Long-Term Debt And Leasing

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Long-Term Debt Financing

Public issue

• Must be registered with the SEC in U.S.

• Almost always issued with the help of investment bankers

• Vast majority are fixed rate offerings.

Private issue

• Loans: private debt agreements with a financial institution

• Term loans or syndicated loans• Most are floating-rate issues, with

the rate set as a fixed spread from some base interest rate.

• Private placements: unregistered issues sold directly to accredited investors

• Rule 144A: most popular private placement

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Debt Covenants

Contractual clauses within debt agreements that constrain borrowers’ actions

Positive covenants

• Things that the borrower “must do,” such as:

• Maintain satisfactory accounting records in accordance with GAAP;

• Maintain a minimum level of net working capital;

• Maintain life insurance on “key employees,” and

• Spend borrowed funds on a proven financial need.Negative

covenants

• Things that the borrower “must not do,” such as:

• Sell accounts receivable to generate cash;• Issue additional debt, unless firm requires

that additional debt be subordinated, and• Avoid certain types of leases or other fixed-

payment obligations.

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Cost of Long-Term Debt

Function of at least four factors

Loan maturity

• Yield curves typically slope upward.• Longer maturities mean longer

terms, and so greater exposure to default risk.

Loan size• Trade-off between administrative

cost per dollar and risk exposure that increases with the loan size

Borrower risk

• The greater the risk of default, the higher the rate that the lender will charge.

Basic cost of money

• The greater the prevailing rate on lowest-risk money (such as Treasury securities), the greater the rate on other loans.

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Term Loans

Private loans that financial institutions make to businesses.

Have initial maturities of more than one year. Generally have maturities of 5-12 years

Term lenders

• Commercial banks• Insurance companies• Pension funds• Regional development companies• Small business administration• Finance companies• Equipment manufacturer finance

subsidiaries

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Characteristics of Term Loans

Payment dates

• Usually monthly, quarterly, semiannual or annual payments

• Usually these payments fully pay the interest and principal over the life of the loan.

• May involve periodic payments followed by a balloon payment of the remaining principalCollateral

requirements

• Secured loans involve the pledging of specific assets as collateral.

• Reduces risk for lender

Stock purchase warrants

• Gives the lender the right to purchase a fixed number of shares of common stock at specified price over a fixed time period

• Can be used as “sweeteners” for both term loans and corporate bond issues

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Syndicated Loans

Large-denomination credit arranged by a group (syndicate) of commercial banks for a single

borrower

Eurocurrency lending: the Eurocurrency loan market is largely a syndicated loan market.

Project finance : loans arranged for infrastructure projects such as toll roads, bridges, etc.

Over $2 trillion worth of syndicated loans are arranged annually (two thirds of which are

corporate).

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Corporate Bonds

Debt security carrying a promise to pay cash flows to the holder

Most maturities range from 10 to 30 years with a par (face) value of $1000

• Main types• Debentures• Subordinated debentures• Income bonds• Mortgage bonds• Collateral trust bonds• Equipment trust certificates

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Legal Aspects of Bonds

Bond indenture

• The bond contract, which specifies:• Payments and payment dates;• Positive and negative covenants;• Security (any collateral), and• Any sinking fund requirements.

Trustee

• Third party who ensures that the issuer does not default on contractual responsibilities

• Can be an individual or a corporation; most often a commercial bank trust department

• Services paid for by the issuer.

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Methods of Issuing Corporate Bonds and Common Features

• Shelf registration• Often used when issuing bonds• Allows firms to register large amounts of debt, then

sell the securities over time as market conditions warrant

• Rule 144A• Allows institutional investors to trade non-registered

securities among themselves• Created a new market for privately-placed issues,

including debt securities• Three special features are often included in the bond

indenture• Call feature• Conversion feature• Stock purchase warrant attachments

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Common Features of Corporate Bonds

Call feature allows the issuer to repurchase bonds prior to maturity at a certain call price.

Call feature gives the issuer the ability to retire an issue early when interest rates fall, so this benefits

issuers.

