Corporate finance

Etienne Redor

eredor@audencia.com

S C H O O L O F M A N A G E M E N T

CFVG
 Exercise

c) What is the price of this bond if we suppose semi annual

coupons rather than annual coupons? (Use a semi-annual
coupon rate of 2.5% and a semi-annual discount rate of 2%)
 Answer

In that case, we will receive $25 each semester

1 2 3 4 5 6 7 8 9 10 11 12

25 25 25 25 25 25 25 25 25 25 25 1025

25 25 25 25 25 25 25
PV       
1.02 1.02 1.02 1.02 1.02 1.02 1.02 7
2 3 4 5 6

25 25 25 25 1,025
 8
 9
 10
 11
 12
 1,052.88
1.02 1.02 1.02 1.02 1.02

1  (1.02) 12 1,000

or PV  25   12
 1,052.88
0.02 1.02
 The yield to maturity (YTM):
a selection tool for bonds

The yield to maturity of a bond is the discount rate that sets the
present value of the promised bond payments equal to the current
market price of the bond.

All things being equal (in particular in terms of risk), an investor

should prefer, the bond with the highest yield to maturity.
The issuer will prefer of course the opposite: a bond with the
lowest yield to maturity.
The yield to maturity of a zero-coupon bond

The yield to maturity of a bond is the discount rate that sets the
present value of the promised bond payments equal to the current
market price of the bond.

The yield to maturity for a zero-coupon bond with n periods to

maturity, current price P and face value FV is given by:

FV
P
(1  YTM ) n
 Exercise

Suppose that the following zero-coupon bonds are trading at the

prices shown below per $100 face value. Determine the
corresponding yield to maturity for each bond.

Bond A Bond B Bond C Bond D

Maturity 1 year 2 years 3 years 4 years
Price $96.62 $92.45 $87.63 $83.06
 Answer
For the first zero-coupon:
FV FV FV
P  1  YTM   YTM   1  3.5%
(1  YTM )1
P P
For the second zero-coupon:
1/ 2
FV FV  FV 
P  (1  YTM ) 2
  YTM     1  4%
(1  YTM ) 2 P  P 
For the third zero-coupon:
1/ 3
FV FV  FV 
P  (1  YTM ) 3
  YTM     1  4.5%
(1  YTM ) 3
P  P 
For the fourth zero-coupon:
1/ 4
FV FV  FV 
P  (1  YTM ) 
4
 YTM     1  4.75%
(1  YTM ) 4
P  P 
The yield to maturity (YTM) of a bullet bond
The yield to maturity of a bond is the discount rate that sets the
present value of the promised bond payments equal to the current
market price of the bond.

We have to find YTM in the following equation:

C C C  FV
P   ... 
1  YTM (1  YTM ) 2 (1  YTM ) n
Or :

1  (1  YTM )  n FV
P C 
YTM (1  YTM ) n
Unfortunately, unlike in the case of zero-coupon bonds, there is no
simple formula to solve for the yield to maturity. Instead, we need to
use the linear interpolation method.
 Example
Consider a 8 year-bond with a 6% coupon rate, annual coupons
and a face value of $100. If this bond is currently trading for a
price of $105, what is the bond’s yield to maturity?
 Example
1st step: Calculation of the price to be paid
We will have to pay $105 to acquire this bond, since the current
trading price is $105.

2nd step: Determination and discouting of the cash-flows

The coupon rate is 6%: each year for 8 years, we will receive
6%×100= $6. The next coupon will be paid in exactly one year.
At the maturity date (in exactly 8 years), we receive the face
value, namely $100.
 Example

3rd step: Determination of the equation

6 6 106
105    ... 
1  YTM (1  YTM ) 2
(1  YTM )8
It can be simplified using the present value of an annuity of $6
to be paid in the next 8 years plus $100 to be paid in 8 years:

8
1  (1  YTM ) 100
105  6   8
YTM (1  YTM )

1  (1  YTM ) 8 100
 0  6  8  105
YTM (1  YTM )
 Example

4th step: Use of the linear interpolation

If we try with i1= 5%, we obtain a residual value of 1.46.

