Medium To Long-Term Debt Markets

Chapter 10
Medium- to long-term
debt
Copyright  2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 10-1
Slides prepared by Peter Phillips
Learning objectives
• Identify the main types of medium- to long-term debt
instruments in the market
– Term loans or fully drawn advances, mortgage finance,
bond markets (debentures, unsecured notes and
subordinated debt) and lease financing
• Describe the main features of these facilities
• Identify the financial institutions and parties involved in
the provision of these facilities
• Undertake calculations related to the pricing of these
debt instruments
• Discuss the availability and appropriateness of these
debt instruments for business

Chapter organisation
10.1 Term loans or fully drawn advances
10.2 Mortgage finance
10.3 Debentures, unsecured notes and subordinated
debt
10.4 Calculations: fixed-interest securities
10.5 Leasing
10.6 Summary

• Term loan
– A loan advanced for a specific period (three to 15 years),
usually for a known purpose; e.g. purchasing land,
premises, plant and equipment
– Secured by mortgage over asset purchased or other assets
of the firm
• Fully drawn advance
– A term loan where the full amount is provided at the start of
the loan
• Provided by:
– mainly commercial banks and finance companies
– to a lesser degree, investment banks, merchant banks,
insurance offices and credit unions
(cont.)
(cont.)
• Term loan structures
– Interest only during term of loan and principal repayment on

maturity
– Amortised or credit foncier loan

▪ Periodic loan instalments consisting of interest due and
reduction of principal
– Deferred repayment loan

▪ Loan instalments commence after a specified period related to
project cash flows and the debt is amortised over the remaining
term of the loan (cont.)
(cont.)
• Term loan structures (cont.)
– Interest may be fixed (for a specified period of time; e.g.

two years) or variable
– Interest rate charged on term loan is based on:

▪ an indicator rate (e.g. BBSW or a bank’s own prime lending
rate) and is also influenced by:
• credit risk of borrower—risk that borrower may default on loan
commitment, giving rise to a risk premium
• term of the loan—usually longer term attracts a higher interest rate
• repayment schedule—frequency of loan repayments (e.g. monthly
or quarterly) and form of the repayment (e.g. amortised or interest-
only loan) (cont.)
(cont.)
• Term loan structures (cont.)
– Other fees include:

▪ establishment fee
▪ service fee
▪ commitment fee
▪ line fee
▪ bill option clause fee
(cont.)
(cont.)
• Loan covenants
– Restrict the business and financial activities of the borrowing
firm
▪ Positive covenant
• Requires borrower to take prescribed actions; e.g. maintain a
minimum level of working capital
▪ Negative covenant
• Restricts the activities and financial structure of borrower; e.g.
maximum D/E ratio, minimum working-capital ratio, unaudited
periodic financial statements
– Breach of covenant results in default of the loan contract,
entitling lender to act
(cont.)
(cont.)
• Calculating the loan instalment—ordinary annuity
A
R
1 (1 i )n
[ ]
i
where :
R  the instalment amount
A  the loan amount (present value)
i  the current nominal interest rate per period expressed as a decimal
n  the number of compounding periods.
(cont.)
(cont.)
(cont.)
– Example 1: Floppy Software Limited has approached Mega

Bank to obtain a term loan to finance the purchase of a new
high-speed CD burner. The bank offers a $150 000 loan,
amortised over five years at 8% per annum, payable
monthly. Calculate the monthly loan instalments.
(cont.)
(cont.)
(cont.)
– Example 1 (cont.)
A  $150 000
0.08
i  0.006667
12
n  5 years  12 months  60
$150 000
R
1 (1 0.006667)60
[ ]
0.006667
R  $3041.49 per month (cont.)
(cont.)
• Calculating the loan instalment—annuity due
A
1 (1 i )n
R
[ ](1 i )
i
(cont.)
(cont.)
• Calculating the loan instalment—annuity due (cont.)
– Example 2: A business proprietor is purchasing a computer

system for the business at a cost of $21 500. A finance
company has offered a term loan over seven years at a rate
of 12% per annum. The loan will be repaid by equal monthly
instalments at the beginning of each month. Calculate the
amount of the loan instalments.
(cont.)
(cont.)
– Example 2 (cont.)
A  $21500
0.12
i  0.01
12
n  7  12  84
$21500
R
1 (1 0.01)84
[ ] (1  0.01)
0.01
$21500

