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2. Characteristics of the bond. We need to know the amount outstanding, the face value, the number of months to maturity, the conversion price, the number of months until the first coupon date, the time between coupons, the annual coupon rate, and the call provisions (the call prices and their timing).
3. Characteristics of the common stock. Since the bond is convertible into common stock, we need to know the current stock price, the equity beta, the expected dividend per share, the ex dividend dates, the number of shares outstanding, the equity volatility, and the amount of senior debt outstanding.
Exhibit 20.19 shows our estimate of the value and the before-tax cost of capital for a sample of seven callable, convertible bonds. The results were provided by McKinsey's convertible securities pricing model. In every case, the before-tax cost of capital for the callable, convertible bond is higher than the coupon rate, and in all but one case the difference is substantial.
Exhibit 20.19 Valuation and Cost of Capital for Convertible Bonds
Company Theoretical Value1 Market Price’ Difference (percent) Coupon Rate (percent) Cost of Capital (percent)
ABB 106.7 106.4 0.3 2.75 11.1
Ahold 110.5 107.0 3.2 3.00 6.8
America Online 1,044.2 1,036.5 0.7 4.00 16-S
Colt Telecom 113.8 111.3 23 2.00 3.3
Hilton 71.9 75.6 -5.1 5.00 10.0
Johnson & Johnson 120.1 120.0 0.1 4.75 10.4
Nestle 88.7 87.5 1.3 1.25 8.0
Texaco 97.3 96.6 0.7 3.50 7.7
Xerox 54.(1 53.9 0.3 0.57 8.3
1 Per $100 face value.
Source: Remco Bos. tortis Investment B.mk
The after-tax cost of the bond depends on the percentage of its opportunity cost that is actually tax-deductible. Thus, an estimate of its after-tax cost is
Option pricing is analogous to flexibility in decision making because the holder of an option can exercise it at his or her discretion. Options can affect every arena of management, and we have illustrated only a few applications. On the assets side of the balance sheet are options to defer, expand, contract, abandon, or switch projects on and off. In addition, these options can appear as compound options, as in phased investments, and may be driven by multiple sources of uncertainty (rainbow options). Net present value analysis, rigidly applied, undervalues assets because it fails to account for the rich set of flexibility options involved in business decisions. On the liabilities side, options can have a significant impact on the cost of capital. We analyzed callable, convertible debt and saw that the true opportunity cost is often substantially higher than the coupon rate. Convertible debt is not a free lunch. It is neither cheap debt nor cheap equity.
21— Valuing Banks
The banking and thrift industries have undergone two decades of change, catalyzed by the globalization of financial markets, privatization, deregulation, the growing popularity of nonbank substitutes, and changes in tax laws. Additionally, the Internet and other technological developments have led to relentless cost reductions by the best banks.
The result has been massive restructuring among financial institutions. This restructuring began in 1988, when the Bank of New York successfully completed its hostile takeover of Irving Trust. In 1991, Chemical Bank and Manufacturers Hanover agreed to merge. The new Chemical Bank merged with Chase Manhattan in 1996. In 1999, Citicorp merged with Travelers to form CitiGroup. In early 2000, the U.S. Congress was in the process of repealing the Glass-Steagall Act, which had kept commercial banks from investment banking activities and certain other financial services. No doubt this repeal will also spur further consolidation in financial services. Valuation is an important tool for helping managers understand and undertake these types of restructuring.
The Difficulty with Valuing Banks
Valuing banks is conceptually difficult. For an outsider, determining the quality of the loan portfolio, measuring the amount of current accounting profits attributable to interest-rate mismatch (for example, the difference between what is earned on loans with long-term rates and deposits compensated by short-term rates), and understanding which business units are driving the bank's profit potential are all hard to do.
For an insider attempting to value a bank, the major issue is transfer pricing. As illustrated in Exhibit 21.1, most banks can be separated into three basic business units (although most have dozens of distinct businesses): a retail bank that may have only 20 cents in loans for each dollar in deposits, a
Exhibit 21.1 Business Unit Structure of Banks
wholesale bank with only 20 cents in deposits for each dollar in loans, and a treasury that stands between them and carries on activities of its own such as securities trading. The excess funds generated by the retail bank can be loaned to the marketplace or to the wholesale bank. If loaned internally, the rate credited to the retail bank and the rate paid by the wholesale bank are crucial transfer prices. If the price credited to the retail bank is set too high, it will appear to be more profitable, and vice versa. It is critical to establish the correct transfer price in order to determine where the bank should allocate its marginal resources—to the retail bank or to the wholesale bank.