FINS 1612 Tutorial questions for Tutorial 3 (week 4)

You don’t need to submit these questions, but you are encouraged to do them before
your tutorial.

Chapter 10

End-chapter essay questions:

3 In a variable rate loan contract, how does a commercial bank allow for higher or
lower credit risk on the part of the prospective borrowers?

• The credit risk of the borrower is the perceived creditworthiness of the

borrower. Each borrower is considered to have a certain level of credit risk.
This level of credit risk varies between borrowers.
• Before granting a loan, a lender will analyse factors such as the total debt-to-
equity ratio of the firm, projected cash flows, the financial strength of the
borrower, past loan repayment performance, the projected performance of
the industry and the economy generally, forecast interest rates, the
management of the firm, the impact of competitors and the life cycle of the
firm’s products.
• Each borrower will be perceived to have a different level of credit risk and
therefore will pay a different rate of interest on the loan.
• The financial institution will usually make the determination of the exact rate
to pay based on some reference rate such as BBSW or LIBOR.
• If the borrower is a higher credit risk, the bank will demand a higher
premium above BBSW and vice versa. The premium might be as low as 10 or
15 basis points. It could be as high as 300 basis points (3 per cent) or more
above BBSW depending on the perceived risks.

5. Westpac Banking Corporation is currently writing a loan contract for a medium-

sized pharmaceutical company. Within the loan contract Westpac intends to
incorporate a number of positive and negative loan covenants.

a. What are loan covenants?

• Loan covenants are specified within a loan contract and typically restrict the business
and financial activities and actions of the borrowing firm.
• Common covenants will require a firm to maintain a minimum level of interest cover;
another may restrict the level of debt that a firm may accumulate relative to its
equity.

b. Explain why a financial institution would incorporate loan covenants into a loan
contract.

• Loan covenants are designed to protect the credit risk exposure of the lender to the
borrower.
• A firm is in technical default on its loan contract if it breaches a loan covenant. The
lender then has the right, within the terms specified in the loan contract, to act to
protect its exposure. This might involve taking possession of the assets of the
company. However, if the company has not defaulted on actual loan repayments, it
is more likely that the term loan may become repayable on demand.

c. Discuss the nature of positive and negative covenants and give two examples of
each.

• Protective loan covenants are classified as either positive covenants or negative

covenants.
• A positive covenant states actions that a company must comply with, such as
maintaining a minimum level of working capital, or the provision of audited financial
statements to the lender within a certain timeframe.
• A negative loan covenant limits or restricts the business activities or financial
structure of the company. For example, there may be a limitation placed on the
amount of a dividend that can be paid to shareholders, or a requirement that the
bank must approve further long-term borrowings of the company.

6. As the owner of a small architectural firm, you approach the Commonwealth Bank
to obtain a term loan so that the firm can buy a new computer-aided drawing
machine. The bank offers your company a loan of $28 500 over a three-year period
at a rate of interest of 8.65 per cent per annum, payable at the end of each month.
Calculate the monthly loan instalment.

where:
R is each monthly instalment amount
A is the loan amount (present value)
i is the current nominal interest rate expressed as a decimal
n is the number of compounding periods

A = $28 500
i = 0.0865 / 12 = 0.007208
n = 3 years x 12 months = 36

7. The architectural firm owner in Question 6 also approaches the National Australia
Bank to obtain a quote on the loan facility. The competitor bank (NAB) also offers the
company a fully drawn advance of $28 500 over a three-year period at a rate of
interest of 8.65 per cent per annum, but payable in advance at the beginning of each
month. Calculate the monthly loan instalment. Explain why the instalment payment
is different from the instalment in Question 6.

where:
R is the instalment amount
A is the loan amount (present value)
i is the current nominal interest rate expressed as a decimal
n is the number of compounding periods
 A = $28 500
i = 0.0865 / 12 = 0.007208
n= 3 years x 12 months = 36

$28500
R=
1 - (1 + 0.007208)− 36 
  (1 + 0.007208)
 0.007208 
R = $895.20

• In question 6, the series of cash flows occurred at the end of each period; this is an
ordinary annuity.
• In question 7, the loan instalments are payable at the beginning of the period; this is
an annuity due.
• The change in the formulae recognizes the change in the timing of the cash flows.
• The earlier loan instalment repayments at the start of each month mean that the
monthly instalment is lower; that is, the principal outstanding is being repaid earlier.

