© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Chapter 17: Long-Term Debt and Leasing Corporate Finance, 3e Graham, Smart, and Megginson

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Basic Choices in Securing External Financing 2 Whether to employ an investment bank to advise and handle offering Choice of public versus private capital market Choice of security and type of offer: equity or debt

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Long-Term Debt Financing 3 Public issue Must be registered with the SEC in U.S. Almost always issued with the help of investment bankers Vast majority are fixed rate offerings. Private issue Loans: private debt agreements with a financial institution Private placements: unregistered issues sold directly to accredited investors

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Cost of Long-Term Debt 4 Function of at least four factors Loan maturity Yield curves typically slope upward. Longer maturities mean greater exposure to the risk of default. Loan size Trade-off between administrative cost per dollar and risk exposure that increases with loan size Borrower risk The greater the risk of default, the higher the rate that the lender will charge. Basic cost of money The greater the prevailing rate on lowest- risk money (such as Treasury securities), the greater the rate on other loans.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Term Loans 5 Private loans made by financial institutions to businesses Initial maturity of more than 1 year, generally 5-12 years Term Lenders –Commercial banks –Insurance companies –Pension funds –Regional development companies –Small Business Administration –Finance companies –Equipment manufacturer finance subsidiaries

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Characteristics of Term Loans 6 Payment dates Usually monthly, quarterly, semiannual or annual payments May involve periodic payments followed by a balloon payment of the remaining principal Collateral requirements Secured loans involve the pledging of specific assets as collateral. Reduce risk for lender Stock purchase warrants Give lender the right to purchase a fixed number of shares of common stock at specified price over a fixed time period Can be used as “sweeteners”

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Corporate Bonds 7 Debt security carrying a promise to pay cash flows to the holder: Most maturities range from 10 to 30 years with a par (face) value of $1000. Coupon –The percentage of par value that is paid in interest each year –Typically in two equal semiannual payments Methods of issuing corporate bonds Shelf Registration Rule 144A

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Unsecured Bonds  Debentures  Subordinated debentures  Income bonds 8

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Secured Bonds 9 Collateral trust bonds Secured by stock/bonds owned by the issuer Equipment trust certificates Used to finance transportation equipment including airplanes, trucks, rail cars, boats A type of leasing Mortgages Secured by real estate or buildings A number of mortgages can be issued against the same collateral.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Legal Aspects of Bonds 10 Bond indenture: The bond contract, which specifies: – Payments and payment dates – Positive and negative covenants – Security (any collateral) – Any sinking fund requirements Trustee Third party who ensures that the issuer does not default on contractual responsibilities Can be an individual or a corporation; most often a commercial bank trust department Services paid for by the issuer

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Corporate Bond Features 11 Call feature: included in most corporate bond issues Gives the issuer the opportunity to repurchase bonds prior to maturity at the call price call price Often par value plus one year of interest (call premium) The issuer can retire an issue early when interest rates fall. Must pay a higher interest rate than would otherwise be necessary in order to compensate bondholders

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Conversion Features and Stock Purchase Warrants 12 Conversion feature: allows bondholders to change each bond into a stated number of shares of common stock Stock purchase warrants: right to purchase a number of shares at a specified price over a certain period of time

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. International Corporate Bond Financing 13 Eurobonds Bond issued by an international borrower and sold to investors in countries with different currency than bond’s currency Foreign bonds Bonds issued by an international borrower in a foreign country, denominated in the foreign country’s currency

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Bond Refunding Options 14 Choices for firms wishing to avoid large single payment at bond maturity Serial bonds: Issues with staggered maturities, often with different interest rates paid to various maturities Refunding bonds by exercising a call Use capital budgeting techniques to determine if exercise of a call is optimal.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Bond Refunding: Tax-Related Points 15 Call premium: amount by which call price exceeds par value of bond Bond discounts and premiums: firm must write off discount or premium in equal portions over life of bond Flotation or issuance costs – must be amortized over life of bond

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Syndicated Loans 16 Large-denomination credit arranged by a group (syndicate) of commercial banks for a single borrower Eurocurrency lending Consists of a large number of international banks that make floating rate loans to international corporate borrowers and governments Limit the risk exposure of any one bank to any one borrower Project finance Lending to stand-alone companies created for the sole purpose of constructing and operating specific projects: toll roads, bridges, power plants, airports Generally backed only by the assets and cash flow of the project

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Leasing 17 Similar to secured long-term debt, involve periodic, tax- deductible payments Lessor Owner of the asset Retains the tax benefit associated with ownership of the asset Lessee User of the asset Makes payments to the lessor under the terms of the lease Types of Leases Operating lease Financial (capital) lease

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Leasing Arrangements 18 Direct lease Lessor acquires the asset to be leased Sale-leaseback One firms sells an asset to another for cash, then leases the asset from the new owner Leveraged lease Third-party lender involved

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Leasing Agreement 19 Maintenance clauses Renewal options

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Lease Versus Purchase Decision 20 Employ a capital budgeting framework to determine whether to lease or buy an asset: Step 1: Find the after-tax cash outflows under the lease alternative. Step 2: Find the after-tax cash outflows under the purchase alternative. Select the alternative with the lower present value of expected cash outflows! Step 3: Calculate PV of expected future cash flows under each alternative.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Advantages of Leasing 21 Allows for the effective depreciation of land, which is not allowed when land is purchased Sale-leaseback can enhance firm liquidity. Leasing can provide 100% financing. Lower claims against the firm in bankruptcy Reduced risk of obsolescence of assets Avoid restrictive covenants that would likely be present in a long-term loan agreement

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Disadvantages of Leasing 22 Leases do not have stated interest cost. Effective cost may be higher than if the firm borrowed money to purchase. At the end of the lease, lessee does not receive any “salvage value” associated with the asset. Lessee may not be allowed to modify or improve leased assets without lessor approval. Even if assets become obsolete or unusable, the remaining lease payments must be made.