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Chapter 17

© 2007 Thomson South-Western

Long-Term Debt And Leasing

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Long-Term Debt and Leasing

Long-term debt and leasing are important sources of capital.

Long-term debt can take the form of term loans or bonds.

Syndicated loans are large credits arranged by a syndicate of commercial banks for a borrower.

Leasing serves as an alternative to borrowing funds to purchase an asset.

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Basic Choices In Securing External Financing

A firm needing external capital faces three basic choices:

Whether to employ an investment bank to advise and handle offering

Choice of public versus private capital market

Choice of security and type of offer: equity or debt

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Long-Term Debt Financing

Public issue

• Must be registered with the SEC in U.S.

• Almost always issued with the help of investment bankers

• Vast majority are fixed rate offerings.

Private issue

• Loans: private debt agreements with a financial institution

• Term loans or syndicated loans• Most are floating-rate issues, with

the rate set as a fixed spread from some base interest rate.

• Private placements: unregistered issues sold directly to accredited investors

• Rule 144A: most popular private placement

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Debt Covenants

Contractual clauses within debt agreements that place constraints on the borrower:

Positive covenants

• Things that the borrower “must do,” such as:

• Maintain satisfactory accounting records in accordance with GAAP

• Maintain a minimum level of net working capital

• Maintain life insurance on “key employees”• Spend borrowed funds on proven financial

needs

Negative covenants

• Things that the borrower “must not do” such as:

• Sell accounts receivable to generate cash

• Issue additional debt or require that additional debt be subordinated

• Arrange certain types of leases or other fixed payment obligations

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Long-Term Debt

Function of at least four factors

Loan maturity

• Yield curves typically slope upward..• Longer maturities mean longer, and

so greater, exposure to the risk of default.

Loan size• Trade-off between administrative

cost per dollar and risk exposure that increases with loan size

Borrower risk

• The greater the risk of default, the higher the rate that the lender will charge.

Basic cost of money

• The greater the prevailing rate on lowest-risk money (such as Treasury securities), the greater the rate on other loans.

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Term Loans

Private loans made by financial institutions to businesses

Have initial maturities of more than one year; generally have maturities of 5-12 years

Term Lenders

– Commercial banks– Insurance companies– Pension funds– Regional development companies– Small business administration– Finance companies– Equipment manufacturer finance

subsidiaries

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Characteristics of Term Loans

Payment dates

• Usually monthly, quarterly, semiannual or annual payments

• Usually these payments fully pay the interest and principal over the life of the loan.

• May involve periodic payments followed by a balloon payment of the remaining principalCollateral

requirements

• Secured loans involve the pledging of specific assets as collateral.

• Reduce risk for lender

Stock purchase warrants

• Give the lender the right to purchase a fixed number of shares of common stock at specified price over a fixed time period

• Can be used as “sweeteners” for both term loans and corporate bond issues

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Corporate Bonds

Debt security carrying a promise to pay cash flows to the holder:

Most maturities range from 10 to 30 years with a par (face) value of $1000.

Coupon– The percentage of par value that is paid

in interest each year– Typically in two equal semi-annual

payments

Methods of issuing

corporate bonds

Shelf Registration

Rule 144A

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Types of Bonds

Debentures• Unsecured, so only creditworthy firms

can issue• Most convertibles are debentures.

Subordinated

debentures

• Unsecured• Claims are not satisfied until senior

debts have been satisfied.

Income bonds

• Payment of interest is only required when earnings are available.

• Commonly issued in reorganization of a failing firm

• Not necessarily in default when interest payments are missed, since these are contingent on earnings

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Types of Bonds

Collateral trust bonds

• Secured by stock/bonds owned by the issuer

Equipment trust

certificates

• Used to finance transportation equipment including airplanes, trucks, rail cars, boats

Mortgages• Secured by real estate or buildings• A number of mortgages can be

issued against the same collateral.

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Legal Aspects of Bonds

Bond indenture: the bond contract, which specifies:

– Payments and payment dates– Positive and negative covenants– Security (any collateral)– Any sinking fund requirements

Trustee

• Third-party who ensures that the issuer does not default on contractual responsibilities

• Can be an individual or a corporation; most often a commercial bank trust department

• Services paid for by the issuer

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Corporate Bond Features

Call feature: included in most corporate bond issues

Gives the issuer the opportunity to repurchase bonds prior to maturity at the call pricecall

price• Often par value plus one year of interest (call premium)

The issuer can retire an issue early when interest rates fall.

Must pay a higher interest rate than would otherwise be necessary in order to compensate

bondholders

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Conversion Features And Stock Purchase Warrants

Conversion feature : allows bondholders to change each bond into a stated number of shares of

common stock.

