Debt Financing

Outline:
I. The nature and the main types of borrowing II.The main considerations for a firm when borrowing long-term or short-term

Examples of debt finance

Debentures and loan stocks Debt Financ e

Bonds

Trust deeds and covenants

Bank borrowing the attractions

Administrative and legal costs are low Speed

Flexibility
Availability to small firms
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Bank borrowing factors to consider

Costs Security information - Arrangement fees - Floating or fixed rates? - Asymmetric

- Collateral - Personal guarantees Repayment - Repayment holidays - Mortgage-style schedules

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Overdrafts
Advantages Drawbacks Risk of withdrawal at short notice Security

Flexibility
Cheapness Useful for seasonal businesses e.g. Fruit growers

Term loans
Repayment structure - Grace period - Balloon structure - Bullet structure Instalment arrangement Drawdown arrangement

Financial gearing
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Convertible bonds
Advantages for the company:
Lower interest Interest is tax deductible Self-liquidating Fewer restrictive covenants Underpriced shares Cheap way to issue shares Available when straight debt/equity is not available
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Convertible bonds
Advantages for the investor
Can wait and see before investing in equities Greater security in the near term The annual coupon is usually higher than the dividend yield
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Trade credit
Advantages
Convenient/informal/cheap Available to all sized of company

Factors determining the terms

Tradition in the industry Bargaining strength of the two parties Product type
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Stages in a factoring deal

2. Right to receive payment on invoice sold to factor 3. 80% of customer Debt available to Seller immediately 5. 20% payable, less factors Fees and interest, after customer pays factor Supplying firm (seller 1. Goods

Factor 4. Customer pays debt to factor a few Weeks after delivery of goods

Customer

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The hire purchase sequence

Plant or equipment

1. Bought by HP company and remains property of HP company until hirer makes all payments

2. Available for immediate use

Hirer (e.g. Firm) Hire Purchase company (e.g. Finance house) 4. When all payments are made hirer becomes the owner 3. Regular payments
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A leasing transaction
Asset (e.g. Plant, machinery, vehicle) Buys asset and retains legal ownership throughout

Rental payments

Finance house (lessor)

Lessee has use of the asset for a period of time

Lessee (company using equipment)

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Leasing
Two types - Operating leases - Financing leases Advantages - Small initial outlay - Certainty - Availability - Fixed-rate finance - Tax relief
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Bond Markets
Bond markets

Domestic market

Foreign bonds

Euro bonds (International bonds)

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International bonds the advantages

Larger loans for longer periods

Often cheaper
Hedge interest rates and exchanges rates Usually unsecured

Lower level of regulation

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International bonds the drawbacks

Only for the largest companies Risks associated with exchange rate fluctuation The secondary market can be illiquid

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Short-term or long-term borrowing? The key factors

Maturity structure

Costs of issue/arrangement
Flexibility The uncertainty of getting future finance

The term structure of interest rates

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Valuing Bonds
Importance of understanding bonds and their pricing:

The prices of risk-free government bonds can be used to determine the risk-free interest rates in the market
Firms issue bonds to fund their own investment too, and the returns investors receive on those bonds is one factor determining a firms cost of capital

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Determinants of bond prices

The price of a bond is determined by the promised cash flows: Risk-free bond (e.g. government bonds)
promised cash flows will be paid with certainty

Risky bond (e.g. corporate bonds)

Cash flows are not known with certainty due to risk of default

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Bond terminology
Bonds:
securities sold by government and corporations to raise money from investors today in exchange fro the promised future payment.

Face Value:
the principal of the bond, also known as par value

Bond certificate:
setting out the terms of the bond; indicating the amount and dates of all payments to be made
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Bond terminology (cont.)

Term to maturity:
time to full repayment by issuer (usually measured in years)

Maturity date: final repayment date Coupon payment: interest payment to bond-holders
For example, a bond that was issued for $1000 and pays $60 of interest each year would be said to have 6% coupon

Coupon rate:
6% in the above example is known as the coupon rate
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Bond terminology (cont.)

