Below are the most frequently used Corporate Finance Terms and their meanings; please provide your feedback to improve this further. There will be a separate post for a more general list of investment and finance both on this blog.
Happy Learning!!!
1.
DEBT
Debt represents money owed by the company to its
creditors(i.e. those who have provided loan). Creditors expect the company to
repay debt, with interest, at some specified future date. Hence, a company can
obtain source of money through Equity or Debt
Bond is a long-term debt
instrument in which the issuer of the bond (i.e. borrower of money) is
obligated to pay the investor of the bond (i.e. lender of the money) a
specified amount of money, usually at specific
intervals, and to repay the principal amount of the loan at maturity. The
periodic payments are based on the rate of interest agreed upon at the time the
instrument is sold.
Face(Par) Value represents the
principal in the loan agreement, which is the amount the issuer pays at maturity
of the bond. It is the amount printed on the bond certificate
and is also called as the Nominal Value of the Security
Coupon Rate is the rate of
interest paid on a debt security (e.g. Bond). Generally stated on
an annual basis, even if the payments are made at some other interval.
Maturity Date is the date
until a security is due to be paid or a loan is to be repaid.
Coupon (s) are the periodic interest
payment(s) made by the issuer of a bond (debt security). Calculated by
multiplying the face value of the security by the coupon rate.
Book Value is the value of an asset as carried
on the balance sheet of a company. In reference to the value of a company, it
is the net worth (equity) of the company.
Liquidity is the ease with which assets or
securities can be sold for cash on short notice at a fair price
Money Market is a market
that specializes in trading short-term, low-risk, very liquid debt securities
Capital Budgeting is the process
of selecting and ranking investment alternatives and capital expenditures.
Assets are investments made by the company
in different items like Machinery, Securities, and Inventories, which are
directly or indirectly, used to produce the products or generate the services
that are sold by the company.
To acquire assets, it is necessary for the
company to raise capital to pay for them. Any capital which is owed by
the company to its creditors or owners is a Liability. Capital,
as said earlier, comes in two basic forms: debt and equity.
The Balance Sheet is a record of assets
held by a business and capital used (liability) to pay for those assets.
It is a snapshot of conditions at a specific point in time, generally at the
end of a quarter or a year.
The Income Statement provides a summary
of a company's operations and profitability over a given period of time (at the
end of a month, quarter, or year). It shows the value of the products and
services sold by the company for the reporting period, the costs incurred in
achieving those sales, and the distribution of the residual income. Since the
Income Statement provides an analyst with clues about the profitability of a company's
operations, it is also called the Profit and Loss Statement.
Cash Flow Statement is the financial statement shows the sources and
uses of a company's funds. It also may be called the "Statement of Changes
in Financial Position" or the "Sources and Uses Statement" or
"Funds Flow Statement".
Fixed Assets are the long-term investments made by the
company in property, manufacturing plants, and equipments etc.
Current Assets are the short-term investments made by a company
in Marketable Securities, Inventories, Cash etc.
Annuity is a series of payments or deposits of equal size
spaced evenly over a specified period of time
Annuity Due is the annuity where the payments are to
be made at the beginning of each period
Yield to Maturity (a.k.a YTM) is the measure of the average rate
of return that will be earned on a debt security that is held until it matures.
Perpetuity is a special case of an annuity with no set
maturity. Payments are made forever.
Ratio Analysis is the process of using financial ratios,
calculated from key accounts found in a company's financial statements, to make
judgments concerning the finances and operations of the firm.
The most common financial ratios can be grouped into five broad
categories:
- Liquidity Ratios
- Asset Management
Ratios
- Debt Management
Ratios
- Profitability Ratios
- Market Value Ratios
Liquidity Ratios attempt to measure the extent to which the
short-term creditors of the company are covered by assets, that are expected to be converted to cash in
roughly the same time period.
Liquidity Ratios include:
- Current Ratio
- Quick (Acid-Test)
Ratio
The Current Ratio is calculated by dividing CURRENT ASSETS by CURRENT LIABILITIES. For e.g. In the attached
balance sheet, the Current Ratio of XYZ corporation is calculated as:
Total Current Assets = $153.0 Million
Total Current Liabilities = $ 61.4 Million
Current Ratio = 153.0 / 61.4 = 2.49 times
Recall that CURRENT ASSETS accounts include CASH, MARKETABLE SECURITIES, INVENTORIES, and PREPAID EXPENSES. The CURRENT LIABILITIES include ACCOUNTS PAYABLE, NOTES PAYABLE, and ACCRUED WAGES AND TAXES. The Current Ratio means that, if necessary, the
company could use its current assets to pay off its current liabilities 2.49
times. If a company is experiencing financial difficulty, it may pay its bills
more slowly. This causes an increase in bank loans and similar activities. If CURRENT LIABILITIES are rising more quickly
than CURRENT ASSETS, the Current Ratio will
fall. This could indicate trouble in the company.
The Quick (Acid-Test) Ratio is computed by subtracting INVENTORIES from CURRENT ASSETS, then dividing the
remainder by CURRENT LIABILITIES. XYZ Corporation's Quick
Ratio can be calculated as follows:
Quick Ratio = (Current
Assets - Inventories) / (Current Liabilities)
= ($153.0 -
$88.7) / ($61.4)
= 1.05 times
Inventories(i.e. Raw Materials, Work in Progress and Finished Goods =
Inventory) usually are the least liquid (recall the term Liquidity??!) of
the current assets. They are the most difficult to convert to cash and most likely
to incur losses in the course of a liquidation. The Quick Ratio gives an
indication of the firm's ability to meet short-term obligations without relying
on the sale of inventories. XYZ Corporation can use its most liquid current
assets to pay off the current liabilities 1.05 times.
Asset Management Ratios are the ratios that attempt to measure how effectively
the company is managing its assets. They tell if the amount of each type of
asset, reported on the Balance Sheet, is reasonable (given the current and
anticipated operations of the firm)
Asset Management Ratios include:
·
Inventory Turnover Ratio
·
Average Collection Period
·
Fixed Assets Turnover Ratio
·
Total Assets Turnover Ratio
The Inventory Turnover (Inventory Utilization) Ratio is
calculated by dividing the Net SALES of the firm by its INVENTORIES.
Inventory Turnover = (Net Sales) / (Inventories)
= ($287.6) / ($88.7)
= 3.24 times
This means that the firm's inventory is roughly sold out and restocked,
or "turned over," a little more than three times per year. Obsolete,
unnecessary, or excess products held in inventories cause the Asset Turnover
Ratio to fall, which may indicate a need for management action.
The analyst should consider two weaknesses of the Inventory Turnover
Ratio.
·
Overstating of Turnover Rate: The first concern is that
sales are stated at market prices, whereas inventories are usually carried at
cost. In an environment with rapidly changing prices, the ratio would overstate
the inventory turnover rate. When market prices are volatile, a more accurate
calculation may be made using Cost of Goods Sold in the numerator.
·
Allow for seasonal Trends: The other weakness is that
sales occur over the entire year, whereas the inventory is valued at a point of
time. A business with highly seasonal trends may calculate the ratio using an
average inventory figure.
The Average Collection Period (ACP) is often used to
appraise ACCOUNTS RECEIVABLE (i.e. Money that the company has to receive
from its debtors or those who have purchased goods sold by the company on
credit.) It
is computed by dividing AVERAGE DAILY SALES by the ACCOUNTS RECEIVABLE. Average daily sales are found by dividing the total
year's SALES by 360 (the number of days in the year). For XYZ
Corporation, the calculation is:
ACP = (Accounts Receivable) / (Average Daily Sales)
= ($50.9) / ($287.6/360 days)
= 63.7 days
The Average Collection Period represents the number of days the company
must wait after a sale is made before receiving cash. If XYZ Corporation gives
its customers credit terms of 30 days, this ratio indicates that the company is
inefficient in collecting its receivables.
Fixed Assets Turnover Ratio : To measure the utilization
of the firm's plant and equipment, the Fixed Assets Turnover (Fixed Asset
Utilization) Ratio can be used. It is the firm's SALES divided by its FIXED ASSETS.
Fixed Assets Turnover = (Sales) / (Net Fixed Assets)
= ($287.6) / ($133.9)
= 2.15 times
This gives the an idea of how well the fixed assets are being utilized.
XYZ Corporation's fixed assets are generating slightly more than two times
their value in sales for the company. Unnecessary or underutilized fixed assets
that do not increase sales cause this ratio to become lower.
In a period of rapidly changing prices, the value of fixed assets on the
Balance Sheet may be seriously understated. This causes a firm with older
equipment to report a higher turnover than a firm with more recently purchased
plants and equipment.
If the industry average for Fixed Assets Turnover is 2.98 times, a
manager of XYZ Corporation may begin to investigate how other companies in the
industry are able to generate more sales from their fixed assets.
The Total Assets Turnover Ratio measures the utilization
of the company's assets. To compute the Total Assets Turnover Ratio, divide SALES by TOTAL ASSETS.
For XYZ Corporation, it is:
Total Assets Turnover = (Sales) / (Total Assets)
= ($287.6) / ($286.9)
= 1.00 times
Like the Fixed Assets Turnover Ratio, this ratio gives an indication of
how well a company is utilizing its assets. The Total Assets Turnover Ratio
indicates how many times the value of all ASSETS is being generated in SALES. The same concerns about understated assets also are
applicable to the Total Assets Turnover Ratio.
Debt Management ratios help to determine the extent of the use of
borrowed funds to finance assets and to determine how many times the income
generated by those assets can be used to make interest payments. These ratios
include:
· Total Debt to Total Assets Ratio
· Times Interest Earned (TIE) Ratio
· Fixed Charge Coverage Ratio
The Total Debt to Total Assets Ratio measures the
percentage of total funds provided by the use of debt. It is calculated by
dividing TOTAL DEBT (LIABILITIES) by TOTAL ASSETS.
For XYZ corp.,
Debt Ratio = (Total Debt) / (Total Assets)
= ($61.4 + $107.4) / ($286.9)
= 58.8%
Notice that TOTAL DEBT includes CURRENT LIABILITIES and LONG-TERM DEBT. This Debt Ratio is used by creditors to help
decide if they will
loan money to the company.
The Times Interest Earned Ratio gives the an idea of how far operating
income can decline before the company is unable to meet its interest payments
on currently held debt. The TIE Ratio for XYZ Corporation is computed by
dividing EARNINGS BEFORE INTEREST AND TAXES (EBIT) by the INTEREST CHARGES.
Times Interest Earned = (EBIT) / (Interest Charges)
= ($22.5) / ($6.0)
= 3.8 times
The calculation uses earnings before interest and taxes in the numerator
because interest payments are tax deductible in many countries, and the ability
to pay current interest is not affected by taxes. The TIE Ratio indicates how
many times the company can make interest payments with the earnings generated
by the firm.
The Fixed Charge Coverage Ratio has one important difference from
the TIE Ratio. Many companies enter long-term lease agreements for assets. This
ratio recognizes those leases as obligations and includes the LEASE PAYMENTS as
fixed charges along with INTEREST PAYMENTS on loans. The Fixed Charge Coverage
Ratio is computed by dividing EBIT plus LEASE PAYMENTS by INTEREST CHARGES plus
LEASE PAYMENTS.
