LECTURE 4

LONG-TERM DEBT AND LEASE

FINANCING
 MAIN CONTENTS
1. Reasons for seeking debt finance
2. Sources of debt finance
3. Factors influencing choice of debt finance
4. The Debt Contract
5. Bond
6. Forms of Bond Financing
7. Bond prices, Yields, and Ratings
8. The Refunding Decision
9. Advantages and Disadvantages of Debt
10.Leasing as a Form of Debt
 REASONS FOR SEEKING DEBT
FINANCE
 Not wish to issue equity capital because:
 Unwilling to contribute additional capital;
 Not wish to involve outside shareholders who will have
more onerous requirements than current members.
 Loss of Control  Takeover Potential
 Asset Disclosure
 Loss of Value
 Responsibility to Stakeholders
 Lesser cost and easier availability, particularly little or no
existing debt finance.
 Debt finance provides tax relief on interest payments
 Long term finance is used for major investments and is
usually more expensive and less flexible
 SOURCES OF DEBT
FINANCE
Bank
loan whether the bonds
What type of will be repaid
financing will (redeemed)
be available?
whether there will be
Bond conversion rights
into shares

whether warrants
will be attached
 FACTORS INFLUENCING CHOICE
OF DEBT FINANCE
 The choice of debt finance that a company can
make depends upon:
 Availability
 Duration
 Fixed or floating rate
 Security and covenants
 THE DEBT CONTRACT
 The corporate bond represents the basic long-
term debt instrument for large corporations, the
bond agreement specifies:
 Par value: the initial value of the bond (the principal or
face value)
 The coupon rate: the actual interest rate on the bond,
payable in semiannual or annual installments.
 The maturity date: the final date on which repayment
of the bond principal is due
 THE DEBT CONTRACT
(CONT'D)
 Security provisions
 Security debt – specific assets are pledged to
bondholders in the event of default
 Pledged assets sold and the proceeds distributed to
bondholders
 The stronger and better secured the initial claim, the
higher the quality of the new security to be received
 Mortgage agreement – real property (plant and
equipment) is pledged as security for the loan
 THE DEBT CONTRACT
(CONT'D)
A mortgage may be senior or junior in nature
 After-acquired property clause – requiring that any new
property be placed under the original mortgage
 The greater the protection offered a given class of
bondholders, the lower is the interest rate on the bond
 THE DEBT CONTRACT
(CONT'D)
Unsecured Debt
 Unsecured debt – the issued debt that is not secured by a
specific claim to assets
 Debenture – a long-term, unsecured corporate bond
 The trend is to issue unsecured debt rather than a
specific lien against an asset
 Subordinated debenture – an unsecured bond in which
payment to the holder will occur only after the senior
debenture holders are satisfied
 THE DEBT CONTRACT
(CONT'D)
Priority of claims
 THE DEBT CONTRACT
(CONT'D)
 Methods of repayment
 Serial Payments:
 Bonds with serial payment provisions are paid off in
installments over the life of the issue
 Each bond has its own predetermined date of maturity
and receives interest only to that point.
 Example: the total issue may span over 20 years, 15 or
20 different maturity dates may be assigned specific
dollar amounts.
 THE DEBT CONTRACT
(CONT'D)
 Methods of repayment
 Conversion
 Debt conversion into common stock
 Although this feature is exercised at the option of the bondholder,
a number of incentives or penalties may be utilized to encourage
conversion.
 Call Feature:
 Allows the corporation to retire or force in the debt issue before
maturity
 The bond issuers will pay a premium over par value—a bargain
value to the corporation if bond prices are up.
 BONDS
 Bond is the term to describe various of long-term debt a
company may issue such as loan notes or debentures,
which may be
 Redeemable: a borrower can repay prior to its
maturity
 Irredeemable
 Bonds or loans come in various forms, including:
 Floating rate debentures
 Zero coupon bonds - Deep discount bonds
 Convertible bonds
 FORMS OF BOND
FINANCING
 Floating rate bond
 The interest rate is tied to the yield on T-bonds (~120%
of the current T-bonds’ yield)
 The floating rate bonds have broad limits that interest
payments can not exceed
 The market value of the floating rate bond is either
constant or almost constant
