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Long Term Source of Finance

TERM LOANS

Term loans, given by financial institutions and banks,


represent a source of debt finance which is generally
repayable as per time schedule agreed at the time of
availing loan.

Term loans are employed to finance fixed assets and


working capital margin
Term Loans–Features
• Maturity
• Direct Negotiations
• Security
• Restrictive Covenants
1. Asset related covenants
2. Liability related covenants
3. Cash flow related covenants
4. Control related covenants
• Convertibility
• Repayment Schedule
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Bonds/ Debentures–Features
• Indenture
• Interest Rate
• Maturity
• Redemption
• Sinking Fund
• Buy-back (call) provisions
• Security
• Yield
• Claim on Assets and Income

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Types of Bonds/ Debentures
• Non – Convertible Debentures
• Fully – Convertible Debentures
• Partly – Convertible Debentures
• With Call or put feature
• Plain vanilla
• Zero Coupon Bonds
• Deep Discount Bonds
• Perpetual Bonds
• Par/ Premium/ Discount Bonds
• Bonds with semi annual interest payment
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PROS AND CONS OF DEBT FINANCING
Pros

• Lower post-tax cost


• No dilution of control
• Disciplining effect
Cons

• Fixed debt servicing burden


• Raises the cost of equity
• Imposes restrictions
Concept of Value
• Book Value
• Replacement Value
• Liquidation Value
• Going Concern Value
• Market Value

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Features of a Bond
• Face Value
• Interest Rate—fixed or floating
• Maturity
• Redemption value
• Market Value

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Bonds Value
• Bonds with maturity
• Pure discount bonds
• Perpetual bonds

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Value of Bonds with Maturity
Bond value = Present value of interest + Present
value of maturity value:
n
INTt Bn
B0   
t 1 (1  kd )t (1  kd ) n

Par/ Premium and Discount Bonds

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Value of Bonds with Maturity- Semi
Annual Coupon Payments
Bond value = Present value of interest paid semi
annually + Present value of maturity value:
n
INTt Bn
B0   
t 1 (1  kd ) (1  kd ) n
t

Value of Zero Coupon Bonds

Mn
B0 
1  kd 
n

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Yield to Maturity
• The yield-to-maturity (YTM) is bond’s internal
rate of return.
• A perpetual bond’s yield-to-maturity:

n 
INT INT
B0   
t 1 (1  kd )t kd

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Yield to Call
• Call period would be different from the maturity
period and the call (or redemption) value could be
different from the maturity value.
• Example: A 10% 10-year Rs 1,000 bond is
redeemable (callable) in 5 years at a call price of Rs
1,050. The bond is currently selling for Rs 950.
5
100 1,050
950   
t 1 1  YTC  1  YTC 
t 5

• The bond’s yield to call is 12.7%.

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Bond Value and Amortisation of Principal

• A bond (debenture) may be amortised every year,


i.e., repayment of principal every year rather at
maturity.
• The formula for determining the value of a bond
or debenture that is amortised every year
n
CFt
B0  
t 1 (1  k d )
t

• Note that cash flow, CF, includes both the interest and
repayment of the principal.

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Yield of Pure Discount Bonds
• Face value of the bond and its lower purchase price
gives the return or YTM to the investor in a discount
bond.
• A company issued pure discount bond of Rs 1,000 face
value for Rs 520 today for a period of five years.
1, 000
520 
1  YTM 
5

1, 000
1  YTM    1.9231
5

520
i  1.92311/ 5  1  0.14 or 14%

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Effective Annual Yield
• EAY = (1 +Quoted Interest Rate/m)m -1
• Realised Yield

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Bond Theorems
• Bond prices are negatively related to Interest rate movements
• For a given change in interest rates, prices of long term bonds will
change more than prices of short term bonds
• For a given change in interest rates prices of lower coupon bonds
change more than prices of higher coupon bonds

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Perpetual Bonds
• Perpetual bonds, also called consols, has an
indefinite life and therefore no maturity value -
rarely found in practice.

