chap016 long-term debt and lease financing

7/24/2019 Chap016 Long-Term Debt and Lease Financing

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Chapter

McGraw-Hill/Irwi Copyright © 2009 by The McGraw-Hill Companies, Inc !ll

Long-Term Debt

and Lease

Financing16



16-2

Chapter Outline

• Analyzing long-term debt

• Bond yield and prices

• Refunding the obligation upon decline ininterest rates

• Long-term lease obligations and its

characteristics• Bankruptcy



16-3

The Expanding Role of Debt

• Growth in corporate debt is attributed to ! Rapid business e"pansion

! #nflationary impact on the economy

! #nade$uate funds generated from the internaloperations of business firms

• %"pansion of the &'(' economy has placed

pressure on &'(' corporations to raisecapital ! )ew set of rules ha*e been de*eloped for

e*aluating corporate bond issues



16-4

Times nterest Earned

for !tandard " #oor$s ndustrials



16-5

The Debt Contract

• Contract bond the basic long-term debtinstrument for most large &'(' corporations

! basic items include

! +ar *alue initial *alue of the bond• +rincipal or face *alue

! Coupon rate actual interest rate on the bond

! ,aturity date final date on which repayment ofbond principal is due

• Bond indenture a supplement to the bond agreement



16-6

!ecurit% #ro&isions

• (ecured debts ha*e specific assets pledgedto bondholders in the e*ent of default ! .hese assets are seldom actually sold and

distributed /proceeds0 ! .erms used to denote collateralized or secured

debts• ,ortgage agreement real property is pledged

• After-ac$uired property clause re$uires any newproperty to be placed under the original mortgage

! Greater the protection offered lower the interestrate on the bond


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'nsecured Debt

• 1ebt that is not secured by a claim to aspecific asset

! 1ebenture unsecured long-term corporatebond

• General claim against the corporation is common fordefaults

! (ubordinated debenture• +ayment to the holder will occur only after the

designated senior debenture holders are satisfied



#riorit% of Claims



(ethods of Repa%ment

• 1oes not always in*ol*e a lump-sumdisbursement at the maturity date

! Repayment of bonds can be done by• (implest method - single-sum payment at maturity

• (erial payments paid off in installments o*er the lifeof the issue

•(inking-fund pro*ision semiannual2annualcontributions made into a fund run by a trustee

• Con*ersion con*erting debt to common stock

• Call feature retire or force in debt issue before

maturity



)ond #rices* +ields* and Ratings

• 3inancial managers must be sensiti*e to thebond market with regard to ! #nterest rate changes

! +rice mo*ements

• ,arket conditions will influence ! .iming of new issues

! Coupon rate offered ! ,aturity date

• Bonds do not maintain stable long-term

price patterns



)ond #rice Table



)ond +ields

• .hree different ways4 computed below ! %"ample par *alue 567774 payment 56772year4

period 67 years4 current price 5877

• Coupon rate /nominal yield0 interest rate 2 par *alue 5677 9 67:

56777

• Current yield in terms of the current price

5677 9 66'66: 5877

• ;ield to maturity for bonds is held until maturity

#nterest rate appro"imate 66'<7: 9 payment of 5677

for 67 years and a final payment of 56777



)ond Ratings

• .wo ma=or bond rating agencies

! ,oody>s #n*estor (er*ice

! (tandard ? +oor>s Corporation

• Ratings are based on a corporation>s

! Ability to make interest payments

! Consistency of performance

! (ize

! 1ebt-e$uity ratio

! @orking capital position etc'



Examining ,ctual )ond Ratings

• .he true return on a bond is measured byyield to maturity

• #f a bond is relati*ely low in $uality

! A corporation pays a yield to maturity althoughthey may be secured in nature



The Refunding Decision

• %"ample bonds issued at 66'<: witnessesa drop in interest rates to 8':

! Assuming that the interest rates will rise• .he e"pensi*e 66'<: bonds may be redeemed

• A new debt at the pre*ailing 8': may be issued

! .his process labeled as a refunding operation

• #t is made possible by the option of call pro*ision



, Capital )udgeting #roblem

• .he refunding decision in*ol*es

! utflows in the form of financing costs related toredeeming and reissuing securities

