Structured Finance: Equity

Ian H. Giddy/NYU Structured Finance-1

Prof. Ian GiddyNew York University

Structured Finance:Equity

Copyright ©2002 Ian H. Giddy Structured Finance 2

Structured Finance

l Asset-backedsecuritization

l Corporate financialrestructuring

l Structured financingtechniques



When Debt and Equity are Not Enough

Valueof future

cash flows

Valueof future

cash flows

Contractual int. & principalNo upside

Senior claimsControl via restrictions



Assets Liabilities

Debt

Residual paymentsUpside and downside

Residual claimsVoting control rights



Equity


When Debt and Equity are Not Enough

Valueof future

cash flows

Valueof future

cash flows





Assets Liabilities

Debt





Equity

Alternatives

n Collateralizedn Asset-securitizedn Project financing

n Preferredn Warrantsn Convertible



Case Studies

l Ban Pu Convertible Bond;l Keppel T&T Convertible;l Singapore Warrant Bonds;l Lyons;l Endesa


A Day in the Lifeof the Eurobond Market

l Examine the dealsuWhich were structured financing?uWhy were each done in that particular

form?uWhat determines the pricing?

l Can you break the hybrids into theircomponent parts?



A Day in the Life...


Equity-Linked Bonds

l Bonds with warrantsl Convertible Bondsl Index-linked Bonds

These are all example of hybrid bondsand should be priced by decomposition



Convertibles

ConversionValue

StraightBond Value

Market ValueMarket Premium

ValueofConvertibleBond

($) 0

Price Per Share of Common Stock


Warrants

TheoreticalValue


Value

of

Warrant

($)

0Price Per Share of Common Stock ($)



Index-Linked

PRINCIPALREPAYMENT


Stock-Purchase Warrants

l Warrants are usually detachable and tradeon the securities exchanges

l Warrants are often added to a large debtissue as “sweeteners” to enhance themarketability of the issue

l Exercise pricel Warrants usually have a limited life of about

10 years or lessl Warrants differ from rights and convertibles



The Implied Price of an AttachedWarrant

l To determine the implied price of an attachedwarrant, the implied price of all warrants attachedto a bond must be determined

l Implied price of all warrants = price of bond withwarrants attached - the straight bond value (ofsimilar-risk bonds)

l The impled price of a single warrant is the impliedprice of all warrants divided by the number ofwarrants attached to each bond


The Value of Warrants

l A warrant has a “theoretical value” at any point intime prior to its expiration date

l The theoretical value can be calculated as:TVW = (Po - E) x NWHERE:

TVW = Theoretical value of a warrantPo = Current market price of one share of

common stockE = Exercise price of the warrantN = Number of shares of common stock

obtainable with one warrant



Sony Warrants

l Sony Electronics has outstanding warrants exercisable atYen400/share that entitle holders to purchase threeshares of common stock per warrant. If Sony’s commonstock is currently selling for Y45/share, the TVW =

l TVW = (Y45 - Y40) x 3 = Y15

l The market value of a warrant is generally greater than itstheoretical value; the difference, known as the warrantpremium is due to investor expectations and opportunitiesfor further gain before expiration.


Values and Warrant Premium

TheoreticalValue


Value

of

Warrant

($)

0Price Per Share of Common Stock ($)

1994, HarperCollins PublishersCopyright



Option Pricing

94.5

Option Price= Intrinsic value + Time value

Option Price

UnderlyingPrice

94.75

Time value depends onn Timen Volatilityn Distance from the strike price

Time value depends onn Timen Volatilityn Distance from the strike price


Option Pricing Model

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

93 93 94 94 95 95 96 96FUTURES PRICE

CA

LL O

PTI

ON

PR

ICE

ENTER THESE DATA:=================

-> FUTURES PRICE 94.75-> STRIKE PRICE 94.5-> TIME IN DAYS 300-> INTEREST RATE 7-> STD DEVIATION 15

CALL PRICE IS......... 0.40PUT PRICE IS....... 0.17



Value of Call Option

INTRINSIC VALUE TIME VALUE

EXPECTED VALUE OF PROFITGIVEN EXERCISE

STRIKE

FUTURES

PRICE

SHADED AREA:

Probability distribution ofthe log of the futuresprice on the expirationdate for values abovethe strike.


