Corporate debt financing

• Important sources of capital.

• Can take the form of bank loans or bonds.

• Term Loan
• Syndicated Bank Loan
• Revolving Line of
Credit
• Asset-Backed Line of
Credit
4
 Term Loans
• Private loans made by financial institutions to businesses.
• Often made to finance permanent working capital needs,
purchase equipment, or liquidate other loans.
• Initial maturity of more than 1 year.
• Repayment:
• 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 principal
• Collateral Requirement:
• Secured loans involve the pledging of specific assets as
collateral. Reduce risk for lender
5
 Corporate Bonds

• Debt security carrying a promise to pay cash flows to

the holder.

6
 Corporate Bonds

• Seniority
• A bondholder’s priority, in the event of a default, in
claiming assets
• Subordinated Debenture
• Has a lower priority claim to the firm’s assets than
other outstanding debt
• Secured vs Unsecured

7
8

Secured Bonds
• Secured by real estate or buildings
Mortgages • A number of mortgages can be issued
against the same collateral.

Collateral
• Secured by stock/bonds owned by the
trust bonds
issuer

Equipment • Used to finance transportation equipment

trust including airplanes, trucks, rail cars, boats
certificates • A type of leasing
9

Unsecured Bonds
• Unsecured, so only creditworthy firms can
Debentures issue
• Most convertibles are debentures.

Subordinated • Unsecured
debentures • Claims are not satisfied until senior debts
have been satisfied.
• Payment of interest is only required when
earnings are available.
Income • Commonly issued in reorganization of a
bonds failing firm
• Not in default when interest payments are
missed, since these are contingent on
earnings
 Corporate Bonds…

• Domestic Bonds
• Issued by a local entity and traded in a local market,
but purchased by foreigners
• Denominated in the local currency

• Foreign Bonds
• Issued by a foreign company in a local market and are
intended for local investors

• International Bonds
• Can be issued in multiple countries, but denominated
in a single currency, usually the issuer’s home
currency. 10
 Foreign Bond

• Issue in a domestic market by a foreign entity in the

domestic market's currency as a means of raising
capital.
• Have different tax laws, restrictions on the amount
issued, and tougher disclosure rules, compared to
domestic bonds
• Example:
• Yankee bonds (United States)
• Panda bonds (China)
• Samurai bonds (Japan)
• Rembrandt bonds (the Netherlands)
• Bulldog bonds (Britain)
11
 International Bond
• Can be issued in multiple countries, but denominated
in a single currency, usually the issuer’s home
currency.
• Raise funds needed in the currency that is needed,
without the forex risk.
• Has no particular connection to Europe or the euro
currency.
• Example:
• U.K.-based company might issue a U.S. dollar-denominated
eurodollar bond in Japan.
• An international financial syndicate issue euroyen bonds
in Singapore, which are denominated in Japanese yen.

12
13

Cost of Long-Term Debt

Function of at least four factors

• Yield curves typically slope upward.

Loan
• Longer maturities mean greater exposure to
maturity
the risk of default.
• Trade-off between administrative cost per
Loan size dollar and risk exposure that increases with
loan size
Borrower • The greater the risk of default, the higher
risk the rate that the lender will charge.

Basic cost of • The greater the prevailing rate on lowest-

risk money (such as Treasury securities), the
money
greater the rate on other loans.
 Other Types of Bonds

• Sovereign Debt
• Debt issued by national governments
• Long bonds
• Bonds issued by the U.S. Treasury with the longest
outstanding maturities (30 years)
• TIPS
• Treasury Inflation-Protected Securities

14
 Coupon Payments on Inflation-
Protected Bonds

Problem
On January 15, 2011, the U.S. Treasury issued a 10-year
inflation-indexed note with a coupon of 1.125%. On
the date of issue, the consumer price index (CPI) was
220.223. On January 15, 2019, the CPI had increased to
251.712. What coupon payment was made on January
15, 2019?

15
 Coupon Payments on Inflation-Protected
Bonds
• CPI appreciated by
251.712
= 1.14299.
220.223

• Consequently, the principal amount of the bond

increased by this amount; that is, the original face value
of $1000 increased to $1142.99.
• Because the bond pays semiannual coupons, the coupon
payment was
$1142.99 × 0.01125
= $6.43.
2
Coupon Payments on Inflation-Protected
Bonds
• On February 15, 2015, the U.S. Treasury issued a 30-year
inflation-indexed bond with a coupon of 0.750%. On the
date of issue, the consumer price index (CPI) was
235.48150. On February 19, 2017, the CPI had increased
to 241.40379. What coupon payment was made on
February 15, 2017?
 Solution….
• CPI appreciated by
241.40379
= 1.02515.
235.48150