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Preference Shares–Features
• Claim on Income and Assets
• Fixed Dividend
• Cumulative Dividend
• Redemption
• Sinking Fund
• Call Feature
• Participation Feature
• Voting Rights
• Convertibility
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Preference Shares
• Similarity to Ordinary Shares:
1. Non payment of dividends does not force
company to insolvency.
2. Dividends are not deductible for tax purposes.
3. Perpetual Preference Shares
• Similarity to Debentures:
1. Dividend rate is fixed.
2. Do not share in residual earnings.
3. Usually do not have voting rights.

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Preference Shares
• Advantages
1. Risk less Leverage
2. Dividend postponability
3. Fixed dividend
4. Limited Voting Rights
• Disadvantages
1. Non-deductibility of Dividends in P & L
2. Commitment to pay dividends

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Valuation of Preference Shares
• Value of the preference share is sum of present
values of dividends and redemption value.
• A formula similar to the valuation of bond can
be used to value preference shares with a
maturity period:
n
PDIV1 Pn
P0   
t 1 (1  k p ) (1  k p ) n
t

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Value of a Preference Share-Example

An investor is considering purchase of a 12-year, 10% Rs 100 par value preference share. The
redemption value of the preference share on maturity is Rs 120. The investor’s required rate of
return is 10.5 percent. What should she be willing to pay for the share now?
We can use the present value annuity factor to value the constant stream of preference
dividends and the present value factor to value the redemption payment.

 1 1  120
P0  10    12 

 0. 105 0. 105  (1.105)  (1.105 )12

 10  6.506  120  0.302  65.06  36.24  Rs101.30


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EQUITY CAPITAL
Equity capital represents ownership capital as equity
shareholders collectively own the company. They enjoy
the rewards and bear the risks of ownership
• Authorised capital
• Issued capital
• Subscribed capital
• Paid-up capital
• Par value
• Issue price
• Book value
• Market value
Ordinary Shares
• Advantages
1. Permanent Capital
2. Base for Borrowing
3. Dividend Payment Discretion
• Disadvantages
1. Cost
2. Risk
3. Earnings Dilution
4. Ownership Dilution

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RIGHTS OF EQUITY SHAREHOLDERS

• Right to Income

• Right to Control

• Pre-emptive Right

• Right in Liquidation
PROS AND CONS OF
EQUITY CAPITAL
Pros
• No compulsion to pay dividends
• No maturity date
• Enhances creditworthiness
• Dividends are tax-exempt for investors
Cons
• Dilution of control
• High cost
Value of Shares
Dividend Capitalisation
• The value of an ordinary share is determined by
capitalising the future dividend stream at the
opportunity cost of capital
DIV1  P1
• Single Period Valuation: P 
1  ke
0

• If the share price is expected to grow at g per cent,


share valuation is
P1  P0 (1  g )
DIV1
P0 
ke  g

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Multi-period Valuation
• If the final period is n, we can write the general formula for
share value as follows:
n
DIVt Pn
P0   
t 1 (1  ke )t (1  ke ) n

• Growth in Dividends
Growth = Retention ratio  Return on equity
g  b  ROE

• Normal Growth
DIV1
P0 
ke  g
• Super-normal Growth
Share value  PV of dividends during finite super-normal growth period 29
Equity Capitalisation Rate
• For firms for which dividends are expected to grow
at a constant rate indefinitely and the current
market price is given

DIV1
ke  g
P0

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SECURITY MARKET LINE
APPROACH
rE = Rf + E [E(RM) – Rf ]
rE = required return on the equity of the company
Rf = risk-free rate
E = beta of the equity of the company
E(RM) = expected return on the market portfolio

Illustration
Rf = 7%, E = 1.2, E(RM) = 15%
rE = 7 + 1.2 [15 – 7] = 16.6%
INTERNAL ACCRUALS

Internal accruals of a firm consist of depreciation


amortisation, and retained earnings.
Pros

• Readily available
• No dilution of control

Cons

• Opportunity cost is high

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