CAPITAL

MARKETS AND INSTITUTIONS

Debt Markets

Overview of debt financing arrangements

Short term debt
Trade credit
Bank overdrafts
Commercial bills
Promissory notes
Negotiable certificates of deposit
Inventory finance, accounts receivable, financing and factoring
Mid-long term debt
Term loans or fully drawn advances
Mortgage finance
Debentures, unsecured notes and subordinated debt
Leasing

Good management
Matching principle
Short-term assets should be funded with short-term liabilities
Long-term assets should be funded with long-term liabilities

Short-term debt is a financing arrangement for a period of less than one year
with various characteristics to suit borrowers particular needs
Timing of repayment, risk, interest rate structures (variable or fixed) and
the source of funds
It sits in the current liabilities of the balance sheet

Trade Credit
A supplier provides goods or services to a purchaser with an arrangement for
payment at a later date
Often includes a discount for early payment (e.g. 2/10, n/30, i.e. 2% discount if
paid within 10 days, otherwise the full amount is due within 30 days)
From providers perspective- offering trade credit
Advantages include increased sales
Disadvantages include costs of discount and increased discount period,
increased total credit period and accounts receivable, increased collection
and bad debt costs

Trade credit opportunity cost

The opportunity cost of the purchaser forgoing the discount on an invoice (1/7,
n/30) is:

Opportunit y cost =

% discount
365

100 % discount days difference between

early and late settlement

1.0 365

99.0 23
= 0.160298 or 16.03% p.a.
=

It is about comparing the opportunity cost vs. after-tax funding rate

Various short term debt financing agreements

Overdraft
Major source of short-term finance
Allows a firm to place its cheque (operating) account into deficit, to an agreed
limit

Commercial Bill
A bill of exchange is a discount security issued with a face value payable at a
future date
A commercial bill is a bill of exchange issued to raise funds for general business
purposes
A bank-accepted bill is a bill that is issued by a corporation and incorporates the
name of a bank as acceptor

Flow of funds of commercial bill

Calculation: Discount securities

Calculations considered

Calculating priceyield known

Calculating face valueissue price and yield known
Calculating yield
Calculating pricediscount rate known
Calculating discount rate

Refer Ch 8 on the basics of finance mathematics. Formulas (next page) are

just derivation of interest calculation in Ch 8

Calculation: Discount securities

Calculating price (yield known)

Calculating face valueissue price and yield known

Face value = price[

365 + (

yield
days to maturity)
100
]
365

Calculating yield

Yield =

(sell price - buy price) (days in year 100)

buy price
days to maturity

Calculation: Discount securities

Used in U.S and Euro markets note the days is 360d

Calculating pricediscount rate known

Price = face value = [1

days to maturity discount rate

]
days in year
100

Calculating discount rate

Discount rate =

face value - current price days in year 100

face value
days to maturity

Promissory notes
Also called P-notes or commercial paper, they are discount securities,
issued in the money market with a face value payable at maturity but sold
today by the issuer for less than face value
Typically available to companies with an excellent credit reputation
because:
there is no acceptor or endorser
they are unsecured instruments
Calculationsuse discount securities formulae
Issue programs
Usually arranged by major commercial banks and money market
corporations
Standardised documentation
Revolving facility
Most P-notes are issued for 90 days

Negotiable certificates of deposit

Short-term discount security issued by banks to manage their liabilities and
liquidity
Maturities range up to 180 days
Issued to institutional investors in the wholesale money market
The short-term money market has an active secondary market in CDs
Calculationsuse discount securities formulae

Inventory and Account receivable financing

Inventory finance
Most common form is floor plan finance
Particularly designed for the needs of motor vehicle dealers to finance
their inventory of vehicles
Bailment commonfinance company holds title to dealerships
stock
Dealer is expected to promote financiers financial products
Accounts receivable financing
A loan to a business secured against its accounts receivable (debtors)
Mainly supplied by finance companies (some banks)
Lending company takes charge of a companys accounts receivable;
however, the borrowing company is still responsible for the debtor
book and bad debts

Factoring
Company sells its accounts receivable to a factoring company
Converting a future cash flow (receivables) into a current cash flow
Factor is responsible for collection of receivables
Notification basis: vendor is required to notify its (accounts receivables)
customers that payment is to be made to the factor
Recourse arrangement
Factor has a claim against the vendor if a receivable is not paid
Non-recourse arrangement
Factor has no claim against vendor company

Term loan & fully drawn advances (Mid Long term)

Term loan
A loan advanced for a specific period (three to 15 years), usually for a
known purpose; e.g. purchasing land, premises, plant and equipment
Secured by mortgage over asset purchased or other assets of the firm
Fully drawn advance
A term loan where the full amount is provided at the start of the loan
Provided by:
mainly commercial banks and finance companies
to a lesser degree, investment banks, merchant banks, insurance offices
and credit unions

Term loan structure

Interest only during term of loan and principal repayment on maturity vs.
Amortised or credit foncier loan
Periodic loan instalments consisting of interest due and reduction of
principal
Deferred repayment loan
Loan instalments commence after a specified period related to project cash
flows and the debt is amortised over the remaining term of the loan
Interest may be fixed (for a specified period of time; e.g.
two years) or variable
Interest rate charged on term loan is based on:
an indicator rate (e.g. BBSW or a banks own prime lending rate) and is also
influenced by:
credit risk of borrower
term of the loan
repayment schedule

Term loan structure

Fees include:
establishment fee, service fee, commitment fee, line fee
Loan covenants
Restrict the business and financial activities of the borrowing firm
Positive covenant
Requires borrower to take prescribed actions; e.g. provision of
financial reporting to the lender
Negative covenant
Restricts the activities and financial structure of borrower; e.g.
maximum D/E ratio, minimum working-capital ratio
Breach of covenant results in default of the loan contract, entitling lender
to act