If we try with i2= 6%, we obtain a residual value of -5.

The YTM can be estimated by:

VA (i)  VA (i1 )
YTM  i1  (i 2  i1 ) 
VA (i 2 )  VA (i1 )
0  1.46
YTM  5%  (6%  5%)   5.23%
 5  1.46

The bond’s YTM is close to 5.23%

 YTM

•Exercise

•You can invest in a five-year bond A

with a 5% coupon rate which trading
price is currently $94.92 or in a five-
year bond B with a 8% coupon rate
but which is currently traded for a
price of $110.62. Both bonds are bullet
bonds with annual coupons, belong to
the same risk class and have a face
value of $100. Would you prefer to
 Bond A
1st step: Calculation of the price to be paid
We will have to pay $94.92 to acquire this bond, since the
current trading price is $94.92.

2nd step: Determination and discouting of the cash-flows

The coupon rate is 5%: each year for 5 years, we will receive
5%×100= $5. The next coupon will be paid in exactly one year.
At the maturity date (in exactly 5 years), we receive the face
value, namely $100.

We can construct the timeline as follows:

5 5 5 5 105

94.92
 Bond A
3rd step: Determination of the equation
5 5 105
94.92    ... 
1  YTM (1  YTM ) 2
(1  YTM ) 5
It can be simplified using the present value of an annuity of $5
to be paid in the next 5 years plus $100 to be paid in 5 years:

5
1  (1  YTM ) 100
94.92  5   5
YTM (1  YTM )

1  (1  YTM ) 5 100
 0  5  5  94.92
YTM (1  YTM )
 Bond A
4th step: Use of the linear interpolation

If we try with i1= 6%, we obtain a residual value of 0.87.

If we try with i2= 7%, we obtain a residual value of -3.12.

The YTM can be estimated by:

VA (i)  VA (i1 )
YTM  i1  (i 2  i1 ) 
VA (i 2 )  VA (i1 )
0  0.87
YTM  6%  (7%  6%)   6.22%
 3.12  0.87
The YTM of bond A is close to 6.22%
 Bond B
1st step: Calculation of the price to be paid
We will have to pay $110.62 to acquire this bond, since the
current trading price is $110.62.
2nd step: Determination and discouting of the cash-flows
The coupon rate is 8%: each year for 5 years, we will receive
8%×100= $8. The next coupon will be paid in exactly one year.
At the maturity date (in exactly 5 years), we receive the face
value, namely $100.

We can construct the timeline as follows:

8 8 8 8 108

110.62
 Bond B
3rd step: Determination of the equation
8 8 108
110 .62    ... 
1  YTM (1  YTM ) 2
(1  YTM ) 5
It can be simplified using the present value of an annuity of $8
to be paid in the next 5 years plus $100 to be paid in 5 years:

5
1  (1  YTM ) 100
110 .62  8   5
YTM (1  YTM )

1  (1  YTM ) 5 100
 0  8  5  110 .62
YTM (1  YTM )
 Bond B
4th step: Use of the linear interpolation

If we try with i1= 5%, we obtain a residual value of 2.37.

If we try with i2= 6%, we obtain a residual value of -2.20.
The YTM can be estimated by:
VA (i)  VA (i1 )
YTM  i1  (i 2  i1 ) 
VA (i 2 )  VA (i1 )
0  2.37
YTM  5%  (6%  5%)   5.52%
 2.20  2.37
The YTM of bond B is close to 5.52%

Thus, despite an higher coupon rate, the YTM of bond B is

lower because its current price is high. For a similar level of
risk, it is better to choose bond A, because its YTM is higher.
 Semi-annual coupon bond

Consider a five-year bond with semi-annual coupons and a

2.5% semi annual coupon rate. Its face value is $1,000. If this
bond is currently trading for a price of $957.35, what is the
bond’s yield to maturity?
 Answer

1st step: Calculation of the price to be paid

We will have to pay $957.35 to acquire this bond, since the
current trading price is $957.35.

