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Financial Institutions, Instruments and Markets

8th edition
Instructor's Resource Manual
Christopher Viney and Peter Phillips

Chapter 10
Medium- to long-term debt
Learning objective 1: Explain term loans and fully drawn advances, including their structure, loan
covenants, and the calculation of a loan instalment

The financial system provides corporations with a wide range of medium- to long-term loan
and debt facilities. These facilities allow a corporation to diversify its funding sources and
match its cash-flow requirements.

The sources of medium- to long-term debt may be intermediated finance provided by


financial institutions or direct finance obtained from either the domestic or the international
capital markets.

A common form of intermediated debt is the term loan or fully drawn advance. The main
providers of term loans are the commercial banks. However, investment banks, finance
companies, insurance offices and credit unions also provide term loans to the business sector.

Term loans are provided to fund a specific purpose or project for a fixed period of time.

The repayment structure of a term loan may be amortised (each periodic instalment
incorporates an interest component and also a principal repayment component), interest only
(each periodic instalment only comprises the interest due on the full loan amount) or deferred
(repayment is deferred for a period until the business project generates positive cash flows).

The normal practice is to price a variable-rate loan at a margin above a reference interest rate.
The margin will reflect the level of credit risk of the borrower.
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During the term of a variable rate loan, the interest rate will be periodically reset in relation
to changes in the specified reference rate, such as LIBOR, BBSW or the banks own prime
rate.

The bank bill swap rate (BBSW) is the mid-point of prime banks bid and offer rates for
eligible securities in the NCD and BAB secondary markets and is published by the AFMA.
Thomson-Reuters publishes LIBOR daily.

A range of fees may also apply, including an establishment fee, a periodic service fee, a
commitment fee or a line fee.

Issues that a lender will consider when determining an interest rate and the margin include
the credit risk of the borrower, the term of the loan and the loan repayment schedule.

A loan contract may include a range of loan covenants to protect the lender. They include
positive covenants, which state actions that must be taken by a borrower (e.g. provision of
financial statements), and negative covenants, which limit the actions of a borrower (e.g.
minimum debt to equity ratio).

The formula used to calculate the instalment on a term loan (when payments occur at the end
of each period) is:

Learning objective 2: Describe the nature, purpose and operation of mortgage finance and the
mortgage market, plus calculate an instalment on a mortgage loan

Mortgage finance is a term loan with a specific type of security attached, being a mortgage
registered over land and the property thereon. The borrower (mortgagor) conveys an interest in
the land to the lender (mortgagee).

If a borrower defaults on loan repayments, the lender has the right of foreclosure, whereby
the lender will take possession of the land and sell it to recover the amounts outstanding.

The mortgage market is very large and includes both residential mortgage loans and commercial
mortgage loans.

A further protection for the lender may be a loan condition that requires the borrower to take
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out mortgage insurance. This is normally required where the loan-to-valuation ratio is above
80 per cent.

The formula to calculate the instalment on a mortgage loan is:

Some mortgage lenders use a process of securitisation to finance continued growth in their
mortgage lending. The lender sells a parcel of existing loans to a trustee of a special-purpose
vehicle. The trustee funds this purchase by issuing new securities such as bonds into the
capital markets. The cash flows due on the mortgage loans held by the special-purpose
vehicle are used to pay interest and principal commitments due on the bonds.

Learning objective 3: Discuss the bond market, in particular the structure and issue of debentures,
unsecured notes and subordinated debt

A corporate bond is a long-term debt security that pays specified periodic interest payments
(coupons) for the term of the bond and the principal is repaid at maturity.

Corporate bond issuers require a good credit rating issued by a credit rating agency to be able
to issue securities direct into the capital markets.

Debentures and unsecured notes are corporate bonds.

A debenture is a corporate bond with security attached. The security is a charge over the
unpledged assets of the borrower. This will include a fixed charge over permanent assets and
a floating charge over other assets such as stock that pass through the business. If the
borrower defaults, the floating charge is said to crystallise and become a fixed charge; the
borrower will then take possession of the assets.

A covered bond is a bond issued by a commercial bank that is supported by a claim over
mortgage securities held by the bank.

An unsecured note is a corporate bond with no security attached.

Corporate bonds may be offered as public issues, family issues or private placement. Bonds are
typically sold at face value; however, issues may include discounted, deep discounted, zero-coupon
and deferred-interest debentures.
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A public issue of bonds requires a prospectus that provides detailed information on the issuer
corporation, the purpose of the funding, company financial statements and projections,
management profiles, expert reports and other material information.

Subordinated debt also pays a specific interest stream, but the claims of subordinated debt
holders are ranked behind all other creditors, but before equity.

Learning objective 4: Calculate the price of a fixed interest bond

The price of a bond is the present value of the future cash flows, being the present value of
the periodic coupons and the present value of the principal payable at maturity.

There is an inverse relationship between the price of an existing bond and current interest
rates in the market. For example, if current yields (interest rates) rise then the price of
existing bonds will fall.

A formula used to calculate the price of a bond at a periodic coupon date is:

The majority of bonds are sold between coupon dates; therefore the above formula is
adjusted by (1 + i)k, where k is the number of elapsed days since the last coupon payment,
expressed as a fraction of the coupon period. Therefore the formula is:

Learning objective 5: Explain lease financing, including types of lease arrangements and lease
structures

A lease is a contract whereby the owner of an asset (the lessor) allows another party (the
lessee) to use that asset for an agreed period in return for lease payments. Major providers of
lease finance are banks and finance companies.

Advantages of lease financing are that it does not use up lines of credit, it provides 100 per
cent financing, payments can be matched with revenue generation, payments are generally
tax deductible, it may not breach existing loan covenants and assets can be leased for the
actual periods they are needed.

An operating lease is a full-service lease where an asset is leased for a relatively short period
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then returned to the lessor. The lessor maintains and insures the asset and leases it again and
again.

A finance lease is a long-term net lease where an asset is leased once. The lessee maintains
and insures the asset and makes periodic lease payments. The lessee is required to make a
lump-sum residual payment at the completion of the lease contract.

Sale and lease-back occurs when the original owner of an asset sells the asset and then enters
into an arrangement to lease the asset.

