SBM Chapter-13
1 Equity
2 Equity markets
3 Fixed interest securities, bonds and leasing
4 Bond markets
5 Bond valuation and yields
6 Credit risk
7 Derivatives
8 Derivative markets
9 Financial reporting and financial instruments
1 Equity: Equity represents the ordinary shares in the
business. Equity shareholders are the owners of the business and through their
voting rights exercise ultimate control.
Preference Share:
Souce of Equity Finance: There are broadly three methods of raising equity: Retentions, Rights issues, New issues
Equity instrument: is any contract
that evidences a residual interest in
the assets of an entity after deducting all of its liabilities.
1.3 Cost of equity and portfolio theory: Returns that investors expect to receive.
Risk can be divided into two categories:
(a) Systematic
risk: this is variability in returns
that is caused by general market factors, such as changes in economic conditions.
(b) Unsystematic
risk or diversifiable risk variations
in returns that are independent of market returns generally.
1.3.2 Beta factors : Systematic
risk can be measured by beta factors.
2 Equity markets- N/A
3 Fixed interest securities, bonds and leasing :
3.3 Bond coupons
3.3.1 Predetermined coupons: Sub-classes here include:
Straight/fixed coupon
bonds –coupon is at a set level for the
entire life of the bond.
Stepped coupon bonds – coupon increases in steps to pre-specified amounts as
the bond moves through its life.
Zero-coupon bonds – no coupon and simply redeem at face value at maturity.
3.4 Debentures : A written acknowledgement of a debt by a company.
3.5 Eurocurrency and Eurobonds N/A
3.7 Redeemable and irredeemable bonds:
3.8
Convertible bonds: A liability that gives the holder the right to convert
into another instrument, normally ordinary shares, at a pre-determined
price/rate and time.
Conversion value = Conversion ratio X Market
price per ordinary share
Conversion premium = Current market value – Current
conversion value
Interactive question 1: Convertibles [Difficulty
level: Intermediate]: The 10%
convertible bonds of Starchwhite are quoted at £142 per £100 nominal. The
earliest date for conversion is in four years time, at the rate of 30 ordinary
shares per £100 nominal. The share price is currently £4.15. Annual interest on
the bonds has just been paid.
Required
(a) Calculate the current conversion value.
(b) Calculate the conversion premium and comment on its
meaning.
3.9 Warrants: A right given by a company to an investor, allowing him to
subscribe for new shares at a future date at a fixed, pre-determined price (the
exercise price).
3.10 Exchangeable bonds: Bonds that are convertible into the ordinary shares of a
subsidiary or associate company of the issuer.
3.11 Hybrid bonds: A security that combines characteristics of both debt
and equity.
3.12 Commercial paper: Short-term unsecured corporate debt. It can only be
issued by large organisations with good credit ratings, normally to fund
short-term expenditure on operating expenses or current assets.
3.13 Medium Term Notes (MTNs): Medium Term Notes (MTNs) describes a facility enabling the
issuer to issue a range of stock from one global facility
The issuer sets up a shelf programme. When the programme
is initially set up terms of:
Maturity (e.g. from one week to ten
years)
Currency (sterling, US dollars,
euro)
Coupon (coupon-paying or zero
coupon)
Instrument (commercial paper,
long-term bonds)
3.14 Repos: An agreement between two counterparties under which one counterparty
agrees to sell a quantity of financial instruments to the other on an agreed
date for an agreed price, and simultaneously agrees to buy back the instruments from
the counterparty at a later date for an agreed higher price.
3.15 Islamic bonds: Islamic bonds or Sukuk are bond issues that satisfy
Islamic principles.
Rab al Mal – provides capital
Mudarib – provides skill and effort
3.17 Leasing: Rather than buying an asset, a business may lease an asset.
Operating
leases: An
operating lease is a lease where the lessor retains most of the risks and
rewards of ownership.
Finance
leases: A
finance lease is a lease that transfers substantially all of the risks and
rewards of ownership of an asset to the lessee. It is an agreement between the
lessee and the lessor for most or all of the asset's expected useful life.
Sale and
leaseback: Sale
and leaseback occurs when a business that owns an asset agrees to sell the
asset to a financial institution and then lease it back on terms specified in a
sale and leaseback agreement.
