The Wharton School

The Wharton School

University of Pennsylvania

FUNDING INVESTMENTS

FINANCE 238/738

David K. Musto

Overview - This course familiarizes students with the different funding techniques available to corporations, with particular attention to credit risk. The first half of the course covers corporate bonds, focusing on the issues related to financial distress: Chapter 11, exchange offers, ratings, and so on. The second half covers the rest of the capital structure. We discuss short-term financing such as commercial paper and trade credit, securitizations, and equity - both common and preferred, with some discussion of the underwriting process. The course is generally though not entirely less quantitative than other finance courses, and is not about optimal capital structure or banking.

Course Material - There is no textbook; there are 22 readings in the bulkpack, to read by the date indicated on the schedule. There will be a 10-20 page handout for each class.

Course Mechanics - The course is in lecture format, with four classes devoted to seven cases, and another class to a project. There are seven homeworks.

Grades – There are two tests, which are both mandatory and closed-book. Tests will be in the evening on the indicated days. The only excuse from either test is a signed note from a doctor stating that the student can not take the test. A document stating that the student went to the hospital is not an excuse, and a prescription is not an excuse. In event of a valid excuse, the student will take a make-up. The tests each count 30%, the seven cases together count 15%, the project counts 5%, and the best 6 of the 7 homeworks together count 15%. Class participation is 5%.

Groups - Homeworks are done individually, and cases are done in groups of three to five.

Prerequisites - I will assume you know the first 20 chapters of Brealey and Myers (though there will be a small amount of review)

Hand-out Fees - You will be charged a fee for handouts.

Overlap with Other Courses - Some discussion of bond pricing in the early classes will overlap with Fixed Income. Some of the issues related to capital structure are also covered in Advanced Corporate Finance. The small amount of option pricing covered is also covered in Speculative Markets.

Teaching Assistants – Puja Bhargava, Marco Di Giacomo, Renee Johnson, and Philip Lam.

Class Schedule

1/13 Introduction and overview of funding sources

1/15 Review of Fixed Income Securities - Valuation and Quotation

Garbade, Pricing of Bonds

Treasury Notes and Bonds

Auction Schedule: on- vs. off-the-run

STRIPs, reconstitutions and synthesizing bonds with other bonds

Quotation conventions: yield-to-maturity and accrued interest

Treasury Bills

Quoted on a discount basis

1/22 Repos, Reverse-Repos, and Securities Lending

Lumpkin, Repurchase and Reverse-Repurchase Agreements

Keane, Repo Rates for New Treasury Notes

Plain-vanilla repo transaction

Quotation of repos

Margin and reverse-margin

Repos as secured borrowing and lending of money

Repos as borrowing and lending of securities

Specialness and its relation to the Treasury auction schedule

Economics of Securities Lending

1/27 Case Discussion: Arbitrage in the Government Bond Market? and

The Boston Company: Securities Lending

1/29 Review of Option Pricing

Repo HW due

Definition of puts and calls

Equivalence between different option portfolios

Binomial option pricing

Effect of dividends on option prices

Effect of variance on option prices

2/3 Case Discussion: Coca-Cola Harmless Warrants and RJR Nabisco

2/5 Corporate Securities as Options

Equity of a levered company as a call option on firm value

Senior debt as a risk-free bond minus a put

Junior debt as one call option minus another call option

Convertible debt as risk-free minus a put plus a call

Effect of variance of firm value on the different securities

Incentive to increase variance after issuing debt

Debt capacity

2/10 Corporate Bond Contracts

Option HW due

Fabozzi, Corporate Debt Instruments

Smith and Warner, On Financial Contracting: An Analysis of Bond Covenants

Role of the bond’s trustee

Covenants

Standard covenants and their economic purposes

Voting rules for changing covenants

Federal Trust Indenture Act

100% approval to change principal, interest or maturity

Credible threat to force bankruptcy: Doomsday Machine

Why bank debt is typically senior

2/12 Chapter 11

Debt Capacity HW due

Teichner, Note on Bankruptcy in the United States

Weiss, The Bankruptcy Code and Violations of Absolute Priority

Chapter 7 Liquidation

Important features of Chapter 11

Automatic stay of creditor claims

Reversal of preference payments

Debtor-in-posession financing

Voting rules for reorganization-plan approval

What actually happens in Chapter 11

Payments to secured creditors

Payments out of order to unsecured creditors, equity

Tax incentives to give equity something

Buying shareholders’ approval of the plan

2/17 Distressed Securities

McConnell and Servaes, The Economics of Pre-Packaged Bankruptcy

Gilson, Managing Default: Some Evidence on How Firms Choose Between Workouts

and Chapter 11"