Fixed Charge = (EBIT + Leases) / (Interest Charges + Leases)
= ($22.5 + $2.1) / ($6.0 + $2.1)
= 3.0 times
This ratio is used more often than the TIE ratio,
especially in industries where leasing of assets is common. It tells how many
times all fixed payments incurred by the company can be made by using all the
earnings of the firm.
All policies and
decisions made by a company are driven by the company's profitability goal. The
previous ratios were designed to provide
information about the operations of a company. Another group of ratios, Profitability
Ratios, highlight the combined effects of liquidity, asset management,
and debt management. These ratios include:
· Profit Margin Ratio
· Basic Earnings Power Ratio
· Return on Total Assets Ratio
· Return on Common Equity Ratio
The Profit
Margin Ratio shows the percentage of sales that is left for
distribution to the common shareholders. The calculation is NET INCOME AVAILABLE TO COMMON SHAREHOLDERS divided by SALES for the period.
For our XYZ
Corporation example, the calculation is:
Profit Margin = (Net Income to Common) / (Sales)
= ($6.2) / ($287.6)
= 2.16%
The Profit
Margin Ratio reveals how much profit the company is generating for each dollar
of sales.
The Basic
Earnings Power Ratio is used to help compare firms with different
degrees of financial leverage and in different tax situations. It provides with
an idea of how effectively the assets are used to generate earnings. The
computation is EARNINGS
BEFORE INTEREST and TAXES (EBIT)
divided by TOTAL ASSETS.
Basic Earnings Power = (EBIT) / (Total Assets)
= ($22.5) / ($286.9)
= 7.84% of Total Assets
EBIT is used in the Basic Earnings Power Ratio to
eliminate any interest payments or tax considerations of the firm. The Basic
Earnings Power Ratio indicates the percentage of TOTAL ASSETS generated as EARNINGS.
The Return on
Total Assets (ROA) Ratio is used to determine the return generated by
the company on its assets. By taking NET INCOME
AVAILABLE TO COMMON SHAREHOLDERS and dividing
it by the value of all the ASSETS, one calculates the return on those assets. For XYZ Corporation, the calculation is:
Return on Total Assets = (Net Income to Common) / (Total Assets)
= ($6.2) / ($286.9)
= 2.16% of Total Assets
ROA is a common measure of the profitability of a
company's ASSETS.
The Return on
Common Equity (ROE) Ratio is a measure of the rate of return on
stockholders' investments. It is calculated by dividing NET INCOME
AVAILABLE TO COMMON SHAREHOLDERS by the TOTAL COMMON EQUITY capital in
the firm.
Return on Common Equity = (Net Income to Common) / (Common Equity)
= ($6.2) / ($105.8)
= 5.86% of Common Equity
The ROE Ratio tells the return that common
shareholders had on their investments
Market Value
Ratios relate the
company's stock price data with the earnings and capital structure of the
company. This information gives an idea of the view investors have of the
company's past performance and also their view of the firm's future prospects.
These ratios include:
· Price / Earnings Ratio
· Market / Book Ratio
Price /
Earnings (P/E) Ratio shows how much investors are willing to pay for every
dollar of the company's reported profits. It is calculated by dividing the
market price per share of Common Stock by EARNINGS PER SHARE (EPS).
The Earnings
per Share calculation is NET INCOME AVAILABLE TO COMMON divided by the Number
of Shares Outstanding. The Number
of Shares can be found next
to the COMMON EQUITY figure on
the Balance Sheet. Be sure to check the units on the Number
of Shares; they may not
always be the same as the other figures on the Balance Sheet. On XYZ Corporation's Balance Sheet, all figures are
in millions.
Earnings per share = (Net Income to Common) / (Number of shares)
= ($6.2) / (8.0 shares)
= $0.775 per share
For our XYZ
Corporation example, if the price of XYZ stock is $12.70 per share, the P/E
Ratio is:
Price / Earnings = (Market price per share) / (Earnings per share)
= ($12.70) / ($0.775)
= 16.4 times
The P/E Ratio indicates that the common shares are
selling for 16.4 times the EARNINGS of XYZ Corporation.
The Market /
Book Ratio shows how much investors are willing to pay relative to the
value of the company as shown on its books. The total market value of a company
is the value that investors in the stock market (where the shares are being
traded) think the company is worth. This value is derived from the stock price
at which the shares are trading. For example, the market value for XYZ
Corporation is $101.6 million (8 million shares times $12.70 per share).
To calculate the
Market / Book Ratio, one must first compute the Book value per Share.
This computation is the value of COMMON EQUITY divided by the Number of
Shares.
Book value per share = (Common Equity) / (Number of shares)
= ($105.8) / (8.0 shares)
= $13.225 per share
The Market / Book
Ratio is calculated by dividing the market price per share by the book value
per share.
Market / Book = (Market price per share) / (Book value per share)
= ($12.70) / ($13.225)
= 0.96 times
The Market /
Book Ratio indicates how many times above (or below) the book value of the
company investors are paying for an equity position. In our XYZ Corporation
example, investors are not quite willing to pay the book value for the equity
of the company. (1.00 times means that the market price and the book price are
the same.)
The ratios we have
so far been analysing, provide us with information about a company's liquidity,
asset management, debt management, and profitability. They also indicate how
market investors value the company's efforts. These ratios also provide
additional insights when compared to the ratios of other companies and when
trends are mapped over a period of time.
Industry Comparisons
An astute analyst
will first calculate a company's ratios and then make comparisons with other
similar companies in that industry or with the
industry as a
whole. Any significant discrepancies will signal that closer inspection may be
needed. For example, if most of the industries competing with XYZ Corporation
have Profit Margin Ratios of over 4% and XYZ has a Profit Margin Ratio of
2.16%, the analyst will begin to look for reasons why XYZ is performing so
poorly. It is important to compare companies within the same industry to gain
useful observations. An automobile manufacturer will have a much different
structure than a consulting company.
Trend
analysis
Trend analysis can
also provide insights into the conditions of a company. By calculating ratios
over a period of several years, an analyst can
uncover potential problems within the firm. For example, if XYZ
Corporation has an Inventory Turnover Ratio of 3.24 times in 1993, 3.86 times
in 1992, and 4.56 times in 1991, an analyst will begin to look for reasons why
it is taking longer for XYZ Corporation to sell its products. These trends give
clues as to whether the financial condition is improving or deteriorating. By
using industry comparisons and trend analysis, the analyst can focus the
investigation on areas of a company that may need attention.
The
term Future value (FV) refers to the value of a cash flow at a
specified rate of interest at the end of a stated length of time. A cash flow
that is received today is worth more than the same amount received in the
future. Cash in hand today may be invested to earn a return over a period of
time.
For example, an
investor receiving $100 today may have the opportunity to invest the $100 for
one year at 10% per annum (p.a.). With a risk-free investment in an environment
free from inflation, the investor will have $110 value at the end of the one
year. If the receipt of the $100 is delayed for one year, the investor will
have only $100 at that time; the opportunity to earn the 10% will have been
lost. The principal plus the return on the investment over time represents the
future value of the investment.
Discounting is the
process we use to equate a future cash flow to its Present Value.The
Present Value refers to the value of the investment at the present time.
Similar to the Interest rate that is used to calculate Future Value, there is a
Discount rate that is used to calculate the Present Value of an investment. The
Discount Rate represents the opportunity cost of money, which is
the rate of return that could have been earned on the best alternative
investment.
The logic is to
estimate the next best return scenario if a different investment decision had
been made. Applying this concept to discount rates, it is said that, given
approximately equal time frames and levels of risk, the appropriate rate to
discount cash flows is the rate of return that represents the next best
alternative in the list of investment choices. The discount rate or opportunity
cost is also called the investor's required rate of return.
In short, Present
Value is the dollar value at the present time (year zero) of a single
cash flow or a stream of future cash flows. The present value is calculated by
discounting the future cash flows.
Basis Point is one-hundredth of one percent (0.01%). Fifty basis
points equal 1/2 of one percent. A basis point is sometimes referred to as a
"tick." e.g. Any type of cost for the Company which is issuing
Bonds i.e. Interest cost, Commitment Fees or Upfront cost for issuing a debt
are all denoted in Basis points. For e.g. if we say that Bond A will give
investors LIBOR (London Inter Bank Offered Interest Rate) + 100 Basis points,
that means if LIBOR is 4% then the interest paid by the bond will be 4 + 1 % =
5 %
Note is a debt agreement in the form of a security issued
by a company or unit of government with a maturity of one to five years.
Because notes are similar to bonds in every aspect except maturity, they are
often grouped together with Bonds when referring to debt securities.
Banker's Acceptance is a
Marketable security, issued on a discount basis, that represents a time draft
that a bank has agreed to pay unconditionally on the maturity date
The international
debt markets may be referred to as the external debt markets or offshore
markets. However, the most common name for the international markets is Euromarket.
International market issues can take place in any location, although London is the most
important issuing market. Most Euromarket issues are listed on the London or Luxembourg
exchanges. These markets are not subject to the direct control of any
government.
The Euromarket is
divided into groups based on the currency in which the issue is denominated.
For example, a Eurobond denominated in Japanese yen is referred to as a Euroyen
bond issue; dollar-denominated bonds are called Eurodollar bonds.
Eurodollar bonds represent the largest share of this market, but other
important currencies include the Deutschemark, British pound sterling, Dutch
guilder, Swiss franc, Japanese yen, Canadian
dollar, and European
Currency Unit (ECU).
Callable bond is a bond that gives the issuer the option of repurchasing
it from investors before maturity. Some bonds have a provision that gives the
issuer an option to repurchase the bonds from investors at a specified price.
The price is referred to as the "call" price. Let's use an example to
explain the process. If a company issues bonds when interest rates are
relatively high, the debt is considered expensive to the company when interest
rates move to lower levels. A callable bond allows the issuer to repurchase the
old bonds at a price that is usually lower than market price. Thus, investors
may not get the full market value for the bonds as they would in an open market
transaction. Investors require issuers to compensate them for the possibility
that the bonds may be called or bought back. Issuers compensate investors in
callable bonds most often by paying a higher interest rate than they would pay
on bonds of similar risk without the call provision. In some callable bond
situations, the borrower issues lowerpriced debt, then uses the proceeds to
call/buy the higher-priced bonds.
Credit Rating is an
evaluation, by independent sources, to determine the ability of an issuer to
repay its debt obligations.
Guaranteed Bond is a bond
backed by the guarantee of repayment by an entity other than the issuer. In
many cases, the guarantor is the parent company of the issuer i.e., a parent
company will guarantee the bonds of a subsidiary. The guarantee may be for the
interest payments on the bonds, the principal repayment, or both. This
arrangement provides security for the investors buying the bond and lowers the
interest rate the issuer pays. In case of default, the guarantor provides the
necessary funds to satisfy the investors.
Bullet Payment is a loan
repayment convention in which the entire principal is repaid at the end of the
loan agreement. During the course of the loan, the borrower pays only interest
and makes no payment on principal until the loan matures. At maturity, the
borrower repays the investor the entire face value of the loan. Most government
securities and many corporate bonds use a bullet payment.