2nd step: Determination and discouting of the cash-flows

The semi annual coupon rate is 2.5%: each semester for 10
semesters, we will receive 2.5%×1,000= $25. The next coupon
will be paid in exactly one semester.
At the maturity date (in exactly 10 semesters), we receive the
face value, namely $1,000.

We can construct the timeline as follows:

25 25 25 25 25 25 25 25 25 1,025

957.35
 Answer
3rd step: Determination of the equation
25 25 1,025
957.35    ... 
1  YTM (1  YTM ) 2
(1  YTM )10
It can be simplified using the present value of an annuity of $25
to be paid in the next 10 semesters plus $1,000 to be paid in 10
semesters:
10
1  (1  YTM ) 1,000
957.35  25   10
YTM (1  YTM )

1  (1  YTM ) 10 1,000

 0  25   10  957.35
YTM (1  YTM )
 Bond B
4th step: Use of the linear interpolation

If we try with i1= 3%, we obtain a residual value of 0.

No need to use the linear interpolation, we found the solution!

YTM=3%
Chapter 4: Stock financing

S C H O O L O F M A N A G E M E N T

CFVG
Part 1: capital increase

S C H O O L O F M A N A G E M E N T

CFVG
 How to finance a deal?

You can use equity or debts to finance a deal.

If you use equity, you will have to increase capital

Each method has advantages and drawbacks…

Capital Increase Debts

Advantages Improvement in debt- No Dilution
to-equity ratio
Drawbacks Dilution of the EPS Deterioration in debt-
Dilution of the voting to-equity ratio
rights
 Dilution of the voting rights
Exercise
TPLT is a Vietnamese company which was established in 1986
by its current CEO Mr. Chang. TPLT would like to consolidate
its leading position with the acquisition of Festi+. The share
capital is made of 600,000 shares. Mr. Chang holds 400,000
TPLT’s shares and owns therefore a majority stake. The
remaining 200,000 shares are held by other small shareholders.
Mr. Chang hesitates between debts or equity to fund its
acquisition.

a) Given that the TPLT shares would be issued at a price of $25

and that Festi+ value is $7,500,000, determine the number of
shares to be issued during the capital increase.

b) What would be, following the capital increase, the

ownership structure of TPLT if no actual shareholder
participates in the capital increase?
 Answer

TPLT needs $7,500,000 to acquire Festi+. The shares are

issued at a price of $25.
TPLT has to issue 300,000 new shares:
7,500,000
 300,000
25
 Answer

Since existing shareholders do not participate in the offer, new

shareholders acquires a stake in TPLT Capital. The total
number of outstanding TPLT shares would reach 900,000
(400,000+200,000+300,000). In that case, Mr. Chang would hold
44.44% (400,000/900,000), the other small shareholders would
have 22.22% (200,000/900,000), and the new shareholders
33,33% (300,000/900,000) of TPLT outstanding shares.
 Answer

After the deal

New 300
Before the deal
shareholders  33%
300,000 shares 900
Small
200 Small
200
shareholders  33% shareholders
 22%
200,000 shares 600 200,000 shares 900
Mr. Mr.
Chang 400 400
 67% Chang
 44%
400,000 600 400,000 900
shares shares
 Exercise
Exercise

