Chapter 14

Debt

Financing

2009 14-1

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Chapter 14

Debt Financing

2009 14-3

Chapter Outline

14.1 Corporate Debt

14.2 Bond Covenants

14.3 Repayment Provisions

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Learning Objectives

• Identify different types of debt financing available to a firm

• Understand limits within bond contracts that protect the interests of bondholders

• Describe the various options available to firms for the early repayment of debt

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14.1 Corporate Debt

• Companies can raise debt using different sources: Public debt, which trades in a public market Private debt, which is negotiated directly with a

bank or a small group of investors.

• The securities that companies issue when raising debt are called corporate bonds.

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Example 14.1a: Calculating the Net Amount of Funds

Problem:

• You are finalizing a bank loan for $200,000 for your small business and the closing fees payable to the bank are 2% of the loan. After paying the fees, what will be the net amount of funds from the loan available to your business?$200,000 x 2% = $4,000

$200,000 - $4,000 = $196,000

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Example 14.1a: Calculating the Net Amount of Funds

Solution:

Plan:

• The net amount of funds available is the amount of loan proceeds left after the fees are paid. Therefore, the plan is to subtract the fees, which are 2% of the $200,000 loan principal, from the loan amount.

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Example 14.1a: Net Funds on Borrowings

Execute:$200,000 x 2% = $4,000

$200,000 - $4,000 = $196,000

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Example 14.1a: Net Funds on Borrowing

Evaluate:

• The actual amount you get to use is $196,000. It is important to consider not only the principal amount and the interest rate, but also the fees and their effect on the funds available to you.

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Example 14.1b: Corporate Debt

Problem:

• Your firm is issuing $100 million in straight bonds at par with a coupon rate of 7% and paying total fees of 5%. What is the net amount of funds that the debt issue will provide for your firm?

2009 14-11

Example 14.1b: Corporate Debt

Solution:Plan:• The net amount of funds your firm will net from the

debt issue is the issue amount less the fees. The coupon rate will be paid semi-annually out of going revenues and is not considered in the initial cash intake. Therefore, the plan is to subtract the fees, which are 5% of the issue amount, from the issue amount to determine how much your firm will net from the debt issue.

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Example 14.1b: Corporate Debt

Execute:

• $100 million x 5% = $5,000,000

• $100 million - $5 million = $95,000,000

• Amount firm has available for its use from issuing $100 million in debt is only $95 million

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Example 14.1b: Corporate Debt

Evaluate:

• There are costs for issuing bonds to the public. Your firm must consider these in assessing its debt issue. The amount your firm will have available from issuing $100 million in debt is only $95 million.

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Private Debt

• Private Debt: debt that is not publicly traded. The private debt market is larger than the public debt market.

• Private debt has the advantage that it avoids the cost and delay of registration with the U.S. Securities and Exchange Commission (SEC).

• The disadvantage is that because it is not publicly traded, it is illiquid, meaning that it is hard for a holder of the firm’s private debt to sell it in a timely manner.

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Private Debt

Bank Loans:

• Term Loan: Loan that lasts for specific time frame (term).

• Syndicate Bank Loan: A single loan is funded by a group banks rather than just a single bank.

• Revolving line of credit: A credit commitment for specific time period up to some limit which a company can use as needed

• Asset Backed line of credit: A company may be able to get a larger line of credit or a lower interest rate if it secures the line of credit by pledging an asset as collateral.

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Private Placement

• Private placement: a bond issue that does not trade on a public market but rather is sold to a small group of investors.

• Advantages It is less costly to issue Privately placed debt also need not conform to the

same standards as public debt; as a consequence, it can be tailored to the particular situation.

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Public Debt

• The Prospectus: A public bond issue is similar to a stock issue.

• The prospectus must include an indenture, a formal contract that specifies the firm’s obligations to the bondholders

• If a coupon bond is issued at a discount, it is called an original issue discount (OID) bond.

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Secured and Unsecured Corporate Debt

• Four types of bonds issued Notes: are unsecured debt with maturities typically

of less than 10 years Debentures: are unsecured debt with maturities of

10 years or longer Mortgage Bonds: are secured by real property Asset backed Bonds: bonds can be secured by any

kind of asset

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Table 14.1 Types of Corporate Debt

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International Bond Markets

• Domestic bonds: issued by a local entity and traded in a local market, but purchased by foreigners. They are denominated in the local currency.

