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Chapter 16

Chapter 16. Long-Term Debt. Long-term Debt. Apart from raising capital from shareholders, start-up firms may borrow money from banks. When the firms become big and mature, they may issue corporate bonds to borrow money from the market directly.

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Chapter 16

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  1. Chapter 16 Long-Term Debt

  2. Long-term Debt • Apart from raising capital from shareholders, start-up firms may borrow money from banks. When the firms become big and mature, they may issue corporate bonds to borrow money from the market directly. • Corporate bond has become the basic long-term debt instrument for most large corporations

  3. Continental Airline Bonds • In 1987, CA issued $350 million of bonds that were secured by their planes • Investors believed that the equipment listed as collateral would protect them from default • So, CA could borrow money at a lower rate • In reality, most of the planes were old models that had little value in the market

  4. Bond Indenture • Investors should read the indenture before buying any particular bond • Indenture : legal agreement detailing the issuer’s obligations pertaining to a bond issue. • The indenture is administered by an independent trustee (e.g. Montreal Trust) under the guidelines of Trust Acts

  5. Secured Bonds • Collateral bonds - specific assets are pledged to bondholders e.g. CA bonds • Mortgage bonds - real property is pledged as security for loan • Senior vs junior claims - first claim vs second claim on assets pledged • Greater protection, lower the yield

  6. Unsecured Bonds • Debenture: an unsecured, long-term corporate bond • Senior and subordinated debenture: subordinated debenture holders receive payment only after senior debenture holders are paid in full • Junk bond: bonds of questionable quality and speculative in nature (with high yield)

  7. Repayment of Principal • 1. Lump-sum payment at maturity • 2. Serial payments: principal is paid off in installments over the life of the bond • 3. Sinking fund: bond issuer make regular contributions to a fund to accumulate the principal at maturity • 4. Conversion: retirement by converting bonds into common stock

  8. Bonds with Special Features • Callable bond: the issuer has an option to retire the bond prior to maturity • Retractable bond: bondholder has an option to sell the bond back to the issuer at par at a specified date before maturity • Extendible bonds: bondholder has an option to extend the maturity date

  9. Bond Ratings • An external assessment of a firm’s long-term creditworthiness, or • An assessment of the probability of default of the firm • highest rating (AAA) means lowest risk • lower rating (BB or below) means below investment grade • Default rating (D)

  10. Bond Ratings cont’ • Rating are based on 6 C’s of Credit • Capacity: firm size • Capital (debt/equity ratio) • Collateral: nature of assets pledged • Condition in the economy • Character of mgt: reliable/speculative • Communication: healthy financial statement

  11. Other Forms of Bond Financing • Zero-Coupon Bond: no regular interest payment but sold at deep discounts • Stripped Bond: similar to zero-coupon bond because coupons are stripped by investment dealer (sell to others) • Floating Rate Bond: interest rate varies with market • Real Return Bond: provide return over inflation

  12. Tax deductibility of interest payment Specific financial obligation Repaid with “cheaper dollars” Lower the total cost of capital Meet financial obligation regardless of the firm’s economic position Burdensome indenture restrictions Too much debt increases bankruptcy risk Benefits and Drawbacks of Debt

  13. Summary - Bond Terminology • Par Value: principal or face value (usually $1,000) • Coupon Rate: stated interest rate • Maturity Date: due date for the repayment of principal • Indenture: legal document detailing the bond issuer’s obligations • Secured Debt: specific asset is pledged to secure the loan • Debenture: Long-term unsecured corporate bond

  14. Summary - Priority of Claims • Secured Debt (Senior first, then Junior) •  • Unsecured Debt (Senior first, then subordinated) •  • Preferred Shareholders •  • Common Shareholders (if there is any left)

  15. Summary - Types of Bond Yields • Nominal Yield: stated yield (i.e. Coupon Rate) • Current Yield or Yield-to-Maturity (YTM): • discount rate that equates the future interest payments and the repayment of principal at maturity to the current market price of the bond • affected by current market interest rates • If mkt rates , YTM , bond price  • also affected by bond rating • If bond rating is high (low risk), YTM 

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