Chapter 6.Long -Term Financing-Debt

Long-Term FinancingDebt

Financial Decisions Revisited

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Section 1Sources of Long-Term

Financing

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The Sources of Long-Term Financing

A range of long-term sources of finance are available to businesses including;a.debt finance;b.leasing;c.venture capital;d.and equity finance;

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Advantages of Debt Financing

The lender is not entitled to interfere borrower’s business decisions. The relationship between two parties is terminated once the debt is settled;

Lender can’t claim on business’s future earnings;

Business may plan for repayments as they are typically fixed and known;

Interest payments are tax deductible which smooth the effect of interest burden;

Finally ,it’s more convenient from legal and regulative perspective;

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Disadvantages of Debt Financing

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Debt amount must be repaid in some future time; Payments never take account company’s business cycle or economy’s future conditions as a result company may confront with insolvency risk in rough financial periods; Interest charge is a cash expense and to cover it some money must be withdrawn from business which limits company’s growth

opportunities; The company is typically required pledge some assets as collateral or sometimes lenders seek for owner’s personal

guarantee;

Reasons for Seeking Debt Finance

Sometimes businesses may needlong-term funds, but may not wish to issue equity capital;a. shareholders will be unwilling to contribute additional capital;b. company may not wish to involve outside shareholder;c. particularly if the company has little or no existing debt finance it may be easily

available;

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SECTION 2Long-Term Debt

Instruments

Bonds and Their FeaturesBasic Terminology

A long-term debt instrument with a final maturity generally being 10 years or more;

a. par value- amount to be paid the lender at the end of maturity(it’s usually $1000);

b. coupon rate- a stated rate of interest on a bond.Calculated by dividing coupon payment by par value;

c. maturity-bond always have a stated maturity when the company is obligated to pay bondholder the par value;.

d. current yield-the amount of return an investor will realize on a bond.Calculated by dividing amount of interest by market value;

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Trustee and IndentureTrustee and Indenture Trustee Trustee – a person or institution

designated by a bond issuer as the official representative of the bondholders. Typically, a bank serves as trustee;

IndentureIndenture – the legal agreement, also called the deed of trustdeed of trust, between the corporation issuing bonds and the

bondholders, establishing the terms of the bond issue and naming the trustee.

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The Risks of BondInterest Rate Risk

Market price of bonds moves inversely to prevailing interest rates in market;

When market interest rates rise bond’s value will decrease;

When market interest rates decrease then an increase in bond’s price will be inevitable;

This situation is relevant only for bondholders who are going to keep instrument until maturity;

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The Risks of BondInterest Rate Risk

As a result of fluctuations in market rates value or market price of bond may change;

If there is an increase in market rates bond’s value tend to decrease and will be sold at discount(less than par value);

On the contrary when market interest rates pursues downward trend then increase in bond price will be expected.This will cause the bond to be traded higher than it’s par value;

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ExampleInterest Rates and Bond Price

You purchased a $10 000 bond at par with a coupon yield of 4%.It means that your $400 per year is guaranteed if you keep the bond until the maturity.Now let’s suppose that you’re intending to sell the bond. Two scenarios are possible;

a)market rate will rise to 5%;b)market rate decrease to 3 %;

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a)If market interest rate rises to 5% your bond offering 4% will seem unattractive to investors(%5 compared to %4).To compensate for this you have to decrease the price of bond to an extent until it promises the same yield with the new bonds . Hence,to offer %5 yield for bond with 4% coupon rate and par value of $1000 you have to sell bond at a price of $8000.

Bond PriceX5%=$400 Bond Price= $8000

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b)If market rates fall below coupon rate then on the contrary your product will be a good option for investors(4% compared to 3%) and you will be able to increase the price of bond again up to an extent that 3% yield is preserved.Hence,to offer %3 yield for bond with 4% coupon rate and par value of $1000 you have to sell bond at a price of $13 300

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Bond PriceX3%= $400 Bond Price= $13 300

The Risks of Bond Reinvestment Risk- danger that bond investors face is

reinvestment risk, which is the risk of having to reinvest proceeds at a lower rate than the funds were previously earning;

Call option*****

Default Risk-possibility of default must be considered;

Inflation Risk-purchasing power will decrease so the real return rate:

Liquidity Risk-repayments are never fully guaranteed;

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Embedded Bond Options Call option-when interest rates fall until the last daythat bond issued then the company will be better of if it calls the existingone back and reissue bond with new prices;

Put option-holder entitled to forcethe issuer to buyback the security.Typically the reason is improved interest rates;

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Types of Bonds Zero-coupon bond is bond that makes no periodic interest

payments and are sold at a deep discount from face value;

Floating-rate notes have a variable coupon,equal to a money market reference rate, like LIBOR or federal funds rate, plus a quoted spread.;

• Junk bond-Companies that issue junk bonds typically have less-

than-stellar credit ratings, and investors demand these higher yields as compensation for the risk of investing in them;

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Types of Bonds(cont.) Convertible bonds include provision of obtaining debt issuing company’s stock in future. Typically lower interest rates are inherent to convertible bonds;

• Eurobond-is a bond issued in a currency other than the currency of the country or market in which it is issued;

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DebenturesDebentures

Investors look to the earning power of the firm as their primary security;

Investors receive some protection by the restrictions imposed in the bond indenture, particularly any negative-pledge clausenegative-pledge clause;

A negative-pledge clause negative-pledge clause precludes the corporation from pledging any of its assets (not already pledged) to other creditors;

Debenture Debenture – A long-term, unsecured debt instrument.

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DebenturesDebentures

In this case, subordinated debenture holders rank behind debenture holders but ahead of preferred and common stockholders in the event of liquidation;

Frequently, the security is convertible into common stock to lower the yield required by subordinated debenture holders (often less than regular debentures);

Subordinated Debenture Subordinated Debenture – A long-term, unsecured debt instrument with a lower claim on assets and income than other classes of debt;

known as junior debt.

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Retirement of BondsRetirement of Bonds

• The corporation makes a cash payment to the trustee, which calls the bond;

• The corporation purchases bonds in the open market and delivers them to the trustee;

Sinking Fund Sinking Fund – Fund established to periodically retire a portion of a security issue before maturity.

The corporation is required to make periodic sinking-fund payments to a trustee.

Two forms for the sinking-fund Two forms for the sinking-fund retirement of a bondretirement of a bond::

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Sinking Fund and the Sinking Fund and the Retirement of BondsRetirement of Bonds

When bonds are called for redemption, the bondholders will receive the sinking-fund call pricesinking-fund call price;

The bonds are called on a lottery basis (by their serial numbers) and published in periodicals like The Wall Street JournalWall Street Journal;

Bonds should be purchased in the open market if the market price is less than the sinking-fund call sinking-fund call priceprice;

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Volatility in interest rates or a decline in the credit quality of the firm could lower the market price of the bond and enhance the value to the firm of having this option;

Bondholders may benefit from the orderly retirement of debt (amortization effect), which reduces the default risk of the firm and adds liquidity to bonds outstanding;

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Many bond issues are designed to have a larger final payment to pay off the debt.

For example, a corporation may undertake a $10 million, 15-year bond issue. The firm is obligated to make $500,000 sinking-fund payments in the 5th through 14th years. The final balloon payment in the 15th year would be for the remaining $5 million of bonds.

Balloon Payment Balloon Payment – A payment on debt that is much larger than other payments.

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Thank You

Economy & Finance

Chapter 6.Long -Term Financing-Debt