LONG-TERM DEBT FINANCING Tina Lumba Elizabeth Harris Christin Burrows 1

What We’re Learning Today What Affects Interest Rates? How Do We Borrow Money? Bonds: Useful Info What Determines the Interest Rate? Bond Valuations 2

How Do Healthcare Providers Raise Capital? Equity (65%) Debt (35%) Short-term (5%): usually < 1 year Long-term (30%): > 1 year Loans Bonds The Breakdown 3

What Affects Interest Rates? 4

The Cost of Money: What affects interest rates? Investment Opportunities Higher profitability = higher rates you can afford to borrow money Profitability means: You can afford higher interest rates if necessary More options are available to you 5

The Cost of Money: What affects interest rates? Time Preferences for Consumption Higher time preference (the sooner the lender needs to money back) = higher rate demanded from lenders Ask: when does the lender need the money back? Who will demand a higher rate to loan you money? Saving for retirement Sole provider for a family of four 6

The Cost of Money: What affects interest rates? Risk Higher risk = higher rate demanded from lenders If both offer 5% interest, which would you invest in? Ray Rice Chex Southwest Airlines What would entice you to consider Ray Rice Chex? Higher interest rate 7

The Cost of Money: What affects interest rates? Inflation Higher expected inflation = higher rate demanded from lenders You expect prices to rise 5% per year for the next 3 years Would you make a 3-year investment with a 8% rate? Would you make the same investment with a 4% rate? Probably No! 8

How Do We Borrow Money? 9

Long-Term Debt Instruments Term Loans Borrowing at an agreed-upon rate for fixed amount of time Usually one lender & one borrower Usually large $ amount Interest and principle payments 10

Long-Term Debt Instruments Bonds Borrowing at fixed rate for fixed amount of time Lender is a group on investors rather than a bank Small $ value, but issue many bonds at a time Coupon and par value payments Bonds Explained derstanding-bonds/ 11

Long-Term Debt Instruments Loans vs. Bonds: Which one should we use? Advantages to Loans Speed: two parties = less documentation Flexibility: two parties = easier negotiation (refinancing) Low Admin Costs: don’t have to go through the SEC Securities and Exchange Commission Advantages to Bonds Risk: rates are fixed (easier to plan for future) Price: can borrow at lower interest rate 12

Bonds: Useful Info 13

Bonds Useful Definitions Par Value: face value of the bond Amount investor (lender) lends the issuer (borrower) What issuer owes back to investors at end of term Maturity Date: when the par value will be repaid Coupon Rate: interest paid on the bond 14

Bonds Bond Types Corporate Bonds: issued by investor-owned firms For-profit hospitals Municipal Bonds: issued by state/local governments Not-for-profit hospitals Zero-Coupon Bond: no coupon payments Buy $1,000 future payment (par value) for $300 today Mortgage Bonds: backed by a real asset 15

Bonds Debt Contracts & Terms to Know Restrictive Covenant: contingent on performance; delinquency = technical default Current Ratio Bond Rating Trustees: single voice that represents bondholders Call Provisions: allows the borrower to “call” (or redeem) the bond early Usually for higher than face value Usually when interest rates drop: like refinancing 16

Bonds Measures a bond’s probability of default Investment grade: AAA through BBB Junk grade: BB through D Bond Ratings Explained: Impact of a downgrade (e.g. from A to BBB): Ability to borrow long-term capital? The cost of that capital? 17 Bond Ratings Harder to borrow Higher risk = Higher coupon rates

Bonds Bond Insurance (a.k.a. Credit Enhancement) Pays investor even in case of default Allows for an upgrade to AAA Low risk to investor Allows businesses to “buy” the AAA rating Review: what does that do to the coupon rates of new issues? 18 Lower risk = Lower coupon rates

What Determines the Interest Rate? 19

Interest Rates Component Real Risk-Free Rate (RRF) The base of all interest rates The rate demanded by investors when: Security is completely risk-free There is no inflation in the economy Accounts just for time value of money Interest Rate = RRF + IP + DRP + LP + PRP + CRP 20

Interest Rates Component Inflation Premium (IP) Expected inflation rate over the life of the security If RRF is the real risk-free rate: Then RRF adjusted for inflation (RRF + IP) would be the: Interest Rate = RRF + IP + DRP + LP + PRP + CRP Risk-Free Rate 21

Interest Rates Component Default Risk Premium (DRP) Compensation for investing in risky securities The lender charges the DRP to: Compensate for the risk-taking Help with potential consequences of default Interest Rate = RRF + IP + DRP + LP + PRP + CRP 22

Interest Rates Component Liquidity Premium (LP) Compensation for investing in illiquid assets You can resell bonds… but it can take some time: Significant transaction costs LP raises interest rate to attract investors to the illiquid security Interest Rate = RRF + IP + DRP + LP + PRP + CRP 23

Interest Rates Component Price Risk Premium (PRP) Compensation for holding a long-term bond Tied directly to the term to maturity: Higher risk with more years Why? Because you’re locked in and interest rates could rise Interest Rate = RRF + IP + DRP + LP + PRP + CRP 24

Interest Rates Component Call Risk Premium (CRP) Compensation for holding a security with an uncertain maturity Callable bonds are risky: Don’t know when it will get called Will have to reinvest after the call at lower rates Interest Rate = RRF + IP + DRP + LP + PRP + CRP 25

Term Structure of Interest Rates Yield Curves Yield Curves: plot interest rates over time Normal curve: longer term = higher interest Inverted curve: shorter term = higher interest (zero or negative PRP) Yield Curve Video: 26

More Interest Rates Economic Factors Federal Reserve Policy Expansionary Policy: money supply & interest rates Federal Budgetary Policy Deficits cause more government borrowing: money supply & interest rates Level of Economic Activity Recessions cause less demand for investments: interest rates 27

Bond Valuation 28

Bonds – Let’s Review Useful Definitions Par Value: face value of the bond Amount investor (lender) lends the issuer (borrower) What issuer owes back to investors at end of term Maturity Date: when the par value will be repaid Coupon Rate: interest paid on the bond 29

Bond Valuation We’ve already learned this stuff! Bond = annuity + lump sum Which part is the annuity? Which part is the lump sum? 15-year bond, 10% coupon rate, $1000 face value PV of $100 annuity for 15 years: $ PV of $1,000 lump sum: $ Bond Value $1, Coupon Rate Par Value 30

Bond Valuation The Most Important Concept Bond sells for par value at coupon rate (10%) If interest rate goes, bond’s current value goes Either way, bond will sell for par value at maturity date *Courtesy of LTC Beauvais 31

Bond Valuation Solving for the Bond’s Value Which of these should be negative? (Hint: from issuer perspective) These two! 32

Bond Valuation Solving for the Bond’s Value Go to Excel! “Finding Bond Values” Tab 33

Bond Valuation Solving for the Yield to Maturity Which of these should be negative? (Hint: from issuer perspective) These two! 34

Bond Valuation Solving for the Yield to Maturity Go to Excel! “Finding the Yield to Maturity” Tab 35

Bond Valuation Semiannual Bonds The same process except: Periods x 2 Interest Rate / 2 Payments / 2 36

Bond Valuation Semiannual Bonds Go to Excel! “Semiannual Bonds” Tab 37

Bond Valuation Callable Bonds The same as regular bonds, but you assume that the issuer will call the bond So use call price And call period Go to Excel! “Callable Bonds” Tab 38

Questions?? 39