Salamon, The Workout Crew

Using pre-packaged bankruptcy to use benefits of Chapter 11

More lenient voting rules

Tax advantages

Exchange offers

Hold-out problem with regular voluntary exchanges

Idea behind Coercive Exchange Offers, with exit consents

Exerting influence on a distressed debtor

Avoiding a creditor-liability problem which reduces seniority

Relation between quantity of junior public debt and workout problems

2/19 Bond Ratings and the Rating Industry

Wakeman, The Real Function of Bond Rating Agencies

Cantor and Packer, The Credit Rating Industry

Altman and Kishore, Almost Everything You Wanted to Know about Recoveries on

Defaulted Bonds

Probability of default vs Recovery of value in case of default

Role of bond ratings in monitoring of money managers

Why issuers buy ratings

Ratings as measures of relative, not absolute, default risk

Default history of different ratings

2/24 Alternatives to Straight Debt

Exchange Offer HW due

Brennan and Schwartz, The Case for Convertibles

50% fire-insurance rationale for issuing convertibles

Delayed equity issuance rationale

Incentive-problem rationale

Easy-to-price rationale

Floating-rate securities

Credit-sensitive notes

Reset bonds

2/26 Case Discussion: Financial Restructuring

3/3 Commercial Paper

Hahn, Commercial Paper

Difference between CP and regular corporate debt

Quoted on a discount basis

Early-exit mechanism of the CP market

Backup Credit Lines and their function

CP before and after the Penn-Central default

Letter of Credit paper

Year-end and quarter-end discounts

3/5 FIRST TEST

3/17 Securitizing Mortgages

Fabozzi, Modigliani, and Ferri, Mortgage-Backed Securities Market

Simple pass-through structure

Prepayment risk due to borrower’s option to refinance

reduces upside from interest-rate decreases

Credit risk borne by insurers, not by investors

Standard pre-payment assumptions; Adjusting pre-payment assumptions

Dividing cash flows into tranches

Designing securities with different maturities

3/19 Securitizing Receivables with Default Risk

Hill, Securitization: A Low-Cost Sweetener for Lemons

Mian and Smith, “Extending Trade Credit and Financing Receivables”

Securitization HW due

Three ways to sell tranches with low credit risk

Buy insurance

Margin account

Create a subordinated debt tranche

Create an equity tranche and hold it yourself

Planned amortization

Securitization of receivables that don’t pay interest

3/24 Case Discussion: Commercial Financial Services Inc. and

American Express TRS Charge-Card Receivables

3/26 Preferred Stock

Plain-vanilla preferred structure

One reason why Utilities sell so much preferred

Tax reasons to sell preferred

Dividends Received Deduction

Trust-intermediated structure

From MIPs to QUIPS and TOPrS, also QUIDS

Get interest deduction with less risk of financial distress

3/31 Case Discussion: Money-Market Preferred Stock

4/2 Underwriting and Rights

Jurin, Raising Equity in an Efficient Market

Raising new equity with a rights offering

Setting exercise price low enough guarantees success

Rarely done in this country, very popular in other countries

Underwriting process

Chronology of an offering

Shelf registration and Rule 144a offerings

Underpricing of IPOs

Returns to investors buying at the offering price

Theories of why IPOs are underpriced

Why pricing underreacts to indications of high demand

4/7 Market Reaction to Security Issuance

Ibbotson, Sindelar and Ritter, The Market’s Problems with the Pricing of Initial

Public Offerings

Smith, Raising Capital: Theory and Evidence

Rights Offering HW due

Managers have inside information about securities’ true value

Evidence that securities are sold when market overvalues them

Long-term underperformance of IPOs, SEOs

Optimism of accounting figures before issuance

Pecking-order theory

Market’s reaction to issuance of different securities

Equity vs. Debt

Transactions that change leverage but don’t raise money

4/9 Secondary-Market Trading

Relation between Informed Trading and Spreads

“Microstructure” of different equity markets

Empirical evidence on retail-investor pathologies

4/14 Projects and Review

Projects Due

4/16 SECOND TEST

4/21 Mutual Funds

Gaming, Speculating

Persistence, Pricing

4/23 Wrap-up

Last HW Due