Financial Resource Information and Glossary

Applied Corporate Finance

Glossary

Click on a letter in the table below to go to definitions beginning with that letter. Click the Back to top link to return to the table. The glossary is under review so if you would like to recommend an entry, please contact ACF with your definition.

Accrual

A portion of a total amount receivable or payable which is determined according to the time elapsed. For example, interest of £10,000 is payable by a company on 31 December on a loan it took on 1 January. The company prepares its annual profit and loss account on 30 June. Even though the interest has not been paid yet, the company must treat it as a cost for calculating its profits for the year ending 30 June so it takes half of the annual amount (since 30 June represents half of the period for which the interest is payable) i.e., an accrual of £5,000. If the company's profit before interest for the year ending 30 June were £12,000,its profit after interest would be £7,000 (not £2,000). The remaining £5,000 of interest not accrued would be included in next year's profit and loss account. Accruals therefore take into account costs and income, even though there has been no corresponding cash flow.

Appreciation

see Depreciation Back to top

Agency risk

The risk that agents will abuse their position and destroy the value of their principals. For example, company directors are agents of shareholders (principals) since shareholders delegate the management of their investment (share capital) to directors. Directors could squander this capital on personal interests such as empire-building, executive jets, and projects, all of which destroy the value of the share capital.

Ask

When a bank provides a two-way quote, the bank's asking price is the rate or amount the bank wants in return for giving something. For example, if a bank quotes an exchange rate of £1:$1.98 - 1.99, the bank's ask rate is 1.99, i.e., the bank wants $1.99 in exchange for £1. The other side of the quote is the bank's bid price, i.e., the rate or amount the bank will give. In this example, the bank will give $1.98 in exchange for £1. Sometimes the Ask is called the Offer

Asset and Liability Management

The process whereby a company's assets and liabilities are manages in combination to ensure company value is maintained or increased. The strategy recognises that changes to one side of the balance sheet without the other can adversely affect the company's net margin, its earnings and hence its value. For example, a company might offer fixed rate loans to borrowers but finance them with variable rate loans. This creates a mismatch in interest rates exposing the company to rising variable interest rates, which would reduce its net interest margin and hence company value. Companies often establish an Asset and Liability Management Committee (ALCO) of senior managers and directors to periodically assess the company's assets and liabilities and ensure they are matched or that mismatches are recognised and managed appropriately.

Asset

Something a company owns (e.g., a factory), as opposed to something it owes (which is a Liability, e.g., tax).

Asset finance

A method to raise finance by using assets as security for repayment. In commercial finance, it refers to the use by companies of plant, equipment, and machinery to raise finance, either for their purchase, or selling these assets and leasing them to raise cash whose amount is based upon the assets' market value (see Asset Securitisation).

Asset Securitisation Back to top

A complex form of secured lending in which a company provides a distinct pool of its assets to a lender as security for finance it raises (usually debt). If the company defaults, the lender can claim the assets and sell them to recover the loan. The lender usually has no rights (recourse) to other assets if the securitised assets are not sufficient to recover the full loan. The assets are usually transferred and ring-fenced (segregated) in a special purpose vehicle (SPV) so they cannot be claimed by the transferring company's other creditors in a bankruptcy. Loans secured over mortgage assets are called mortgage-backed securities; those secured over other assets are called, asset-backed securities. These securities have been responsible for the current melt-down of the US credit markets, owing to investor concerns about the true value of the assets securing them, especially those where the assets are sub-prime mortgages.

Amortise

The process whereby an amount is processed over a period of time rather than all at once. For example, if a company pays a bank £100,000 as a fee for granting it a £10m loan that lasts 5 years, some companies would have a policy of amortising the fee over the life of the corresponding transaction i.e., they would post £20,000 to the P&L account each year as a cost. Some companies would have a policy to write the whole cost off immediately in which case the cost in the P&L would be £100,000 in year 1 and nothing in years 2-5 inclusive. The second policy has a much greater effect on the reported P&L in year 1.

Asymmetric information

The difference in information between market participants that results in those with more information having a price advantage over those without. In strongly efficient markets, all participants would have the same information at the same time. (See Efficient Markets Hypothesis)

B Back to top

Balance sheet

A statement of a company's assets and liabilities at a point in time. A company must always have an equal balance in terms of value, of assets and liabilities on its balance sheet. Where there is a difference (such as a revaluation of assets), the equity value rises or falls.

