Convertible Securities and Some Unusual Bonds

Unlike the common or garden bond, a convertible security can change its spots. It starts life as a bond (or preferred stock) but subsequently may turn into common stock. For example, in March 2017, Tesla issued $850 million of 2.375% convertible senior notes due in 2022. Each bond can be converted at any time

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Bank Loans

Bonds are generally long-term loans and more often than not are issued publicly by the bor­rowing company. It is now time to look at shorter-term debt. This is not usually issued pub­licly and is largely supplied by banks. Whereas the typical bond issue has a maturity of 10 years, the bank loan is generally

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Commercial Paper and Medium-Term Notes

1. Commercial Paper Banks borrow money from one group of firms or individuals and relend the money to another group. They make their profit by charging the borrowers a higher rate of interest than they offer the lender. Sometimes it is convenient to have a bank in the middle. It saves the lenders the

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What Is a Lease?

Leases come in many forms, but in all cases the lessee (user) promises to make a series of payments to the lessor (owner). The lease contract specifies the monthly or semiannual pay­ments, with the first payment usually due as soon as the contract is signed. The payments are generally level, but their time pattern

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Why Lease?

You hear many suggestions about why companies should lease equipment rather than buy it. Let us look at some sensible reasons and then at four more dubious ones. 1. Sensible Reasons for Leasing Short-Term Leases Are Convenient Suppose you want the use of a car for a week. You could buy one and sell

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Operating Leases

Remember our discussion of equivalent annual costs in Chapter 6? We defined the equivalent annual cost of, say, a machine as the annual rental payment sufficient to cover the present value of all the costs of owning and operating it. In Chapter 6’s examples, the rental payments were hypothetical—just a way of converting a

Valuing Financial Leases

For operating leases, the decision centers on “lease versus buy.” For financial leases, the deci­sion amounts to “lease versus borrow.” Financial leases extend over most of the economic life of the leased equipment. They are not cancelable. The lease payments are fixed obligations equivalent to debt service. Financial leases make sense when the company

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When Do Financial Leases Pay?

We have examined the value of a lease from the viewpoint of the lessee. The lessor’s criterion is simply the reverse. As long as lessor and lessee are in the same tax bracket, every cash out­flow to the lessee is an inflow to the lessor, and vice versa. In our numerical example, the bus

Leveraged Leases

Big-ticket leases are usually leveraged leases. The structure of a leveraged lease is summa­rized in Figure 25.1. In this example, the leasing company (or a syndicate of several leasing companies) sets up a special-purpose entity (SPE) to buy and lease a commercial aircraft. The SPE raises up to 80% of the cost of the

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I Part Eight: Risk Management

ife is punctuated by unforeseen and unforeseeable shocks. Wars, banking and currency crises, political upheavals, pandemics, and natural catastrophes such as earthquakes and floods can all cause severe economic disruption. For example, if you want to make your hair stand on end, look at Table 26.1, which lists some of the greatest macroeconomic disasters

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Why Manage Risk?

Financial transactions undertaken solely to reduce risk do not add value in perfect and effi­cient markets. Why not? There are two basic reasons. Reason 1: Hedging is a zero-sum game. A corporation that insures or hedges a risk does not eliminate it. It simply passes the risk to someone else. For example, suppose that

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Insurance for Managing Risk

Most businesses buy insurance against a variety of hazards—the risk that their plants will be damaged by fire; that their ships, planes, or vehicles will be involved in accidents; that the firm will be held liable for environmental damage; and so on. When a firm takes out insurance, it is simply transferring the risk

Reducing Risk with Options

Managers regularly buy options on currencies, inter­est rates, and commodities to limit downside risk. Consider, for example, the problem faced by the Mexican government. A hefty portion of its revenue comes from Pemex, the state-owned oil company. So, when oil prices fall, the government may be compelled to reduce its planned spending. The government’s

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Forward and Futures Contracts

Hedging involves taking on one risk to offset another. It potentially removes all uncertainty, eliminating the chance of both happy and unhappy surprises. We explain shortly how to set up a hedge, but first we give some examples and describe some tools that are specially designed for hedging. These are forwards, futures, and swaps.

Swaps for Managing Risk

Some company cash flows are fixed. Others vary with the level of interest rates, rates of exchange, prices of commodities, and so on. These characteristics may not always result in the desired risk profile. For example, a company that pays a fixed rate of interest on its debt might prefer to pay a floating

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How to Set Up a Hedge

There can be many ways to hedge a risk exposure. Some hedges are zero maintenance: Once established, the financial manager can walk away and worry about other matters. Other hedges are dynamic: They work only if adjusted at frequent intervals. The forward contract between Northern Refineries and Arctic Fuels, which we described in Section

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Is “Derivative” a Four-Letter Word?

Our wheat farmer sold wheat futures to reduce business risk. But if you were to copy the farmer and sell futures without an offsetting holding of wheat, you would increase risk, not reduce it. You would be speculating. Speculators in search of large profits (and prepared to tolerate large losses) are attracted by the

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The Foreign Exchange Market

An American company that imports goods from France may need to buy euros to pay for the purchase. An American company exporting to France may receive euros, which it sells in exchange for dollars. Both firms make use of the foreign exchange market. The foreign exchange market has no central marketplace. Business is conducted

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Some Basic Relationships for Managing International Risks

You can’t develop a consistent international financial policy until you understand the rea­sons for the differences in exchange rates and interest rates. We consider the following four problems: Problem 1. Why is the dollar rate of interest different from, say, the rate on Ruritanian pesos (RUPs)? Problem 2. Why is the forward rate of

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Hedging Currency Risk

Sharp exchange rate movements can make a large dent in corporate profits. To illustrate how companies cope with this problem, we look at a typical company in the United States, Outland Steel, and walk through its foreign exchange operations. EXAMPLE 27.1 ● Outland Steel Outland Steel has a small but profitable export business. Contracts

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