Debt Financing

Outline:

I. The nature and the main types of

borrowing

II.The main considerations for a firm

when borrowing long-term or short-
term
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Examples of debt finance
wm
Debenture
s and loan
stocks

Debt
Bonds Financ
e

Trust deeds
and
covenants

2
 Bank borrowing the
attractions
Administrative and legal costs are low

Speed

Flexibility

Availability to small firms

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 Bank borrowing factors to
consider
Costs - Arrangement fees
- Floating or fixed rates?
Security - Asymmetric information
- Collateral
- Personal guarantees
Repayment- Repayment holidays
- Mortgage-style schedules

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 Overdrafts
Advantages Drawbacks

Flexibility Risk of withdrawal

at short notice
Cheapness
Security

Useful for seasonal

businesses e.g.
Fruit growers
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 Term loans
Repayment structure - Grace period
- Balloon structure
- Bullet structure
Instalment arrangement

Drawdown arrangement

Financial gearing

6
 Convertible bonds
Advantages for the company:
Lower interest
Interest is tax deductible
Self-liquidating
Fewer restrictive covenants
Underpriced shares
Cheap way to issue shares
Available when straight debt/equity is
not available

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 Convertible bonds
Advantages for the investor

Can wait and see before investing in

equities

Greater security in the near term

The annual coupon is usually higher

than the dividend yield
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 Trade credit
Advantages
Convenient/informal/cheap
Available to all sized of company

Factors determining the terms

Tradition in the industry
Bargaining strength of the two parties
Product type

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 Stages in a factoring deal
2. Right to receive
Supplying
payment on invoice
firm
sold to factor
(seller
3. 80% of customer 1. Goods
Debt available to
Seller immediately

5. 20% payable, less factors

Fees and interest, after
customer pays factor

Factor
Customer
4. Customer pays debt to factor a few
Weeks after delivery of goods
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The hire purchase sequence

Plant or
equipment

1. Bought by HP company 2. Available

and remains property of for
HP company until hirer immediate
makes all payments use
Hirer (e.g.
Firm)
Hire Purchase
company (e.g.
Finance house)
4. When all payments
are made hirer 3. Regular payments
becomes the owner
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 A leasing transaction

Asset (e.g. Plant,

machinery,
vehicle)

Buys asset and retains

legal ownership
throughout Rental payments

Finance house Lessee has use Lessee

(lessor) of the asset for a (company using
period of time equipment)

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 Leasing
Two types
- Operating leases
- Financing leases

Advantages
- Small initial outlay
- Certainty
- Availability
- Fixed-rate finance
- Tax relief

13
 Bond Markets

Bond markets

Domestic market Foreign bonds Euro bonds

(International
bonds)

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 International bonds the
advantages
Larger loans for longer periods

Often cheaper

Hedge interest rates and exchanges rates

Usually unsecured

Lower level of regulation

15
 International bonds the
drawbacks
Only for the largest companies

Risks associated with exchange rate

fluctuation

The secondary market can be illiquid

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 Short-term or long-term
borrowing? The key factors
Maturity structure

Costs of issue/arrangement

Flexibility

The uncertainty of getting future

finance

The term structure of interest rates

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 Valuing Bonds
Importance of understanding bonds and their pricing:

The prices of risk-free government bonds can be used

to determine the risk-free interest rates in the market

Firms issue bonds to fund their own investment too,

and the returns investors receive on those bonds is
one factor determining a firms cost of capital

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 Determinants of bond prices
The price of a bond is determined by the
promised cash flows:
Risk-free bond (e.g. government bonds)
promised cash flows will be paid with certainty
Risky bond (e.g. corporate bonds)
Cash flows are not known with certainty due to
risk of default

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 Bond terminology
Bonds:
securities sold by government and corporations to raise
money from investors today in exchange fro the promised
future payment.

Face Value:
the principal of the bond, also known as par value

Bond certificate:
setting out the terms of the bond; indicating the amount
and dates of all payments to be made

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 Bond terminology (cont.)
Term to maturity:
time to full repayment by issuer (usually measured in years)

Maturity date: final repayment date

Coupon payment: interest payment to bond-holders

For example, a bond that was issued for $1000 and pays $60 of
interest each year would be said to have 6% coupon

Coupon rate:
6% in the above example is known as the coupon rate

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 Bond terminology (cont.)
Yield to maturity
the annual rate the bondholder will receive if the bond is held to
maturity
yield to maturity is the interest rate that equates the present value of the
expected future cash flows to be received on the bond to the initial
investment in the bond, which is its current price.
It is widely accepted as a proxy for average return (the IRR)

where Pb is the current price of the bond;

