Long-Term Debt and Lease Financing 16 Chapter Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

16-2 Chapter Outline Considerations in analyzing long-term debt Bond yield analysis Corporate decision as to call in and reissue of debt when interest rates decline Long-term lease obligations and its characteristics Bankruptcy – failure to meet financial obligations

16-3 The Expanding Role of Debt Growth in corporate debt is attributed to: –Rapid business expansion –Inflationary impact on the economy –Inadequate funds generated from the internal operations of business firms Expansion of the U.S. economy has placed pressure on U.S. corporations to raise capital –New set of rules have been developed for evaluating corporate bond issues

16-4 Times Interest Earned for Standard & Poor’s Industrials

16-5 The Debt Contract Corporate bond: The basic long-term debt instrument Basic items of a bond agreement include: –Par value: Initial or principal or face value of the bond –Coupon rate: Actual interest rate on the bond –Maturity date: Final date on which repayment of bond principal is due Bond indenture, a supplement to the bond agreement

16-6 Security Provisions Secured debts have specific assets pledged to bondholders in the event of default –These assets are seldom actually sold and proceeds are distributed –Terms used to denote collateralized or secured debts: Mortgage agreement: Real property is pledged After-acquired property clause requires any new property to be placed under the original mortgage –Greater the protection offered, lower is the interest rate on the bond

16-7 Unsecured Debt Debt that is not secured by a claim to a specific asset –Debenture: Unsecured, long-term corporate bond with a general claim against the corporation May be high-ranking and subordinated –Subordinated debenture Payment to the holder will occur only after the designated senior debenture holders are satisfied

16-8 Priority of Claims

16-9 Methods of Repayment Does not always involve a lump-sum disbursement at the maturity date Repayment of bonds can be done by: –Simplest method: Single-sum payment at maturity –Serial payments: Paid off in installments over the life of the issue –Sinking-fund provision: Semiannual/annual contributions made into a fund run by a trustee –Conversion: Converting debt to common stock –Call feature: Retire or force in debt issue before maturity

16-10 Bond Prices, Yields, and Ratings Financial managers must be sensitive to the bond market with regard to: –Interest rate changes –Price movements Market conditions will influence: –Timing of new issues –Coupon rate offered –Maturity date Bonds do not maintain stable long-term price patterns

16-11 Bond Price Table The longer the life of the issue, the greater the influence of interest rate changes on the price of the bond

16-12 Bond Yields Three different ways: –Coupon rate (nominal yield): Stated interest payment  Par value –Current yield: Stated interest payment  Current price –Yield to maturity: The interest rate that equates future interest payments and the payment at maturity to the current market price

16-13 Bond Ratings Ratings are based on a corporation’s: –Ability to make interest payments –Consistency of performance –Size –Debt-equity ratio –Working capital position, etc. Two major bond rating agencies: –Moody’s Investor Service Nine categories of ranking: Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C with numerical modifiers (1 for highest, 2 for midrange, and 3 for lowest) –Standard & Poor’s Corporation Similar to Moody’s with + and − modifiers

16-14 Examining Actual Bond Ratings High rated securities carry lower risk and hence the lower interest payments The true return on a bond is measured by yield to maturity Bonds of equal quality (rating) and maturity may be sold at different prices depending upon their coupon rates and yields to maturity

16-15 The Refunding Decision Example: Bonds issued at 11.75% witnesses a drop in interest rates to 9.5% –Assuming that the interest rates will rise: The expensive 11.75% bonds may be redeemed A new debt at the prevailing 9.5% may be issued –This process is labeled as a refunding operation It is made feasible by the option of call provision

16-16 Capital Budgeting Problem The refunding decision involves: –Outflows in the form of financing costs related to redeeming and reissuing securities –Inflows represented by savings in annual interest costs and tax savings

16-17 Capital Budgeting Problem - Example

16-18 Capital Budgeting Problem – Example (cont’d) A. Outflow considerations: 1. Payment of call premium 2. Underwriting cost on new issue B. Inflow considerations: 3. Cost savings in lower interest rates 4. Underwriting cost on old issue C. Net present value: –Present value of inflow – Present value of outflow = Net present value

16-19 Step A – Outflow Considerations Payment of call premium : The First outflow is the 10 percent call premium on $10 million, or $1 million resulting in an after-tax cost of $650,000 (i.e. $1,000,000 (1 − T) = $1,000,000 (1 − 0.35) = $650,000) Underwriting cost on new issue: The second outflow is the $200,000; considering the present value of future tax savings on noncash write-off of underwriting cost, net cost of underwriting would be: Actual expenditure $200,000 − PV of future tax savings ,145 [$3,500 × (n = 20, i = 6%)] Net cost of underwriting expense on the new issue …………………………… $159,855

