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FM 03 Corporate Finance

Part III: Long Term Financing


(Chapters 14 and 15)

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Raising Equity Capital


(Chapter 14)

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Chapter 14 Outline
14.1 Equity Financing for Private Companies 14.2 Taking Your Firm Public: The Initial Public Offering 14.3 IPO Puzzles 14.4 Raising Additional Capital: The Seasoned Equity Offering

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14.1 Equity Financing for Private Companies


Sources of Funding:
A private company can seek funding from several potential sources:
Angel Investors Venture Capital Firms Institutional Investors Corporate Investors

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14.1 Equity Financing for Private Companies


Angel Investors:
Individual investors who buy equity in small private firms The first round of outside private equity financing is often obtained from angels

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14.1 Equity Financing for Private Companies


Venture Capital Firms:
Specialize in raising money to invest in the private equity of young firms In return, venture capitalists often demand a great deal of control of the company

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Figure 14.2 Venture Capital Funding in the United States

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14.1 Equity Financing for Private Companies


Institutional Investors:
Pension funds, insurance companies, and foundations
May invest directly May invest indirectly by becoming limited partners in venture capital firms

Corporate Investors:
Many established corporations purchase equity in younger, private companies
corporate strategic objectives desire for investment returns
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14.1 Equity Financing for Private Companies


Securities and Valuation
When a company decides to sell equity to outside investors for the first time, it is typical to issue preferred stock rather than common stock to raise capital
It is called convertible preferred stock if the owner can convert it into common stock at a future date

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Example 14.1 Funding and Ownership


Problem:
You founded your own firm two years ago. You initially contributed $100,000 of your money and, in return received 1,500,000 shares of stock. Since then, you have sold an additional 500,000 shares to angel investors. You are now considering raising even more capital from a venture capitalist (VC).

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Example 14.1 Funding and Ownership


Problem (cont d):
This VC would invest $6 million and would receive 3 million newly issued shares. What is the post-money valuation? Assuming that this is the VC s first investment in your company, what percentage of the firm will she end up owning? What percentage will you own? What is the value of your shares?

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Example 14.1 Funding and Ownership


Solution: Plan:
After this funding round, there will be a total of 5,000,000 shares outstanding: Your shares 1,500,000 Angel investors shares 500,000 Newly issued shares 3,000,000 Total 5,000,000

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Example 14.1 Funding and Ownership Plan (cont d):


The VC is paying $6,000,000/3,000,000=$2/ share. The post-money valuation will be the total number of shares multiplied by the price paid by the VC. The percentage of the firm owned by the VC is her shares divided by the total number of shares. Your percentage will be your shares divided by the total shares and the value of your shares will be the number of shares you own multiplied by the price the VC paid.
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Example 14.1 Funding and Ownership Execute:


There are 5,000,000 shares and the VC paid $2 per share. Therefore, the post-money valuation would be 5,000,000($2) = $10 million. Because she is buying 3,000,000 shares, and there will be 5,000,000 total shares outstanding after the funding round, the VC will end up owning 3,000,000/5,000,000=60% of the firm. You will own 1,500,000/5,000,000=30% of the firm, and the post-money valuation of your shares is 1,500,000($2) = $3,000,000.
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Example 14.1 Funding and Ownership


Evaluate:
Funding your firm with new equity capital, be it from an angel or venture capitalist, involves a tradeoffyou must give-up part of the ownership of the firm in return for the money you need to grow. The higher is the price you can negotiate per share, the smaller is the percentage of your firm you have to give up for a given amount of capital.