Conversion feature allows bondholders to change each bond into a stated number of shares of

common stock.

Stock purchase warrants give the bondholder the right to purchase a certain number of shares at a

specified price over a certain period of time.

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International Corporate Bond Financing

Eurobonds

• Issued by an international borrower and sold to investors in countries whose native currency is different than the bond’s denomination

• For example, bonds sold in Europe by a U.S. firm, denominated in U.S. dollars

Foreign bonds

• Bonds issued by an international borrower in a foreign country, denominated in the foreign country’s currency

Most international bonds are bearer securities

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Bond Refunding Options

A firm has two options if it tries to avoid a single repayment in the future or wants to refund a bond

prior to maturity:Serial bonds are issues with staggered maturities, often with different interest rates paid to various

maturities.

If interest rates drop, issuers with call provisions may consider a refunding (refinancing) operation.

Existing bonds are retired; new, lower-interest bonds issued.

Bonds are called when the marginal benefit of doing so (stream of reduced paid interest) exceeds

marginal cost.

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Bond Refunding Analysis

• Step 1: Find the initial investment required to call the old issue and issue new bonds:

• Include the call premium, flotation costs of the new bond, overlapping interest, unamortized discount and flotation costs of the old bond.

• Step 2: Find the cash flow savings:• Largest impact will be from the differential interest costs.

• Step 3: Find the NPV of the refunding operation:• If NPV > 0, the refunding operation is recommended.

Refunding decision is based on capital budgeting analysis

The capital budgeting procedure:

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Bond Refunding Analysis: Example• Contemplated bond refunding operation:

• Existing bond issue ($50 million)• 30-year bonds issued 5 years ago with a coupon

interest rate of 9%, callable at a price of $1,090• Initially issue netted $48.5 million due to a discount of

$30 per bond• Initial flotation cost was $400,000

• Proposed bond issue ($50 million of 25-year bonds)• Expected to sell at par value with a coupon interest

rate of 7%• Flotation costs estimated at $450,000

• Other Data• Firm’s tax rate is 30%; after-tax cost of debt is 4.9% =

(1-0.30) x 7%• Two months of overlapping interest is expected

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Step 1: Find the Initial Investment

After-tax cost of the call premium:

• Call premium: $90 per bond, (tax deductible)• Before taxes ($90 x 50,000 bonds) $4,500,000• Less: tax savings (0.30 x $4,500,000) 1,350,000• After-tax cost of premium $3,150,000

Flotation cost of new bond was given as $450,000.

Overlapping interest:

• Before taxes ($0.09 x (2/12) x 50,000 bonds) $750,000• Less: tax savings (0.30 x $750,000) 225,000• After-tax cost of overlapping interest $525,000

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Step 1: Find the Initial Investment

Unamortized discount on old bond

• Discount ($1,500,000 = $50,000,000 - $48,500,000) was amortized over thirty years

• Only five years of amortization have been used• Firm can deduct the remaining twenty-five years as a lump sum• Reduced taxes (25/30 x $1,500,000 x 0.30) ($375,000)

Unamortized floatation cost of old bond:

• Initial floatation cost ($400,000) was amortized over thirty years• Reduced taxes (25/30 x $400,000 x 0.30) ($100,000)

Initial investment is $3,650,000

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Step 2: Find the Cash Flow Savings

• Interest cost of old bond• Annually: ($50,000,000 x 0.09 x (1-0.30)) $3,150,000

• Amortization of discount on old bond• Annually: (($1,500,000/25) x 0.30) ($15,000)

• Amortization of floatation cost on old bond• Annually: (($400,000/25) x 0.30) ($4,000)

• Interest cost of new bond• Annually: ($50,000,000 x 0.07 x (1-0.30)) ($2,450,000)

• Amortization of flotation cost on new bond• Annually: (($450,000/25) x 0.30) $5,400

• Total annual cash flow savings $686,400

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Step 3: Finding the NPV of the Refunding Operation

Since the NPV is positive, recommend the bond refunding operation.