A Mortgage Bond
gives the bondholders a lien, or claim, against the pledged assets
(generally property owned by the firm). In other words, the bondholder has a
legal right to sell the mortgaged property to satisfy unpaid obligations to the
bondholders. Even though the bondholders have a right to this asset, it is
unusual for the assets to be sold. In most default cases, the company undergoes
a financial reorganization that provides a settlement of the debt for the
bondholders. The mortgage provides a strong bargaining position for the
bondholders in the reorganization negotiations. Generally, mortgage bonds pay
the lowest rate of interest, all other factors being equal.
Zero-coupon
Securities require no
interest payments during the time of the agreement. The borrower receives less
than the face value of the loan at the time of the agreement (i.e., the bonds
are sold at a discount). A zero-coupon security charges an implied interest
rate that is represented by the rate of return earned by the investor.
Example For example, an issuer sells a $1,000 bond at a
discount and receives an amount that is less than $1,000 from the investor at
the time of the transaction. During the time the loan agreement is in force,
the borrower makes no interest payments. When the loan is due at maturity, the
borrower repays the investor $1,000.
Some companies do not
own any fixed assets (such as property or equipment) to which a mortgage can be
attached. Many of these companies are holding companies that own the securities
of other companies. These holding firms can satisfy their debt holders' demands
for backing by issuing Collateral Trust Bonds. The issuer pledges
whatever assets (stocks, notes, bonds) are necessary to provide security and
collateral for investors. These investors have claim on the collateral assets
in the case of default. Once again, default generally results in some type of
reorganization rather than a direct sell-off of the assets.
Debentures are not secured by any specific assets owned by the
issuer. Only the earnings potential of the issuer backs these debt instruments.
The investor in debentures is a general creditor of the company. In the event
of default or bankruptcy, debenture holders have a claim on the assets of the
defaulting firm only after all of the secured bondholders have been satisfied.
In a financial reorganization, these bondholders have relatively little
bargaining power. Debenture holders do have claim on assets before equity
holders. To compensate investors for these disadvantages, debentures typically
pay a higher rate of interest, all other factors being equal.
Lending
institutions pool high-quality loans that they have made and use them as
collateral for raising capital through the sale of Asset-backed
Securities. Investors buying these securities receive their earnings
from the interest and principal payments generated by the loans in the pool.
There are many types of asset-backed securities. The most common assets being
securitized include automobile loans, credit card receivables, residential and
commercial mortgages, and computer and truck leases.
The term "Securitization"
refers to the process of packaging groups of small, illiquid assets into a
marketable security with an active secondary market.
The participants of
the process of Securitization are:
·
The party who creates the loans to be pooled
is called the originator. This is typically a lending or
financing institution that wishes to sell its claim on a future set of cash
flows (interest on the loans or leases plus principal repayment), for an
immediate cash payment.
·
The issuer of the asset-backed
security is usually a trust created by the originator for this special purpose.
The issuer acquires the assets from the originator and pools them together as
marketable securities. The issuer raises money for this purchase by selling the
securities to investors.
·
One party acts as the servicer
to look after the day-to-day details of the loans. Most often, the originator
fills this role to maintain its relationship with its customers.
·
The investment bank acts as the trustee
for the transaction. Its role is essentially a policing one to ensure that the
security holders are being treated
fairly, that the assets are being collected, and that investors are paid on
time.
·
The enhancer serves
to guarantee against default for the underlying assets. This ensures that the
investors will receive interest and principal
payments in a timely manner. An investment bank or insurance company
fulfills the role of enhancer.
·
Finally, the investment bank
that assists in the issue of the assetbacked securities helps provide liquidity
in the secondary market. This allows investors to buy and sell the securities
on the secondary market in a timely manner and at fair prices.
An
alternative method for classifying debt securities is by the priority of the
claim on the assets of the issuer in case of a reorganization or bankruptcy.
The terms "Senior
debt" and "Subordinated debt" refer to the relative
position of the bondholders in a reorganization or bankruptcy. Senior debt has
the highest priority. Generally, secured debt is senior; however, the
prospectus specifies the claims to which the investor is entitled. Subordinated
bonds are usually last in the line of creditors for a claim on the assets of
the issuer. The terms "senior" and "subordinated" are
sometimes used with the classification system that describes claims on assets. For
example, a subordinated debenture has claim after senior debentures. The issuer
pays a higher rate of interest to compensate investors for relinquishing their
claims on specific assets.
Two methods for
issuing debt securities are Public offering and Private
placement.
In a public
offering, a company offers its debt securities to all participants in the
market.
In
a private placement, a company places its debt directly with private investors
without a public registration of the offering
Current yield relates the annual coupon interest to the market price of
the security. The formula for calculating current yield is:
Current yield = Annual coupon interest / Market price
The current yield is always
higher than the coupon rate for bonds selling at a discount to par value. For
bonds selling at a premium, the current yield is always less than the coupon
rate. Many secondary market bond quotations list a bond's current yield as well
as its pricing information.
One weakness of the current
yield calculation is that it includes only one of the three sources of
potential income: the periodic interest payment. It does not account for the
reinvestment of interest payments or for any capital gains or losses.
Full Coupon Bond A bond with a
coupon rate above, at or just slightly below current market interest rates. The
bond is thus selling at around its par value (provided that the applicable
required rate of return is almost the same as the coupon rate). If the market
interest rate rises, and the bond's coupon rate is fixed, then the bond's price
will decline. If the market interest
rate falls and the bond's price stays fixed, then the bond's price will rise.
Treasury bills (or T-Bills ) are short-term securities that
are issued by the Treasury Department of the government of a country and backed
by the full faith and credit of the Government. The Treasury Department holds a
monthly auction to issue three-month, six-month, and 52-week securities.
Treasury bills are zero-coupon instruments; therefore, they are quoted on a
discount basis. Treasury bill quotes are based on a 360-day year. Other
Treasury securities are quoted on a price basis, which makes it difficult to
directly compare Treasury bills with other Treasury instruments.
The market for Treasury
bills is large and very liquid. The backing of the government makes these instruments popular
for risk adverse investors. Most investors in Treasury bills are institutional;
however, some large individual investors participate in the Treasury bill
market.
Commercial paper (CP)
is an unsecured promissory note issued for a specific amount that matures on a
specific date. It is sold on a discount basis, with the investor receiving face
value at maturity. Most commercial paper is issued with 30-day maturities.
Companies that issue commercial paper usually do not have sufficient funds in
30 days to repay the loan and, therefore, they expect to "roll over"
the paper (issue new commercial paper to pay off the maturing securities). The
interest rates paid on commercial paper depend on:
·
Maturity
·
Amount the borrower wishes to raise
·
General level of interest rates
·
Credit rating of the issuer
Due to the
possibility of default, rates generally are slightly higher than the rate paid
on the Treasury bills. Many issuers back their securities with a bank line of
credit. Since investors typically hold commercial paper until maturity,
liquidity is a problem in the secondary market. This also causes rates to be higher.
Issuers of commercial paper are generally companies with high
credit ratings. Most investors will not purchase the commercial paper of
companies with lower ratings. Traditionally, large, well-established industrial
and manufacturing firms issued commercial paper. Today, financial companies are
large issuers; banks, foreign companies, government agencies, and sovereigns
also have begun to enter the market. Many financial companies sell their paper
directly to investors, while manufacturing and other companies use dealers.
Investors The majority of
investors in commercial paper are institutional investors, including money
market funds, pension funds, commercial bank trust departments, and some
non-financial firms seeking short-term investments.
A Certificate of Deposit (CD)
is a certificate issued by a bank that indicates a specified sum of money has
been deposited at the issuing depository institution. Financial institutions
use CDs to raise funds to finance their activities. CDs have a minimum maturity
of 14 days, with most tenors in the one- to six-month range. Some five-year and
seven-year CDs exist, but they are not common.
Certificates of deposit are issued at face value. Shorter-term
instruments (less than one year) pay interest at maturity, while longer
instruments make semiannual interest payments. CD rates are quoted on a 360-day
year basis. Yields on CDs are determined by the:
·
General
level of interest rates
·
Credit
rating of the issuer
·
Supply
and demand for the securities
Interest Rates are higher
for CDs than for Treasury bills because of the credit risk associated with the
issuer and the lower level of liquidity in the secondary market. Because most
CDs have high face values, they usually attract institutional investors.
Medium-term Notes (MTNs)
began as an extension of commercial paper, providing longer maturities for
issuers and investors who wanted the characteristics of commercial paper for
longer investment periods. A medium-term note program usually offers securities
with a range of maturities and a different rate associated with each tenor. An
investment banker, acting as a dealer for the issuer, posts rates for the
different maturities and sells the paper "off the shelf" to investors.
The notes are sold on a best efforts basis and continuously offered to
investors during the time specified by the registration. Investors choose which
maturity and rate best meet their investment needs and buy the selected
securities from the dealer. The issuer may encourage investors to buy a
particular maturity by offering it at a better yield than other tenors.
Interest
rates Most MTNs are interest-bearing securities,
paying a semiannual coupon. The interest rate is quoted on a 360-day year
basis. The notes sell at par, with the interest rate fixed at the time of
purchase. The maturity of the security, the overall level of interest rates,
and the credit rating of the investor determine the rate. Usually, the rate is
quoted as a spread over Treasury instruments of similar tenor.
Innovations
Floating
rate MTNs (with rates reset monthly, quarterly, or semiannually) have become
more common. Other innovations include credit-supported MTNs, collateralized
MTNs, and multicurrency
MTNs.
Issuers Typical
issuers are companies with high credit ratings. The process for rating MTNs is
the same as that used for rating corporate bonds The wide investor base for
MTNs includes both institutions and individuals. Investors in MTNs are fairly
sophisticated and require a variety of features being offered in the market.
Treasury Notes are coupon-paying
securities (with maturities of two to ten years) issued by the country's
Treasury Department. The full faith and credit of the government backs these
securities. The Treasury Department issues the notes through a monthly or
quarterly auction, depending on the maturity of the security. Treasury notes
pay semiannual interest and repay the face value at maturity. The market for Treasury notes is large and
very liquid. Investors can easily buy and sell securities at fair prices. Most
investors are institutional; however, there are some individual participants.
Last week, We saw the various short-term
market instruments like
·
T-Bills
·
Banker's Acceptance
·
Commercial Paper
·
Certificate of Deposits
·
Repurchase Agreements
and the various Medium-Term market
instruments like
·
Treasury Notes
·
Medium-Term Notes
In the coming weeks, we shall see the
various Long-Term market Instruments like
·
Treasury Bonds
·
Corporate Bonds
·
Municipal Bonds
·
Eurobonds & Brady Bonds (already
discussed!)
and other Complex Debt Securities like
·
Equity Linked Debt
- Convertible Debt
- Warrants
·
Dual Currency Debt
A Repurchase Agreement (or
"repo") is a common investment vehicle for lenders with funds
available for very short-term investments. A repo involves the sale of a
security with a commitment to repurchase the same security at a designated date
and price. It is actually a collateralized loan, with the collateral being the
security that is sold and repurchased. The difference between the sale price
and the purchase price is the interest cost of the loan. Repo interest rates
closely follow the interest rates being paid on other money market securities.
Interest rates for repos are quoted on a 360-day year basis. From the
borrower's point of view, the rate paid on a repo is usually less than the rate
paid on bank financing. For the investor, repos provide an attractive rate of
return on a short-term secured loan with a highly liquid secondary market.