Basis point

one hundredth of one percent (0.01%). It is often used to state the additional interest payable (called the margin) on loans over a market interest rate such as LIBOR. For example, if LIBOR is 5% pa, a company that pays LIBOR plus a margin of 5bp pays a total interest rate of 5.05% pa

Bid

See Ask

Bond

A form of debt that is tradeable and usually has a fixed interest rate. Bonds are usually issued with maturity dates ranging from a few years to 100 years or even no maturity (perpetual). Bonds with a variable (floating) rate of interest are called floating rate notes (FRN). Those that may be converted into equity are called convertible bonds. Bonds issued with a medium term maturity are called Medium Term Notes (MTNs). Many other variations exist. Bonds are usually unsecured, and hence their interest rate varies according to the credit risk of the issuer (the company that borrows money in exchange for the bond certificates). See Eurobond.

Bridging Loan Back to top

A short-term loan often used by companies where time is critical, e.g., to acquire a company, or property at auction, or to meet an urgent liability such as a tax demand or interest payment, or avoid insolvency. The loan may be repaid at any time and its interest rate is usually higher than other loans. Lenders will usually look at only the value of the security not the credit status of the borrower, and hence will not usually lend more than 70% of its market value, unless additional security is provided. Once the urgency has passed, borrowers will often seek to refinance or repay the bridging loan. For example, the property bought at auction has been remortgaged, or renovated and sold. Bridging loans thus 'bridge' the funding gap until a longer-term solution is available.

Broker

An intermediary whose aim is to match the needs of borrowers and lenders. The broker is usually appointed by the borrower or investor to find the optimum product for a purpose, such as a bridging loan to acquire a property at auction, company shares to add to an investment portfolio, or a pension plan to pay into. Independent brokers are able to use their independence to find the optimum product from the whole of the market for their client. With so many products and lenders, considerable time and effort can be saved by a borrower appointing a broker to undertake the research to find the optimum product and lender. Brokers may charge for their service in the form of a percentage of the amount involved, and/or a fee based upon their time and/or their performance.

Bullet

Repayment of a loan in full at its maturity date, instead of by installments over its life.

Business Angels

Individuals who are seeking to invest their money in relatively higher-risk opportunities - compared to conventional low-risk investments such as bank deposits, and who also offer their knowledge and time to their recipients, such as start-up companies. Angels might also take a seat on the board of the company. Investments tend to start from £100,000.

Buy-to-Let

A form of mortgage where the security is a property (a house, or commercial premises such as an office) that the borrower has acquired for the purpose of letting it to receive rental income. Such mortgages are thus for investment purposes rather than residential occupation by the borrower.

C Back to top

Capital

Long term finance. The capital of a company is its equity and long-term debt. Capital markets are financial markets to raise such finance.

Capital Asset Pricing Model (CAPM)

A model to determine the cost of equity of a company. The equity cost (Ke) is a premium (Rm) over the rate free rate of return(Rf), adjusted for the volatility of that company's returns relative to the market (its Beta). Cost of equity = Rf + Beta * (Rm-Rf). Investors in more volatile (more risky) shares thus can expect a higher rate of return Ke.

Capital adequacy

The level of capital (equity and equity-equivalent securities) of regulated entities (banks, building societies, and insurance companies) that is considered adequate by regulators to support their assets. More risk assets will require more capital. Basle 2 is the latest set of regulatory rules governing the capital adequacy of affected entities.

Capital structure

The relative amounts and types of a company's capital liabilities (basically, its debt and equity) (see Gearing ratio). For example, some companies have much more debt than equity (such as banks where debt can be 20 times the equity). Other companies have no debt only equity (such as some pharmaceutical companies); others have a ratio between these extremes. Considerable research has been undertaken on the determinants of a company's capital structure. One determinant is the industry the company belongs to i.e., the rate at which it generates cash flow.; another is its stage of development. The optimum capital structure of a company is that which maximises company value.

Capitalisation

Converting an amount, such as interest, into capital. In mortgages, interest that has not been paid can be added to the principal to become principal also, on which interest is charged. The interest previously owed no longer appears as interest payable. This has the effect of artificially improving the appearance of loans that had interest arrears.

Collar Back to top

A combination of an interest rate cap option and an interest rate floor option. The effect is to create a range over which interest rates can rise or fall but beyond which a different effect is observed, depending on whether these options have been sold or bought. For example, if a collar consists of a cap bought and a floor sold, then if rates rise, the cap holder will pay rates up to the cap. If rates fall, the lowest rate the floor seller will pay is the floor rate. This collar would be suitable for a borrower who is concerned about the risk of rising interest rates on debt and does not expect rates to fall over the period of the floor, and who wants to offset the premium cost of the cap with premium income of the floor.

