CHAPTE

16

LONG-TERM
DEBT AND
LEASE
FINANCING

PowerPoint Presentation Prepared by Michel Paquet, SAIT Polytechnic

2015 McGraw-Hill Ryerson Ltd. All Rights Reserved

16-1

Chapter 16 - Outline

Key Features of Long-term Debt

Bond Prices, Yields, and Ratings
The Refunding Decision
Innovative Forms of Bond Financing
Advantages and Disadvantages of Debt
Lease vs. Borrow-to-Purchase Decision
Summary and Conclusions

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)
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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)

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The Debt Contract

Debt financing is an essential component of
a firms capital structure.
Bonds are the basic long-term debt
instrument for large corporations and
governments.
A bond is a contract between the borrower
(firm/government) and the lender (investor).
It specifies features responsibilities and
privileges for both parties.
LO1

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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

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Table 16-1

Coupon rates, yields, and pricing

Issuer

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

Coupon rate Actual interest rate on the bond

Price Market value of the bond
Maturity The final date on which repayment of the bond principal is due
YTM Yield to Maturity

LO2

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More Bond Features

Indenture:
legal document detailing the corporations obligations

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

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More Bond Features

Restrictive Covenants
Promises or covenants made by the firm in the
indenture

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

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Figure 16-2

Priority of claims
Secured Debt
Senior
Senior

First claim on assets pledged

Junior
Junior

Second claim on assets pledged

Unsecured debt
(debentures)

Remaining assets are distributed below

Senior
Senior
Subordinated
Subordinated
Lower priority of
claims

Subordinated debenture holders will not

received payment unless designated
senior debenture holders are paid in full

Preferredstock
stock
Preferred
Commonstock
stock
Common

LO3

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Methods of Repayment
Single-Sum Payment:
lump-sum payment when bond is due

Serial payments:
bond is paid off in installments

Sinking fund Provision:

corporation contributes regularly to a trust fund used to buy back
bonds

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

Bond Prices, Yields and Ratings

If Bond prices P

Yields

If Bond prices P

Yields

Longer life bonds are more price

sensitive (bigger changes) to market
yield changes.
LO1

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Table 16-2

Interest rates and bond prices (the bond pays 12

percent interest, semi-annually)
Rate in the Market

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

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Figure 16-3

Long-term yields on government bonds

20
18
16
14
12
10
Yield (%)
8
6
4
2
0

Source: Bank of Canada, Government Bonds, Series V122544, www.bankofcanada.ca

LO2

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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

and bond rating

If rating high (low risk), YTM
LO2

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Check your Understanding

P. 564; # 3 ( 5 Min.)

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

Speculative or medium quality

Default

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Check your understanding

P. 564; #1 (7-10 Min.)

16-19

16-20

Journal Exercise
P. 564; #2 ( 5-7 Min.)

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16-22

Calculating Bond Prices

P. 565; #6 Take 2-3 min to read the
problem
--------------------------------------------------------PV of Principal + PV of all Interest
Payments
--------------------------------------------------------------------------------------------FV=$1,000
PMT= (based on coupon rate)
I= (Cap. Rate)
N= (based on compounding mode)
PV= ?
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Check your Understanding

P. 565; #6 ( 5 Min.)
P. 565; # 7 ( 5 Min.)

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16-25

16-26

Homework assgt BEFORE next

class!
P. 546-549 - The Refunding Decision

16-27

The Refunding Decision

When market interest rates decline, selling new
low coupon rate bonds to buy back the existing
high coupon rate bonds is called a refunding
operation.
To refund a bond, the bond indenture agreement
should include a call provision.
The refunding decision is analyzed as a capital
budgeting problem.
The goal is to see whether savings in interest
costs exceed financing costs related to
redeeming and reissuing bonds.
LO3

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16-29

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Check your understanding

P. 565; #17 (Wagner)- Take 5 Min to read
and absorb the problem.

16-32

16-33

Innovative Forms of Bond Financing

Zero-Coupon Bond / Strip Bond:
does not pay coupon (interest)
is issued at a deep discount from face value
zero-coupon bond was created when coupons stripped from a coupon
bond and were traded separately from the face value

Floating Rate Bond:

Interest/coupon rate paid on the bond changes with market conditions

Real Return Bond

principal adjusted for inflation

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

Corporate Debt for the Medium Term

Term Loans
a loan advanced against capital asset security
the length of time is 3 to 10 years
principal and interest payments are monthly or
quarterly with a balloon payment of principal at the
end of the term

Operating Loans
Generally advanced based on current asset security
Payable on demand

Medium Term Notes (MTNs)

of 3 to maybe 10 years duration
LO4

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Corporate Debt for the Medium Term

Mortgage Financing
a loan advanced against property
Formal appraisal of the property required
Terms of 6 months to 10 years

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

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Advantages and Disadvantages of Debt

Advantages:
interest payments are tax deductible to a firm
wise use of debt may lower a firms weighted average
cost of capital (WACC)
during inflation, debt is repaid with cheaper dollars

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

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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

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Table 16-6

Net Present Value of Borrow-Purchase

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)

*$5,000 x 10% = $500

LO6

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Table 16-7

Net Present Value of Operating Lease Outflows

Year

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)
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Table 16-8

Summary of lease versus borrow to purchase

analysis
Borrow-to-Purchase Alternative
Cost of asset

(5,000)

PV of CCA shield

1,495

PV of borrowing

(3,505)

Operating Lease Alternative

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
NPV of borrow-to-purchase
LO6

(5,782)
2,182
(3,600)
$95
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Check your Understanding

P. 569; #28
(review for 2-3 min.)

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44 of 45

2012 McGraw-Hill Ryerson Limited

16-45

Try another One!

P. 569; # 29 ( 5-7 Min.)

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16-47

Financial Alternatives for

Distressed Firms
Insolvency refers to a firms inability to generate enough
cash to pay its bills as they come due.
A firm may be technically insolvent even though it has
a positive net worth.
If a firm has a negative net worth (i.e., the fair market
value of its assets is less than its total liabilities), under
the Bankruptcy and Insolvency Act, either management
or creditors can initiate legal action to have the firm
declared bankrupt and have its assets liquidated.
A technically insolvent firm may participate in out-ofcourt settlements or in-court formal bankruptcy
proceedings.
APP-16A

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Out-of-Court Settlement:
Four Alternatives
1. Extension:

creditors agree to allow the firm more time to meet its financial
obligations

2. Composition:

creditors agree to accept a fractional settlement of their original

claim

3. Creditor Committee:

a committee is set up by creditors to run the business

4. Assignment:

APP-16A

creditors agree on asset liquidation values and the relative

priority of claims and liquidate assets without going through
formal court action
16-49

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

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Summary and Conclusions

Corporations have been using more and more
debt financing since the 1960s.
Bonds are the basic form of debt financing.
They can be secured or unsecured
(debentures).
Corporate bonds may have sinking-fund, call,
or conversion features.
Bond price and yield are inversely related and
based upon the level of market interest rates
and bond ratings.

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Summary and Conclusions

When interest rates decline significantly,
corporations may decide to refund their
existing high interest (coupon) rate bonds.
Long-term capital leases are an
alternative form of long-term financing.
Both a bond refunding decision and a
lease versus borrow-to-purchase
decision can be treated as capital
budgeting problems.
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End of Chap Assgt

P. 565; #9
P. 564; # 4
P. 569; # 30

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