Fall 2022 Midterm Test Solutions on Loan Stock - Finance Exam, University of Illinois Chicago
Check out the below midterm test questions and answers on loan stock tested in Fall 2022 at the University of Illinois Chicago. We discuss the concept of loan stock in detail in a way that will help you understand how best to do your finance tests. Our blog is a guide with well-researched solutions to help you with revision. You can also hire our qualified experts to take your tests on loan stock and get yourself those top grades.Exam Question:
Explain the main types of loan stock that are relevant for corporate finance transactions and discuss their features
Exam Solution: Unlike shareholders, holders of loan stock do not participate pro rata in the earnings of the company. The return is fixed at the level of the coupon on the loan stock and does not vary if the profits increase. If profits decrease or indeed eliminated, there is still a legal obligation on the company to pay the interest or be subject to various legal sanctions which may be taken by or on behalf of the holders of the loan stock. The rights of the holders are set down in a trust deed or other document showing the terms on which the issue is made.
Two main types of loan stock are relevant for corporate finance transactions, unsecured loan stock with no conversion rights and convertible loan stock.
- Unsecured loan stock
- Convertible loan stock
Issues of straight unsecured loan stock tend to appeal mainly to institutional investors, particularly pension funds and insurance companies. These institutions have long-term obligations which they seek to match with assets providing steady long-term income. Unsecured loan stocks have final maturities ranging from say 5 to 15 years or longer. At least for a proportion of their portfolio, institutions prefer a conservative investment, ranking ahead of ordinary shares and protected by various covenants. The degree of added security compensates such holders for the lack of any potential increase in their income. A serious breach of the covenants of the loan stock will constitute a default by the company on its obligations and will trigger repayment of the loan stock and other sanctions. Some characteristics of unsecured loan stock include:
Restrictions on issuing group:The trust deed which constitutes the loan stock contains restrictions on how the issuing company is financed and managed. These restrictions may include an overall limit on the borrowings of the company and its subsidiaries and a lower or "inner' limit on borrowings that rank ahead of the loan stockholders. Loan stock may be issued by a holding company or a special-purpose off-shore subsidiary guaranteed by the holding company. If this is so, all borrowings by subsidiary companies conducting the group's main business rank ahead of the loan stockholders in practice, assuming the major assets of the group are held by such subsidiaries. The inner limit, therefore, includes both secured borrowings and borrowings of subsidiaries.
There is usually a covenant not to dispose of any major assets (unless the proceeds are reinvested in similar assets or used to repay the debt) without the consent of loan stockholders or to make a major change in the nature of the business. It is assumed that stockholders will have made their decision to invest on the basis of the assets and business of the group at that time and might not take the same attitude if substantial changes are made. Trustees for the stockholders will represent their interests as a class and act as a representative available for discussions with the issuing company on points the company may wish to take up relating to the terms of the loan stock.
Interest:The coupon on the loan stock is normally fixed and payable semi-annually. The stock will be valued by discounting the stream of interest payments and the final repayment of principal at maturity by the rate considered appropriate by the market from time to time for a stock of that particular risk and maturity. If interest rates drop, the value of the stock will rise and vice versa.
It is possible to set the coupon by reference to some floating rate, for example, the rate of interest payable in the inter-bank market. Obligations of this kind are I called floating rate notes. The interest rate may vary by reference to other benchmarks, provided there is some objective way of determining what the interest payment should be. Some floating rate bonds have a maximum and minimum payment built into their terms. Others may become fixed when the interest rate drops or rises to a certain specified amount.
Some bonds have been issued without any coupon payable at all, called, appropriately enough, zero coupon bonds. Such bonds are issued at a substantial discount to their face value. The discount is calculated to compensate holders for the lack of income until maturity by reference to the rates of return available on bonds of a comparable maturity and risk. This type of bond is attractive to some holders, as the 'income' is automatically reinvested at the same rate of return. If interest is actually paid, the recipient must seek a similarly attractive investment. Zero coupon bonds may be considered a speculative investment by bond standards. Their market value will fluctuate more than any other kind of bond for a given rise or fall in interest rates.
Unsecured loan stocks with low or poor investment ratings but high coupons have become extensively used to finance leveraged buy-outs. They are known in the market as 'junk bonds' and some curbs on their use seem likely to be imposed. However, unsecured loan stocks have an important role in takeover offers, being used not only as a means of raising capital for the offeror but also to provide an increase in income to the target company's shareholders. The coupon on an unsecured loan stock will almost certainly be higher than the dividend yield of the target company's shares at the offer price.