! #nflows represented by sa*ings in annualinterest costs and ta" sa*ings



Restatement of Facts



!teps

A' utflow considerations

6' +ayment of call premium

' &nderwriting cost on new issue

B' #nflow considerations

D' Cost sa*ings in lower interest rates

E' &nderwriting cost on old issue

C' )et present *alue

! +resent *alue of inflow ! present *alue ofoutflow 9 net present *alue



16-19

!tep C - et #resent .alue



Other Forms of )ond Financing

• .wo inno*ati*e forms of bond financing thatare popular include

! Fero-coupon rate bond

! 3loating rate bond



16-21

/ero-coupon Rate )ond

• A bond that does not pay interest ! Ad*antages to the corporation

• #mmediate cash inflow no outflow until maturity

• .he difference in the *alue at maturity can beamortized for ta" purposes

! Ad*antage to the in*estor• Allows lock in of a multiplier of the initial in*estment

! 1isad*antages• Annual increase in the *alue of the bonds is ta"able

as ordinary income

• +rices are *olatile in nature



16-22

/ero-Coupon

and Floating Rate )onds



16-23

Floating Rate )ond

• .he interest rate paid on the bond changeswith market conditions

! Ad*antage to the in*estor• A constant market *alue for the security although

interest rates *ary

! %"ception

• .hese bonds often ha*e broad limits that interestpayments cannot e"ceed



16-24

,d&antages of Debt

• #nterest payments are ta"-deductible

• .he financial obligation is clearly specifiedand of a fi"ed nature

! %"ception floating rate bonds

• #n an inflationary economy debt may be paidwith cheaper dollars>

• .he use of debt up to a prudent point maylower the cost of capital to the firm



16-25

Dra0bacs of Debt

• #nterest and principal payment obligationsare set by contract and must be met

• #ndenture agreements may place unduerestrictions on the firm

! Bondholders may take *irtual control of the firmif important indenture pro*isions are not met

• &tilized beyond a gi*en point debt maydepress outstanding common stock *alues



16-26

Eurobond (aret

• A bond payable in the borrower>s currencybut sold outside the borrower>s country

! &sually sold by an international syndicate of

in*estment bankers

! 1isclosure re$uirements in the %urobond marketare less demanding



16-27

Examples of Eurobonds



16-28

Leasing as a Form of Debt

• Leasing has the characteristics of a debt

! A corporation contracts to lease and signs anoncancelable long-term agreement

! Companies are e"pected to fully di*ulge allinformation about leasing obligations

• Leasing was made official as a result of

(tatement of 3inancial Accounting(tandards /(3A(0 )o' 6D

! issued by the 3A(B in )o*ember 68<H



16-29

Capital Lease 2Financing Lease3

• 3our conditions for identification include ! .he arrangement transfers ownership of the

property to the lessee by the end of the leaseterm

! .he lease contains a bargain purchase price atthe end of the lease

! .he lease term is e$ual to <: or more of theestimated life of the leased property

! .he present *alue of the minimum leasepayments e$uals 87: or more of the fair *alueof the leased property at the inception of thelease



16-30

Operating Lease

• 1oes not meet the conditions of a capitallease

• &sually short-term cancelable at the optionof the lessee

• .he lessor may pro*ide for the maintenanceand upkeep of the asset

• 1oes not re$uire a capitalization orpresentation of a full obligation on thebalance sheet



16-31

ncome !tatement Effect

• Capital lease

! Re$uires treatment similar to a purchase-borrowing arrangement

• #ntangible asset is amortized or written off o*er thelife of the lease - annual e"pense deduction

• Liability account is written off through regularamortization - implied interest cost on the balance

• perating lease

! Re$uires annual e"pense deduction e$ual to thelease payment with no specific amortization



16-32

,d&antages of Leasing

• .akes care of lack of sufficient funds or thecredit capability issues to purchase assets

• bligation may be substantially lessrestricti*e

• ,ay not re$uire a down payment

•Lessor>s e"pertise may reduce negati*eeffects of obsolescence

• Lease on chattels ha*e no limitations forbankruptcy and reorganization proceedings



Other ,d&antages of Leasing

• .a" ad*antage factors include

! 1epreciation write-off or research-related ta"credits

• #nfusion of capital can occur if a firmchooses to engage in a sale-leasebackarrangement

! Allows the lessee to continue the usage of theasset

chap016 long-term debt and lease financing

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