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Slides_Higgins_12e_Ch_5.pptxFinancial Instruments and Markets
Chapter Five
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Higgins, Analysis for Financial Management, 12e
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1
Financial Executive as Marketing Executive
Financial executives need to raise money to finance the current operations and future growth of their companies.
To do so they must market the future cash flows of their firm.
Marketing entails the packaging of cash flows in order to fetch the highest price possible.
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Packaging
Packaging cash flows involves security design.
Designing securities requires knowledge of different financial instruments.
This chapter focuses on:
Financial instruments
Financial markets
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Financial Instruments
Companies do not face major constraints when choosing financial instruments.
Instruments must appeal to investors and meet the needs of the company.
SEC does not pass judgment on the merits of a security, although some states do have merit regulation (blue sky laws).
SEC regulations require adequate disclosure before purchase.
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Financial Markets
Financial markets describe the distribution system by which cash-deficit entities engage in transactions with cash-surplus entities.
Besides businesses, the entities in question include government agencies, universities, pension funds, endowments, individuals, commercial banks, insurance companies, etc.
Money markets vs. capital markets distinguishes short-term vs. long-term contracts.
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Three Variables
When designing a financial instrument, a financial executive works with three variables:
Investors’ claims on future cash flows
Investors’ right to participate in company decisions
Investors’ claims on company assets in the event of liquidation
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Types of Securities
Debt instruments offer fixed claims.
Equity offers residual claims.
Derivatives are a third security type.
Claims to derivatives depend on the value of underlying assets.
Options are an example of a derivative.
Hybrids, such as convertible debt, combine both debt and equity.
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Bonds
Bonds are fixed-income securities.
Bonds promise interest income and repayment of principal at maturity.
Bonds are sold to the public in small increments, such as $1,000, and can be traded on an exchange after issue.
Ch. 5 8
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Relative Size
In recent years, 69% of business financing has come from retained earnings and depreciation.
44% of external financing has come from corporate bonds.
10% of external financing has come from loans from banks and other financial firms.
In 2016, small manufacturing firms relied on bank loans for 36% of their financing, vs. 8% for larger firms.
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Bond Characteristics
Par value ($1,000 is typical in the U.S.)
Coupon rate
Maturity date
Sinking fund for periodic repayment of principal
Direct payment to creditors via repurchase or retirement at par value
Variable rate vs. fixed rate bonds
Ch. 5 10
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Bond Example
Ch. 5 11
What semiannual coupon payment would be received on this bond? (Assume a $1,000 par value.)
Higgins, Analysis for Financial Management, 12e
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(0.065 × 1,000)/2 = $32.50
11
Call Provisions
Right to retire bonds prior to maturity
Call price is typically a modest premium above par
Delayed call prevents retirement before some date
Call provisions help companies:
take advantage of declines in interest rates and
rearrange capital structure
Investors require a premium for call provisions.
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Covenants
Contractual terms to protect bondholders by impacting management decisions
Examples:
Lower limit on current ratio
Upper limit on D/E ratio
Required approval by bondholders before major acquisition or sale of assets
Bondholders have no direct say in a company unless it defaults on its interest, sinking fund, or covenant obligations.
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Rights in Liquidation
Rights of absolute priority
Government in respect to taxes past due
Senior creditors
General creditors
Subordinated creditors
Preferred shareholders
Common shareholders
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Secured Creditors
Secured credit involves collateral.
In liquidation, proceeds from the sale of collateral only go to the secured creditor, up to the amount of the secured credit.
Any residual goes into the pot shared by the pool of investors.
If the sale of collateral is insufficient, the secured creditor becomes a general creditor for the balance.
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Bonds as an Investment
Bonds are not necessarily safe.
Real vs. nominal returns
See Table 5.1
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TABLE 5.1 Rate of Return on Selected U.S. Securities, 1928–2016
Ch. 5 17
What’s the real return on long-term government bonds?
What’s the default premium on long-term corporate bonds?
Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
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Real return ≈ 5.2 − 3.1 ≈ 2.1% (Exact real return = (1.052)/(1.031) − 1 = 2.0%)
Default premium = 5.7% − 5.2% = 0.5%
17
Bond Ratings
Rating agencies rate bonds for risk.
S&P, Moody’s, Fitch
Analysts use techniques discussed in earlier chapters, such as debt ratios and coverage ratios.
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TABLE 5.2 S&P Debt-Rating Definitions
Ch. 5 19
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Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
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Junk Bonds
Investment grade is “BBB” and above.