A cross-border lease occurs when parties to a lease extend into another country; it involves
foreign exchange risk.

A direct finance lease involves two parties, the lessor and the lessee. The lessor retains
ownership of the asset and may also seek additional guarantees to support the lease contract.

A leveraged finance lease is an arrangement whereby the lessor borrows to fund the purchase
of an asset that is to be leased. Often a lessor partnership is formed for big-ticket items such
as ships and aircraft. Because of the complexity of leveraged leasing arrangements, a lease
manager will be responsible for the management of the contract.

Essay questions
Thefollowingsuggestedanswersincorporatethemainpointsthatshouldberecognisedbyastudent.An
instructorshouldadvisestudentsofthedepthofanalysisanddiscussionthatisrequiredforaparticular
question. For example, an undergraduate student may only be required to briefly introduce points,
explainintheirownwordsandprovideanexample.Ontheotherhand,apostgraduatestudentmaybe
requiredtoprovidemuchgreaterdepthofanalysisanddiscussion.
1. The chief financial officer (CFO) of a corporation has arranged a term loan for the company
with the following conditions attached. The loan will have a variable rate of interest of BBSW plus
95 basis points. The loan interest will be reset every three months for the duration of the loan.
(a) Explain the operation of these specific loan conditions. (LO 10.1)

A term loan is a loan provided by a bank, or other financial institution, for a specific purpose, over a
defined period of time.
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The amount and period of the loan is specified in the loan contract.

A loan with a variable interest rate means that the interest rate charged on the principal amount
outstanding will be reset periodically under the terms of the loan contract.

A variable rate loan contract will specify a reference interest rate.

Within Australia, the main published reference rates used for loan pricing are BBSW or the banks
own prime rate. In the international markets common rate used are LIBOR, SIBOR or USCP.

(b) How would the CFO obtain the new interest rate every three months?

The above loan is using BBSW, the Bank Bill Swap Rate, which is the average mid-point of banks
bid and offer rates in the bank bill secondary market.

The loan is set at BBSW plus 95 basis points, therefore if BBSW is currently 5.35% per annum, then
the loan interest rate will be 6.30% per annum.

Both the borrower and lender are able to find BBSW published electronically daily by ThomsonReuters.

At the reset date each three months they will look up the relevant Thomson-Reuters BBSW threemonth money screen to ascertain the new rate.

2. One of the National Banks commercial lending managers has a meeting scheduled with a
business client. The purpose of the meeting is to review the structure of the loans provided by
the bank. The business client operates in the mining sector and is very concerned at the
possibility of a significant slowdown in the sector. The client wishes to discuss the relationship
of its longer-term debt commitments and the forecast future cash flows being generated by the
business. (LO 10.1)
(a) Within the context of the forecast slow down in the mining sector, why is the client concerned
about the timing of cash flows?

A slow down in demand in the mining sector may result in lower sales volumes and also a lower
price per tonne for the mineral being mined. Clearly this will have an adverse impact on forecast
future cash flows for the mining company.

Therefore, when structuring its funding arrangements the mining company should endeavour to
match the maturity structure of its assets with the maturity structure of its sources of funds, being its
liabilities and shareholder funds.

With long-term mining projects it is essential that the repayment schedule associated with debt
finance should be aligned with the forecast future cash flows generated from the project.

The mining company needs to carefully consider the timing of its cash flows at the commencement
of a project and throughout the life of the project.

In the event of a slow down in the mining sector, the borrower must ensure that lower sales volumes
and lower mineral prices; that is, reduced future cash flows, are still sufficient to cover loan
repayments.

The borrower needs to consider a potential worst-case scenario when making a borrowing decision
in relation to a project.

(b) Discuss with the client the different longer-term loan repayment structures that the National
Bank may be able to offer the business client.

The bank may be able to offer the borrower a number of choices on how it will structure the loan
repayments.

One alternative is to structure the loan whereby the loan repayment schedule only requires interest
payments to be made during the term of the loan, and the repayment of principal is due in full on the
maturity of the loan.

Another alternative is for a loan repayment schedule that requires regular periodic loan instalments
to be paid. Each loan instalment will comprise the payment of interest and part repayment of the
principal. With the payment of the final loan instalment the loan will have been fully repaid. This
type of loan is said to be an amortised loan, or a credit foncier loan.

A further option is for the bank to provide the business with a loan that takes into consideration that
it may be some time before the mining project generates positive cash flows. In this situation it may
be preferable to arrange a deferred repayment type of loan. Under such an arrangement, loan
instalments will only commence after a specified period, which is determined on the basis of
expectations about when the project will generate positive cash flows, with amortisation of the debt
to be achieved over the remaining loan term.
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3. When a bank provides a loan to a corporation, the interest rate charged on the loan will depend
on the banks analysis of a number of factors, including the credit risk of the borrower, the
term of the loan and the repayment schedule. Discuss why these factors will impact the interest
rate charged by a bank. (LO 10.1)
1.Thecreditriskoftheborrower.

Thisistheperceivedcreditworthinessoftheborrower.Eachborrowerisconsideredtohavea
certainlevelofcreditrisk.Thislevelofcreditriskvariesbetweenborrowers.

Beforegrantingaloan,alenderwillanalysefactorssuchasthetotaldebttoequityratioofthe
firm,projectedcashflows,thefinancialstrengthoftheborrower,pastloanrepayment
performance,theprojectedperformanceoftheindustryandtheeconomygenerally,forecast
interestrates,themanagementofthefirm,theimpactofcompetitorsandthelifecycleofthefirms
products.

Eachborrowerwillbeperceivedtohaveadifferentlevelofcreditriskandthereforewillpaya
differentrateofinterestontheloan.

2.Thetermoftheloan.

Typically,longertermloanswillattractahigherrateofinterestthanshorttermloansduetothe
assumedhigherriskofalongertermcommitment.

Forexample,riskfactorsthataffectinterestratesincludechangesintheofficialinterestratebythe
centralbankandtheamountofliquidityinthecreditmarkets.Theseandotherfactorsaffectthe
costoffundstothelenderandthereforearepassedontotheborrower.

3.Therepaymentschedule.

Thefrequencyofloanrepaymentsandtheformofrepaymentmayinfluencetheinterestrateapplied
toaloan.