Lorient Express has expected earnings of $ 250,000,000 in year

n.
a) Given that, at the end of year n, Lorient Express capital is
made of 50 millions shares, what will be the Earnings Per Share
of the firm?
 Answer
The EPS can be calculated by dividing firm’s earnings by the
number of shares of the firm. Lorient express’ EPS is therefore
given by 250,000,000/50,000,000 that is $5

b) Nevertheless, in order to fund its own development, Lorient

Express decided to carry out a capital increase some time in
year n for $100,000,000. 4,000,000 new shares will be issued
for a unit-price of $25. If we suppose expected earnings still
equal to $250,000,000, determine the impact of this capital
increase on Lorient Express’ EPS ?
 Answer
If TPLT increases its capital, the number of outstanding
shares will increase and the EPS will decrease. The number
of outstanding shares will be 54,000,000 (50,000,000 +
4,000,000). Thus, the EPS will be $4.63 (250,000,000 /
54,000,000). The capital increase results in a dilution of the
EPS of 7.4 % :

c) Suppose that this capital increase allows to invest in value

creating projects so that Lorient Express’ earnings increase
by 10 %, what is the impact of this capital increase on the
firm’s EPS ?
 Answer

If earnings increase by 10 %, they will amount to $ 275,000,000

(250,000,000×1.1). In that case, Lorient Express’ EPS will be
$5.09 (275,000,000/54,000,000). The capital increase would
result in an EPS increase of 1.8% :

5.09 - 5
EPS increase   1.8%
5
 Fixing of the date and of the price

Capital increase when the market is high or when the market is

low?
may be interesting to do a deferred capital increase
(convertible bonds or bond with equity warrant)

Why are new shares issued at a discount to a market price of

20 to 30%?
Risk of setting a too high discount
Risk of setting a too low discount

How will react the market at the announcement of a capital

increase according to this discount?
 Preferential subscription rights

To ensure that existing shareholders will not be

aggrieved, they receive preferential subscription
rights (PSR)= right attached to each existing share
allowing its holder to subscribe to the new share
issue on a pro rata basis of the number of shares
held.

This right can be bought and sold on the market.

 Preferential subscription rights
The market value of the firm’s shares before the capital
increase plus the market value of firm’s shares issued
during the capital increase should be equal to the market
value of the firm’s shares after the deal, therefore :

N 0  P0  N i  Pi  ( N 0  N i )  P1
N 0 P0  N e Pe  ( N 0  N e )P1
P0 : Stock price of shares before the capital increase
N0 : Number of shares before the capital increase
Pi : Issue price of the new shares (Pi<P0)
Ni : Number of shares issued
P1 : Stock price after the capital increase
 Preferential subscription rights

N 0  P0  N i  Pi
N 0  P0  N i  Pi  ( N 0  N i )  P1 P1 
N0  Ni
If we note n the rights issue ratio (n=N0/Ni), we obtain :

n  P0  Pi
P1 
n 1
By definition, PPSR is equal to the difference between the stock
price before the capital increase and the stock price after the
capital increase :

P0  Pi P1  Pi
PPSR  P0  P1  
n 1 n
 Exercise

Exercise
Jawadi has issued stocks at a price of $12 per share, one new
share being issued for each 5 old shares. Before the capital
increase, there were 15,000,000 outstanding shares and their
price was $15.

a) Determine the amount received during this capital increase.

 Answer

Since one new share is issued for each five old shares and
before the deal there were 15,000,000 outstanding shares,
Jawadi will issue 3,000,000 new shares (15 000 000/5). The
issue price is $12, Jawadi will thus receive $36,000,000
(3,000,000×12) during this capital increase.

b) Determine the theoretical price of a preferential

subscription right.
 Answer
We can find the theoretical price of a preferential subscription
right based on the stock price before the capital increase (P0),
the issue price (Pi) and the rights issue ratio (n).

