1 Chapter Six Lecture Notes Long-Term Financing

2  Used to pay for capital assets when capital costs exceed the cash available from operations or it would not be prudent to use operating cash flow for capital purposes.  Equity - additions to the permanent capital of an organization.  Capital Campaigns - fundraising drives aimed at raising money to pay for long-lived assets.  Long-Term Debt - borrowed money with a maturity of more than one year. Short-term debt refers to borrowed money that must be repaid within one year.  Leases - contracts to make fixed payments in return for the right to use a capital asset.

3 Types of Long-Term Debt n Long-Term Notes - unsecured loans. n Can be secured or unsecured (i.e. “collateralized”) n Mortgages - loans that are backed by a security interest in land and/or buildings that are owned by the borrower. n Bonds - standardized loan agreements between borrowers and lenders. Big amounts.

4 Calculating Mortgage Payments n Mortgages call for equal periodic payments which repay the amount borrowed and pay interest to the lender. n At the beginning payments are mostly interest and near the end they are mostly principal. Mortgage payments are annuities. n Assume a 30-year, $500,000, 12% per year mortgage with monthly payments: %... $500,000 PMT PMT PMT N = 360, i = 1%, PV = $500,000, PMT = ? Mortgage PMT = $5, per month

5 Bond Characteristics n Bond agreements specify: - the amount to be repaid, called the par, principal, stated, face, or maturity value of the bond; -the maturity date when the money must be repaid; - the rate of interest, called a coupon rate or stated rate, to - be paid on the face value of the bond; and, - the time intervals at which the interest must be paid, usually every six months (semi-annual). n These factors are fixed for the life of the bond.

6 Typical Bond Cash Flows n Bonds are an example of mixed cash flows. Here is the time line for a ten-year, $1,000,000 face value bond that bears an interest rate of 10% per annum and pays interest every six months % 0 $50,000 $50,000 $50,000 $1,000,000 Principal Annuity Single Payment...

7 Valuing a Bond n Normally, bonds can be sold by their owners. But, interest rates fluctuate on a daily basis. n Since the cash flows from bonds are fixed, bond prices vary with changes in interest rates. n Bonds are worth the PV of the stream of cash flows paid by borrower discounted at the prevailing market rate of interest. n Example: Suppose that we own a $1,000,000, 10%, 10-year semi- annual bond and want to sell it in a market where interest rates have risen to 12%. What will the bond be worth?

8 The Cash Flows Are Fixed! % 0 $50, $50,000 $50,000 $1,000,000 Principal The cash flows are unchanged! To value the bond we only change the interest rate used in the PV calculations to reflect the prevailing market rate!

9 The Calculations First, calculate the PV of the $50,000 annuity using the 12% market interest rate. N = 20, i = 6%, PMT = $50,000, PV = ? PV = $573,496 Second, calculate the PV of the $1,000,000 repayment of principal. N = 20, i = 6%, FV = $1,000,000, PV = ? PV = $311,805 Then, add the two PVs to get the value of the bond. Value of Bond = $573,496 + $311,805 = $885,301 Note: Excel and some calculators can do this as one calculation. Enter N, i, FV, and PMT. Solve for PV. =PV(rate, nper, pmt, fv, type) =PV(6%,20,-50000, )

10 Term Versus Serial Bonds n Term bonds are all paid at one maturity date. However, amounts can be paid into a Sinking Fund at various times to accumulate money to repay principal at maturity. n Serial Bonds have a number of different maturity dates. This allows some of the principal to be paid back each year over a range of years, rather than all at once. n Call provisions allow bonds to be “called in” or repaid before the maturity date. n Call provisions generally increase the interest rate on the bond when first issued, since it creates an advantage for the borrower.

11 Calculating Interest Rates for Serial Bonds – NIC Method $10,000 serial bond, principal payments of $1,000 at the end of Years 1 and 2, $2,000 at the end of year 3, and $3,000 at the end of years 4 and 5. Interest rates are 3, 4, 5, 6 and 7% on the respective maturities, and the bond issue is initially sold at a $100 discount. Par or Principal Coupon Rate Years Interest $1,000 x 3% x1 = $ 30 1,000x 4% x2= 80 2,000x5% x3= 300 3,000x6% x4= 720 3,000x7% x5= 1,050 Interest Payments $2,180 Plus Discount 100 Total Interest $2,280

12 Calculating the NIC Interest Rate for Serial Bonds, continued Calculate Bond Dollar Years $10,000 x 1 =$10,000 9,000x 1= 9,000 8,000x1= 8,000 6,000x1= 6,000 3,000x1= 3,000 Bond Year Dollars$36,000 Then the NIC is calculated as: Total Interest (-premium+discount) $2,280 NIC = = = 6.333% Bond Dollar Years $36,000

13 Calculating the TIC Interest Rate for Serial Bonds Par or Coupon ________Interest Paid at the End of___ _____ Principal Rate Year 1 Year 2 Year 3 Year 4 Year 5 Total $1,000 x 3% = $ 30 $ 30 1,000 x 4% = ,000 x 5% = ,000 x 6% = ,000 x 7% = ,050 Interest Payment $560 $530 $490 $390 $210 $2,180 Principal Payment 1,000 1,000 2,000 3,000 3,000 10,000 Total Payment $1,560 $1,530 $2,490 $3,390 $3,210 $12,180

14 Calculating the TIC Interest Rate for Serial Bonds, continued Therefore, the TIC is the interest rate that makes: $9,900 = (PV of $1,560, N=1) + (PV of $1,530, N=2) + (PV of $2,490, N=3) + (PV of $3,390, N=4) + (PV of $3,210, N=5) Using a spreadsheet program such as Excel®, this can be solved using the IRR function. In Excel®, the solution formula would be: = IRR(values, guess) = 6.347%

15 Leases n Types of leases è Operating Leases: All short-term or cancelable leases è Capital Leases: Some long-term and non-cancelable leases n Possible advantages of Leasing è flexibility and protection against obsolescence è Bypass legal governmental debt requirements equipment cost, and tax-related savings n Possible disadvantages of leasing è tendency toward higher costs n Capital lease obligations are valued at the PV of the remaining future lease payments