Equities and Fixed Income Investments - Assignment Example

? Equities and Fixed Income Investments Table of Contents Part 3 a 3 b 8 c. 11 d. 12 e 13 Part 2 15 Reference List 18 Part a Whether the company in a position to issue debt securities or should it consider issuing equity instead? In order to find out if Severn Trent is in a position to issue debt securities or should it consider issuing equity is found out by the analysis of gearing ratio, FCFF, FCFE and EBITDA. The analysis will reveal if the company is able to service the debt payments and should it consider issuing the debt securities. The gearing ratio will include the portion of capital of the firm is financed through loan capital or in other words it will indicate if the firm is in a position to add extra risk to its business by including loans (Garnier and Gasse, 2011). While the analysis of the free cash flow will indicate if the company enjoys an unobstructed flow of cash. The analysis of the free cash flow to equity will indicate if the company is in a position to service the equity holders after clearing all the expenses, reinvestment and repayment of debt. The analysis of the EBITDA indicates the cash flow from the operations (Hatten and Ruhland, 2005). The cash flow from the operations will indicate if able to optimize its operational performance. With the increase in the efficiency of the operations the cash flow of the firm will increase. Table 1: Tabulation of different ratios   2013 2012 2011 2010 2009 Gearing ratio 0.95 0.91 0.90 0.90 0.90 EBITDA 492.2 469.8 497.7 507.4 451 FCFE N/A -86.8 -89.9 -376.6 -162.1 FCFF N/A 252,286.60 239,185.37 220,906.19 2,284,070.11 Source: (Severn Trent Annual Report, 2013) Fig 1: Gearing ratio Source: (Severn Trent Annual Report, 2013) The gearing ratio increased considerably in the last 5 years. This indicates that Severn Trent increasingly resorted to debt financing. The increase in the debt financing puts Severn Trent in a risky state, since higher the debt, higher the chance of insolvency, if the company is not able to finance the debt with the revenue (Jang and Namkung, 2009). This also indicates that the company has already resorted to huge amount of debt financing Severn Trent is in a highly leveraged position due to the presence of significant percentage of debt in its capital structure. Being in a highly leveraged position indicates that the company has a strong credit score otherwise the investors would not have taken Severn Trent into confidence (Kutner, Nachtsheim and Neter, 2004.). The highly leveraged position of Severn Trent also puts enormous pressure on the company to finance the debts. Fig 2: EBITDA Source: (Severn Trent Annual Report, 2013) The EBITDA does not indicate a linear increasing trend or decreasing trend. It is a mixed trend of intermittent ups and downs. Earnings before interest, tax, depreciation and amortization are highest in year 2010, while it is lowest in the year 2009. The increasing trend in the EBITDA is an indication that the company is in a position to finance the interest payments quite efficiently (Miravete, 2003). Although the previous graphs already indicate that the company is already in a highly leveraged state. This means that although the EBITDA shows an increasing trend but the highly leveraged position of the company are putting severe pressure on the EBITDA due to the need to clear the interest payments (Pinhanez, 2001). Fig 3: FCFE Source: (Severn Trent Annual Report, 2013) The free cash flow to equity showing a constant negative trend for the past 4 years, which is a cause of concern. The negative value of the ratio indicates that the company has been suffering cash crunch for the past 4 years. This clearly indicates that the company faced trouble trying to clear the dividend for the equity holders (Stumpf, Dunbar and Mullen, 2001). This is because of the reason that the equity holders are paid only after clearing the expenses for reinvestment and debt repayment. The negative ratio of the free cash flow to the equity shareholders is a clear sign of the fact that the expense due to the reinvestment and debt repayment puts the company under severe pressure. The gearing ratio already indicates the fact that the company is already in a highly leveraged position. The high leveraged position increases the pressure on the company to clear the debts repayments. The increasing trend of EBITDA thus after all may not be enough to pay for the dividends of the equity holders (Gillin, 2006). This is because of the reason that the company incurs significant expense in reinvestment, debt repayments and clearing other type of expenses. So on one hand the company is already in a high leveraged position indicating it’s over dependency on debt financing. On the other hand the heavy dependency on loan has increased its obligation to clear the debt (Inman and Zeelenberg, 2002). This is coupled with the heavy reinvestment and other type of expenses which is depleting the cash level to such a position that the company is finding it hard to pay for the equity holders. Considering the fact that equity financing is better off than debt financing