Some of the features of convertible loan stock include:
Rights and restrictions:The rights and restrictions contained in the document which constitutes a convertible loan stock tend to be along the same lines as those for a straight loan stock. If anything, covenants may be less strict, as the holders of the convertible are likely to be regarded partly as shareholders as well as holders of debt.
The right to convert will be carefully defined and protected. Conversion rights usually start shortly after the stock is issued and last until it is redeemed. The conversion price may be at the present market price of the shares or at a small premium, normally not more than 10%. The holder converts by completing a form on the back of the stock certificate. The number of shares he receives is calculated by dividing the nominal value of the loan stock he tenders by the conversion price. If he tenders a stock certificate with a nominal value of $1,000 and the conversion price is $2, he will receive 500 shares. The market value of the stock and the shares is not relevant for this purpose. It should be noted that the stockholder pays no cash but simply exchanges his stock for shares, Likewise, the company receives no cash. Its outstanding debt is reduced by the nominal amount of stock redeemed and its issued share capital (and share premium account, if appropriate) goes by the same amount. A conversion therefore has a doubly beneficial effect on gearing, reducing debt at the same time as equity is increased. Many convertibles contain a clause that enables the company to force all holders to convert if over 75% of the holders have converted their loan stock. More controversially, conversion may also be forced if the share price exceeds the conversion price by a minimum amount (say 50%) for a minimum period. Such a provision puts a 'cap' on the value of the stock. The conversion procedures normally contain provisions that prevent an investor collecting interest and dividends in respect of the same period.
Most convertible loan stock is convertible into the ordinary shares of the company which issues the stock. However, there is nothing to prevent the stock being converted into the shares of another company if the issuing company has such shares under its control. In this case, a convertible issue could be a disguised method of placing out a significant holding in another company that might not be marketable as one block. The convertible loan stock could also be converted into, for example, straight loan stock or preference shares.
Reasons for issue:A convertible loan stock may be issued by a company that wishes to issue further equity but not at a discount to market price (as is usually necessary), or when it is unable to issue equity because of market conditions or other constraints. On the other hand, a company may prefer to issue debt but is prevented because the straight debt market does not view its paper as of sufficient quality. In this case, the company may compensate for the additional risk by including an element of equity in the package.
On the other hand, the coupon payable on convertible loan stock will be lower than that on a standard unsecured loan stock reflecting the value of the conversion right. Straight debt has no possibility of price appreciation in line with expected rises in the price of the shares.
In takeovers, a convertible loan stock is often used to increase the value of an offer while avoiding dilution in earnings per share.
Timing of conversion:Experience shows that convertible loan stocks are generally converted. An investor will tend to convert when dividends rise on the ordinary shares to such an extent that the dividend income receivable after conversion (adjusting for the tax position of the investor) is greater than the interest receivable from the loan stock, provided that the investor believes the dividend level can be maintained. The other reason for conversion before maturity is to increase marketability. The convertible loan stock of a company may be less marketable than the ordinary shares because of fewer holders, a lower amount in issue and a tendency for such issues to be 'salted away' in portfolios. It should be noted that conversion will not necessarily occur simply because the market price of the ordinary shares is greater than the conversion price. Subject to marketability, the market price of the convertible will in this case rise above par and the investor can take his profit by selling the loan stock. He has no need to convert. The income differential should still be the main determining factor until the end of the conversion period approaches.
Explain the two methods through which valuation of convertible loan stock can be done.
Exam Solution: The valuation of convertible loan stock can be approached in two ways. If it is considered as 'deferred equity', it will be valued on the basis of the market price of the number of shares into which a holding can be converted, added to which is the income advantage in receiving for a period a higher level of interest than dividend. Alternatively, it can be considered to have a base value as straight debt; the convertible feature can be regarded as a kind of option and valued as such. This may be illustrated as follows:
Coupon on convertible loan stock is 8%. Stock is issued in $100 amounts, Dividend yield on ordinary shares at the conversion price is 4% and dividends are expected to grow at 15% per annum.
Tax on interest and dividends is ignored for this example.
|Year||Interest||Dividend income||Differential||Present value of differential at 10%|
Conversion price is set at 21, a 5% premium to market price of 20.
Value on conversion is 100/21 x20 = 95.2
Present value of income differential 10.4
Estimated value of convertible 105.6
Straight unsecured loan stocks with an 8% coupon and similar maturities and perceived risks are standing at approximately 88%.
Warrants of similar life and gearing issued by comparable companies are selling at a 15% premium.
Value as straight bond 88
Value of conversion option, say 15
The results of the two methods will not be identical (except by coincidence) but should not be far apart.