Repo Issuers
Primary
users of repurchase agreements are government securities dealers who need
short-term funds. For example, consider a government securities dealer who
needs $10 million to purchase a particular Treasury security that the dealer
plans to hold overnight. To obtain financing for the purchase, the dealer can
arrange a bank loan, use the dealer's own funds, or enter a repo using other
securities in the dealer's portfolio as the collateral.
Repo Investors
The
lender in the repurchase agreement may be any entity with excess funds for
short-term investment. Common lenders in the repo market are municipal
governments, other securities dealers, and government agencies. Corporations
with excess cash also enter the repo market to earn interest on their holdings,
even if the investment period is only one day. One-day repurchase agreements
are called "overnight repos." Repos that are arranged for longer
periods are referred to as "term repos."
The
Treasury Department of any country for e.g. U.S., issues bonds with maturities
of 10, 20, and 30 years. It offers the securities at a monthly or quarterly
auction, depending on the maturity of the instrument. Treasury bonds are
coupon-paying instruments, with semiannual interest payments, that repay the
face value at maturity. The bonds are backed by the full faith and credit of
the U.S.
government. The secondary market for Treasury bonds is large and very liquid.
Most investors are institutional, although there are some individual
participants in the long-term market.
The Corporate
Bond market is very large and includes a wide variety of instruments.
We have discussed several methods for paying off debt (Bullet Payment,
Callable Debt etc.) and for providing security for debt instruments. In the
corporate bond market, these features are combined to form an almost endless
number of different debt securities that meet the needs of both issuers and
investors. The overall level of interest rates and the issuer's credit rating
generally determine the interest rates paid on corporate bonds. Most domestic
corporate bonds make semiannual coupon payments;Most corporate bond issues are
underwritten.
o Plain Vanilla Debt
The terms "straight debt" and "plain
vanilla debt" refer to simple bonds that make periodic interest payments
and repay the entire face value at maturity. These bonds are the easiest to
evaluate.
o Floating rate notes
Another common type of corporate bond is
the floating rate note (FRN). As the name suggests, these securities have a
floating interest rate payment, usually benchmarked against a market rate such
as LIBOR or Treasuries plus a spread. The spread is determined by the credit
rating of the company, the maturity of the instrument, plus a possible
liquidity premium. FRNs have a wide range of maturities that fall into both the
medium-term and long-term markets. FRN rates can be set either before the
coupon payment period (predetermined) or at the time the coupon is due (postdetermined
or "back-end" set).
Municipal
bonds are securities issued by government
entities other than the country’s government. They include state, county,
district and city governments. The distinguishing feature of municipal bonds is
that interest payments are not subject to taxation by the government, which
makes them attractive to many investors with tax concerns. Local governments
issue most municipal bonds to finance capital projects. Two types are general
obligation bonds and revenue bonds.
1. General
obligation bonds (GOBs) are backed by the full faith and credit of the
local government. The ability of the government entity to collect taxes to
repay the bonds provides security for investors.
2. Revenue
bonds are backed by the income generated by the project for which the bonds
provided funding. For example, the expected revenue from a toll bridge may be
used to provide security for the bond.
Complex
Debt Securities
Equity
Linked Debt:
Companies with lower credit ratings often need to provide investors with
incentives to purchase their debt securities at reasonable rates. One common
incentive links the debt to the company's equity by providing investors with an
opportunity to participate in the earnings of the company. Companies use two
basic methods to link debt with equity: convertible debt and warrants.
Convertible
Debt
Convertible
debt gives a bondholder the option of exchanging the bond for a predetermined
number of shares in the issuing company. Sometimes the bondholder can convert
the debt into the shares of another company. This may occur when another
company provides a guarantee for the bonds of the issuer. Some bonds are
convertible into other assets, such as commodities like gold or oil. Other
convertible bonds may allow conversion from fixed-rate debt to floating debt.
Most of these conversions occur at a time that is most advantageous for the
bondholders. Usually the conversion rates, regardless of the asset being
converted, are preset at the time the bonds are issued.
Warrants
The
other type of equity-linked debt instruments have warrants attached. A
warrant is a negotiable certificate that gives the owner the right to purchase
a predetermined number of shares of the issuing company at a specified price
during a specified period. Warrants have value as stand alone securities, and
often are separated from the bonds to which they were originally attached. This
"detachability" provides investors with greater flexibility than
investors in convertible bonds. Investors can detach the warrants and sell
either the bonds or the warrants as their investment needs change. The
secondary market for some warrants is very active and liquid. A company also
may issue warrants that are not attached to bonds. These are called "naked
warrants."
The
purpose of attaching warrants is to lower the interest rate the issuer pays on
the debt. When warrants are removed, bonds often trade at deep discounts to
face value because the interest rate is much lower than the prevailing rate for
bonds of similar maturity and risk. Most investors will value warrants and
bonds separately, even if they do not plan to detach them. Typically, investors
exercise the warrants when the market price of the stock is greater than the
exercise price. Many warrants expire with no value because the stock price
never exceeds the exercise price during the life of the warrant. Companies
issue most convertible bonds or bonds with warrants as straight debt.
Typically, they pay semiannual coupons with the face value repaid at maturity.
Some
debt instruments are linked to other assets or securities to create hybrid
securities. One common hybrid is the dual currency bond. Dual currency
bonds make interest payments in one currency and repay the principal in
another currency. This structure is designed to meet expected cash flows the
company will generate from the use of capital raised by the bonds. Companies
with operations in more than one country and earnings in more than one currency
are typical issuers of dual currency bonds. These bonds allow issuers to take
advantage of the relatively low level of interest rates associated with strong
currencies which, in turn, lowers their overall costs of borrowing. The
redemption rate usually is set at the time the bonds are issued, so that
exchange rates are known to the investors. The bonds are usually straight debt
instruments, with semiannual coupon payments.
Yield-to-call is conceptually similar to yield-to-maturity. The
major difference is that yield-to-call assumes the issuer will call (Recall
the word Call?? Repurchase...)the bond at the first opportunity. The
yield-to-call calculation is the same as the yield-to-maturity calculation
except that the number of interest paying periods until the first
opportunity to call is used instead of the number of periods until
maturity. Yield-to-call, like yield-to-maturity, assumes that interest
payments are reinvested at the same rate as the yield-to-call rate. Another
weakness of yield-to-call is that it does not consider what happens to the
proceeds of the bond if it is called. The bond purchaser often has an
investment horizon that is longer than the period until first call. This
measure does not allow a direct comparison with investment opportunities for
such an investor.
The final measure, Realized
Compound Yield, adjusts for interest payments that are reinvested at a
different rate than the yield-to-maturity. One problem with realized compound
yield is that one may not know the reinvestment rate. When comparing
investments, one can use the same arbitrary reinvestment rate for all
investment alternatives. Usually, its best to use the yield-to-maturity for
comparison purposes if the reinvestment rate is not known.
Equity securities
may be issued in one of three forms:
1. Registered
shares
2. Bearer shares
3. Depository
receipts
Registered Shares
If a company
records and maintains a current list of shareholders who own its stock
certificates, then the shares are said to be registered. Each
transaction involving the shares of a company is reported to the company so
that the registration list may be updated. Several countries, including the United States and United Kingdom, require companies
to register their shares. Tax collection is the most common reason for this
requirement
A Depository
Receipt is a negotiable certificate representing a certain number of
shares of a company traded on an exchange other than the exchange where the
issuer resides. Depository receipts offer advantages to investors and issuers.
Advantage to investors
Investors can
participate in foreign markets without having to be concerned with the
regulations of that market or the complexities associated with trading in a
foreign currency.
Advantage to issuers
Issuers avoid many
of the costly and time-consuming regulations found in some countries. Usually,
the host country's regulating agency will have only minimum requirements
concerning the size of the issuing company and the size of the issue.
Bearer
shareholders are not recorded by the issuing company. Possession of
the actual stock certificates is the only proof of ownership. Bearer shares are
common on most European stock exchanges (except in the United Kingdom).
A company usually
issues equity to investors as a security in the form of shares of stock
in the company. Each share represents a claim of ownership on the assets of the
firm. Publicly-held companies issue two types of equity:
o Common stock and
o Preferred stock.
Each type of equity
has specific characteristics and functions.
Common stock represents an ownership claim on the assets of a
company. A prospectus is a document that details the ownership rights of common
stockholders. The
prospectus also specifies the voting rights of the shares.
Shareholder rights An owner of
a company's common stock is entitled to share in the profits of that company.
This participation usually takes place in two ways:
1. A dividend
(distribution of earnings) paid by the company to the share owners
2. An appreciation
in the price of the stock (capital gain) generated by the future
prospects of the company Common stock has no maturity date; the shareholders
are entitled to these earnings for as long as they own the shares and the
company is in business.
Voting rights The common
shares of many firms also give shareholders the right to vote. Shareholders
vote to determine the directors of the company or to approve broad strategy and
policy choices presented by the directors. Usually, each share represents one
vote; however, some common shares have no voting rights or they may have
multiple voting rights. A recent common stock innovation is super-voting shares
that represent a higher number of votes. Companies issue these shares to select
investors to ensure that the majority ownership remains with the
designated
shareholders. To meet different capital needs, a company may issue several
types (or classes) of common stock. Each class possesses different rights and
voting privileges. Companies use a different letter classification, such as
"class A shares," "class B shares," to distinguish shares
with different voting powers.
Preemptive purchase of new issues Owners of common shares also may enjoy a preemptive power, which gives
existing shareholders the right to purchase newly-issued shares before they are
offered to other investors. This right is usually proportional to the amount of
shares currently owned by each investor in order to protect the dilution of
value for current stockholders.
Preferred
Stock, often called a
hybrid (mixed) source of capital, preferred stock is similar to common stock in
some respects and to bonds (debt capital) in other respects.
Shareholder rights
Like common
stockholders, preferred stockholders participate in the earnings of a company.
Like bond holders, preferred stockholders receive a regular dividend payment
based on the shares' face (par) value. This payment is usually determined when
the shares are issued and is generally stated as a percentage of the par value.
The dividend may be based on a fixed percentage rate of par or at a floating
percentage rate that is tied to some market interest rate. For this reason,
many analysts believe that the price of preferred stock behaves like bonds in
response to changes in interest rates. A company must pay a dividend to
preferred shareholders before it pays a dividend to the common shareholders,
hence the term "preferred." The par value establishes the amount due
to the preferred stockholders in the event of liquidation of the company. Thus,
preferred stock has a priority claim on both earnings and assets. A
company may decide not to pay preferred dividends at certain times (such as
periods of financial distress or large internal growth). However, these
"passed" dividends must be paid before any common stock dividend may
be paid. Financial analysts often consider preferred shares as a liability
because shareholders receive their dividends before any earnings distribution
to common shareholders. Most accountants classify preferred stock as equity and
list it in the equity section of the balance sheet.
Voting rights Preferred
stock also may have other ownership provisions. Generally, preferred shareholders
do not have voting rights. However, some preferred stocks grant a voting right
if the company fails to pay the preferred dividend for a specified period (such
as four or eight quarters). This provides incentive for the directors to make
great efforts to pay the preferred dividend.
Buy Back rights Many newer
issues of preferred stock allow for a sinking fund. This entitles the company
to retire (buy back from investors) a certain percentage of the preferred
shares each year. Some preferred shares may have a call provision that allows
the company to repurchase the shares at a set price, usually at a premium over
the par value.