it can be safely said that the company can consider issuing equities instead of debt securities. Issuing debt securities will save the company from unnecessary burden. The company can cut down on the expenses and reinvestments. This will enable the company with enough savings to pay for the equity holders thus improving the free cash flow to equity ratio. If Severn Trent decides to issue bond then it will be strictly a bullet bond. Fig 4: FCFF Source: (Severn Trent Annual Report, 2013) b The advantages and disadvantages of issuing a bullet bond Advantages The bullet bonds allow the issuer to reinvest the principal amount of the bond on projects which are viable throughout the life of the bond. This kind of bond is chosen by the investors because this bond pays interest at a fixed rate on the principle for the whole bond life (Kim and Kwon, 2003). Other type of advantages are that the issue of the bullet bond reduces the pressure on the issuer of the bond, this is because of the reason that the issuer does not have to consider paying a lump sum amount of money once the bond matures. Instead the issuer can ease the payment of the bind through a life time period. Disadvantages Although the issuer is saved from the obligation to pay a huge lump sum amount of money once the bond matures, but the issuer has to always furnish a fixed interest payment throughout the life time of the bond. The other type of disadvantage is that the payment of the bullet bond once it matures (Kutner, Nachtsheim and Neter, 2004). The credit risk of the bullet bond tend to remain the same as the whole risk is only associated with the payment of the principal. The principal is paid at the time of maturity. Pricing a bullet bond The bullet bond is priced using the following formulae Source: (Miravete, 2003) The following example explains the way the above formula is used in pricing the bullet bond. The coupon rate of a European government bond is 7% and it has 5 years to maturity. The latest interest payment or the annual interest payment just took place (Pinhanez, 2001). The current rate of interest for the government bonds to maturity is 6%. The following are the steps used in the calculation of the European government bullet bond. PV ={0.07 * ?1/(1+0.06)n + 1(1+0.06)5}*100 -(0.07 * 4.21237 + 0.74726) * 100 = 104.21. The fair price of the bond is thus calculated as 104.21. Calculation of the discounting factor 1 1/ (1 + 0.06)1 2 1/ (1 + 0.06)2 3 1/ (1 + 0.06)3 4 1/ (1 + 0.06)4 5 1/ (1 + 0.06)5 Sum 4.21237 Source: (Stumpf, Dunbar and Mullen, 2001) The risks and costs associated with the issuance of bullet bond are low among all the types of bonds for any type of company. In the present case if Severn Trent decides to issue bullet bonds then it can be safely said that other than the risk or burden top clear the annual interest payment of the bond the company does not face any significant types of risks. The only risk the company faces is when the bond matures and then the company is obliged to pay the required amount (Weerawardena, 2006). Other than that Severn Trent is also saved from any troubles it may have to face if the debtor decides to redeem the bond before it mature because then the company is obliged to pay a certain amount of money which again puts pressure on the company. Discussion of credit spread The credit spread is the difference between the treasury securities and the non treasury securities, which are same in every respect, other than the rating of the quality. The difference in the credit spreads between the treasury securities and the non treasury securities indicates the presence of the risk. c. The choice between callable and puttable bond The choice of the callable and puttable bond can put Severn Trent in a different advantageous position. For example if Severn Trent decides to go for callable bond then the issuer of the bond, in this case, Severn Trent can call a bond before its date of maturity. If Severn Trent decides to issue long term bond, they are obliged to pay the interest for that period. If Severn Trent observes that the huge payment of the bond is drawing hugely on the revenue of the company then it can issue a callable bond (Jang and Namkung, 2009). In other words, issue of callable bond will enable the company to buy back the bonds and again issue bonds which are offering low interest rate. This would enable the company to cut down on the expenses through reduced interest payments. If Severn Trent decides to issue a puttable bond then the investor or the debtor enjoys an upper hand. This is because of the reason that the investor is now capable of selling the bond after a certain point of time (Littunen, 2012). In this case the investor enjoys the right to sell the bond. The bond is sold and instead a lower yielding bond is offered. The choice of the bond will be definitely callable. In callable the investor being in a long position will by the bond and at same time sell the call option. These enable the issuer to issue the bond at more favourable terms. Whereas this represents a kind of drawback since the price behaviour of the security displays negative convexity once