Financing – Debt Finance

Chapter 5

The key features of debt financing arise from this 'arm's length
relationship' are:

a) Interest is paid out of pre-tax profits as an expense of the

business. Therefore, paying interest reduces the taxable
profits of the business and hence the tax payable.

b) Debt finance carries a risk of default if interest and principal

payments are not met.

Fixed charge=

Lender is put at the front of queue in the event of liquidity. Secured

against a specific asset such as land or buildings.

Floating charge=

Debt secured against the general assets of the business. Status of

preferred creditor is given and is higher in the list of creditors but not
first.

Covenants=

Dividend restrictions, financial ratios, financial reports, issue of

further debt. Once a covenant is broken the lender has the right to
call back the obligation or a penalty must be paid by the borrower.
More on covenant’s:

Covenants are put in place by lenders to protect themselves from

borrowers defaulting on their obligations due to financial actions
detrimental to themselves or the business.

Impact on lender and borrower:

Debt covenants benefit both the lender and the borrower:

a) debt restrictions could protect the lender by requiring or

prohibiting certain activities of the lender: in other words, debt
covenants should restrict the borrower from making decisions
that would be detrimental to the lender; and

b) debt restrictions could benefit the borrower by reducing the

cost of borrowing (e.g. through lower interest rates and higher
credit ratings).

Positive and negative debt covenants:

Negative debt covenants state what the borrower cannot do and

may include the following:

a) Incur additional long-term debt (or require that additional

borrowing be subordinated to the original borrowing)
b) Pay cash dividends exceeding certain threshold
c) Sell certain assets (e.g. sell accounts receivable)
d) Enter into leases
Positive debt covenants state what the borrower must do and may
include the following:

a) Maintain certain minimum financial ratios

b) Maintain accounting records in accordance with generally
accepted accounting principles
c) Provide audited financial statements (normally within a
specified amount of time after the year-end)

A debt covenant breach represents a breach of contract. Lender’s

response to the breach of contract usually depends on the severity of
the breach as well as the terms of the debt agreement.

Types of debt finance:

Debt may be raised from two general sources – banks or capital

markets.

Bank finance:

For companies that are unlisted, and for many listed companies, the
first port of call for borrowing money would be the banks.

These could be the high street banks or, more likely for larger
companies, merchant banks.

Terms and conditions are negotiable dependent on the term of the

borrowing, the amount borrowed, and the credit rating of the
company wishing to make the borrowing.
Capital markets:

As an alternative to borrowing funds from a bank, a listed company

may issue (long term) bonds or (short term) commercial paper in the
capital markets.

Criteria for selecting debt instruments:

Most companies can borrow from banks, but view direct borrowing
from a bank as more restrictive and expensive than selling bonds on
the capital market.

Entities deciding whether issue a bond or borrow from a bank to

finance a particular investment should consider
a) liquidity,
b) timescale and
c) cost as determining factors.

Types of debt finance=

A) Bank finance=

a) Money market borrowing’s=

Participants here are looking to borrow and lend short

term, i.e. days to just under a year. Banks borrowing and
lending from each other.
 b) RCF’s=

Borrower may withdraw funds up to a credit limit, the

amount of credit decreases and increases as funds are
borrowed and then repaid. Minimize interest payments
because amount of funds borrowed fluctuates over time.

B) Capital markets=

a) Bonds=

Bond holder have a creditors stake in the company and

shareholders have an equity stake. Defined term of
maturity after which bond is redeemed.

b) Commercial paper=

Issued by large profit-making entities and is an unsecured

short-term loan. Mature in 9 months. Can be traded at
any time before maturity.

A bond is meant to finance a long-term investment, whereas a bank

borrowing is more suitable for short-term needs. Bond market offers
liquidity, lower costs and flexibility. Though the bond market implies
costly and cumbersome hurdles bank borrowings are easier.

Accessibility to the market is a major difference between the two.

SME’S generally use bank borrowings because of the flexibility and

everyday relationship with local banks.
On the bonds market entities generally, entities need to build a
reputation and communicate their credit quality which would
determine interest rates on the bond.

Bonds are highly standardized and enable entities to create liquidity.

Bond market=

a) Issuers
b) Underwriters
c) Purchasers

How to issue bonds on the stock market:

Listing of the bonds, admission to trading (ORB= secondary market

which retail investors can invest in), market making.

