Chapter 10

Medium- to long-term debt

True/False questions
1. F A term loan provided by a commercial bank to a corporate client will always have a fixed
interest rate structure.
2. T A fully drawn advance provided by a commercial bank is simply another name for a term
loan.
3. T An amortised loan is one in which the loan is repaid through a series of regular equal
instalments that comprise interest and principal.
4. T A variable rate loan contract will specify a reference interest rate; changes in the reference
interest rate will impact the interest paid on a variable rate loan.
. T !he lender"s assessment of the credit risk of a borrower will affect the rate of interest
charged on a term loan.
#. F A 1$%year term loan with a fixed interest rate will not be re%priced for the entire period of
the loan.
&. F LIBOR (London inter-bank offered rate) is the rate of interest charged on short-term
corporate loans in the UK market.
'. T (euters is a ma)or provider of electronic information to participants in the financial
markets.
*. F A company is paying ++,- plus ' basis points on a loan. ++,- is currently &.$$ per
cent per annum. !he cost of the loan is therefore 1.$$ per cent per annum.
1$. F .f a bank provides a company with a term loan with a fixed%interest rate/ the company will
not have to pay any other fees as they are incorporated in the fixed rate.
11. F A loan covenant is a guarantee provided by the directors of a company that a term loan will
be repaid by the maturity date.
12. T A mortgage is a form of security taken over land that is granted by a borrower as collateral
to support a loan facility.
13. T -ith mortgage finance/ the mortgagor is the borrower and the mortgagee is the lender.
14. T .f a borrower defaults on a mortgage loan/ the lender will foreclose and sell the property to
recover loan funds outstanding.
1. F !he terms debenture and unsecured note can be interchanged/ since they are both corporate
bonds that have identical features.
1#. T The crowding-out effect contends that there will be a negative correlation in the growth in
the corporate bond market with any significant change in the amount government borrows in the
capital markets.
1&. F ,ubordinated debt holders receive their interest payments and are able to redeem their
principal before other corporate bondholders.
1'. T An operating lease tends to be a short%term relationship/ wherein the lessor may lease the
same asset to successive lessees in order to earn a return on the asset.
1*. F 0ne of the attractions of a finance lease from the point of view of the lessor is that at the
end of the lease the ownership of the asset passes to the lessee/ and thus the lessor is not faced with
residual value risk.
2$. F .n a leveraged lease arrangement/ the lessors contribute the bulk of the finance for the
acquisition of the asset that is to be leased and borrow a small proportion of the total required
finance from the debt parties.
Essay questions
The following suggested answers incorporate the main points that should be recognised by a student.
An instructor should advise students of the depth of analysis and discussion that is required for a
particular question. For example, an undergraduate student may only be required to briefly introduce
points, explain in their own words and provide an example. On the other hand, a post-graduate
student may be required to provide much greater depth of analysis and discussion.
1. The commercial lending manager at A! "an# has a meeting scheduled $ith a business
client. The purpose o% the meeting is to re&ie$ the structure o% the loans pro&ided by the ban#.
'n the period %ollo$ing the economic slo$-do$n that occurred a%ter the global %inancial crisis(
the business is concerned about the relationship o% its longer-term debt commitments and the
cash %lo$s being generated by the business.
)a* +ithin the conte,t o% the economic do$n-turn( $hy is the client concerned about the
timing o% cash %lo$s-
A firm should endeavour to match the maturity structure of its assets with the maturity structure
of its sources of funds/ being its liabilities and shareholder funds.
1or long%term pro)ects it is preferable for the repayment schedule associated with debt finance to
be aligned with the expected future cash flows generated from the pro)ect.
A firm also needs to consider the timing of its cash flows at the commencement of a pro)ect and
throughout the life of the pro)ect.
.n the event of an economic downturn/ the borrower may find that its business contracts and
therefore its expected cash flows will decline and may not be enough to cover loan repayments.
A borrower needs to consider a potential worst%case scenario when making a borrowing decision
in relation to a pro)ect.
)b* .iscuss $ith the client the di%%erent longer-term loan repayment structures that A! "an#
o%%ers.
1irm may have a number of choices on how it will structure the repayments/ or outward cash
flows/ on its longer%term liabilities.
0ne alternative is to obtain debt whereby the debt repayment schedule only requires interest
payments to be made during the term of the loan/ and the repayment of principal is due in full on
the maturity of the loan.
Another loan repayment schedule may require regular periodic loan instalments to be paid. 2ach
loan instalment will require the payment of interest and part repayment of the principal. -ith the
payment of the final loan instalment the loan will have been fully repaid. !his type of loan is said
to be an amortised loan/ or a credit foncier loan.
A further option is for the business to obtain a loan that takes into consideration that it may be
some time before the pro)ect generates positive cash flows. .n this situation it may be preferable
to arrange a deferred repayment type of loan. 3nder such an arrangement/ loan instalments will
only commence after a specified period/ which is determined on the basis of expectations about
when the pro)ect will generate positive cash flows/ with amortisation of the debt to be achieved
over the remaining loan term.
/. The chie% %inancial o%%icer )CF0* o% a corporation has arranged a term loan %or the company
$ith the %ollo$ing conditions attached. The loan $ill ha&e a &ariable rate o% interest o% ""1+