the interest rate falls (Salter and Martin, 2001). The effect in the pricing of the issue for callable and puttable bond If Severn Trent decides to issue callable bonds then the issue price of the bond must be less than the price at which the bond is bought back. The pricing of the bond depends upon yield to maturity rate of the bond, the duration of the bond and the probability should the bond prices fall or the interest rate rise (Narzt and Pomberger, 2006). This is because of the reason that the price at which the bond is bought back has to be greater than the initial price at which the bond is issue. d. Convertible bonds The analysis of the gearing ratio and other ratios like the FCFE and FCF indicates that Severn Trent is in a severely disadvantaged position. The high leveraged condition compounded with huge expenses and reinvestment is leaving little to pay for the equity holders. This presents an ideal scenario to go for convertible bonds. It will enable the company to raise easy money through debt and at same time cut back on the interest payments through the conversion of debt to equity. The mechanism of convertible bond is explained with the help of example Let interest rate on semi-annual coupon bonds be 8%. And for every $1000, $40 needs to be paid. So, Semi-Annual Interest = (Coupon Rate / 2) x Face Value, i.e. Payment = (8.00% / 2) x $1,000 = $40. The convertible bonds are issued at face value of $1000 and the price of conversion is $125. So the ratio of conversion is $1,000 / $125 = 8 shares. Let current share price be $100/share. So parity = Conversion Ratio * Current Share Price = 8* 1000 = $800. If the current market price of the convertible is $1,185, then the conversion premium is == (Market Price – Parity Price) / Parity Price = = ($1,185 - $800) / $800 = = 48.13%. This is indicates that the investors want to pay a premium of 48.13% in order to have the features available for the bond also available over the equity. This is a brief mathematical explanation of the convertible bonds. The pricing of bond actually involves more complex methods like the Black-Scholes model, or Finite Difference Methods or Binomial Tree. The investor buys the bond from the issuer. The issuers continue to pay the interest rate on the bond to the bond holder (Stumpf, Dunbar and Mullen, 2001). After some point of time and with agreement between the issuer and the bond holder, instead of paying the interest or the principal of the bond, the bond issuer will convert the bond into equities. The conversion can take place either on fully or partially. Cost and payoff implications to both Severn Trent PLC and the Investors if convertible bonds are considered The pay offs for Severn Trent is that the conversion of the bonds into equities will decrease the burden of debt repayment, while the conversion of the bonds into equities will help in the investor to diversify their fixed income portfolio. It also increases the total return of fixed income portfolio for investors (Weerawardena, 2006). The costs associated with such conversion can be detrimental for the investors if all the bonds are converted into equities. Then the investor is not left with any option to protect any downslide of the equities. e Justification for using or not using or not using inflation linked bond If Severn Trent considers an inflation linked bond then the investors will be paid interest as well as principal at maturity which is adjusted for inflation. Not too many companies use the inflation linked bonds since it puts extra pressure on the company to clear the payments at an inflated rate. Although in the present case the use of inflation linked bonds will improve the investor confidence over Severe Trent although it does have other side effects. The mechanism of inflation linked bonds are explained with the help of an example Let the British government bond rate be 8% in 2020. Whereas the British inflation linked gilt is maturing in 2021. As the inflation which is linked to the CPI increases the principal also increases (Littunen, 2012). The CPI which was 1.4% in 1995 the principal amount was increased by 1.4% also. The British inflation linked gilt was introduced in the year 1990 and since then the principal amount increased by 4% and is currently ?104. The coupon rate of 4.5$ is now generating a payment of ? 4.68 where as the previous paid amount was ? 