2 Chapter ObjectivesUnderstand how issuing bonds creates a fixed-cost solution to raising funds.Describe what types of bonds are available and how they are secured.Understand how a company repays bondholders.Understand the dynamics of using government- issued bonds to finance sports facilities.Describe capital structuring through various examples.
3 BondsA bond is an obligation that needs to be repaid with interest, similar to a loan from a bank.They are typically issued by larger corporations or government entities with a good repayment history and are sought after by investors because of either favorable interest rates or tax benefits.Bonds have the financing characteristics of loans as well as a market in which they can be bought and sold, like stocks.
4 Corporate BondsA bond is similar to a long-term loan; it is a contract under which a borrower agrees to make specified interest and principal payments on specified dates for a specified time period.There are many types of bonds:Convertible bonds, warrant bonds, income bonds, indexed bonds, zero coupon bonds (or discount bonds), junk bonds(continued)
5 Corporate Bonds (continued) Bond FinancingAdvantagesInterest on bonds is tax deductible (versus stock dividends, which are not deductible).Bond financing can be reasonably inexpensive for an established company with a good credit rating.There is a strong, established market for trading and issuing bonds.(continued)
6 Corporate Bonds (continued) Bond FinancingDisadvantagesInterest is a fixed charge that needs to be paid regardless of whether income was or was not earned.The principal loaned amount must be paid in full when the bond matures.Issuing bonds can harm a company’s credit rating and make it more difficult for the company to borrow money in the future.If the bond is secured by collateral, a corporation might not be able to sell or otherwise dispose of the asset without bondholder approval.Bondholders have the upper hand whenever a company declares bankruptcy.(continued)
7 Corporate Bonds (continued) Secured BondsIf an asset is secured, the corporation does not have exclusive use of the asset and might need to obtain approval before using the asset for various activities.A secured bondholder receives preferential treatment.Unsecured BondsThese bonds provide the greatest flexibility for the issuing corporation but minimal protection for the bond purchaser.(continued)
8 Corporate Bonds (continued) DebenturesThese are unsecured bonds.Only companies with the best credit rating can issue debentures.Subordinate debentures: Assets are pledged to back them; claims on these assets are subordinate to senior claims against the assets.Bearer BondsBondholder retains possession of the bond document.Bonds typically have coupons attached to them that the bondholder can redeem at the bank on a semiannual basis to receive the specified interest payment.(continued)
9 Corporate Bonds (continued) Issue Size and MaturityThe primary concern associated with bonds is determining the appropriate interest rate to attach to the bonds and determining how many bonds should be issued.Moody’s Investors Service and Standard & Poor’s rate bonds.Examine the bond issuer and determine the potential for default based on various factors such as revenue stream to repay the bonds, current economic conditions, interest rates, and past repayment historyBonds with high ratings have the lowest risk for default and do not need to pay as high an interest rate.Bonds that have a low rating are sometimes classified as junk bonds and need to pay a much higher interest rate to attract investors.(continued)
10 Corporate Bonds (continued) Issue Size and MaturityDemand for long-term funds arises from four major sources:Mortgage borrowingCorporate bond financingState and local government bond financingLong-term U.S. Treasury borrowingSuppliers for long-term funds include the following:Life insurance companiesSavings and loan associationsMutual savings banksInsurance companies (fire, property, and casualty)Corporate pension fundsState and local government retirement fundsMutual funds that purchase bonds
11 Costs of Issuing BondsPrimary cost associated with issuing bonds is the required interest payments.Payments are due on a semiannual basis for as long as the bond is outstanding.For example, a 20-year $100 million bond issued with 10% interest would require semiannual payments of $5 million for 20 years.There is a discount or risk premium at which bonds are sold.For example, if a discount for a $100 million bond issue is $5 million, the issuing or selling entity for the bonds would take $5 million (5%) as a fee to process and help sell the bonds.
