Long-Term Debt andLease Financing

Chapter 16

Chapter 16 - Outline

Bond TerminologyPriority of ClaimsMethods of Repayment3 Types of Bond YieldsOther Forms of Bond FinancingThe Refunding DecisionAdvantages and Disadvantages of DebtAdvantages of LeasingCapital and Operating LeasesLease versus Buy Decision

Bond Terminology (Review)

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

More Bond Terminology (new)

Indenture:legal document detailing the corporation’s obligations

Secured Debt:where specific assets are pledged to bondholders in

the event of defaultDebenture:

a L/T unsecured corporate bondSubordinated Debenture:

unsecured bond that is paid after senior debenture holders are satisfied

Priority of claims

Methods of Repayment

Besides paying the principal at maturity, there are other methods:

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

3 Types of Bond Yields

Nominal Yield (or Coupon Rate):

– (stated interest rate / par value)Current Yield:

– yield in terms of the current price of the bond (current interest / current price)

Yield-to-Maturity (YTM):

– yield received if bond is held until maturity

Other Forms of Bond FinancingZero-Coupon Bond:

– does not pay interest– is sold at a deep discount from face value

Floating Rate Bond:

– interest rate paid on the bond changes with market conditions

– popular in European capital markets

Advantages and Disadvantagesof Debt

Advantages of Debt:– interest payments are tax deductible to a firm– obligation is known.– wise use of debt may lower a firm’s weighted

average cost of capital (WACC)– during inflation, debt is repaid with “cheaper

dollars” Disadvantages of Debt:

– interest and principal must always be met when due, regardless of a firm’s financial position

– poor use of debt may lower a firm’s value (stock price)

– may place burdensome restrictions on the firm

Advantages of Leasing- May be easier to get lease approval

- Less related restrictions

- No down payment required

- Less exposure to asset value changes

Leasing- SFAS 13 (1976) – requires certain leases to

be shown on financial statements.

- Capital Leases (also called financing leases) must be capitalized (present-valued) on the balance sheet.

- Two types of leases: - Capital lease- Operating Lease

Capital Lease- A lease is a capital lease when substantially

all the benefits and risks of ownership are transferred in the lease. A lease is a capital lease if any one of the following applies:

- Ownership is transferred- Bargain purchase is part of lease- Lease term is 75% or more of life of leased

asset- PV of lease payments is 90% or more of

leased asset’s value.

Accounting for a Capital Lease

- A capital lease is recorded on the Balance Sheet:- Liability under capital lease obligations- Asset under leased property under capital lease- Can change debt related ratios

- Recorded on Income Statement- Annual expense written off on income statement

and amortized to lower balance sheet accounts.

Operating Lease- If a lease is not a capital lease, then it is an

operating lease.

- Operating leases are NOT reported on the balance sheet

- Lease payments are an expensed item on the income statement.

The Refunding (refinancing) Decision

Outflow ConsiderationsPayment of call premium is tax deductible when incurredUnderwriting costs on new issue are amortized (written off

over the life of the new issue)

Inflow ConsiderationsInterest savings per year are calculated on an after tax basisUnamortized costs less PV of costs that would have been

written off in any case are tax write-offs today (i.e., provide tax savings)

Just like other capital budgeting problems, take NPV of inflows and outflows, and if NPV > 0, do it (Refund!).

Refunding Sample

Old Issue New Issue

Size . . . . . . . . $10,000,000 $10,000,000Interest rate . . . . 11.75% 9.5%Total life . . . . . . 25 years 20 yearsRemaining life. . . 20 years 20 yearsCall premium . . . 10% --Underwriting costs . . $125,000 $200,000

Tax bracket . . . . . 35%Discount rate . . . . 6%

Refund since +Net Present Value

We now compare our outflows and our inflows from the prior pages.

Outflows Inflows

1. Net cost of call . . . $650,000 3. Cost savings in lowerpremium . . . . interest rates . . . $1,677,488

2. Net cost of under- 4. Net gain from under-writing expense on writing cost onnew issue . . . . 159,855 old issue . . . 14,928

$809,855 $1,692,416

Present value of inflows . . $ 1,692,416Present value of outflows . . 809,855Net present value . . . . $ 882,561

Lease versus Buy Decision

- Compute after tax cost of leasing - Operating lease payments are tax deductible

- Compute after tax cost of buying- Consider tax shield from depreciation- Consider tax shields from interest payments

- Compute amortization schedule to get interest payments

- Compute present value of after tax costs of each alternative- all else equal, pick lower cost (lease or buy)

alternative