Forexample,therateforaborrowerwhohasaloanthatrequiresmonthlyrepaymentsmaybe
differentfromthatofaborrowerwhomakesquarterlyloanrepayments.

Also, different interest rates may be applied between an amortised loan and an interest-only loan.

4.Asthefinancemanagerofasmallmanufacturingbusiness,youarenegotiatingafullydrawn
advancefromthelocalbank,buttheboardofdirectorshaveindicatedthattheyareconcernedat
thefeesbeingchargedbythebank.Explaintothedirectorstherangeoffeestypicallycharged,
andwhythebankchargesthesefees.(LO10.1)

Establishment feerepresents the costs incurred by the bank in considering the loan application and
in the preparation of documentation on approval of the loan.

Service feerepresents the ongoing administrative costs incurred by the bank in maintaining the
loan account. Service fees are generally charged monthly.

Once a loan has been approved, the borrower will be given a short period to draw-down the loan,
that is, to take the funds from the bank.

Commitment feewill usually be applied by the bank to any portion of the total approved loan
amount that is not drawn-down within a specified period, usually paid in arrears.

Line feeapplied to the total amount of the facility and is normally payable in advance.

Note: a lender may not charge all these fees. For example, in a competitive market establishment
fees charged are sometimes waived on certain types of loans in order to try and attract further
borrowers. Also, honeymoon periods may be offered where periodic fees are not charged for a
nominated period, at which point they will commence.

5. Westpac Banking Corporation is currently writing a loan contract for a medium-sized


pharmaceutical company. Within the loan contract Westpac intends to incorporate a number of
positive and negative loan covenants. (LO 10.1)
(a) What are loan covenants?

Loan covenants are specified within a loan contract and typically restrict the business and financial
activities and actions of the borrowing firm.

Common covenants will require a firm to maintain a minimum level of interest cover; another may
restrict the level of debt that a firm may accumulate relative to its equity.

(b) Explain why a financial institution would incorporate loan covenants into a loan contract.

Loan covenants are designed to protect the credit risk exposure of the lender to the borrower.
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A firm is in technical default on its loan contract if it breaches a loan covenant. The lender then has
the right, within the terms specified in the loan contract, to act to protect its exposure. This might
involve taking possession of the assets of the company. However, if the company has not defaulted
on actual loan repayments, it is more likely that the term loan may become repayable on demand.

(c) Discuss the nature of positive and negative covenants and give two examples of each.

Protective loan covenants are classified as either positive covenants or negative covenants.

A positive covenant states actions that a company must comply with, such as maintaining a
minimum level of working capital, or the provision of audited financial statements to the lender
within a certain timeframe.

A negative loan covenant limits or restricts the business activities or financial structure of the
company. For example, there may be a limitation placed on the amount of a dividend that can be
paid to shareholders, or a requirement that the bank must approve further long-term borrowings of
the company.

6.Astheownerofasmallarchitecturalfirm,youapproachtheCommonwealthBanktoobtaina
termloansothatthefirmcanbuyanewcomputeraideddrawingmachine.Thebankoffersyour
companyaloanof$28500overathreeyearperiodatarateofinterestof8.65percentper
annum,payableattheendofeachmonth.Calculatethemonthlyloaninstalment.(LO10.1)

A
1 - 1 i n

where:
Ristheinstalmentamount
Aistheloanamount(presentvalue)
iisthecurrentnominalinterestrateexpressedasadecimal
nisthenumberofcompoundingperiods
A=$28500
10

i=0.0865/12=0.007208
n=3yearsx12months=36

$28500

1 - 1 0.007208 36

0.007208

R $901.65 per month

7. ThearchitecturalfirmownerinQuestion6alsoapproachestheNationalAustraliaBankto
obtainaquoteontheloanfacility.Thecompetitorbank(NAB)alsooffersthecompanyafully
drawnadvanceof$28500overathreeyearperiodatarateofinterestof8.65percentper
annum, payable in advance at the beginning of each month. Calculate the monthly loan
instalment.ExplainwhytheinstalmentpaymentisdifferentfromtheinstalmentinQuestion6.
(LO10.1)
R

A
1 - 1 i n

1 i
i

where:
Ristheinstalmentamount
Aistheloanamount(presentvalue)
iisthecurrentnominalinterestrateexpressedasadecimal
nisthenumberofcompoundingperiods
A=$28500
i=0.0865/12=0.007208
n=3yearsx12months=36
$28500
1 - 1 0.007208 36

1 0.007208
0.007208

R $895.20
R

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In question 6, the series of cash flows occurred at the end of each period; this is an ordinary annuity.

In question 7, the loan instalments are payable at the beginning of the period; this is an annuity due.

The change in the formulae recognises the change in the timing of the cash flows.

The earlier loan instalment repayments at the start of each month mean that the monthly instalment
is lower; that is, the principal outstanding is being repaid earlier.

8. MrandMrsSimcoxhaverecentlymarriedandareintheprocessofpurchasingtheirfirst
home.TheyhavelodgedanapplicationwiththeCommonwealthBankforahousingloan.The
bank has offered them a mortgage loan. Outline the main features of a mortgage loan. In
particular,defineamortgage,explainthepurposeandoperationofamortgageloanandidentify
anddescribethepartiestoamortgageloan.(LO10.2)

A mortgage is a form of security against which a loan is advanced.

Under a mortgage contract, the borrower (mortgagor) conveys an interest in the land or property to
the lender (mortgagee).

The mortgage is discharged when the loan is repaid.

During the life of the contract, if the mortgagor fails to meet the terms of the loan, the mortgagee is
entitled to take control of the property, and to dispose of it in order to recover the amount of the debt
outstanding. This is called the right of foreclosure.

A mortgage loan is simply a term loan with a specific form of security attached, being the mortgage.

Mortgage finance lenders include banks, building societies, life insurance offices, superannuation
funds, trustee institutions, finance companies, private individuals, and government and semigovernment instrumentalities.

There are residential mortgages and commercial mortgages.

Residential mortgages (housing loans) are typically taken over 30 years in Australia.

Commercial mortgages are usually for a period of less than 10 years.

Fixed interest and variable interest rate mortgage loans are available; however, a fixed rate loan will
typically be reset every two to three years.

