Long-Term Debt

Chapter and Lease

16
Financing

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Outline
• Considerations in analyzing long-term debt
• Bond yield analysis
• Corporate decision as to call in and reissue
of debt when interest rates decline
• Long-term lease obligations and its
characteristics
• Bankruptcy – failure to meet financial
obligations
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 The Expanding Role of Debt
• Growth in corporate debt is attributed to:
– Rapid business expansion
– Inflationary impact on the economy
– Inadequate funds generated from the internal
operations of business firms
• Expansion of the U.S. economy has placed
pressure on U.S. corporations to raise
capital
– New set of rules have been developed for
evaluating corporate bond issues
16-3
 Times Interest Earned
for Standard & Poor’s Industrials

16-4
 The Debt Contract
• Corporate bond: The basic long-term debt
instrument
• Basic items of a bond agreement include:
– Par value: Initial or principal or face value of the
bond
– Coupon rate: Actual interest rate on the bond
– Maturity date: Final date on which repayment of
bond principal is due
• Bond indenture, a supplement to the bond
agreement
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 Security Provisions
• Secured debts have specific assets pledged
to bondholders in the event of default
– These assets are seldom actually sold and
proceeds are distributed
– Terms used to denote collateralized or secured
debts:
• Mortgage agreement: Real property is pledged
• After-acquired property clause requires any new
property to be placed under the original mortgage
– Greater the protection offered, lower is the
interest rate on the bond
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 Unsecured Debt
• Debt that is not secured by a claim to a
specific asset
– Debenture: Unsecured, long-term corporate
bond with a general claim against the
corporation
• May be high-ranking and subordinated
– Subordinated debenture
• Payment to the holder will occur only after the
designated senior debenture holders are satisfied

16-7
Priority of Claims

16-8
 Methods of Repayment
• Does not always involve a lump-sum
disbursement at the maturity date
• Repayment of bonds can be done by:
– Simplest method: Single-sum payment at maturity
– Serial payments: Paid off in installments over the
life of the issue
– Sinking-fund provision: Semiannual/annual
contributions made into a fund run by a trustee
– Conversion: Converting debt to common stock
– Call feature: Retire or force in debt issue before
maturity
16-9
 Bond Prices, Yields, and Ratings
• Financial managers must be sensitive to the
bond market with regard to:
– Interest rate changes
– Price movements
• Market conditions will influence:
– Timing of new issues
– Coupon rate offered
– Maturity date
• Bonds do not maintain stable long-term
price patterns
16-10
 Bond Price Table

• The longer the life of the issue, the greater

the influence of interest rate changes on
the price of the bond
16-11
 Bond Yields
• Three different ways:
– Coupon rate (nominal yield):
Stated interest payment  Par value
– Current yield:
Stated interest payment  Current price
– Yield to maturity: The interest rate that equates
future interest payments and the payment at
maturity to the current market price

16-12
 Bond Ratings
• Ratings are based on a corporation’s:
– Ability to make interest payments
– Consistency of performance
– Size
– Debt-equity ratio
– Working capital position, etc.
• Two major bond rating agencies:
– Moody’s Investor Service
• Nine categories of ranking: Aaa, Aa, A, Baa, Ba, B, Caa,
Ca, and C with numerical modifiers (1 for highest, 2 for
midrange, and 3 for lowest)
– Standard & Poor’s Corporation
• Similar to Moody’s with + and − modifiers
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 Examining Actual Bond Ratings
• High rated securities carry lower risk and
hence the lower interest payments
• The true return on a bond is measured by
yield to maturity
• Bonds of equal quality (rating) and maturity
may be sold at different prices depending
upon their coupon rates and yields to
maturity

16-14
 The Refunding Decision
• Example: Bonds issued at 11.75%
witnesses a drop in interest rates to 9.5%
– Assuming that the interest rates will rise:
• The expensive 11.75% bonds may be redeemed
• A new debt at the prevailing 9.5% may be issued
– This process is labeled as a refunding operation
• It is made feasible by the option of call provision

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 Capital Budgeting Problem
• The refunding decision involves:
– Outflows in the form of financing costs related to
redeeming and reissuing securities
– Inflows represented by savings in annual
interest costs and tax savings

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Capital Budgeting Problem -
Example

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 Capital Budgeting Problem –
Example (cont’d)
A. Outflow considerations:
1. Payment of call premium
2. Underwriting cost on new issue
B. Inflow considerations:
3. Cost savings in lower interest rates
4. Underwriting cost on old issue
C. Net present value:
– Present value of inflow – Present value of
outflow = Net present value
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 Step A – Outflow Considerations
• Payment of call premium : The First outflow is the 10
percent call premium on $10 million, or $1 million resulting
in an after-tax cost of $650,000 (i.e. $1,000,000 (1 − T) =
$1,000,000 (1 − 0.35) = $650,000)
• Underwriting cost on new issue: The second outflow is the
$200,000; considering the present value of future tax
savings on noncash write-off of underwriting cost, net cost
of underwriting would be:
Actual expenditure .................................... $200,000
− PV of future tax savings ......................... 40,145
[$3,500 × 11.470 (n = 20, i = 6%)]
Net cost of underwriting expense on the
new issue ……………………………............ $159,855