9. After three years of excellent business growth, a local mattress manufacturer

decides to expand and purchase new business premises costing $1 250 000. In
addition, establishment expenses of 0.50 per cent of the purchase price, plus
estimated legal expenses of $15 000 are payable. The total cost to purchase the
property will be financed by $225 000 of the firm’s own funds plus a mortgage loan
from ANZ Bank. The bank offers a mortgage loan at 8.15 per cent per annum. The
loan will be amortized by monthly instalments over the next 12 years, payable at the
end of each month. What is the amount of each monthly instalment?

Total outlays:
• cost of premises $1 250 000
• establishment expenses $6 250
• legal expenses $15 000 $1 271 250

Funding arrangements:

• own savings $225 000

 • mortgage finance $1 046 250 $1 271 250

Formula: R = A
1 – (1 + i)-n
i
where: A = $1 046 250
i = 0.00679167 (8.15% p.a. / 12 months)
n = 144 (12 years * 12 months)
R = 1 046 250

1 – (1.00679167) -144
0.00679167
R = $11 411.39 monthly instalment

13 Woodside Petroleum Limited has issued $100 million of debentures, with a

fixed-interest coupon equal to current interest rates of 7.70 per cent per
annum, coupons paid half-yearly and a maturity of 10 years.

a. What amount will Woodside raise on the initial issue of the debentures?

• The amount raised by Woodside on the initial issue of the debentures

into the market will be equal to the face value of the debentures; that is,
$100 million.
• This is because current yields on this type of security, at the issue date,
are equal to the fixed interest rate paid on the debenture.

b. After three years, yields on identical types of securities have risen to 8.75
per cent per annum. The existing debentures now have exactly seven years to
maturity. What is the value, or price, of the existing debentures in the
secondary market?

In order to calculate the value, or price, of the existing debentures in the

market, it is necessary to determine the present value of the face value, plus
the present value of the coupon stream (note: the price is being calculated
at a coupon date exactly one year after initial issue).
 1 - (1 + i )−n  
 + A(1 + i ) 
−n
P = C 
  i  
 A = $100 000 000
C = $3 850 000
n = 7 x 2 = 14
i = 0.0875 / 2 = 0.043750
Present value of the face value:
= A(1 + i)-n
= $100 000 000 (1 + 0.043750)-14
= $54 909 711.40
plus:
Present value of coupon stream:
= C [1 - (1 + i)-n ]
i
= $3 850 000 [1 - (1 + 0.043750)-14 ]
0.043750
= $39 679 453.97
Price of the debenture: = $54 909 711.40 + $39 679 453.97
= $94 589 165.37

c. Discuss why the value of the debenture has changed; that is, explain the
bond price/yield relationship using the above example.
• The price of the existing fixed interest security (debenture) has fallen
because yields in the market have risen.
• That is, there is an inverse relationship between interest rate movements
and price.
• The coupon payments on the existing bond are fixed; therefore, the lower
coupon (7.70% p.a.) being paid on the existing bond is worth less to an
investor. However, the investor will require the current yield of 8.75%
p.a. and as the fixed 7.70% coupon cannot be adjusted, the equalizing
adjustment occurs with the lowering of the price of the existing bond.

14. On 1 January 2019 a company issued five-year fixed-interest bonds with a face
value of $2 million to an institutional investor, paying half-yearly coupons at 8.36 per
cent per annum. Coupons are payable on 30 June and 31 December each year until
maturity. On 15 August 2020 the holder of the bonds sells at a current yield of 8.84
per cent per annum. Calculate the price at which the institutional investor sold the
bonds.
 é é1- (1+ i )-n ù -n ù k
P = êC ê ú + A(1+ i ) ú(1+ i )
êë êë i úû úû

C = each coupon payment i = interest rate

A = the Bond’s face value
k = the fraction of elapsed interest period since the last coupon payment.
Therefore:
i = 0.0884/2 = 0.044200
n = 7 [one coupon due 31.12.20, then 2021 (2), 2022 (2), and 2023 (2)]
C = $2 000 000 x 0.0836/2 = $83 600
k = last coupon paid 30 June 2020; sold 15 August 2020 – therefore 46 days elapsed
in 184 day period = 46/184 = 0.25
(a) Present value of face value:
= $2 000 000 (1 + 0.0442) –7
= $1 477 556.76
plus
(b) Present value of coupon stream:
1 − (1 + .0442) −7 
= $83600 
 .0442 
= $494075.28

Therefore: (a) + (b) = $1 477 556.76 + $494 075.28

= $1 971 632.04

Price (adjusted for elapsed day):

= $1 971 632.04 (1.0442)0.25

= $1 993 066.50
Note – elapsed days July 31
August 15
46 days elapsed
Note – days in the full coupon period = 184
Therefore: k = 46 / 184
= 0.2500

15 At GE Finance you are the manager of lease finance. You have begun to talk to
local companies to try and sell the concept of lease finance for their businesses.
 a. Explain to the companies the nature of lease finance, and distinguish between
operating leases, finance leases, sale and lease-back leases, and cross-border
leases.

