Long-Term Debt And Leasing

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Long-Term Debt And Leasing

• Professor XXXXX
• Course Name / Number

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Long-Term Debt Financing
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Debt Covenants
Contractual clauses within debt agreements that
constrain borrowers actions
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Cost of Long-Term Debt
Function of at least four factors
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Term Loans
Private loans that financial institutions make to
businesses.
Have initial maturities of more than one year.
Generally have maturities of 5-12 years
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Characteristics of Term Loans
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Syndicated Loans
Large-denomination credit arranged by a group
(syndicate) of commercial banks for a single
borrower
Over 2 trillion worth of syndicated loans are
arranged annually (two thirds of which are
corporate).
Eurocurrency lending the Eurocurrency loan
market is largely a syndicated loan market.
Project finance loans arranged for
infrastructure projects such as toll roads,
bridges, etc.
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Corporate Bonds
Debt security carrying a promise to pay cash
flows to the holder
Most maturities range from 10 to 30 years with a
par (face) value of 1000

• Main types
• Debentures
• Subordinated debentures
• Income bonds
• Mortgage bonds
• Collateral trust bonds
• Equipment trust certificates

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Legal Aspects of Bonds
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Methods of Issuing Corporate Bonds and Common
Features

• Shelf registration
• Often used when issuing bonds
• Allows firms to register large amounts of debt,
  then sell the securities over time as market
  conditions warrant
• Rule 144A
• Allows institutional investors to trade
  non-registered securities among themselves
• Created a new market for privately-placed issues,
  including debt securities
• Three special features are often included in the
  bond indenture
• Call feature
• Conversion feature
• Stock purchase warrant attachments

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Common Features of Corporate Bonds
Call feature allows the issuer to repurchase
bonds prior to maturity at a certain call price.
Call feature gives the issuer the ability to
retire an issue early when interest rates fall,
so this benefits issuers.
Conversion feature allows bondholders to change
each bond into a stated number of shares of
common stock.
Stock purchase warrants give the bondholder the
right to purchase a certain number of shares at a
specified price over a certain period of time.
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International Corporate Bond Financing
Most international bonds are bearer securities
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Bond Refunding Options
A firm has two options if it tries to avoid a
single repayment in the future or wants to refund
a bond prior to maturity
Serial bonds are issues with staggered
maturities, often with different interest rates
paid to various maturities.
If interest rates drop, issuers with call
provisions may consider a refunding (refinancing)
operation.
Existing bonds are retired new, lower-interest
bonds issued.
Bonds are called when the marginal benefit of
doing so (stream of reduced paid interest)
exceeds marginal cost.
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Bond Refunding Analysis
Refunding decision is based on capital budgeting
analysis
The capital budgeting procedure

• Step 1 Find the initial investment required to
  call the old issue and issue new bonds
• Include the call premium, flotation costs of the
  new bond, overlapping interest, unamortized
  discount and flotation costs of the old bond.
• Step 2 Find the cash flow savings
• Largest impact will be from the differential
  interest costs.
• Step 3 Find the NPV of the refunding operation
• If NPV gt 0, the refunding operation is
  recommended.

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Bond Refunding Analysis Example

• Contemplated bond refunding operation
• Existing bond issue (50 million)
• 30-year bonds issued 5 years ago with a coupon
  interest rate of 9, callable at a price of
  1,090
• Initially issue netted 48.5 million due to a
  discount of 30 per bond
• Initial flotation cost was 400,000
• Proposed bond issue (50 million of 25-year
  bonds)
• Expected to sell at par value with a coupon
  interest rate of 7
• Flotation costs estimated at 450,000
• Other Data
• Firms tax rate is 30 after-tax cost of debt is
  4.9 (1-0.30) x 7
• Two months of overlapping interest is expected

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Step 1 Find the Initial Investment
After-tax cost of the call premium

• Call premium 90 per bond, (tax deductible)
• Before taxes (90 x 50,000 bonds)
  4,500,000
• Less tax savings (0.30 x 4,500,000)
  1,350,000
• After-tax cost of premium
  3,150,000

Flotation cost of new bond was given as 450,000.
Overlapping interest

• Before taxes (0.09 x (2/12) x 50,000 bonds)
  750,000
• Less tax savings (0.30 x 750,000)
  225,000
• After-tax cost of overlapping interest
  525,000

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Step 1 Find the Initial Investment
Unamortized discount on old bond

• Discount (1,500,000 50,000,000 - 48,500,000)
  was amortized over thirty years
• Only five years of amortization have been used
• Firm can deduct the remaining twenty-five years
  as a lump sum
• Reduced taxes (25/30 x 1,500,000 x 0.30)
  (375,000)

