond with 5 years to maturity,
– Price5 = Rs.1000 / (1.09)5 = Rs.649.93
 Tax Treatment of Zero
Coupon Bond
• Imputed interest expense is equal to the
expected price appreciation, based on
initial yield.
• Bond has initial yield of 9%, expected
price at end of first year is:
– Price4 = Rs.1000 / (1.09)4 = Rs.708.43
• Imputed interest = Rs.708.43 –
Rs.649.93
= Rs.58.5
 Tax Deduction
• Company deducts Rs.58.5 in the first year,
even though it makes no cash payment of
interest.
• Imputed interest payment changes each
year as price of bond (based on original
9% yield) approaches Rs.1000.
 Perpetual Bonds: Recent
Controversy: SEBI vs. MoF
Consequence of SEBI Proposal
• Perpetual bonds have a five-year call option, which allows holders to
exit instead of staying invested permanently. Fund managers had
opposed the latest Sebi rule as it required debt schemes to value
this security as a 100-year paper instead of a valuation assigned to
a shorter maturity. This could result in yields on perpetual bonds
shooting up and prices falling, causing losses to holders. Bond
yields and prices move in opposite directions.
• With the capital market regulator changing the valuation rule, bond
traders were expecting a surge in yields of as much as 100 basis
points. Banks, major issuers of perpetual paper, would have faced
higher costs in seeking to raise funds through the avenue.
• Banks have issued nearly 93% of total outstanding
perpetual bonds, pegged at Rs 1.46 lakh crore.
Financing Strategy in Aviation
Industry
 Lease Financing
• As the world’s third largest domestic aviation market, the
time is ripe for India to enter into aircraft financing and
leasing activities from Indian shores,” Finance Minister
Nirmala Sitharaman said in her maiden budget speech
(Feb 2019)
• The ability to fund purchases and lease aircraft locally
will be a boon for local carriers like InterGlobe Aviation
Ltd.’s IndiGo and SpiceJet Ltd., as it will significantly
insulate them from foreign exchange fluctuations.
Airlines are increasingly moving toward an asset-light
model, under which they sell aircraft to lessors for a
profit, only to lease them back, which helps them keep a
younger fleet.
 Asset Monetisation: Financing
infrastructure
• Cabinet Committee approved ( Sept 2020) monetisation of
assets of POWERGRID, a Public Sector Undertaking (PSU)
under Ministry of Power, through Infrastructure Investment
Trust (InvIT) model. This is the first time any PSU in Power
Sector will undertake asset recycling by monetising its assets
through the InvIT model and using the proceeds to fund the
new and under-construction capital projects.
• POWERGRID to monetise in the first lot, assets with gross
block value of more than 7000 crore. These assets, which are
mainly High Voltage Transmission lines and substations.
• The CAPEX plan of POWERGRID for next two years (2020-
21 and 2021-22) is Rs. 20,500 cr.
• Is Asset Monetization tax efficient?
 Raising Money through Equity
• Private Placement
• Public Offering
• Right Issues
• In a private placement, such as to angels
or VCs, securities are sold to a few
investors rather than to the public at large.
• In a public offering, securities are offered
to the public and must be registered with
SEBI.
 What is a road show?
• Senior management team, investment
banker, and lawyer visit potential
institutional investors
• Usually travel to ten to twenty cities in a
two-week period, making three to five
presentations each day.
• Management can’t say anything that is not
in prospectus, because company is in
“quiet period.”
 What is “book building?”
• Investment banker asks investors to
indicate how many shares they plan to
buy, and records this in a “book”.
• Investment banker hopes for
oversubscribed issue.
• Based on demand, investment banker sets
final offer price on evening before IPO.
 What are the direct and indirect
costs of an IPO?
• Underwriter usually charges a 5-7%
spread between offer price and
proceeds to issuer.
• Direct costs to lawyers, printers,
accountants, etc. can be over a crore of
rupees.
• Preparing for IPO consumes most of
management’s attention during the pre-
IPO months.
 IPO Underpricing
• May be difficult to price an IPO because there
is not a current market price available.
• Private companies tend to have more
asymmetric information than companies that
are already publicly traded.
• Underwriters want to ensure that, on
average, their clients earn a good return on
IPOs.
• Underpricing causes the issuer to “leave
money on the table.”
The Announcement of New Equity
and the Value of the Firm
• The market value of existing equity drops on the
announcement of a new issue of common stock.
• Reasons include
– Managerial Information
Since the managers are the insiders, perhaps they are
selling new stock because they think it is overpriced.
– Debt Capacity
If the market infers that the managers are issuing new
equity to reduce their debt-equity ratio due to the
specter of financial distress, the stock price will fall.
 Rights
• If a preemptive right is contained in the
firm’s articles of incorporation, the firm
must offer any new issue of common stock
first to existing shareholders.
• This allows shareholders to maintain their
percentage ownership if they so desire.
 Mechanics of Rights Offerings
• The management of the firm must decide:
– The exercise price (the price existing
shareholders must pay for new shares).
– How many rights will be required to purchase
one new share of stock.
• These rights have value:
– Shareholders can either exercise their rights
or sell their rights.
 Rights Offering Example
• Popular Delusions, Inc. is proposing a
rights offering. There are 200,000 shares
outstanding trading at $25 each. There will
be 10,000 new shares issued at a $20
subscription price.
• What is the new market value of the firm?
• What is the ex-rights price?
• What is the value of a right?
 What is the new market value
of the firm?
$ 25 $ 20
$ 5 , 200 , 000 = 200 , 000 shares  + 10 , 000 shares 
share shares

There are 200,000 There will be 10,000 new

outstanding shares at shares issued at a $20
$25 each. subscription price.
What Is the Ex-Rights Price?