57.21494
 $375.78 monthly instalment

debt
10.5 Leasing
10.6 Summary

• A mortgage is a form of security for a loan
– The borrower (mortgagor) conveys an interest in the land
and property to the lender (mortgagee)
• The mortgage is discharged when the loan is repaid
• If the mortgagor defaults on the loan the mortgagee is

entitled to foreclose on the property, i.e. take
possession of assets and realise any amount owing on
the loan
(cont.)
10.2 Mortgage finance (cont.)
• Use of mortgage finance
– Mainly retail home loans
▪ Up to 30-year terms
– To a lesser degree commercial property loans
▪ Up to 10 years as businesses generate cash flows enabling
earlier repayment
• Providers (lenders) of mortgage finance

– Commercial banks, building societies, life insurance offices,
superannuation funds, trustee institutions, finance
companies and mortgage originators
(cont.)
• Interest rates
– Both variable and fixed interest rate loans are available to
borrowers
▪ With fixed interest loans, interest rates reset every five years or
less
– With interest-only mortgage loans, interest-only period is
normally a maximum of five years
• Mortgagee (lender) may reduce their risk exposure to

borrower default by:
– requiring the mortgagor to take out mortgage insurance up
to 100% of the mortgage value
(cont.)
• Calculating the instalment on a mortgage loan
A
R
1 (1 i )n
[ ]
i
(cont.)
• Calculating the instalment on a mortgage loan (cont.)
– Example 3: A company is seeking a fully amortised

commercial mortgage loan of $650 000 from its bank. The
conditions attached to the loan include an interest rate of 8%
per annum, payable over five years by equal end-of-quarter
instalments. The company treasurer needs to ascertain the
quarterly instalment amount.
(cont.)
• Calculating the instalment on a mortgage loan (cont.)
– Example 3 (cont.):
A  $650 000
0.08
i  0.02
4
n  5  4  20
$650 000
R
1 (1 0.02)20
[ ]
0.02
 $39 751.87 monthly instalment
(cont.)
• Securitisation and mortgage finance
– Mortgage originators, commercial banks and other

institutions use securitisation to manage their mortgage loan
portfolios
– Involves conversion of non-liquid assets into new asset-

backed securities that are serviced with cash flows from the
original assets
– Original lender sells bundled mortgage loans to a special-

purpose vehicle
▪ That is, a trust set up to hold securitised assets and issue
asset-backed securities like bonds, providing investors with
security and payments of interest and principal
(cont.)
• The securitisation of mortgage finance suffered a large
contraction during the GFC.
– Securitised mortgage assets in 2007: $215 billion
– Securitised mortgage assets in 2010: $112 billion
• These falls were recorded in Australia despite the much
lower default rates experienced on mortgages
compared to other parts of the world.

debt
10.5 Leasing
10.6 Summary

10.3 Debentures, unsecured notes and
subordinated debt
• These securities are issued in the corporate bond
market
– Markets for the direct issue of longer term debt securities

– Lenders attract higher:
▪ risk compared with lending indirectly through intermediaries
▪ yield owing to sharing in the profit margin usually taken by
intermediaries
(cont.)
subordinated debt (cont.)
• Debentures and unsecured notes
– Are corporate bonds
– Specify that the lender will receive regular interest payments
(coupon) during the term of the bond and receive repayment
of the face value at maturity
– Unsecured notes are bonds with no underlying security
attached
– Debentures:
▪ are secured by either a fixed or floating charge over the
issuer’s unpledged assets
▪ are listed and traded on the stock exchange
▪ have a higher claim over a company’s assets (e.g. on
liquidation) than unsecured note holders
(cont.)
• Issuing debentures and notes
– There are three principal issue methods