Commercial paper (CP)

An unsecured promissory note issued by companies to capital market investors, with a maturity of up to 1 year. Since the CP is unsecured, issuers tend to be highly-rated. CP secured by assets is called asset-backed CP (ABCP). CP is arranged as a programme of issuance enabling the issuer to issue CP and repay it periodically (similar to a revolving credit facility - see Credit facility). CP programmes are provided and administered by banks, using their conduits. An ABCP programme where the bank has multiple issuers using it is called a multi-seller programme. The assets can vary ranging from cars, mortgages, leases, credit cards, and other assets. Interest is in the form of a discount on the face amount of the CP issued.

Commitment Fee

A fee payable to a lender on a loan that commits the lender to lend when the borrower requests a loan. To make the loan available when requested, the lender will have to set aside capital to support the commitment. The fee is calculated by applying a percentage figure to the loan amount for the period of the commitment. The cost of capital determines the percentage figure. To encourage borrowers to use the loan facility, some lenders charge a non-utilisation fee based on the unused amount of the loan.

Conduit

A company that acts as an intermediary between a company that is borrowing and lenders. This might be necessary where the company wants to pledge specific assets as security rather than the whole of the company's assets and which are to be ring-fenced from the company's credit risk (see Asset Securitisation). Conduits are sometimes called Special Purpose Vehicles (SPVs).

Contrarian

An investor who buys securities when their price is falling, which is contrary to the actions of most other investors who are selling the same securities because their price if falling, and who aims to sell the securities when their price rises, to earn a capital gain. This contrasts with a momentum investor.

Convertible Back to top

The ability to convert a financial instrument into another instrument. For example, the holder of a convertible bond has the right to convert it into equity. Companies issuing convertibles offer this incentive in return for paying a lower interest rate compared to debt that is not convertible.

Corporate Finance

A wide-ranging subject that deals with practical aspects such as the raising, investing, and managing a company's finances, and academic aspects such as deriving hypotheses and theories of corporate financial markets, behaviour, and activities, such as how companies determine their capital structure, whether capital markets are efficient, the evolution of financial products, how to price assets (the capital asset pricing model) or cash flows (e.g. the adjusted present value methods). Applied Corporate Finance is the application of the knowledge of corporate finance.

Cost of capital

The cost of a company's debt and equity. This is sometimes calculated as a weighted average, and called its weighted average cost of capital (WACC). For debt, the cost is basically the interest rate after corporation tax, but could also include costs of borrowing such as commitment and arrangement fees. The cost of equity is the rate of return shareholders require for investing in the company's shares, including issue costs and capital appreciation. The equity cost can be determined by using the Capital Asset Pricing Model (CAPM) or other models, in addition to market data on the company's share price and dividend. See also Capital structure.

Covenant

A promise given by a borrower to the lender in relation to the loan. For example, a covenant that the borrower will not sell certain assets or grant security over them to another lender. Breach of a covenant (see Default and Gearing) might lead to serious consequences.

Credit crunch Back to top

Jargon meaning there is a shortage of credit (finance) available to companies. The current situation in financial markets where banks have reduced their lending to each other and to companies in the wake of the sub-prime mortgage market defaults, or have made their lending terms more onerous, is an example of a credit crunch.

Credit facility

An agreement between a lender and a borrower whereby the lender makes credit (money) available to the borrower over a period of time according to the terms and conditions set out in the facility agreement documents. Credit facilities are available in many forms to suit the borrower. A bilateral loan facility is an example of a credit facility, between two parties. A syndicated credit facility is a facility between a group (syndicate) of several lenders lending collectively to one borrower (or to a group of borrowers). A revolving credit facility is one where the loan is repaid and may be re-borrowed several times, so has the effect of principal revolving. A term loan facility by contrast is usually borrowed once and repaid without the ability to re-borrow the principal repaid. A multi-currency credit facility allows money to be borrowed in multiple currencies.

Credit rating

An independent assessment by a credit rating agency of the likelihood that a company will pay principal and interest owed by it to an investor, on time. These agencies use codes to indicate their rating, for example, a AAA rating assigned to a company is the highest possible and indicates that the company is extremely unlikely to default, whereas a company whose rating is below BBB is much more likely to default. Ratings exist for short periods (up to 1 year) and longer periods, e.g., a company can have a short term rating of A1+ (the highest possible) and a long term rating of BBB+, indicating it is extremely unlikely to default in the short term but has a greater likelihood of defaulting over the longer term, but not as great as a BBB company. Companies and their debt can have separate credit ratings to reflect the particular risk of each. For example, a company may issue debt whose risk of repayment would be unaffected if the company experienced financial distress, in which case, the debt could have a higher credit rating than the company itself. The rating can be upgraded or downgraded periodically to reflect the changing risk of the debt or company.

