FINANCE IN A CANADIAN SETTING Sixth Canadian Edition Lusztig, Cleary, Schwab

CHAPTERTHIRTEEN Debt and Preferred Equity

Learning Objectives 1. Identify the senior securities and explain why they are so designated. 2. Explain why the effective yield of a debt instrument seldom coincides with its coupon rate. 3. Name three types of options that allow for changes to the maturity dates of debt issues, and explain how they differ. 4. Describe the role of preferred shares from the point of view of the issuer and of the borrower.

Introduction - Long-Term Debt Debt is a contractual obligation Debt is a contractual obligation Maturity > 10 years Maturity > 10 years Traditionally dominated by government issues Traditionally dominated by government issues Corporate issues rapidly growing in recent years Corporate issues rapidly growing in recent years Holders of corporate debt are creditors of the firm but have no say in management decisions Holders of corporate debt are creditors of the firm but have no say in management decisions Other types of debt include: Other types of debt include: equipment trust certificates equipment trust certificates income bonds income bonds zeros zeros

Yields and Payment Provisions Long-term debt provides fixed interest rate payments, usually semi-annually or annually throughout the life of the issue Long-term debt provides fixed interest rate payments, usually semi-annually or annually throughout the life of the issue Interest payments are tax deductible for the issuer and are taxable income in the hands of the recipient. Interest payments are tax deductible for the issuer and are taxable income in the hands of the recipient. Zero coupon bonds – bonds that have no interest rate payments and are sold at a discount from the face value Zero coupon bonds – bonds that have no interest rate payments and are sold at a discount from the face value

Risks Associated with Bonds Interest rate risk Interest rate risk When interest rate  bond prices  When interest rate  bond prices  When interest rate  bond prices  When interest rate  bond prices  Foreign currency debt risks include: Foreign currency debt risks include: changes in foreign exchange risk changes in foreign exchange risk Default risk Default risk to assist investors, independent agencies provide bond rating services for both corporate and government issues to assist investors, independent agencies provide bond rating services for both corporate and government issues

Debt Rating Categories

Types of Bonds Bond – a debt instrument in which specific assets are pledged Bond – a debt instrument in which specific assets are pledged also known as a mortgage bond also known as a mortgage bond Debenture – a debt instrument that is unsecured and backed only by the earning power of the borrower and claims against residual assets Debenture – a debt instrument that is unsecured and backed only by the earning power of the borrower and claims against residual assets Subordinated debentures – debt certificates with claims that rank behind those of ordinary debenture holders Subordinated debentures – debt certificates with claims that rank behind those of ordinary debenture holders

Maturity and Repayment Provisions When a bond matures the outstanding certificates must redeem at face value When a bond matures the outstanding certificates must redeem at face value Risk and uncertainty surrounding longer-term bonds has given way to more flexible options for either the borrower or lender Risk and uncertainty surrounding longer-term bonds has given way to more flexible options for either the borrower or lender Retractable and extendable bonds or debentures give the option to the investor Retractable and extendable bonds or debentures give the option to the investor Call features give the issuing firm the opportunity for early redemption Call features give the issuing firm the opportunity for early redemption

Retractables and Extendibles Retractable debt – debt instruments that give investors the right to move the maturity date forward and cash in the certificate at full face value on specified dates before maturity Retractable debt – debt instruments that give investors the right to move the maturity date forward and cash in the certificate at full face value on specified dates before maturity Extendible debt – original debt contract specifies a short maturity, but the investor has an option to extend the life of the debt Extendible debt – original debt contract specifies a short maturity, but the investor has an option to extend the life of the debt Convertible debt – gives the holder the right to convert the debt into a specified number of shares Convertible debt – gives the holder the right to convert the debt into a specified number of shares

Call Features and Repayment Provisions Call feature – when the option for early redemption rests with the borrower, allowing the issuing firm to repurchase its debt before the maturity date at a predetermined price Call feature – when the option for early redemption rests with the borrower, allowing the issuing firm to repurchase its debt before the maturity date at a predetermined price To avoid problems at maturity, gradual retirement may be achieved through sinking funds or serial bonds To avoid problems at maturity, gradual retirement may be achieved through sinking funds or serial bonds

Call Features and Repayment Provisions Sinking Fund – issuing firm makes periodic payments to the trustee, who uses the funds to retire debt Sinking Fund – issuing firm makes periodic payments to the trustee, who uses the funds to retire debt Serial Bonds – bonds that provide for staggered maturities for different serial numbers in the issue Serial Bonds – bonds that provide for staggered maturities for different serial numbers in the issue

