16 Chapter Long-Term Debt and Lease Financing Revised By: P Chua Prepared by: Terry Fegarty May 4, 2005 McGraw-Hill Ryerson ©2003 McGraw-Hill Ryerson Limited

Chapter 16 - Outline Bonds Bond Terminology PPT 16-2 Chapter 16 - Outline Bonds Bond Terminology Priority of Claims on Bankruptcy Methods of Retiring (Repaying) Bonds Reading Bond Price Quotations 3 Types of Bond Yields Bond Ratings Other Forms of Bond Financing Lease vs. Purchase 2 Types of Leases Advantages/Disadvantages of Debt Advantages/Disadvantages of Leasing Summary and Conclusions

PPT 16-4 Bonds Firms and governments “borrow” money from investors by selling bonds A bond is a written promise that the borrower (firm) will pay the lender (investor) at a stated future date, the principal plus a stated rate of interest Bonds differ from one another in terms of maturity (payment date), potential yield (interest rate), and investment quality (risk) Several companies rate the quality of various bonds Discussed on pages 652-655. Notes: Government bonds: safe investments, but the safety of the investment can be eroded over time for longer terms. Federal bonds are backed by the Canadian government. Typically they are sold in large blocks to institutional investors seeking large amounts of more secure investments to balance their portfolios. Pension funds, banks, insurance companies and private investors also invest in bonds. Municipal bonds (provincial and local governments) sell bonds to raise capital for government projects. Municipal bond interest is not taxable. Banks will invest in bonds near their maturity date as a safe and liquid investment. Bonds are generally sold through the over-the-counter market, and not traded on an organized exchange. Activities: Building Your Business Skills, p.666. Concluding Case 21-1: Wham! Bang! Pow! The Marvel of Going Public, p.667. 13 13

Bond Terminology Par Value: principal or face value (usually $1,000) PPT 16-5 Bond Terminology Par Value: principal or face value (usually $1,000) Coupon Rate: stated interest rate Maturity Date: date when repayment of principal is due Indenture: legal document detailing the corporation’s obligations and Restrictive Covenants Secured Debt: where specific assets are pledged in the event of default Debenture: a L/T unsecured corporate bond

Figure 16-2 Priority of claims PPT 16-6 Figure 16-2 Priority of claims Senior Junior Preferred stock Common stock Unsecured debt (debentures) First claim on assets pledged Second claim on assets pledged Remaining assets are distributed below. Lower priority of claims Subordinated debenture holders will not receive payment unless designated senior debenture holders are paid in full. Secured debt Subordinated

Methods of Retiring (Repaying) Bonds PPT 16-7 Methods of Retiring (Repaying) Bonds Principal at maturity: lump-sum payment when bond is due Serial payments: bond is paid off in installments Sinking fund: corporation contributes regularly to a trust fund used to buy back bonds Conversion: bond can be converted into shares of common stock at the option of the bondholder Call feature: corporation can redeem bonds early by paying a premium over par value

Reading Bond Price Quotations PPT 16-9 Reading Bond Price Quotations Maturity Date (April 8, 2022) Coupon (interest rate %) Company Name Change (Closing price up $1.11 from previous day) Price (Last transaction price = $138.50/ $100) Yield (Annual interest Market price) 20 20

PPT 16-10 Table 16-2: Interest rates and bond prices (the bond pays 12 percent interest)

3 Types of Bond Yields Coupon Rate (or Nominal Yield ): PPT 16-11 3 Types of Bond Yields Coupon Rate (or Nominal Yield ): interest payment divided by par value Current Yield: interest payment divided by current price of the bond Yield-to-Maturity (YTM): interest rate that equates the future (expected) interest payments and payment at maturity to the current market price of the bond affected by current market interest rates If rates , YTM , bond price  and bond rating If rating high (low risk), YTM 

Figure 16-3 Long-term yields on corporate debt PPT 16-12 Figure 16-3 Long-term yields on corporate debt

Bond Ratings Bond Ratings PPT 16-13 Medium Grade High (Investment Poor Rating Service Grade Grade) Speculative Grade Moody's Aaa Aa A Baa Ba B Caa to C Standard & Poor's AAA AA A BBB BB B CCC to D Dominion AAA BBB B C Risk Factor Low High 14 14

Table 16-3 Outstanding debt issues, March 1, 2002 PPT 16-14 Table 16-3 Outstanding debt issues, March 1, 2002 Rating/Issuer Coupon Maturity Date Price Yield to Maturity AAA CARDS Trust Receivables 5.630 Dec. 21/05 102.94 4.77 Government of Canada 5.750 Sept. 01/06 104.10 4.72 Government of Canada 8.000 June 01/27 127.72 5.88 AA BMO 8.150 May 9/06 111.29 5.11 BMO 6.685 Dec. 31/11 101.69 6.45 Nav Canada 6.600 Dec 01/06 106.13 5.12 Nav Canada 7.400 June 01/27 109.78 6.60 A Bell Canada 6.700 June 28/07 105.74 5.44 Bell Canada 7.850 April 02/31 106.11 7.34 Loblaw 6.000 June 02/08 101.92 5.63 Loblaw 6.650 Nov. O8/27 96.67 6.93 BBB Domtar 10.000 Apr. 15/11 108.21 8.68 Talisman 5.800 Jan. 30/07 97.69 6.35 BB Rogers Cable 10.500 June 01/06 103.00 9.61 B Air Canada 6.750 Feb 02/04 72.00 26.29 Saskatchewan Wheat Pool 6.600 July 18/07 71.00 14.56