Mortgage loans are usually amortised (credit foncier) with monthly loan instalments.
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Mortgage loans for amounts above 80 per cent of the loan-to-valuation-ratio will generally require
mortgage insurance.

9. After three years of excellent business growth, a local mattress manufacturer decides to expand
and purchase new business premises costing $1 250 000. In addition, establishment expenses of
0.50 per cent of the purchase price, plus estimated legal expenses of $15 000 are payable. The total
cost to purchase the property will be financed by $225 000 of the firms own funds plus a
mortgage loan from ANZ bank. The bank offers a mortgage loan at 8.15 per cent per annum. The
loan will be amortised by monthly instalments over the next 12 years, payable at the end of each
month. What is the amount of each monthly instalment? (LO 10.2)
Total outlays:
cost of premises

$1 250 000

establishment expenses

$6 250

legal expenses

$15 000

$1 271 250

Funding arrangements:
own savings

$225 000

mortgage finance
Formula:

$1 046 250

R =

$1 271 250

A
1 (1 + i)-n
i

where: A = $1 046 250


i = 0.00679167 (8.15% p.a. / 12 months)
n = 144 (12 years * 12 months)
R =

1 046 250
1 (1.00679167) -144
0.00679167
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R =

$11 411.39 monthly instalment

10. BHP Billiton Limited is listed on the ASX and is expanding its business operations into
China. In order to expand, the company will need to raise additional funds through the
issue of corporate bonds direct to the capital markets. Two securities that are often
issued into the corporate bond market are debentures and unsecured notes. (LO 10.3)
(a) Discuss the structure and attributes of each of these securities.

Debentures and unsecured notes are both corporate bonds issued into what is often described as the
corporate bond market.

Debentures and unsecured notes are contracts between the borrower and the lender that specify that
the lender will receive regular interest payments during the term of the loan, and receive the face
value of the bond on the maturity date.

A debenture is the form of security attached to a corporate bond. The security takes the form of
either a fixed and/or a floating charge over the issuing companys unpledged assets (see 10 (b)
below).

Unsecured notes are corporate bonds issued on an unsecured basis.

Issues to the public require a prospectus. This is time consuming and expensive. Therefore many
issuers tend to issue by direct placement with institutional investors, where the prospectus
requirements are less stringent.

The yield (cost of borrowing) on a debenture will be lower than that on an unsecured note, reflecting
the lower risk because of the underlying security and the higher liquidity of debentures listed on the
stock exchange.

(b) Within the context of a bond issued by a corporation, discuss the nature of a fixed and floating
charge.

A company that issues debentures will usually convey a fixed charge over assets of the
company that are described as being permanent assets; that is, assets that are not to be sold in
the normal course of the business operations.

For example, such fixed assets might include manufacturing equipment, computer
systems and a vehicle fleet.
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The issuing company will also hold assets it expects to sell in the normal course of its
business operations. For example, BHP Billiton is a mining company. The company will
accumulate a stock of iron ore that is awaiting export to China. The company cannot issue a
fixed charge over the iron ore stockpile as it will export the iron ore to generate income. In
this case it will issue a floating charge over those assets. A floating charge allows the
company to continue to operate and sell its mineral exports.

However, if BHP Billiton should default on bond payments the floating charge is said to
crystallise and become a fixed charge. At that point the bond holder will take possession of
the remaining assets that are currently held by the company.

The ranking of bond holders is as follows:


o First: fixed charge debenture holders are entitled to the proceeds of the sale of the assets over
which the charge has been placed. If the proceeds from the sale prove to be inadequate to repay
the debenture holders in full the outstanding balance ranks equally with unsecured debt holders.
o Second: floating charge debenture holders have no claim over the proceeds from the sale of the
pledged assets (until fixed charge debenture holders claims have been satisfied). However, they
rank ahead of unsecured creditors in their entitlement to the proceeds of the sale of unpledged
assets.
o Third: unsecured note holders have no priority claim over the assets of the company and rank
equally with other unsecured creditors. However, note holders may be somewhat protected if a
deed limits the company in relation to total secured liabilities relative to total liabilities.

(c) Explain which types of borrowers will have access to funds through the issue of debentures and
unsecured notes into the capital markets.

A principal determinant of a corporations ability to issue bonds into the capital markets is its
reputation in the markets and its credit rating. Therefore an issuer of corporate bonds will need to
obtain a credit rating on the bond issue.

Typically, different minimum credit ratings are required within certain capital markets. For example,
to issue bonds into the US capital markets a corporation may require an investment grade credit
rating of BBB or above issued by a credit rating agency such as Standard and Poors.

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Only issuers with a very good rating will be able to issue unsecured notes because of the higher risk
associated with this type of paper. Issuers of debentures will generally also require an investment
grade credit rating, but the security of the debenture may lower the cost of funds (yield).

Issuers of debentures and unsecured notes include finance companies, multi-national corporations
and commercial banks.

11. The major global financial markets each have an active corporate bond market. These
corporate bond markets are a significant source of funds for corporations raising finance direct
from the capital markets. (LO 10.3)
(a) Describe the structure and operation of the corporate bond markets. In you answer explain
why corporations seek to raise debt funds direct from the markets, why investors provide debt
funds directly to the capital markets and the main providers of direct finance in the capital
markets.

Direct finance occurs when a borrower issues a financial security into the debt markets in order to
raise funds.

The corporate bond markets include the issue of debentures, unsecured notes and subordinated debt.

Debenturea corporate bond issued with a fixed or floating charge over the assets of the issuer.

Unsecured notea corporate bond issued without any form of underlying security attached.

Includes both domestic and international capital markets.

Why do corporations seek to raise debt funds direct from the markets?

If a corporation can borrow without the need to use a bank, then it is able to save the cost of the
banks profit margin.

Another important reason that a corporation will borrow direct from the markets is to diversify its
funding sources.

If a corporation obtains debt funds from a number of different sources, then it is able to choose the
most cost effective sources.

Why do investors provide debt funds directly to the market?

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By lending direct, an investor is accepting the credit risk associated with the ultimate borrower and
should receive a higher return for the higher risk.

Investors will endeavour to measure the credit risk of a particular debt issuer.

One international standard used as a measure of the credit worthiness of a borrower is a credit
rating.

