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.
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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
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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
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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
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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
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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
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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
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• 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
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– 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
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• 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
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• 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:
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Payments and payment dates
Positive and negative covenants
Security (any collateral)
Any sinking fund requirements
Trustee
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• 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.
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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
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Bond Ratings
Credit risk assessments by independent bond rating
agencies, such as Moody’s and Standard & Poor’s
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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
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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
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Syndicated Loans
Large-denomination credit arranged by a group
(syndicate) of commercial banks for a single borrower
Eurocurrency
lending
Project
finance
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• 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
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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
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– 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
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• 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
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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.
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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
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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
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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.
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