Long-Term Debt and Lease Financing

1. Long-Term Debt and Lease Financing 16

2. Chapter Outline • Analyzing long-term debt. • Bond yield and prices. • Refunding the obligation upon decline in interest rates. • Innovative bond forms. • Long-term lease obligations and its characteristics.

3. 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 the Government to raise capital. • New set of rules have been developed for evaluating corporate bond issues.

4. Times Interest Earned for Standard and Poor’s Industrials

5. The Debt Contract • Contract bond: the basic long-term debt instrument for most large U.S corporations – basic items include: • Par value: initial value of the bond. • Principal or face value. • Coupon rate: actual interest rate on the bond. • Maturity date: repayment date of the principal. • Bond indenture, a supplement to the bond agreement.

6. Security Provisions • Secured debts have specific assets pledged to bondholders in the event of default. • These assets are seldom actually sold and distributed (proceeds). • 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 the interest rate on the bond.

7. Unsecured Debt • Debt that is not secured by a claim to a specific asset. • Debenture: unsecured long-term corporate bond. • General claim against the corporation, is common for defaults. • Subordinated debenture • Payment to the holder will occur only after the designated senior debenture holders are satisfied.

8. Priority of Claims

9. 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.

10. 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.

11. Bond Price Table

12. Bond Yields • Three different ways; computed below: • Example: par value: $1,000; payment: $100/ year; period: 10 years; current price: $900. • Coupon rate (nominal yield): interest rate / par value. $100 = 10% $1,000 • Current yield: in terms of the current price. $100 = 11.11% $900 • Yield to maturity: for bonds is held until maturity. Interest rate approximate: 11.70% = payment of $100 for 10 years and a final payment of $1,000.

13. Bond Ratings • Two major bond rating agencies: • Moody’s Investor Service. • Standard and Poor’s. • Ratings are based on a corporation’s: • Ability to make interest payments. • Consistency of performance. • Size. • Debt-equity ratio. • Working capital position etc.

14. Examining Actual Bond Ratings • The true return on a bond is measured by yield to maturity. • If a bond is relatively low in quality: • A corporation pays a yield to maturity, although they may be secured in nature.

15. 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 labeled as a refunding operation. • It is made possible by the option of call provision.

16. A 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.

17. Restatement of Facts

18. Steps A. Outflow consideration: 1. Payment of call premium. 2. Underwriting cost on new issue. B. Inflow consideration: 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

19. Step C- Net Present Value

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

21. 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 of 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.

22. Zero-Coupon and Floating Rate Bonds

23. 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.

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

25. Drawbacks of Debt • Interest and principal payment obligations are set by contract and must be met. • 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.

26. 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.

27. Examples of Eurobonds

28. Leasing as a Form of Debt • Leasing has the characteristics of a debt. • A corporation contracts to lease and signs a non-cancelable, non-term agreement. • Companies are expected to fully divulge all information about leasing obligations. • Leasing was made official as a result of Statement of Financial Accounting Standards (SFAS): • No. 13, issued by the FASB in November 1976.

29. Capital Lease (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.

30. 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 a full obligation on the balance sheet.

31. Income Statement Effect • Capital lease • Requires treatment similar to a purchase-borrowing arrangement. • Intangible asset is amortized, or written off, over the life of the lease - annual expense deduction. • Liability account is written off through regular amortization - implied interest cost on the balance. • Operating lease • Requires annual expense deduction equal to the lease payment, with no specific amortization.

32. Advantages of Leasing • Takes care of lack sufficient funds or the credit capability issues to purchase assets. • Obligation may be substantially less restrictive. • May not require a down payment. • Lessor’s expertise – may reduce negative effects of obsolescence. • Lease on chattels have no such limitations for bankruptcy and reorganization proceedings.

33. 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.