Refinancing Decision Major reasons for refinancing include: Major reasons for refinancing include: 1. The outstanding debt matures, but the borrower wishes to extend the term of the borrowing so a new debt is issued to repay old creditors 2. A firm has debt outstanding at an interest rate higher than current rates 3. A firm may have debt outstanding under terms that impose operating restrictions that management finds constraining

Managing Interest Rate Risk Financial instruments used to provide partial protection against interest rate risk include: Financial instruments used to provide partial protection against interest rate risk include: Interest rate futures contracts – the seller agrees to deliver to the buyer a specified debt instrument at a fixed price on future date Interest rate futures contracts – the seller agrees to deliver to the buyer a specified debt instrument at a fixed price on future date Swaps – two parties exchange their debt commitments because each finds the other's obligation more attractive Swaps – two parties exchange their debt commitments because each finds the other's obligation more attractive

Receivership and Bankruptcy When a business cannot meet its debts when they come due it is said to be insolvent and the mechanisms of receivership, bankruptcy, and composition are used to settle claims between debtors and creditors. When a business cannot meet its debts when they come due it is said to be insolvent and the mechanisms of receivership, bankruptcy, and composition are used to settle claims between debtors and creditors. Receivership – the state of being dealt with by a receiver. The receiver may operate the business, try to refinance the debt, or sell the assets of the business and distribute the proceeds to the creditors. Receivership – the state of being dealt with by a receiver. The receiver may operate the business, try to refinance the debt, or sell the assets of the business and distribute the proceeds to the creditors.

Receivership and Bankruptcy Bankruptcy – a legal state whereby a person, partnership, or corporation commits an act of bankruptcy, the most common being failure to meet liabilities Bankruptcy – a legal state whereby a person, partnership, or corporation commits an act of bankruptcy, the most common being failure to meet liabilities Composition – an agreement between an insolvent debtor and her creditors whereby the creditors agree to accept less than the full claim in order to receive an immediate payment Composition – an agreement between an insolvent debtor and her creditors whereby the creditors agree to accept less than the full claim in order to receive an immediate payment

Preferred Shares Hybrid securities (between debt and equity) Hybrid securities (between debt and equity) Preferred shares have: Preferred shares have: no claims against issuing firm no claims against issuing firm fixed returns but dividends are not guaranteed fixed returns but dividends are not guaranteed no voice in management no voice in management seniority over common shareholders in case of liquidation seniority over common shareholders in case of liquidation more risk than debt more risk than debt

Risk Assessment Risk Assessment A major consideration for preferred share investors is to determine the firm’s ability to meet its obligations. A major consideration for preferred share investors is to determine the firm’s ability to meet its obligations. The quality of preferred shares is rated by debt agencies. The quality of preferred shares is rated by debt agencies.

Maturity and Early Redemption Preferred shares typically have no maturity date Preferred shares typically have no maturity date Redemption may occur through the establishment of a sinking fund or purchase fund Redemption may occur through the establishment of a sinking fund or purchase fund To protect against interest rate risk, some preferred shares provide for early redemption to either the investor or issuing firm or both To protect against interest rate risk, some preferred shares provide for early redemption to either the investor or issuing firm or both

Summary 1. Long-term debt can be viewed as a promissory note with a life of ten or more years. Such promissory notes are transferable and traded in financial markets. They normally provide for periodic interest payments. The holders of debt instruments are creditors of the issuing firm, and are entitled to future payments as stipulated by the debt contract.

Summary 2. The effective yield of a debt instrument need not coincide with its coupon rate, as the market price of outstanding securities will adjust to reflect changing market rates of interest. In international markets, mixed currency instruments have been introduced to reduce foreign exchange risk.

Summary 3. Debt may be classified by collateral. Bonds are secured by the pledge of specific assets. Debentures are unsecured or backed by a floating charge against remaining assets. 4. Most debt issues have provided for a specified maturity. Retractable and extendible bonds provide the right to alter the maturity date originally specified. Sinking fund payments or serial bonds with staggered maturities specify periodic retirement payments over the life of the issue.

Summary 5. A firm refinances or refunds debt when it replaces outstanding securities with a new issue at or before maturity. In the absence of call premiums or transaction costs, outstanding debt should be called whenever interest rates fall below the level provided for in the outstanding issue.

Summary 6. To deal with increased concern over the interest rate risk, interest rate futures and swaps have become popular in financial markets. Other special types of debt include equipment trust units and income bonds. 7. The features of preferred shares place them somewhere between debt and common equity. They commonly contain a variety of clauses that strengthen the position of the investor because of the comparatively weak claim on income.