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GROWING INTEREST IN DEBT • Lesser support in the form of term loans • Complete freedom in designing debt instruments • Credit rating agencies
• ‘Wholesale Debt Market’ segment
• Massive investments in infrastructure • Volatility of equity market
RISK IN DEBT • Interest rate risk • Inflation risk • Real interest rate risk • Default risk • Reinvestment risk • Foreign exchange risk .
.DEBT RATING A debt rating essentially reflects the probability of timely payment of interest and principal by the borrower.
FUNCTIONS OF DEBT RATINGS (OR DEBT RATING FIRMS) • Provide superior information. . • Serve as a basis for a proper risk-return tradeoff. • Impose a healthy discipline on corporate borrowers. • Offer low-cost information. • Lend greater credence to financial and other representations. • Facilitate the formulation of public policy guidelines on institutional investment.
Debt rating is not: •A recommendation to buy/sell/hold •An overall evaluation of the issuing organization •Indicative of a fiduciary relationship between issuer and rating agency •An auditing of issuer •A one time evaluation over the life of the security .
quality of accounting • Subjective judgment often plays an important role.structure.managerial capability of issuer •Financial Analysis:earning power. competitive position of issuer.financial flexibility.asset protection. risk characteristics. .cash flow adequacy.risks. and (ii) financial analysis •Industry & business analysis:Growth rates. • Industry risk characteristics are likely to set the upper limit on rating.RATING METHODOLOGY •Two broad types of analyses are done: (i) industry and business analysis.
CRISIL DEBENTURE RATING SYMBOLS AAA Highest safety AA A BBB BB B C D High safety Adequate safety Sufficient safety Inadequate safety Susceptible to default Vulnerable to default In default .
DESIGN OF DEBT ISSUES • Maturity period • Fixed versus floating rate • Sinking fund • Options .
INNOVATIONS IN DEBT SECURITIES • Deep discount bonds • Floating rate bonds • Commodity – linked bonds • Bonds with embedded options • Extendable bonds • Structured notes • Inverse floaters • Junk bonds .
WAYS IN WHICH SHAREHOLDERS AND THEIR AGENT-MANAGERS CAN HURT BONDHOLDERS • Dividend payment • Claim dilution • Asset substitution • Underinvestment .
• The firm agrees to set up a sinking fund for redemption of debt. . • The firm agrees to maintain a certain working capital. • The firm has to maintain a certain net worth. • The firm has to mortgage its assets. Here are some examples of positive covenants: • The firm has to periodically furnish certain reports and financial statements to the lenders.POSITIVE BOND COVENANTS A positive (or affirmative) covenant states what the borrowing firm should do during the term of the loan (bond).
NEGATIVE BOND COVENANTS A negative covenant prohibits or restricts certain actions by the borrowing firm. • The firm may not dispose or lease its major assets. Here are some typical negative covenants: • The firm cannot raise additional long-term debt. • The firm may not pay dividends in excess of a certain percentage. . unless the same are approved by the prior permission of the lender. • The firm cannot undertake a diversification project or acquire another firm or merge with another firm.
the decision rule is: Refund the bond if the present value of the stream of net cash savings is greater than the initial cash outlay. .BOND-REFUNDING DECISION The bond-refunding decision should be analysed the way any other capital budgeting decision is analysed. Hence.
INITIAL OUTLAY Initial outlay = Cost of calling the old bonds – Net proceeds of the new issue – Tax savings on taxdeductible expenses The terms on the right-hand side of the above expression are defined as follows: Cost of calling the old bonds = Face value of the bonds + Call premium Net proceeds of the new issue = Gross proceeds – Floatation costs (issue expense + discount) Tax savings on taxCall premium + Unamortised floatation = Tax rate deductible expenses costs on the old bond issue .
ANNUAL NET CASH SAVINGS Annual net cash outflow Annual net cash outflow Annual net cash savings = – on new bonds on old bonds The terms on the right-hand side of the above expression are defined below: Tax saving on interest Annual net cash outflow = Interest expense .expense and amortisation on old bonds of floatation cost Tax saving on interest Annual net cash outflow = Interest expense – expense and amortisation on new bonds of issue cost .
The unamortised portion of the issue costs on the old bonds is Rs.100 million issue of 10year bonds carrying a coupon rate of 16 percent. Acme's marginal tax rate is 40 percent. . 18 percent bonds outstanding with 10 years remaining to maturity. The call premium will be 5 percent. As interest rates have fallen. Acme can refund these bonds with a Rs.100 million. The issue costs on the new bonds will be Rs.3 million and this can be written off no sooner the old bonds are called.ILLUSTRATION To illustrate how the bond-refunding decision should be analysed. let us consider an example. Acme Chemicals has Rs.5 million.
000 + 5.000 95.ILLUSTRATION The bond-refunding decision may be analysed as follows: 1.000.200.800.4[5.000 – 5.000.000 .000.000.000 + 3.000 105.000.000.000.000 100.000. Initial Outlay (a) Cost of calling the old bonds Face value of the old bonds + Call premium (b) Net proceeds of the new issue Gross proceeds – Issue costs (c) Tax savings on tax-deductible expenses Tax rate [Call premium + Unamortised issue costs on the old bond issue] 0.000 6.000 3.000] Initial Outlay : 1 (a) – 1 (b) – 1 (c) 100.
000.000 + 300.000.000 + 5.Tax saving on interest expense and amortisation of issue cost 0.000/10] 18.Tax savings on interest expense and amortisation of issue costs 0.000 9.000 (b) Annual net cash outflow on new bonds Interests expense . Annual Net Cash Savings (a) Annual net cash outflow on old bonds Interest expense .000 6.000/10] Annual net cash savings: 2 (a) – 2(b) 16.000 1.680.000 10.000.600.4 [16.000 .000.ILLUSTRATION 2.280.000.4 [18.7.320.400.000 .
800.000 x 6. Present Value of the Annual Cash Savings Present value of a 10-year annuity of 1.202.280.560 .002.560 6.ILLUSTRATION 3.252) 4.002.560 8.280. Net Present Value of Refunding the Bonds (a) Present value of annual cash savings (b) Net initial outlay 8.000 using a discount rate of 9.6 percent after-tax cost of new bonds (1.000 (c) Net present value of refunding the bonds 1.
VALUATION OF COMPULSORILY CONVERTIBLE (PARTLY OR FULLY) DEBENTURES n It aPi n Fi V0 = + + t = 1 (1+ kd)t (1+ ks)i j=m (1+ kd) j where V0 = It = n = a = value of the convertible debenture at the time of issue interest receivable at the end of period t life of the debenture number of equity shares receivable when part-conversion or full occurs at the end of period i Pi = expected price per equity share at the end of period i Fj = instalment of principal repayment at the end of period j kd = investors’ required rate of return on the debt component ks = investors’ required rate of return on the equity component .