Ch05-Medium - To Long-Term

11/5/2022
Chapter 05
Medium- to Long-term
Debt
10-1
Learning Objectives
• Identify the types of medium- to long-term debt
instruments in the market
• 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
10-2
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Chapter Organisation
5.1 Term Loans or Fully Drawn Advances
5.2 Mortgage Finance
5.3 Debentures, Unsecured Notes and
Subordinated Debt
5.4 Calculations: Fixed-interest Securities
5.5 Leasing
5.6 Summary
10-3

• Term loan
– A loan advanced for a specific period (3 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
10-4
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(cont.)
• Provided by
– Mainly commercial banks and finance companies
– To a lesser degree, investment and merchant banks,
insurance offices and credit unions
10-5

(cont.)
• Term loan structures
– Interest only during term of loan and principal repayment
on maturity
– Amortised 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
10-6
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(cont.)
• Term loan structures (cont.)
– Interest may be fixed (for a specified period of time, e.g.
2 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)
10-7

(cont.)
• Term loan structures (cont.)
– Other fees include
▪ Establishment fee
▪ Service fee
▪ Commitment fee
▪ Line fee
▪ Bill option clause fee
10-8
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(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
10-9

(cont.)
• Calculating the loan instalment—ordinary annuity
A
R=
1− (1+ i )−n
[ ]
i (10.1)
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 compoundin g periods.
10-10
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(cont.)
• Calculating the loan instalment— ordinary annuity
(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.
10-11

(cont.)
• Calculating the loan instalment— ordinary annuity
(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
10-12
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(cont.)
• Calculating the loan instalment—annuity due
A
1− (1+ i )−n
R=
[ ](1 + i )
i (10.2)
10-13

(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.
10-14
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(cont.)
– Example 2 (cont.)
A = $21 500
0.12
i= = 0.01
12
n = 7  12 = 84
$21 500
R=
1 − (1 + 0.01) −84
[ ] (1 + 0.01)
0.01
$21 500
=
57.21494
= $375.78 monthly instalment
10-15
Subordinated Debt
10.5 Leasing
10.6 Summary
10-16
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• 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 asset and realise any
amount owing on the loan
10-17
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
10-18
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• Interest rates
– Both variable and fixed interest rate loans are available to
borrowers
▪ With fixed interest loans, interest rates reset every 5 years
or less
– With interest-only mortgage loans, interest-only period is
normally a maximum of 5 years
• Mortgagee (lender) may reduce their risk exposure
to borrower default by
– Requiring mortgagor to take out mortgage insurance up
to 100% of the mortgage value
10-19

• 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
▪ i.e. a trust setup to hold securitised assets and issue asset-
back securities like bonds, providing investors with security
and payments of interest and principal
10-20
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• Calculating the instalment on a mortgage loan
A
R=
1 − (1 + i )−n
[ ]
i
(10.3)
10-21

(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.
10-22
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(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
10-23
Subordinated Debt
10.5 Leasing
10.6 Summary
10-24
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Subordinated Debt
• These securities are issued in the corporate bond
market
– Markets for the direct issue of longer-term debt securities
– Lenders face higher
▪ Risk compared to lending indirectly through intermediaries
▪ Yield due to sharing in the profit margin usually taken by
intermediaries
10-25

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
10-26
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• Debentures and unsecured notes (cont.)
– 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
10-27

• Issuing debentures and notes
– There are three principal issue methods
▪ Public issue—issued to the public at large, by prospectus
▪ Family issue—issued to existing shareholders and
investors, by prospectus
▪ 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
10-28
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• Subordinated debt
– More like equity than debt. i.e. quasi-equity
– Claims of debt holders are ‘subordinated’ behind all other
company liabilities
– Agreement may specify that the debt is not 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
10-29
Subordinated Debt
10.5 Leasing
10.6 Summary
10-30
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• 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
(10.4)
10-31
10.4 Calculations: Fixed-interest

Securities (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
10-32
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Securities (cont.)
10-33

Securities (cont.)
• Price of a fixed-interest bond between coupon
dates
 1− (1+ i )−n  −n  k

P = C   + A(1+ i ) (1+ i )
  i  
(10.7)
10-34
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Securities (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 2012,
would be sold on 20 May 2007 at a price of:
10-35

Securities (cont.)
10-36
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Securities (cont.)
10-37
Subordinated Debt
10.5 Leasing
10.6 Summary
10-38
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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
10-39
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)
– Rental payments are tax deductible
10-40
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• 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
10-41

• 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
10-42
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• 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
10-43

• 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
10-44
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• 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
10-45

• 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
10-46
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• 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
10-47
Subordinated Debt
10.5 Leasing
10.6 Summary
10-48
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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
– Leasing an asset as opposed to buying an asset
10-49
25

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11/5/2022

10.1 Term Loans or Fully Drawn Advances

10.1 Term Loans or Fully Drawn Advances

10.1 Term Loans or Fully Drawn Advances

10.1 Term Loans or Fully Drawn Advances

10.1 Term Loans or Fully Drawn Advances

10.1 Term Loans or Fully Drawn Advances

10.1 Term Loans or Fully Drawn Advances

10.1 Term Loans or Fully Drawn Advances

10.1 Term Loans or Fully Drawn Advances

10.1 Term Loans or Fully Drawn Advances

10.1 Term Loans or Fully Drawn Advances

– Example 2: A business proprietor is purchasing a

10.1 Term Loans or Fully Drawn Advances

10.2 Mortgage Finance

10.2 Mortgage Finance (cont.)

10.2 Mortgage Finance (cont.)

10.2 Mortgage Finance (cont.)

10.2 Mortgage Finance (cont.)

10.2 Mortgage Finance (cont.)

– Example 3: A company is seeking a fully-amortised

10.2 Mortgage Finance (cont.)

10.3 Debentures, Unsecured Notes and

10.3 Debentures, Unsecured Notes and

10.3 Debentures, Unsecured Notes and

10.3 Debentures, Unsecured Notes and

10.3 Debentures, Unsecured Notes and

10.4 Calculations: Fixed-interest Securities

• Price of a fixed-interest bond at coupon date

10.4 Calculations: Fixed-interest

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

10.4 Calculations: Fixed-interest

10.4 Calculations: Fixed-interest

 1− (1+ i )−n  −n  k

10.4 Calculations: Fixed-interest

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

10.4 Calculations: Fixed-interest

10.4 Calculations: Fixed-interest

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

– Leasing is the borrowing (renting) of an asset, instead of

10.5 Leasing (cont.)

10.5 Leasing (cont.)

– Leasing has relatively low level of overall risk as asset

10.5 Leasing (cont.)

10.5 Leasing (cont.)

10.5 Leasing (cont.)

10.5 Leasing (cont.)

10.5 Leasing (cont.)

10.5 Leasing (cont.)

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