FINANCIAL MARKETS AND INSTITUTIONS

Debt Markets

1
Overview of debt financing arrangements

Short term debt

• Trade credit
• Bank overdrafts
• Commercial bills
• Promissory notes
• Negotiable certificates of deposit
• Inventory finance, accounts receivable, financing and factoring
Mid-long term debt
• Term loans or fully drawn advances
• Mortgage finance
• Debentures, unsecured notes and subordinated debt
• Leasing
Good management

• Matching principle
• Short-term assets should be funded with short-term liabilities
• Long-term assets should be funded with long-term liabilities

• Short-term debt is a financing arrangement for a period of less than one year
with various characteristics to suit borrowers’ particular needs
• Timing of repayment, risk, interest rate structures (variable or fixed) and
the source of funds
• It sits in the current liabilities of the balance sheet
Trade Credit

• A supplier provides goods or services to a purchaser with an arrangement for

payment at a later date

• Often includes a discount for early payment (e.g. 2/10, n/30, i.e. 2% discount if
paid within 10 days, otherwise the full amount is due within 30 days)

• From provider’s perspective- offering trade credit

• Advantages include increased sales
• Disadvantages include costs of discount and increased discount period,
increased total credit period and accounts receivable, increased collection
and bad debt costs
Trade credit – opportunity cost

• The opportunity cost of the purchaser forgoing the discount on an invoice (1/7,
n/30) is:

% discount 365
Opportunity cost  
100  % discount days difference between
early and late settlement
1.0 365
 
99.0 23
 0.160298 or 16.03% p.a.

• It is about comparing the opportunity cost vs. after-tax funding rate

Various short term debt financing agreements

Overdraft
• Major source of short-term finance
• Allows a firm to place its cheque (operating) account into deficit, to an agreed
limit

Commercial Bill
• A bill of exchange is a discount security issued with a face value payable at a
future date
• A commercial bill is a bill of exchange issued to raise funds for general business
purposes
• A bank-accepted bill is a bill that is issued by a corporation and incorporates the
name of a bank as acceptor
Flow of funds of commercial bill
Calculation: Discount securities

• Calculations considered

• Calculating price—yield known

• Calculating face value—issue price and yield known
• Calculating yield
• Calculating price—discount rate known
• Calculating discount rate

Refer Ch 8 on the basics of finance mathematics. Formulas (next page) are

just derivation of interest calculation in Ch 8
Calculation: Discount securities

• Calculating price (yield known)

• Calculating face value—issue price and yield known

yield
365  (  days to maturity)
Face value  price[ 100 ]
365

• Calculating yield

(sell price - buy price) (days in year  100)

Yield  
buy price days to maturity
Calculation: Discount securities

• Used in U.S and Euro markets – note the days is 360d

• Calculating price—discount rate known

days to maturity discount rate

Price  face value  [1   ]
days in year 100

• Calculating discount rate

face value - current price days in year  100

Discount rate  
face value days to maturity
Promissory notes

• Also called P-notes or commercial paper, they are discount securities,

issued in the money market with a face value payable at maturity but sold
today by the issuer for less than face value

• Typically available to companies with an excellent credit reputation

because:

• there is no acceptor or endorser

• they are unsecured instruments

• Calculations—use discount securities formulae

• Issue programs
• Usually arranged by major commercial banks and money market
corporations
• Standardised documentation
• Revolving facility
• Most P-notes are issued for 90 days
Negotiable certificates of deposit

• Short-term discount security issued by banks to manage their liabilities and

liquidity

• Maturities range up to 180 days

• Issued to institutional investors in the wholesale money market

• The short-term money market has an active secondary market in CDs

• Calculations—use discount securities formulae

Inventory and Account receivable financing

• Inventory finance

• Most common form is ‘floor plan finance’

• Particularly designed for the needs of motor vehicle dealers to finance
their inventory of vehicles
• Bailment common—finance company holds title to dealership’s
stock
• Dealer is expected to promote financier’s financial products