Credit risk

The risk that a lender will not receive their investment and the agreed return on it, because the borrower defaults on the terms of the agreement. Companies that are more likely to default pay a higher interest rate owing to their higher credit risk.

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Debt

One of the main forms of finance raised by companies (the other being equity). It is characterised by having an interest rate payable on it, usually, (there are forms of debt that have no interest payable - zero-coupon debt), the principal must be repaid (except for perpetual or irredeemable debt), interest is payable periodically (e.g., monthly, quarterly, annually), the interest rate is either fixed or variable, the debt principal is repaid either in full on the maturity date or by installments prior to maturity, can be for periods from overnight to 100 years or longer. There are many other characteristics and terms and conditions that are set according to what the borrower and lender negotiate. These terms are often set out in a formal loan agreement. Debt is less risk than equity since it is expected to be repaid before equity if the company is liquidated.

Depreciation

This has two financial meanings:

a)The process where the value of an asset is reduced over time to reflect its deterioration in value caused by wear and tear and obsolescence. This value after depreciation is recorded in the company's balance sheet to give a fairer assessment of value than if the original value were stated. For example, a car bought new for £10000- and which has a useful life of 5 years will depreciate in value by £2000 yearly (using the straight-line depreciation method) as it gets used and newer models appear. Its book value after 3 years will be £4,000. If the depreciation were an accurate indicator of the car's market value, then if the car were sold after 3 years, the company should receive £4,000 for it - which is what the balance sheet said it was worth at that time.

b) The decrease in the value of a currency in relation to another currency. For example, if the US dollar could be exchanged for £1 at £1:$1.50 one year ago but would be exchanged now at £1:$2.0, the $ has depreciated against the £ (the £ has appreciated against the $).

Default

The event where a company has failed to meet one or more terms set out in an agreement. For example, if the company borrowed money and agreed to maintain a ratio of debt to equity of 2:1, but this ratio was actually 3:1, then the company has breached this covenant and is in default. The lender might be able to take remedial action against the company - such as demanding full repayment of the loan. A cross-default is the situation where default of one agreement automatically triggers defaults in other agreements.

DCF Back to top

Discounted cash Flow is the mathematical process to determine the present value of a stream of future cash flows. It is based on the concept that cash received in future is less valuable than cash received today, so future cash flows are discounted to convert them into a present value. Once all cash flows are shown as present values, one stream of cash flows (a project) can be compared to another stream even though the cash flows occur at different times. DCF is thus useful to compare steams of cash flows that are different. Where an investor has limited cash to invest, he/she will tend to invest in the project that has the highest present value. The discounting is performed using a discount factor which is a rate of interest whose value is determined by investors' risk-adjusted required rate of return for investing in a stream of cash flows. The riskier the stream of cash flows. or the longer the time in future when they occur, the higher the discount rate so the lower their present value. Cash flows. that represent inflows have a different sign to outflows so their present values are netted to produce the net present value (NPV).

Distressed debt

Debt whose market price has fallen significantly (e.g., below 70% of its face value), or debt of a company that is insolvent or in bankruptcy, or debt that is trading at a yield substantially above government debt. Certain investors choose to invest in such debt if they believe the company will recover and its debt value rise, so providing investors with a capital gain.

Economic risk

A form of currency risk that relates to future unknown trade receipts or payments. For example, an exporting company expects to sell its products overseas in future but it is not certain how much it will sell or to which countries. Because it is not sure how much currency exposure it has, it is difficult for it to manage its currency risk precisely in advance. This exposure might rise or fall in relation to the corresponding economic exposure of its competitors who are located in another country and which also exports to the same buying company that is located in a different company to both exporters. See Transaction risk; Translation risk.

Efficient Market Hypothesis

A theory that markets are efficient in the distribution of information about them to those involved in them. Where markets are strongly efficient, all information is available at the same time to all participants so there is no opportunity for one participant to have an advantage over another. The existence of insider dealing in a market (such as the equity market) proves that that market is not strongly efficient, at that time, but semi-strong. Other markets, such as the FX market in major currencies, are considered to be more efficient than others much of the time.

Equity Back to top

One of the two main types of finance available to companies (the other being debt). Equity is characterised by: not being repayable by the receiver, the periodic return to the holder of equity is in the form of a dividend plus an appreciation in the value of the principal amount; ownership of the company; voting rights; being last in line to receive proceeds if the company is liquidated. There are various forms of equity. The characteristics described above refer to the riskiest type of equity: ordinary shares. Shares that are less risky because they receive preferential treatment, are called preference shares.

