FINS1612 SUMMARIES

Week 7
Medium to long-term Debt
1/5 Term loans or Fully Drawn Advances
Note: both are provided mainly by commercial banks and finance companies,
though to a lesser degree also by investment banks, merchant banks, insurance
offices and credit unions.
Term loan:
A loan advanced for a specific period (3-15 years) usually for a known purpose
(such as land, PPE), secured by mortgage over asset purchased or other assets of
the entity. (A Fully drawn advance is a term loan where the full amount is
provided at the start of the loan.

Structures of term loans:

o Interest only during term of loan and principal repayment (in
entirety) on maturity.
o Amortised or credit foncier has periodic loan instalments
consisting of interest due and reduction of principal. (Note similarity
to annuity)
o Deferred repayment loan has loan instalments that commence
after a specified period related to project cash flows and the debt is
amortised over the remaining term of the loan. (Note similarity to
annuity)

Interest may be fixed or variable and is based upon an

indicator rate (Recall BBSW) as well as;
Credit risk of borrower (risk of default) giving a risk
premium
Term of the loan (longer terms are higher rates)
Repayment schedule and form of the repayment.

o Other fees include establishment fee, service fee, commitment fee,

line fee, bill option clause fee (where the bank is allowed to convert
the term loan into a commercial bill to sell into money markets and
Additional
Loan
Covenants:
gain quick
cash. Contract
Borrower Information
must still repay
amount)
Positive Covenant requires borrower to take prescribed actions (maintain
minimum Working Capital level for example)
Negative covenant restricts the activities and financial structure of borrower
(maximum D/E ratio, minimum working capital ratio, period unaudited financial
statements for example).

Recall that this is the PV annuity

Calculating the loan instalment (ORDINARY ANNUITY)
just changed around to have C
(normally coupon) as the
VL
=C
element to be determined.
a ( r t 1 )

r1
Note that r must be changed to
be 0.08/12 (for 8% p.a monthly
Calculating the loan instalment (ANNUITY DUE)
instalments), and t would then
be 12 per year of repayment.
VL
(r)=C
t
a ( r 1 )
r1
Note how this is not different the only change is an additional r (say, 1.01 for
12%p.a payments at the beginning of each month). It is an ordinary annuity, just

2/5 Mortgage Finance

A form of security for a loan where the borrower (mortgagor) conveys an interest
in the land and property to the lender (mortgagee) which is discharged when
the loan is repaid.

Calculation is the same as loan payments (though may have to use

quarters rather than months)
Providers include commercial banks, building societies, life insurance offices,
superannuation funds, trustee institutions, finance companies and mortgage
originators.

If the mortgagor defaults on the loan then the mortgagee is entitled to

foreclose on the property (take possession of assets and realise any amount
owing on the loan)
Uses: are usually around retail home loans (up to 30 years) but also
sometimes commercial property loans (up to 10 years) as businesses
generate cash flows that enable earlier repayment.
Interest Rates: can be both variable and fixed (fixed are reset every 5
years or less)
o Mortgagee may also reduce risk by requiring mortgagor to take out
mortgage insurance of up to 100% of mortgage value.

Securitisation:
o This involves conversion of non-liquid assets into new asset-backed
securities that are serviced with cash flows from the original assets.
o Original lenders sell bundled mortgage loans to a special purpose
vehicle

That is, a trust is set up to hold securitised assets and issue

asset-backed securities like bonds, providing investors with
security and payments of interest and principal.

3/5 Debentures, Unsecured Notes and Subordinated

Debt;

These are all issued in the corporate bond market (markets for the direct
issue of longer term debt securities)
o Lenders attract higher risk (compared with lending indirectly
through intermediaries) and higher yield (owing to sharing in the
profit margin usually taken by intermediaries)

Debentures and unsecured notes what are they?

These are corporate bonds

Specify that the lender will receive regular interest payments (coupon)
during the term of the bond and receive repayment of the face value at
maturity.

Unsecured notes bonds with no underlying security attached

Debentures are secured by either a fixed (higher claim than floating)

or floating charge over the issuers unpledged assets.
o These are listed and traded on the stock exchange
o They also have a higher claim over a companys assets than
unsecured note holders.

