Chapter 17 Long-Term Debt And Leasing Professor XXXXX Course Name / # © 2007 Thomson South-Western Long-Term Debt and Leasing Long-term debt and leasing are important sources of capital. Long-term debt can take the form of term loans or bonds. Syndicated loans are large credits arranged by a syndicate of commercial banks for a borrower. Leasing serves as an alternative to borrowing funds to purchase an asset. 2 Basic Choices In Securing External Financing A firm needing external capital faces three basic choices: Choice of public versus private capital market Whether to employ an investment bank to advise and handle offering Choice of security and type of offer: equity or debt 3 Long-Term Debt Financing Public issue • Must be registered with the SEC in U.S. • Almost always issued with the help of investment bankers • Vast majority are fixed rate offerings. • Loans: private debt agreements with a Private issue • • • • 4 financial institution Term loans or syndicated loans Most are floating-rate issues, with the rate set as a fixed spread from some base interest rate. Private placements: unregistered issues sold directly to accredited investors Rule 144A: most popular private placement Debt Covenants Contractual clauses within debt agreements that place constraints on the borrower: Positive covenants Negative covenants 5 • • • • • Things that the borrower “must do,” such as: Maintain satisfactory accounting records in accordance with GAAP Maintain a minimum level of net working capital Maintain life insurance on “key employees” Spend borrowed funds on proven financial needs • Things that the borrower “must not do” such as: • Sell accounts receivable to generate cash • Issue additional debt or require that additional debt be subordinated • Arrange certain types of leases or other fixed payment obligations Long-Term Debt Function of at least four factors 6 Loan maturity • Yield curves typically slope upward.. • Longer maturities mean longer, and so greater, exposure to the risk of default. Loan size • Trade-off between administrative cost per dollar and risk exposure that increases with loan size Borrower risk • The greater the risk of default, the higher the rate that the lender will charge. Basic cost of money • The greater the prevailing rate on lowestrisk money (such as Treasury securities), the greater the rate on other loans. Term Loans Private loans made by financial institutions to businesses Have initial maturities of more than one year; generally have maturities of 5-12 years Term Lenders 7 – – – – – – – Commercial banks Insurance companies Pension funds Regional development companies Small business administration Finance companies Equipment manufacturer finance subsidiaries Characteristics of Term Loans Payment dates Collateral requirements Stock purchase warrants 8 • Usually monthly, quarterly, semiannual or annual payments • Usually these payments fully pay the interest and principal over the life of the loan. • May involve periodic payments followed by a balloon payment of the remaining principal • Secured loans involve the pledging of specific assets as collateral. • Reduce risk for lender • Give the lender the right to purchase a fixed number of shares of common stock at specified price over a fixed time period • Can be used as “sweeteners” for both term loans and corporate bond issues Corporate Bonds Debt security carrying a promise to pay cash flows to the holder: Most maturities range from 10 to 30 years with a par (face) value of $1000. Coupon Methods of issuing corporate bonds 9 – The percentage of par value that is paid in interest each year – Typically in two equal semi-annual payments Shelf Registration Rule 144A Types of Bonds Debentures • Unsecured, so only creditworthy firms can issue • Most convertibles are debentures. Subordinated debentures • Unsecured • Claims are not satisfied until senior debts have been satisfied. Income bonds 10 • Payment of interest is only required when earnings are available. • Commonly issued in reorganization of a failing firm • Not necessarily in default when interest payments are missed, since these are contingent on earnings Types of Bonds Collateral trust bonds 11 • Secured by stock/bonds owned by the issuer Mortgages • Secured by real estate or buildings • A number of mortgages can be issued against the same collateral. Equipment trust certificates • Used to finance transportation equipment including airplanes, trucks, rail cars, boats Legal Aspects of Bonds Bond indenture: the bond contract, which specifies: – – – – Payments and payment dates Positive and negative covenants Security (any collateral) Any sinking fund requirements Trustee 12 • Third-party who ensures that the issuer does not default on contractual responsibilities • Can be an individual or a corporation; most often a commercial bank trust department • Services paid for by the issuer Corporate Bond Features Call feature: included in most corporate bond issues Gives the issuer the opportunity to repurchase bonds prior to maturity at the call call price price • Often par value plus one year of interest (call premium) The issuer can retire an issue early when interest rates fall. 13 Must pay a higher interest rate than would otherwise be necessary in order to compensate bondholders Conversion Features And Stock Purchase Warrants Conversion feature : allows bondholders to change each bond into a stated number of shares of common stock. Convert only when the stock price is greater than the