Junk bonds, aka speculative or high-yield bonds, are below investment grade.
Junk bond market is an alternative to bank and insurance company loans for smaller, less prominent companies.
Junk bonds have been used to finance mergers and acquisitions.
Ch. 5 20
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Ratings Firms and the Financial Crisis
Criticism of excessive optimism in ratings of complex mortgage-backed securities.
Error #1: discounted possibility of nationwide fall in housing prices
Error #2: ignored deterioration in mortgage lending standards
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Bond Ratings and the Chance of Default
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Common Stock
A residual income security
Shareholders are represented through a board of directors, through which they exercise control.
The degree of control is variable, in terms of the fraction of share ownership required to control the board.
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Shareholder Control
If there is no dominant shareholder group, management might control the board.
Checks against this:
Product market competition
Need for external financing
Market for corporate control
In Europe, banks take equity positions and exercise direct control, more so than in the U.S.
Japanese keiretsu and South Korean chaebol have similar effects.
Ch. 5 24
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Common Stock as an Investment
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Price of GE stock, beginning of 2016 = $30.55
Dividends paid per share during 2016 = $0.93
Price of GE stock, end of 2016 = $31.60
Ch. 5 26
You try it. Calculate the annual return on General Electric for 2016.
Higgins, Analysis for Financial Management, 12e
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Annual return = (31.60 – 30.55 + 0.93)/30.55 = 6.5%
26
Investment Performance of Stocks
Between 1928 and 2016, dividend yields on large common stocks were 3.7%, and capital appreciation was 7.5%.
Recent decade 2.1% and 6.4%
In general, stocks are a hedge against inflation.
1973 to 1981 was an exception to the rule, when stocks returned 5.2% and inflation was 9.2%.
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Equity Premium
Stocks returned 6.2% more than government bonds between 1928 and 2016.
The real return to stocks over this period was 8.3%.
See Figure 5.1 for cumulative return representation.
See Figure 5.2 for depiction of volatility.
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FIGURE 5.1 Value of $1 Invested at the Beginning of 1928
Ch. 5 29
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Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
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Challenge Question!
$1 invested in bonds in 1928 would be worth $71 in 2016.
$1 invested in stocks in 1928 would be worth $3,286 in 2016.
Suppose you invested $1 in 1928, but at the beginning of each month you switched your investment into bonds or stocks, depending on which would do better that month (you are blessed with perfect foresight).
What would your investment be worth by the end of 2016?
(Just for fun)
Ch. 5 30
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Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
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The answer is $35,994,544,921. (Estimated from monthly returns on S&P 500 and 30-year treasurys over the period.)
30
FIGURE 5.2 Distribution of Annual Return on Stocks, 1928–2016
Ch. 5 31
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Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
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FIGURE 5.2 Distribution of Annual Return on Bonds, 1928–2016
Ch. 5 32
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Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
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Preferred Stock
Hybrid security, mixing features of both debt and equity
Promises annual fixed dividend = coupon rate × par value
Dividend discretionary
Dividend is not tax deductible, in contrast to interest payments
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Cumulative Preferred
Preferred shareholders have higher priority than common shareholders.
Common shareholders receive no dividend until preferred shareholders are paid in full, including past arrears.
Control features of preferred stock vary from required approval to no voice at all unless dividend payments are in arrears.
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Perspectives on Preferred
Some managers view preferred as cheap equity, because the dividends are fixed even when earnings grow.
Other managers view preferred as debt with a tax disadvantage.
Preferred stock is not widely used.
About 16% of S&P 500 companies
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Financial Markets
Three illustrative cases:
A startup
A candidate for an IPO
A multinational
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Startup Financing
Startup: too risky for bank lending and too small to attract the attention of investors in public markets
Funding options include:
loans against stable cash flows such as A/R
personal savings
friends and family
venture capitalists
strategic investors (large firms who provide seed money but with potential acquisition on their minds)
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Venture Capitalists
Wealthy investors, often referred to as “angel investors”
Professional venture capital companies, who make high risk investments in entrepreneurial businesses capable of rapid growth and high investment returns
Big stakes, active role in management, investment horizon of 5-6 years (5-10x)
View many proposals and are highly selective
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Internet-Driven Finance
Crowdfunding
Rewards-based crowdfunding
Equity crowdfunding (aka regulation crowdfunding)
Peer-to-peer (P2P) lending
Internet-based financing may soon account for more funding than traditional venture capital.