• A lease is a contract whereby the owner of an asset, the lessor, grants to

another party, the lessee, the exclusive right to use the asset, usually for an
agreed period of time, in return for the payment of rent.
• Lessor—the owner of an asset that is subject to a lease agreement; receives
lease rental payments.
• Lessee—the user of an asset subject to a lease agreement; makes lease
rental payments.
• Leasing is the borrowing (renting) of an asset instead of the borrowing of
funds to purchase the asset.
Operating lease:
• A short-term arrangement where the lessor may lease the same asset to
successive lessees over time in order to earn a return on the asset.
• The lease arrangements normally contain only minor penalties for
cancellation of the lease. This feature leaves the risk of obsolescence of the
asset with the lessor.
• An operating lease is usually a full service lease; that is, the maintenance and
insurance of the leased asset is the responsibility of the lessor.
Finance lease:
• Generally a longer-term arrangement between the lessor and the lessee.
• The lessor earns a return on the asset from the one lease contract.
• The lessor's role is essentially one of financing.
• The lessee contracts to make regular lease rental payments, usually monthly,
over the period of the lease, which may be for more than two years.
• A distinguishing characteristic of the finance lease is that the lessee contracts
to make a lump sum payment, representing the residual value of the asset,
at the end of the lease period.
• When the residual payment is made, the ownership of the asset normally
passes to the lessee and appears on its balance sheet.
 • A finance lease is usually a net lease; the costs of ownership and operation of
the asset are borne by the lessee. These costs include maintenance and
repairs, insurance, taxes and stamp duties associated with the lease.
Sale and lease-back lease:
• A sale and lease-back lease involves the sale of an asset by its original owner,
but the original owner immediately enters into an agreement with the new
owner to lease back the asset for an agreed period.
• There is no need to continue funding the asset from the balance sheet.
• Lease payments are derived from the income earned from leasing the asset.
Cross-border lease:
• With a cross-border lease, a lessor in one country leases an asset to a lessee
in another country.
• Additional factors would need to be considered, including:
• how to recover an asset if the lessee should default on the agreement
• foreign exchange risk; that is, cash flows will need to be converted into
another currency at the current exchange rate
• the legal jurisdiction that will apply if legal action needs to be taken under
the terms of the lease.

b. Provide examples of how a business might use each of these forms of lease
arrangement.

• Operating lease: a plumber may lease a mechanical digger for a short-term

to install gas pipes in a new residential development. Alternatively, a special
events organiser may lease an outdoor sound system for a weekend festival.
• Finance lease: a corporation leases a number of desktop computer systems
for (say) two years; or a government department leases a motor vehicle fleet
for (say) three years.
• Sale and lease-back lease: a government may sell its railway rolling stock to
an investment company and then immediately lease the railway stock back
to continue operating the railway service.
• Cross-border lease: an airline company such as Qantas may lease aircraft
from an international finance group, or perhaps lease surplus aircraft from
British Airways over the summer tourist season.
c. List and explain the advantages of lease finance to a business.

• Leasing does not involve the use of the company's capital and other unused
lines of credit. This allows the company to use its capital to take advantage
of other investment opportunities that may arise.
• Leasing provides 100 per cent financing in that the lessor provides the asset
required for use by the company. Other forms of debt funding may require
the borrower to contribute a portion of its own funds.
• Rental payments under the lease agreement may be structured to reflect the
cash flows generated by the asset, that is, repayment scheduling may be
more flexible under lease agreements than under other forms of debt
repayment schedules.
• Lease rental payments are generally tax-deductible, and so it is important to
structure the repayments to match taxable income streams.
• Existing borrowing covenants in loan and note agreements may allow lease
financing while restricting further debt funding.
• Where the asset that is the subject of the lease is required for only a
relatively short term, it may be preferable to lease, rather than to buy and
then have to seek to dispose of the asset at the end of the period.

d. From the perspective of a lessor, explain the structure of a direct finance lease
versus a leveraged finance lease contract.
• A direct lease involves two parties, the lessor and the lessee. The lessor
retains ownership of the asset and may also seek additional guarantees to
support the lease contract.
• A leveraged lease is an arrangement whereby the lessor borrows to fund the
purchase of an asset that is to be leased. Often a lessor partnership is
formed for very large ticket items such as ships and aircraft. Because of the
complexity of leveraged leasing arrangements, a lease manager will be
responsible for the management of the contract.