International debt finance=

Matching concept: Large companies can borrow money in foreign

currencies as well as their own domestic currency from banks at
home or abroad.

The main reason for wanting to borrow in a foreign currency is to

fund a foreign investment project or foreign subsidiary.

Eurobond markets=

Bonds issued on the international capital markets, may be listed on

the domestic currency exchange but are not traded on the. They are
usually bearer instruments that pay interest annually gross of tax.
Normal bonds are traded and listed on domestic stock exchanges
and are registered to a named holder.
Interest rate risk:

Interest Rate Swaps:

An interest rate swap is a contractual agreement between two

parties to exchange interest payments.

How it works:

The most common type of interest rate swap is one in which Party A
agrees to make payments to Party B based on a fixed interest rate,
and Party B agrees to make payments to Party A based on a floating
interest rate.

The floating rate is tied to a reference rate.

(In almost all cases, the London Interbank Offered Rate, or LIBOR).
For example:

Assume that Charles owns a $1M investment that pays him LIBOR +
1% every month.

As LIBOR goes up and down, the payment Charlie receives changes.

Now assume that Sammy owns a $1M investment that pays her 1.5%
every month. The payment she receives never changes.

Charles decides that that he would rather lock in a constant payment

and Sammy decides that she'd rather take a chance on receiving
higher payments. So Charles and Sammy agree to enter into an
interest rate swap contract.

Under the terms of their contract, Charles agrees to pay Sammy

LIBOR + 1% per month on a $1M principal amount (called the
"notional principal" or "notional amount"). Sammy agrees to pay
Charlie 1.5% per month on the $1M notional amount.
Let's see what this deal looks like under different scenarios.

Scenario A: LIBOR = 0.25%

Charles receives a monthly payment of $12,500 from his investment

($1,000,000 x (0.25% + 1%)). Sammy receives a monthly payment of
$15,000 from her investment ($1,000,000 x 1.5%).

Now, under the terms of the swap agreement, Charles owes Sammy
$12,500 ($1,000,000 x LIBOR+1%), and she owes him $15,000
($1,000,000 x 1.5%).

The two transactions partially offset each other and Sammy owes
Charles the difference: $2,500.
Scenario B: LIBOR = 1.0%

Now, with LIBOR at 1%, Charles receives a monthly payment of

$20,000 from his investment ($1,00,000 x (1% + 1%)). Sammy still
receives a monthly payment of $15,000 from her investment
($1,000,000 x 1.5%).

With LIBOR at 1%, Charles is obligated under the terms of the swap
to pay Sammy $20,000 ($1,000,000 x LIBOR+1%), and Sammy still has
to pay Charles $15,000. The two transactions partially offset each
other and now Charles owes Sammy the difference between swap
interest payments: $5,000.
Note that the interest rate swap has allowed Charles to guarantee
himself a $15,000 payout; if LIBOR is low, Sammy will owe him
under the swap, but if LIBOR is higher, he will owe Sammy money.
Either way, he has locked in a 1.5% monthly return on his
investment.

Sammy has exposed herself to variation in her monthly returns.

Under Scenario A, she made 1.25% after paying Charles $2,500, but
under Scenario B she made 2% after Charles paid her an additional
$5,000. Charles was able to transfer the risk of interest rate
fluctuations to Sammy, who agreed to assume that risk for the
potential for higher returns.

One more thing to note is that in an interest rate swap, the parties
never exchange the principal amounts.

On the payment date, it is only the difference between the fixed and
variable interest amounts that is paid; there is no exchange of the
full interest amounts.

Why it Matters:

Interest rate swaps provide a way for businesses to hedge their

exposure to changes in interest rates.

If a company believes long-term interest rates are likely to rise, it can

hedge its exposure to interest rate changes by exchanging its floating
rate payments for fixed rate payments.

Example: Citigroup Trading Desk Made $300 Million on Rate Swaps

How the Swap works=

a) Have fixed, want flexible= Bid (first rate).

b) Have flexible, want fixed= Ask (second rate).

LIBOR changes daily so in order to workout cash flows in a swap

an interest fixing date is agreed and the LIBOR on this date is
used in this calculation.

EXAMPLE:

Company ABC has a 12-month borrowing at a fixed rate of 5% but

would like to swap to a variable rate. It can currently borrow at a
variable rate of LIBOR + 12 basis points.

