Fundamentals of Corporate Finance

Fourth Canadian Edition

Chapter 15
Debt Financing

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Chapter Outline
15.1 Corporate Debt
15.2. Other Types of Debt
15.3 Bond Covenants
15.4 Repayment Provisions

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Learning Objectives
• Identify different types of debt financing available to a
firm
• Understand limits within bond contracts that protect
the interests of bondholders
• Describe the various options available to firms for the
early repayment of debt

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15.1 Corporate Debt (1 of 7)
• Private Debt
– Bank Loans
 Term Loan
 Syndicated Bank Loan
 Revolving Line of Credit
 Asset-Backed Line of Credit
– Private Placements

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15.1 Corporate Debt (2 of 7)
• Public Debt
– The Prospectus
 Indenture
– A formal contract between a bond issuer and a trust
company, which represents the bondholders’ interests
 Original Issue Discount (OID) Bond
– A coupon bond issued at a discount

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15.1 Corporate Debt (3 of 7)
• Public Debt
– Unsecured Corporate Debt
 Notes
 Debentures
– Secured Corporate Debt
 Mortgage Bonds
 Asset-Backed Bonds

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15.1 Corporate Debt (4 of 7)
• Public Debt
– Seniority
 A bondholder’s priority, in the event of a default, in
claiming assets not already securing other debt
 Subordinated Debenture
– A debenture issue that has a lower priority claim to the
firm’s assets than other outstanding debt
 Tranches
– Different classes of securities that comprise a single bond
issuance

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15.1 Corporate Debt (5 of 7)
• Public Debt
– International 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
intended for local investors
– Denominated in the local currency

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15.1 Corporate Debt (6 of 7)
• Public Debt
– International Bonds
 Foreign Bonds
– Yankee bonds
• Foreign bonds issued in the United States
 Eurobonds
– International bonds that are not denominated in the local
currency of the country in which they are issued

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15.1 Corporate Debt (7 of 7)
• Public Debt
– International Bonds
 Global Bonds
– Combines the features of domestic, foreign, and
Eurobonds, and are offered for sale in several different
markets simultaneously
– Can be offered for sale in the same currency as the
country of issuance

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Key Terms and Definitions (1 of 6)
• Private debt: Debt that is not publicly traded.
• Term loan: A bank loan that lasts for a specific term.
• Syndicated bank loan: A single loan that is funded by
a group of banks rather than just a single bank.
• Private placement: A bond issue that does not trade
on a public market but rather is sold to a small group
of investors.

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Key Terms and Definitions (2 of 6)
• Indenture A formal contract between a bond issuer
and a trust company that specifies the firm’s
obligations to the bondholders
• Unsecured debt: A type of corporate debt that, in the
event of a bankruptcy, gives bondholders a claim to
only the assets of the firm that are not already
pledged as collateral on other debt.

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Key Terms and Definitions (3 of 6)
• Secured debt: A type of corporate loan or debt
security in which specific assets are pledged as a
firm’s collateral that bondholders have a direct claim
to in the event of a bankruptcy.
• Mortgage bonds: A type of secured corporate debt in
which real property is pledged as collateral.
• Asset-backed bonds: A type of secured corporate
debt in which specific assets are pledged as collateral.

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Key Terms and Definitions (4 of 6)
• Seniority: A bondholder’s priority, in the event of a
default, in claiming assets not already securing other
debt.
• Subordinated debenture: A debenture issue that has
a lower priority claim to the firm’s assets than other
outstanding debt.
• Tranches: Different classes of securities that make up
a single bond issuance.

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Key Terms and Definitions (5 of 6)
• Domestic bonds: Bonds issued by a local entity,
denominated in the local currency and traded in a
local market, but purchased by foreigners.
• Foreign bonds: Bonds issued by a foreign company
in a local market and intended for local investors.
They are also denominated in the local currency.

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Key Terms and Definitions (6 of 6)
• Eurobonds: International bonds that are not
denominated in the local currency of the country in
which they are issued.
• Global bonds: Bonds that are offered for sale in
several different markets simultaneously.

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15.2 Other Types of Debt (1 of 2)
• Sovereign Debt
– Sovereign debt is debt issued by national governments.
• Agency Securities
– Agency securities are issued by Crown corporations of
the Canadian federal government.

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15.2 Other Types of Debt (2 of 2)

• Provincial and Municipal Bonds

– Provincial and municipal bonds are issued by provincial
and local governments and their Crown corporations
(e.g., Manitoba Hydro or Hydro Quebec).
 General obligation bonds: backed by the full faith and
credit of a local government;
 Double-barrelled bonds: Bonds with payments tied to a
particular revenue source in addition to the full faith and
credit of the local government
 Revenue bonds: Bonds backed by the revenues generated
by projects initially financed by the bond issue but not
backed by the full faith and credit of the local government.

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Example 15.1: Coupon Payments on
Real Return Bonds Problem
• Suppose that in January 2000 the Government of
Canada issued a 30-year real return bond with a
coupon rate of 4%. On the date of issue, the
consumer price index (CPI) was 93.5. In July 2008,
the CPI had increased to 116.1. What coupon
payment was made in July 2008? What coupon
payment was made in January 2017 when the CPI
was 129.0?

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Example 15.1: Coupon Payments on
Real Return Bonds Solution
• Between the issue date and July 2008, the CPI
appreciated by a factor of 116.1  93.5 = 1.24171.
• The principal amount of the bond increased by this
amount; that is, the original face value of $1000
increased to $1241.71.
• Because the bond pays semi-annual coupons, the
coupon payment was $1241.17  0.04/2 = $24.83. In
January 2017, the coupon payment was:
$1000  129/93.5  0.04/2 = $27.59

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15.3 Bond Covenants (1 of 2)
• Covenants
– Restrictive clauses in a bond contract that limit the
issuer from taking actions that may undercut its ability
to repay the bonds

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15.3 Bond Covenants (2 of 2)
• 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

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15.4 Repayment Provisions
• Call Provisions
– Callable Bond
 Call Date
 Call Price
 Call Premium

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15.4 Repayment Provisions
• Call Provisions
– Call Provisions and Bond Prices
 Investors will pay less for a callable bond than for an
otherwise identical noncallable bond
 A firm raising capital by issuing callable bonds instead of
non-callable bonds will either have to pay a higher
coupon rate or accept lower proceeds

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15.4 Repayment Provisions
• Call Provisions
– Yield to Call
 The yield of a callable bond calculated under the
assumption that the bond will be called on the earliest
call date
– Yield to Worst
 Quoted by bond traders as the lower of the yield to call
or yield to maturity

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15.4 Repayment Provision
• The Canada Call or Make-whole Call Provision
– This call provision sets the call price as the present
value of the all remaining payments of the bond, which
is calculated using a rate that adjusts with changes in
prevailing interest rates in the economy.

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15.4 Repayment Provisions
• Sinking Fund
– A method for repaying a bond in which 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 the lower of
the bond’s par value or market price.

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15.4 Repayment Provisions
• 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.

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Chapter Quiz (1 of 2)
1. List the four types of corporate public debt that are
typically issued.
2. Why can bond covenants reduce a firm’s borrowing
costs?

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Chapter Quiz (2 of 2)
3. Do callable bonds have a higher or lower yield than
otherwise identical bonds without a call feature?
Why?
4. What is a sinking fund?

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