4.5. During maturity the principal amount will increase as inflation increases and this way the return from the principal can exceed the return from the normal bond. Reasons for which Seven Trent will benefit more from the issue of inflation linked bonds The inflation linked bonds help the investor to compensate for the loss in value due to increase in the interest rate. The company settles the payment for the principal and interest by making adjustments with the inflation rate. If the economy is witnessing sharp rise in the inflation rate then the demand for the inflation indexed bonds increases (Miravete, 2003). At present the economic scenario of UK is bleak with rising inflation rate and cost of living. This indicates that the near future is going to witness significant increase in the demand of inflation linked bonds. The high demand of the inflation linked bond will automatically lead to an increase bond prices. This opportunity can be utilized by Severn Trent to raise easy money through debt financing. Cost and payoff implications to both Severn Trent PLC and Investors If the price of the bonds increases due to increased demand of inflation indexed bonds then it will provide an easy way to raise capital for Severn Trent. On the other hand if the inflation rate keeps on increasing then the rate of interest and the payment of the principal needs to be settled at the increased inflation rate. This puts extra pressure on the company. The investors on the other hand are left better off since adjusted interest payment and the payment of the principal amount is more than the original amount (Pinhanez, 2001). If the reverse condition occurs that is the rate of inflation keeps on decreasing then Severn Trent will not have to bother to pay an inflated interest and principal amount. This saves on the part of the part of Severn Trent from incurring the extra cost. The investors are left at a disadvantaged position. The payment of the interest and the principal amount take place at a value which is lower than the actual interest rate in the beginning and apart from that the principal amount is also paid at a decreased value. Part 2 The calculation of the price, coupon, yield to maturity and the modified duration of a 5 year GBP par bullet bond Face Value 1000 Annual Coupon Rate 0.08 Annual Required Return 0.095 Years to Maturity 5 Years to Call 1 Call Premium % 0.03 Payment Frequency 2     Value of Bond 941.3774     Bond Yield Calculations   Current Yield 0.084982 Yield to Maturity 0.095 Yield to Call 0.175173 The face value of the 5 year GBP par bullet bond is taken as 1000. Other than that the other assumptions that are also made are the annual coupon rate and the annual rate of return. The annual coupon rate is taken as 0.08 while the annual required return is considered as 0.095. The years to maturity is assumed as 5 years. The current yield is calculated by multiplying the face value and annual coupon rate and then dividing the same by value of the bond. The yield to maturity is calculated by considering various factors like annual interest, par value, market price and the number of years to maturity. The formulae of calculating the yield to maturity is shown below Source: (Stumpf, Dunbar and Mullen, 2001) The yield to call is calculated by taking into consideration of annual interest, call price, market price and the number of years to call. The Source: (Jang and Namkung, 2009) The value of the bond is given by the following formulae. Or, Source: (Jang, S. and Namkung, Y., 2009) The factors that are assumed in calculating the price of the bond are coupon rate of the bond, the number of payments, interest rate or required yield of the bond, and the value at maturity or the par value. The value of the bond in this case is 941.37, where the face value of the bond is 1000. The price of a bond is the sum of present values of all the expected coupon payments as well as the present value of the par value at maturity. As observed from the way the coupon of the bond keep changing, the price of the bond also changes if they are having fixed YTM. The modified duration is measurement of the price sensitivity of a bond to the movements of the interest rate. The formulae for calculating the bond duration is (Bond Duration)/ (1+YTM). The projecting cash flows from the fixed income securities can be found in a more or less easy way, although the complications rise if the investor or the issuer is has an option to change the due date of the contract when the principal amount is paid. Reference List Garnier, B. and Gasse, Y., 2011. Utilisation of local newspapers for training potential entrepreneurs. Jsbe, 5(3), p. 20 Gillin, L. M., 2006. Entrepreneurship education: The Australian perspective for the nineties. Jsbe, 9(1), p. 60. Hatten, T. and Ruhland S., 2005. 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International Journal of Entrepreneurial Behavior & Research, 6(6), p. 295 Miravete, E., 2003. Choosing the wrong calling plan? Ignorance and learning. American Economic Review, 93(1), pp. 297-310. Narzt, W. and Pomberger, G., 2006. Augmented reality navigation systems. Universal Access in the Information Society, 5(3), pp. 177-87. Pinhanez, C. S., 2001. The everywhere displays projector: A device to create ubiquitous graphical interfaces. Berlin: Springer. Salter, A. J. and Martin, B. R., 2001. The economic benefits of publicly funded basic research: a critical review. Research Policy, 30(3), pp. 509-532. Severn Trent Annual Report, 2013. Annual Report of Financial Performance. [online] Available at [Accessed 10 June 2013]. Stumpf, S.S., Dunbar, R.L., and Mullen, T.P., 2001. Simulations in entrepreneurship education: Oxymoron or untapped opportunity. Frontiers in Entrepreneurship Research, 6(8), p. 6. Weerawardena, J. M., 2006. Investigating social entrepreneurship: a multidimensional model. Journal of World Business, 41(1), pp. 21–35. Read More