A floating charge is the same as a fixed charge except it is

applied to assets that the business sells during the normal
course of business (usually inventory). If the company does
default, floating may turn to fixed charge (crystallisation)

Debentures and unsecured notes issuing?

There are three methods of issuing and this is usually at face value but may be
issued at a discount or with deferred or zero interest.
1) Public issue Issue to the public at large, by prospectus
2) Family issue issue to existing shareholders and investors by prospectus
3) Private placement Issue to institutional investors, by information
memorandum
Subordinated Debt?
Claims of debt holders are subordinated to all other company liabilities.

This is more like equity than debt but can be considered quasi-equity.

o May be regarded as equity in the balance sheet, improving credit

rating of issuer.

The agreement may specify that the debt not be presented for redemption
until after a certain period has elapsed.

4/5 Calculations Fixed interest securities;

Because each Coupon Payment will undergo progressively less

computations with the yield (market interest rate) this can be considered
a modified annuity;

a ( r t 1 )
V B =C
r1

What about between coupon dates?;

V B= C

)]

a ( r t 1 )
1
+f
(1+r )k
t
r1
( 1+r )

I.e there must be an adjustment (like moving a loan instalment) by a factor

k where k is the proportion of the time left until the next coupon payment.

o For example a semi-annual bond maturing on May 20 (non-leapyear) bought on 1st of january and to be sold on 31st of December
would have;

K=140/181 because
Jan (31) Feb (28) Mar (31) Apr (30) May (31) June (30) is
181 days.

o But until may 20

th

is 140 days. Hence 140/181

5/5 Leasing;
Contract where the owner of an asset (lessor) grants another party (lessee) the
right to use the asset for an agreed period of time in return for periodic rental
payments
>>>Borrowing an asset itself rather than the funds to purchase an asset
Advantages over borrow-and-purchase for lessee:
o Conserve capital
o Provides 100% financing
o Matches cash flows (rental
payments with income
generated by the asset)

o Less likely to breach any existing

loan covenants
o Rental payments are tax
deductable

 Advantages over giving straight loans for lessor:

o Leasing has relatively low level of overall risk as asset can be taken
back if lessee defaults
o Leasing can be administratively cheaper than providing a loan
o Leasing is an attractive alternative source of finance to both business
and government
Types:
Operating Lease:
o Short-term lease that may be leased to successive lessees. (Good
for short-term projects). Full-service lease Maintenance and
insurance of the asset is provided by the lessor.
o Minor penalties for lease cancellation and obsolescence risk remains
with lessor
Finance lease:
o Longer term financing where lessor finances the asset and earns a
return from a single lease contract and, whilst (Net lease) lessee
pays for maintenance and repairs, insurance, taxes and stamp duties
associated with lease. There is a Residual amount due at the end of
the lease that the lessee pays to transfer ownership of asset.

Cross-border lease:
o A lessor in one country leases an asset to a lessee in another country.

Sale and lease back:

o Existing assets owned by a company or government are sold to raise
cash (such as government car fleet)

The assets are then lease back from the new owner

o This removes expensive assets from the (new) lessees (old owners)
balance sheet.

Lease structures:
Direct Finance Lease:
o Involves two parties (lessor and lessee) where the lessor purchases
equipment with own funds and leases the asset to lessee
o The lessor retains legal ownership of the asset and takes control of
the asset if lessee defaults.
o Generally lessor is a bank or specialist leasing company.

Security of the lessor is provided by lease agreement or

leasing guarantee (agreement by third party to meet
commitments of the lessee in the event of default).

Leveraged finance lease:

o Lessor contributes limited equity and borrows the majority of funds to
purchase the asset and lease to lessee.
o A lease manager structures and negotiates the lease and manages
it for its life as well as brings together the lessor (or equity
participants), debt parties and lessee
o The lessor gains tax advantages from the depreciation of
equipment and the interest paid to debt parties.

Equity Leasing:
o Similar to leveraged lease, except that funds needed to buy the asset
are provided by the lessor (hence usually smaller than leveraged
lease)
o Has many of the characteristics of a leveraged lease, including the
formation of a partnership to purchase the asset, but not the
advantage of leverage.