• Foreign bonds: issued by a foreign company in a local market and are intended for local investors. They are also denominated in the local currency.

• Eurobonds: are international bonds that are not denominated in the local currency of the country in which they are issued. Consequently, there is no connection between the physical location of the market on which they trade and the location of the issuing entity.

• Global bonds: combine the features of domestic, foreign, and Eurobonds, and are offered for sale in several different markets simultaneously.

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14.2 Bond Covenants

• Covenants: restrictive clauses in bond contract limiting the issuer from taking actions that may undercut its ability to repay the bonds.

• Advantages By including more covenants, firms can reduce their costs of

borrowing. The reduction in the firm’s borrowing cost can more than

outweigh the cost of the loss of flexibility associated with covenants.

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Table 14.4 Typical Bond Covenants

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14.3 Repayment Provisions

• Call Provisions: Firms can repay bonds by exercising a call provision.

• Callable Bonds: Allow the firm to repurchase the bonds at a predetermined price.

• YTC: Yield to Call on a callable bond

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Table 14.6 Bond Calls and Yields

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Example 14.1 Calculating the Yield to Call

Problem:• IBM has just issued a callable (at par) five-year,

8% coupon bond with annual coupon payments. The bond can be called at par in one year or anytime thereafter on a coupon payment date. It has a price of $103 per $100 face value, implying a yield to maturity of 7.26%. What is the bond’s yield to call?

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Example 14.1 Calculating the Yield to Call

Solution:Plan:• The timeline of the promised payments for this bond (if it is not called) is:

• If IBM calls the bond at the first available opportunity, it will call the bond at year 1. At that time, it will have to pay the coupon payment for year 1 ($8 per $100 of face value) and the face value ($100). The timeline of the payments if the bond is called at the first available opportunity (at year 1).

• To solve the YTC, we use these cash flows set the price equal to the discounted cash flows and solving for the discount rate.

0 1 2 … 5

$8 $8 $108

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Example 14.1 Calculating the Yield to Call

Execute:

• For the YTC, setting the present value of these payments equal to the current price gives

103 = 108 YTC= 108 -1= 4.85% ( 1+ YTC) 103

Given: 1 -103 8 100

Solve for: 4.85

Excel Formula: =RATE(NPER, PMT, PV,FV) = RATE(1,8,-103,100)

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Example 14.1 Calculating the Yield to Call

Evaluate:• The YTM is higher than the YTC because it assumes

that you will continue receiving your coupon payments for 5 years, even though interest rates have dropped below 8%. While under the YTC assumptions, you are repaid the face value sooner, you are deprived of the extra 4 years of coupon payments, so your total return is lower.

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Repayment Provisions

• Sinking Funds: a provision that allows the company to make regular payments into a fund administered by a trustee over the life of the bond instead of repaying the entire principal balance on the maturity date

• Balloon Payment: Large payments on a maturity date

• Convertible Provisions: Corporate bonds with a provision that gives the bondholder an option to convert each bond owned into a fixed number of shares of common stock at a ratio called the conversion ratio.

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Convertible Bonds and Stock Prices

• The likelihood of eventually converting a convertible bond depends upon the current stock price.

• When the stock price is low, conversion is unlikely, and the value of the convertible bond is close to that of a straight bond

• When the stock price is much higher than the conversion price, conversion is verylikely and the convertible bond’s price is close to the price of the converted shares.

• When the stock price is the middle range, near the conversion price, there is the greatest uncertainty about the whether it will be optimal to convert or not

• Convertible debt carries a lower interest rate than other comparable non-convertible debt.

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Figure 14.2 Convertible Bond Value

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Combining Features

• Combining Features: Companies have flexibility in setting the features of the bonds they issue.

• Subordinated bonds typically have a higher yield because of their riskier position relative to senior bond

• Leveraged Buyouts: a public company becoming private, in this case through a leveraged buyout. In a leveraged buyout (LBO), a group of private investors purchases all the equity of a public corporation

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Chapter Quiz

1. What are the different types of corporate debt?2. Explain some of the differences between a public debt offering

and a private debt offering.3. Explain the difference between a secured corporate and an

unsecured corporate bond.4. Why would a call feature be valuable to a company issuing

bonds?5. What is the effect of including a call feature on the price a

company can receive for its bonds?6. Why is the yield on a convertible bond lower than the yield on

an otherwise identical bond without a conversion feature?