Lease or buy? - The
decision whether to lease or buy an asset involves two steps.
The acquisition decision:
The financing decision
Worked example: Lease or buy decisions 1: Mallen and Mullins Co has decided to install a new
milling machine. The machine costs $20,000 and it would have a useful life of
five years with a trade-in value of $4,000 at the end of the fifth year.
Additional net cash generated from the machine would be
$8,000 a year for five years. A decision still has to be taken about the method
of financing the project. Two methods of finance are being considered:
The company could purchase the
machine for cash, using bank loan facilities on which the current rate of
interest is 13% before tax.
The company could lease the machine
under an agreement which would entail payment of $4,800 at the end of each year
for the next five years.
The company's weighted average cost of capital, normally
used for evaluating projects, is 12% after tax.
The rate of company tax is 21%. If the machine is
purchased, the company will be able to claim an annual tax depreciation allowance
of 20% of the reducing balance.
Requirement: Advise the management on whether to acquire the machine, on the
most economical method of finance, and on any other matter which should be
considered before finally deciding which method of finance should be adopted.
4 Bond markets: N/A
5 Bond valuation and yields
Returns on bonds can be measured
using flat yield and/or gross redemption yield. Yield is a
measure of the return on the bond as a percentage of the
bond’s market value.
There is an inverse relationship
between bond yields and bond prices. As interest rates rise, the price of bonds
falls (and bond prices rise when yields fall).
The yield curve is a graphical
representation of the structure of interest rates, where the yield offered by
bonds is plotted against maturity.
5.1 Bond pricing: Bonds can be priced at par, at a premium or at a
discount.
General method: The
price of a bond is the sum of the present values of all expected coupon
payments plus the present value of the redemption value at maturity
The formula for calculating the price of a bond is as
follows:
Worked example: Bond pricing: A bond has a par value of £2,500 which is to be redeemed
in 15 years' time at par. The coupon rate of the bond is 8% and there is a
required yield of 10%. Coupon payments are made every six months and the next
payment is due in six months' time.
Requirement
What is the price of the bond?
Zero coupon bonds:
Worked example: Zero coupon bonds: What is the price of a zero coupon bond that matures in
10 years' time, has a required yield of 7% and a redemption value of £3,200?
Assume that coupon payments occur semi-annually.
Solution
5.2 Flat yield: The simplest measure of return in the bond market is the
flat yield. This is also referred to as the running yield or the interest
yield.
5.3 Gross redemption yield (yield to maturity): The gross redemption yield considers the flows of money
arising from a bond. Each flow is then converted into its present value by
discounting the future flow.
5.5 The yield curve: The yield curve (Figure 13.2) is a
graphical representation of the term structure of interest rates, where the
yield offered by bonds is plotted against maturity. It is often calculated by
reference to the gross redemption yield.
A ‘normal’ yield curve is upward-sloping, which means
that the yields required by investors are higher for longer-dated debt
instruments.
13
5.7 Sensitivity to yield: The sensitivity of any bond to movements in the
yield/interest rate will be determined by a number of factors.
5.7.2 Sensitivity to maturity: Longer-dated bonds will be more sensitive to changes in
the interest rate than shorter dated stocks.
5.7.3 Sensitivity to coupon : Lower coupon stocks demonstrate the greatest level of
sensitivity to the yield. It should be noted that the relationship between
yield and price is not symmetrical. This is a relationship that is known as convexity.
5.7.4 The impact of the yield : If yields are particularly high, then the flows in the
future are worth relatively little and the sensitivity is diminished.
Conversely, if the yield is low then the value of flows in the future is
enhanced and the bond is more sensitive to the changing GRY.
5.7.5 Summary of volatility
High volatility Low volatility
6 Credit risk : also referred to as default risk, is the
risk that the borrower will default either on interest payments or
on the repayment of principal on the due date, or on both.
Loss given default (LGD) is the difference between the amount of money owed by the borrower and the amount of money recovered.
Expected loss (EL) from credit risk shows the amount of money the lender should expect to
lose
from the investment in a bond or loan with credit risk.
