1FI3300Corporate Finance 010Spring Semester 2010Dr. Isabel TkatchAssistant Professor of Finance1Learning Objectives☺ What is a financial security?☺ Identify the main differences between debt and equity securities☺ Describe various types of debt securities 2☺ Describe the basic rights and privileges of a shareholder☺ Describe different types of securities markets ☺ Explain the risk-return relations for debt and equity securities What is a financial security?☺ The financial security is a contract between the provider of funds and the user of funds.☺ The contract specifies:☺ The amount of money that has been provided☺ Terms & conditions: how the user is going to 3ggrepay the provider (amount and timing of CFs)☺ Provider: you (ordinary investor), the bank, venture capitalist, etc. ☺ User: entrepreneur or firm with good business idea/product but no (or not enough) money to execute the idea.Simple exampleBank loan as a financial security:You (user) borrow 7.5 million dollars, from a bank (provider) at 8 percent interest p.a. to start a new firm4start a new firm.Your contract stipulates that you will repay the bank loan in 10 equal yearly installments. Each installment is approximately 1.118 million dollars. Valuation of financial securitiesFor the owner of the financial security (investor):- The security is a represented by a stream of expected future cash flows- The value of the security is the PV of the CF stream5Valuation of financial securities:- Use the contract to determine the CF stream- Find the required rate of return- Use the appropriate TVM formula to calculate the PV of the CF streamCommon financial securities Debt Security Equity Security The owner of the security is a creditor of the firmCreditors have no control rights: no say in firm’s business decisionsThe owner of the security is the owner of the firmOwners have control rights: decide (vote) on firm’s business decisionsThe payment is fixed The payment is risky, not fixed6pypy y,Receives payment before anything is paid to firm owners (equity holders)Residual claim: receives whatever is left after all debt holders/creditors are paidIf the firm cannot pay, debt holders will take over its assetsIf the firm cannot pay its debt, equity holders loose their control rightsLimited liability Limited liability2Types of debt securitiesz Fixed-coupon bondz Zero-coupon bondz Consol (Perpetual bond)7z Variable-rate bondz Income bondz Convertible bondz Callable bondFixed-coupon bond☺Firm pays a fixed amount (‘coupon’)every period until the bond matures☺At maturity, firm pays the bond’s face l( l)8value(par value)☺The most common face value is $1,000 ☺The period can be one year, 6 months, one quarter (3 months) etc. How to ‘read’ a fixed-coupon bondA firm issues an 8%, 30-year bond with annual coupon payments. Par value is $1,000.Coupon rate = 8%Period = annual coupon paymentsPar (face) value CF = $1,000 paid at maturity9pyMaturity, T = 30 yearsCoupon CF = Coupon rate x Par = 8% x 1,000 = $80 paid every year, at the end of the year$80 $80 … $80 … $1,080 |------------|-----------|--------- … -----|----- … --------|----> time0 1 2 t T =30ExampleA firm issues an 8%, 30-year bond. The par value is $1,000 and the (effective) annual cost of capital is 10%.1 What is the value of the bond if coupon 101. What is the value of the bond if coupon payments are annual?2. What is the value of the bond if coupon payments are semi-annual?ExampleA bond with par value of $10,000 matures in 2 years. The annual coupon rate is 10% with semiannual installments. 11The bond is expected to make the next semiannual coupon payment 6 months from now. The (effective) annual cost of capital is 8%. What is the price of the bond today?Read carefully: the coupon rate IS NOT the cost of capitalZero-coupon & consolZero-coupon bond☺ No coupon payments during bond’s lifetime (coupon rate = 0)☺ One payment at maturity: the face (par) value12Consol☺ Fixed coupon payments, every period, forever☺ No maturity3ExampleThe (effective) annual interest rate is 12%. 1. What is the current price of a 12-month T-bill (zero-coupon bond, with face-value of $10,000 and 12 th t t it)?1312 months to maturity)?2. What is the current price of a 6-month T-bill (zero-coupon bond, with face-value of $10,000 and 6 months to maturity)?Other types of bondsVariable-rate bond: the coupon rate is tied to a specific interest rate (not fixed) Income bond: pays the coupon only when firm’s earnings are high enough14Convertible bond: a bond + an option to convert the it to another security (e.g., an option to convert the bond to common stock)Callable bond: a bond + the issuer has the right to buy it back, before maturity, for a predetermined priceEquity securities (common stock)☺ Common stock / equity holders have control rights:☺ Have the right to decide on (control) firm’s operations ☺ Exercise their control rights by voting on issues brought up at the shareholders’ meeting☺ The board of directors: El t d b th h h ld ( ) t b th i 15☺Elected by the shareholders (owners) to be their representatives☺ Supervise the management and make sure it acts in the best interests of shareholders – maximize their wealth☺ Cash flows associated with common stock:☺ Cash outflow when the investor buys shares☺ Cash inflow when the firm pays dividends☺ Cash inflow when the investor sells his sharesPreferred stock☺ Owners of preferred stock are paid after debt holders, but before equity holders☺ Preferred stock have no maturity date☺Preferred stock have stated par value 16☺Preferred stock have stated par value and dividend, but the firm is not in default if it cannot pay the dividend☺ The owners of preferred stocks usually don’t have control rights (non-voting security)Securities markets 1☺ Standardized financial securities are traded on securities markets (trade = transfer of ownership)☺ Primary market: ☺ Markets in which companies raise money by selling securities to investors – new securities17☺ Every security sells only once in the primary market – new issue ☺ Initial public offering (IPO) market: firms become publicly owned by issuing (selling) shares to investors for the first time ☺ Secondary market:☺ Markets in which existing securities trade☺ Most of the trading activity is among investorsSecurities markets