Convert only when the stock price is greater than the conversion price

Stock purchase warrants: right to purchase a number of shares at a specified price over a certain

period of time

Attached to bonds as an added “sweetener” for bondholder to help sell a bond issue

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Bond Ratings

Credit risk assessments by independent bond rating agencies, such as Moody’s and Standard & Poor’s

Inverse relationship between bond ratings and bond promised rates of return

Investment grade bonds

Rated Baa or above (Moody’s), BBB or above (S&P)

High-yield (junk) bonds

Rated below investment gradeIf downgraded to “junk,” called “fallen

angels”

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International Corporate Bond Financing

Eurobonds

• Bond issued by an international borrower and sold to investors in countries with different currency than bond’s currency

Foreign bonds

• Bonds issued by an international borrower in a foreign country, denominated in the foreign country’s currency

Most international bonds are bearer securities

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Bond-Refunding Options

Choices for firms wishing to avoid large single payment at bond maturity

Serial bonds: issues with staggered maturities, often with different interest rates paid to various

maturities

Refunding bonds by exercising a call

Use capital budgeting techniques to determine if exercise of a call is optimal

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Syndicated Loans

Large-denomination credit arranged by a group (syndicate) of commercial banks for a single

borrower

Eurocurrency lending

• Consists of a large number of international banks that make floating rate loans to international corporate borrowers and governments

• Limit the risk exposure of any one bank to any one borrower

Project finance

• Lending to stand-alone companies created for the sole purpose of constructing and operating specific projects: toll roads, bridges, power plants, airports

• Generally backed only by the assets and cash flow of the project

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Leasing

Similar to secured long-term debt, leases involve periodic, tax-deductible payments

LessorOwner of the asset

Retains the tax benefit associated with ownership of the asset

LesseeUser of the asset

Makes payments to the lessor under the terms of the lease

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Types of Leases

Used for short-lived assets, such as computers or automobiles Normally can be cancelled after some time period May be re-leased by lessor after initial leasing agreement Lessors original cost generally exceeds total value of original

lessee’s payments

Operating Leases

Financial (capital) leases

– Used to obtain the use of longer-lived assets such as land, buildings, and large pieces of equipment

– Cannot be cancelled, so obligate the lessee to make payments over a defined period of time

– Total payments are greater than the lessor’s cost

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Leasing Arrangements

Direct lease• Lessor acquires the asset to be leased

(did not previously own the asset).

Sale-leaseback

arrangement

• One firms sells an asset to another for cash, then leases the asset from the new owner.

• Attractive for firms that need cash and are willing to exchange a promise to make periodic lease payments for immediate cash

Leveraged leases

• Third party lender is involved.• Lessor provides only a portion of the

cost of asset; the balance provided by the lender.

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Leasing Agreement

Maintenance clauses

• Leasing agreements usually specify who is responsible for maintenance of leased assets.

• Operating leases usually require the lessor to pay for maintenance, insurance, and taxes.

• Financial leases usually require lessee pay these costs.

Renewal options

• Lessee usually has the option to renew a lease at expiration.

• Operating leases commonly can be renewed, as the useful life of the asset normally extends beyond the original lease.

• Lessee may also have a purchase option at the end of the original leasing agreement.

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Lease Versus Purchase DecisionEmploy a capital budgeting framework to

determine whether to lease or buy an asset:

Step 1: Find the after-tax cash outflows under the lease alternative.

Step 2: Find the after-tax cash outflows under the purchase alternative.

Select the alternative with the lower present value of expected cash outflows!

Step 3: Calculate PV of expected future cash flows under each alternative.

PV

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The Lease Versus Purchase Decision

Alternatives: Lease the asset Borrow funds and purchase the asset Purchase the asset with available liquid resources

Employ a capital budgeting framework: Step 1: Find the after-tax cash outflows under the

lease alternative Step 2: Find the after-tax cash outflows under the

purchase alternative Step 3: Calculate the present value of the expected

future cash flows under each of the alternatives, discounting at the firm’s after-tax cost of debt

Step 4: Select the alternative with the lower present value of expected cash outflows

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Advantages of Leasing

1) Allows for the effective depreciation of land, which is not allowed when land is purchased

2) Sale-leaseback can enhance firm liquidity.

3) Leasing can provide 100% financing.

4) Lower claims against the firm in bankruptcy

5) Reduced risk of obsolescence of assets

6) Avoid restrictive covenants that would likely be present in a long term loan agreement

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Disadvantages of Leasing

1) Leases do not have stated interest cost. Effective cost may be higher than if the firm borrowed

money.

2) At the end of the lease, lessee does not receive any “salvage value” associated with the asset.

3) Lessee may not be allowed to modify or improve leased assets without lessor approval.

4) Even if assets become obsolete or unusable, the remaining lease payments must be made.