A credit rating is the rating agencys view of the credit worthiness of a debt issue.

Where do direct investment funds come from?

Deregulation of the financial system with the removal of constraints that would otherwise limit the
flow of funds around the world, coupled with technology to support the rapid and efficient conduct
of financial transactions, has encouraged the development of direct investment markets.

Increased investor sophistication and the expectation of higher yields on investments have also
drawn a greater pool of investors into the markets, in particular, managed funds.

In many countries there is an ever-increasing pool of accumulated retirement and superannuation


savings that are available for investment.

Ifagovernmentseekstolimitorreducetheirnetdebtoutstanding,thiswillresultinanevengreater
pooloffundsavailablefordirectbusinessinvestment.

(b)Commercialbanksalsoissuebondsintothecapitalmarkets.Someofthesebondsmaybe
describedascoveredbonds.Whatarecoveredbondsissuedbycommercialbanks?

Covered bonds is the term used to describe a bond issued into the capital markets by commercial
banks that have a specific form of security attached.

Covered bonds are regarded as being less risky as they are supported by an underlying security,
being a claim against mortgage securities held by the issuer bank.

If the commercial bank issuer defaulted on bond repayments, then the holder of the bonds is able to
seek repayment of the bonds from the sale of mortgage assets held by the bank.

12. Minnow Limited is a subsidiary of a large multinational organisation that has a BBB credit
rating issued by Standard and Poors credit rating agency. Minnow Limited plans to issue
debentures to raise additional funds to finance further growth within the company. The
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investment bank advising the company on the debenture issue has informed the company that it
could issue the debentures through a public issue, a family issue or a private placement. (LO 10.3)
(a)

Explain each of the three issue methods; that is public issue, family issue and

private placement.

Adebentureisacorporatebondissuedwithafixedorfloatingchargeovertheassetsoftheissuer.

Apublicissueoccurswhenthedebentureofferismadetothepublicatlarge.

Afamilyissueoccurswhenthedebenturesareofferedtopartiesassociatedwiththeissuersuchas
partieswhoarealreadyholdersofthecompanyssecurities,includingshareholders,bondholders
andholdersofconvertiblenotes.

Aprivateplacementoccurswhentheofferismadeonlytoinstitutionalinvestorssuchasfunds
managersandinsuranceoffices.

(b) Briefly discuss the prospectus and information memorandum requirements that will be required
with each type of issue.

Corporationslawwillrequirethatanofferofdebenturestothepublicmustbeaccompaniedbya
prospectus thathasfirstbeenregisteredwiththeregulator(ASIC).

A prospectus is a formal written offer to sell securities to the public and will provide detailed
information on the business, including:
o financial statements
o directors and executive managers
o specialist accounting, taxation and legal reports
o any material information that may affect the company
o strategic business plans and the intended use of the funds gained from the issue.

The prospectus should enable an investor to make an informed decision regarding the investment
opportunity.

A prospectus is time-consuming to prepare and register, which can be especially costly during periods of
volatile interest rates. The time delay could prevent a borrower being able to come to the market with an
issue at the most advantageous time.

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A private placement does not require the preparation of a prospectus; rather the issuer only needs to
provide institutional investors with an information memorandum.

Institutional investors are more informed than the general public and therefore it is not necessary to
provide the full extent of the detail that is incorporated in a prospectus.

The information memorandum must include up-to-date financial statements, material changes that may
affect the business and the purpose of the debt issue.

13. Woodside Petroleum Limited has issued $100 million of debentures, with a fixed-interest
coupon equal to current interest rates of 7.70 per cent per annum, coupons paid half-yearly and a
maturity of 10 years. (LO 10.4)
(a) What amount will Woodside raise on the initial issue of the debentures?

The amount raised by Woodside on the initial issue of the debentures into the market will be equal to
the face value of the debentures; that is, $100 million.

This is because current yields on this type of security, at the issue date, are equal to the fixed interest
rate paid on the debenture.

(b) After three year, yields on identical types of securities have risen to 8.75 per cent per annum.
The existing debentures now have exactly seven years to maturity. What is the value, or price, of
the existing debentures in the secondary market?
In order to calculate the value, or price, of the existing debentures in the market, it is
necessary to determine the present value of the face value, plus the present value of
the coupon stream (note: the price is being calculated at a coupon date exactly one
year after initial issue).

P C

1 - 1 i n

n
A1 i

A = $100 000 000


C = $3 850 000
n = 7 x 2 = 14
i = 0.0875 / 2 = 0.043750
Present value of the face value:
19

= A(1 + i)-n
= $100 000 000 (1 + 0.043750)-14
= $54 909 711.40
plus:
Present value of coupon stream:
= C [1 - (1 + i)-n ]
i
= $3 850 000 [1 - (1 + 0.043750)-14 ]
0.043750
= $39 679 453.97
Price of the debenture:

= $54 909 711.40 + $39 679 453.97


= $94 589 165.37

(c) Discuss why the value of the debenture has changed;thatis,explainusingtheaboveexample


thebondprice/yieldrelationship.

The price of the existing fixed interest security (debenture) has fallen because yields in the market
have risen.

That is, there is an inverse relationship between interest rate movements and price.

The coupon payments on the existing bond are fixed; therefore the lower coupon (7.70% p.a.) being
paid on the existing bond is worth less to an investor. However, the investor will require the current
yield of 8.75% p.a. and as the fixed 7.70% coupon cannot be adjusted, the equalising adjustment
occurs with the lowering of the price of the existing bond.

