Long-Term Debt And Leasing Professor XXXXX Course Name / Number

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

Debt Covenants Positive covenants Negative covenants Contractual clauses within debt agreements that constrain borrowers’ actions 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,” and Spend borrowed funds on a proven financial need. Negative covenants Things that the borrower “must not do,” such as: Sell accounts receivable to generate cash; Issue additional debt, unless firm requires that additional debt be subordinated, and Avoid certain types of leases or other fixed- payment obligations.

Function of at least four factors Cost of Long-Term Debt Function of at least four factors Loan maturity Yield curves typically slope upward. Longer maturities mean longer terms, and so greater exposure to default risk. Loan size Trade-off between administrative cost per dollar and risk exposure that increases with the 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.

Private loans that financial institutions make to businesses. Term Loans Private loans that financial institutions make 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

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 principal Collateral requirements Secured loans involve the pledging of specific assets as collateral. Reduces risk for lender Stock purchase warrants Gives 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

Syndicated Loans Large-denomination credit arranged by a group (syndicate) of commercial banks for a single borrower Over $2 trillion worth of syndicated loans are arranged annually (two thirds of which are corporate). Eurocurrency lending: the Eurocurrency loan market is largely a syndicated loan market. Project finance : loans arranged for infrastructure projects such as toll roads, bridges, etc.

Debt security carrying a promise to pay cash flows to the holder 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 Main types Debentures Subordinated debentures Income bonds Mortgage bonds Collateral trust bonds Equipment trust certificates

Legal Aspects of Bonds Bond indenture Trustee The bond contract, which specifies: Payments and payment dates; Positive and negative covenants; Security (any collateral), and 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.

Methods of Issuing Corporate Bonds and Common Features Shelf registration Often used when issuing bonds Allows firms to register large amounts of debt, then sell the securities over time as market conditions warrant Rule 144A Allows institutional investors to trade non-registered securities among themselves Created a new market for privately-placed issues, including debt securities Three special features are often included in the bond indenture Call feature Conversion feature Stock purchase warrant attachments

Common Features of Corporate Bonds Call feature allows the issuer to repurchase bonds prior to maturity at a certain call price. Call feature gives the issuer the ability to retire an issue early when interest rates fall, so this benefits issuers. Conversion feature allows bondholders to change each bond into a stated number of shares of common stock. Stock purchase warrants give the bondholder the right to purchase a certain number of shares at a specified price over a certain period of time.

International Corporate Bond Financing Eurobonds Issued by an international borrower and sold to investors in countries whose native currency is different than the bond’s denomination For example, bonds sold in Europe by a U.S. firm, denominated in U.S. dollars 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

Bond Refunding Options A firm has two options if it tries to avoid a single repayment in the future or wants to refund a bond prior to maturity: Serial bonds are issues with staggered maturities, often with different interest rates paid to various maturities. If interest rates drop, issuers with call provisions may consider a refunding (refinancing) operation. Existing bonds are retired; new, lower-interest bonds issued. Bonds are called when the marginal benefit of doing so (stream of reduced paid interest) exceeds marginal cost.

Bond Refunding Analysis Refunding decision is based on capital budgeting analysis The capital budgeting procedure: Step 1: Find the initial investment required to call the old issue and issue new bonds: Include the call premium, flotation costs of the new bond, overlapping interest, unamortized discount and flotation costs of the old bond. Step 2: Find the cash flow savings: Largest impact will be from the differential interest costs. Step 3: Find the NPV of the refunding operation: If NPV > 0, the refunding operation is recommended.

Bond Refunding Analysis: Example Contemplated bond refunding operation: Existing bond issue ($50 million) 30-year bonds issued 5 years ago with a coupon interest rate of 9%, callable at a price of $1,090 Initially issue netted $48.5 million due to a discount of $30 per bond Initial flotation cost was $400,000 Proposed bond issue ($50 million of 25-year bonds) Expected to sell at par value with a coupon interest rate of 7% Flotation costs estimated at $450,000 Other Data Firm’s tax rate is 30%; after-tax cost of debt is 4.9% = (1-0.30) x 7% Two months of overlapping interest is expected

Step 1: Find the Initial Investment After-tax cost of the call premium: Call premium: $90 per bond, (tax deductible) Before taxes ($90 x 50,000 bonds) $4,500,000 Less: tax savings (0.30 x $4,500,000) 1,350,000 After-tax cost of premium $3,150,000 Flotation cost of new bond was given as $450,000. Overlapping interest: Before taxes ($0.09 x (2/12) x 50,000 bonds) $750,000 Less: tax savings (0.30 x $750,000) 225,000 After-tax cost of overlapping interest $525,000