Black-Scholes Option Valuation

Co = SoN(d1) - Xe-rTN(d2)d1 = [ln(So/X) + (r + σ2/2)T] / (σ T1/2)d2 = d1 - (σ T1/2)whereCo = Current call option value.So = Current stock priceN(d) = probability that a random draw from a

normal dist. will be less than d.



Convertible Bonds

l Bond may be converted into stockl The Conversion Ratio is the number of

shares of common stock that can bereceived in exchange for eachconvertible security

l The Conversion Price is the per sharecommon stock price at which theexchange effectively takes place


Convertibles

u The Conversion Period is a limited timewithin which a security may be exchangedfor common stock

u The Conversion Value is the market value ofthe security based upon the conversionratio times the current market price of thefirm's common stock

u Earnings effects:w Firms must report Primary EPS, treating all contingent securities

that derive their value from their conversion privileges orcommon stock characteristics as common stock

w Firms must report Fully Diluted EPS treating all contingentsecurities as common stock



Example: Hyundai Euroconvertible

l If Hyundai issues a Eurobond with a $1,000 parvalue that is convertible at $40 per share ofcommon stock, the conversion ratio =

$1,000 = 25 $40l If Hyundai had stated the conversion ratio at 20,

the conversion price =$1,000 = $50 20


Financing With Convertibles

l Motives for using convertibles include:u It is a deferred sale of common stock that decreases

the dilution of both ownership and earningsuThey can be used as a “sweetener” for financinguThey can be sold at a lower interest rate than

nonconvertiblesuThey have far fewer restrictive covenants than

nonconvertiblesu It provides a temporarily cheap source of funds

(assuming bonds) for financing projectsl Most convertibles have a call feature that enables the

issuer to force conversion when the price of the commonstock rises above the conversion price



Determining the Value of a ConvertibleBond

There are three values associated with aconvertible bond:uStraight Bond Value is the price at which the bond

would sell in the market without the conversion featureuThe Conversion Value is the product of the current

market price of stock times the conversion ratio of thebond

uThe Market Value is the straight or conversion valueplus a market premium based upon future (expected)stock price movements that will enhance the value ofthe conversion feature


Siam Cement

l Siam Cement sold a $1,000 par value, 20-year convertible bond witha 12% coupon. A straight bond would have been sold with a 14%coupon. The conversion ratio is 20

l Straight Bond Value$120 x (PVIFA14%,20) + $1,000 x (PVIF14%,20) =$120 x (6.623) + $1,000 x (.073) = $867.76

uConversion Value at various market prices of stockStock Price Conversion Value

$30 $ 600 40 800 50 (Conversion Price) 1,000 (Par Value) 60 1,200

70 1,400 80 1,600l The straight bond value is the minimum price at which the convertible

bond would be traded



Values and Market Premium

ConversionValue

StraightBond Value


Value

of

Convertible

Bond

($) 0

Price Per Share of Common Stock


Breaking Down a Convertible: Kodak

l At the end of 2001, Kodak (EK) had a 5.25%convertible bond, coming due in 2009, tradingat $1300. The face value was $1000. It alsohad straight bonds, with the same maturity,trading in December 2001 at a yield of 8.4%.uWhat’s the straight bond component worth?uWhat’s the convertible option worth?uAssume the conversion ratio is 24, and Kodak

stock is priced at $51. How would you determinewhether the investor is overpaying?



Breaking Down a Convertible

Coupon rate on Convertible Bond = 8.25%Market Interest Rate on Straight Bond of same Risk = 8.40%Price of Convertible Bond = 1400Maturity of Convertible Bond = 8

Value of Straight Bond Portion = 991.51$ Value of Conversion Option = 408.49$


Case Study:Banpu Convertible

nHow did this work?nWhy did Banpu use this technique?nWhy did investors buy it?



Banpu Convertible

Huh?


Thai Time

n 1994 n 1997 n 1999 n 2004



Motivations for Issuing Hybrid Bonds

l Company has a viewl There are constraints on what the

company can issuel The company can arbitrage to save

moneyl Always ask: given my goal, is there an

alternative way of achieving the sameeffect (e.g., using derivatives?)


Why Use a Hybrid?

Motivations for Hybrids

Linked tobusiness risk

Linked tomarket risk

Cannot hedgewith derivatives

Driven by investorneeds

Companyhedges

Companydoes not

hedge

Debt or

equity areNot good enough



Contact Info

Ian H. GiddyNYU Stern School of BusinessTel 212-998-0426; Fax [email protected]://giddy.org

Documents

Structured Finance: Equity