FINANCIAL INSTRUMENTS AND COST OF CAPITAL

BONDS

Definition of a Bond


A bond is a security that obligates the issuer to make specified interest and principal payments to the holder on specified dates.
 Coupon rate  Face value (or par)  Maturity (or term)

Bonds are sometimes called fixed income securities. securities.

Types of Bonds


Pure Discount or Zero-Coupon Bonds Zero Pay no coupons prior to maturity.  Pay the bonds face value at maturity. Coupon Bonds  Pay a stated coupon at periodic intervals prior to maturity.  Pay the bonds face value at maturity. Perpetual Bonds (Consols)  No maturity date.  Pay a stated coupon at periodic intervals.

 Types of Bonds  Revenue bondproceeds are to be used to pay for a project bond
 that will produce revenue, such as a toll road or bridge. General obligation bondproceeds are to be used to pay for a bond project that will not produce any revenue, such as a new state police post. Can be sold only by governmental units that have the power to levy taxes. Interest payments are exempt from federal income tax. Secured bond Corporate bond backed by a specific pledge of company assets. Debentures Corporate bonds backed only by the issuing firms financial reputation. Mortgage pass-through security Backed by a self-liquidating pool passselfof mortgage loans purchased from lenders.

  

 

Bond Issuers
   

Government Financial Institutions Countries Corporations

Bond Ratings
Moodys Aaa Aa A Baa Ba B Caa Ca C D S&P AAA AA A BBB BB B CCC CC C Quality of Issue Highest quality. Very small risk of default. High quality. Small risk of default. High-Medium quality. Strong attributes, but potentially vulnerable. Medium quality. Currently adequate, but potentially unreliable. Some speculative element. Long-run prospects questionable. Able to pay currently, but at risk of default in the future. Poor quality. Clear danger of default . High specullative quality. May be in default. Lowest rated. Poor prospects of repayment. In default.

Bond Valuation: An Example


What is the market price of a U.S. Treasury bond that has a coupon rate of 9%, a face value of 1,000 and matures exactly 10 years from today if the required yield to maturity is 10% compounded semiannually? 6 12 Months 45 45 18 24 ... 120

B !

45 1 1000  ! $ 9 3 7. 6 9 1  0 .0 5 1. 0 5 2 0 1. 0 5 2 0

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Bond Prices and Yields

Bond Price
Longer term bonds are more sensitive to changes in interest rates than shorter term bonds.

Yield

 Quality Ratings for Bonds  Two factors determine the price of a bond: its risk and its interest rate.  Bond rating A rating of a bonds level of risk.  Higher interest rates bring higher bond prices.  Market interest rates also influences bond prices.  Retiring Bonds  Firms must have necessary funds to pay bonds at maturity.  Some firms issue serial bonds, an issue of bonds that mature at different rates.  Call provision Allows the issuer to redeem the bond before its maturity at a prespecified price.

DERIVATIVES

Derivative
 Derivative A financial instrument: instrument: Whose value changes in response to changes in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or similar variable (which is known as the underlying), That requires no initial net investment or little initial net investment relative to other types of contracts that have a similar response to changes in market conditions, and That is settled at a future date. date.

Embedded Derivative

 An embedded derivative is the derivative component of a financial instrument that includes both a derivative and a host contract. contract. o If an enterprise is required by PAS 39 to separate an embedded derivative from its host contract but is unable to separately measure the embedded derivative, it should treat the entire combined contract as a financial instrument held for trading (PAS 39.26).

Derivatives
 A financial contract of pre-determined preduration, whose value is derived from the value of an underlying asset
 Securities  commodities  bullion  precious metals  currency  livestock  index such as interest rates, exchange rates

What do derivatives do?

 Derivatives attempt either to minimize the loss arising from adverse price movements of the underlying asset  Or maximize the profits arising out of favorable price fluctuation. Since derivatives derive their value from the underlying asset they are called as derivatives.

Derivative Instruments.
 Forward contracts  Futures
 Commodity  Financial (Stock index, interest rate & currency )

 Options
 Put  Call

 Swaps.
 Interest Rate  Currency

Forward Contracts.
 A one to one bipartite contract, which is to be performed in future at the terms decided today.  Eg: Jay and Viru enter into a contract to trade in one stock on Infosys 3 months from today the date of the contract @ a price of Rs4675/Rs4675/ Note: Product ,Price ,Quantity & Time have been determined in advance by both the parties.  Delivery and payments will take place as per the terms of this contract on the designated date and place. This is a simple example of forward contract.

Options
 An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An date. option is a security, just like a stock or bond, and is a binding contract with strictly defined terms and properties.

Options Lingo
 Underlying: This is the specific security / asset on which an options contract is based.  Option Premium: Premium is the price paid by the buyer to the seller to acquire the right to buy or sell. It is the total cost of an option. It is the difference between the higher price paid for a security and the security's face amount at issue. The premium of an option is basically the sum of the option's intrinsic and time value.

Strike Price or Exercise Price :price of an option is the specified/ pre-determined price preof the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day. Expiration date: The date on which the option date: expires is known as Expiration Date Exercise: An action by an option holder taking advantage of a favourable market situation .Trade in the option for stock.

 Exercise Date: is the date on which the option is actually exercised. exercised.  European style of options: The European kind of option is the one which can be exercised by the buyer on the expiration day only & not anytime before that.  American style of options: An American style option is the one which can be exercised by the buyer on or before the expiration date, i.e. anytime between the day of purchase of the option and the day of its expiry.

