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16
LONG-TERM
DEBT AND
LEASE
FINANCING
16-1
Chapter 16 - Outline
16-2
Learning Objectives
1. Identify and describe the key features of
long-term debt. (LO1)
2. Differentiate bond yields and prices as
influenced by how corporations and
governments are rated by bond rating
services. (LO2)
3. Analyze the decision of whether or not to
call in and reissue debt (refund the
obligation) when interest rates have
declined. (LO3)
16-3
Learning Objectives
4. Outline some of the features of innovative
forms of raising long-term financing, including
zero-coupon rate bonds, floating rate bonds
and real return bonds. (LO4)
5. Outline the characteristics of long-term lease
financing that make it an alternative form of
long-term financing. (LO5)
6. Analyze a lease-versus-borrow-to-purchase
decision. (LO6)
16-4
16-5
Bond Features
Par Value:
principal or face value (usually $1,000)
Coupon Rate:
actual or stated interest rate (distinguish from
yield)
Maturity Date:
date when repayment of principal is due
LO1
16-6
Table 16-1
Coupon Rate
Price
Maturity
YTM
TD Bank
9.150
1,526.50
May 2025
3.34
Hydro One
3.790
938.20
July 2062
4.08
George Weston...
6.690
1,211.00
Mar. 2033
4.94
TransAlta..
7.300
1,106.10
Oct. 2029
6.21
LO2
16-7
Secured Debt:
where specific assets are pledged to bondholders in the
event of default
Debenture:
a long-term unsecured corporate bond
Subordinated Debenture:
unsecured bond that is paid after senior debenture holders
are satisfied
LO1
16-8
Negative pledge
Covenant that limits the securing of subsequent
debt
Minimum ratios
Restriction on maintaining minimum ratios such as
debt/equity, working capital and dividend payout
LO1
16-9
Figure 16-2
Priority of claims
Secured Debt
Senior
Senior
Junior
Junior
Unsecured debt
(debentures)
Senior
Senior
Subordinated
Subordinated
Lower priority of
claims
Preferredstock
stock
Preferred
Commonstock
stock
Common
LO3
16-10
Methods of Repayment
Single-Sum Payment:
lump-sum payment when bond is due
Serial payments:
bond is paid off in installments
Conversion:
bond can be converted into shares of common stock at the
option of the bondholder
Call feature:
corporation can redeem bonds early by paying a premium over
par value
LO1
16-11
Yields
If Bond prices P
Yields
16-12
Table 16-2
Years to
Maturity
8%
10%
12%
14%
16%
$1,037.72
$1,018.59
$1,000
$981.92
$964.33
15
1,345.84
1,153.72
1,000
875.91
774.84
25
1,429.64
1,182.56
1,000
861.99
755.33
Note: This table is based on semi-annual interest payments, with annualized interest rates.
LO2
16-13
Figure 16-3
LO2
16-14
Bond Yields
Coupon Rate (Nominal Yield) = annual interest payment
par (maturity) value
Current Yield = annual interest payment
current price of bond
Yield-to-Maturity (YTM):
The interest rate that equates future interest payments
and the payment at maturity to the current market price
affected by current market interest rates
If market interest rates , YTM , bond price
16-15
16-16
16-17
Bond Ratings
Bond rating services provide a somewhat objective
assessment of the investment quality of securities
Dominion Bond Rating Service (DBRS) in Canada and
Standard and Poors in the US provide bond ratings
Rating systems of DBRS and Standard and Poors
AAA
AA
A
BBB
BB
CCC
D
LO2
Highest quality
16-18
16-19
16-20
Journal Exercise
P. 564; #2 ( 5-7 Min.)
16-21
16-22
16-24
16-25
16-26
16-27
16-28
16-29
16-30
16-31
16-32
16-33
Revenue Bond
security based upon cash flow
Eurobond:
bond issued in a country other than the one in which currency the bond
is denominated
LO4
16-34
Operating Loans
Generally advanced based on current asset security
Payable on demand
16-35
Asset-Backed Securities
Current assets sold into a trust
Firm gets immediate capital in exchange for its
assets
Investor receives a steady return as the receivables
are collected
LO4
16-36
Disadvantages:
interest and principal must always be met when due,
regardless of a firms financial position
poor use of debt may lower a firms stock price
may place burdensome restrictions on the firm
LO4
16-37
2 Types of Leases
Capital Lease (or Financing Lease):
a purchase in essence rather than a lease
firm actually buys the property
must be shown on a firms balance sheet
e.g. oil drilling equipment and airplanes
Operating Lease:
a conventional rental agreement
firm doesnt expect to own property
is not shown on a firms balance sheet
e.g. automobiles and office equipment
LO5
16-38
Advantages of Leasing
A loan may be more expensive or even refused
There may be no down payment on a lease, but usually
a down payment with a loan
A lease may have fewer restrictions than a loan
There is a fixed payment on a lease, but loan interest
may vary with prime
Lease from a manufacturer may have attractive terms
(e.g.: lower interest cost) or provide specialist expertise
Using a lease may restrict creditor claims in bankruptcy
Lease may be preferable for equipment with rapid
obsolescence (e.g.: computers)
Using a lease may be tax advantageous
LO5
16-39
Table 16-6
Year
(1)
Payment
(2)
Loan
Interest
(3)
Interest
Tax Shield
(2) X 0.4
(4)
Aftertax
Cost of
(1) + (3)
(5)
Present
Value at 6%
($1,319)
$500*
$200
($1,119)
($1,056)
(1,319)
418
167
(1,152)
(1,025)
(1,319)
328
131
(1,188)
(997)
(1,319)
229
92
(1,227)
(972)
(1,319)
120
48
(1,271)
(950)
(5,000)
LO6
16-40
Table 16-7
Tax Payment
Shield
Aftertax Cost of
Leasing
($1,295)
$0
($1,295)
($1,295)
(1,295)
518
(777)
(733)
(1,295)
518
(777)
(692)
(1,295)
518
(777)
(652)
(1,295)
518
(777)
(615)
518
518
387
Present
Value at 6%
($3,600)
We can use the calculator and simplify the process
0-4 Lease payments
PMT(BGN) = (1,295), N = 5, I/Y = 6%, FV = 0
1-5 Tax savings
PMT(END) = 518, N = 5, I/Y = 6%, FV = 0
PV of leasing
LO6
(5,782)
2,182
(3,600)
16-41
Table 16-8
(5,000)
PV of CCA shield
1,495
PV of borrowing
(3,505)
(5,782)
2,182
(3,600)
$95
16-42
16-43
44 of 45
16-45
16-46
16-47
16-48
Out-of-Court Settlement:
Four Alternatives
1. Extension:
creditors agree to allow the firm more time to meet its financial
obligations
2. Composition:
3. Creditor Committee:
4. Assignment:
APP-16A
In-Court Settlements
Proposal for an Arrangement under the
Bankruptcy and Insolvency Act:
Proposals to reorganize the firm can now come from the firm itself,
the trustee, the liquidator, or the receiver
Secured creditors can be part of the restructuring.
The firm may be reorganized internally or externally.
Liquidation:
Assets are sold off and proceeds are used to satisfy the demands
of the parties involved by following the absolute priority rule.
APP-16A
16-50
16-51
16-53
16-54
16-55
16-56