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14.1 Equity Financing for Private Companies


Exiting an Investment in a Private Company
Acquisition Public Offering

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14.2 Taking Your Firm Public: The Initial Public Offering


The process of selling stock to the public for the first time is called an initial public offering (IPO)

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14.2 Taking Your Firm Public: The Initial Public Offering


Advantages and Disadvantages of Going Public
Advantages:
Greater liquidity Better access to capital

Disadvantages:
Equity holders more dispersed Must satisfy requirements of public companies

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14.2 Taking Your Firm Public: The Initial Public Offering


IPOs include both Primary and Secondary offerings Underwriters and the Syndicate
Underwriter: an investment banking firm that manages the offering and designs its structure
Lead Underwriter

Syndicate: other underwriters that help market and sell the issue

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Table 14.2 International IPO Underwriter Ranking Report for 2007

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Figure 14.3 The Cover Page of RealNetworks IPO Prospectus

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14.2 Taking Your Firm Public: The Initial Public Offering


Valuation
Underwriters work with the company to come up with a price
Estimate the future cash flows and compute the present value Use market multiples approach

Road Show Book Building

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Example 14.2 Valuing an IPO Using Comparables


Problem:
Wagner, Inc., is a private company that designs, manufactures, and distributes branded consumer products. During the most recent fiscal year, Wagner had revenues of $325 million and earnings of $15 million. Wagner has filed a registration statement with the SEC for its IPO.

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Example 14.2 Valuing an IPO Using Comparables


Problem (cont'd):
Before the stock is offered, Wagner s investment bankers would like to estimate the value of the company using comparable companies. The investment bankers have assembled the following information based on data for other companies in the same industry that have recently gone public. In each case, the ratios are based on the IPO price.

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Example 14.2 Valuing an IPO Using Comparables


Problem (cont'd)

After the IPO, Wagner will have 20 million shares outstanding. Estimate the IPO price for Wagner using the price/earnings ratio and the price/revenues ratio.
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Example 14.2 Valuing an IPO Using Comparables


Solution: Plan:
If the IPO price of Wagner is based on a price/earnings ratio that is similar to those for recent IPOs, then this ratio will equal the average of recent deals. Thus, to compute the IPO price based on the P/E ratio, we will first take the average P/E ratio from the comparison group and multiply it by Wagner s total earnings. This will give us a total value of equity for Wagner. To get the per share IPO price, we need to divide the total equity value by the number of shares outstanding after the IPO (20 million). The approach will be the same for the price-to-revenues ratio.

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Example 14.2 Valuing an IPO Using Comparables


Execute:
The average P/E ratio for recent deals is 21.2. Given earnings of $15 million, we estimate the total market value of Wagner s stock to be ($15 million)(21.2) = $318 million. With 20 million shares outstanding, the price per share should be $318 million / 20 million = $15.90. Similarly, if Wagner s IPO price implies a price/revenues ratio equal to the recent average of 0.9, then using its revenues of $325 million, the total market value of Wagner will be ($325 million)(0.9) = $292.5 million, or ($292.5/20) = $14.63/share

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14.2 Taking Your Firm Public: The Initial Public Offering Pricing the Deal and Managing Risk
Firm Commitment IPO: the underwriter guarantees that it will sell all of the stock at the offer price Over-allotment allocation, or Greenshoe provision: allows the underwriter to issue more stock, amounting to 15% of the original offer size, at the IPO offer price

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14.2 Taking Your Firm Public: The Initial Public Offering Other IPO Types
Best-Efforts Basis: the underwriter does not guarantee that the stock will be sold, but instead tries to sell the stock for the best possible price Auction IPO: The company or its investment bankers auction off the shares, allowing the market to determine the price of the stock

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Table 14.3 Bids Received to Purchase Shares in a Hypothetical Auction IPO

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Figure 14.4 Aggregating the Shares Sought in the Hypothetical Auction IPO

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Example 14.3 Auction IPO Pricing


Problem:
Fleming Educational Software, Inc., is selling 500,000 shares of stock in an auction IPO. At the end of the bidding period, Fleming s investment bank has received the following bids:

What will the offer price of the shares be?


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Example 14.3 Auction IPO Pricing


Solution: Plan:
First, we must compute the total number of shares demanded at or above any given price. Then, we pick the lowest price that will allow us to sell the full issue (500,000 shares).