Conversion rights Finally,
many preferred stock issues include a conversion feature that allows the
shareholders to exchange the preferred stock for common stock at a set rate.
This conversion is usually at the option of the shareholder.
If a privately held
company decides to raise capital by selling equity to investors, it does so
through an initial public offering. This is often called "taking a company
public." There are two major types of IPO: a firm commitment offering and
a best efforts offering. These two offerings are distinguished by the
role that the investment bank plays in the process of bringing the issue to
investors.
Bank as underwriter
In a firm
commitment offering, the investment bank serves as the underwriter of the
issue. The investment bank actually purchases the shares from the issuer at a
discount, then resells them to investors. This is called underwriting the
issue.
Bank as sales
representative
In a best efforts
offering, the investment bank agrees to use its "best efforts" to
sell the shares; but the bank does not actually purchase the shares from the
company. In most cases, the issuer does not choose the type of offering it
prefers; the nature of the company and the type of deal dictate which offering
will bring the best results. We will describe the process for both types of
offerings in the coming days.....
Firm Commitment Offering
There are several
steps in the process of issuing a firm commitment IPO.
·
Select
investment bank
An issuing company
begins the process by selecting an investment bank to manage the underwriting.
The company and the underwriter then discuss the financing requirements of the
company. The two groups draft a "letter of intent" that outlines the
proposed terms of the stock issue and the underwriter's compensation for
participating in the issue.
·
Draft a
Registration Statement
Next, the
underwriter assists the issuer in drafting a registration statement. The
company submits the registration to the appropriate government regulatory
agency for examination and approval. In the United States, the Securities and
Exchange Commission (SEC) is the agency responsible for regulating securities
markets. In the United Kingdom,
the Securities and Investments Board is responsible for regulation; in Japan, the Ministry of Finance is the
appropriate agency and in India
its SEBI (Securities Exchange Board of India). The registration statement
contains all the information a potential investor needs to make an educated
decision about the offering, including:
_ Description of the business, its operations, and its
current capital structure
_ Terms of the offering and proposed use of the proceeds
_ Set of audited financial statements
_ Description of the future prospects of the firm,
including potential risks
_ Background of the management group and current major
shareholders in the company
_ Identity of the underwriter
_ Disclosure of the underwriting agreements to which the
offering company is party
·
Generate
investor interest
Underwriters show
the informational section of the registration statement to potential investors
in the form of a preliminary prospectus, sometimes referred to as a "red
herring." This gives the underwriter an idea of how much investor demand
there is for the issue. The preliminary prospectus gives an estimated price per
share because the final price is determined just prior to issue.
Representatives of the company and the bank may also conduct information
meetings with prospective investors to generate interest in the issue. These
meetings are often called "road shows" or "dog and pony
shows."
·
Finalize
price of issue and number of shares
A day or two after
receiving approval from the appropriate regulatory agency, the issuer and the
underwriter (or syndicate) meet to finalize the issue - including the number of
shares to be issued and the price of the shares. It is not unusual for the
number of shares and the price figures to be drastically different from the
figures on the preliminary prospectus. The official prospectus is then prepared
and sent to the government agency for a routine acceptance.
·
Underwriter
sells stock
After the pricing
meeting, the underwriter (or syndicate) sells the stock to investors. This sale
takes place a few hours, or perhaps the next morning, after the last meeting
between the issuer and the underwriters. The sale occurs quickly because the
underwriter has identified potential investors prior to the actual sale. In a
firm commitment offering, the underwriter has essentially guaranteed that the
issuer will receive the net proceeds (amount received from the sale of the
stock less the underwriter's expenses and fees) agreed upon at the pricing
meeting. The underwriter prepares a simple, boxed advertisement called a tombstone
to be placed in the financial section of an appropriate newspaper. The
tombstone is released on the day following the offering to advertise that the
stock issue has taken place.
·
Issuer risk
Substantial
proceeds risk exists for the issuer from the time of the registration statement
filing to the issue. During that time, market conditions may weaken which can
reduce the demand for the new issue. This will affect the amount of capital the
company can raise through the offering.
Best Efforts Offering
In a best efforts
offering, the investment bank does not underwrite the issue, although the bank
is still often referred to as the underwriter. Instead, the bank agrees to use
its "best efforts" to sell the shares.
·
More risk
for issuer
This arrangement
exposes the issuer to more risk than the firm commitment. In a best efforts
offering, the investment banker essentially acts as an advisor and a marketing
agent. The company and the investment bank agree on an issuing price and a
minimum and maximum number of shares to be sold. The investment bank tries to
generate interest in the issue so that the issuing company can sell enough
shares to meet its capital needs. Best efforts offerings are more common with
smaller issues.
·
Issuing
process
The registration
process for best efforts offerings is the same as for the firm commitment
offering. Following approval by the appropriate government regulatory agency,
the investment bank sets up an escrow account for potential investors. These
investors deposit money in the account to reserve their shares.
·
Direct costs
The investment bank
typically charges a commission (between 8% and 11%) on the shares sold in the
offering, in addition to the other fees and expenses. This commission is often
higher than the spread in a firm commitment offering. In some best efforts
agreements, if the minimum number of shares is not sold in the prescribed
amount of time, the offering is withdrawn and the investors' money is returned.
The issuer does not receive any capital. This arrangement is similar to an
all-or-nothing agreement, but the minimum number of shares to be sold in the
best efforts agreement is much smaller. Other best efforts agreements specify
that the investment bank sell as many shares as possible (up to the maximum
number specified).
Although
firm commitment and best efforts are by far the most common types of IPOs,
investment bankers and issuers sometimes use other, less common types as well.
An all-or-nothing
offering is a contract specifying that the investment bank will
withdraw the offer if it is unable to place (sell) the issue. This is similar
to a best efforts offering with a minimum acceptable percentage of shares to be
sold. Some variations of the all-or-nothing offering will set a minimum
acceptable percentage (such as 90%).
An open-price
offering is an arrangement where investors bid on the shares. The
investment bank then places the offering with the investors who make the
highest bids and work down until enough capital has been raised. Most
open-price offerings will specify a minimum bid by investors. Open-price
offerings are more common for companies that issue shares in several different
markets at the same time.
For
e.g. i-flex IPO was an open-price offering where the minimum bid price was kept
at Rs.530
Suppose
that a company has successfully placed an IPO, and those shares are being
traded in the equity market. Now, the company needs more capital and wants to
raise it through an additional equity offering called a Seasoned Offering.
The process of issuing additional shares is similar to an initial public offering.
There are two types of seasoned offerings:
o
a general cash offering and
o a rights
offering.
If a
company offers the additional shares to all potential investors (not just
current stockholders), the offering is called a General Cash Offering.
The shares are sold to investors using the same methods as for the initial
public offering.
Direct
costs Typical general
cash offerings incur direct administrative expenses of approximately 1.5% of
the offering, and the investment banker's spread averages about 5%. A lower
percentage of the total issue amount is charged for larger issues, indicating
economies of scale in the costs of issuing the equity.
Indirect
costs An indirect cost
of a seasoned offering results from the tendency of the stock price to fall
when the offering is announced. This price change may range from 2% to 6% of
the total value of the firm. Two
theories have been proposed to explain this phenomenon.
One
theory is that company is more likely to issue additional stock when the
current stock is overvalued - they try to take advantage of the mispricing in
order to maximize the capital raised by the firm. Investors believe that a
general cash offering is a signal that the shares are overpriced.
Another
theory is based on the idea that a stock issue announcement indicates that the
company is having cash flow problems and needs to raise capital that doesn't
require interest payments. Since equity issues do not require any interest
payments (and debt issues do), investors view the stock issue as a sign of
problems.
The
second type of seasoned offering is a Rights Offering, which
gives the existing shareholders a preemptive right to buy the new equity
securities.
Companies allow current shareholders the first right to purchase the new equity
so that their holdings are not diluted.
Let's
look at an example that illustrates the concept of diluting shares of current
stockholders.
Consider
a company with 4 million outstanding shares of common equity. One particular
investor, a mutual fund, owns 200,000 shares of the company, which represents a
5% ownership share in the firm. The company issues 500,000 new shares and the
mutual fund is not able to purchase any. Therefore, after the issue, the fund's
200,000 shares represent only a 4.44% ownership in the firm. This is referred
to as "dilution of ownership in the firm."
The direct
costs of a rights offering are usually much less than those of a general
cash offering because the existing shareholders are already familiar with the
company and its operations. The investment bank may only serve as a standby
underwriter in case the shares are not all sold.
The indirect
costs for a rights offering are similar to a general cash offering. Most
issue announcements are met with a 3% to 4% fall in the share price of the
existing shares. Theories explaining price decreases are much the same as for
the general cash offering.
We have seen
different methods of offering
securities. Now, having issued securities on the equities markets, companies
must track the value of their stock. Investors also need to estimate the value
of equity securities to make educated investment decisions. A variety of
techniques are available for estimating the value of equity securities. We
shall now see the most commonly used methods for estimating the value of equity
and discuss their relative strengths and weaknesses.
Three valuing
methods
There are three
standard methods for estimating the value of common equity. They are:
1. Ratio valuation
2. Relative
valuation
3. Discounted cash
flow valuation
Most investment
analysts consider the discounted cash flow method to be the best method
for estimating the value of a company or for estimating the value created by a
potential project. By focusing on cash flows rather than net income or other
values, one can eliminate the bias incurred by various accounting conventions.
Discounted cash flow analysis also attempts to account for risk, whereas other
methods do not. Many managers,
especially those without a strong analytical background, still use ratio and relative
valuation methods. While not as
comprehensive as discounting cash flows, these methods can be good
"first-cut" types of analyses (a quick, back-of-the-envelope
calculation) that will give you a beginning point for comparison. Let's see one
by one in the next few days.....
Using
price-to-characteristics ratios to estimate the value of common stock is very
popular. You can find the data needed to calculate ratios in the financial
statements of the company, which are published in the annual report. Most of
the calculations are simple and straightforward. This is the same as the RATIO
ANALYSIS that we discussed in Corporate Finance.
_ Price / earnings ratio
_ Market / book ratio
_ Dividend valuation
_ Other price-to-characteristics ratios
The Price /
Earnings ratio gives information about the value the market attaches to
the earnings of a company. The formula for calculating the price / earnings
(P/E) ratio is:
P/E = (Market price
per share) / (Earnings per share)
Description and
uses of P/E ratio
The P/E ratio shows
how much investors are paying for each dollar of income generated by the firm.
High P/E ratios indicate that investors are very optimistic about the future
prospects of the company. They are willing to pay more for the current earnings
of the firm because they feel that the future earnings will be even higher.
Likewise, lower P/E ratios indicate less optimism for the company by investors.
P/E ratios are often used to compare companies as potential investment
opportunities. It is appropriate to compare companies within the same industry
because of their similar structure and operations. For example, one would
compare the P/E ratios of Ford Motor Company and General Motors as part of
their analysis. They would not compare the P/E ratio of Ford with the P/E ratio
of IBM.
