The Wharton School s1

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