1. Chapter 20 Fixed-Income Financing and Pension Liability

2. Features of Debt Coupon rate is fixed return of long-term debt
Trustee represents the interests of bondholders
Indenture contains the terms of the bond issue and the restrictions placed on the company (protective covenants)
Bond ratings reflect a rating agency’s opinion as to the creditworthiness of publicly traded debt
High-yield debt is rated Ba/BB or below
Sinking funds retire a portion of the bonds prior to maturity
Issuer’s option
Nasty accumulators

3. Floating-Rate Notes (FRNs)
The interest rate can float with some short-term rate, such as the (LIBOR), Treasury bill, or commercial paper rate
Used in a volatile interest rate environment to reduce risk
Special features
Options Declining spread Fixed-rate provision

4. European Corporate Bond Issuance
Lacked depth and breadth necessary to be attractive before Euro
Bond issue denominated in the Euro has become the vehicle of choice in cross-border financing
Viable European corporate bond market has developed

5. Types of Debt Financing
Debentures
Subordinated debentures
Mortgage bonds
Income bonds
Equipment trust certificates
Equity-linked debt
Debt + warrants
Convertible bond
Project financing
Nonrecourse basis
Sharing rules

6. Call Feature and Refunding
Embedded options
Sinking fund
Call feature
Gives the issuer the option to buy back a debt instrument at a specific price (call price) before maturity
Forms of the provision
Immediately callable
Deferred for a period of time
Gives the company flexibility
Call the bonds and refinance if interest rates decline significantly
Unduly restrictive protective covenants

7. Refunding Versus Redemption
Refunding means refinancing the bond issue with a new bond issue at a lower interest cost
Many bond issues can be redeemed provided the source of the redemption is not a refunding
Investor has no call protection
Redemption price often is the face value
The line of demarcation between a call and a redemption is blurred

8. Value of Call Privilege
Determined by supply and demand forces in the market for callable securities
Investors are unwilling to invest in callable bonds unless such bonds yield more than noncallable bonds
Borrower has to be able to refund at a profit

9. Valuation in an Option Pricing Context
More volatility increases the value of the call option
Equilibrium pricing
Callable bond = Noncallable bond - Call option
Level and volatility of interest rates are key factors in giving value to the call feature
Identifies arbitrage opportunities

10. Refunding a Bond Issue in a Capital Budget Framework
A riskless investment project after new bonds are sold
Calculate the net investment
Net cash outflow at time 0
Calculate the interest savings
Cash inflows
Calculate the net present value of refunding
Timing of refunding
Based on expectations of future interest rates

11. Problems With Analyzing Bond Refunding
Longer maturity of new issue
Sinking-fund bonds or serial bonds
Decrease in the leverage of the firm

12. Private Placement Features
Speed of the commitment
Terms tailored to the needs of the borrower
Renegotiation is possible
Actual borrowing does not have to take place all at once
No registration with SEC
Company avoids making certain detailed information available to the public
Slightly higher interest rate
Lower floatation costs

13. Developments in the Market for Private Placements
Considerable popularity over the last two decades
Allowance for secondary trading
Distinction between private placement and public market has blurred

14. Preferred Stock
A form of fixed-income security, but the dividend is at the discretion of the company’s board
Adds to the equity base of the company and enhances the ability of the company to borrow in the future
Cumulative feature provides for unpaid dividends to be carried forward
Voting power
Normally not given unless management defaults

15. Retirement of Preferred Stock
Call feature affords the company flexibility to retire the issue
Sinking fund partially assures an orderly retirement of the stock
Convertibility
Convertible into common stock at the option of the holder
Force conversion by calling the preferred stock

16. Tax Treatment of Preferred Dividend
Taxed as ordinary income for individual investors
If the investor is a corporation, 70% is not subject to taxation (intercorporate dividend exclusion)
Preferred stock dividend paid is not tax deductible

17. Tax-Deductible Preferred Stock
Instrument devised to be tax-deductible
A special-purpose vehicle (SPV) is created
Most widely used instruments
MIPS
QUIPS
TOPrS

18. Auction-Rate Preferred Stock
An instrument whose interest rate floats with money market rates
70% intercorporate dividend exclusion does apply
Money market preferred stock (MMP)
Rate is set by auction every 49 days, the effective maturity date
Tax arbitrage involved in the instrument benefits both investor and issuer at the expense of the federal government

19. Pension Fund Liability
Binding claim under (ERISA)
Types of pension plans
Defined benefit plans are a liability of the employer to provide retirement benefits
Flat benefit formula
Unit benefit formula
Defined contribution plans are not a liability of the employer

20. Funded and Unfunded Liabilities of a Defined Benefit Plan
Liability to currently retired employees depends on their average life expectancy and the discount rate used
Liability to employees not yet retired
Past employment
Future service
Total pension liability of a company must be valued
The present value of liabilities is calculated by discounting to present value likely future benefits to be paid based on past service and expected future service

21. Unfunded Liability PV of pension liabilities - PV of pension assets
Reported on the balance sheet as a liability
FASB No. 87
Matter of concern to creditors
Pension Benefit Guarantee Corporation (PBGC) makes good on most of the total obligations for a bankrupt company

22. Accounting for Pensions
FASB No. 87 brought a consistent treatment of pension expense accounting together with bringing pension liability firmly onto the balance sheet
Expenses
Interest cost
Service cost for additional benefits that employees earn during the year
Amortization of any accumulated deficit
Expected investment return (offset expenses)