Mortgage finance
A mortgage is a form of security for a loan
The borrower (mortgagor) conveys an interest in the land and property to
the lender (mortgagee)
The mortgage is discharged when the loan is repaid
If the mortgagor defaults on the loan the mortgagee is entitled to foreclose on
the property, i.e. take possession of assets and realise any amount owing on the
loan
Use of mortgage finance
Mainly retail home loans - Up to 30-year terms
To a lesser degree commercial property loans - Up to 10 years as
businesses generate cash flows enabling earlier repayment
Providers (lenders) of mortgage finance
Commercial banks, building societies, life insurance offices, superannuation
funds, trustee institutions, finance companies and mortgage originators

Debentures, unsecured notes and subordinated debt

Debentures and unsecured notes issued in corporate bond market
Are corporate bonds
Specify that the lender will receive regular interest payments (coupon)
during the term of the bond and receive repayment of the face value at
maturity
Unsecured notes are bonds with no underlying security attached
Debentures:
are secured by either a fixed or floating charge over the issuers
unpledged assets
are listed and traded on the stock exchange
have a higher claim over a companys assets (e.g. on liquidation) than
unsecured note holders

Issuing debentures and notes

There are three principal issue methods
1. Public issueissued to the public at large, by prospectus
2. Family issueissued to existing shareholders and investors, by
prospectus
3. Private placementissued to institutional investors, by information
memorandum
Usually issued at face value, but may be issued at a discount or with deferred or
zero interest
A prospectus contains detailed information about the business

Subordinated debt
More like equity than debt, i.e. quasi-equity

Claims of debt holders are subordinated to all other company liabilities

Agreement may specify that the debt not be presented for redemption until
after a certain period has elapsed

May be regarded as equity in the balance sheet, improving the credit rating of
the issuer

Price of a fixed-interest bond at coupon date

The price of a fixed-interest security is the sum of the present value of the face
value and the present value of the coupon stream

1 (1+ i )n
P = C[
] + A(1+ i )n
i
Current AA+ corporate bond yields in the market are 8% per annum. What
is the price of an existing AA+ corporate bond with a face value of $100
000, paying 10% per annum half-yearly coupons, and exactly six years to
maturity?

A = $100 000
C = $100 000 x 0.10/2 = $5000
i = 0.08/2 = 0.04
n = 6 x 2 = 12

Price of a fixed-interest bond at coupon date

1 (1+ i )n
P = C[
] + A(1+ i )n
i

Price of a fixed-interest bond between coupon dates

1 (1+ i )n

n
k
P = C
+ A(1+ i ) (1+ i )
i

K is the # of days elapsed since last coupon payment, expressed as a

fraction of the coupon period

Price of a fixed-interest bond between coupon dates

Current AA+ corporate bond yields in the market are 8% per annum. An existing
AA+ corporate bond with a face value of $100 000, paying 10% per annum halfyearly coupons, maturing 31 December 2016, would be sold on 20 May 2011 at
what price?

Leasing
Definition:
A lease is a contract where the owner of an asset (lessor) grants another party
(lessee) the right to use the asset for an agreed period of time in return for
periodic rental payments
Leasing is the borrowing (renting) of an asset, instead of borrowing the funds to
purchase the asset

Leasing
Advantages of leasing for lessee over borrow and purchase alternative
Conserves capital
Provides 100% financing
Matches cash flows (i.e. rental payments with income generated by the
asset)
Less likely to breach any existing loan covenants
Rental payments are tax deductible
Advantages of leasing for lessor over a straight loan provided to a lessee
Leasing has relatively low level of overall risk as asset can be repossessed if
lessee defaults
Leasing can be administratively cheaper than providing a loan
Leasing is an attractive alternative source of finance to both business and
government

Types of Leasing
Operating lease
Short-term lease
Lessor may lease the asset to successive lessees (e.g. short-term use
of equipment)
Lessee can lease asset for a short-term project
Full-service leasemaintenance and insurance of the asset is provided by
the lessor
Minor penalties for lease cancellation
Obsolescence risk remains with lessor

Types of Leasing
Finance lease
Longer term financing
Lessor finances the asset
Lessor earns a return from a single lease contract
Net leaselessee pays for maintenance and repairs, insurance, taxes and
stamp duties associated with lease
Residual amount due at end of lease period
Ownership of the asset passes to lessee on payment of the residual
amount

Types of Leasing
Sale and lease back
Existing assets owned by a company or government are sold to raise cash;
e.g. government car fleet
The assets are then leased back from the new owner
This removes expensive assets from the lessees balance sheet
Cross-border lease
A lessor in one country leases an asset to a lessee in another country

Types of Leasing
Direct finance lease
Involves two parties (lessor and lessee)
Lessor purchases equipment with own funds and leases asset to lessee
Lessor retains legal ownership of asset and takes control or possession of
asset if lessee defaults
Security of the lessor provided by:
lease agreement
leasing guaranteean agreement by a third party to meet
commitments of the lessee in the event of default

Types of Leasing
Leveraged finance lease
Lessor contributes limited equity and borrows the majority of funds
required to purchase the asset
Lease manager
Structures and negotiates the lease and manages it for its life
Brings together the lessor (or equity participants), debt parties and
lessee
Lessor gains tax advantages from the depreciation of equipment and the
interest paid to the debt parties
Equity leasing
Similar to a leveraged lease, except funds needed to buy asset are provided
by the lessor
Therefore, it is usually smaller than a leveraged lease
Has many characteristics of a leveraged lease, including the formation of a
partnership to purchase the asset, but not the advantage of leverage