1. Chapter 15
Debt Financing

2. Chapter Outline 15.1 Corporate Debt 15.2 Bond Covenants
15.3 Repayment Provisions
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3. Learning Objectives
Identify different types of debt financing available to a firm
Understand limits within bond contracts that protect the interests of bondholders
Describe the various options available to firms for the early repayment of debt
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4. 15.1 Corporate Debt Companies can raise debt using different sources:
Public debt, which trades in a public market
Private debt, which is negotiated directly with a bank or a small group of investors.
The securities that companies issue when raising debt are called corporate bonds.
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5. Example 15.1a: Calculating the Net Amount of Funds
Problem:
You are finalizing a bank loan for $200,000 for your small business and the closing fees payable to the bank are 2% of the loan. After paying the fees, what will be the net amount of funds from the loan available to your business?
$200,000 x 2% = $4,000
$200,000 - $4,000 = $196,000
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6. Example 15.1a: Calculating the Net Amount of Funds
Solution:
Plan:
The net amount of funds available is the amount of loan proceeds left after the fees are paid. Therefore, the plan is to subtract the fees, which are 2% of the $200,000 loan principal, from the loan amount.
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7. Example 15.1a: Net Funds on Borrowings
Execute:
$200,000 x 2% = $4,000
$200,000 - $4,000 = $196,000
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8. Example 15.1a: Net Funds on Borrowing
Evaluate:
The actual amount you get to use is $196,000. It is important to consider not only the principal amount and the interest rate, but also the fees and their effect on the funds available to you.
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9. Example 15.1b: Corporate Debt
Problem:
Your firm is issuing $100 million in straight bonds at par with a coupon rate of 7% and paying total fees of 5%. What is the net amount of funds that the debt issue will provide for your firm?
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10. Example 15.1b: Corporate Debt
Solution:
Plan:
The net amount of funds your firm will net from the debt issue is the issue amount less the fees. The coupon rate will be paid semi-annually out of going revenues and is not considered in the initial cash intake. Therefore, the plan is to subtract the fees, which are 5% of the issue amount, from the issue amount to determine how much your firm will net from the debt issue.
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11. Example 15.1b: Corporate Debt
Execute:
$100 million x 5% = $5,000,000
$100 million - $5 million = $95,000,000
Amount firm has available for its use from issuing $100 million in debt is only $95 million
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12. Example 15.1b: Corporate Debt
Evaluate:
There are costs for issuing bonds to the public. Your firm must consider these in assessing its debt issue. The amount your firm will have available from issuing $100 million in debt is only $95 million.
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13. Private Debt
Private Debt: debt that is not publicly traded. The private debt market is larger than the public debt market.
Private debt has the advantage that it avoids the cost and delay of registration with the U.S. Securities and Exchange Commission (SEC).
The disadvantage is that because it is not publicly traded, it is illiquid, meaning that it is hard for a holder of the firm’s private debt to sell it in a timely manner.
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14. Private Debt Bank Loans:
Term Loan: Loan that lasts for specific time frame (term).
Syndicate Bank Loan: A single loan is funded by a group banks rather than just a single bank.
Revolving line of credit: A credit commitment for specific time period up to some limit which a company can use as needed
Asset Backed line of credit: A company may be able to get a larger line of credit or a lower interest rate if it secures the line of credit by pledging an asset as collateral.
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15. Private Placement
Private placement: a bond issue that does not trade on a public market but rather is sold to a small group of investors.
Advantages
It is less costly to issue
Privately placed debt also need not conform to the same standards as public debt; as a consequence, it can be tailored to the particular situation.
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16. Public Debt
The Prospectus: A public bond issue is similar to a stock issue.
The prospectus must include an indenture, a formal contract that specifies the firm’s obligations to the bondholders
If a coupon bond is issued at a discount, it is called an original issue discount (OID) bond.
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17. Secured and Unsecured Corporate Debt
Four types of bonds issued
Notes: are unsecured debt with maturities typically of less than 10 years
Debentures: are unsecured debt with maturities of 10 years or longer
Mortgage Bonds: are secured by real property
Asset backed Bonds: bonds can be secured by any kind of asset
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18. Table 15.1 Types of Corporate Debt
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19. International Bond Markets
Domestic bonds: issued by a local entity and traded in a local market, but purchased by foreigners. They are denominated in the local currency.