Unamortized floatation cost of old bond

• Initial floatation cost (400,000) was amortized
  over thirty years
• Reduced taxes (25/30 x 400,000 x 0.30)
  (100,000)

Initial investment is 3,650,000
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Step 2 Find the Cash Flow Savings

• Interest cost of old bond
• Annually (50,000,000 x 0.09 x (1-0.30))
  3,150,000
• Amortization of discount on old bond
• Annually ((1,500,000/25) x 0.30)
  (15,000)
• Amortization of floatation cost on old bond
• Annually ((400,000/25) x 0.30)
  (4,000)

• Interest cost of new bond
• Annually (50,000,000 x 0.07 x (1-0.30))
  (2,450,000)
• Amortization of flotation cost on new bond
• Annually ((450,000/25) x 0.30)
  5,400

• Total annual cash flow savings
  686,400

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Step 3 Finding the NPV of the Refunding Operation
Since the NPV is positive, recommend the bond
refunding operation.
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Leasing
Similar to long-term debt, leases involve
periodic, tax-deductible payments.
Payments may be fixed or variable.

• Owner of the asset
• Retains the tax benefit associated with ownership
  of the asset

Lessor

• User of the asset
• Makes payments to the lessor under the terms of
  the lease

Lessee
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Leasing

• For relatively short-lived assets, such as
  computers or automobiles
• Can be cancelled after some time period
• May be re-leased by lessor after initial leasing
  agreement
• Lessors original cost generally exceeds total
  value of original lessees payments

Operating leases

• For longer-lived assets such as land, buildings,
  and large pieces of equipment
• Cannot be cancelled, obligate the lessee to make
  payments over a defined period of time
• Total payments are greater than the lessors cost.

Financial (capital) leases
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Leasing Arrangements

• Lessor acquires the asset(s) to be leased to the
  given lessee (did not previously own the asset).

Direct lease

• One firms sells an asset to another for cash,
  then leases the asset from the new owner.
• Attractive for firms that need cash and are
  willing to exchange a promise to make periodic
  lease payments for immediate cash.

Sale-leaseback arrangement

• A third party lender is involved.
• Lessor provides only a portion, about 20 of the
  asset value lender provides the balance.
• Popular way of structuring very expensive leases

Leveraged leases
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Leasing Arrangements

• Leasing agreements usually specify who is
  responsible for maintenance of leased assets.
• Operating leases usually require the lessor to
  pay for maintenance, insurance, and taxes.
• Financial leases usually require lessee pay these
  costs.

Maintenance clauses

• Lessee usually has the option to renew a lease at
  expiration.
• Operating leases commonly can be renewed, as the
  useful life of the asset normally extends beyond
  the original lease.
• Instead of renewing the lease, lessee may also
  have a purchase option at the end of the original
  leasing agreement.

Renewal options
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The Lease versus Purchase Decision

• Lease the asset
• Borrow funds and purchase the asset
• Purchase the asset with available liquid resources

Alternatives
Employ a capital budgeting framework

• Step 1 Find the after-tax cash outflows under
  the lease alternative.
• Step 2 Find the after-tax cash outflows under
  the purchase alternative.
• Step 3 Calculate the present value of the
  expected future cash flows under each of the
  alternatives, discounting at the firms
  after-tax cost of debt.
• Step 4 Select the alternative with the lower
  present value of expected cash outflows.

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Effects of Leasing on Future Financing
Similar to long-term debt, leases involve
periodic, tax-deductible payments.
FASB (13) requires explicit disclosure of
financial lease obligations on the firms balance
sheet.
Must be shown as both an asset and as a liability
on firms balance sheet.
Under FASB (13), calculated financial ratios
assessing debt load will include leases along
with other obligations.
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Advantages and Disadvantages of Leasing

• Allows for the effective depreciation of land,
  which is not allowed when land is purchased
• Sale-leaseback can enhance firm liquidity.
• Leasing can provide 100 financing.
• Lower claims against the firm in bankruptcy
• Avoid restrictive covenants that would likely be
  present in a long term loan agreement
• May enhance a firms financing flexibility

Advantages

• Leases do not have stated interest cost.
  Effective cost may be considerably higher than if
  the firm borrowed money.
• At the end of the lease, lessee does not receive
  any salvage value associated with the asset.
• Lessee may not be allowed to modify or improve
  leased assets without lessors approval.
• Even if assets become obsolete or unusable, the
  remaining lease payments must be made.

Disadvantages
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Long-Term Debt And Leasing
Long term debt and leases are important sources
of capital for businesses. The conditions of a
term loan are specified in the loan
agreement. The conditions of a bond issue are
specified in the bond indenture. Leasing serves
as an alternative to borrowing funds to purchase
an asset.