20-0 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Corporate Finance Ross Westerfield Jaffe Sixth Edition 20 Chapter Twenty Long-Term Debt Prepared by Gady Jacoby University of Manitoba and Sebouh Aintablian American University of Beirut

20-1 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Chapter 20 Long-Term Debt 20.1 Long Term Debt: A Review 20.2 The Public Issue of Bonds 20.3 Bond Refunding 20.4 Bond Ratings 20.5 Some Different Types of Bonds 20.6 Direct Placement Compared to Public Issues 20.7 Long-Term Syndicated Bank Loans 20.8 Summary and Conclusions

20-2 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 20.1 Long Term Debt: A Review Corporate debt can be short-term (maturity less than one year) or long-term. Different from common stock: –Creditors claim on corporation is specified –Promised cash flows –Most are callable Over half of outstanding bonds are owned by life insurance companies & pension funds Plain vanilla bonds to kitchen sink bonds

20-3 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Features of a Typical Bond The indenture usually lists –Amount of Issue, Date of Issue, Maturity –Denomination (Par value) –Annual Coupon, Dates of Coupon Payments –Security –Sinking Funds –Call Provisions –Covenants Features that may change over time –Rating –Yield-to-Maturity –Market price

20-4 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Features of a Hypothetical Bond

20-5 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 20.2 The Public Issue of Bonds The general procedure is similar to the issuance of stock, as described in the previous chapter. Indentures and covenants are not relevant to stock issuance. The indenture is a written agreement between the borrower and a trust company. The indenture usually lists –Amount of Issue, Date of Issue, Maturity –Denomination (Par value) –Annual Coupon, Dates of Coupon Payments –Security –Sinking Funds –Call Provisions –Covenants

20-6 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Principal Repayment Term bonds versus serial bonds Sinking funds: How do they work? –Fractional repayment each year –Good news---security –Bad news---unfavourable calls –How trustee redeems

20-7 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Protective Covenants Agreements to protect bondholders Negative covenant: Thou shalt not: –pay dividends beyond specified amount –sell more senior debt and amount of new debt is limited –refund existing bond issue with new bonds paying lower interest rate –buy another companys bonds Positive covenant: Thou shalt: –use proceeds from sale of assets for other assets –allow redemption in event of merger or spinoff –maintain good condition of assets –provide audited financial information

20-8 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited The Sinking Fund There are many different kinds of sinking-fund arrangements: –Most start between 5 and 10 years after initial issuance. –Some establish equal payments over the life of the bond. –Most high-quality bond issues establish payments to the sinking fund that are not sufficient to redeem the entire issue. Sinking funds provide extra protection to bondholders. Sinking funds provide the firm with an option.

20-9 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited The Call Provision A call provision lets the company repurchase or call the entire bond issue at a predetermined price overa specified period. The difference between the call price and the face value is the call premium. Many long-term corporate bonds outstanding in Canada have call provisions. New corporate debt features a different call provision referred to as a Canada plus call. The Canada plus call is designed to replace the traditional call feature by making it unattractive for the issuer ever to call the bonds.

20-10 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 20.3 Bond Refunding Replacing all or part of a bond issue is called refunding. Bond refunding raises two questions: –Should firms issue callable bonds? –Given that callable bonds have been issued, when should the bonds be called?

20-11 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Should firms issue callable bonds? Common sense tells us that call provisions have value. A call works to the advantage of the issuer. If interest rates fall and bond prices go up, the option to buy back the bonds at the call price is valuable. In bond refunding, firms will typically replace the called bonds with a new bond issue. The new bonds will have a lower coupon rate than the called bonds.

20-12 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Why are callable bonds issued in the real world? Four specific reasons why a company might use a call provision: 1.Superior interest rate predictions 2.Taxes 3.Financial flexibility for future investment opportunities 4.Less interest-rate risk

20-13 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Callable Bonds versus Noncallable Bonds Most bonds are callable; some sensible reasons for call provisions include: taxes, managerial flexibility, and the fact that callable bonds have less interest rate risk.

20-14 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Calling Bonds: When does it make sense? In a world with no transaction costs, it can be shown that the company should call its bonds whenever the callable bond value exceeds the call price. This policy minimizes the value of the callable bonds. The costs from issuing new bonds change the refunding rule to allow bonds to trade at prices above the call price. The objective of the company is to minimize the sum of the value of the callable bonds plus new issue costs.