The expected
loss (EL) is the product of the loss given default (LGD) and the probability of default (PD).
EL= PD X LGD
If the probability of default is, say, 10%, the expected
loss from investing in the above bond is:
EL = 0.10 X 20 = £2 per £100 nominal value of the bond.
For all bonds, regardless of their credit rating, the probability
of default increases with the future time period covered. For example, the
probability of default for a bond may be a 0.05% probability of default within
the next two months, a 1.2% probability of default within two years, a 2.0%
probability of default within the next three years, and so on.
6.1.2 Credit risk measurement: An estimate of the ability of an organization to fulfil
their financial commitments, based on previous dealings. The measurement of
credit risk is quite complex. All the approaches concentrate on the estimation
of the default probability and the recovery rate. Below shows the credit rating
used by rating agencies.
Standard & Poor's Moody's Description of
category
7 Derivatives: are instruments based on (derived from) underlying assets such as
bonds, shares, indices, commodities, currencies and property. They enable
investors to reduce risk or enhance returns on these investments.
7.1 Forward contracts: A forward
contract is an agreement
off-exchange between two parties to make or take delivery of an asset for an
agreed price at a future date.
7.2 Forward rate agreement (FRA) : A forward rate agreement is an over-the-counter (OTC)
agreement between a company and its bank that fixes a future short-term
interest rate. For example, a 3v9 FRA fixes an interest rate for a period beginning
at the end of the third month from the date the FRA agreement is made and
ending at the end of the ninth month.
7.3 Futures : A future is an exchange-traded agreement to buy or sell a standard quantity of a specified
asset on a fixed future date at a price
agreed today. They can be described as
exchange-traded standardised forward contracts.
7.4 Options: An option is a contract that gives its holder/buyer the right, but
not the obligation, to buy or sell an underlying asset at a given price (the
exercise price or strike price) on or before a given date.
The right to buy the underlying item at the exercise
price is known as a call option.
The right to sell the underlying item at the exercise
price is known as a put option.
7.6 The Black-Scholes formula : The Black-Scholes formula for the valuation of European
call options was developed in 1973. (European options are options that can only
be exercised on the expiry date, as opposed to American options, which can be
exercised on any date up till the expiry date.) The formula is based on the
principle that the equivalent of an investment in a call option can be set up
by combining an investment in shares with borrowing the present value of the
option exercise price.
7.6.3 Value of European put options: The
value of a European put option can be calculated by using the Put Call Parity.
p = c – Pa + Pe e–rt
Where: p
= value of the put option
c = value of the call option
7.6.4 Value of American call options : Although American options can be exercised any time
during their lifetime. The value of an American option will therefore be the
same as the value of an equivalent European option and the Black-Scholes
formula can be used to calculate its price.
7.6.5 Value of American put options: Unfortunately, no exact analytic formula for the value
of an American put option on a non-dividendpaying stock has been produced.
Numerical procedures and analytic approximations for calculating American put
values are used instead.
Worked example: Black-Scholes formula: In this example, the Black-Scholes formula is used to
calculate the value of an option on shares. Consider the situation where the
share price six months from the expiry of an option is $42, the exercise price
of the option is $40, the risk-free interest rate is 10% p.a. and the
volatility is 20% p.a.
Interactive question 2: Black-Scholes formula [Difficulty
level: Intermediate]
The current share price of Cathlynn plc is £3.50. Using
the Black-Scholes formula, estimate the value of a European call option on the
shares of the company that has an exercise price of £3.30 and three months to
run before it expires. The risk free rate of interest is 8% and the variance of
the rate of return on the share has been 12%.
See Answer at the end of this chapter.
7.7 Monte Carlo simulation model: The Monte Carlo simulation model is widely used in
situations involving uncertainty. It is particularly useful for non-traded
derivatives, where the Black-Scholes formula is not appropriate. The method amounts
to adopting a particular probability distribution for the uncertain (random)
variables that affect the option price and then using simulations to generate
values of the random variables.
7.8 Swaps : A
swap is an OTC contract that commits two counterparties to exchange, over an
agreed period, two streams of cash or commodities. 3
Examples of swaps include:
Interest rate
Currency
Equity –
where one cash flow is based on a reference interest rate such as LIBOR, the
other is based on the performance of an equity, a basket of equities or an
equity index.
