Chap016 LT+Debt+and+Leasing+Finance (2)

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16
Long-Term Debt
and Lease
Financing
Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies,
Inc. All rights reserved.
Chapter Outline
• Analyzing long-term debt
• Bond yield and prices
• Refunding the obligation upon decline in
interest rates
• Long-term lease obligations and its
characteristics
• Bankruptcy
1-2
Corporate Debt (Bonds)
• Investing in highly rated bonds of firms such as:
GE, P&G, IBM  very little to worry about (higher
returns vs. U.S. government securities)
• Other industries can be more riskier:
homebuilders, telecommunications (“default risk”)
1-3
The Expanding Role of Debt
• Dramatic growth in corporate debt (past 3
decades) is attributed to:
– Rapid business expansion
– Inflationary impact on the economy
– Inadequate funds generated from the internal operations
of business firms
• Expansion of the U.S. economy has placed
pressure on U.S. corporations to raise capital
– New set of rules have been developed for evaluating
corporate bond issues
1-4
Expanding Role of Debt
• Times Interest Earned Ratio
– Divides earnings before interest and taxes (EBIT) by
interest expense
– Interest-expense coverage for firm
16-5
Figure 16-1 Times Interest Earned for Walmart Stores,
Inc. and AAA Long-Term Debt Rates, 1998-2015
16-6
The Debt Contract
• Corporate bond: the basic long-term debt
instrument for most large U.S. corporations
• Basic items include:
– Par value: initial value of the bond (Principal or Face
Value)
– Coupon rate: actual interest rate on the bond
– Maturity date: final date on which repayment of bond
principal is due
1-7
Security Provisions
• Secured debts have specific assets pledged to
bondholders in the event of default
– These assets are seldom actually sold and distributed
(proceeds)
– Terms used to denote collateralized or secured debts:
• Mortgage agreement: real property is pledged
• After-acquired property clause: requires any new property
to be placed under the original mortgage
– Greater the protection offered, lower the interest rate on
the bond
1-8
Unsecured Debt (Bond)
• Debt that is not secured by a claim to a specific
asset
– Debenture: unsecured, long-term corporate bond (Exxon
Mobil, IBM, Intel)
• General claim against the corporation, is common for
defaults
– Subordinated debenture: unsecured bond
• Payment to the holder will occur only after the
designated senior debenture holders are satisfied
1-9
Priority of
Claims /
Hierarchy of
Obligations
1-10
Methods of Repayment
• Does not always involve a lump-sum disbursement
at the maturity date
– Repayment of bonds can be done by:
• Simplest method - single-sum payment at maturity
• Serial payments: paid off in installments over the life
of the issue
• Sinking-fund provision: semiannual/annual
contributions made into a fund run by a trustee
• Conversion: converting debt to common stock
• Call feature: retire or force in debt issue before
maturity
1-11
Bond Prices, Yields, and Ratings
• Financial managers must be sensitive to the bond
market with regard to:
– Interest rate changes
– Price movements
• Market conditions will influence:
– Timing of new issues
– Coupon rate offered
– Maturity date
• Bonds do not maintain stable long-term price
patterns
1-12
Table 16-1 Eli Lilly’s Bond Offering
Table 16-2 Interest Rates and Bond Prices (Face
Value)
• Longer issue life, greater influence of interest rate
changes on bond price
16-14
Bond Yields
• Three different ways; computed below:
– Example: par value: $1,000; payment: $100/year; period: 10
years; current price: $900
1) Coupon rate (nominal yield): interest rate / par value
$100
= 10%
$1,000
2) Current yield: in terms of the current price
$100 = 11.11%
$900
1-15
Bond Yields
3) Yield to maturity: for bonds is held until maturity
Interest rate approximate: 11.70% = payment of $100
for 10 years and a final payment of $1,000
Approximate
Yield to
Maturity
Principal payment - Price of the bond
Number of years to maturity
.6 (Price of the bond) + .4 (Principal payment)
Annual interest payment +
=
Y = $100 + ($1,000 - $900)/10 = $110 = 11.7%
0.6 ($900) + 0.4 ($1,000)
$940
1-16
Bond Ratings
• Two major bond rating agencies:
– Moody’s Investor Service
– Standard & Poor’s Corporation  9 categories of
ranking : Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C
• Ratings are based on a corporation’s:
–
–
–
–
–
Ability to make interest payments
Consistency of performance
Size
Debt-equity ratio
Working capital position, etc.
1-17
Examining Actual Bond Ratings
• The true return on a bond is measured by yield to
maturity)
• If a bond is relatively low in quality:
– A corporation pays a higher yield to maturity, although
they may be secured in nature
1-18
Examining Actual Bond Ratings
• Table 16.3 illustrates different bond offerings
Yield
to
Maturit
y
Coupon
Coupon
Type
7.00
Fixed
Microsoft Corp.
3.50
Fixed
Maturity S&P
Collateral
Date Rating Price
5/15/209
Debenture
8
AA- 1,470.63
2/12/203
SR Unsecured
5
AAA 1,007.39
Apple Inc.
4.45
Fixed
SR Unsecured 5/6/2044
AA+
1,103.38
3.86
3.00
Step
Coupon
3/20/203
SR Unsecured
0
AA-
1,000.00
3.81
Name
Coca-Cola
Enterprises
Toyota Motor
Corp.