Eurobond

A form of bond issued in a jurisdiction that is NOT that of the currency the eurobond is denominated in. For example a euro-yen bond is a bond denominated in Yen issued outside of Japan. The borrower targets balances of Yen held outside of Japan, for example by companies that have accumulated large balances of Yen in bank accounts held at European banks, perhaps through trade with Japanese companies.

First charge

The lender with a first charge over specific security provided for a loan, has the right to the proceeds of the sale of the security before second charge holders. A first charge is thus a form of senior debt whereas a second charge is subordinated debt. See Subordinated.

Forward contract Back to top

A currency hedging instrument that fixes the buyer's exchange rate on the future settlement date of a foreign currency payable or receivable so it is not dependent on the spot rate at that time. See Transaction risk. In the example, the Canadian exporter could have used a forward contract (with a forward rate of say C$1:€0.65) that settles on the invoice settlement date. This would have produced C$985,000 - considerably more than if no hedge had been taken out and the spot rate used was C$1:€0.70 Forward contracts are the currency equivalent of forward rate agreements (FRAs) used to manage interest rate risk. See Forward Rate Agreement (FRA).

Forward Rate Agreement (FRA)

An interest rate hedging instrument that fixes the FRA buyer's interest rate for the period of the FRA. For example a 3v9 FRA with a rate of 8.5% will fix the buyer's interest rate at 8.5% pa for 6 months starting in 3 months' time, regardless of what the market rate is in 3 months' time. A company due to borrow at variable rate in 3 months' time for 6 months, that is concerned about rising interest rates could buy a FRA to fix its cost of interest at 8.5%, thereby removing the risk of rates rising. If rates actually fell, the borrower would still be obliged to pay an effective interest rate of 8.5%. See Interest Rate cap

Freehold

The absolute right of ownership in perpetuity over an asset - including the right to sell it. Sometimes, the freehold is registered with a registry (such as the Land registry). Title deeds are legal documents providing details of the asset (such as a map of its location) and any charges over it. Leasehold property is property that the occupier does not own but holds a lease instead, according to which the leaseholder pays the freeholder a rent for its use. Leases have defined end dates (such as 5 or 55 years) after which the property is handed back to the freeholder. Many flats and shops are leased.

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Gearing

The ratio of debt to equity of a company (sometimes stated as: debt to (debt plus equity)). It is sometimes called leverage. Companies with a high ratio are at risk of being unable to pay interest on the high level of debt if their company's performance deteriorates (in a recession for example), i.e., of getting into financial distress. To avoid this, lending banks might insist on a covenant in loan documents that limits the company's gearing ratio. see Capital structure; Covenant; Default

GDV

Gross Development Value. The projected value of a property development when completed. A percentage of GDV is taken to determine the maximum loan amount a company will lend to the property developer.

Gilts

UK Government long-term debt.

Haircut

Jargon that means a deposit invested by a borrower and demanded by a lender (who provides a loan), which acts as a first loss on an investment purchased with the haircut and the loan. The haircut can increase or decrease depending on the market value of the corresponding investment.

Hedge

Jargon that means: taking protection. For example, an interest rate hedge means taking protection against interest rates. An interest rate swap is a hedging instrument, i.e., an instrument that can be used for protection.

Hedge fund

An investment fund managed to generate a positive (absolute) return for investors rather than beating a benchmark that might be negative from time to time. The fund has relatively more scope to generate returns such as short-selling, derivatives, FX, and distressed debt, to complement securities held by more conservative funds such as mutual funds, such as equities and bonds.

High water mark

The level of earnings a fund must reach before the fund's manager is entitled to receive a performance fee for a particular year. The level can be that at which performance fees were last payable.

Hurdle rate

A rate of return, expressed as a percentage, which must be reached before a performance fee is payable to a fund manager. It is often set in relation to a benchmark rate, such as LIBOR. A hurdle rate can also be a minimum rate of return that an investment project must achieve for it to be accepted. The rate is often the project's cost of finance or weighted average cost of capital (WACC). See Weighted average cost of capital.

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Interest rate swap

A hedging instrument (see Hedge) that changes the interest rate paid or received by a company and in so doing, protects the company from interest rate risk. For example, consider a company that has a loan from Bank A whose interest rate is fixed and whose income rises or falls as market interest rates rise or fall. The company will be unable to pay a low interest rate if market interest rates fall. This would reduce its earnings because its income will fall as interest rates fall and in extreme situations the company might default on its loan agreement. The company has exposure to interest rate risk. The company may mitigate this risk by entering into an interest rate swap with a bank (Bank B) whereby Bank B pays a fixed rate of interest to the company and the company pays Bank B a variable rate of interest. The company uses the fixed rate interest received from B to pay A and pays B the lower interest rate as market rates fall. With this swap, the company is able to lower its interest payment amount to match more closely the fall in income as interest rates fall. Conversely, if interest rates unexpectedly rise, the company is not exposed because the higher income will offset the higher interest payable on the swap. Many variations of this basic swap are available.