16-20 Step B – Inflow Considerations Cost savings in lower interest rates: The corporation will enjoy a 2.25 percentage point drop in interest rates, from percent to 9.50 percent, on $10 million of bonds –Saving in interest results in payment of more tax –Determining the present value of cost saving in interest rates Interest savings = $10 million  2.25% = $225,000 After-tax savings = $225,000  (1  0.35) = $146,250 Present value of after-tax interest savings = $146,250 × (n = 20, i = 6%) = $1,677,488

16-21 Step B – Inflow Considerations (cont’d) Underwriting cost on old issue: Total underwriting costs = $125,000 $5,000 a year for 5 years = $25,000 Unamortized cost = $100,000 Present value of future write-off = $5,000 × (n = 20, i = 6%) = $57,350 Gain from immediate write-off = $100,000 - $57,350 = $42,650 Tax savings on amortizing old underwriting costs $42,650 × 0.35 = $14,928

16-22 Step C – Net Present Value

16-23 Other Forms of Bond Financing Two innovative forms of bond financing that are popular include: –Zero-coupon rate bond –Floating rate bond

16-24 Zero-coupon Rate Bond A bond that does not pay interest –Advantages to the corporation: Immediate cash inflow, no outflow until maturity The difference in the value at maturity can be amortized for tax purposes –Advantage to the investor: Allows lock in a multiplier of the initial investment –Disadvantages: Annual increase in the value of the bonds is taxable as ordinary income Prices are volatile in nature

16-25 Floating Rate Bond The interest rate paid on the bond changes with market conditions –Advantage to the investor: A constant market value for the security, although interest rates vary –Exception: These bonds often have broad limits that interest payments cannot exceed

16-26 Zero-Coupon and Floating Rate Bonds

16-27 Advantages of Debt Interest payments are tax-deductible The financial obligation is clearly specified and is of a fixed nature –Exception: Floating rate bonds In an inflationary economy, debt may be paid back with ‘cheaper dollars’ The use of debt, up to a prudent point, may lower the cost of capital to the firm

16-28 Drawbacks of Debt Interest and principal payment obligations set by contract must be met regardless of economic position of the firm Indenture agreements may place undue restrictions on the firm –Bondholders may take virtual control of the firm if important indenture provisions are not met Utilized beyond a given point, debt may depress outstanding common stock values

16-29 Eurobond Market A bond payable in the borrower’s currency but sold outside the borrower’s country –Usually sold by an international syndicate of investment bankers –Disclosure requirements in the Eurobond market are less demanding than those of SEC or other domestic regulatory agencies

16-30 Examples of Eurobonds

16-31 Leasing – A Form of Debt Leasing has the characteristics of a debt –A corporation contracts to lease and signs a noncancelable, long-term agreement –Companies are expected to fully divulge all information about leasing obligations SFAS No. 13 issued by the FASB requires: –Certain types of leases must be shown as long- term obligations on the financial statements of the firm Lease may be capital (financing) lease or operating lease

16-32 Capital (Financing) Lease Four conditions for identification include: –The arrangement transfers ownership of the property to the lessee by the end of the lease term –The lease contains a bargain purchase price at the end of the lease –The lease term is equal to 75% or more of the estimated life of the leased property –The present value of the minimum lease payments equals 90% or more of the fair value of the leased property at the inception of the lease The discount rate for this test is the leasing firm’s new cost of borrowing or the lessor’s implied rate of return under the lease The lower of the two must be used when both are known

16-33 Operating Lease Does not meet the conditions of a capital lease Usually short-term, cancelable at the option of the lessee The lessor may provide for the maintenance and upkeep of the asset Does not require a capitalization, or presentation, of the full obligation on the balance sheet

16-34 Income Statement Effect Capital lease –Requires treatment similar to a purchase- borrowing arrangement It is amortized, or written off, over the life of the lease with an annual expense deduction Liability account is written off through regular amortization with an implied interest cost on the balance Operating lease –Requires annual expense deduction equal to the lease payment, with no specific amortization

16-35 Advantages of Leasing Takes care of lack of sufficient funds or the credit capability issues to purchase assets Obligation may be substantially less restrictive than those of a bond indenture May not require a down payment Lessor’s expertise may reduce negative effects of obsolescence Lease on chattels have no limitations of bankruptcy and reorganization proceedings

16-36 Other Advantages of Leasing Tax advantage factors include: –Depreciation write-off or research-related tax credits Infusion of capital can occur if a firm chooses to engage in a sale-leaseback arrangement –Allows the lessee to continue the usage of the asset