12 Loan RepaymentBond repayment occurs when the bond matures and the issuer repays all remaining obligations.Repayment can occur via the following:Sinking fundsSerial bondsBond redemption before maturityConvertible bonds(continued)
13 Loan Repayment (continued) Sinking FundsThese are the most common technique for repaying a note.Money is set aside, either in preset amounts or on a variable basis.Serial BondsThe bonds are issued with maturity dates at predetermined redemption dates.They are often issued by states and municipalities that have fairly reliable tax revenue.(continued)
14 Loan Repayment (continued) Bond Redemption Before MaturityCorporations may issue newer bonds with more favorable interest rates and use the proceeds to buy older bonds on the open market.Bonds often have a call provision to allow the corporation to repurchase the bonds at a moderate premium if interest rates drastically change.If a bond is not callable, a company can purchase a bond on the open market or from a bondholder who is willing to exchange it voluntarily.(continued)
15 Loan Repayment (continued) Convertible BondsThese bonds can be converted to common stock.They are designed to redeem themselves and retire the debt through converting the debt to equity ownership.Buyers often prefer convertible bonds because investors can obtain interest payments on their investment but can also choose to switch to the equity ownership option if the corporation starts to experience significant growth.Buyers also prefer convertibles because they still retain the position of a secured creditor but also have an option to purchase stock.(continued)
16 Loan Repayment (continued) Convertible BondsCompanies can benefit in the following ways:Conversion usually occurs at a share price that is higher than it would have been if the shares had been purchased earlier.A corporation can lower its debt obligation by exchanging that obligation for shares that are valued significantly less on the corporate books.
17 Government-Issued Bonds Bonds represent the most likely funding source for publicly financed projects such as stadiums and arenas.The primary types of government bonds are:General obligation bondsRevenue bonds(continued)
18 Government-Issued Bonds (continued) General Obligation BondsThey are often called full faith and credit obligations.The city, county, municipality, state, or other government unit pledges to repay the obligation with existing tax revenues or by levying new taxes.Strength of the tax base is one of the most important criteria for GOBs.Small city vs. a large cityRevenue BondsThe tax revenue to support repayment may come from the project itself.For example, an entrance tax per ticket to a sporting event could be charged, and all revenues from this tax would first be allocated to repaying the revenue bond.(continued)
19 Government-Issued Bonds (continued) Repayment SourcesUtility taxesTicket surchargesReal estate taxesSpecific sales taxesTourist development taxesRestaurant sales taxesExcise or sin taxesLottery and gaming revenueNontax fees such as permitsGeneral sales and use taxes(continued)
20 Government-Issued Bonds (continued) Contractually Obligated RevenuesThis refers to any contract whereby a party agrees to pay a specific sum for a guaranteed number of years.This approach has two primary functions:Used as a source of revenue to guarantee repayment of bonds or other loansUtilized as an independent funding source(continued)
21 Government-Issued Bonds (continued) Contractually Obligated RevenuesHere are typical long-term contracts that form the basis of COR:Premium seat contractsLuxury box contractsConcession and novelty rights contractsNaming rights contractsPouring rights (beer and soft drink) contractsPersonal seat licensesParking rights contracts(continued)
22 Government-Issued Bonds (continued) Industrial Development BondsThese are mainly used for small businesses.Government units in each state have the authority, through sport authorities, economic development commissions, and similar divisions, to offer small-issue IDBs.A business owner can raise up to $10 million using IDBs, carrying an interest rate ranging from one-half to three-quarters of the prime interest rate, with a 30-year maturity.They are tax free.
23 Potential Capitalization Problems OvercapitalizationThe company raises too much money and does not have the financial means to pay everything off.Issuing too much bond-backed capital most serious form.UndercapitalizationThe business issues too few shares or bonds in relation to the expected earnings.If most of the funds for growth come from internal sources such as retained earnings, the business may have a hard time raising funds externally.
24 Questions for Class Discussion Should the general population pay the debt service for bonds issued to pay for a stadium or arena that is used primarily by a privately owned professional team? Debate the topic, citing all the pros and cons associated with the question. What innovative ideas could be used to help repay the bonds?What is the value of bonds versus stocks?What happens when a company defaults on paying a bond?Is a bond a safer investment for an investor than other investing options such as stocks?(continued)
25 Questions for Class Discussion (continued) Should companies be allowed to sell junk bonds?Besides the various backings for bonds highlighted in this chapter, what other resources can be tapped to help repay government-backed bonds to build stadiums and arenas?What do you think the biggest problems are with under- and overcapitalization?