Chapter 14
Debt
Financing
2009
14-1
Chapter 14
Debt
Financing
Copyright © 2009 Pearson Prentice Hall. All rights reserved.
Chapter Outline
14.1 Corporate Debt
14.2 Bond Covenants
14.3 Repayment Provisions
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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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14.1 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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Example 14.1a: 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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Example 14.1a: 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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Example 14.1a: Net Funds on
Borrowings
Execute:
$200,000 x 2% = $4,000
$200,000 - $4,000 = $196,000
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Example 14.1a: 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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Example 14.1b: 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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Example 14.1b: 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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Example 14.1b: 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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Example 14.1b: 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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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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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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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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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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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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Table 14.1 Types of Corporate Debt
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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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14.2 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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Table 14.4 Typical Bond Covenants
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14.3 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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Table 14.6 Bond Calls and Yields
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Example 14.1
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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Example 14.1
Calculating the Yield to Call
Solution:
Plan:
• The timeline of the promised payments for this bond (if it is not called) is:
0
1
2…
5
$8
$8
$108
• 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.
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Example 14.1
Calculating the Yield to Call
Execute:
• For the YTC, setting the present value of these
payments equal to the current price gives
103 = 108
( 1+ YTC)
Given:
Solve for:
1
YTC=
-103
108 -1= 4.85%
103
8
100
4.85
Excel Formula: =RATE(NPER, PMT, PV,FV) = RATE(1,8,-103,100)
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Example 14.1
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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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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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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Figure 14.2 Convertible Bond Value
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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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Chapter Quiz
1. What are the different types of corporate debt?
2. Explain some of the differences between a public debt offering
and a private debt offering.
3. Explain the difference between a secured corporate and an
unsecured corporate bond.
4. Why would a call feature be valuable to a company issuing
bonds?
5. What is the effect of including a call feature on the price a
company can receive for its bonds?
6. 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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