▪ 1. Public issue—issued to the public at large, by
prospectus
▪ 2. Family issue—issued to existing shareholders and
investors, by prospectus
▪ 3. Private placement—issued to institutional investors, by
information memorandum
– Usually issued at face value, but may be issued at a
discount or with deferred or zero interest
– A prospectus contains detailed information about the
business
(cont.)
• Subordinated debt
– More like equity than debt, i.e. quasi-equity

– Claims of debt holders are ‘subordinated’ to all other
company liabilities
– Agreement may specify that the debt not be presented for
redemption until after a certain period has elapsed
– May be regarded as equity in the balance sheet, improving
the credit rating of the issuer

debt
10.5 Leasing
10.6 Summary

• Price of a fixed-interest bond at coupon date
– The price of a fixed-interest security is the sum of the

present value of the face value and the present value of the
coupon stream
1 (1 i )n
P  C[ ]  A(1 i )n
i
(cont.)
(cont.)
• Price of a fixed-interest bond at coupon date (cont.)
– Example 4: Current AA+ corporate bond yields in the market

are 8% per annum. What is the price of an existing AA+
corporate bond with a face value of $100 000, paying 10%
per annum half-yearly coupons, and exactly six years to
maturity?
A = $100 000
C = $100 000 x 0.10/2 = $5000
i = 0.08/2 = 0.04
n = 6 x 2 = 12
(cont.)
(cont.)
(cont.)
(cont.)
• Price of a fixed-interest bond between coupon dates
 1 (1 i )n  n  k

P  C    A(1  i )  (1  i )
  i  
(cont.)
(cont.)
• Price of a fixed-interest bond between coupon dates
(cont.)
– Example 5: Current AA+ corporate bond yields in the market

are 8% per annum. An existing AA+ corporate bond with a
face value of $100 000, paying 10% per annum half-yearly
coupons, maturing 31 December 2016, would be sold on 20
May 2011 at what price?
(cont.)
(cont.)
(cont.)
(cont.)

debt
10.5 Leasing
10.6 Summary

10.5 Leasing
• Leasing defined
– A lease is a contract where the owner of an asset (lessor)

grants another party (lessee) the right to use the asset for
an agreed period of time in return for periodic rental
payments
– Leasing is the borrowing (renting) of an asset, instead of
borrowing the funds to purchase the asset
(cont.)
10.5 Leasing (cont.)
• Advantages of leasing for lessee over ‘borrow and

purchase’ alternative
– Conserves capital
– Provides 100% financing
– Matches cash flows (i.e. rental payments with income
generated by the asset)
– Less likely to breach any existing loan covenants
– Rental payments are tax deductible
(cont.)
• Advantages of leasing for lessor over a straight loan
provided to a lessee
– Leasing has relatively low level of overall risk as asset can be

repossessed if lessee defaults
– Leasing can be administratively cheaper than providing a loan
– Leasing is an attractive alternative source of finance to both
business and government
(cont.)
• Types of leases
– Operating lease
▪ Short-term lease
• Lessor may lease the asset to successive lessees (e.g. short-term
use of equipment)
• Lessee can lease asset for a short-term project
▪ Full-service lease—maintenance and insurance of the asset is
provided by the lessor
▪ Minor penalties for lease cancellation
▪ Obsolescence risk remains with lessor
(cont.)
• Types of leases (cont.)
– Finance lease
▪ Longer term financing
▪ Lessor finances the asset
▪ Lessor earns a return from a single lease contract
▪ Net lease—lessee pays for maintenance and repairs, insurance,
taxes and stamp duties associated with lease
▪ Residual amount due at end of lease period
▪ Ownership of the asset passes to lessee on payment of the
residual amount
(cont.)
• Types of leases (cont.)
– Sale and lease back

▪ Existing assets owned by a company or government are sold to
raise cash; e.g. government car fleet
▪ The assets are then leased back from the new owner
▪ This removes expensive assets from the lessee’s balance sheet
– Cross-border lease
▪ A lessor in one country leases an asset to a lessee in another
country
(cont.)
• Lease structures
– Direct finance lease