Interest Rate Cap

A hedging instrument that is an option contract (see Hedge; see Option) that protects the holder from rising interest rates but also allows the holder to benefit from falling interest rates (compare to a FRA). If a company has a loan where interest is a variable rate and market rates of interest might rise above 8% (thereby reducing the company's earnings), the company could protect against rates rising above 8% by buying a cap with a strike rate of 8%. If rates do rise (say, to 9%), the company will pay 9% on the loan, but it would exercise its cap and claim compensation of 1% from the cap seller so the company's net cost would be 8%. If the market interest rate unexpectedly fell to 5%, the company would not exercise its cap and instead would pay the market rate of 5%. See also Interest rate floor, and Collar

Interest Rate Floor Back to top

A hedging instrument that is an option contract (see Hedge; see Option) that protects the holder from falling interest rates but also allows the holder to benefit from rising interest rates (compare to a FRA). If a company has a deposit where interest is a variable rate and market rates of interest might fall below 4% (thereby reducing the company's income), the company could protect against rates falling below 4% by buying a floor with a strike rate of 4%. If rates do fall (say, to 3%), the company will receive 3% on the deposit, but it would exercise its floor and claim compensation of 1% from the floor seller so the company's net income would be 4%. If the market interest rate unexpectedly rose to 5%, the company would not exercise its cap and instead would receive the market rate of 5%. See also Interest rate cap, and Collar

Insolvency

The state where a company fails to pay its liabilities as they fall due. This could be because the company is under financial distress, such as insufficient cash flow to pay interest.

J Back to top

Junk

Low credit status, high risk securities. For example, high-yielding bonds are called junk bonds.

Jumbo

Jargon meaning high value. For example, residential mortgages over a certain limit (e.g., £1 million) could be called jumbo mortgages.

LBO

Leveraged Buy Out. The process where a group of investors (some of whom will be managers of the company) raise relatively high levels of debt to finance the buyout of a division or company from another company. The high level of debt in relation to equity means the company is leveraged, hence the description: leveraged buyout. The investors will include former managers of the company bought. They and the LBO investors manage the LBO with the aim of selling their investment for a substantial return in a relatively short period of time, around 5 years, by making the company a public company or selling it to another company. The LBO investors often take a close interest in the running of the LBO including a seat on its board. If a buyout is not as highly leveraged and does not involve outside investors who are as active as LBO investors, and there is no determined exit strategy, the buyout is referred to as a management buyout (MBO) or management buy-in (MBI). See Venture capital.

Leasehold Back to top

See Freehold

LIBOR

Abbreviation of London Interbank Offered Rate. The variable interest rate set by banks daily at which they will lend to each other for specific periods ranging from overnight, 1 week, 1 month, 3 months, 6 months to 12 months. At the end of the period, the LIBOR rate is reset for a further period. LIBOR is often used as the rate banks will lend to companies, plus or minus a margin (see Margin).

LTV

Loan to Value ratio. It indicates the amount of a loan in relation to the value of the underlying security. For property transactions, lenders might limit their loans to a LTV limit, e.g., 75% of the security's market value at the time of the loan. This gives the lender a cushion (an equity cushion) in case the property value declines, i.e., the value could decline by 25% and the lender would still recover its loan by selling the property for 75% of its original value. The loser of the 25% is the equity cushion provider, i.e., other investor in the property (usually the buyer). See Negative equity

M Back to top

Margin

This can have multiple meanings

a) The additional interest rate (on top of the underlying rate such as LIBOR) charged by banks for loans to companies. For example, a bank might charge a rate of LIBOR plus 50 basis points per annum on a loan. The size of the margin is a reflection of the credit risk of the borrower. Margins can change under certain events, such as failure to pay on time, or after a certain period of time has elapsed. See LIBOR

b) The difference between the rate earned on assets and the rate paid on liabilities, of a company. For example, a company that is in the business of lending money might charge LIBOR plus 3% on loans it provides and pay LIBOR plus 1% on loans it receives, so its gross margin (before operational costs such as salaries and rent) is 2% of the loans.

Material Adverse Change (MAC)

A clause in loan agreements which gives the lender the right to recover the loan if it believes in its opinion, that the borrower has undergone a material adverse change. A change might be the sale of assets, an acquisition, a change of strategy, a loss of a supplier. The key concern for the borrower is that the lender makes a subjective decision that the borrower feels is unreasonable.