The bank is currently quoting 12-month swap rates at 4.90% - 4.95%

for LIBOR.

Show the result of the swap arrangement and the financial position:
SOLUTION:

First go to the main rules always:

Have fixed want variable= bid rate

Have variable, want fixed= ask rate

If using bid rate, you will subtract

If using ask rate, you will add.

In this situation we have fixed and want variable, hence we will use
the bid rate.

What are we paying right now? 5%

What will we receive from the -4.90 (bid rate)

bank?

LIBOR + 0.10 (Remember we want

Net interest from the swap variable rate so LIBOR is added to
final answer)

What can we borrow variable at in the market right now? LIBOR +

0.12

By having a swap agreement what is our net interest? LIBOR + 0.10

Hence, by entering the swap we made a saving of 0.02%.

EXAMPLE 2:

ABC company has a $10M floating rate borrowing at a rate of LIBOR

+ 0.50%

The directors have set up a swap, to fix the company’s interest rate
for a period of three years from the 1st of January 2020 to the 31st of
December 2020.

The banks quoted a swap rate of 3.80% - 4.00% for LIBOR.

LIBOR information:

LIBOR on 1st of January 2020 was 4.10%

LIBOR on 1st of July 2020 was 4.05%

LIBOR on 31st of December was 4.75%

What was the difference in overall net interest paid in the year
2020 because of using the swap?
SOLUTION 2:

First go to the main rules always:

Have fixed want variable= bid rate

Have variable, want fixed= ask rate

If using bid rate, you will subtract

If using ask rate, you will add.

In this situation we have variable and want fix, hence the ask rate
will be used. And because ask rate is being used, we will add.

What are we paying right now? LIBOR + 0.5%

What will we receive from the + 4.00 (ask rate)

bank?

4.50% (Remember we want Fixed

Net interest from the swap rate so LIBOR is not needed in the
final answer)

The interest fixing date is the start date of the year which is the 1st
of January, so relevant LIBOR rate is 4.10%.

We end up paying 4.50% because of the swap = 4.50% * 10M loan =

450000

We would have paid 4.10% + 0.50% = 4.60% * 10M loan = 460000

Hence, making a saving of $10000 by entering the swap.

Advantages of using interest rate swaps:

a) To manage fixed and floating rate debt profiles without having

to change underlying borrowing.

b) To hedge against variations in interest on floating rate debt, or

conversely to protect the fair value of fixed rate debt
instruments.

c) A swap can be used to obtain cheaper finance. For example, it

may be cheaper to obtain floating rate finance by, say, issuing a
bond and swapping into a floating rate rather than borrowing
at floating rate directly from a bank.

Disadvantages of using interest rate swaps:

a) Interest rates may change in the future and the company might
be locked into an unfavourable rate.

b) Creditworthiness of the bank – the company and the bank

arrange to make payments to each other for a fixed period. The
company must therefore be confident about the
creditworthiness of the bank before signing up to the swap.
Currency risk:

Cross currency SWAP allows a company to swap a currency it

currently holds for a different currency for a fixed period and then
swap back at the same rate at the end of the period. Company
entering the cross-currency SWAP will end up with the currency it
needs and also the type of interest it prefers.

a) Exchange on spot

b) Pay interest in home

c) Receive interest in foreign

d) Pay bond interest

e) Swap back principals at spot.

f) Use of this is that the company uses the funds in its home
currency for the year and pays an interest on that amount.
EXAMPLE 1:

ABC company is a company in the United states that has issued a

100M Euros bond on which it pays a six-monthly fixed rate of 6%.
ABC company has many operations in the United states, so wants to
swap its euro into US dollars using a fixed for fixed cross currency
swap.

ABC company’s bank has quoted a cross currency swap exchange

rate as 1EUR = 1.10 USD, and fixed interest rates of 5.5% on USD in
exchange for 6% on EUR, with interest payable semi-annually.

Show how the fixed for fixed swap will work?