• There are 210,000 outstanding shares

of a firm with a market value of
$5,200,000.
• Thus the value of an ex-rights share
is:
$5,200,000
= $24.7619
210,000 shares
 What Is the Ex-Rights Price?
• Thus, the value of a right is:

$0.2381 = $25 – $24.7619

 The Private Equity Market
• The previous sections assumed that a
company is big enough, successful
enough, and old enough to raise capital in
the public equity market.
• For start-up firms and firms in financial
trouble, the public equity market is often
not available.
• Institutional trading platform (ITP) in India
 Private Placements
• Private placements avoid the costly
procedures associated with the
registration requirements that are a part of
public issues.
• The SEC/ SEBI restricts private placement
issues to no more than a couple of dozen
knowledgeable investors, including
institutions such as insurance companies
and pension funds.
• The biggest drawback is that the securities
cannot be easily resold.
 ADS
• An American Depositary Share ("ADS") is a U.S.
dollar denominated form of equity ownership in a
non-U.S. company. It represents the foreign
shares of the company held on deposit by a
custodian bank in the company's home country
and carries the corporate and economic rights of
the foreign shares, subject to the terms specified
on the ADR certificate.
• An American Depositary Receipt ("ADR") is a
physical certificate evidencing ownership in one
or several ADSs. The terms ADR and ADS are
often used interchangeably.
 Types of ADR Programmes
• Sponsored Programmes:
– In a sponsored program, the non-U.S. company whose ordinary
shares underlie the ADRs is a party to the agreement governing
the arrangement (known as a “deposit agreement”) along with
the depositary bank and is able to exercise control regarding the
terms and conditions of the ADR program, including how many
ADRs are registered for trading and what rights the holders of
those ADRs are granted.
• Unsponsored Programmes:
– An unsponsored ADR program is one that is established by a
depositary bank without the participation or consent of the
issuer. Since an issuer is not involved in the implementation or in
the maintenance of the unsponsored ADR program, it has limited
or no influence on the treatment of ADR holders.
 Types of Sponsored ADRs
• Level I ADRs The most basic form of sponsored ADR
program, a Level I is used when the issuer is not initially
seeking to raise capital in the U.S. markets or does not
wish to, or can't, list its ADRs on an exchange or on
Nasdaq. A Level I ADR program offers an easy and
relatively inexpensive way for an issuer to gauge interest
in its securities and begin building a presence in the U.S.
securities markets.
• Level I ADRs are traded in the over-the-counter (OTC)
market, with bid and ask prices published daily and
distributed by the National Daily Quotation Bureau in the
pink sheets.
• Level I ADR programs currently require minimal SEC
registration
 Types of ADRs
• Level II ADRs In a Level II ADR program, the ADRs are listed
on the U.S. securities exchange or quoted on Nasdaq,
thereby offering higher visibility in the U.S. market, more
active trading, and greater liquidity.
• Level II ADR programs must comply with the full registration
and reporting requirements of the SEC's Exchange Act, which
entails the following:

– Form F-6 registration statement, to register the ADRs to be

issued

– Form 20-F registration statement, which contains detailed

financial disclosure about the issuer, including financial
statements and a reconciliation of those statements to U.S.
GAAP, to register the listing of the ADRs

– Annual reports and any interim financial statements submitted on

a regular, timely basis to the SEC
 Types of ADRs
• Level III ADRs In the most high-profile form of
sponsored ADR program, Level III, an issuer floats a
public offering of ADRs in the United States and lists the
ADRs on one of the U.S. exchanges or Nasdaq. The
benefits of a Level III program are substantial: It allows
the issuer to raise capital and leads to much greater
visibility in the U.S. market.
• Level III ADRs can be listed and traded on one of the
U.S. securities exchanges (including NYSE and Amex)
or on Nasdaq
• Level III ADR programs must comply with various SEC
rules, including the full registration and reporting
requirements of the SEC's Exchange Act
 Other kinds of ADRs
• Rule 144A ADRs
– Many companies seek to raise capital in the U.S. markets
privately by issuing restricted securities under Rule 144A,
which do not require SEC review. Rule 144A facilitates the
trading of privately placed securities by sophisticated
institutional investors (also known as Qualified Institutional
Buyers, or QIBs; they must own or manage at least $100
million in securities).
• Global Depositary Receipts (GDRs)
GDRs allow issuers to raise capital in two or more markets
simultaneously, thus broadening their shareholder base. They
can be settled outside the U.S. and can be traded in the Rule
144A private market. Under SEC Regulation S, securities
offered or sold to investors outside the U.S. are not subject to
SEC registration requirements.
 Fungibility of ADRs
• Two-way fungibility of ADRs/GDRs issued by
Indian Companies was permitted by the
Government of India and the RBI.
• Two-way fungibility implies that an investor who
holds ADRs/GDRs can cancel them with the
depository and sell the underlying shares in the
market. The company can then issue fresh
ADRs to the extent of shares cancelled.
• No specific permission of the RBI will be
required for the re-conversion.
 Benefits of two-way fungibility
• Under the one-way fungibility regime, though
identical assets (namely stocks in the domestic
market and ADRs/GDRs in the overseas markets)
traded at different prices (at a discount/premium),
the arbitrage opportunities went a begging because
of restrictions on the capital account. By introducing
two-way fungibility, market forces may trigger a
realignment of prices, minimising the widely
divergent premium/discount levels prevailing
between ADR/GDR prices and the domestic stock
prices.