The theoretical price of a preferential subscription right is $0.5.

c) Determine the theoretical price of a share just after the capital

increase. What is the impact of this capital increase on Jawadi’s
stock price?
 Answer

n  P0  Pi 5 15  12
P1    14.5
n 1 6
After the capital increase, Jawadi’s stock price will be $14.5.
As previously forecast, Jawadi’s stock price has decreased
following the capital increase (from $15 to $14.5).
14.5 - 15
Stock price decrease   3.33%
15
This represents a decrease in the stock price of -3.33%.

d) Show that despite this stock price decrease, the wealth of

an existing shareholder who is not participating in the offer is
not affected.
 Answer
Before the capital increase, every shareholder owned one
share whose value was $15. After the capital increase, each
shareholder owns one share whose value is only $14.5 but also
a subscription right whose value is $0.5. After the capital
increase, the shareholder’s wealth is $15 (14.5+0.5) and is
therefore unaffected by the deal.

Suppose that Jawadi’s CEO has changed its mind and cancels
this capital increase at a price of $12. He decides to increase
the firm’s capital by issuing shares at a price of $10.

e) How many shares should be issued, if the firm wants to

obtain the same amount as the one in the first question?
 Answer
In that case, the issue price would be $10. Since Jawadi’s CEO
wants to receive $36,000,000, they will have to issue 3,600,000
shares (36,000,000/10).

f) What is the new rights issue ratio?

 Answer
Since the number of issued shares has increased, the rights
issue ratio will decrease. We determine the rights issue ratio
based on the number of outstanding shares and the number of
shares issued in the offer.
number of shares before the deal 15,000,000
n   4.17
number of shares issued 3,600,000
We need to hold 4.17 shares before the offer in order to
participate in the capital increase.

g) Show that the existing shareholder’s wealth who is

participating in the offer does not decrease:
- if the shares are issued at a price of $12
- if the shares are issued at a price of $10
 Answer
1st case: The shares are issued at $12:
If the shares are issued at a price of $12, the shareholder needs
to hold 5 shares before the capital increase plus $12 in cash to
participate in the offer.
Since the stock price before the capital increase is $15, its
personal wealth before the deal is $87 (15×5+12).
Following the capital increase, the preferential subscription
rights are transformed into a sixth share for $12 but each share
is only worth $14.5. Its total wealth is therefore $87 (14.5×6).

Before the capital increase After the capital increase

5 shares at a price of $15 +$12 6 shares at a price of $ 14.5

 Answer
2nd case : The shares are issued at $10
If the shares are issued at a price of $10, the shareholder
needs to hold 4.17 shares before the capital increase to
participate in the offer. If this is the case, the shareholder may
acquire a Jawadi’s extra share for $10. The stock price before
the capital increase is $15, its total wealth before the deal is
$72.55 (15×4.17+10).
Following the capital increase, the shareholder has
transformed his preferential subscription rights into a new
share for $10. After the capital increase, he holds 5.17 shares.
We also need to compute P1, the Jawadi’s theoretical stock
price after the capital increase:

n  P0  Pi 4.17 15  10
P1    $14.03
n 1 5.17
 Answer
Therefore, shareholder wealth after the capital increase is
$72.55 (14.03×5.17).
Before the capital increase After the capital increase

4.17 shares at a price of $15 +$10 5.17 shares at a price of $14.03

Thus, whatever the issue price is ($10 or $12), the shareholder

wealth is the same before and after the capital increase. The
issue price has no impact on shareholder’s wealth if the
shareholders participate in the offer.
h) Show that a non-shareholder investor has no interest to
acquire preferential subscription rights on the stock market
before the deal to participate in the capital increase. Suppose
that the issue price is $12.
 Answer
If the stocks are issued at the price of $12, the investor has to
buy 5 preferential subscription rights to participate in the offer.
Since the preferential subscription rights’ theoretical price is
$0.5, he will have to pay $2.5 (5×0.5). In that case, he can
participate in the offer, and, thus acquire a share at a price of
$12. Overall, he will have paid $14.5 € (12+2.5).

This amount corresponds exactly to the Jawadi’s theoretical

stock price after the capital increase. Therefore, the non-
shareholder investor has no interest to acquire preferential
subscription rights before the deal to participate in the offer.