Other Forms of Bond Financing PPT 16-17 Other Forms of Bond Financing Zero-Coupon Bond / Strip Bond: does not pay interest is issued at a deep discount from face value Floating Rate Bond: interest rate paid on the bond changes with market conditions Real Return Bond principal adjusted for inflation Revenue Bond security based upon cash flow Eurobond: bond issued in another country

Table 16-4 Examples of Eurobonds PPT 16-18 Table 16-4 Examples of Eurobonds Amount Outstanding Currency Rating Coupon Maturity ($ millions) Denomination* Petro-Canada Baa1 9.25% 2021 300.0 U.S.$ Procter & Gamble Co. Aa2 10.88% 2003 200.0 C$ Sony Corporation Aa3 1.40% 2005 300.0 Yen Telecom Corporation Aa1 7.50% 2003 100.0 N Z$ *C$ is Canadian dollar, and N Z $ is New Zealand dollar. Source: Mergent Bond Report,July 2000 Source: Moody’s Bond Record, July 1998..

Advantages and Disadvantages of Debt PPT 16-19 Advantages and Disadvantages of Debt Advantages of Debt: interest payments are tax deductible to a firm wise use of debt may lower a firm’s weighted average cost of capital (WACC) financial obligation is fixed no reduction in control or equity of present shareholders company may get a better return on equity from leverage

Advantages and Disadvantages of Debt PPT 16-20 Advantages and Disadvantages of Debt Disadvantages of Debt: interest and principal must always be met when due, regardless of a firm’s financial position agreements may restrict financial management in firm poor use of debt may lower a firm’s stock price expensive financing when interest rates are high

2 Types of Leases Capital Lease (or Financing Lease): PPT 16-21 2 Types of Leases Capital Lease (or Financing Lease): Lease payments are usually sufficient to fully cover the lessor’s cost of purchasing the assets and provide the lessor a return on investment The lessee is usually responsible for the upkeep of the asset Generally, lease cannot be cancelled must be shown on a firm’s balance sheet ex., oil drilling equipment and airplanes

2 Types of Leases Operating Lease: Usually a shorter term lease PPT 16-21 2 Types of Leases Operating Lease: Usually a shorter term lease a conventional rental agreement Often cancellable on short notice Lessor is responsible for upkeep of asset firm doesn’t expect to own the asset is not shown on a firm’s balance sheet ex., automobiles and office equipment

Capital Lease Criteria A lease is considered a Capital Lease if it meets one of the following criteria: The lease transfers ownership of the asset to the lessee at the end the lease term Lessee has the option to purchase the asset at a price below the fair market value when the lease expires. The lease term is 75% or more of the estimated economic life of the asset The PV of the lease payments is at least 90% of the fair market value of the asset at the start of the lease

Advantages of Leasing A loan may be more expensive / refused PPT 16-22 Advantages of Leasing A loan may be more expensive / refused There may be no down payment on a lease, but usually a down payment with a loan A lease may have fewer restrictions than a loan There is a fixed payment on a lease, but loan interest may vary with prime Lease from a manufacturer may have attractive terms (ex: lower interest cost) or provide specialist expertise Using a lease may restrict creditor claims in bankruptcy Lease may be preferable for equipment with rapid obsolescence (ex: computers) May have more tax advantages using a lease

Lease vs Borrow-Purchase Problem A Firm is considering the purchase of an asset as opposed to leasing it. The asset costs $5,000. To purchase it, the firm must get a loan from its bank. The loan amortization will be $1,319 for 5 years at 10%. Interest payments from yrs. 1 to 5 are: $500, $418, $328, $229, and $120. CCA rate is 20 %. To lease the asset, the firm must pay $1,250 during the 1st and 2nd years, and $1,800 during the 3rd to 5th years. Note that lease payments are made at the beginning of each year. Tax rate is 40% Which option is less costly?

Table 16-7 Net present value of borrow-purchase PPT 16-23 Table 16-7 Net present value of borrow-purchase

Table 16-8 Net present value of operating lease outflows PPT 16-24 Table 16-8 Net present value of operating lease outflows

Summary and Conclusions PPT 16-25 Summary and Conclusions Debt financing by major corporations often involves the sale of secured bonds or unsecured bonds (debentures). Corporate bonds may have sinking-fund, call, or conversion features causing retirement before maturity. Bond prices and yields are inversely related and are based upon the level of interest rates and bond ratings Long-term capital leases are an alternative form of long-term financing