Transcript Long-Term Debt and Lease Financing

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.
• Innovative bond forms.
• Long-term lease obligations and its
characteristics.
16-2
The Expanding Role of Debt
• Growth in corporate debt 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 the Government to raise capital.
– New set of rules have been developed for
evaluating corporate bond issues.
16-3
Times Interest Earned for Standard
and Poor’s Industrials
16-4
The Debt Contract
• Contract 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: repayment date of the principal.
• Bond indenture, a supplement to the bond
agreement.
16-5
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.
16-6
Unsecured Debt
• Debt that is not secured by a claim to a
specific asset.
– Debenture: unsecured long-term corporate
bond.
• General claim against the corporation, is common for
defaults.
– Subordinated debenture
• Payment to the holder will occur only after the
designated senior debenture holders are satisfied.
16-7
Priority of Claims
16-8
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.
16-9
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.
16-10
Bond Price Table
16-11
Bond Yields
• Three different ways; computed below:
– Example: par value: $1,000; payment: $100/
year; period: 10 years; current price: $900.
• Coupon rate (nominal yield): interest rate / par value.
$100 = 10%
$1,000
• Current yield: in terms of the current price.
$100 = 11.11%
$900
• 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.
16-12
Bond Ratings
• Two major bond rating agencies:
– Moody’s Investor Service.
– Standard and Poor’s.
• Ratings are based on a corporation’s:
– Ability to make interest payments.
– Consistency of performance.
– Size.
– Debt-equity ratio.
– Working capital position etc.
16-13
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 yield to maturity, although
they may be secured in nature.
16-14
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.
16-15
A Capital Budgeting Problem
• The refunding decision involves:
– Outflows in the form of financing costs related to
redeeming and reissuing securities.
– Inflows represented by savings in annual
interest costs and tax savings.
16-16
Restatement of Facts
16-17
Steps
A. Outflow consideration:
1. Payment of call premium.
2. Underwriting cost on new issue.
B. Inflow consideration:
3. Cost savings in lower interest rates.
4. Underwriting cost on old issue.
C. Net present value:
– Present value of inflow – present value of
outflow = net present value
16-18
Step C- Net Present Value
16-19
Other Forms of Bond Financing
• Two innovative forms of bond financing that
are popular include:
– Zero-coupon rate bond.
– Floating rate bond.
16-20
Zero-coupon Rate Bond
• A bond that does not pay interest.
– 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.
16-21
Zero-Coupon and Floating Rate
Bonds
16-22
Floating Rate Bond
• The interest rate paid on the bond changes
with market conditions.
– 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.
16-23
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.
16-24
Drawbacks of Debt
• Interest and principal payment obligations
are set by contract and must be met.
• Indenture agreements may place undue
restrictions on the firm.
– Bondholders may take virtual control of the firm
if important indenture provisions are not met.
• Utilized beyond a given point, debt may
depress outstanding common stock values.
16-25
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.
16-26
Examples of Eurobonds
16-27
Leasing as a Form of Debt
• Leasing has the characteristics of a debt.
– A corporation contracts to lease and signs a
non-cancelable, non-term agreement.
– Companies are expected to fully divulge all
information about leasing obligations.
• Leasing was made official as a result of
Statement of Financial Accounting
Standards (SFAS):
– No. 13, issued by the FASB in November 1976.
16-28
Capital Lease (Financing Lease)
• Four conditions for identification include:
– The arrangement transfers ownership of the
property to the lessee by the end of the lease
term.
– The lease contains a bargain purchase price at
the end of the lease.
– The lease term is equal to 75% or more of the
estimated life of the leased property.
– The present value of the minimum lease
payments equals 90% or more of the fair value
of the leased property at the inception of the
lease.
16-29
Operating Lease
• Does not meet the conditions of a capital
lease.
• Usually short-term, cancelable at the option
of the lessee.
• The lessor may provide for the maintenance
and upkeep of the asset.
• Does not require a capitalization, or
presentation, of a full obligation on the
balance sheet.
16-30
Income Statement Effect
• Capital lease
– Requires treatment similar to a purchaseborrowing arrangement.
• Intangible asset is amortized, or written off, over the
life of the lease - annual expense deduction.
• Liability account is written off through regular
amortization - implied interest cost on the balance.
• Operating lease
– Requires annual expense deduction equal to the
lease payment, with no specific amortization.
16-31
Advantages of Leasing
• Takes care of lack sufficient funds or the
credit capability issues to purchase assets.
• Obligation may be substantially less
restrictive.
• May not require a down payment.
• Lessor’s expertise – may reduce negative
effects of obsolescence.
• Lease on chattels have no such limitations
for bankruptcy and reorganization
proceedings.
16-32
Other Advantages of Leasing
• Tax advantage factors include:
– Depreciation write-off or research related tax
credits.
• Infusion of capital can occur if a firm
chooses to engage in a sale-leaseback
arrangement.
– Allows the lessee to continue the usage of the
asset.
16-33