Chapter

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Long-Term Debt and Lease Financing16

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.

16-3

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.

16-4

Times Interest Earned for Standard and Poor’s Industrials

16-5

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.

16-6

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.

16-7

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.

16-8

Priority of Claims

16-9

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.

16-10

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.

16-11

Bond Price Table

16-12

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.

16-13

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.

16-14

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.

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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.

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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.

16-17

Restatement of Facts

16-18

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

16-19

Step C- Net Present Value

16-20

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 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.

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Zero-Coupon and Floating Rate Bonds

16-23

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.

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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.

16-25

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.

16-26

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.

16-27

Examples of Eurobonds

16-28

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.

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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.

16-30

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.

16-31

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.

16-32

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.

16-33

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.