conversion price Stock purchase warrants: right to purchase a number of shares at a specified price over a certain period of time Attached to bonds as an added “sweetener” for bondholder to help sell a bond issue 14 Bond Ratings Credit risk assessments by independent bond rating agencies, such as Moody’s and Standard & Poor’s 15 Investment grade bonds Rated Baa or above (Moody’s), BBB or above (S&P) High-yield (junk) bonds Rated below investment grade If downgraded to “junk,” called “fallen angels” Inverse relationship between bond ratings and bond promised rates of return International Corporate Bond Financing Eurobonds • Bond issued by an international borrower and sold to investors in countries with different currency than bond’s currency Foreign bonds • Bonds issued by an international borrower in a foreign country, denominated in the foreign country’s currency Most international bonds are bearer securities 16 Bond-Refunding Options Choices for firms wishing to avoid large single payment at bond maturity Serial bonds: issues with staggered maturities, often with different interest rates paid to various maturities Refunding bonds by exercising a call Use capital budgeting techniques to determine if exercise of a call is optimal 17 Syndicated Loans Large-denomination credit arranged by a group (syndicate) of commercial banks for a single borrower Eurocurrency lending Project finance 18 • Consists of a large number of international banks that make floating rate loans to international corporate borrowers and governments • Limit the risk exposure of any one bank to any one borrower • Lending to stand-alone companies created for the sole purpose of constructing and operating specific projects: toll roads, bridges, power plants, airports • Generally backed only by the assets and cash flow of the project Leasing Similar to secured long-term debt, leases involve periodic, tax-deductible payments Owner of the asset Lessor Retains the tax benefit associated with ownership of the asset User of the asset Lessee 19 Makes payments to the lessor under the terms of the lease Types of Leases Operating Leases Used for short-lived assets, such as computers or automobiles Normally can be cancelled after some time period May be re-leased by lessor after initial leasing agreement Lessors original cost generally exceeds total value of original lessee’s payments Financial (capital) leases 20 – Used to obtain the use of longer-lived assets such as land, buildings, and large pieces of equipment – Cannot be cancelled, so obligate the lessee to make payments over a defined period of time – Total payments are greater than the lessor’s cost Leasing Arrangements Direct lease 21 • Lessor acquires the asset to be leased (did not previously own the asset). Saleleaseback arrangement • One firms sells an asset to another for cash, then leases the asset from the new owner. • Attractive for firms that need cash and are willing to exchange a promise to make periodic lease payments for immediate cash Leveraged leases • Third party lender is involved. • Lessor provides only a portion of the cost of asset; the balance provided by the lender. Leasing Agreement 22 Maintenance clauses • Leasing agreements usually specify who is responsible for maintenance of leased assets. • Operating leases usually require the lessor to pay for maintenance, insurance, and taxes. • Financial leases usually require lessee pay these costs. Renewal options • Lessee usually has the option to renew a lease at expiration. • Operating leases commonly can be renewed, as the useful life of the asset normally extends beyond the original lease. • Lessee may also have a purchase option at the end of the original leasing agreement. Lease Versus Purchase Decision Employ a capital budgeting framework to determine whether to lease or buy an asset: Step 1: Find the after-tax cash outflows under the lease alternative. Step 2: Find the after-tax cash outflows under the purchase alternative. PV of expected future cash flows Step 3: Calculate PV under each alternative. 23 Select the alternative with the lower present value of expected cash outflows! The Lease Versus Purchase Decision Alternatives: Lease the asset Borrow funds and purchase the asset Purchase the asset with available liquid resources Employ a capital budgeting framework: Step 1: Find the after-tax cash outflows under the lease alternative Step 2: Find the after-tax cash outflows under the purchase alternative Step 3: Calculate the present value of the expected future cash flows under each of the alternatives, discounting at the firm’s after-tax cost of debt Step 4: Select the alternative with the lower present value of expected cash outflows 24 Advantages of Leasing 1) Allows for the effective depreciation of land, which is not allowed when land is purchased 2) Sale-leaseback can enhance firm liquidity. 3) Leasing can provide 100% financing. 4) Lower claims against the firm in bankruptcy 5) Reduced risk of obsolescence of assets 25 6) Avoid restrictive covenants that would likely be present in a long term loan agreement Disadvantages of Leasing 1) Leases do not have stated interest cost. Effective cost may be higher than if the firm borrowed money. 2) At the end of the lease, lessee does not receive any “salvage value” associated with the asset. 3) Lessee may not be allowed to modify or improve leased assets without lessor approval. 4) Even if assets become obsolete or unusable, the remaining lease payments must be made. 26