C is the coupon payment on the bond;
M is maturity value, or the original bond issue price;
y is the yield to maturity or interest rate;
n is the number to maturity

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 Zero coupon bonds
Make no coupon payments

The only cash payment investors receive is the face value of the bond on the maturity date

Must sold at a discount (i.e. at a price less than its face value), hence also called pure discount
bonds

The YTM for an n-year zero-coupon is the risk-free rate that all n-year risk-free investments
must earn in the market

or

The cost of capital for a risk-free cash flow that occurs on date n is YTMn

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 Coupon bonds
Characteristics:
Pay investors their face value at maturity
Make regular coupon interest payments
Examples:
US Treasury notes (1 to 10 years maturities)
US Treasury bonds (more than 10 years maturities)
Finding of YTM for coupon bonds
Same as that shown in slide 5.

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 An Example of finding YTM
A coupon bond with a face value of 1000 and an
annual coupon of 8% has four more years to run. It
currently has a market value of 1069.3. Find its
yield to maturity.
Solve for r below:

r (the YTM) is approximately equal to 6%

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 An example of finding the price of a
coupon bond (assuming no default)
The price of a coupon bond must equal the present
value of its coupon payment and face value
discounted at the competitive market interest rates:
For a 3-year, 1000 bond with 10% annual coupons
and the YTM of 4.4%, its price is:

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Pricing of coupon bond with the risk of
default
The issuer of corporate bonds may default:
It might not pay back the full amount promised in the bond
prospectus.

This risk of default means that the bonds cash flows are
not known with certainty

Hence, investors will pay less and demand higher yield for
bonds with default risk than that of otherwise identical
default-free bonds.

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 Example 1: No default case
Suppose that the one-year zero-coupon bond has a yield to
maturity of 4%, the price and yield of a one-year, 1000, zero
coupon bond issued by Apple Corporation will be:

Note that since we are assuming that Apple Corporation will

not default within the next year, hence this bond is risk free
and should earn the same yield as the one-year zero coupon
bond (i.e. 4%)

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 Example 2: Certain Default case
Suppose that investors believe that Apple Corporation will
certainly default at the end of one year and will be able to pay
only 90% of its outstanding obligations.
Investors can predict this shortfall perfectly, so the 900
payment is risk free, and the bond is still a one-year risk-free
investment.
The price of this defaultable bond can be found by discounting
this new cash flow using the risk-free interest rate as the
firms debt cost of capital:

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 Example 2 (cont.)

Finding YTM of the defaultable bond:

Given the bonds price on slide 12, we can compute the bonds YTM
using the promised rather than the actual cash flows.

The 15.56% YTM of Apples bond is much higher than the YTM of
the default-free government bond. But this does not mean that
investors of the bond will earn 15.56% return because it will default.
In fact, the expected return of the bond only equals its 4% cost of
capital:

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 Example 3: Risk of default
Examples 1 & 2 are two extreme cases with bond payoffs
known with certainty

Example 3: Bond payoffs are uncertain (e.g. 50% chance to

get repayment in full and 50% chance to receive only 900
when the company default, so on average, 950 will be
received)

Investors demand a risk premium on top of the risk-free rate

to invest in this bond

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 Example 3 (Cont.)
Suppose investors demand a risk premium of 1.1%
for this bond, the appropriate cost of capital is 5.1%
(4% +1 .1%), the price of the bond will be:

The YTM of the bond is 10.63%:

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 Example 3 (cont.)
The 10.63% promised yield is the most investors will
receive.
If Apple defaults, they will receive only 900, for a
return of:

The average return is:

This 5.1% is known as the bonds cost of capital

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 Summary
A bonds price decreases, and its yield to maturity
increases, with a greater likelihood of default

Conversely, the bonds expected return, which is

equal to the firms debt cost of capital, is less than the
yield to maturity if there is a risk of default

A higher YTM does not necessarily imply that a

bonds expected return is higher.

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 Bond ratings
Moodys Standard & Poors Description

Aaa AAA The best quality

(0.1% default probability)
Aa AA High quality
(0.3% default probability)
A A Upper medium grade
(0.7% default probability)
Baa BBB Medium grade
(3.5% default probability)
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 Bond ratings
Moodys Standard & Poors Description

Aaa AAA The best quality

(0.1% default probability)
Aa AA High quality
(0.3% default probability)
A A Upper medium grade
(0.7% default probability)
Baa BBB Medium grade
(3.5% default probability)
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