SOLUTION 1:

Timing Explanation Cash flows

NOW Exchange the Pay 100M EUR to

principals at the receive 110M USD.
given rate

Pay USD 3.025M

6months time
Interest to bank
(5.5% * 110M *
6/12)

Pay USD 3.025M

End of the year
Interest to bank
(5.5% * 110M *
6/12)
Pay 110M USD to
receive 100M EUR.
Swap back the
principals at original
rate

The net result of this is that ABC company has the use of the 110M
USD for the year and pays interest on this amount at 5.5%.
EXAMPLE 2:

ABC company is a UK based company that has borrowed 10M GBP at

a fixed rate of 5.25% per year, with interest paid annually.

The company is planning to expand into Europe so wants to swap

GBP 10M for euros and its fixed rate for a floating rate

The bank has quoted a cross currency swap exchange rate of 1GBP=
1.30 EUR and interest rates of LIBOR + 0.50% on EUR in exchange of
5.25% on GBP with interest paid annually.

Assume that LIBOR is 5% at the date of the Swap.

Show how this fixed for floating swap will work?

SOLUTION:

Timing Explanation Cash flows

NOW Exchange the Pay 10M GBP to

principals at the receive 13M EUR
given rate

Pay EUR 0.715M

End of the year
Interest to bank
(LIBOR + 0.50% *
13M EUR)

Pay 13M EUR to

receive 10M GBP.
Swap back the
principals at original
rate

The net result of this is that ABC company has the use of the 13M
EUR for the year and pays floating interest on this amount at LIBOR
+ 0.50%
Advantages of using cross currency swaps:

a) A cross currency swap is a useful tool for changing the currency

profile of debt.

b) This may help reduce interest costs where debt can be raised
more easily or at a competitive rate in a second currency and it
proves to be cheaper or easier overall to borrow in one
currency and simultaneously enter into a swap to change the
currency profile into another currency or several different
currencies as required.

c) Cross currency swaps may also be used as part of a broader

strategy for managing currency risk. For example, by obtaining
foreign currency borrowings to on-lend to foreign subsidiaries
denominated in their local currencies.

Disadvantages of using cross currency swaps:

a) The main disadvantage is that, as in an interest rate swap,

there is a risk that the other party to the contract might default
on the arrangement. This is an even greater risk for cross
currency swaps because: – the cash flows are in different
currencies (and hence there can be no agreement to net them
as there could be for interest rate swaps),
Other sources of finance=

A) Retained earnings/existing cash balances=

Company cannot fund new projects if does not have enough

cash in hand. Retained earnings cannot be used.

B) Sale and leaseback=

Funds are released without any loss of use of assets, popular

for large retail organizations.

C) Grants=

Technology, job creation, and regional policy.

D) Debt with warrants attached=

Option to buy shares at a future date for a specified exercise

price. They can also be sold.

E) Convertible debt=

Same as warrant except that a warrant cannot be detached

and traded separately. Convertible debt is where the debt
can itself be converted into shares at a pre-determined
future price.
 F) Venture capital=

Mainly in the form of equity finance provided to smaller

companies to expand. A typical exit route is an IPO or
flotation which enables venture capitalist to sell his shares
and earn a profit if firm is successful.

G) Business angels

H) Government assistance.

Lease vs buy decision=

Lease= is a commercial arrangement where an equipment owner

(lessor) conveys the right to use the equipment user (lessee) of a
specified rental over a pre-agreed period of time.

Reasons for leasing=

a) It is a readily available form of finance especially for plant

and machinery and motor vehicles.

b) Removes the need for a significant capital outlay at

beginning of a project’s life.

c) May be cheaper in financial terms that debt financing.

Lease v buy evaluation:

If an asset is needed for a major new investment, and the asset can
be leased, then a critical decision is:

a) should the asset be leased? or

b) should the asset be purchased and the purchase cost financed
by debt issue?

The traditional approach to the evaluation is to use the NPV method

i.e. determine the present value cost of leasing and compare this to
the present value cost of borrowing to buy.

In the lease v buy evaluation, it is considered that the risk associated

with the lease option is comparable to the risk associated with the
borrow to buy option.

Hence the same discount rate should be used for both NPV
calculations.

The discount rate to use is the post-tax cost of debt finance – clearly
this rate applies to the borrow to buy option, and it is considered to
be appropriate to the leasing option too, since the post-tax cost of
debt is effectively the opportunity cost of leasing.
Example 1 to evaluate:

(Source: Kaplan F3 Textbook)

Advanced Example 2:

(Source: Kaplan F3 Textbook)