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Example 14.3 Auction IPO Pricing


Execute:
Convert the table of bids into a table of cumulative demand:

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Example 14.3 Auction IPO Pricing Execute (cont'd):


For example, the company has received bids for a total of 125,000 shares at $7.75 per share or higher (25,000 + 100,000 = 125,000). Fleming is offering a total of 500,000 shares. The winning auction price would be $7.00 per share, because investors have placed orders for a total of 500,000 shares at a price of $7.00 or higher. All investors who placed bids of at least this price will be able to buy the stock for $7.00 per share, even if their initial bid was higher.
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Example 14.3 Auction IPO Pricing


Execute (cont'd):
In this example, the cumulative demand at the winning price exactly equals the supply. If total demand at this price were greater than supply, all auction participants who bid prices higher than the winning price would receive their full bid (at the winning price). Shares would be awarded on a pro rata basis to bidders who bid exactly the winning price.

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Example 14.3 Auction IPO Pricing


Evaluate:
While the auction IPO does not provide the certainty of the firm commitment, it has the advantage of using the market to determine the offer price. It also reduces the underwriter s role, and consequently, fees.

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Table 14.4 Summary of IPO Methods

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14.3 IPO Puzzles


Four IPO puzzles:
Underpricing of IPOs Hot and Cold IPO markets High underwriting costs Poor long-run performance of IPOs

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14.3 IPO Puzzles


Underpriced IPOs
On average, between 1960 and 2003, the price in the U.S. aftermarket was 18.3% higher at the end of the first day of trading
Who wins and who loses because of underpricing?

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14.3 IPO Puzzles


Hot and Cold IPO Markets
It appears that the number of IPOs is not solely driven by the demand for capital. Sometimes firms and investors seem to favor IPOs; at other times firms appear to rely on alternative sources of capital

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Figure 14.6 Cyclicality of Initial Public Offerings in the United States, (1980-2009)

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14.3 IPO Puzzles


High Cost of Issuing an IPO
In the U.S., the discount below the issue price at which the underwriter purchases the shares from the issuing firm is 7% of the issue price. This fee is large, especially considering the additional cost to the firm associated with underpricing.

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14.3 IPO Puzzles


Poor Post-IPO Long-Run Stock Performance
Newly listed firms appear to perform relatively poorly over the following three to five years after their IPOs That underperformance might not result from the issue of equity itself, but rather from the conditions that motivated the equity issuance in the first place

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14.4 Raising Additional Capital: The Seasoned Equity Offering A firm s need for outside capital rarely ends at the IPO
Seasoned Equity Offering (SEO): firms return to the equity markets and offer new shares for sale

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14.4 Raising Additional Capital: The Seasoned Equity Offering SEO Process
When a firm issues stock using an SEO, it follows many of the same steps as for an IPO. Main difference is that the price-setting process is not necessary.

Two kinds of seasoned equity offerings:


Cash offer Rights offer

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Example 14.4 Raising Money with Rights Offers


Problem:
You are the CFO of a company that has a market capitalization of $1 billion. The firm has 100 million shares outstanding, so the shares are trading at $10 per share. You need to raise $200 million and have announced a rights issue. Each existing shareholder is sent one right for every share he or she owns.

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Example 14.4 Raising Money with Rights Offers


Problem (cont'd):
You have not decided how many rights you will require to purchase a share of new stock. You will require either four rights to purchase one share at a price of $8 per share, or five rights to purchase two new shares at a price of $5 per share. Which approach will raise more money?

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Example 14.4 Raising Money with Rights Offers


Solution: Plan:
In order to know how much money will be raised, we need to compute how many total shares would be purchased if everyone exercises their rights. Then we can multiply it by the price per share to calculate the total amount raised.