• Accounts receivable financing

• A loan to a business secured against its accounts receivable (debtors)

• Mainly supplied by finance companies (some banks)
• Lending company takes charge of a company’s accounts receivable;
however, the borrowing company is still responsible for the debtor
book and bad debts
Factoring

• Company sells its accounts receivable to a factoring company

• Converting a future cash flow (receivables) into a current cash flow

• Factor is responsible for collection of receivables

• Notification basis: vendor is required to notify its (accounts receivables)
customers that payment is to be made to the factor

• Recourse arrangement

• Factor has a claim against the vendor if a receivable is not paid

• Non-recourse arrangement

• Factor has no claim against vendor company

Term loan & fully drawn advances (Mid – Long term)

• Term loan
• A loan advanced for a specific period (three to 15 years), usually for a
known purpose; e.g. purchasing land, premises, plant and equipment
• Secured by mortgage over asset purchased or other assets of the firm
• Fully drawn advance
• A term loan where the full amount is provided at the start of the loan
• Provided by:
• mainly commercial banks and finance companies
• to a lesser degree, investment banks, merchant banks, insurance offices
and credit unions
Term loan structure

• Interest only during term of loan and principal repayment on maturity vs.
• Amortised or credit foncier loan
• Periodic loan instalments consisting of interest due and reduction of
principal
• Deferred repayment loan
• Loan instalments commence after a specified period related to project cash
flows and the debt is amortised over the remaining term of the loan
• Interest may be fixed (for a specified period of time; e.g.
two years) or variable
• Interest rate charged on term loan is based on:
• an indicator rate (e.g. BBSW or a bank’s own prime lending rate) and is also
influenced by:
• credit risk of borrower
• term of the loan
• repayment schedule
Term loan structure

• Fees include:
• establishment fee, service fee, commitment fee, line fee
• Loan covenants
• Restrict the business and financial activities of the borrowing firm
• Positive covenant
• Requires borrower to take prescribed actions; e.g. provision of
financial reporting to the lender
• Negative covenant
• Restricts the activities and financial structure of borrower; e.g.
maximum D/E ratio, minimum working-capital ratio
• Breach of covenant results in default of the loan contract, entitling lender
to act
Mortgage finance

• A mortgage is a form of security for a loan

• The borrower (mortgagor) conveys an interest in the land and property to
the lender (mortgagee)
• The mortgage is discharged when the loan is repaid
• If the mortgagor defaults on the loan the mortgagee is entitled to foreclose on
the property, i.e. take possession of assets and realise any amount owing on the
loan
• Use of mortgage finance
• Mainly retail home loans - Up to 30-year terms
• To a lesser degree commercial property loans - Up to 10 years as
businesses generate cash flows enabling earlier repayment
• Providers (lenders) of mortgage finance
• Commercial banks, building societies, life insurance offices, superannuation
funds, trustee institutions, finance companies and mortgage originators
Debentures, unsecured notes and subordinated debt

• Debentures and unsecured notes – issued in corporate bond market

• Are corporate bonds
• Specify that the lender will receive regular interest payments (coupon)
during the term of the bond and receive repayment of the face value at
maturity
• Unsecured notes are bonds with no underlying security attached
• Debentures:
• are secured by either a fixed or floating charge over the issuer’s
unpledged assets
• are listed and traded on the stock exchange
• have a higher claim over a company’s assets (e.g. on liquidation) than
unsecured note holders
Issuing debentures and notes

• There are three principal issue methods

• 1. Public issue—issued to the public at large, by prospectus
• 2. Family issue—issued to existing shareholders and investors, by
prospectus
• 3. Private placement—issued to institutional investors, by information
memorandum
• Usually issued at face value, but may be issued at a discount or with deferred or
zero interest
• A prospectus contains detailed information about the business
Subordinated debt

• More like equity than debt, i.e. quasi-equity

• Claims of debt holders are ‘subordinated’ to all other company liabilities

• Agreement may specify that the debt not be presented for redemption until
after a certain period has elapsed

• May be regarded as equity in the balance sheet, improving the credit rating of
the issuer
Price of a fixed-interest bond at coupon date

• The price of a fixed-interest security is the sum of the present value of the face
value and the present value of the coupon stream

1 (1  i )n
P  C[ ]  A(1  i )n
i
• Current AA+ corporate bond yields in the market are 8% per annum. What
is the price of an existing AA+ corporate bond with a face value of $100
000, paying 10% per annum half-yearly coupons, and exactly six years to
maturity?