Commodity
Credit swaps –
discussed below.
7.9 Credit derivatives: A derivative whose value is
derived from the credit risk associated with an asset.
The market in credit derivatives has increased
substantially in size over the past ten years or so, in spite of the global
financial crisis in 2007-2008. The industry has centred around London, which
has global market share in excess of 40%.
For example, an investor may buy a credit derivative on
£5 million nominal value of a fixed rate bond issued by ABC plc. If ABC plc
defaults on a payment of the bond before the expiry date of the credit derivative,
the seller of the derivative must pay an amount in compensation to the buyer.
7.11 Limitations of using derivatives: It might be assumed that derivatives should always be
used to hedge interest rate and foreign exchange rate risk. However in many
instances organisations could have perfectly legitimate reasons for not using derivatives
or forward contracts.
Cost
Attitudes
to risk
Uncertainty
over payments and receipts
Lack
of expertise
Accountancy
and tax complications
8 Derivative markets
9 Financial reporting and financial instruments
IAS
32: Financial Instruments:
Presentation
IAS
39: Financial Instruments:
Recognition and Measurement
IFRS
7: Financial Instruments:
Disclosure.
IAS 39 is to be replaced by IFRS 9 Financial Instruments, and will be mandatory for accounting periods beginning
on or after 1 January 2018. At the moment, you are required to know the
provisions of IAS 39, and not IFRS 9.
9.3 Derecognition: When
a derivative is derecognised, the difference between the carrying amount and
any consideration received should be recognised in profit or loss. Any
accumulated gains or losses that have been recognised in other comprehensive
income should also be reclassified to profit or loss on derecognition of the
asset.
Interactive question 3: On 1 November 20X5, a company enters into a forward contract with
its bank to sell US$750,000 on 1 February 20X6 in exchange for sterling, at a
forward rate of $1.50 = £1. The company’s year-end is 31 December. At 31
December 20X5, the $/£ rate has changed to $1.55 and at settlement on 1
February 20X6 the spot exchange rate is $1.60.
How should this forward contract be accounted for by the
company?
Answer to Interactive question 3: The asset is
classified as a financial asset or liability at fair value through profit or
loss. On 1 November 20X5 it has no value as an asset or liability.
At 31 December 20X5, the financial instrument should be
revalued to $750,000/1.55 = £483,871. The company will be receiving £500,000 on
1 February; therefore it has gained from the exchange rate movement. The gain
of £16,129 (£500,000 - £483,871) should be recognised in profit for the year to
31 December 20X5.
On 1 February 20X6 when the forward contract is settled,
the spot value of the dollars that the
company must pay to receive £500,000 is now just
£468,750 ($750,000/1.60). The total gain on the forward contract has been
£31,250. As £16,129 was recognised in profit or loss for 20X5, a further £15,121
will be recognised in profit for the year to 31 December 20X6.
9.5 Reporting on leasing arrangements: VVI see printing Book
IQ 3 Finance lease liabilities
IQ 4 Operating Lease
IQ 5 Sale and finance leaseback
IQ 6 Sale and operating lease back
IQ 7 Provision for onerous lease
Self-test question 2 Shareholders and bondholders
(a) Discuss why conflicts of
interest might exist between shareholders and bondholders.
(b) Provide examples of covenants
that might be attached to bonds, and briefly discuss the advantages and
disadvantages to companies of covenants.
Answer: Shareholders and
bondholders
(a)
(i) Different attitudes to risk
and return:
(ii) Dividends:
(iii) Priority in insolvency
(iv) Attitudes to further finance
(v) Restrictions imposed by
bondholders
(b) A covenant in a loan
agreement is an obligation placed on the borrower. The various types of
covenant are:
- Positive covenants
: These require a borrower to do something, for example to provide the
bank with its regular management accounts. This would allow the bank to
check on the financial performance of the company, and to ensure that it
is likely to be able to repay the loan as planned.
- Loan covenants:
- Asset covenants:
- Accounting
covenants
- Dividend covenants
- Investment
covenants
- Repayment covenants
Advantages of covenants
Disadvantages of covenants
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