Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Long-Term Debt and Lease Financing 16

1-2 Chapter 16 - Outline Bonds Bond Terminology Priority of Claims on Bankruptcy Methods of Retiring (Repaying) Bonds Reading Bond Price Quotations 3 Types of Bond Yields Bond Ratings The Refunding Decision Other Forms of Bond Financing Advantages and Disadvantages of Debt 2 Types of Leases Advantages of Leasing Lease vs. Purchase Summary and Conclusions PPT 16-2

1-3 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 U.S. corporations to raise capital –New set of rules have been developed for evaluating corporate bond issues

1-4 Times Interest Earned for Standard & Poor’s Industrials

1-5 Firms and governments “ borrow ” money from investors by selling bonds A bond is a written promise that the borrower (firm) will pay the lender (investor) at a stated future date, the principal plus a stated rate of interest Bonds differ from one another in terms of maturity (payment date), potential yield (interest rate), and investment quality (risk) Several companies rate the quality of various bonds Bonds PPT 16-4

1-6 Bond Terminology Par Value: –principal or face value (usually $1,000) Coupon Rate: –actual or stated interest rate Maturity Date: –date when repayment of principal is due Indenture: –legal document detailing the corporation’s obligations Secured Debt: –where specific assets are pledged in the event of default Debenture: –a L/T unsecured corporate bond PPT 16-5

1-7 Security provisions Secured claim – specific assets are pledge to bondholders in the event of default. mortgage agreement –real property is pledged as security for loan. Senior claims –require satisfaction in liquidation proceedings prior to junior claims New property may become subject to a security provision by an “ after acquired property clause ”

1-8 Unsecured Debt Debenture: – an unsecured, long-term corporate bond. Subordinated debenture : – an unsecured bond in which payment will be made only after the holders of designated senior debt issues have been satisfied. Junk bond : –debt obligation of questionable quality ( with a rating below investment grade BBB), usually with a high expected yield.

1-9 Priority of Claims Secured Debt (first priority)  Unsecured Debt (or Debenture)  Preferred Shareholders  Common Shareholders (last to receive any money)

1-10 Priority of Claims

1-11 Methods of Retiring (Repaying) Bonds Principal at maturity: –lump-sum payment when bond is due Serial payments: –bond is paid off in installments Sinking fund: –corporation contributes regularly to a trust fund used to buy back bonds Conversion: –bond can be converted into shares of common stock at the option of the bondholder Call feature: –corporation can redeem bonds early by paying a premium over par value PPT 16-7

1-12 Table 16-1 Bonds: Corporate (partial) PPT 16-8 Bombardier (formerly Bombardier-MLW Ltd.) 8.3% Debentures, due July 28, 2003 DBRS Rating: AAug 4, 2000 Issued: $150,000,000July 28, 1993 O/S: $150,000,000Dec. 31, 1997 Interest: 8.30% (S)Jan 28/July 28 Redemption: Redeem, at any time at the greater of Canada Yield Price (Canada Yield %) and par Lead Underwriter(s): ScotiaMcLeod Inc. Trustee: Computershare Investor Services Inc.

1-13 Company Name Coupon (interest rate %) Maturity Date (April 8, 2022) Price (Last transaction price = $138.50/ $100) Yield (Annual interest Market price) Change(Closing price up $1.11 from previous day) Reading Bond Price Quotations PPT 16-9

1-14 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

1-15 Bond Price Table

Types of Bond Yields Nominal Yield (or Coupon Rate): –stated interest rate divided by par value Current Yield: –Stated interest rate divided by current price of the bond Yield-to-Maturity (YTM): – interest rate that equates the future (expected) interest payments and payment at maturity to the current market price of the bond –affected by current market interest rates If rates , YTM , bond price  – and bond rating If rating high (low risk), YTM  PPT 16-11

1-17 Bond Ratings Two major bond rating agencies: –Moody’s Investor Service –Standard & Poor’s Corporation Ratings are based on a corporation’s: –Ability to make interest payments –Consistency of performance –Size –Debt-equity ratio –Working capital position, etc.

1-18 Bond Ratings Rating Service High Grade Medium Grade (Investment Grade) Speculative Poor Grade Moody's Aaa AaA BaaBa B Caa to C Standard & Poor's AAA AAA BBBBB B CCC to D Dominion AAABBB CB Risk FactorLowHigh Bond Ratings PPT 16-13

1-19 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

1-20 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

1-21 Restatement of Facts

1-22 Steps A. Outflow considerations: 1. Payment of call premium 2. Underwriting cost on new issue B. Inflow considerations: 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

1-23 Step C - Net Present Value

1-24 Other Forms of Bond Financing Zero-Coupon Bond / Strip Bond: –does not pay interest –is issued at a deep discount from face value Floating Rate Bond: –interest rate paid on the bond changes with market conditions Real Return Bond –principal adjusted for inflation Revenue Bond –security based upon cash flow Eurobond: –bond issued in another country PPT 16-17

1-25 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

1-26 Zero-Coupon and Floating Rate Bonds

1-27 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

1-28 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

1-29 Examples of Eurobonds

1-30 Advantages and Disadvantages of Debt Advantages of Debt: –interest payments are tax deductible to a firm –wise use of debt may lower a firm’s weighted average cost of capital (WACC) –financial obligation is fixed –no reduction in control or equity of present shareholders –company may get a better return on equity from leverage PPT 16-19

1-31 Advantages and Disadvantages of Debt Disadvantages of Debt: –interest and principal must always be met when due, regardless of a firm’s financial position –agreements may restrict financial management in firm –poor use of debt may lower a firm’s stock price –expensive financing when interest rates are high PPT 16-20

1-32 Leasing as a Form of Debt Leasing has the characteristics of a debt –A corporation contracts to lease and signs a noncancelable, long-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

1-33 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

1-34 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

1-35 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

1-36 Advantages of Leasing A loan may be more expensive / refused There may be no down payment on a lease, but usually a down payment with a loan A lease may have fewer restrictions than a loan There is a fixed payment on a lease, but loan interest may vary with prime Lease from a manufacturer may have attractive terms (ex: lower interest cost) or provide specialist expertise Using a lease may restrict creditor claims in bankruptcy Lease may be preferable for equipment with rapid obsolescence (ex: computers) May be tax advantages using a lease PPT 16-22

1-37 Summary and Conclusions Debt financing by major corporations often involves the sale of secured bonds or unsecured bonds (debentures). Corporate bonds may have sinking-fund, call, or conversion features causing retirement before maturity. Bond prices and yields are inversely related and are based upon the level of interest rates and bond ratings Long-term capital leases are an alternative form of long-term financing PPT OK, LET’S REVIEW...