Chapter

16

Long-Term Debt and Lease Financing

Revised By: P Chua Prepared by: Terry Fegarty May 4, 2005

McGraw-Hill Ryerson

2003 2003 McGraw-Hill RyersonLimited McGraw-Hill Ryerson Limited

PPT 16-2

Chapter 16 - Outline
Bonds

Terminology Priority of Claims on Bankruptcy Methods of Retiring (Repaying) Bonds Reading Bond Price Quotations 3 Types of Bond Yields Bond Ratings Other Forms of Bond Financing Lease vs. Purchase 2 Types of Leases Advantages/Disadvantages of Debt Advantages/Disadvantages of Leasing Summary and Conclusions
2003 McGraw-Hill Ryerson Limited

Bond

PPT 16-4

Bonds
Firms

and governments borrow money from investors by selling bonds A bond is a written promise that the borrower (firm) will pay the lender (investor) at a stated future date, the principal plus a stated rate of interest Bonds differ from one another in terms of maturity (payment date), potential yield (interest rate), and investment quality (risk) Several companies rate the quality of various bonds
2003 McGraw-Hill Ryerson Limited

PPT 16-5

Bond Terminology
Par Value: principal or face value (usually $1,000) Coupon Rate: stated interest rate Maturity Date: date when repayment of principal is due Indenture: legal document detailing the corporations obligations and Restrictive Covenants Secured Debt: where specific assets are pledged in the event of default Debenture: a L/T unsecured corporate bond
2003 McGraw-Hill Ryerson Limited

PPT 16-6

Figure 16-2

Priority of claims
Secured debt Senior Junior Unsecured debt (debentures) Senior Subordinated Subordinated debenture holders will not receive payment unless designated senior debenture holders are paid in full. First claim on assets pledged Second claim on assets pledged

Remaining assets are distributed below.

Lower priority of claims Preferred stock Common stock

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PPT 16-7

Methods of Retiring (Repaying) Bonds

Principal at maturity: lump-sum payment when bond is due Serial payments: bond is paid off in installments Sinking fund: 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
2003 McGraw-Hill Ryerson Limited

PPT 16-9

Reading Bond Price Quotations

Company Name
Issuer

Coupon
(interest rate %)
Your Daily Paper
Coupon Maturity Price

Maturity Date
(April 8, 2022)
Yield Change

BC Tel

9.65

Apr 8-22 138.5

6.488

+1.118

Price
(Last transaction price = $138.50/ $100)

Change

Yield
(Annual interest Market price)

(Closing price up $1.11 from previous day)

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Table 16-2:

PPT 16-10

Interest rates and bond prices (the bond pays 12 percent interest)
Years to Maturity Rate in the Market (percent)

1 15 25

8% 10% $1,037.72 $1,018.59 1,345.84 1,153.72 1,429.64 1,182.56

12% $1,000 1,000 1,000

14% $981.92 875.91 861.99

16% $964.33 774.84 755.33

Note: This table is based on semiannual interest payments, with annualized interest rates

2003 McGraw-Hill Ryerson Limited

PPT 16-11

3 Types of Bond Yields

Coupon Rate (or Nominal Yield ): interest payment divided by par value Current Yield: interest payment divided by current price of the bond Yield-to-Maturity (YTM): interest rate that equates the future (expected) interest payments and payment at maturity to the current market price of the bond affected by current market interest rates
If rates , YTM , bond price

and bond rating

If rating high (low risk), YTM
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Figure 16-3

PPT 16-12

Long-term yields on corporate debt

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PPT 16-13

Bond Ratings
Bond Ratings
Rating Service High Grade Aaa Aa AAA AA AAA Low Medium Grade (Investment Poor Speculative Grade Grade) A Baa A BBB BBB Ba B BB B B Caa to C CCC to D C High

Moody's Standard & Poor's Dominion

Risk Factor

2003 McGraw-Hill Ryerson Limited

PPT 16-14

Table 16-3
Rating/Issuer

Outstanding debt issues, March 1, 2002

Coupon 5.630 5.750 8.000 8.150 6.685 6.600 7.400 6.700 7.850 6.000 6.650 10.000 5.800 10.500 6.750 6.600 Maturity Date Dec. 21/05 Sept. 01/06 June 01/27 May 9/06 Dec. 31/11 Dec 01/06 June 01/27 June 28/07 April 02/31 June 02/08 Nov. O8/27 Apr. 15/11 Jan. 30/07 June 01/06 Feb 02/04 July 18/07 Price 102.94 104.10 127.72 111.29 101.69 106.13 109.78 105.74 106.11 101.92 96.67 108.21 97.69 103.00 72.00 71.00 Yield to Maturity 4.77 4.72 5.88 5.11 6.45 5.12 6.60 5.44 7.34 5.63 6.93 8.68 6.35 9.61 26.29 14.56 AAA CARDS Trust Receivables Government of Canada Government of Canada AA BMO BMO Nav Canada Nav Canada A Bell Canada Bell Canada Loblaw Loblaw BBB Domtar Talisman BB Rogers Cable B Air Canada Saskatchewan Wheat Pool