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Private Equity
Structured as limited partnerships with a specified duration such as 10 years
The general partner is the private equity firm, which raises a pool of money from limited partners, such as institutional investors and insurance companies.
Limited partners have limited liability.
Typical fee structure is “2 and 20”, the sum of a management fee and carried interest.
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Value and Investment Horizon
Private equity partnerships induce managers to work for them, creating value over the long run without having to manage to short-run fluctuations.
The horizon is long run, but not the very long run, so managers are under pressure to create a cash exit event for private equity investors.
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How Big is Private Equity?
Add up the number of workers in companies in private equity firms’ portfolios.
5 of 10 biggest American employers are private equity firms.
#1. Walmart
#2. Carlyle (Private equity firm)
#3. KKR (Private equity firm)
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Initial Public Offerings
Six years ago, Genomic Devices:
raised $15 million from venture capitalists.
had two more rounds of funding ($40 million).
needed a $25 million equity infusion to keep growing now that it was successful.
IPO can provide additional equity along with an exit route for venture investors.
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Investment Banking
“Bake off” to assess proposals from investment bankers and choose one
Winning investment bank becomes the “managing underwriter” and begins to:
advise the company on security design
register the issue with the SEC (30-90 days)
orchestrate a “road show”
assemble an underwriting syndicate who engage in book building
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IPO Risks
Syndicate acts as wholesaler
Offer price set hours before stock goes public
Company bears price risk during the registration process
Syndicate bears risk associated with unsold shares, which they cannot sell above the offer price
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Seasoned Issues
A multinational firm wants to raise $200 million in new debt, using a U.S. “shelf registration.”
Shelf registration is a general purpose registration, good up to two years, that allows the firm to get quick approval for the use of public markets.
A single underwriter often buys the entire issue.
Competitive bids lower the issue costs.
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Market Timing
Shelf registrations provide managers with ability to time issues of new equity.
“Universal” shelf registrations provide flexibility in respect to choice of debt or equity, and public announcement of intentions.
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Private Placement
Large corporations can avoid registering with the SEC by placing debt privately with one or more institutional investors.
The private placement market might be half the size of the public market, excluding bank loans.
Attractive option if public investors not especially receptive for reasons of complexity or familiarity
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Rule 144a
In the past, privately placed debt was not especially liquid.
SEC Rule 144a now allows for trading of privately placed debt among institutional investors.
Result is two parallel markets for corporate securities, one public and the other among institutional investors
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International Markets
Large corporations use foreign financial markets because they want the contract to be in a foreign currency; they can get better terms than in the U.S.
Foreign markets often impose fees and restrictions on foreign investors.
International markets allow the currency specified in the transaction to be outside the control of issuing country’s monetary authority.
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Reserve Requirements and Bearer Bonds
Financial firms operating in international markets need not hold reserves with a central bank such as the Fed.
Unlike the U.S., which requires registration of ownership, bonds can be issued to anonymous bearers, who can collect interest payments and avoid paying tax.
Bearer bonds are cheaper for issuers.
Have international markets stripped away protective regulation?
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U.S. Regulation
Sarbanes-Oxley
Dodd-Frank
Will these drive business away from the U.S.?
Lower IPO activity
More going-private transactions
Shadow markets
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Issue Costs
1. Fees to the underwriter, called the spread
2. Legal, accounting, and printing fees
3. Underpricing
Investment bankers often underprice issues to quell investors’ concerns about information asymmetries.
Not a direct cost, but an implicit dilution cost to existing shareholders
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Example of Issue Costs
ABC Corp. wants to sell 10 million new shares of stock.
Current stock price is $20
Underwriter offers to sell the stock at $19 with a spread of $1.50 per share
This means the underpricing is $1.
Company nets $17.50 × 10 million = $175 million
Underwriter gets $1.50 × 10 million = $15 million
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Newport Industries needs to raise $100 million in an equity offering.
Newport’s current stock price is $80.
The underwriter says the issue must be underpriced by 5%.
The underwriters require a spread of $5/share.
1. How much will the company net from each share?
2. How many shares must the company sell?
Ch. 5 55
You try it. Analyze the issue costs for a stock offering.
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Issue price = 80 × 0.95 = 76; 76 – 5 = $71/share.
2. 100,000,000/71 = 1,408,451 shares.