A = $100 000
C = $100 000 x 0.10/2 = $5000
i = 0.08/2 = 0.04
n = 6 x 2 = 12
Price of a fixed-interest bond at coupon date

1 (1  i )n
P  C[ ]  A(1  i )n
i
Price of a fixed-interest bond between coupon dates

 1 (1  i )n   n  k
P  C    A(1  i ) (1  i )
  i  

K is the # of days elapsed since last coupon payment, expressed as a

fraction of the coupon period
Price of a fixed-interest bond between coupon dates

Current AA+ corporate bond yields in the market are 8% per annum. An existing
AA+ corporate bond with a face value of $100 000, paying 10% per annum half-
yearly coupons, maturing 31 December 2016, would be sold on 20 May 2011 at
what price?
Leasing

Definition:
• A lease is a contract where the owner of an asset (lessor) grants another party
(lessee) the right to use the asset for an agreed period of time in return for
periodic rental payments
• Leasing is the borrowing (renting) of an asset, instead of borrowing the funds to
purchase the asset
Leasing

• Advantages of leasing for lessee over ‘borrow and purchase’ alternative

• Conserves capital
• Provides 100% financing
• Matches cash flows (i.e. rental payments with income generated by the
asset)
• Less likely to breach any existing loan covenants
• Rental payments are tax deductible
• Advantages of leasing for lessor over a straight loan provided to a lessee
• Leasing has relatively low level of overall risk as asset can be repossessed if
lessee defaults
• Leasing can be administratively cheaper than providing a loan
• Leasing is an attractive alternative source of finance to both business and
government
Types of Leasing

• Operating lease
• Short-term lease
• Lessor may lease the asset to successive lessees (e.g. short-term use
of equipment)
• Lessee can lease asset for a short-term project
• Full-service lease—maintenance and insurance of the asset is provided by
the lessor
• Minor penalties for lease cancellation
• Obsolescence risk remains with lessor
Types of Leasing

• Finance lease
• Longer term financing
• Lessor finances the asset
• Lessor earns a return from a single lease contract
• Net lease—lessee pays for maintenance and repairs, insurance, taxes and
stamp duties associated with lease
• Residual amount due at end of lease period
• Ownership of the asset passes to lessee on payment of the residual amount
Types of Leasing

• Sale and lease back

• Existing assets owned by a company or government are sold to raise cash;
e.g. government car fleet
• The assets are then leased back from the new owner
• This removes expensive assets from the lessee’s balance sheet
• Cross-border lease
• A lessor in one country leases an asset to a lessee in another country
Types of Leasing

• Direct finance lease

• Involves two parties (lessor and lessee)
• Lessor purchases equipment with own funds and leases asset to lessee
• Lessor retains legal ownership of asset and takes control or possession of
asset if lessee defaults
• Security of the lessor provided by:
• lease agreement
• leasing guarantee—an agreement by a third party to meet
commitments of the lessee in the event of default
Types of Leasing

• Leveraged finance lease

• Lessor contributes limited equity and borrows the majority of funds
required to purchase the asset
• Lease manager
• Structures and negotiates the lease and manages it for its life
• Brings together the lessor (or equity participants), debt parties and
lessee
• Lessor gains tax advantages from the depreciation of equipment and the
interest paid to the debt parties
• Equity leasing
• Similar to a leveraged lease, except funds needed to buy asset are provided
by the lessor
• Therefore, it is usually smaller than a leveraged lease
• Has many characteristics of a leveraged lease, including the formation of a
partnership to purchase the asset, but not the advantage of leverage