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Example 14.4 Raising Money with Rights Offers


Execute:
There are 100 million shares, each with one right attached. In the first case, 4 rights will be needed to purchase a new share, so 100 million / 4 = 25 million new shares will be purchased. At a price of $8 per share, that would raise $8 x 25 million = $200 million.

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Example 14.4 Raising Money with Rights Offers


Execute (cont d):
In the second case, for every 5 rights, 2 new shares can be purchased, so there will be 2 x (100 million / 5) = 40 million new shares. At a price of $5 per share, that would also raise $200 million. If all shareholders exercise their rights, both approaches will raise the same amount of money.

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Example 14.4 Raising Money with Rights Offers Evaluate:


In both cases, the value of the firm after the issue is $1.2 billion. In the first case, there are 125 million shares outstanding after the issue, so the price per share after the issue is $1.2 billion / 125 million = $9.60. This price exceeds the issue price of $8, so the shareholders will exercise their rights. Because exercising will yield a profit of ($9.60 $8.00)/4 = $0.40 per right, the total value per share to each shareholder is $9.60 + 0.40 = $10.00.
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Example 14.4 Raising Money with Rights Offers


Evaluate (cont'd):
In the second case, the number of shares outstanding will grow to 140 million, resulting in a post-issue stock price of $1.2 billion / 140 million shares = $8.57 per share (also higher than the issue price). Again, the shareholders will exercise their rights, and receive a total value per share of $8.57 + 2($8.57 - $5.00)/5 = $10.00. Thus, in both cases the same amount of money is raised and shareholders are equally well off.

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Debt Financing
(Chapter 15)

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Chapter Outline
15.1 Corporate Debt 15.2 Bond Covenants 15.3 Repayment Provisions

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15.1 Corporate Debt


Private Debt
Bank Loans
Term Loan Syndicated Bank Loan Revolving Line of Credit Asset-Backed Line of Credit

Private Placements

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15.1 Corporate Debt


Public Debt
The Prospectus
Indenture
A formal contract between a bond issuer and a trust company, which represents the bondholders interests

Original Issue Discount (OID) Bond


A coupon bond issued at a discount

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Figure 15.1 Front Cover of the Offering Memorandum for the Hertz Junk Bond Issue

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15.1 Corporate Debt


Public Debt
Unsecured Corporate Debt
Notes Debentures

Secured Corporate Debt


Mortgage Bonds Asset-Backed Bonds

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15.1 Corporate Debt


Public Debt
Seniority
A bondholder s priority, in the event of a default, in claiming assets not already securing other debt Subordinated Debenture
A debenture issue that has a lower priority claim to the firm s assets than other outstanding debt

Tranches
Different classes of securities that comprise a single bond issuance

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Table 15.2 Hertz s December 2005 Junk Bond Issues

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15.1 Corporate Debt


Public Debt
International Bonds
Domestic Bonds
Issued by a local entity and traded in a local market, but purchased by foreigners Denominated in the local currency

Foreign Bonds
Issued by a foreign company in a local market and are intended for local investors Denominated in the local currency

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15.1 Corporate Debt


Public Debt
International Bonds
Foreign Bonds
Yankee bonds Foreign bonds issued in the United States

Eurobonds
International bonds that are not denominated in the local currency of the country in which they are issued

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15.1 Corporate Debt


Public Debt
International Bonds
Global Bonds
Combines the features of domestic, foreign, and Eurobonds, and are offered for sale in several different markets simultaneously Can be offered for sale in the same currency as the country of issuance

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Table 15.3 Summary of New Debt Issued as Part of the Hertz LBO

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15.2 Bond Covenants


Covenants
Restrictive clauses in a bond contract that limit the issuer from taking actions that may undercut its ability to repay the bonds

Advantages of Covenants
With more covenants, a firm firms can reduce its costs of borrowing.
The reduction in the firm s borrowing cost can more than outweigh the cost of the loss of flexibility associated with covenants

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Table 15.4 Typical Bond Covenants