20-15 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 20.4 Bond Ratings What is rated: –The likelihood that the firm will default. –The protection afforded by the loan contract in the event of default. Who pays for ratings: –Firms pay to have their bonds rated. –The ratings are constructed from the financial statements supplied by the firm. Ratings can change. Raters can disagree.

20-16 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Bond Ratings: Investment Grade

20-17 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Bond Ratings: Below Investment Grade

20-18 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Junk bonds Anything less than an S&P BB or a Moodys Ba is a junk bond. A polite euphemism for junk is high-yield bond. There are two types of junk bonds: –Original issue junkpossibly not rated –Fallen angelsrated Current status of junk bond market –Private placement Yield premiums versus default risk

20-19 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 20.5 Different Types of Bonds Callable Bonds Puttable Bonds Convertible Bonds Zero Coupon Bonds Floating-Rate Bonds Other Types of Bonds

20-20 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Puttable bonds Put provisions –Put price –Put date –Put deferment Extendible bonds Value of the put feature Cost of the put feature

20-21 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Convertible Bonds Why are they issued? Why are they purchased? Conversion ratio: –Number of shares of stock acquired by conversion Conversion price: –Bond par value / Conversion ratio Conversion value: –Price per share of stock x Conversion ratio In-the-money versus out-the-money

20-22 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Convertible Bond Prices

20-23 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Example of a Convertible Bond

20-24 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited More on Convertibles Exchangeable bonds –Convertible into a set number of shares of a third companys common stock. Minimum (floor) value of convertible is the greater of: –Straight or intrinsic bond value –Conversion value Conversion option value –Bondholders pay for the conversion option by accepting a lower coupon rate on convertible bonds versus otherwise- identical nonconvertible bonds.

20-25 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Example of an Exchangeable Bond

20-26 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Zero-Coupon Bonds A bond that pays no coupons at all must be offered at a price that is much lower than its stated value. For tax purposes, the issuer of a zero-coupon bond deducts interest every year even though no interest is actually paid. Zero-coupon bonds, often in the form of stripped coupons, are attractive to individual investors for tax-sheltered Registered Retirement Savings Plans (RRSPs).

20-27 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Floating Rate Bonds With floating rate bonds, the coupon payments are adjustable.The adjustments are tied to the Treasury bill rate or another short-term interest rate. Majority of floaters have the following features: 1.The holder has the right to redeem her note at par on the coupon payment date after some specified amount of time. 2.The coupon rate has a floor and a ceiling. i.e., a minimum and a maximum.

20-28 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Financial Engineering and Bonds Income bonds: coupon payments are dependent on company income. Retractable bonds: allow the holder to force the issuer to buy the bond at the stated price. Examples are Canada Savings Bonds (CSBs). A stripped real-return bond is a zero coupon bond with inflation protection.

20-29 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 20.6 Direct Placement Compared to Public Issues There are two basic forms of direct private long-term financing: 1.Term loans 2.Private placements Differences between direct private long-term financing and public issues of debt are: 1.Registration costs are lower for direct financing. 2.Direct financing is likely to have more restrictive covenants. 3.It is easier to renegotiate a term loan or a private placement in the event of default.

20-30 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 20.7 Long-Term Syndicated Bank Loans A syndicated loan is a corporate loan made by a group (or syndicate) of banks and other institutional investors. A syndicated loan may be publicly traded. It may be a line of credit and be undrawn or it may be drawn and be used by a firm. Syndicated loans are always rated investment grade.

20-31 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 20.8 Summary and Conclusions The details of the long-term debt contract are contained in the indenture. The main provisions are: security, repayment, protective covenants, and call provisions. Protective covenants are designed to protect bondholders from management decisions that favour stockholders at bondholders expense. Most public industrial bonds are unsecuredthey are general claims on the companys value. Most utility bonds are secured. If the firm defaults on secured bonds, the trustee can repossess the asset.

20-32 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 20.8 Summary and Conclusions (cont.) Long-term bonds usually provide for repayment of principal before maturity. This is usually accomplished with a sinking fund whereby a firm retires a certain number of bonds each year. Most publicly issued bonds are callable. There is no single reason for call provisions. Some sensible reasons include taxes, greater flexibility, and the fact that callable bonds are less sensitive to interest- rate changes. There are many different types of bonds, including floating-rate bonds, deep-discount bonds, and income bonds.