14. On 1 January 2016 a company issued five-year fixed-interest bonds with a face value of $2
million to an institutional investor, paying half-yearly coupons at 8.36 per cent per annum.
Coupons are payable on 30 June and 31 December each year until maturity. On 15 August 2017
the holder of the bonds sells at a current yield of 8.84 per cent per annum. Calculate the price at
which the institutional investor sold the bonds. (LO 10.4)
20

1 - 1 i n
n
k
P C
A1 i 1 i
i

where k is the fraction of elapsed interest period since the last coupon payment.
Therefore:
i = 0.0884/2 = 0.044200
n = 7 [one coupon due 31.12.17, then 2018 (2), 2019 (2), and 2020 (2)]
C = $2 000 000 x 0.0836/2 = $83 600
k = last coupon paid 30 June 2017; sold 15 August 2017 therefore 46 days elapsed in 184
day period = 46/184 = 0.25
(a) Present value of face value:
= $2 000 000 (1 + 0.0442) 7
= $1 477 556.76
plus
(b) Present value of coupon stream:
1 (1 .0442) 7

.0442

$83600

$494075.28

Therefore: (a) + (b) = $1 477 556.76 + $494 075.28


= $1 971 632.04
Price (adjusted for elapsed day):
= $1 971 632.04 (1.0442)0.25
= $1 993 066.50
Note elapsed days July

31

August

15
46 days elapsed

Note days in the full coupon period = 184


Therefore:

= 46 / 184
21

= 0.2500
15. At GE Finance you are the manager of lease finance. You have begun to talk to local
companies to try and sell the concept of lease finance for their businesses. (LO 10.5)
(a) Explain to the nature of lease finance, and distinguish between operating leases, finance leases,
saleandleasebackleases,andcrossborderleases.

A lease is a contract whereby the owner of an asset, the lessor, grants to another party, the lessee, the
exclusive right to use the asset, usually for an agreed period of time, in return for the payment of
rent.

Lessorthe owner of an asset that is subject to a lease agreement; receives lease rental payments.

Lesseethe user of an asset subject to a lease agreement; makes lease rental payments.

Leasing is the borrowing (renting) of an asset instead of the borrowing of funds to purchase the
asset.

Operating lease:

A short-term arrangement where the lessor may lease the same asset to successive lessees over time
in order to earn a return on the asset.

The lease arrangements normally contain only minor penalties for cancellation of the lease. This
feature leaves the risk of obsolescence of the asset with the lessor.

An operating lease is usually a full service lease; that is, the maintenance and insurance of the leased
asset is the responsibility of the lessor.

Finance lease:

Generally a longer-term arrangement between the lessor and the lessee.

The lessor earns a return on the asset from the one lease contract.

The lessor's role is essentially one of financing.

The lessee contracts to make regular lease rental payments, usually monthly, over the period of the
lease, which may be for more than two years.

A distinguishing characteristic of the finance lease is that the lessee contracts to make a lump sum
payment, representing the residual value of the asset, at the end of the lease period.

22

When the residual payment is made, the ownership of the asset normally passes to the lessee and
appears on its balance sheet.

A finance lease is usually a net lease; the costs of ownership and operation of the asset are borne by
the lessee. These costs include maintenance and repairs, insurance, taxes and stamp duties associated
with the lease.

Sale and lease-back lease:

Asaleandleasebackleaseinvolvesthesaleofanassetbyitsoriginalowner,buttheoriginalowner
immediatelyentersintoanagreementwiththenewownertoleasebacktheassetforanagreed
period.

Thereisnoneedtocontinuefundingtheassetfromthebalancesheet.

Leasepaymentsarederivedfromtheincomeearnedfromleasingtheasset.

Cross-border lease:

Withacrossborderlease,alessorinonecountryleasesanassettoalesseeinanothercountry.

Additionalfactorswouldneedtobeconsidered,including:
howtorecoveranassetifthelesseeshoulddefaultontheagreement
foreignexchangerisk;thatis,cashflowswillneedtobeconvertedintoanothercurrencyat
thecurrentexchangerate
thelegaljurisdictionthatwillapplyiflegalactionneedstobetakenunderthetermsofthe
lease.

(b) Provide examples of how a business might use each of these forms of lease arrangement.

Operating lease: a plumber may lease a mechanical digger for a short-term to install gas pipes in a
new residential development. Alternatively, a special events organiser may lease an outdoor sound
system for a weekend festival.

Finance lease: a corporation leases a number of desktop computer systems for (say) two years; or a
government department leases a motor vehicle fleet for (say) three years.

Sale and lease-back lease: a government may sell its railway rolling stock to an investment company
and then immediately lease the railway stock back to continue operating the railway service.

23

Cross-border lease: an airline company such as Qantas may lease aircraft from an international
finance group, or perhaps lease surplus aircraft from British Airways over the summer tourist
season.

(c) List and explain the advantages of lease finance to a business.

Leasing does not involve the use of the company's capital and other unused lines of credit. This
allows the company to use its capital to take advantage of other investment opportunities that may
arise.

Leasing provides 100 per cent financing in that the lessor provides the asset required for use by the
company. Other forms of debt funding may require the borrower to contribute a portion of its own
funds.

Rental payments under the lease agreement may be structured to reflect the cash flows generated by
the asset, that is, repayment scheduling may be more flexible under lease agreements than under
other forms of debt repayment schedules.

Lease rental payments are generally tax-deductible, and so it is important to structure the
repayments to match taxable income streams.

Existing borrowing covenants in loan and note agreements may allow lease financing while
restricting further debt funding.

Where the asset that is the subject of the lease is required for only a relatively short term, it may be
preferable to lease, rather than to buy and then have to seek to dispose of the asset at the end of the
period.

(d)Fromtheperspectiveofalessor,explainthestructureofadirectfinanceleaseversusa
leveragedfinanceleasecontract.

Adirectleaseinvolvestwoparties,thelessorandthelessee.Thelessorretainsownershipofthe
assetandmayalsoseekadditionalguaranteestosupporttheleasecontract.

Aleveragedleaseisanarrangementwherebythelessorborrowstofundthepurchaseofanassetthat
istobeleased.Oftenalessorpartnershipisformedforverylargeticketitemssuchasshipsand
aircraft.Becauseofthecomplexityofleveragedleasingarrangements,aleasemanagerwillbe
24

responsibleforthemanagementofthecontract.

Extended learning questions


16. (a) Explain why the process of securitisation has grown into a major financial market.

Securitisation is a form of financing in which the cash flows associated with existing financial assets
are used to service funding raised through the issue of asset-backed securities.

For example, the securitisation of mortgages involves the pooling of like assets such as registered
first mortgages, and then issuing securities that give investors a proportional entitlement to the assets
and the income stream that the underlying assets generate.

(b) Draw a diagram that shows the basic securitisation structure and its associated cash flows.