• Consequently, the principal amount of the bond

increased by this amount; that is, the original face value
of $1000 increased to $1025.15.
• Because the bond pays semiannual coupons, the coupon
payment was
$1025.15 × 0.0075
= $7.69.
2
 Bond indenture

• Bond indenture: The bond contract, which specifies:

– Payments and payment dates
– Positive and negative covenants
– Security (any collateral)
– 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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 Bond Covenants

• Contractual clauses within debt agreements that place

constraints on the borrower:
• Limit the issuer from taking actions that may undercut
its ability to repay the bonds
Advantages of Covenants
• With more covenants, a firm firms can reduce its costs
of borrowing.
• The reduction in the firm’s borrowing cost can more
than outweigh the cost of the loss of flexibility
associated with covenants

21
22

Covenants
Things the borrower “must do,” such as:
Positive • Maintain satisfactory accounting records in
accordance with GAAP
covenants
• Maintain facilities in good working order
• Maintain a minimum level of net working
capital
• Maintain life insurance on “key employees”

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

• Sell accounts receivable to generate cash
Negative
• Issue additional debt of equal or greater
covenants seniority
• Arrange certain types of leases or other fixed
payment obligations
• Pay excessively large salaries and/or dividends
 Covenants: Some Typical Examples

Restrictions on: Typical Restrictions

Issuing new debt New debt must be subordinate to existing debt
No new debt unless firm maintains specific leverage or interest
coverage ratios
Dividends and share Payouts can be made only from earnings generated after the bond
repurchases issue
Payouts can be made only if earnings exceed some threshold
Mergers and acquisitions Mergers and acquisitions Mergers are allowed only if the combined
firm has a minimum ratio of net tangible assets to debt
Asset disposition Maximum amount of assets that can be sold, and/or minimum
amount of assets that must be maintained
Restrictions on making loans or any other provision of credit
Requiring Maintenance Blank
of:
Accounting measures Minimum retained earnings, working capital, and/or net assets
Maximum leverage ratios 23
 Call Feature
• Gives the issuer the opportunity to repurchase bonds
prior to maturity at the call price
• The issuer can retire an issue early when interest rates
fall.
• Must pay a higher interest rate than would otherwise
be necessary in order to compensate bondholders
• Callable Bond must specify the following in the bond
indenture.
• Call Date
• Call Price
• Call Premium

24
 Example: Call Features of Hertz’s
Bonds
Blank
Tranche 1: Senior
Dollar-Denominated
Note
Call Features Up to 35% of the
outstanding
principal callable at
108.875% in the first three
years.
After four years, fully
callable at:
• 104.438% in 2010.
• 102.219% in 2011.
• Par thereafter.
Tranche 3: Senior
Subordinated
Tranche 2: Senior Dollar-
Euro-Denominated Denominated
Note Note
Up to 35% of the Up to 35% of the
outstanding outstanding
principal callable at principal callable at
107.875% in the first 110.5% in the first
three years. three years.
After four years, fully After five years, fully
callable at: callable at:
• 103.938% in 2010. • 105.25% in 2011.
• 101.969% in 2011. • 103.50% in 2012.
• Par thereafter. • 101.75% in 2013.
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 Callable Bonds and Yields

Bond coupons Bond price Likelihood of Yield to Worst

relative to is . . . call is . . . is . . .
market yields
Coupons are At a premium High Yield to call
higher
Coupons are At a discount Low Yield to maturity
lower

26
 Calculating the Yield to Call

• IBM has just issued a callable (at par) five-year, 8%

coupon bond with annual coupon payments. The bond
can be called at par in one year or anytime thereafter
on a coupon payment date. It has a price of $103 per
$100 face value, implying a yield to maturity of 7.26%.
What is the bond’s yield to call?

27
 Continue…
• If IBM calls the bond at the first available opportunity,
it will call the bond at year 1.

• Using financial calculator:

N = 1; I/Y = ?? PV = -103; PMT = 8; FV = 100

• Using Excel formula:

=RATE(NPER,PMT,PV,FV,0) = 4.85%
28
 Problem….
• Sirius XM Holdings has just issued a callable (at par)
ten-year, 4.65% coupon bond with annual coupon
payments. The bond can be called at par in five years
or anytime thereafter on a coupon payment date. It has
a price of $89.250 per $100 face value, implying a yield
to maturity of 6.09%. What is the bond’s yield to call?

• Answer: YTC = 7.29%

29
 Repayment Provisions
• Sinking Fund
• A company makes regular payments into a fund
administered by a trustee over the life of the bond
• These payments are then used to repurchase bonds,
usually at par.

• Balloon Payment
• A large payment that must be made on the maturity
date of a bond when the sinking fund payments are
not sufficient to retire the entire bond issue

30