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 Step B – Inflow Considerations
• Cost savings in lower interest rates: The
corporation will enjoy a 2.25 percentage point drop
in interest rates, from 11.75 percent to 9.50
percent, on $10 million of bonds
– Saving in interest results in payment of more tax
– Determining the present value of cost saving in interest
rates
Interest savings = $10 million 2.25% = $225,000
After-tax savings = $225,000 (1  0.35) = $146,250
Present value of after-tax interest savings =
$146,250 × 11.470 (n = 20, i = 6%) = $1,677,488
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 Step B – Inflow Considerations
(cont’d)
• Underwriting cost on old issue:
Total underwriting costs = $125,000
Amortized @ $5,000 a year for 5 years = $25,000
Unamortized cost = $100,000
Present value of future write-off =
$5,000 × 11.470 (n = 20, i = 6%) = $57,350
Gain from immediate write-off =
$100,000 - $57,350 = $42,650
Tax savings on amortizing old underwriting costs
$42,650 × 0.35 = $14,928
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Step C – Net Present Value

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 Other Forms of Bond Financing
• Two innovative forms of bond financing that
are popular include:
– Zero-coupon rate bond
– Floating rate bond

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 Zero-coupon Rate Bond
• A bond that does not pay interest
– Advantages to the corporation:
• Immediate cash inflow, no outflow until maturity
• The difference in the value at maturity can be
amortized for tax purposes
– Advantage to the investor:
• Allows lock in a multiplier of the initial investment
– Disadvantages:
• Annual increase in the value of the bonds is taxable
as ordinary income
• Prices are volatile in nature
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 Floating Rate Bond
• The interest rate paid on the bond changes
with market conditions
– Advantage to the investor:
• A constant market value for the security, although
interest rates vary
– Exception:
• These bonds often have broad limits that interest
payments cannot exceed

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 Zero-Coupon
and Floating Rate Bonds

16-26
 Advantages of Debt
• Interest payments are tax-deductible
• The financial obligation is clearly specified
and is of a fixed nature
– Exception: Floating rate bonds
• In an inflationary economy, debt may be
paid back with ‘cheaper dollars’
• The use of debt, up to a prudent point, may
lower the cost of capital to the firm

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 Drawbacks of Debt
• Interest and principal payment obligations
set by contract must be met regardless of
economic position of the firm
• Indenture agreements may place undue
restrictions on the firm
– Bondholders may take virtual control of the firm
if important indenture provisions are not met
• Utilized beyond a given point, debt may
depress outstanding common stock values
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 Eurobond Market
• A bond payable in the borrower’s currency
but sold outside the borrower’s country
– Usually sold by an international syndicate of
investment bankers
– Disclosure requirements in the Eurobond
market are less demanding than those of SEC
or other domestic regulatory agencies

16-29
Examples of Eurobonds

16-30
 Leasing – A Form of Debt
• Leasing has the characteristics of a debt
– A corporation contracts to lease and signs a
noncancelable, long-term agreement
– Companies are expected to fully divulge all
information about leasing obligations
• SFAS No. 13 issued by the FASB requires:
– Certain types of leases must be shown as long-
term obligations on the financial statements of the
firm
• Lease may be capital (financing) lease or
operating lease 16-31
 Capital (Financing) Lease
• Four conditions for identification include:
– The arrangement transfers 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
– The present value of the minimum lease payments
equals 90% or more of the fair value of the leased
property at the inception of the lease
• The discount rate for this test is the leasing firm’s new
cost of borrowing or the lessor’s implied rate of return
under the lease
• The lower of the two must be used when both are known
16-32
 Operating Lease
• Does not meet the conditions of a capital
lease
• Usually short-term, cancelable at the option
of the lessee
• The lessor may provide for the maintenance
and upkeep of the asset
• Does not require a capitalization, or
presentation, of the full obligation on the
balance sheet
16-33
 Income Statement Effect
• Capital lease
– Requires treatment similar to a purchase-
borrowing arrangement
• It is amortized, or written off, over the life of the lease
with an annual expense deduction
• Liability account is written off through regular
amortization with an implied interest cost on the
balance
• Operating lease
– Requires annual expense deduction equal to the
lease payment, with no specific amortization
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 Advantages of Leasing
• Takes care of lack of sufficient funds or the
credit capability issues to purchase assets
• Obligation may be substantially less
restrictive than those of a bond indenture
• May not require a down payment
• Lessor’s expertise may reduce negative
effects of obsolescence
• Lease on chattels have no limitations of
bankruptcy and reorganization proceedings
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 Other Advantages of Leasing
• Tax advantage factors include:
– Depreciation write-off or research-related tax
credits
• Infusion of capital can occur if a firm
chooses to engage in a sale-leaseback
arrangement
– Allows the lessee to continue the usage of the
asset

16-36