1. © Prentice Hall, 1997 1 MBA 622 Types of Debt Financing

2. © Prentice Hall, 1997 2 Types of Long-Term Debt è Secured debt èMortgage bonds èCollateral trust bonds èEquipment trust certificates èConditional sales certificates è Unsecured debt è Tax-exempt corporate debt

3. © Prentice Hall, 1997 3 Main Features of Corporate Debt è Stated maturity è Stated principal amount è Stated coupon rate of interest è Mandatory redemption (or sinking fund) schedule è Optional redemption provision è Protective covenants

4. © Prentice Hall, 1997 4 Sinking Fund Requirements è A sinking fund requires the firm to repay the debt in installments, rather than in a lump sum. è Serves as a monitoring device è Reduces the effective life of the debt. èAverage life èDuration

5. © Prentice Hall, 1997 5 Setting the Coupon Rate è Deep discount bonds èCoupon rate is set to zero. èReduces lender’s reinvestment risk. èBorrowers benefited from tax asymmetry (until 1982). è Fixed versus floating rate bonds

6. © Prentice Hall, 1997 6 Optional Redemption Provisions è Call Provisions èBond is usually protected against calls in the first few years of its life. èCall price declines over time.

7. © Prentice Hall, 1997 7 Convertible Bonds è Why do firms issue convertible bonds? èGives investors limited downside risk and unlimited upside risk. èAllows equity to be “sold” later with no transactions costs èMakes debt self-liquidating if conversion occurs

8. © Prentice Hall, 1997 8 Risk Considerations è Bond Ratings èSee the list at http://www.bondsonline.com/asp/research/bondr atings.asp http://www.bondsonline.com/asp/research/bondr atings.asp è Effect on Risk of the Company è Effect on Risk of the Common Stock è Effect on the Cost of Capital

9. © Prentice Hall, 1997 9 Short-Term Financing è Trade Credit è Secured and unsecured bank loans è Commercial Paper

10. © Prentice Hall, 1997 10 Cost of Trade Credit Discount Music Stores buys its inventory on “1/10, net 30” terms. What is the cost of not taking the discount?

11. © Prentice Hall, 1997 11 Cost of Trade Credit è Let d = the amount of the discount (= 1%) è Let DP = the discount period (= 10 days) è Let TP = the total payment period (= 30 days)

12. © Prentice Hall, 1997 12 Cost of Trade Credit

13. © Prentice Hall, 1997 13 Effective Use of Trade Credit è Advantages: èReadily available èInformal èFlexible èStretching payments è Disadvantages èHigh cost of discounts foregone èExcessive stretching of payments

14. © Prentice Hall, 1997 14 Bank Loans è Short-term unsecured loans èTransaction loan èLine of credit èRevolving credit agreement è Term loans èBullet maturity èBalloon payment

15. © Prentice Hall, 1997 15 Commercial Paper è Commercial paper is a negotiable business IOU note. è It is sold by the largest, most creditworthy firms on a discount basis. è Maturity is set to less than 270 days. èRegistration with the SEC is not required. è 40% of commercial paper is sold through dealers. èCommission of about 0.125% on an annualized basis.

16. © Prentice Hall, 1997 16 Commercial Paper Current average yields on commercial paper