Foreign bonds: issued by a foreign company in a local market and are intended for local investors. They are also denominated in the local currency.
Eurobonds: are international bonds that are not denominated in the local currency of the country in which they are issued. Consequently, there is no connection between the physical location of the market on which they trade and the location of the issuing entity.
Global bonds: combine the features of domestic, foreign, and Eurobonds, and are offered for sale in several different markets simultaneously.
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20. 15.2 Bond Covenants
Covenants: restrictive clauses in bond contract limiting the issuer from taking actions that may undercut its ability to repay the bonds.
Advantages
By including more covenants, firms can reduce their costs of borrowing.
The reduction in the firm’s borrowing cost can more than outweigh the cost of the loss of flexibility associated with covenants.
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21. Table 15.4 Typical Bond Covenants
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22. 15.3 Repayment Provisions
Call Provisions: Firms can repay bonds by exercising a call provision.
Callable Bonds: Allow the firm to repurchase the bonds at a predetermined price.
YTC: Yield to Call on a callable bond
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23. Table 15.6 Bond Calls and Yields
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24. Example 15.1 Calculating the Yield to Call
Problem:
IBM has just issued a callable (at par) five-year, 8% coupon bond with annual coupon payments. The bond can be called at par in one year or anytime thereafter on a coupon payment date. It has a price of $103 per $100 face value, implying a yield to maturity of 7.26%. What is the bond’s yield to call?
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25. Example 15.1 Calculating the Yield to Call
Solution:
Plan:
The timeline of the promised payments for this bond (if it is not called) is:
If IBM calls the bond at the first available opportunity, it will call the bond at year 1. At that time, it will have to pay the coupon payment for year 1 ($8 per $100 of face value) and the face value ($100). The timeline of the payments if the bond is called at the first available opportunity (at year 1).
To solve the YTC, we use these cash flows set the price equal to the discounted cash flows and solving for the discount rate. 1
2 … 5 $8
$108
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26. Example 15.1 Calculating the Yield to Call
Execute:
For the YTC, setting the present value of these payments equal to the current price gives
103 = YTC= = 4.85%
( 1+ YTC)
Given: 1
-103 8
100
Solve for:
4.85
Excel Formula: =RATE(NPER, PMT, PV,FV) = RATE(1,8,-103,100)
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27. Example 15.1 Calculating the Yield to Call
Evaluate:
The YTM is higher than the YTC because it assumes that you will continue receiving your coupon payments for 5 years, even though interest rates have dropped below 8%. While under the YTC assumptions, you are repaid the face value sooner, you are deprived of the extra 4 years of coupon payments, so your total return is lower.
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28. Repayment Provisions
Sinking Funds: a provision that allows the company to make regular payments into a fund administered by a trustee over the life of the bond instead of repaying the entire principal balance on the maturity date
Balloon Payment: Large payments on a maturity date
Convertible Provisions: Corporate bonds with a provision that gives the bondholder an option to convert each bond owned into a fixed number of shares of common stock at a ratio called the conversion ratio.
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29. Convertible Bonds and Stock Prices
The likelihood of eventually converting a convertible bond depends upon the current stock price.
When the stock price is low, conversion is unlikely, and the value of the convertible bond is close to that of a straight bond
When the stock price is much higher than the conversion price, conversion is verylikely and the convertible bond’s price is close to the price of the converted shares.
When the stock price is the middle range, near the conversion price, there is the greatest uncertainty about the whether it will be optimal to convert or not
Convertible debt carries a lower interest rate than other comparable non-convertible debt.
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30. Figure 15.2 Convertible Bond Value
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31. Combining Features
Combining Features: Companies have flexibility in setting the features of the bonds they issue.
Subordinated bonds typically have a higher yield because of their riskier position relative to senior bond
Leveraged Buyouts: a public company becoming private, in this case through a leveraged buyout. In a leveraged buyout (LBO), a group of private investors purchases all the equity of a public corporation
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32. Chapter Quiz What are the different types of corporate debt?
Explain some of the differences between a public debt offering and a private debt offering.
Explain the difference between a secured corporate and an unsecured corporate bond.
Why would a call feature be valuable to a company issuing bonds?
What is the effect of including a call feature on the price a company can receive for its bonds?
Why is the yield on a convertible bond lower than the yield on an otherwise identical bond without a conversion feature?
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