1 MBA 622 Types of Debt Financing

2 Types of Long-Term Debt è Secured debt èMortgage bonds èCollateral trust bonds èEquipment trust certificates èConditional sales certificates è Unsecured debt è Tax-exempt corporate debt

3 Main Features of Corporate Debt è Stated maturity è Stated principal amount è Stated coupon rate of interest è Mandatory redemption (or sinking fund) schedule è Optional redemption provision è Protective covenants

4 Optional Redemption Provisions è Call Provisions èBond is usually protected against calls in the first few years of its life. èCall price declines over time.

5 Convertible Bonds è Why do firms issue convertible bonds? èGives investors limited downside risk and unlimited upside risk. èAllows equity to be “sold” later with no transactions costs èMakes debt self-liquidating if conversion occurs

6 Risk Considerations è Bond Ratings èSee the list at atings.asp atings.asp è Effect on Risk of the Company è Effect on Risk of the Common Stock è Effect on the Cost of Capital

7 Short-Term Financing è Trade Credit è Secured and unsecured bank loans è Commercial Paper

8 Cost of Trade Credit Discount Music Stores buys its inventory on “1/10, net 30” terms. What is the cost of not taking the discount?

9 Cost of Trade Credit è Let d = the amount of the discount (= 1%) è Let DP = the discount period (= 10 days) è Let TP = the total payment period (= 30 days)

10 Cost of Trade Credit

11 Effective Use of Trade Credit è Advantages: èReadily available èInformal èFlexible èStretching payments è Disadvantages èHigh cost of discounts foregone èExcessive stretching of payments

12 Bank Loans è Short-term unsecured loans èTransaction loan èLine of credit èRevolving credit agreement è Term loans èBullet maturity èBalloon payment

13 4 Major Criteria for Granting Bank Loans (1) What is the character of the borrower? This goes beyond just being honest and trustworthy. It involves the level of commitment on the part of the borrower to repay the loan. Will they stick it out for the long haul even if things get nasty? Will they do everything they can to make sure that the debt is paid? Do the managers have enough experience and expertise to do what they say they are going to do?

14 4 Major Criteria for Granting Bank Loans How will the lender assess your honesty? è Do you have good business references? è Do you have a good credit history? (Don’t omit any bad news.) è Do you have ties to the business? (Equity stake) è Do you have ties to the area? è Will you personally guarantee the loan?

15 4 Major Criteria for Granting Bank Loans (2) What is the purpose of the loan? The lenders want to know that the money will be used for a legitimate business purpose. They will look for whether there is congruency between the loan and its stated use. They will also want to see a link between the loan use and the source of its repayment. In addition, they will be looking to fund the portion of the business’s activities that are relatively SAFE.

16 4 Major Criteria for Granting Bank Loans The lender wants to be able to separate the IDEA from the COMMON FACTORS OF PRODUCTION. The IDEA is a risky, nebulous, hard to describe, hard to market thing. Thus, it is not appealing to a banker. Bankers do not finance ideas. The COMMON FACTORS OF PRODUCTION are the things that the business owns that are needed to do what the business does: equipment, inventory, etc. These items are tangible and more easily values. While they are not always completely liquid, there is usually some sort of marketability associated with them. Thus, they can be turned into cash if necessary. Bankers will finance these common factors of production. To get the loan, you need to show that the funds will be used to acquire or support the common factors of production ­ not the idea.

17 4 Major Criteria for Granting Bank Loans (3) What is the primary source of repayment? è Needs to be dependable. è Must be supported by the CASH CYCLE of the business.

18 4 Major Criteria for Granting Bank Loans (4) What is the secondary source of repayment? Needs to be absolutely dependable. This is invoked when the cash cycle fails. COLLATERAL is usually the basis for the secondary source of repayment – generally inventory, accounts receivable, or liens on fixed assets. Collateral means that the lender has FIRST RIGHTS to the assets that are pledged. However, in the case of a Chapter 11 filing, the law requires a 90-day “cooling off period”, after which there can still be a lot of court interference. So, collateral is not as secure as it might seem. To the lenders, it is a last resort to be able to recover some of their money.

19 4 Major Criteria for Granting Bank Loans If a loan is UNSECURED, it means that there is no collateral. In the case of a bankruptcy, unsecured lenders share equally in the sale value of the company’s assets after all secured debt has been paid from the proceeds of the secured assets.

20 The Four C’s of Credit You will also hear about the 4 (or 5) C’s of credit, which are similar to the above. They are: è Character of the borrower(s) è Capacity to repay the loan and service the debt è Capital (sometimes listed as Collateral or listed separately) – the security behind the loan è Conditions in the economy that will impact the company

21 Credit Scoring A typical credit scoring system is the following: è 35%: Credit history – account payment information of specific types of accounts and contracts è 30%: Amounts owed against income and net worth è 15%: Length of credit history è 10%: New credit – number and amounts of recently opened accounts è 10%: Types of credit used (credit cards, installment loans, mortgages, etc.)

22 Sources of Start-Up Funding So, if it’s so hard to get a bank loan to start a business, what do people who need credit do? According to a 2004 Wall Street Journal Article (The Great Money Hunt – Nov 2004): “Among small businesses using credit, the percentage that tap these types of funding to finance their operations are:”

23 Sources of Start-Up Funding