4.72
3.45
16-19
Bond Rating Changes
Example GM’s Bond Rating Drop
In May 2005, bond rating agencies reduced GM and Ford’s bond
ratings from investment grade to junk bond status.
 the required yield on GM bonds rose 50 basis points ( or +0.5%).
Several factors led to GM’s rating drop:
– the firm reported a first quarter loss
– it has significant unfunded pension liabilities
– the firm pays a large dividend which threatens to diminish the assets
available to pay bond holders.
1-20
The Refunding Decision
• The process of “calling” outstanding bonds and replacing
them with new ones is termed refunding. This action is
most likely to be pursued by businesses during periods of
declining interest rates.
• Interest savings from refunding can be substantial over the
life of a bond but the costs of refunding can also be very
large.
1-21
The Refunding Decision
• Example: bonds issued at 11.75% witnesses a
drop in interest rates to 9.5%
– Assuming that the interest rates will rise:
• The expensive 11.75% bonds may be redeemed
• A new debt at the prevailing 9.5% may be issued
– This process labeled as a refunding operation
• It is made possible by the option of call provision
1-22
The Refunding Decision
Refunding decision = Capital Budget Problem
• The refunding costs constitute the investment
– Outflows in the form of financing costs related to
redeeming and reissuing securities
– Inflows represented by savings in annual interest costs
and tax savings
– Inflows - Outflows = Net Present Value
1-23
Restatement of Facts
Assuming the Corporation issued $10 million worth of 11.75% bonds
with 25-yr. maturity. 5 years late the Corp. decides to buy back the old
debt at 10% above Par (the Call Premium) and issued new debt at
9.5% interest with 20-yr. life.
1-24
Calculation - Outflow
A. Outflow considerations:
1. Payment of call premium = $1 million (tax deductible:
- 35%) = $650,000
2. Underwriting cost on new issue minus the PV of the
future tax savings (35% each year for n = 20 yrs. and
i= 6% interest)
PV = $3,500 (annuity) x 11.47 (PVIFA) = $40,145
 Net Cost of Underwriting = $200,000 - $40,145 =
$159,855
1-25
Calculation - Inflow
B. Inflow considerations:
3. Cost savings in lower interest rates = (11.75% - 9.50%)
x $10 million
= $225,000  minus taxes on benefits (35%) =
$146,250 per year (after-tax benefits)
Applying 6% discount rate for a 20yr. Annuity:
= $146,250 x 11.47 (PVIFA) = $1,677,488 (Cost Savings
in lower interests)
1-26
Calculation - Inflow
4. Underwriting cost on old issue = $125,000 (spent 5 yrs.
ago and was to be written off over 25 yrs.)
• $100,000 of old underwriting costs have not been
amortized
• If we extend the write-off over the remaining life of
bonds: $5,000 for 20 yrs.  discounting this value over
20 yrs at 6% interest:
PV = $5,000 x 11.47 (=PVIFA) = $57,350
Gain from immediate write-off = $100,000 - $57,350
= $42,650 … x taxes (35%) = $14,928
1-27
Net Present Value
1-28
Refunding Decision
• R.D. has a positive NPV suggesting that interest rates have
dropped to a sufficiently low level providing a positive result
for this operation.
• The only question is… “will interest rates go lower
indicating a still better moment for refunding?”
 No easy answer…
1-29
Other Forms of Bond Financing
• Two innovative forms of bond financing that
are popular include:
– Zero-coupon rate bond
– Floating rate bond
1-30
Zero-coupon Rate Bond
• A bond that does not pay interest and sold at deep discount
from face value
• The Return to the investor is the difference between the
Investor’s Bond Cost and the Face Value:
Ex: In 1982, PepsiCo offered a ZCB with 30-yrs. Maturity, $1,000 Par
Value issue at $26.43 Cost… providing a Yield of 12.75% per year
 the purchase price per bond of $26.43 would be remunerated at
$1,000, 30 yrs late
1-31
Zero Coupon Bonds (Pros and Cons)
– Advantages to the corporation:
• Immediate cash inflow, no outflow until maturity
• The difference in the value at maturity can be
amortized for tax purposes
– Advantage to the investor:
• Allows lock in of a multiplier of the initial investment
– Disadvantages:
• Annual increase in the value of the bonds is taxable
as ordinary income
• Prices are volatile in nature
1-32
Floating Rate Bond
• The interest rate paid on the bond changes with
market conditions (popular in European markets)
– Advantage to the investor:
• A constant market value for the security, although
interest rates vary
– Exception:
• These bonds often have broad limits that interest
payments cannot exceed
1-33
Zero-Coupon
and Floating Rate Bonds
1-34
Advantages of Debt
• Interest payments are tax-deductible
• The financial obligation is clearly specified and of a fixed
nature
– Exception: floating rate bonds
• In an inflationary economy, debt may be paid with ‘cheaper
dollars’
• The use of debt, up to a prudent point, may lower the cost
of capital to the firm (remember Capital Structure chapter)
1-35
Drawbacks of Debt
• Interest and principal payment obligations are set
by contract and must be met regardless of the
economic position of the firm
• Utilized beyond a given point, debt may depress
outstanding common stock values (by increasing
risk for the firm)
1-36
Eurobond Market
• A bond payable in the borrower’s currency but sold
outside the borrower’s country
– Usually sold by an international syndicate of investment
bankers
– Disclosure requirements in the Eurobond market are
less demanding
– Usually sold by companies in Switzerland, Japan,
Germany, U.S. and Britain
1-37
Examples of Eurobonds
1-38
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