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.
Corporate Financial Strategy 3
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)
Corporate Financial Strategy 4
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.)
Corporate Financial Strategy 5
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
Corporate Financial Strategy 6
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
Corporate Financial Strategy 7
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)
Corporate Financial Strategy 8
Continuum of financial instruments
Ordinary
Required shares
return
Preference
shares
Convertibles
Mezzanine
High yield debt
Unsecured
Secured debt
debt
Perceived risk
Corporate Financial Strategy 9
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
Corporate Financial Strategy 10
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)
Corporate Financial Strategy 11
Mezzanine and convertibles give return in two ways
Required
return
Return from capital gain
Return from yield
Perceived risk
Corporate Financial Strategy 12
Mezzanine and convertibles, from lender’s point of view
MEZZANINE CONVERTIBLES
Initial investment in Year 0 Initial investment in Year 0
Interest received in years 1 to n Interest received in years 1 to n
In Year n, two things happen In Year n, one of two things will
1. The loan is repaid happen
And Either
2. Warrant is exercised to receive 1. The loan is repaid
shares Or
2. Loan is converted into shares
Corporate Financial Strategy 13
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
Corporate Financial Strategy 14
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
Corporate Financial Strategy 15
Features of convertibles
Gearing effect If under-priced, dilutes
Attracts investors eps more than
Tax advantages necessary
For issuer Self-liquidating If over-priced, have to
Cheaper yield repay at inopportune
Less eps dilution time
Higher yield than equity Possibility of non-
Upside of capital gain repayment
Can decide if/when to If share price doesn’t
For holder
convert rise – lost out by
allowing cheap debt
Advantages Disadvantages
Corporate Financial Strategy 16