55
Representative Cost Comparisons
2.2% for straight debt
3.8% for convertible bonds
7.1% for secondary offerings of public companies
11% for IPOs
Economies of scale:
for equity, 3% @ $100 million becomes 20% for $500,000
for debt, range can be 0.9% to 10%
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Efficient Markets
A recurring issue in raising new capital is timing.
Managers devote considerable time and energy into predicting future price trends in financial markets.
Should managers abandon prediction and timing because markets fully reflect all available information correctly into prices?
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Controversial Issues
Evidence about market efficiency has been overstated.
Working assumption is that markets are more or less efficient
Degree of efficiency is an empirical question
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What is an Efficient Market?
Issue is how competitive prices respond to new information
How long does it take for news to impact prices?
Recent research indicates that price adjustment can occur within fractions of seconds.
See Figure 5.3
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FIGURE 5.3 Average Stock Price Reaction to Takeover Announcements for 6,150 firms
Ch. 5 60
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Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
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Efficiency in Degrees
A market is:
weak-form efficient when prices fully reflect all information about past prices.
semistrong-form efficient when prices fully reflect all publicly available information.
strong-form efficient when prices fully reflect all information, public or private.
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Empirical Evidence
Markets are not strong-form efficient.
With limited exceptions, markets are semistrong-form efficient.
Typical investors should not expect to earn abnormal returns trading on publicly available information, especially if they pay brokerage commissions.
Future studies might uncover inefficiencies not generally known at present.
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Implications of Efficiency
When markets are semistrong-form efficient, a series of statements hold true:
Publicly available information has no predictive power in respect to market prices.
The best forecast of future price is current price adjusted for trend.
It is pointless to time the purchase or sale of the firm’s securities.
Investors cannot expect to earn positive risk-adjusted returns.
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Bubbles and Efficiency
Two notions of efficiency:
Markets are unbeatable.
Prices are rational and coincide with intrinsic value.
Bubbles can occur in unbeatable markets that are not rational.
Important to distinguish in context of bubbles and the financial crisis
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Conclusions to Draw
Managers have private information about their own companies, and can justifiably make timing decisions based on such information.
Managers should not make timing decisions based on their personal beliefs about where markets are headed, if those beliefs are based on public information alone.
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APPENDIX: Using Derivatives to Manage Risk
Derivative: A financial instrument whose value is derived from some other asset.
Dangerous when used improperly (see financial crisis of 2008)
Very useful for risk management when used properly
Includes forwards, futures, swaps, options, etc.
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Why Learn about Derivatives?
Derivative markets are huge, over $600 trillion in 2016.
→ Total value of all world equity markets ≈ $70 trillion
Most large companies use them (90%+ of the world’s 500 largest companies).
Misuse of derivatives can be disastrous.
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Forward Markets
You can buy spot today for immediate delivery.
You can contract today at a predetermined price for future delivery.
You can use forward markets to speculate, by betting on the future spot price, using today’s known forward price.
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Hedging with Forward Contracts
Amber Waves Inc. needs to sell grain in 6 months
100,000 bushels
Needs at least $4/bushel
Ch. 5 69
Midwest Bread Inc. needs to buy grain in 6 months
100,000 bushels
Can pay at most $5/bushel
Forward Contract:
MBI agrees to buy 100,000 bushels from AWI in 6 months at a price of, say, $4.60/bushel
Higgins, Analysis for Financial Management, 12e
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Hedging with Futures Contracts
Amber Waves Inc. shorts (sells) 20 contracts of 5,000 bushels each @ $4.60/bushel (contract matures in 6 months)
Ch. 5 70
Midwest Bread Inc. longs (buys) 20 contracts of 5,000 bushels each @ $4.60/bushel (contract matures in 6 months)
Chicago Board Options Exchange:
CBOE acts as an intermediary, dealing with AWI and MBI separately
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Hedging Example
In March, MBI longs 20 September wheat futures contracts (5,000 bushels each) at a price of $4.60/bushel.
In September, suppose the futures price has risen to $5.10/bushel.
MBI closes out futures contracts
Gain on futures = ($5.10 – $4.60) × 100,000 = $50,000
MBI buys 100,000 bushels in spot market for $510,000
Net cost to MBI is $510,000 – $50,000 = $460,000
Ch. 5 71
Why is the spot price the same as the futures price?
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Hedging Example (cont.)
In September, suppose instead that the futures price has fallen to $4.35/bushel.
