Chapter 15 Debt Financing

Chapter Outline 15.1 Corporate Debt 15.2 Bond Covenants 15.3 Repayment Provisions

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

15.1 Corporate Debt Private Debt – Bank Loans Term Loan Syndicated Bank Loan Revolving Line of Credit Asset-Backed Line of Credit – Private Placements

15.1 Corporate Debt Public Debt – The Prospectus Indenture – A formal contract between a bond issuer and a trust company, which represents the bondholders’ interests Original Issue Discount (OID) Bond – A coupon bond issued at a discount

Figure 15.1 Front Cover of the Offering Memorandum for the Hertz Junk Bond Issue

15.1 Corporate Debt Public Debt – Unsecured Corporate Debt Notes Debentures – Secured Corporate Debt Mortgage Bonds Asset-Backed Bonds

Table 15.1 Types of Corporate Debt

15.1 Corporate Debt Public Debt – Seniority A bondholder’s priority, in the event of a default, in claiming assets not already securing other debt Subordinated Debenture – A debenture issue that has a lower priority claim to the firm’s assets than other outstanding debt Tranches – Different classes of securities that comprise a single bond issuance

Table 15.2 Hertz’s December 2005 Junk Bond Issues

15.1 Corporate Debt Public Debt – International Bonds Domestic Bonds – Issued by a local entity and traded in a local market, but purchased by foreigners – Denominated in the local currency Foreign Bonds – Issued by a foreign company in a local market and are intended for local investors – Denominated in the local currency – Yankee bonds » Foreign bonds issued in the United States

15.1 Corporate Debt Public Debt – International Bonds Eurobonds – International bonds that are not denominated in the local currency of the country in which they are issued Global Bonds – Combines the features of domestic, foreign, and Eurobonds, and are offered for sale in several different markets simultaneously – Can be offered for sale in the same currency as the country of issuance

Table 15.3 Summary of New Debt Issued as Part of the Hertz LBO

15.2 Bond Covenants Covenants – Restrictive clauses in a bond contract that limit the issuer from taking actions that may undercut its ability to repay the bonds Advantages of Covenants – With more covenants, a firm firms can reduce its 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

Table 15.4 Typical Bond Covenants

15.3 Repayment Provisions Call Provisions – Callable Bond Call Date Call Price Call Premium

Table 15.5 Call Features of Hertz’s Bonds

15.3 Repayment Provisions Call Provisions Call Provisions and Bond Prices – Investors will pay less for a callable bond than for an otherwise identical noncallable bond – A firm raising capital by issuing callable bonds instead of non- callable bonds will either have to pay a higher coupon rate or accept lower proceeds

15.3 Repayment Provisions Call Provisions Yield to Call – The yield of a callable bond calculated under the assumption that the bond will be called on the earliest call date Yield to Worst – Quoted by bond traders as the lower of the yield to call or yield to maturity

Table 15.6 Bond Calls and Yields

Example 15.1 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?

Example 15.1 Calculating the Yield to Call Solution: Plan: The timeline of the promised payments for this bond (if it is not called) is:

Example 15.1 Calculating the Yield to Call Solution: Plan: (cont’d) 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) is:

Example 15.1 Calculating the Yield to Call Solution: Plan: (cont’d) To solve the YTC, we use these cash flows, set the price equal to the bond’s current price and solve for the discount rate.

Example 15.1 Calculating the Yield to Call Execute: For the YTC, setting the present value of these payments equal to the current price gives : Given: Solve for:4.85 Excel Formula: =RATE(NPER, PMT, PV,FV) = RATE(1,8,-103,100)

Example 15.1 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.

15.3 Repayment Provisions Sinking Fund – A company makes regular payments into a fund administered by a trustee over the life of the bond – These payments are then used to repurchase bonds, usually at par Balloon Payment – A large payment that must be made on the maturity date of a bond when the sinking fund payments are not sufficient to retire the entire bond issue

15.3 Repayment Provisions Convertible Provisions – Convertible Bonds – Conversion Ratio

15.3 Repayment Provisions Convertible Provisions – Convertible Bond Pricing Consider a convertible bond with a $1000 face value and a conversion ratio of 20 If you converted the bond into stock on its maturity date, you would receive 20 shares – If you did not convert, you would receive $1000 Conversion Price – By converting the bond you essentially “paid” $1000 for 20 shares, implying a conversion price per share of $1,000/20 = $50

15.3 Repayment Provisions Convertible Provisions – Convertible Bond Pricing Straight (Plain-Vanilla) Bond – A non-callable, non-convertible bond – Convertible Bonds and Stock Prices When a firm’s stock price is much higher than the conversion price, conversion is very likely and the convertible bond’s price is close to the price of the converted shares

Figure 15.2 Convertible Bond Value

15.3 Repayment Provisions Convertible Provisions – Combining Features Companies have flexibility in setting the features of the bonds they issue – Leveraged Buyout (LBO) When a group of private investors purchases all the equity of a public corporation and finances the purchase primarily with debt

Table 15.7 RealNetworks’ 2003 Convertible Debt Issue