 Asian style of options: these are in-between options: inEuropean and American. An Asian option's payoff depends on the average price of the underlying asset over a certain period of time.  Option Holder  Option seller/ writer  Call option: An option contract giving the option: owner the right to buy a specified amount of an underlying security at a specified price within a specified time.  Put Option: An option contract giving the Option: owner the right to sell a specified amount of an underlying security at a specified price within a specified time

 In-the-money: For a call option, in-theIn-thein-themoney is when the option's strike price is below the market price of the underlying stock. For a put option, in the money is when the strike price is above the market price of the underlying stock. In other words, this is when the stock option is worth money and can be turned around and exercised for a profit.

 Intrinsic Value: The intrinsic value of an option is defined as the amount by which an option is in-thein-themoney, or the immediate exercise value of the option when the underlying position is marked-tomarked-tomarket.  For a call option: Intrinsic Value = Spot Price - Strike Price  For a put option: Intrinsic Value = Strike Price - Spot Price

Swaps
 An agreement between two parties to exchange one set of cash flows for another. In essence it is a portfolio of forward contracts. While a forward contract involves one exchange at a specific future date, a swap contract entitles multiple exchanges over a period of time. The most popular are interest rate swaps and currency swaps.

Derivatives Used for Hedging

 Hedging - use of derivatives to offset negative impacts of changes in  interest rates or  foreign currency exchange rates.
Fair Value Hedge Fair Value

Two types

Hedge

Cash Flow Hedge

Variables Affect on Option Prices

Variable
Stock Price Strike Price Volatility Interest Rate Time Call Options  Direct  Inverse  Direct  Direct  Direct Put Options  Inverse  Direct  Direct  Inverse  Direct

What impact do the following parameters have on a call options value?

 Current stock price: Call option value increases as the current stock price increases.  Strike price: As the exercise price increases, a call options value decreases.

EQUITY

Common Stock Valuation

 Just like with bonds, the first step in valuing common stocks is to determine the cash flows  For a stock, there are two:  Dividend payments  The future selling price  Again, finding the present values of these cash flows and adding them together will give us the value

COMMON STOCK
 In valuing the common stock, we have made two assumptions:  We know the dividends that will be paid in the future  We know how much you will be able to sell the stock for in the future  Both of these assumptions are unrealistic, especially knowledge of the future selling price  Furthermore, suppose that you intend on holding on to the stock for twenty years, the calculations would be very tedious!

COMMON STOCK
Disadvantages of Equity Financing  Dilution of ownership and power due to more shares of stock outstanding.  Lower earnings per share/stock price  A lot more work than Debt offering  Flotation costs (expensive)  Fees paid to investment bankers, lawyers, accountants, printers, SEC  Usually much higher than for debt issues.

Advantages of Equity Financing

   

No interest or principle to pay (unlike debt) No obligation to pay dividends. Management doesnt like debt (risk averse) Reduces financial risk (total debt ratio)  This may be a more important advantage to firms that already are relatively risky due to the kind of business they do (e.g. high tech has high business risk)

Advantages of Equity Financing

   

No interest or principle to pay (unlike debt) No obligation to pay dividends. Management doesnt like debt (risk averse) Reduces financial risk (total debt ratio)  This may be a more important advantage to firms that already are relatively risky due to the kind of business they do (e.g. high tech has high business risk)

PREFERRED STOCK

 Preferred stock is an equity security  Preferred stock is classified as a fixedfixed-income security from an investment perspective  Utility companies are common issuers of preferred stock

Characteristics of preferred stock:

 Pay higher dividends than common stock  Preferred shareholders have priority over common shareholders in the event of corporate liquidation  Preferred shareholders must receive their dividends before common shareholders receive anything

PREFERRED STOCK
 Advantages include:
 Its existence increases the firm's financial leverage  It is more flexible than debt when it comes to missing an annual payment  It is useful for corporate restructuring

PREFERRED STOCK
 Disadvantages include:  Its senior status to common stockholders jeopardizes common stockholders' returns  Its cost is generally greater than that of debt financing  It is sometimes difficult to sell since dividends can be passed (unpaid) and returns are generally fixed

COST OF CAPITALCAPITALCURRENT

Weighted Average Cost of Capital (WACC)

 WACC weights the cost of equity and the cost of debt by the percentage of each used in a firms capital structure  WACC=(E/ V) x RE + (D/ V) x RD x (1-TC) (1 (E/V)= Equity % of total value  (D/V)=Debt % of total value  (1-Tc)=After-tax % or reciprocal of corp tax (1-Tc)=Afterrate Tc. The after-tax rate must be considered afterbecause interest on corporate debt is deductible

Capital Components
 Capital components are sources of funding that come from investors.  Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital.  We do adjust for these items when calculating the cash flows of a project, but not when calculating the cost of capital.
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Capital components
 Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the WACC.  We do adjust for these items when calculating project cash flows, but not when calculating the WACC.

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The Impact of Taxes

 The total claims of corporate taxes, debt holders, and equity holders are borne by the prepre-tax cash flow produced by the firm.  If the firm uses more debt, and interest on that debt is tax-deductible, this produces a taxgreater tax shield, reducing the government share of the value of the private enterprise, the WACC must go down.
 Here we assume a zero-sum game (that value is zeronot destroyed through the use of financial leverage)

COST OF CAPITAL-NEW CAPITAL-

Marginal Cost of Capital

 Externally raised capital can have large flotation costs, which increase the cost of capital.  Investors often perceive large capital budgets as being risky, which drives up the cost of capital.

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Marginal Cost of Capital

If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital.

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