2003 McGraw-Hill Ryerson Limited

PPT 16-17

Other Forms of Bond Financing

Zero-Coupon Bond / Strip Bond: does not pay interest is issued at a deep discount from face value Floating Rate Bond: interest 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 another country
2003 McGraw-Hill Ryerson Limited

PPT 16-18

Table 16-4

Examples of Eurobonds
Amount Outstanding Currency Rating Coupon Maturity ($ millions) Denomination*

Petro-Canada Procter & Gamble Co. Sony Corporation Telecom Corporation

Baa1 Aa2 Aa3 Aa1

9.25% 10.88% 1.40% 7.50%

2021 2003 2005 2003

300.0 200.0 300.0 100.0

U.S.$ C$ Yen N Z$

*C$ is Canadian dollar, and N Z $ is New Zealand dollar.

Source: Mergent Bond Report,July 2000

Source: Moodys Bond Record, July 1998..

2003 McGraw-Hill Ryerson Limited

PPT 16-19

Advantages and Disadvantages of Debt

Advantages of Debt: interest payments are tax deductible to a firm wise use of debt may lower a firms weighted average cost of capital (WACC) financial obligation is fixed no reduction in control or equity of present shareholders company may get a better return on equity from leverage
2003 McGraw-Hill Ryerson Limited

PPT 16-20

Advantages and Disadvantages of Debt

Disadvantages of Debt:

interest

and principal must always be met when due, regardless of a firms financial position agreements may restrict financial management in firm poor use of debt may lower a firms stock price expensive financing when interest rates are high
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PPT 16-21

2 Types of Leases
Capital Lease (or Financing Lease):
Lease payments are usually sufficient to fully cover the lessors cost of purchasing the assets and provide the lessor a return on investment The lessee is usually responsible for the upkeep of the asset Generally, lease cannot be cancelled must be shown on a firms balance sheet ex., oil drilling equipment and airplanes

2003 McGraw-Hill Ryerson Limited

PPT 16-21

2 Types of Leases
Operating Lease:
Usually a shorter term lease a conventional rental agreement Often cancellable on short notice Lessor is responsible for upkeep of asset firm doesnt expect to own the asset is not shown on a firms balance sheet ex., automobiles and office equipment

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Capital Lease Criteria

A lease is considered a Capital Lease if it meets one of the following criteria: The lease transfers ownership of the asset to the lessee at the end the lease term Lessee has the option to purchase the asset at a price below the fair market value when the lease expires. The lease term is 75% or more of the estimated economic life of the asset The PV of the lease payments is at least 90% of the fair market value of the asset at the start of the lease
2003 McGraw-Hill Ryerson Limited

PPT 16-22

Advantages of Leasing

A loan may be more expensive / 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 (ex: 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 (ex: computers) May have more tax advantages using a lease
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Lease vs Borrow-Purchase Problem

A Firm is considering the purchase of an asset as opposed to leasing it. The asset costs $5,000. To purchase it, the firm must get a loan from its bank. The loan amortization will be $1,319 for 5 years at 10%. Interest payments from yrs. 1 to 5 are: $500, $418, $328, $229, and $120. CCA rate is 20 %. To lease the asset, the firm must pay $1,250 during the 1st and 2nd years, and $1,800 during the 3rd to 5th years. Note that lease payments are made at the beginning of each year. Tax rate is 40% Which option is less costly?

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Table 16-7

PPT 16-23

Net present value of borrow-purchase

Year (1) PV of CCA Shield (2) (3) Interest Tax Shield (4) Aftertax Cost of (2)-(3) (5) Present Value at 6%

Payment

1............ 2............ 3............ 4............ 5............

($1,319) ($1,319) ($1,319) ($1,319) ($1,319)

$500 x .4 $418 x .4 $328 x .4 $229 x .4 $120 x .4

$(1,119) (1,152) (1,188) (1,227) (1,271)

$(1,056) (1,025) (997) (972) (950) (5,000)

Or

Cost of asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . PV of CCA shield . . . . . . . . . . . . . . . . . . . . . . . . . . . . PV of borrowing alternative . . . . . . . . . . . . . . . . . . .

(5,000) 1,495 ($3,505)

2003 McGraw-Hill Ryerson Limited

Table 16-8

PPT 16-24

Net present value of operating lease outflows

Year Payment Tax Shield Aftertax Cost of Leasing Present Value at 6%

0 . . . . . . . . ($1,250) 1........ 2........ 3........ 4........ 5........ (1,250) (1,800) (1,800) (1,800) 0

$ 0 500 500 720 720 720

($1,250) (750) (1,300) (1,080) (1,080) 720

($1,250) (708) (1,157) ( 907) ( 855) 538 ($4,339)

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PPT 16-25

Summary and Conclusions

Debt

financing by major corporations often involves the sale of secured bonds or unsecured bonds (debentures). Corporate bonds may have sinking-fund, call, or conversion features causing retirement before maturity. Bond prices and yields are inversely related and are based upon the level of interest rates and bond ratings Long-term capital leases are an alternative form of long-term financing
2003 McGraw-Hill Ryerson Limited