 FINANCING
(CONT'D)
 Zero-coupon bond
 Zero coupon bonds are bonds that are issued at a
discount to their redemption value, but no interest is
paid on them
 Borrower: can be used to raise cash immediately, and
there is no cash repayment until redemption date
 The price of the bond tends to be highly volatile in
relation to the changes in interest rate
 FORMS OF BOND
FINANCING
(CONT'D)
 Zero-coupon bond
 Create the tax-shield with the difference between the
initial bond price and the maturity value over the life of
the bond
 The increase in the value of bonds is taxable annually
even though the bondholders does not get any cash flow
until maturity
 FORMS OF BOND
FINANCING (CONT'D)
 Convertible bonds
 Convertible bonds are bonds that give the holder the
right to convert to other securities, normally ordinary
shares, at a pre-determined price/rate and time
 BOND PRICES, YIELDS,
AND RATING
 Bond Yields
 Coupon rate
 Current yield
 Yield to maturity
 BOND PRICES, YIELDS,
AND RATING (CONT'D)
 Coupon rate
 Current Yield
 Yield to maturity is the interest rate that will equate
future interest payments and the payment at maturity
(principal payment) to the current market price
 BOND PRICES, YIELDS,
AND RATING (CONT'D)
Example: The bond with the par value of $1,000; the
current price of the bond is $1050, the coupon rate is 10%.
Maturity years are 5 yrs. What is the YTM ?
 BOND PRICES, YIELDS,
AND RATING (CONT'D)
 Bond Ratings
 Two major bond rating agencies—Moody’s Investor
Service
and Standard & Poor’s Corporation
 The higher the rating assigned a given issue, the lower
the required interest payments
 BOND PRICES, YIELDS,
AND RATING (CONT'D)
 Bond Ratings
 An example of bond rating systems, Moody’s Investor
Service:
Moody’s S&P Quality of Issue
Highest quality. Very small risk of default.
Aaa AAA
High quality. Small risk of default.
Aa AA
High-Medium quality. Strong attributes, but potentially
A A
vulnerable.
Baa BBB Medium quality. Currently adequate, but potentially unreliable.
Ba BB Some speculative element. Long-run prospects questionable.
B B Able to pay currently, but at risk of default in the future.
Poor quality. Clear danger of default .
Caa CCC
Highly speculative. May be in default.
Ca CC
Lowest rated. Poor prospects of repayment.
C C
In default.
D -
 ADVANTAGES AND
DISADVANTAGES OF DEBT
 Benefits of Debt
 Interest payments are tax-deductible
 The financial obligation is clearly specified (except the
floating rate bonds)
 In an inflationary economy, debt may be paid back with
“cheaper dollar”
 The use of debt may lower the cost of capital to the firm
 DISADVANTAGES
OF DEBT (CONT'D)
 Drawbacks of Debt
 Interest and principal payment obligations must be met
regardless of the economic position of the firm
 Indenture agreements - must satisfy the demand of the
bondholders for financial restrictions such as level of
working capital, future debt…
 Debt may depress outstanding common stock values
 DISADVANTAGES
OF DEBT (CONT'D)
 Eurobond
 Eurobond – a bond payable in the borrower’s currency
but sold outside the borrower’s country
 The Eurobond is usually sold by an international
syndicate of investment bankers
 Switzerland, Japan, the Netherlands, Germany, the
United States, and Britain are the most popular
countries.
 Disclosure requirements are less demanding than those of
the Securities and Exchange Commission or other
domestic regulatory agencies.
 LEASING AS FORM OF
DEBT
 What is a finance lease
 A finance lease is a lease that transfers substantially all
the risks and rewards incidental to ownership of an
asset to the lessee
 A finance lease’s characteristics
 Non-cancelable
 Long-term
 The purchase of an asset on credit.
 LEASING AS FORM OF
DEBT
 A company’s balance sheet
 Creates both an asset and a liability.
Parties: The lessee and the lessor.
 The lessee is the party that uses the asset
 The lessor is the party that provides the asset to the
lessee.
 LEASING AS FORM OF
DEBT
 A company’s balance sheet before entering a finance
lease

 Total debt/total assets= 100/200=50%

 LEASING AS FORM OF
DEBT
 A company’s balance sheet after entering a finance lease
 The commitment to making lease payments is recorded
on the books as a liability, and the leased property is
presented on the balance sheet as an asset