Mezzanine debt

Debt that sits in a company's capital structure between senior debt and equity (hence the name, mezzanine). It has a higher rate of interest than senior debt because it is lower in the pecking order, (and so carries greater risk of loss) and might be convertible into equity.

Momentum investor

An investor who buys securities when their price is rising and sells when their price falls. The strategy contrasts with that of a contrarian investor.

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Negative equity

The situation where the value of an asset (e.g., property) has declined in value below the equity investor's original investment. See LTV.

Net Present Value (NPV)

See DCF

Nominal

The face value of a security, which might be different from its market value. For example, companies might issue shares with a nominal value of £0.05 but whose market value might be £0.22. In relation to debt securities, such as a bond, the nominal value is used for calculating interest and repaying the loan at its maturity date.

O Back to top

Offer

See Ask

Offering circular

Document prepared by a bank for a company that wishes to raise money in the capital markets. It provides details to prospective investors of the transaction, e.g., parties involved and their roles, amount to be raised, interest rate, maturity, currency, repayment, the assets as security, and the company's activities and senior management. Details of risk factors investors should be aware of are also included. see Terms sheet

Option

A financial instrument that gives the holder the right but not the obligation to take some action or not take it. See Interest Rate Cap for an illustration of an option. Holders of options usually pay a premium to buy them, and sellers receive a premium for selling them. The premium is affected by the option strike rate (the level at which it is worthwhile to exercise), how long it is available for, the level of market interest rates, the volatility of the underlying rate or asset price (e.g. an interest rate option will have a higher premium if the rate it is associated with is very volatile versus a rate that is stable).

Par

This usually means 100% of the face value of a security. For example, if a bond is issued at par and has a nominal value of £100, investors would pay the face value of the security for it (£100). If it were issued at a discount, say of 2%, they would pay below par (£98). If the security was issued above par (at a premium) investors would pay more than £100. See Nominal.

Planning gain

An investment in land that has the potential for receiving planning consent from the local authority to build property on it (usually residential property), which is expected to increase its value many times over, providing a capital gain for the investor.

Premium

See Par

Prepayment

See Redemption Back to top

Redemption

The repayment (called prepayment if the redemption is before the maturity date of the agreement) of money to investors or lenders by borrowers. For example, when a borrower repays his/her mortgage, the mortgage is redeemed. The rate of redemption (sometimes called the prepayment rate if the loan is redeemed before its maturity date) is affected by market interest rates in relation to the mortgage rate. If the mortgage rate is relatively high and fixed, mortgage redemption rates will rise, i.e., more borrowers will decide to redeem their mortgages and take out new mortgages (remortgage) at the lower market interest rate.

Secondary market

A market where instruments and securities may be traded after they have been issued. For example, a company issues a eurobond in the Primary market. The next day, these initial buyers might sell their bonds to other investors in the secondary market. Companies can also use the secondary market to buy their own bonds back.

Security Back to top

This can have at least 2 meanings:

a) it is the pledging of an asset by a borrower to an investor in case the borrower defaults

b) it is another name for a financial instrument that is tradeable. Bonds, CP, FRNs, MTNs, are all securities. A bank deposit is a financial instrument but since it not tradeable it not a security.

Short-selling

The practice of borrowing and then selling securities (such as shares) of a company with the intention of buying them back later (and returning them to the lender) at a lower price than sold, so making a profit. Naked short-selling is the practice of selling securities that have not been acquired first, and is illegal. In naked short-selling, a hedge fund might inform its broker to sell shares which in fact the fund does not have, but says it has. The broker, acting in good faith, sells these shares, which settle as a 'fail to deliver' trade because the fund cannot deliver shares it does not own. Alternatively, the broker, might be instructed by the hedge fund to locate and borrow the shares to be short sold. The broker, wanting to retain the hedge fund as a client, might falsely sell shares it cannot locate, or it will sell shares it has already sold on behalf of other hedge fund clients, so short-selling the same shares several times and collecting several sets of transaction commissions.

Subordinated

Lower in status or rank. For example, debt that ranks behind senior debt when lenders are repaid from proceeds of a liquidation of a company, is considered subordinated debt. Since equity is repaid last, equity is subordinated to subordinated debt. Debt that ranks between subordinated and senior debt is called mezzanine debt. Subordinated debt is sometimes called junior debt

Stress test

A test that credit rating agencies perform on a transaction to be assigned a credit rating to determine if the transaction is able to withstand a stressed scenario, such as extreme asset value deterioration, high interest rates payable on debt or low income on assets, high asset defaults, economic recession, counterparty default. If the transaction is able, this will confirm the intended credit rating to be assigned. If it fails, the transaction might be assigned a lower rating to reflect its higher risk, or instead it might be given additional support to withstand the stresses (such as additional equity or more assets). These enhancements are costly for a company so undesirable. On the other hand, if a rating is lower than desired, investors will demand additional interest or return from the company to compensate them for the greater risk of the transaction they are investing in.

