#16813 - Capital Structure - Banking Law Notes

Aims and Objectives:

• Basic understanding of finance and finance theory; and

• Its significance for the law of credit and security.

  • The interdependence between funds, funds theory, and funds law.

  • E.g. How can a bank minimise the risk that it incurs in making a loan? By taking security over the borrower’s assets.

What is finance?

• How to value things, and, in particular, financial assets.

  • E.g. shares, bonds, companies, investment projects, etc.

  • Valuation.

• How to allocate resources accordingly.

  • Role of Chief Financial Officer = Identifying viable financial projects + Deciding whether or not to invest in these projects.

  • Also, thinking of how to raise the necessary capital for these purposes. Identifying what the cheapest possible source of funding is.

• A hybrid of:

  • Economics — making choices under constraint and assessing the profit-making capacity of each project;

  • Statistics — dealing with risks and randomness; and

  • Accounting — the language of business.

How can a company raise capital?

• Equity vs Debt financing.

  • Equity = Issuing shares in the company.

  • Debt = Borrowing money.

• This course focuses on the legal structure that support debt financing (and all its various variations and emanation).

• Do not confuse:

  • Securities: Negotiable instruments tradable in financial markets (e.g. shares, bonds, notes, and commercial papers); and

  • Security interests: Proprietary interests in assets in order to ensure repayment of debt (e.g. pledge, fixed and floating charges, mortgages).

Course Overview:

• Building blocks of finance and finance theory:

  • Capital structure and financial statements;

  • Compounding and Discounting; and

    • Valuation of how much I would be paying for this particular cash flow if I invest in something.

  • Capital budgeting and Net Present Value.

    • Relates to the decision-making process of investments; should I invest?

• Their impact on the law of credit and security:

  • Syndicated lending;

  • Debt securities;

  • Secured credit;

  • Title-based financing;

  • Derivatives; and

  • Securitisation.

Capital Structure: Types of Financial Assets.

• Rolls-Royce:

  • RR is not a single company; it is a group of companies that are somehow linked together.

    • Rolls-Royce Holdings plc = Holding company of the RR group.

    • The group itself consists of a multitude of companies spread throughout North America, Europe, etc.

  • Who owns RR?

    • What is ownership? How is it defined in property law?
      Most comprehensive right that one have have which gives one the right to exclude others. Right in rem that is enforceable against all others in society?

    • But is this definition really applicable in this context?
      Company = Separate legal person under English company law. RR can itself own assets. How then can one own another person?

    • The shareholders do not really own the company; the company cannot be owned, and shareholders merely own the shares in the company.

  • RR’s Capital Structure:

    • Bank loans = 611 million.

    • Various types of notes (of which some are subject to interest rate swap agreements) = 2,720 million.

    • Obligations under finance leases = 137 million.

    • Trade and other payables.

    • Ordinary shares = 1,840,000,000 with a nominal value of 368 million.
      Note that 1,840,000,000 = The market value at which RR shares are trading, whilst 368,000,000 = Par value.

• What is ownership in the context of this module?

  • Ownership = Cash flow rights + Control rights.

  • Debt = Fixed claim to a company cash flow.

    • Debt is fixed in the sense that it has to be paid at a certain time or at certain time intervals, irrespective of whether the company is making money or not.

    • But, as will be seen later, the amount of debt can vary with the prevailing interest rates.

  • Equity = Residual claim that remains after fixed claims have been paid.

    • Payout on equity — through a declaration of dividends — will generally only be made if the company is making a profit.

    • During liquidation, equity is last in priority — i.e. only when all the company’s debts have been resolved.

• Debt vs Equity:

  • Residual firm value (after debt has been paid) then goes to equity. I.e. When the firm value exceeds debt, the remainder after debt is deducted then goes to equity.

Typical Capital Structure:

• Shareholders

  • Shareholder who hold equity (i.e. common shares) or quasi-equity in the holding company.

• Holding Company

  • The holding company holds all, if not a majority, of the shares in the different operating companies.

  • Various tranches of debt securities with different interest rates and maturity (including bonds and notes).

  • Bank loans, including term loans and revolving credit facilities.

• Operating companies.

• Profits are moved upstream by way of payment of dividends.

Structural subordination:

• Creating a SPV to sit between the shareholders and the holding company.

• Assigning the debt securities to the SPV, whilst the bank loans remain with the holding company.

• The bank loans now take priority over the debt securities; the latter is therefore subordinated to the former.

  • This is because the holding company must first pay its debts before moving the profits — by way of a payment of dividends on the shares that the SPV holds in the holding company — upstream.

Bank Loan:

• Term loan for capital expenditure VS Revolving credit facility for working capital.

  • Working capital = Whatever capital needs that arises from time to time in relation to the company’s daily operations.

  • The longer the term of the loan, the greater the risk (that the borrower will not pay back), and therefore the more expensive the loan. All this typically = higher interest rates on term loan than revolving credit facilities.

• Amortising vs Non-amortising (known also as bullet loans).

• Possibly guaranteed by group companies and possible secured on the assets of group companies.

• The...