MBI closes out futures contracts
Gain on futures = ($4.35 – $4.60) × 100,000 = –$25,000 (i.e., a loss)
MBI buys 100,000 bushels in spot market for $435,000
Net cost to MBI is $435,000 + $25,000 = $460,000
Net cost to MBI is the same whether price increases or decreases between March and September
Ch. 5 72
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Different Types of Futures
Commodity Futures
Wheat, corn, milk, cattle, gold, etc.
Currency Futures
Exchange one currency for another at a predetermined exchange rate at a future date
Interest Rate Futures
Lock in a futures interest rate by buying or selling an interest-bearing instrument (e.g. a Treasury bond)
Ch. 5 73
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Hedging with Swaps
A swap is an agreement to pay one series of payments in return for another series of payments.
Interest rate swap
Trade fixed-rate payments for floating-rate payments
Currency swap
Trade liabilities denominated in different currencies
Ch. 5 74
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Interest Rate Swaps
One party pays a fixed rate on a set amount of “notional” principal
One party pays a floating rate, often LIBOR.
Notional principal is never exchanged.
Most popular of all derivatives
For what purposes do companies use interest rate swaps?
Ch. 5 75
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Interest Rate Swap Example
Ch. 5 76
BP asks HSBC for a swap in which BP makes fixed payments on $100 million notional. HSBC quotes a 2.1% fixed rate in return for LIBOR payments.
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Currency Swaps
One party pays a fixed rate on a set amount of principal in one currency.
One party pays a fixed rate in another currency.
Principal is exchanged at the beginning and the end.
For what purposes do companies use currency swaps?
Ch. 5 77
Why is the principal exchanged in currency swaps but not in interest rate swaps?
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Currency Swap Example
Ch. 5 78
McDonald’s arranges a currency swap with Deutsche Bank in which McDonald’s receives a fixed rate of 2.5 percent on $100 million in exchange for paying a 3.0 percent rate on €90 million.
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Hedging with Options
Forward contracts are obligations to accept delivery, if long, or to deliver, if short, at a pre-specified price.
Options are rights, but not obligations, to either take delivery or to deliver, at a pre-specified (exercise) price.
Call options confer the right to buy.
Put options confer the right to sell.
Ch. 5 79
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Option Example
Price of Snap stock = $25
For $5 you can buy (long) an option that gives you the right to buy Snap stock for $30 at any time in the next 60 days
$5 is the premium
$30 is the strike price (or exercise price)
60 days is the maturity
Ch. 5 80
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FIGURE 5A.1 Option Market Payoffs
Ch. 5 81
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Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
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FIGURE 5A.1 Option Market Payoffs (cont.)
Ch. 5 82
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Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
A call option on Walmart stock with a $2 premium has a strike price of $81. What is the profit on the option (net of initial cost) if the price of Walmart stock at the option’s maturity is (a) $85? (b) $75?
A put option on Chevron stock with a $6 premium has a strike price of $115. What is the profit on the option (net of initial cost) if the price of Chevron stock at the option’s maturity is (a) $120? (b) $110?
Ch. 5 83
You try it. Calculate call and put payoffs.
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1a. Payoff=85–81=4. Profit=4–2=$2. 1b. Payoff=0. Profit=0–2=–$2.
2a. Payoff=0. Profit=0–6=–$6. 2b. Payoff=115–110=5. Profit=5–6=–$1.
83
Limitations of Financial Market Hedging
More difficult to hedge if asset does not trade in financial markets
More difficult if amount and timing of cash flows not known with certainty
Do companies even need to hedge? Under what circumstances and why?
Ch. 5 84
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Valuing Options
In theory, the value of an option depends upon:
the current price of the underlying asset
the option’s time to maturity
the option’s strike price
the interest rate
the expected volatility on the underlying asset
but not the expected future value of the underlying asset
Ch. 5 85
How can the expected value of a stock be irrelevant to the value of a call option on that stock?
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Effects of Inputs on Option Prices
Ch. 5 86
| As this variable increases | The call option value | The put option value |
| Price of underlying | Increases | Decreases |
| Strike price | Decreases | Increases |
| Time to maturity | Increases | Increases |
| Volatility of underlying | Increases | Increases |
Higgins, Analysis for Financial Management, 12e
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The Black–Scholes Formula
It’s complicated; we won’t do it by hand
Find an on-line calculator such as the one at erieri.com/blackscholes
Enter the 5 inputs, the calculator gives you the price
Ch. 5 87
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