Syndicated loan Back to top

See Credit facility

Terms sheet

A short document that sets out the major terms (final or indicative) of a proposed financing transaction. The document is prepared after negotiation between a company that wants to borrow and its advising bank and should take into consideration what potential lenders will expect - such as covenants and rate of return. It is sent to potential lenders for their consideration and to other parties that would be involved, such as credit rating agencies and lawyers.

Tranche

A portion of the total money raised in a financing transaction. For example, asset securitisation transactions often involve the issue of several securities simultaneously to investors. These securities have different terms and conditions (such as credit rating, currency, interest rate type, and maturity date) to suit different types of investors. Each type of security is called a tranche. In a £500m securitisation transaction their is usually at least 4 tranches of securities: the senior AAA-rated, the mezzanine AA-rated, the junior BBB-rated,,and the unrated subordinated loan tranche. Investors choose which tranche they wish to invest in.

Transaction risk Back to top

A form of currency risk associated with transactions involving receivables or payables denominated in a foreign currency whose value is known in the foreign currency (e.g., because there is an invoice outstanding) but not in the company's home currency. The risk is that the transaction's value to the company in its home currency will fall owing to an adverse movement in exchange rates prior to the transaction settlement date. For example a grain importer in Canada is owed €640,000 in 3 months' time when the grain invoice is due to be settled (paid in cash) in €. The exporter intends to sell the € for C$, and at today's forward rate the exchange would produce C$1million (C$1:€0.64). If the € depreciates to C$1:€0.70 on the settlement date, the value of the invoice will fall to C$914,000 - a reduction in value of C$86,000. Transaction risk can be managed using forward contracts (see Forward contracts; Economic risk; Translation risk)

Translation risk

A form of currency risk associated with assets and liabilities of overseas subsidiaries of a company that are denominated in a foreign currency. When the company's consolidated group accounts are produced, foreign currency values are translated into the home currency equivalent. This translation can create an exchange (translation) difference in the year-on-year value of those same assets and liabilities. The difference might necessitate a decrease in the equity value on the balance sheet which can send a negative market signal to shareholders possibly causing the share value to fall. Some commentators and practitioners do not hedge translation risk on the grounds that it is not a cash flow risk (unlike transaction risk), however,if the effect is to cause the gearing ratio to breach gearing covenants in loan agreements, the effect can become a cash flow. risk if the lending banks demand immediate repayment of their loans. See Transaction risk; Economic risk

U Back to top

Underwrite

To agree to provide funds in the event that insufficient funds are provided by the target group of investors. Companies who need certainty that their bond issue will raise the full amount expected, can ensure that they will get paid any shortfall in the amount provided by investors, by obtaining insurance from the underwriting bank. For example, if a company needs £100m but investors only invest £80m, the £20m shortfall is paid to the company by the underwriting bank buying the £20m of unsold bonds. As with most forms of insurance, the company will pay the underwriter a fee (premium) for removing the risk of a shortfall.

Venture capital

Finance provided to companies by investors called venture capitalists. This type of finance is targetted at high-risk high-return ventures, where the investors seek to recover their investment in a defined period (usually about 5 years) and where they exercise strong control of the venture and its managers. Often the venture is a new business seeking to exploit an opportunity such as a new product or market (for example, IT or oil exploration). The investors' exit route is usually by making the company a public company, i.e., offering its shares to investors, the proceeds of which are used to return the capitalists' investment plus their return on their investment. See Business Angels and LBO

Warehouse facility

A temporary bank loan which is used to enable a company to amass a portfolio of assets that are then refinanced with the proceeds being used to repay the warehouse facility. Refinancing often is in the form of a capital markets transaction, such as a bond issue, or asset securitisation.

Weighted average cost of capital

A company's cost of financing is often a mixture of debt and equity capital provided by investors. The corresponding investors' required rates of returns are weighted by the amounts of each capital, to form a weighted average cost of capital (WACC).

X Back to top

Yield Curve

A graphical presentation of interest rates over time. In a positive yield curve, interest rates are higher for longer maturities, possibly reflecting the extra return investors charge for relinquishing the use of their money for a longer period of time (liquidity premium) and/or the greater risk that their investment might not be returned by the borrower (credit risk premium).