Chapter 16 Long-Term Debt and Lease Financing

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 16-1 FIGURE 16-1 Times interest earned for Standard & Poor’s industrials

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 16-2 FIGURE 16-2 Priority of claims

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 16-3 TABLE 16-3 Bond price table

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Restatement of Facts PPT 16-4 Old IssueNew Issue Size $10,000,000$10,000,000 Interest rate %9.5% Total life years20 years Remaining life...20 years 20 years Call premium...10% -- Underwriting costs..$125,000 $200,000 Tax bracket % Discount rate.... 6%

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Step C—Net Present Value PPT 16-5 We now compare our outflows and our inflows from the prior pages. OutflowsInflows 1. Net cost of call..$650,0003.Cost savings in lower premium....interest rates... $1,677,488 2.Net cost of under-4.Net gain from under- writing expense onwriting cost on new issue...159,855old issue....14,928 $809,855$1,692,416 Present value of inflows...$ 1,692,416 Present value of outflows ,855 Net present value.....$882,561

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 16-6 TABLE 16-5 Zero-coupon and floating rate bonds

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 16-7 TABLE 16-6 Examples of Eurobonds

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 16 - Outline LT 16-1 Bond Terminology More Bond Terminology Priority of Claims Methods of Repayment 3 Types of Bond Yields Other Forms of Bond Financing Advantages and Disadvantages of Debt 2 Types of Leases Advantages of Leasing

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Bond Terminology LT 16-2 Par Value: principal or face value (usually $1,000) Coupon Rate: actual or stated interest rate Maturity Date: date when repayment of principal is due

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. More Bond Terminology LT 16-3 Indenture: legal document detailing the corporation’s obligations Secured Debt: where specific assets are pledged to bondholders in the event of default Debenture: a L/T unsecured corporate bond Subordinated Debenture: unsecured bond that is paid after senior debenture holders are satisfied

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Priority of Claims LT 16-4 Secured Debt (first priority) Unsecured Debt (or Debentures) Preferred Stockholders Common Stockholders (last to receive any money)

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Methods of Repayment LT 16-5 Besides paying the principal at maturity, there are other methods: 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

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3 Types of Bond Yields LT 16-6 Nominal Yield (or Coupon Rate): –stated interest rate / par value Current Yield: – yield in terms of the current price of the bond Yield-to-Maturity (YTM): – yield received if bond is held until maturity

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Other Forms of Bond Financing LT 16-7 Zero-Coupon Bond: – does not pay interest – is sold at a deep discount from face value Floating Rate Bond: – interest rate paid on the bond changes with market conditions – popular in European capital markets

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Advantages and Disadvantages of Debt LT 16-8 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) – during inflation, debt is repaid with “cheaper dollars” Disadvantages of Debt: – interest and principal must always be met when due, regardless of a firm’s financial position – poor use of debt may lower a firm’s stock price – may place burdensome restrictions on the firm

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 Types of Leases LT 16-9 Capital Lease (or Financing Lease): – a purchase rather than a lease – firm actually buys the property – must be shown on a firm’s balance sheet – ex., oil drilling equipment and airplanes Operating Lease: – a conventional rental agreement – firm doesn’t expect to own property – is not shown on a firm’s balance sheet – ex., automobiles and office equipment

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Advantages of Leasing Lessee may lack sufficient funds to purchase the asset Provisions of a lease obligation may be less restrictive than a bond indenture There may be no down payment requirement (generally required when purchasing an asset) LT 16-10