▪ Involves two parties (lessor and lessee)
▪ Lessor purchases equipment with own funds and leases asset to
lessee
▪ Lessor retains legal ownership of asset and takes control or
possession of asset if lessee defaults
▪ Security of the lessor provided by:
• lease agreement
• leasing guarantee—an agreement by a third party to meet
commitments of the lessee in the event of default
(cont.)
• Lease structures (cont.)
– Leveraged finance lease

▪ Lessor contributes limited equity and borrows the majority of
funds required to purchase the asset
▪ Lease manager
• Structures and negotiates the lease and manages it for its life
• Brings together the lessor (or equity participants), debt parties and
lessee
▪ Asset then leased to lessee
▪ Lessor gains tax advantages from the depreciation of equipment
and the interest paid to the debt parties
(cont.)
• Lease structures (cont.)
– Equity leasing
▪ Similar to a leveraged lease, except funds needed to buy asset
are provided by the lessor
▪ Therefore, it is usually smaller than a leveraged lease
▪ Has many characteristics of a leveraged lease, including the
formation of a partnership to purchase the asset, but not the
advantage of leverage

debt
10.5 Leasing
10.6 Summary

10.6 Summary
• When choosing the most appropriate source of medium-
to long-term debt, a borrower should consider the
following factors:
– Fixed or variable interest rate
– Term of the financing arrangement
– Repayment schedule
– Loan covenants
– Whether secured by fixed or floating charge, or unsecured
– The merits of leasing an asset as opposed to buying an asset


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Chapter 10

Copyright  2012 McGraw-Hill Australia Pty Ltd

Copyright  2012 McGraw-Hill Australia Pty Ltd

Copyright  2012 McGraw-Hill Australia Pty Ltd

• Term loan structures

– Interest only during term of loan and principal repayment on

– Amortised or credit foncier loan

– Deferred repayment loan

• Term loan structures (cont.)

– Interest may be fixed (for a specified period of time; e.g.

– Interest rate charged on term loan is based on:

• Term loan structures (cont.)

– Other fees include:

– Example 1: Floppy Software Limited has approached Mega

– Example 2: A business proprietor is purchasing a computer

Copyright  2012 McGraw-Hill Australia Pty Ltd

Copyright  2012 McGraw-Hill Australia Pty Ltd

• The mortgage is discharged when the loan is repaid

• If the mortgagor defaults on the loan the mortgagee is

• Providers (lenders) of mortgage finance

• Mortgagee (lender) may reduce their risk exposure to

• Calculating the instalment on a mortgage loan

• Calculating the instalment on a mortgage loan (cont.)

– Example 3: A company is seeking a fully amortised

– Mortgage originators, commercial banks and other

– Involves conversion of non-liquid assets into new asset-

– Original lender sells bundled mortgage loans to a special-

Copyright  2012 McGraw-Hill Australia Pty Ltd

Copyright  2012 McGraw-Hill Australia Pty Ltd

– Markets for the direct issue of longer term debt securities

• Issuing debentures and notes

– There are three principal issue methods

– More like equity than debt, i.e. quasi-equity

Copyright  2012 McGraw-Hill Australia Pty Ltd

Copyright  2012 McGraw-Hill Australia Pty Ltd

• Price of a fixed-interest bond at coupon date

– The price of a fixed-interest security is the sum of the

• Price of a fixed-interest bond at coupon date (cont.)

– Example 4: Current AA+ corporate bond yields in the market

 1 (1 i )n  n  k

– Example 5: Current AA+ corporate bond yields in the market

Copyright  2012 McGraw-Hill Australia Pty Ltd

Copyright  2012 McGraw-Hill Australia Pty Ltd

– A lease is a contract where the owner of an asset (lessor)

• Advantages of leasing for lessee over ‘borrow and

– Leasing has relatively low level of overall risk as asset can be

– Sale and lease back

– Direct finance lease

– Leveraged finance lease

Copyright  2012 McGraw-Hill Australia Pty Ltd

Copyright  2012 McGraw-Hill Australia Pty Ltd

Copyright  2012 McGraw-Hill Australia Pty Ltd

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