• Present value of cash flow savings $9,771,792 ($686,400 per year for 25 years, discounted at 4.9%)

• Less: total initial investment $3,650,000• Equals NPV $6,121,792

792,771,9$(1.049)

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0.049

1400,686$

r)(1

11

r

1400,686$PVA

25nnr

• Present value of cash flow savings computed as annual cash flow savings x Present value interest factor of a r %, n-year annuity (PVAr,n)

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Leasing

Similar to long-term debt, leases involve periodic, tax-deductible payments.

Lessor

• Owner of the asset• Retains the tax benefit associated with

ownership of the asset

Lessee• User of the asset• Makes payments to the lessor under the

terms of the lease

Payments may be fixed or variable.

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Leasing

Operating leases

• For relatively short-lived assets, such as computers or automobiles

• Can be cancelled after some time period• May be re-leased by lessor after initial

leasing agreement• Lessor’s original cost generally exceeds

total value of original lessee’s payments

Financial (capital) leases

• For longer-lived assets such as land, buildings, and large pieces of equipment:

• Cannot be cancelled, obligate the lessee to make payments over a defined period of time

• Total payments are greater than the lessor’s cost.

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Leasing Arrangements

Direct lease

• Lessor acquires the asset(s) to be leased to the given lessee (did not previously own the asset).

Sale-leaseback arrangeme

nt

• One firms sells an asset to another for cash, then leases the asset from the new owner.

• Attractive for firms that need cash and are willing to exchange a promise to make periodic lease payments for immediate cash.

Leveraged leases

• A third party lender is involved.• Lessor provides only a portion, about 20%

of the asset value; lender provides the balance.

• Popular way of structuring very expensive leases

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Leasing Arrangements

Maintenance clauses

• Leasing agreements usually specify who is responsible for maintenance of leased assets.

• Operating leases usually require the lessor to pay for maintenance, insurance, and taxes.

• Financial leases usually require lessee pay these costs.

Renewal options

• Lessee usually has the option to renew a lease at expiration.

• Operating leases commonly can be renewed, as the useful life of the asset normally extends beyond the original lease.

• Instead of renewing the lease, lessee may also have a purchase option at the end of the original leasing agreement.

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The Lease versus Purchase Decision

Alternatives

• Lease the asset• Borrow funds and purchase the asset• Purchase the asset with available liquid

resources

Employ a capital budgeting framework:

• Step 1: Find the after-tax cash outflows under the lease alternative.

• Step 2: Find the after-tax cash outflows under the purchase alternative.

• Step 3: Calculate the present value of the expected future cash flows under each of the alternatives, discounting at the firm’s after-tax cost of debt.

• Step 4: Select the alternative with the lower present value of expected cash outflows.

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Effects of Leasing on Future Financing

Similar to long-term debt, leases involve periodic, tax-deductible payments.

FASB (13) requires explicit disclosure of financial lease obligations on the firm’s balance sheet.

Must be shown as both an asset and as a liability on firm’s balance sheet.

Under FASB (13), calculated financial ratios assessing debt load will include leases along with

other obligations.

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Advantages and Disadvantages of Leasing

Advantages

• Allows for the effective depreciation of land, which is not allowed when land is purchased

• Sale-leaseback can enhance firm liquidity.• Leasing can provide 100% financing.• Lower claims against the firm in bankruptcy• Avoid restrictive covenants that would likely

be present in a long term loan agreement• May enhance a firm’s financing flexibility

Disadvantages

• Leases do not have stated interest cost. Effective cost may be considerably higher than if the firm borrowed money.

• At the end of the lease, lessee does not receive any “salvage value” associated with the asset.

• Lessee may not be allowed to modify or improve leased assets without lessor’s approval.

• Even if assets become obsolete or unusable, the remaining lease payments must be made.

Long term debt and leases are important sources of capital for businesses.

The conditions of a term loan are specified in the loan agreement.

The conditions of a bond issue are specified in the bond indenture.

Leasing serves as an alternative to borrowing funds to purchase an asset.

Long-Term Debt And Leasing