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15.3 Repayment Provisions


Call Provisions
Callable Bond
Call Date Call Price Call Premium

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Table 15.5 Call Features of Hertz s Bonds

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15.3 Repayment Provisions


Call Provisions
Call Provisions and Bond Prices
Investors will pay less for a callable bond than for an otherwise identical noncallable bond A firm raising capital by issuing callable bonds instead of non-callable bonds will either have to pay a higher coupon rate or accept lower proceeds

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15.3 Repayment Provisions


Call Provisions
Yield to Call
The yield of a callable bond calculated under the assumption that the bond will be called on the earliest call date

Yield to Worst
Quoted by bond traders as the lower of the yield to call or yield to maturity

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Table 15.6 Bond Calls and Yields

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Example 15.1 Calculating the Yield to Call


Problem:
IBM has just issued a callable (at par) five-year, 8% coupon bond with annual coupon payments. The bond can be called at par in one year or anytime thereafter on a coupon payment date. It has a price of $103 per $100 face value, implying a yield to maturity of 7.26%. What is the bond s yield to call?

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Example 15.1 Calculating the Yield to Call


Solution: Plan:
The timeline of the promised payments for this bond (if it is not called) is:

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Example 15.1 Calculating the Yield to Call


Solution: Plan: (cont d)
If IBM calls the bond at the first available opportunity, it will call the bond at year 1. At that time, it will have to pay the coupon payment for year 1 ($8 per $100 of face value) and the face value ($100). The timeline of the payments if the bond is called at the first available opportunity (at year 1) is:

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Example 15.1 Calculating the Yield to Call


Solution: Plan: (cont d)
To solve the YTC, we use these cash flows, set the price equal to the bond s current price and solve for the discount rate.

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Example 15.1 Calculating the Yield to Call


Execute:
For the YTC, setting the present value of these payments equal to the current price gives:

103 =

108 Solving for the yield to call gives: (1 + YTC) 108 YTC = ! 1 = 4.85% 103

Given: Solve for:

1 4.85

-103

100

Excel Formula: =RATE(NPER, PMT, PV,FV) = RATE(1,8,-103,100)


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Example 15.1 Calculating the Yield to Call


Evaluate:
The YTM is higher than the YTC because it assumes that you will continue receiving your coupon payments for 5 years, even though interest rates have dropped below 8%. While under the YTC assumptions, you are repaid the face value sooner, you are deprived of the extra 4 years of coupon payments, so your total return is lower.

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15.3 Repayment Provisions


Sinking Fund
A company makes regular payments into a fund administered by a trustee over the life of the bond. These payments are then used to repurchase bonds, usually at par.

Balloon Payment
A large payment that must be made on the maturity date of a bond when the sinking fund payments are not sufficient to retire the entire bond issue.
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15.3 Repayment Provisions


Convertible Provisions
Convertible Bonds Conversion Ratio

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15.3 Repayment Provisions


Convertible Provisions
Convertible Bond Pricing
Consider a convertible bond with a $1000 face value and a conversion ratio of 20 If you converted the bond into stock on its maturity date, you would receive 20 shares
If you did not convert, you would receive $1000

Conversion Price
By converting the bond you essentially paid $1000 for 20 shares, implying a conversion price per share of $1,000/20 = $50.

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15.3 Repayment Provisions


Convertible Provisions
Convertible Bond Pricing
Straight (Plain-Vanilla) Bond
A non-callable, non-convertible bond

Convertible Bonds and Stock Prices


When a firm s stock price is much higher than the conversion price, conversion is very likely and the convertible bond s price is close to the price of the converted shares

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Figure 15.2 Convertible Bond Value

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15.3 Repayment Provisions


Convertible Provisions
Combining Features
Companies have flexibility in setting the features of the bonds they issue

Leveraged Buyout (LBO)


When a group of private investors purchases all the equity of a public corporation and finances the purchase primarily with debt.

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Table 15.7 RealNetworks 2003 Convertible Debt Issue

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