corp_Ch18_09

corp_Ch18_09 - CLASS NOTES WEEK VI BMA Ch.18 Does Debt...

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IRPGEN424 Corporate Finance Alex Kane 1 CLASS NOTES WEEK VI BMA Ch.18 Does Debt Policy Matter?
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IRPGEN424 Corporate Finance Alex Kane 2 A firm with debt A corporation is a nexus of contracts among all stakeholders In the simplest case, shareholders (SH) alone own claims on the assets and thus the CF When a corporation issues debt, it sells a claim to debt holders (DH) on these same CF At this point, CF from the assets (the firm) are divided between SH and DH in a pre-specified way DH get fixed amounts, SH keep claim to residual CF
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IRPGEN424 Corporate Finance Alex Kane 3 Why issue debt? There are four possible reasons to issue debt The firm needs capital and SH do not wish to put up capital or give up control by issuing more equity Issue cost (investment banking and required disclosure -- less than for equity) is smaller for debt than for equity. Corporate governance failure: executives benefit from issuing debt more than equity Perhaps the value of the firm can be increased The decision of how much debt to carry is called the capital structure decision
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IRPGEN424 Corporate Finance Alex Kane 4 The firm with debt Lumping all debt into one category, the balance sheet of the firm is Assets Liabilities + net worth A D Note: in Market Values, __ E A(book) usually not V V V With no debt, D=0; E=V D=0: SH wealth is maximized when V is maximized. This is achieved by choosing assets with highest NPV With D>0, SH control both D and E. Should SH still maximize V ? This issue is part of the capital structure decision
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IRPGEN424 Corporate Finance Alex Kane 5 About debt contracts Unlike stock which has few nuances (mostly voting rights and dividends), the array of debt instruments is very rich Debt is differentiated by the covenants of the bond (with parallels in bank debt) The standard covenants shared by all debt are: face (par) value maturity date coupon rate (CR) -- may be zero (pure discount bond)
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IRPGEN424 Corporate Finance Alex Kane 6 Valuation of simple bonds The CR determines the interest (CR*Par value) Most coupons are semi-annual. By convention: CR(semi annual) = CR(annual)/2 The yield to maturity (ytm) of the bond is simply the IRR of the cash flows, where (1) investment = market price of the bond (2) last CF = coupon plus par value Only when a bond sells at par, CR=ytm The a bond is priced in the market (determines ytm= IRR) so that expected return (≠ytm, why?) is in accordance with systematic risk. As with all securities, NPV(bond) = 0
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IRPGEN424 Corporate Finance Alex Kane 7 Other covenants Other common covenants are of two types Contingencies such as call and conversion provisions. These are options tacked on the bond contract.
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corp_Ch18_09 - CLASS NOTES WEEK VI BMA Ch.18 Does Debt...

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