Financial
intermediary

Sellloanassets

Specialpurpose
vehicle(trustee)

Receivefunds

Receivefunds

Investors

Issuesecurities
Creditenhancer

Cashflowsfromloanasset
repayments

Service
manager

Cashflowstoinvestorsin
assetbackedsecurities

(c) Using your diagram (above), explain in detail the securitisation process and the different cash
flows that will occur.
The diagrammatic representation of the securitisation process may be summarised as follows:

Financial assets, for example housing loans, accumulate and are funded on a balance sheet by the
loan originator.

Assets with comparable maturity and risk structuresincluding interest rate, liquidity and credit
risksare pooled together and sold into a special-purpose vehicle (SPV) controlled by a trustee. The
assets have now moved from the balance sheet of the originator to the balance sheet of the SPV.
25

The SPV trustee issues new negotiable securities to investors to raise funds to finance the purchase
of the assets into the SPV. The new securities are attractive to investors because they are supported
by the mortgage assets held by the trustee, and by the associated future cash flows, being the
periodic interest and principal repayments due from the original housing loan borrowers.

To improve the marketability of the new issue, a AA+ credit enhancement may be created by
guarantees given by a financial institution and supported by the credit rating issued by a credit rating
agency.

A service or administration manager will generally be appointed by the SPV trustee to manage the
associated cash flows. These are the receipts from repayments due from the original borrowers, and
payment of interest and principal due on the asset-backed securities issued by the trustee to
investors. The service manager may also provide custodial services for the underlying securities.
The trustee may outsource these roles back to the originator.

As cash flows are received from the original assets, they are used by the trustee to repay interest and
principal due on the asset-backed securities issued to investors.

17. Up until mid-2007, the growth in the securitisation of assets in the international capital
markets had been enormous. (LO 10.6)
(a) Identify and discuss at least six reasons why this form of funding had become so attractive.

Increased return on equity: business growth is increased without the need to dilute shareholders'
funds.

A source of finance when other traditional sources of intermediated and debt finance may not be
available.

Improved return on assets, particularly where, through the securitisation process, assets with lower
credit ratings are upgraded with credit enhancement.

Diversify funding sources: asset-backed securities are often attractive to a new range of investors.

Reduced credit exposure: the sale of assets may transfer the credit risk associated with the pooled
assets to the SPV and ultimate investors.

Regulatory advantage: banks in particular are required to maintain minimum capital requirements
based, in part, on their balance-sheet assets. Securitisation, where there is no recourse back to the
bank, removes assets from the balance sheet and removes the capital cost imposition.
26

Increased balance-sheet liquidity: assets which previously were non-liquid and remained on the
balance sheet are converted to cash.

Reduced asset concentration: for example, banks tend to provide a large proportion of their asset
portfolio in mortgage finance. Securitisation allows the bank to divest itself of some of these assets
and to give new mortgage finance without increasing its overall mortgage asset concentration.

Accelerated income: by divesting assets through securitisation, an institution effectively brings


forward returns that would otherwise have progressively occurred over time.

Improved financial ratios: return on investment and return on equity may be improved through the
process of securitisation.

(b) What occurred after mid-2007 to significantly slow-down growth in the securitisation market?

The initial event that occurred that had a negative impact on the securitisation market was the subprime crisis in the USA.

Large amounts of mortgage loans in the USA had been securitised into the international financial
markets.

Significant increases in loan default rates caused the failure of some financial institutions and
diminished confidence in the market.

The mortgage loan problems extended to other countries, in particular, the UK, further impacting the
securitisation market.

The sub-prime crisis evolved into a credit crisis within the financial system and ultimately led to a
major global economic downturn.

In an economic downturn it is expected that default rates on loans will increase which also reduced
any remaining confidence in the securitisation market.

The global financial crisis was further compounded by a massive increase in sovereign debt,
particularly in the USA, the Euro-zone and the UK. As the sovereign debt crisis worsened, investors
withdrew further from the bond markets, including securitised assets.

(c) Do you think the market will recover? Why?

Once global economic growth and international financial market credit conditions return to normal it
is expected that confidence will slowly return to the securitisation market.
27

However, it is also expected that the risk structure of future securitised issues will change; that is,
investors will seek greater protection from default losses.

FINANCIAL NEWS CASE STUDY


This case study allows us to extend our understanding of a further component of the longer-term
debt markets: the market for covered bonds. A covered bond is a corporate bond issued mainly
by banks that provide covered bond investors recourse to a pool of mortgage assets held by the
issuer bank. Extracts from the following article discuss the development of the relatively new
covered bond market.
Overthetwoyearssincethepassageofenablinglegislation,coveredbondshaveproven
tobeausefulsourceoffundingforAustralianbanks.AboutA$57billionhasbeenraised,
predominantlyinoffshoremarkets.Thisrepresentsjustoveronequarterofthebanks'longterm
debtissuanceoverthisperiod,althoughthepatternofissuancehasevolvedwithfinancial
marketconditions.Inparticular,coveredbondshaveprovenusefulasawholesalefunding
sourcethatislesssensitivetoglobalriskeventsthantraditionalunsecuredfunding.Thiswas
evidentinthebanks'issuanceofpredominantlycoveredbondsinearly2012asconditionsin
fundingmarketsdeterioratedbecauseofsovereigndebtconcerns,particularlyinEurope.
Aroundthattime,theReserveBanknotedthatthedelineationbetweensecuredand
unsecuredfundingforthebankingsystemwasperhapsnotasstarkasmarketconditions
implied.Asitturnedout,conditionsinglobalunsecuredfundingmarketsimprovedfrommid
2012,andAustralianbanksreturnedtowhatmightbeconsideredmoretypicalpatternsof
issuanceraisingthemajorityoftheirwholesalefundingviaunsecuredbonds.
Importantly,coveredbondshaveenabledbankstodiversifytheirinvestorbaseand
reducetheirfundingrisk.Australianbanks'coveredbondshaveconsistentlybeenratedAAA,
whichhasallowedthebankstoattractnewfundingfrominvestorswithAAAmandates.Thismay
alsohaveassistedthosebanksrepurchasingtheirgovernmentguaranteeddebt,asthebanks
wereabletoofferinvestorsanalternativeAAAassettoinvestin.