Disadvantage of P/E
ratio
The problem with
using P/E ratios to make investment decisions is that the analysis is
short-sighted. For example, some investors believe that by choosing companies
with lower P/E ratios, they are getting a bargain. If two similar companies are
being considered and one has a P/E ratio of 8, and the other has a P/E ratio of
12, investors probably will choose the company with a P/E of 8 because they
will pay less for each dollar of income generated by the company. However, the
company with a P/E of 12 may still be a better investment because of its future
earnings potential. The P/E ratio is based on the most recent earnings figure,
not the future earnings potential; therefore, it can be short-sighted when used
as the only investment criterion.
The market /
book ratio relates the market price of the shares with the book value of
the company on a per share basis. The formula is:
Market / Book =
(Market price per share) / (Book price per share)
Description and
uses of market / book ratio
This ratio
describes how much investors are paying for the company divided by the value of
the company according to accounting methods. In other words, the market / book
ratio gives a multiple of the market price of the company in relation to its
book value. Some investors consider the book value as the floor for the market
price of the company. They feel that if the market value ever falls below the
book value, the company can sell off its assets at book value to maintain its
price. Those investors may also argue that low market / book ratios indicate
the company is a safer investment; but
the book value may not be the price the company could get by selling off its
assets.
Disadvantage of
market / book
The market / book
ratio is even less useful as a stand-alone tool than the P/E ratio. Problems
occur even when comparing companies in the same industry. Most accounting
conventions require that assets be carried at their historical cost on the
books. It can be difficult to find a company with similar operations and
similar assets to serve an appropriate point of comparison. Companies with
older, less-costly assets will have lower market / book ratios than similar
companies with newer, more modern assets (all other factors being equal).
However, some less-sophisticated investors continue to use the market / book
ratio as a major investment decision-making tool.
If a company pays a
regular dividend, analysts can estimate the firm value based on those dividend
payments using the dividend valuation ratio. There are two ways to estimate the
value, depending on whether we assume that the dividends paid on the common
stock are a perpetuity or a growing perpetuity. The ratio for estimating the
value of common stock as a perpetuity is:
V = D / R
Where:
V = Value of common
stock
D = Recent dividend
payment
R = Estimated
discount rate
The growing
perpetuity formula is:
V = D1 / (R - G)
Where:
V = Value of common
stock
D1 = Expected
dividend in the next period, calculated as D1 = D x (1 + G)
R = Estimated
discount rate
G = Estimated
dividend growth rate
Notice that both
ratios require an estimated discount rate. That rate is the investor's required
rate of return or the earnings an investor expects to make on an equity
investment.
Disadvantages If a company does not pay dividends, or if our
assumptions concerning future dividends do not fit a perpetuity, then this
method is of little value. For example, if a company is very erratic in its
dividend payments, then the assumption of dividend perpetuity may not be valid.
There may be other
price-to-characteristics ratios that can help one understand a company or
industry. For example:
·
A price-to-revenues
ratio may provide insight into how much investors are paying for the revenues
being generated by the company.
·
The price-to-EBITD
(Earnings Before Interest, Taxes, and Depreciation) ratio shows how much value
market investors place on the earnings (without interest payments, taxes, and
depreciation) of the company.
The price-to-cash flow ratio relates the price
of the firm to the cash flow generated by the firm. The calculation of these
ratios is similar to the P/E ratio (price per share divided by EBITD or cash
flow).
Relative valuation
methods provide information about a company relative to other companies in the
same industry. Most of these valuation methods provide an estimate of the
entire firm value. By dividing the firm value by the number of shares
outstanding, one can find per share value estimates. These methods of valuation
often require that one should be very familiar with the operations of a
particular company and its industry. The information needed to make these kinds
of estimates is usually not readily available to most investors.In this
section, we shall see:
-
Liquidation value
-
Asset-based
valuation
Description and uses
If a company sells
all of its assets and uses the proceeds to pay its creditors, the liquidation
value is the amount left to distribute to shareholders. Analysts often consider
the liquidation value to be the floor price of the stock. If the stock price
falls below this value, investors are better off having the company liquidated.
Corporate raiders often use liquidation value as a criterion to evaluate
potential takeovers. They may notice that a stock price is less than the
liquidation value on a per share basis and will make an offer for all of the
stock of the company. The raider then gains control, sells off the assets, and
pays the creditors. The value remaining represents the raider's gain (less the original
investment).
Disadvantages However, it may be very difficult to estimate the
liquidation value of a company. This is especially true if there is little or
no market for the assets of the company. One must have a thorough understanding
of the company and its industry to make an accurate estimate of the company's
liquidation value.
Description and
Uses
Some may want to
value the individual assets of a company at a market price according to the
cash flow generated by the asset groups. They often use the asset-based
valuation method for companies with several different operations. For example,
consider a media company that owns television stations, radio stations, some
newspaper publishers, and a book publisher. The market most likely will value
earnings from each business at a different P/E ratio. One with access to a
breakdown of the cash flow generated by each unit may discover that one unit is
undervalued. This unit will be worth more to other investors as either a
stand-alone entity or as part of another company. Spin-offs, mergers, and
acquisitions are often motivated by this type of asset valuation.
The discounted cash
flow method involves a more detailed analysis than ratio and relative valuation
methods. It requires the investor or analyst to make several assumptions about
the future prospects of the company being analyzed. We will briefly describe
the four-step process:
Four-step
process
1) Forecast cash
flows
2) Estimate cost of
capital
3) Estimate
residual value
4) Discount cash
flows
The
first step in discounting cash flow is to develop a set of projected cash flows
for an appropriate time frame based on certain assumptions. Usually one's sense
of the accuracy of the estimates and assumptions will dictate the time frame
used for the analysis. That may be somewhere between three and twenty-five
years. Figure 1 is an example of how assumptions for five years may be
organized for XYZ Corporation.
ASSUMPTIONS:
|
Year
|
1
|
2
|
3
|
4
|
5
|
(A)
|
Sales
Growth
|
4.00%
|
4.00%
|
4.00%
|
4.00%
|
4.00%
|
(B)
|
Profit
Margin Incremental Net
|
12.00%
|
12.00%
|
12.00%
|
12.00%
|
12.00%
|
(C)
|
Cash
Income Tax
|
35.00%
|
35.00%
|
35.00%
|
35.00%
|
35.00%
|
(D)
|
Incremental
Working Capital Investment
|
13.00%
|
13.00%
|
13.00%
|
13.00%
|
13.00%
|
|
(E)
|
Fixed Asset Investment (% of Sales
Increase)
|
18.00%
|
18.00%
|
18.00%
|
18.00%
|
18.00%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Figure 1: Assumptions for Forecasting Cash
Flows
The
most common procedure for estimating cash flows begins with the most recent
sales figure. First, one estimates future sales based on an assumed revenue
growth rate (A). Next, one makes assumptions about the projected profit margin
of the firm (B) and estimates a future cash tax rate (C). You can also make
assumptions about the company's future investment in working (D) and fixed (E)
capital assets. One with access to this information will use the company's
actual projected figures. Else, you can make an estimate based on the
investment rates as percentages of incremental sales. Having completed the set
of assumptions, one is ready to forecast future cash flows for XYZ Corporation.
Based on the assumptions in Figure 1, estimated cash flows for each of the five
years are shown in Figure 2.
ESTIMATES:
Year (Figures in Millions)
|
1
|
2
|
3
|
4
|
5
|
Sales
|
$104.00
|
$108.16
|
$112.49
|
$116.99
|
$121.67
|
Operating Profit
|
12.48
|
12.98
|
13.50
|
14.04
|
14.60
|
Cash Income Taxes
|
4.37
|
4.54
|
4.72
|
4.91
|
5.11
|
EBIAT
|
8.11
|
8.44
|
8.77
|
9.12
|
9.49
|
Fixed Capital Investment
|
0.72
|
0.75
|
0.78
|
0.81
|
0.84
|
Working Capital Investment
|
0.52
|
0.54
|
0.56
|
0.58
|
0.61
|
Free Cash Flow
|
6.87
|
7.15
|
7.43
|
7.73
|
8.04
|
Figure 2: Five-year Cash Flow Forecast
Let's look at how to use the assumptions to calculate
the cash flow for Year 1.
Sales for the past year (Year 0) totaled $100 million.
Sales = Sales for Year 0 (1 + Forecast growth rate)
=
$100 million x (1.04)
=
$104 million
Operating Profit = Sales x Expected profit margin
=
$104 million x 0.12
=
$12.48 million
Income Tax = Operating profit x Tax rate
=
$12.48 million x 0.35
=
$4.37 million
EBIAT (Earnings before interest after taxes ) =
Operating profit - Taxes
= $12.48 million - $4.37 million
=
$8.11 million
If we do not have
access to exact figures from the company's fixed capital and working capital
investment plans, then we must make estimates. As mentioned earlier, a common
method is to assume a certain investment rate based on the incremental increase
in sales. We can base our assumptions on a careful study of the company's past
investment patterns.
In our example, the
Year 1 sales increase is $4 million ($104 million - $100 million). One expects
the firm to invest 13% of each year's sales increase in working capital and 18%
in fixed capital assets. This is the investment net of depreciation. The
calculations for investments in Year 1 are:
Fixed Capital
Investment
=
Incremental sales increase x Fixed asset investment rate
= $4
million x 0.18
=
$0.72 million
Working Capital
Investment
= Incremental sales increase x Working
capital investment rate
= $4 million x 0.13
= $0.52 million
Now we calculate
the cash flow.
Projected Cash Flow
= EBIAT - (Fixed + Working capital
investment)
= $8.11 million - ($0.72 million + $0.52
million)
= $6.87 million
The estimated cash
flow for XYZ Corporation for Year 1 is $6.87 million.
We
shall see step 2 - Estimation of Cost of Capital in tomorrows mail.........
The next step in
the discounted cash flow valuation is to estimate the cost of capital
for the firm. This is the required rate of return that the firm must earn
for its investors to properly reward them for the risk they take by investing
in the company. It is the rate that will be used to discount the projected cash
flows to calculate the present value of the company.
The best method for
estimating the cost of capital is by using the weighted average cost of
capital. This method accounts for each source of capital (debt, preferred
stock, and common equity) and the cost associated with its use. The formula for
calculating the weighted average cost of capital is:
ka = Wd kd (1 - T) + Wp kp + We ke
Where:
ka = Weighted average cost of capital
Wd =
Percentage of capital using debt
kd = Cost of
debt
T = Marginal
tax rate of company
Wp =
Percentage of capital using preferred stock
kp = Cost of
preferred stock
We =
Percentage of capital using equity
ke = Cost of
equity
Debt : The formula multiplies the cost of each source of
capital by its relative weight in the capital structure of the firm. It adjusts
the cost of debt for the tax-deductibility of interest payments by multiplying
k by one minus the tax rate. One estimates the cost of debt as the interest
rate that the company will pay on new debt.
Preferred
stock : Preferred dividends
are divided by the price of the preferred shares to calculate the cost of
preferred shares. This gives an estimate of the rate of return that preferred
shareholders are earning on their investment.
Common
equity :To estimate the
cost of common equity, many analysts use the capital asset pricing model.
Another method commonly used is dividend valuation, which we discussed last
week.
To continue our
example of XYZ Corporation, suppose that the cost of debt is 6.0%, the cost of
preferred stock is 8.5%, and the cost of common equity is 13.0%. The expected
capital structure is 40% debt, 10% preferred equity, and 50% common stock. The
cash tax rate is expected to be 35%. You can estimate the weighted average cost
of capital as follows:
ka = Wd kd (1 - T) + Wp kp + We ke
ka =
(0.40)(0.06)(1 - 0.35) + (0.10)(0.085) + (0.50)(0.13)
ka = 0.0891 or
8.91%
The required rate
of return for investors (discount rate) is 8.91%.