plus 1/0 basis points. The loan interest $ill be reset e&ery si, months %or the duration o% the
loan.
)a* E,plain the operation o% these speci%ic loan conditions.
A term loan is a loan provided by a bank/ or other financial institution/ for a specific purpose/
over a defined period of time.
!he amount and period of the loan is specified in the loan contract.
A loan with a variable interest rate means that the interest rate charged on the principal amount
outstanding will be reset periodically under the terms of the loan contract.
A variable rate loan contract will specify a reference interest rate.
4arious published reference rates are available including ++,-/ 5.+0(/ 3,67 or an
institution"s own prime rate.
8b9 2o$ $ould the CF0 obtain the ne$ interest rate e&ery si, months- )30 10.1*
the above loan is using ++,-/ the +ank +ill ,wap (ate/ which is the average mid%point of
bank"s bid and offer rates in the bank bill secondary market
the loan is set at ++,- plus 12$ basis points/ therefore if ++,- is currently #.4: per annum
then the loan interest rate will be &.#: per annum
both the borrower and lender are able to find ++,- published electronically daily by (euters
At the reset date each six months they will look up the relevant (euter"s ++,- #%month money
screen to ascertain the new rate
4. +hen a ban# pro&ides a loan to a corporation( the interest rate charged on the loan $ill
depend on the ban#5s analysis o% a number o% %actors( including the credit ris# o% the
borro$er( the term o% the loan and the repayment schedule. .iscuss $hy these %actors $ill
impact the interest rate charged by a ban#. )30 10.1*
!he credit risk of the borrower
This is the perceived creditworthiness of the borrower
Before granting a loan, a lender will analyse factors such as the total debt-to-equity ratio of the
firm, projected cash flows, the financial strength of the borrower, past loan repayment
performance, the projected performance of the industry and the economy generally, forecast
interest rates, the management of the firm, and the life cycle of the firms products
Each borrower will be perceived to have a different level of credit risk and therefore will pay a
different rate of interest on the loan.
The term of the loan
Typically, longer-term loans will attract a higher rate of interest than short-term loans due to the
assumed higher risk of a longer-term commitment.
For example, risk factors that affect interest rates include changes in the official interest rate by
the central bank and the amount of liquidity in the credit markets. These and other factors affect
the cost of funds to the lender and therefore are passed on to the borrower.
The repayment schedule
The frequency of loan repayments and the form of repayment may influence the interest rate
applied to a loan; for example, the rate for a borrower who has a loan which requires monthly
repayments may be different from that of a borrower who makes quarterly loan repayments.
;ifferent interest rates may be applied between an amortised loan and an interest%only loan.
4. As the finance manager of a small manufacturing business, you are negotiating a fully
drawn advance from the local bank, but the board of directors has indicated concern at the
fees being charged by the bank. Explain to the directors the range of fees typically charged,
and why the bank charges these %ees. (LO 10.1)
2stablishment fee<represents the costs incurred by the bank in considering the loan application
and in the preparation of documentation on approval of the loan
,ervice fee<represents the ongoing administrative costs incurred by the bank in maintaining the
loan account. ,ervice fees are generally charged monthly
0nce a loan has been approved/ the borrower will be given a short period to draw%down the loan=
that is/ to take the funds from the bank
A commitment fee will usually be applied by the bank to any portion of the total approved loan
amount that is not drawn%down within a specified period/ usually paid in arrears
5ine fee<applied to the total amount of the facility and is normally payable in advance.
6. +estpac "an#ing Corporation is currently $riting a loan contract %or a medium-si7ed
pharmaceutical company. +ithin the loan contract +estpac intends to incorporate a number
o% positi&e and negati&e loan co&enants.
)a* +hat are loan co&enants-
5oan covenants are specified within a loan contract and typically restrict the business and
financial activities and actions of the borrowing firm.
6ommon covenants will require a firm to maintain a minimum level of interest cover= another
may restrict the level of debt that a firm may accumulate relative to its equity.
)b* E,plain $hy a %inancial institution $ould incorporate loan co&enants into a loan contract.
5oan covenants are designed to protect the exposure of the lender to the borrower.
A firm is in technical default on its loan contract if it breaches a loan covenant. !he lender then
has the right/ within the terms specified in the loan contract/ to act to protect its exposure. !his
might involve taking possession of the assets of the company. >owever/ if the company has not
defaulted on loan repayments/ it is more likely that the term loan may become repayable on
demand.
)c* .iscuss the nature o% positi&e and negati&e co&enants and gi&e t$o e,amples o% each. )30
10.1*
7rotective loan covenants are classified as either positive covenants or negative covenants.
A positive covenant states actions that a company must comply with/ such as maintaining a
minimum level of working capital/ or the provision of audited financial statements.
A negative loan covenant limits or restricts the business activities or financial structure of the
company. 1or example/ there may be a limitation placed on the amount of a dividend that can be
paid to shareholders/ or a requirement that the bank must approve further long%term borrowings
of the company.
6. As the owner of a small architectural firm, you approach the Commonwealth Bank to
obtain a term loan so that the firm can buy a new computer %aided drawing machine. The
bank offers your company a loan of $37 000 over a four-year period at a rate of interest of 9.25
per cent per annum( payable at the end o% each month. Calculate the monthly loan instalment.
)30 10.1*
( )