28

Thereisalsosomeevidenceofabroadeninginbanks'investorbasealongthe
geographicaldimension,withregionalcentralbanksamongthebuyersofAustralianbanks'
coveredbonds.Europeaninvestorshavealsoprovideddemandfortheseinstruments,reflecting
theirfamiliaritywiththeassetclass.Thishascontributedtothebanksissuingwholesaledebt
acrossabroaderrangeofcurrenciesinthepasttwoyears,comparedwiththeirissuance
patternspriortotheintroductionofcoveredbonds.
Coveredbondshavealsoenabledthebankstoincreasethetenoroftheirissuance,which
hashelpedtosmooththematurityprofileoftheiroutstandingdebt.Thebankshavetypically
issuedcoveredbondsattenorsof5to10years,comparedwithanormof3to5yearsfortheir
unsecuredissuance.Morestrikingly,thebankshaveissuedcoveredbondsatverylongtenors,
sometimesexceeding15years.

SOURCE: Aylmer C., Head RBA Domestic Markets Department, Developments in secured issuance and RBA
reporting initiatives, 11 November 2013, www.rba.gov.au/speeches/2013.

DISCUSSION POINTS

What is a covered bond? Explain the structure of a covered bond and why banks
may issue this type of debt security.
A covered bond is a bond with a form of security attached.
A bond is a long-term debt instrument issued directly into the capital markets that pays
the bond holder periodic interest coupons and the principal is repaid at maturity.
Covered bonds are bonds issued by commercial banks that are supported by security,
being mortgage assets held by the bank issuing the covered bonds.
Covered bonds are regarded as having less risk than an unsecured bond and therefore the
yield or cost of borrowing for a particular bank issuing covered bonds will be less than if
that bank issued unsecured bonds.
Covered bonds, because they are supported by mortgage assets, receive a more
favourable capital adequacy treatment; that is, banks can include covered bonds as part of
their overall capital base for capital adequacy purposes.
29

Within the context of Australian banks issuance of paper for wholesale funding,
discuss why the issuance of covered bonds versus the issuance of unsecured debt has
varied as market conditions changed.
As mentioned above, covered bonds may be included as part of a banks capital adequacy
requirement. This relates to a cost advantage of covered bonds versus unsecured bonds.
Covered bonds issued by Australias major commercial banks generally receive a AAA
credit rating, which also lowers the banks cost of funds.
Australian banks raise a large proportion of their debt funds in the overseas capital
markets, but during the global financial crisis investors were very wary of lending to
international banks. However, Australian banks, with their AAA credit rating, found it
possible to continue raising funds with bond issues, particularly if those bonds were
covered bonds.
As the international bond markets have recovered from the global financial crisis and
investor confidence has returned, the commercial banks have not needed to rely as much
on the covered bond market.

Aylmer notes in the discussion paper that covered bonds have enabled banks to
diversify further their investor base and extend the tenor of their issuance. What
does this mean and why might it be important for the banks?
Central banks around the world tend to invest part of their surplus funds in high-quality
debt securities. Many central banks now include covered bonds issued by Australias
major commercial banks as part of their investment portfolio.
Often managed funds, both in Australia and overseas, establish risk management policies
that restrict the type of securities the fund may hold in their portfolios. Typically, many
balanced investment funds are only permitted to buy debt securities that have a high
investment grade AAA credit rating. The covered bonds now issued by Australian major
commercial banks have a AAA rating and therefore are being held in large managed fund
portfolios.
Banks, as part of their interest rate risk management strategies, measure and manage the
maturity structure of their bond portfolios. Because of their lower level of credit risk,
covered bonds may be issued with longer terms to maturity than unsecured bonds issued
30

by the same issuer. This gives the issuer banks more flexibility to manage the maturity
structure of their portfolio and thus reduce interest rate risk and funding risk.

True/False questions
1. T A term loan provided by a commercial bank is also known as a fully drawn advance.
2. T With a term loan, the lender may take a charge over the assets of the borrower as
security for the loan.
3. F An amortised loan is one in which the loan is repaid through a series of regular interest
instalments and the principal is paid as a lump sum at the loan maturity date.
4. T A variable rate loan contract will specify a reference interest rate; changes in the
reference interest rate will impact the interest paid on a variable rate loan.
5. T A banks assessment of the credit risk of a borrower will be included in the margin
charged above a reference interest rate on a variable rate loan.
6. F Usually, with a 10-year fixed-interest term loan the fixed interest rate is lock-in for the
entire period of the loan.
7. T BBSW is the mid-point of prime banks bid and offer rates for eligible securities in the
NCD and BAB secondary markets.
8. F The bank prime reference interest rate is set daily by the Australian Financial Markets
Association (AFMA).
9. T A company is paying BBSW plus 122 basis points on a term loan. BBSW is currently
6.78 per cent per annum. The current cost of the loan is therefore 8.00 per cent per annum.
10.

F If a bank provides a company with a term loan with a fixed-interest rate, the

company will not have to pay any other fees as they are incorporated in the fixed rate.
11.

F Positive loan covenants specify actions that must be taken by borrowers, while

negative covenants are actions that must be adhered to by the lending bank.
12.

T A mortgage is a form of security taken over land that is provided by a borrower

as collateral to support a loan facility.


13.

T With mortgage finance, the mortgagor is the borrower and the mortgagee is the

lender.
31

14.

T If a borrower should default on a mortgage loan, the lender is entitled to

foreclose and sell the property to recover loan funds outstanding.


15.

F The terms debenture and unsecured note can be interchanged, since they are

both corporate bonds that have identical features.


16.

T The crowding-out effect contends that any significant change in the amount

government borrows in the capital markets will have an impact on the amount of funds
available for lending in the corporate bond market.
17.

F Subordinated debt holders receive their interest payments and are able to

redeem their principal before other corporate bond holders.


18.

T An operating lease tends to be a short-term relationship, wherein the lessor may

lease the same asset to successive lessees in order to earn a return on the asset.
19.

F A disadvantage of leasing is that the lessee is usually required to fund 20 per

cent of the cost of the leased asset from its own capital.
20.

F In a leveraged lease arrangement, the lessors contribute the bulk of the finance

for the acquisition of the asset that is to be leased and borrow a small proportion of the total
required finance from the debt parties.

32