We shall discuss
the Step 3 - Estimate Residual Value in tomorrow's mail
The third step in
the discounted cash flow valuation is to calculate the residual value. Residual
value is the estimated value of the company at the end of the forecasted
periods.
Based on
liquidation value
There are several
methods that can be used to make this estimate. If one knows that the company
will be terminated at the end of the forecast, then you may want to use an
estimated liquidation value of the assets or an estimated price at which the
company may reasonably be sold at that time.
Based on returns
matching cost of capital
If one expects that
the company will continue to operate and generate cash flows for the investors,
the analyst will want to make a different estimate. One method is to assume
that the company will continue to earn a rate of return that matches the cost
of capital invested in the company. Under this assumption, the value of the
company is:
Residual value = (EBIAT) / ka
Where:
ka = Weighted average
cost of capital (which we saw in yesterday's mail)
The convention is
to use the earnings before interest after taxes (EBIAT) for the last forecasted
year, divided by the average cost of capital (discount rate) for that year. By
using this method, one makes the implicit assumption that the company is not
creating (or destroying) any value for the shareholders of the company. All
investors (debt, preferred, and common) are earning their expected rates of
return by investing in the company.
Based on returns
above cost of capital
Some companies may
anticipate that they will continue earning returns above their cost of capital
after the forecast period. In these cases, a growing perpetuity method may be
appropriate for estimating the residual value. The formula for placing value on
a growing perpetuity is:
Residual value = [EBIAT x (1 + g)] /
(ka - g)
Where:
g = Expected growth rate
ka = Weighted average
cost of capital
One important thing
to remember when using this method is that the cost of capital must be larger
than the expected growth rate.
Example We want to estimate the residual value of XYZ
Corporation at the end of five years. Let's assume that the residual value is a
perpetuity of $9.49 million (Year 5 earnings before interest after tax). We can
use our formula to estimate the residual value with a weighted average cost of
capital of 8.91%.
Residual value =
($9.49 million) / (0.0891)
= $106.51 million
The final step is
to discount the projected cash flows, including the residual value, to a
present value using the weighted average cost of capital (discount rate). In
Figure 3, we discount the cash flows of XYZ Corporation and calculate the
firm's present value:
Year
|
Cash
Flow (Millions)
|
Present Value
Factor*
|
Present Value
(Millions)
|
1
|
6.87
|
1/(1.0891)1
|
6.31
|
2
|
7.15
|
1/(1.0891)2
|
6.03
|
3
|
7.43
|
1/(1.0891)3
|
5.75
|
4
|
7.73
|
1/(1.0891)4
|
5.49
|
5
|
8.04
|
1/(1.0891)5
|
5.25
|
Residual Value
|
106.51
|
1/(1.0891)5
|
69.51
|
|
|
Total Firm Value
|
98.34
|
* Present Value
Factor = 1 / (1 + Weighted Average Cost of Capital)T T = Year
Figure 3: Present
Value of XYZ Corporation
This discounting
process gives us the total present value of the company - based on our earlier
assumptions concerning growth, investment, and cost of capital. To find the
value of the common equity, we deduct the value of the debt and the value of
the preferred stock.
In our example, the
company has approximately $35 million in debt and $8 million in preferred stock
on its books. Thus, the value of the common equity is $55.34 million ($98.34
million - $43 million). If the company has 2.5 million shares of common stock
outstanding, we can divide the value of the equity by the number of shares to
get the firm value on a per share basis ($55.34 million / 2.5 million = $22.14
per share).
Perpectuity
Method
The most common
method for estimating the value of preferred shares is to use a perpetuity
method. The dividend paid on each share is considered a perpetuity. We can
estimate the value of the preferred shares by dividing the dividend by the
investors' required rate of return. The formula is:
Value = Dividend / Discount rate
Example If we know
that a company pays a yearly dividend of $6.25 on its preferred shares and that
an investor can earn an 8.5% rate of return on investments with similar risk,
then we can estimate the value of the preferred shares.
Value = $6.25 / 0.085
= $73.53
This means that an
investor with a required rate of return of 8.5% would be willing to pay $73.53
for a preferred share that pays a $6.25 yearly dividend.
Estimating cost of preferred
shares
Analysts use this
same relationship to estimate the cost of preferred shares when trying to find
the weighted average cost of capital. The analyst will have access to the
dividend and price per share information, and will solve the equation for the
discount rate (which represents the cost of the preferred stock to the
company).
For example,
suppose that a company has preferred shares that are currently selling for
$43.50 and pay a yearly dividend of $4.80. The cost of the preferred shares can
then be estimated.
Discount rate = Dividend /
Share price
= $4.80 / $43.50
= 0.1103 or 11.03%
Tariffs are taxes that are placed on imported goods to:
·
Protect domestic
businesses from foreign competition
·
Discriminate, if
they apply unequally to products of different countries
·
Retaliate, if they
are designed to compel another country to remove artificial trade barriers
The tariff imposed
on Japanese motorcycles is an example of a protective tariff. In 1983,
Harley-Davidson, a US
manufacturer, was having difficulty competing with the heavyweight bikes
imported from Japan by Honda
and Kawasaki.
The US Government imposed a five-year tariff on Japanese bikes imported into
the United States.
This gave Harley-Davidson management time to reorganize the company and become
competitive again - without pressure from the Japanese imports. By 1987, Harley-Davidson
had regained its share of the market in the heavyweight class of bikes and
requested that the tariff be lifted a year early.
Nontariff
barriers consist of a
variety of measures that restrict imports. These measures include testing,
certification, or bureaucratic hurdles. Example An interesting
example of bureaucratic hurdles occurred in France in 1983. The French
government decided to reduce the importation
of foreign video
recorders and mandated that all recorders had to be sent to the customs station
at Poitiers -
which was far from the normal transportation routes. Because the station was
understaffed, operated only a few days per week, and each individual package
had to be opened, the import of video recorders was effectively stopped.
Meanwhile, the French were able to assert their adherence to international
agreements.
Quotas are restrictions on the quantity of specific products that can be
imported and exported. Sometimes import quotas are imposed to prevent damage to
a domestic industry, e.g. clothing and textiles. Occasionally, this action has
unexpected results.
Example For example, in the early 1970s, quotas placed on tuna
fish packed in oil from Japan
prevented the tuna from entering the US market. This forced the Japanese
to concentrate on packing tuna in water even though, at that time, only 7% of
tuna was packed in water. The Japanese became quite successful and created a
niche for themselves in the tuna-packed-in-water market. Export quotas are set
for reasons of national defense, economic stability, and price support. For
example, it is United States
government policy to control the export of weapons and high technology that may
have an adverse effect on national security. Tariffs, non-tariff barriers, and
import and export quotas all function to restrict or limit foreign trade. There
also are several methods that serve to promote global trade.
A trade
agreement is an agreement between two or more countries concerning the
buying and selling of each country’s goods and services. Countries enter into
trade agreements to facilitate trade among the member countries. Their
objectives are to:
·
Diversify export
markets
·
Create or explore
trade opportunities without barriers
·
Protect products from
other markets
·
Encourage economic
development of the region
While there are
many trade agreements in different parts of the world, one plays a major role
in Europe (the European Community [EC]), and three of them directly influence
trade in Latin America: North American Free
Trade Agreement (NAFTA), MERCOSUR, and Pacto Andino.
Export
Credit Agencies are national
organizations that support and expand local exports to benefit the country’s
balance of payments and, as a result, create jobs in the local market. The ECA
programs enable the Bank’s customers (exporters) to remain competitive with
businesses from other countries. Importers also benefit from access to
preferential rates and terms for loans from programs of the exporting countries.
ECA programs ECA assistance is provided in the form of guarantees
or insurance as well as direct lending. ECA programs include:
·
Insurance to
national exporters and commercial banks against commercial (credit) and/or
country risks
·
Payment guarantees
to commercial banks involved in export financing
·
Preferential fixed
interest rate loans to foreign importers
Governments working
together have established institutions whose purpose is to maintain orderly
international financial conditions and to provide capital and advice for
economic development, particularly in those countries that lack the resources
to do it themselves. These institutions or multilateral agencies
play an increasing role in the financing of large export contracts and
projects. We shall discuss first the globally-oriented World Bank, its entities
and affiliates, and then examine the role of regional development banks.
The World
Bank Group is comprised of the International Bank for Reconstruction
and Development (IBRD) and the International
Development Association (IDA) and two affiliates, the International Finance Corporation (IFC) and the Multilateral Investment Guarantee Agency (MIGA). Let’s examine their specific roles.
World Bank
The World Bank is a
multilateral development agency. Its purpose is to help member countries
progress economically and socially so that their people may live better and
fuller lives. The World Bank is the primary source of funding for projects in
emerging-market countries when private capital cannot be raised. In addition to
lending medium and long-term funds directly to governments in the emerging
markets, the World
Bank provides
technical and financial aid to private-sector companies for direct investments.
World Bank
entities: IBRD and IDA
The term “World
Bank” refers to two legally and financially distinct entities: the
International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA). The IBRD and IDA have three
related functions:
·
Lend funds
·
Provide economic
advice and technical assistance
·
Serve as a catalyst
to investment by others
Both the IBRD
and the IDA provide training and technical advice to help developing countries
address their own problems. However, the IBRD makes market-rate loans to newly industrialized
countries (e.g. Korea, Brazil) by
borrowing in the world capital markets. The IDA extends
assistance to the
poorest countries on easier terms
(e.g., interest-free loans), largely from resources provided by its wealthier
members.
Funds from such
other sources as governments, commercial banks, export credit agencies, and
other multilateral institutions are increasingly being paired with World Bank
funds to co-finance projects.
SEDOL stands for Stock Exchange Daily Official List, a
list of security identifiers used in the United
Kingdom and Ireland
for clearing purposes. The numbers are assigned by the London Stock Exchange, on request by the
security issuer. SEDOLs serve as the NSIN for all securities issued in the United
Kingdom and are therefore part of the security's ISIN as well.
Although SEDOL was to
have been superseded by ISIN, problems with the ISIN system have since forced a
reversal of this decision. In particular, a single ISIN is used to identify the
shares of a company no matter what exchange it is being traded on, making it
impossible to specify a trade on a particular exchange or currency. For
instance, Chrysler
trades on twenty-two different exchanges worldwide, and is priced in five
different currencies. An expanded ISIN standard is currently being formulated
to address this problem.
SEDOLs are seven
characters in length, consisting of two parts: a six-place alphanumeric code
and a trailing check digit. SEDOLs issued prior to January 26, 2004
were composed only of numbers. For those older SEDOLs, those from Asia and
Africa typically begin with 6, those from the UK
and Ireland (until Ireland joined the EU) typically begin with 0 or
3 those from Europe typically began with 4, 5 or 7 and those from the Americas began
with 2. After January 26, 2004, SEDOLs were changed to be alpha-numeric and are
issued sequentially, beginning with B000009. At each character position numbers
precede letters and vowels are never used. All new SEDOLs, therefore, begin
with a letter. Ranges beginning with 9 are reserved for end user allocation.