 Total debt/total assets= 200/300=66.67%

 LEASING AS FORM OF DEBT
(CONT'D)
 Capital Lease vs Operating Lease
Capital lease satisfies one of the following conditions:
 Transferring ownership of the property to the lessee by
the end of the lease term
 The lease contains a bargain purchase price at the end
of the lease
 The lease term is equal to 75% or more of the estimated
life of the leased property
 LEASING AS FORM OF DEBT
(CONT'D)
 Capital Lease vs Operating Lease
Capital lease satisfies one of the following conditions:
 The present value of the minimum lease payment
equals 90% or more of the fair value of leased property
at the inception of the lease
 The asset is of such a specialized nature that it probably
has no alternative use to the lessor at the end of the
lease term.
 LEASING AS FORM OF DEBT
(CONT'D)
 Operating lease:
 Not meet any of the 5 criteria
 A short-term and cancelable
 The lessor may provide for the maintenance and
upkeep of the asset, since he is likely to get it back
 Does not require the presentation of the full obligation
on the balance sheet
 It contains automobiles, office equipment…
 LEASING AS FORM OF DEBT
(CONT'D)
 Income Statement Effect
 Under the capital lease, the fixed asset account is
amortized over the life of the lease; and the liability is
also written off through regular amortization
 For an operating lease, it calls for an annual expense
deduction equal to the lease payment without specific
amortization
 LEASING AS FORM OF DEBT
(CONT'D)
 Income Statement Effect
 LEASING AS FORM OF DEBT
(CONT'D)
 Advantages of Leasing
 The lessee may lack sufficient funds or the credit
capability to purchase the asset from a manufacturer
 The provisions of a lease obligation may be less
restrictive than those of a bond indenture
 There may be no down payment requirement as the case
of the purchase of an asset
 For the lessor, the negative effects of obsolescence may
be reduced
 THE DEBT CONTRACT
(CONT'D)
 Methods of repayment
 Sinking-Fund Provision
 A less structured but more popular method of debt retirement
 Method of debt retirement is through the use of a sinking fund
 Semiannual or annual contributions are made by the corporation
into a fund administered by a trustee for purposes of debt
retirement.
 The trustee takes the proceeds and purchases bonds from willing
sellers.
 If no willing sellers are available, a lottery system may be used
among outstanding bondholders.
 THE REFUNDING
DECISION

11.75
%

IR will rise
rather sink
further
IR
Now, the firm prevailin Situation:
buys back the g 9.5%
What
bonds at close to
should
par, rather than at
Refunding high market
we do?
operation values
Then, the firm issues
new debt at the current
interest rate of 9.5%
 THE REFUNDING DECISION
(CONT'D)
 Should we make a refunding decision at the interest
rate of 9.5% ? Assume :
 The corporation now has the opportunity to buy back
the old debt at 10 percent above par (the call premium)
 Discount rate – aftertax cost of new debt: 9.5%(1-35%)
 THE REFUNDING DECISION
(CONT'D)
 Should we make a refunding decision at the interest
rate of 9.5% ?
financing costs related
to
Redeeming
Outflows
financing costs
Refundin reissuing securities
g
decision savings in annual
interest costs
Inflows

tax savings
 THE REFUNDING DECISION
(CONT'D)
 Should we make a refunding decision at the interest
rate of 9.5% ?

Total NPV of Total PV Total PV

cost saving in = of Cash - of cash
lower interest inflow outflow
rate

 If NPV > 0: the firm should make decision

 If NPV < 0: the firm should not
 THE REFUNDING DECISION
(CONT'D)
 Step 1: Outflow considerations
 Payment of call premium
 Increase in cost means reducing the tax expense
=>Net cost of call premium = $10,000,000 x 10% x(1 –
35%) = $650,000
 Underwriting cost on new issue:
 Each year tax saving caused by the underwriting costs:
($200,000 / 20)*35% = $3,500
 Total PV of the tax saving in 20 years: $40,145
=> Net cost of underwriting expense on the new issue:
$200,000 - $40,145 = $159,855
 THE REFUNDING DECISION
(CONT'D)
 Step 2: Inflow considerations
 Cost savings in lower interest rate:
 Increase in cost saving means increasing the tax expense
 Each year, annual aftertax benefit:
[(11.75% - 9.5%)*$10,000,000](1-35%) = $146,250
=> Total PV of cost saving in 20 years with the lower
interest rate: $1,677,475
 THE REFUNDING DECISION
(CONT'D)
 Underwriting cost on old issue:
 As calling the bond in now, we take the write-off below
sooner:
($125,000 - $125,000 x 5 / 25) = $100,000
 As calling the bond in now, each year we loose the cost
saving for tax:
($125,000 / 25) = $5,000
 The total PV of the cost saving (lost) in the remaining
20 years: = $57,350
 The net gain from the underwriting on the old issue:
$100,000 x 35% (*) - $57,350 x 35% = $14,928
 THE REFUNDING DECISION
(CONT'D)
 Step 3: NPV
 Total NPV of cost saving in lower interest rate = Total
Cash inflow – Total cash outflow
 Total NPV = (1,677,144 + 14,928) - (650,000 + 159,855)
= $882,561 >0
=> The firm should make refunding decision in case that
the interest rate fall to 9.5% During the next 20 years