Yield to maturity the annual rate the bondholder will receive if the bond is held to maturity yield to maturity is the interest rate that equates the present value of the expected future cash flows to be received on the bond to the initial investment in the bond, which is its current price. It is widely accepted as a proxy for average return (the IRR)

where Pb is the current price of the bond; C is the coupon payment on the bond; M is maturity value, or the original bond issue price; y is the yield to maturity or interest rate; n is the number to maturity
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Zero coupon bonds

Make no coupon payments The only cash payment investors receive is the face value of the bond on the maturity date

Must sold at a discount (i.e. at a price less than its face value), hence also called pure discount bonds
The YTM for an n-year zero-coupon is the risk-free rate that all n-year risk-free investments must earn in the market

or

The cost of capital for a risk-free cash flow that occurs on date n is YTMn

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Coupon bonds
Characteristics:
Pay investors their face value at maturity Make regular coupon interest payments Examples:
US Treasury notes (1 to 10 years maturities) US Treasury bonds (more than 10 years maturities)

Finding of YTM for coupon bonds

Same as that shown in slide 5.

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An Example of finding YTM

A coupon bond with a face value of 1000 and an annual coupon of 8% has four more years to run. It currently has a market value of 1069.3. Find its yield to maturity. Solve for r below:

r (the YTM) is approximately equal to 6%

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An example of finding the price of a coupon bond (assuming no default)

The price of a coupon bond must equal the present value of its coupon payment and face value discounted at the competitive market interest rates: For a 3-year, 1000 bond with 10% annual coupons and the YTM of 4.4%, its price is:

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Pricing of coupon bond with the risk of default

The issuer of corporate bonds may default:
It might not pay back the full amount promised in the bond prospectus. This risk of default means that the bonds cash flows are not known with certainty Hence, investors will pay less and demand higher yield for bonds with default risk than that of otherwise identical default-free bonds.

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Example 1: No default case

Suppose that the one-year zero-coupon bond has a yield to maturity of 4%, the price and yield of a one-year, 1000, zero coupon bond issued by Apple Corporation will be:

Note that since we are assuming that Apple Corporation will not default within the next year, hence this bond is risk free and should earn the same yield as the one-year zero coupon bond (i.e. 4%)

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Example 2: Certain Default case

Suppose that investors believe that Apple Corporation will certainly default at the end of one year and will be able to pay only 90% of its outstanding obligations. Investors can predict this shortfall perfectly, so the 900 payment is risk free, and the bond is still a one-year risk-free investment.

The price of this defaultable bond can be found by discounting this new cash flow using the risk-free interest rate as the firms debt cost of capital:

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Example 2 (cont.)
Finding YTM of the defaultable bond: Given the bonds price on slide 12, we can compute the bonds YTM using the promised rather than the actual cash flows.

The 15.56% YTM of Apples bond is much higher than the YTM of the default-free government bond. But this does not mean that investors of the bond will earn 15.56% return because it will default. In fact, the expected return of the bond only equals its 4% cost of capital:

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Example 3: Risk of default

Examples 1 & 2 are two extreme cases with bond payoffs known with certainty Example 3: Bond payoffs are uncertain (e.g. 50% chance to get repayment in full and 50% chance to receive only 900 when the company default, so on average, 950 will be received) Investors demand a risk premium on top of the risk-free rate to invest in this bond

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Example 3 (Cont.)
Suppose investors demand a risk premium of 1.1% for this bond, the appropriate cost of capital is 5.1% (4% +1 .1%), the price of the bond will be:

The YTM of the bond is 10.63%:

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Example 3 (cont.)
The 10.63% promised yield is the most investors will receive. If Apple defaults, they will receive only 900, for a return of: The average return is:

This 5.1% is known as the bonds cost of capital

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Summary
A bonds price decreases, and its yield to maturity increases, with a greater likelihood of default Conversely, the bonds expected return, which is equal to the firms debt cost of capital, is less than the yield to maturity if there is a risk of default A higher YTM does not necessarily imply that a bonds expected return is higher.

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Bond ratings
Moodys Standard & Poors Description

Aaa Aa A Baa

AAA AA A BBB

The best quality (0.1% default probability) High quality (0.3% default probability) Upper medium grade (0.7% default probability) Medium grade (3.5% default probability)
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Bond ratings
Moodys Aaa Aa A Baa Standard & Poors Description AAA AA A BBB The best quality (0.1% default probability) High quality (0.3% default probability) Upper medium grade (0.7% default probability) Medium grade (3.5% default probability)
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