The check digit for a
SEDOL is chosen to make the total weighted sum of all seven characters a
multiple of 10. The check digit is computed using a weighted sum of the first
six characters. Letters are converted to numbers by adding their ordinal
position in the alphabet to 9, such that B = 11 and Z = 35. While vowels are
never used in SEDOLs, they are not ignored when computing this weighted sum
(e.g. H = 17 and J = 19, even though I is not used), simplifying code to
compute this sum. The resulting string of numbers is then multiplied by the
weighting factor as follows:
First 1
Second 3
Third 1
Fourth 7
Fifth 3
Sixth 9
Seventh 1 (the check digit)
The character values are
multiplied by the weights. The check digit is chosen to make the total sum,
including the check digit, a multiple of 10, which can be calculated from the
weighted sum of the first six characters as (10 - (this sum modulo 10) modulo 10.
For British and Irish
securities, SEDOLs are converted to ISINs by padding the front with two zeros,
then adding the country code on the front and the ISIN check digit at the end.
An International
Securities Identifying Number (ISIN) uniquely identifies a security. Its structure is defined in ISO 6166.
Securities for which ISINs are issued include bonds,
commercial
paper, equities
and warrants. The ISIN code is a 12-character
alpha-numerical code that does not contain information characterizing financial
instruments but serves for uniform identification of a security at trading and settlement.
Securities with which
ISINs can be used include debt securities, shares, options, derivatives and
futures. The ISIN identifies the security, not the exchange
(if any) on which it trades; it is not a ticker
symbol. For instance, DaimlerChrysler stock trades on twenty-two different
stock exchanges worldwide, and is priced in five different currencies; it has
the same ISIN on each, though not the same ticker symbol. ISIN cannot specify a
particular trade in this case, and another identifier, typically the
three-letter exchange code, will
have to be specified in addition to the ISIN. The SEDOL board of the London Stock Exchange is currently revising
their own standards to address this issue.
ISINs consist of three
parts: a two letter country code, a nine character alpha-numeric national
security identifier, and a single check digit.
The country code is the ISO 3166-1 alpha-2 code for the country of
issue, which is not necessarily the country in which the issuing company is
domiciled. International securities cleared through Clearstream
or Euroclear,
which are Europe-wide, use "XS" as the country code.
The nine-digit security
identifier is the National Securities Identifying Number, or NSIN, assigned by
governing bodies in each country, known as the national numbering agency (NNA). In North America
the NNA is the CUSIP
organization, meaning that CUSIPs can easily be converted into ISINs by adding
the US
or CA country code to the beginning of the existing CUSIP code and adding an
additional check digit at the end. In the United
Kingdom and Ireland the NNA is the London Stock Exchange and the NSIN is the SEDOL, converted in a
similar fashion after padding the SEDOL number out with leading zeros. Most
other countries use similar conversions, but if no country NNA exists then
regional NNAs are used instead.
The procedure for
calculating ISIN check digits is similar to the "Modulus 10 Double Add
Double" technique used in CUSIPs. To calculate the check digit, first
convert any letters to numbers by adding their ordinal position in the alphabet
to 9, such that A = 10 and M = 22. Starting with the right most digit, every
other digit is multiplied by two. (For CUSIP check digits, these two steps are
reversed.) The resulting string of digits (numbers greater than 9 becoming two
separate digits) are added up. Subtract this sum from the smallest number ending
with zero that is greater than or equal to it: this gives the check digit which
is also known as the ten's complement of the sum modulo 10. That is, the
resulting sum, including the check-digit, is a multiple of 10.
ISINs are slowly being
introduced worldwide. At present, many countries have adopted ISINs as a
secondary measure of identifying securities, but as of yet only some of those
countries have moved to using ISINs as their primary means of identifying
securities.
Apple Inc.:
ISIN US0378331005, expanded from CUSIP 037833100 The main body of
the ISIN is the original CUSIP, assigned in the 1970s. The country code "US" has
been added on the front, and an additional check digit at the end. The check
digit is calculated in this way...
Convert any letters to
numbers:
U = 30, S = 28.
US037833100 -> 3028037833100.
Collect odd and even
characters:
3028037833100 = (3, 2,
0, 7, 3, 1, 0), (0, 8, 3, 8, 3, 0)
Multiply the group
containing the rightmost character (which is the FIRST group) by 2:
(6, 4, 0, 14, 6, 2, 0)
Add up the individual
digits:
(6 + 4 + 0 + (1 + 4) + 6
+ 2 + 0) + (0 + 8 + 3 + 8 + 3 + 0) = 45
Take the 10s modulus of
the sum:
45 mod 10 = 5
Subtract from 10:
10 - 5 = 5
Take the 10s modulus of
the result (this final step is important in the instance where the modulus of
the sum is 0, as the resulting check digit would be 10).
5 mod 10 = 5
So the ISIN check digit
is five.
TREASURY CORP VICTORIA 5 3/4%
2005-2016: ISIN AU0000XVGZA3
Convert any letters to
numbers:
A = 10, G = 16, U = 30,
V = 31, X = 33, Z = 35. AU0000XVGZA -> 103000003331163510.
Collect odd and even
characters:
103000003331163510 = (1,
3, 0, 0, 3, 3, 1, 3, 1), (0, 0, 0, 0, 3, 1, 6, 5, 0)
Multiply the group
containing the rightmost character (which is the SECOND group) by 2:
(0, 0, 0, 0, 6, 2, 12,
10, 0)
Add up the individual
digits:
(1 + 3 + 0 + 0 + 3 + 3 +
1 + 3 + 1) + (0 + 0 + 0 + 0 + 6 + 2 + (1 + 2) + (1 + 0) + 0) = 27
Take the 10s modulus of
the sum:
27 mod 10 = 7
Subtract from 10:
10 - 7 = 3
Take the 10s modulus of
the result (this final step is important in the instance where the modulus of
the sum is 0, as the resulting check digit would be 10).
3 mod 10 = 3
So the ISIN check digit
is three.
Conversion table for
characters is :
A = 10
|
F = 15
|
K = 20
|
P = 25
|
U = 30
|
Z = 35
|
B = 11
|
G = 16
|
L = 21
|
Q = 26
|
V = 31
|
|
C = 12
|
H = 17
|
M = 22
|
R = 27
|
W = 32
|
|
D = 13
|
I = 18
|
N = 23
|
S = 28
|
X = 33
|
|
E = 14
|
J = 19
|
O = 24
|
T = 29
|
Y = 34
|
|
BAE Systems:
ISIN GB0002634946, expanded from SEDOL 0263494
The main body is the
SEDOL, padded on the front with the addition of two zeros. The country code
"GB" is then added on the front, and the check digit on the end as in
the example above.
The Non-Profit Partnership “National Depository Centre” became a
member of the Association of National
Numbering Agencies (ANNA). The admission decision was made at the General
Members’ Meeting of the Association in New
York on 15 November 1999.
ANNA comprises 61 organizations handling the functions of
national numbering agencies assigning international securities identification
numbers (ISINs) to securities and other financial instruments in their
countries.
The purpose of ISIN assignment is to ensure the
standardized identification of issue-grade securities and other financial
instruments within a uniform system and the distribution of data to securities
market participants. ISINs and standard descriptions of securities are used in
all sectors of the securities industry, and are important in performing precise
and effective settlement and clearing.
In the period of non-existence of such organization in Russia its functions were temporarily carried
out by Wertpapier-Mitteilungen Company (Germany), responsible for assigning
ISINs to all Russian securities, with which NDC entered into the Service
Agreement on the delivery of ISIN assignment services.
In accordance with the Articles of Incorporation of ANNA,
the functions of NDC are as follows:
·
assigning ISINs to domestic
securities and other financial instruments
·
facilitating the application of
provisions of ISO 6166
·
making available for the
members of ANNA and all securities market participants information on ISINs and
their assignment within the uniform ISIN structure for different securities
trading and management purposes under international securities transactions
participation in creating an effective international
securities identification system.
In the 1980s there was
an attempt to expand the CUSIP system for international securities as well. The
resulting CINS (CUSIP International Numbering System) has seen
little use as it was introduced at about the same time as the truly
international ISIN system. CINS
identifiers do appear in the ISIDPlus directory,
however.
The first six characters
are known as the "base" (or "CUSIP-6"), and uniquely
identify the issuer. Issuer codes are assigned alphabetically from a series
that includes deliberate built-in "gaps" for future expansion. The
last two characters of the issuer code can be letters, in order to provide more
room for expansion. The numbers from 990000 up are reserved, as are xxx990 and
up within each group of 1000 (ie, 100990 to 1009ZZ).
The 7th and 8th digit
identify the exact issue, the format is dependent on the type of security. In
general, numbers are used for equity and letters are used for fixed income. For
commercial paper the first issue character is generated by taking the letter
code of the maturity month, the second issue character is the day of the
maturity date, with letters used for numbers over 9. The first security issued
by any particular issuer is numbered "10". Newer issues are numbered
by adding ten to the last used number up to 80, at which point the next issue
is "88" and then goes down by tens. The issue number "01"
is used to label all options on equities from that issuer.
Fixed income issues are
labeled using a similar fashion, but due to there being so many of them they
use letters instead of digits. The first issue is labeled "AA", the
next "A2", then "2A" and onto "A3". To avoid
confusion, the letters I and O are not used to avoid confusion with the digits
1 and 0.
The 9th digit is an
automatically generated check digit using the "Modulus 10 Double Add
Double" technique. To calculate the check digit every second digit is
multiplied by two. Letters are converted to numbers by adding their ordinal
position in the alphabet to 9, such that A = 10 and M = 22. The resulting
string of digits (numbers greater than 10 becoming two separate digits) are
added up. The ten's-complement of the last number is the check digit. In other
words, the sum of the digits, including the check-digit, is a multiple of 10.
Some clearing bodies ignore or truncate the last digit.
CINS adds a single
country code letter to be the beginning of an otherwise similar CUSIP. These
are not standard country codes, for instance Norway is
"R". A table of the country codes appears on the CUSIP web site.
The low-numbered issuer
number, 037833, is a side effect of the company name starting with the letter
"A". Their stock is the first issue they released, and is thus
numbered "10".
The check digit is
calculated by first collecting the even and odd digits, converting any letters
to numbers if need be (not in this case):
(0, 7, 3, 1), (3, 8, 3,
0)
The second set is then
multiplied by two:
(6, 16, 6, 0)
The individual digits
are then added together:
(0 + 7 + 3 + 1) + (6 +
(1 + 6) + 6 + 0) = 30
The check digit is the
ten's complement of the last digit of 30, which is 0, so the check digit is 0.
The ten's complement of a digit is the result of subtracting that digit from
10, except that the ten's complement of 0 is 0.
Similar to the Apple
example, but with a name appearing near the end of the dictionary. The check
digit is (9 + 1 + 4 + 1) + (6 + 2 + 4 + 0) = 27, the ten's complement of 7 is
3.
A National Securities
Identifying Number or NSIN is a generic nine digit number which
identifies a fungible
security. The NSIN is issued by a national
numbering agency (NNA)
designated for that country. Regional substitute NNAs have been allocated the
task of functioning as NNAs in those countries where NNAs have not yet been
established. NSINs are used as part of the makeup of a product's ISIN.