Step 1: Find the Initial Investment Unamortized discount on old bond Discount ($1,500,000 = $50,000,000 - $48,500,000) was amortized over thirty years Only five years of amortization have been used Firm can deduct the remaining twenty-five years as a lump sum Reduced taxes (25/30 x $1,500,000 x 0.30) ($375,000) Unamortized floatation cost of old bond: Initial floatation cost ($400,000) was amortized over thirty years Reduced taxes (25/30 x $400,000 x 0.30) ($100,000) Initial investment is $3,650,000

Step 2: Find the Cash Flow Savings Interest cost of old bond Annually: ($50,000,000 x 0.09 x (1-0.30)) $3,150,000 Amortization of discount on old bond Annually: (($1,500,000/25) x 0.30) ($15,000) Amortization of floatation cost on old bond Annually: (($400,000/25) x 0.30) ($4,000) Interest cost of new bond Annually: ($50,000,000 x 0.07 x (1-0.30)) ($2,450,000) Amortization of flotation cost on new bond Annually: (($450,000/25) x 0.30) $5,400 Total annual cash flow savings $686,400

Step 3: Finding the NPV of the Refunding Operation Present value of cash flow savings $9,771,792 ($686,400 per year for 25 years, discounted at 4.9%) Less: total initial investment $3,650,000 Equals NPV $6,121,792 Present value of cash flow savings computed as annual cash flow savings x Present value interest factor of a r %, n-year annuity (PVAr,n) Since the NPV is positive, recommend the bond refunding operation.

Payments may be fixed or variable. Leasing Similar to long-term debt, leases involve periodic, tax-deductible payments. Payments may be fixed or variable. Owner of the asset Retains the tax benefit associated with ownership of the asset Lessor User of the asset Makes payments to the lessor under the terms of the lease Lessee

Financial (capital) leases Leasing For relatively short-lived assets, such as computers or automobiles Can be cancelled after some time period May be re-leased by lessor after initial leasing agreement Lessor’s original cost generally exceeds total value of original lessee’s payments Operating leases For longer-lived assets such as land, buildings, and large pieces of equipment: Cannot be cancelled, obligate the lessee to make payments over a defined period of time Total payments are greater than the lessor’s cost. Financial (capital) leases

Sale-leaseback arrangement Leasing Arrangements Lessor acquires the asset(s) to be leased to the given lessee (did not previously own the asset). Direct lease 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. Sale-leaseback arrangement A third party lender is involved. Lessor provides only a portion, about 20% of the asset value; lender provides the balance. Popular way of structuring very expensive leases Leveraged leases

Leasing Arrangements Maintenance clauses Renewal options 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. Maintenance clauses 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. Instead of renewing the lease, lessee may also have a purchase option at the end of the original leasing agreement. Renewal options

The Lease versus Purchase Decision Lease the asset Borrow funds and purchase the asset Purchase the asset with available liquid resources Alternatives 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.

Effects of Leasing on Future Financing Similar to long-term debt, leases involve periodic, tax-deductible payments. FASB (13) requires explicit disclosure of financial lease obligations on the firm’s balance sheet. Must be shown as both an asset and as a liability on firm’s balance sheet. Under FASB (13), calculated financial ratios assessing debt load will include leases along with other obligations.

Advantages and Disadvantages of Leasing Allows for the effective depreciation of land, which is not allowed when land is purchased Sale-leaseback can enhance firm liquidity. Leasing can provide 100% financing. Lower claims against the firm in bankruptcy Avoid restrictive covenants that would likely be present in a long term loan agreement May enhance a firm’s financing flexibility Advantages Leases do not have stated interest cost. Effective cost may be considerably higher than if the firm borrowed money. At the end of the lease, lessee does not receive any “salvage value” associated with the asset. Lessee may not be allowed to modify or improve leased assets without lessor’s approval. Even if assets become obsolete or unusable, the remaining lease payments must be made. Disadvantages

Long-Term Debt And Leasing Long term debt and leases are important sources of capital for businesses. The conditions of a term loan are specified in the loan agreement. The conditions of a bond issue are specified in the bond indenture. Leasing serves as an alternative to borrowing funds to purchase an asset.