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.

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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)

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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.)

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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

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 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

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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)

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 Continuum of financial instruments

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

Perceived risk

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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

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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)

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Mezzanine and convertibles give return in two ways

Required
return

Return from capital gain

Return from yield

Perceived risk

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

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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

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Features of convertibles
 Gearing effect
 Attracts investors
 Tax advantages
For issuer  Self-liquidating
 Cheaper yield
 Less eps dilution
 Higher yield than equity
 Upside of capital gain
 Can decide if/when to
For holder
convert
Advantages
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 If under-priced, dilutes
eps more than
necessary
 If over-priced, have to
repay at inopportune
time
 Possibility of non-
repayment
 If share price doesn’t
rise – lost out by
allowing cheap debt
Disadvantages