+
=

i
i
A
R
n
1 % 1
where:
R is the instalment amount
A is the loan amount (present value)
i is the current nominal interest rate expressed as a decimal
n is the number of compounding periods
A = $37 000
i = 0.0925 / 12 = 0.007708
n= 4 years x 12 months = 48
( )
month per ?*2.11
$$&&$' . $
$.$$&&$' 1 % 1
?3&$$$

4'
=

+
=

R
R
8. The architectural firm owner in Question 6 also approaches the National Australia Bank to
obtain a quote on the loan facility. The competitor bank (NAB) offers the company a fully
drawn advance of $37 000 over a four-year period at a rate of interest of 9.25 per cent per
annum, payable in advance at the beginning of each month. Calculate the monthly loan
instalment. E,plain $hy the instalment payment is di%%erent %rom the instalment in 9uestion :.
)30 10.1*
( )
( ) i
i
i
A
R
n
+

+
=

1
1 % 1
where:
R is the instalment amount
A is the loan amount (present value)
i is the current nominal interest rate expressed as a decimal
n is the number of compounding periods
A = $37 000
i = 0.0925 / 12 = 0.007708
n= 4 years x 12 months = 48
( )
( )
$# . *1' ?
$$&&$' . $ 1
$$&&$' . $
$$&&$' . $ 1 % 1
3&$$$ ?

4'
=
+

+
=

R

R
.n question # the series of cash flows occurred at the end of each period= this is an ordinary
annuity.
.n question & the loan instalments are payable at the beginning of the period= this is an annuity
due.
!he change in the formulae recognises the change in the timing of the cash flows.
!he earlier loan instalment repayments at the start of each month mean that the monthly
instalment is lower.
;. Mr and Mrs Lim have recently married and are in the process of purchasing their first
home. They have lodged an application to the Commonwealth Bank for a housing loan. The
bank has offered them a mortgage loan. Outline the main features of a mortgage loan. In
particular, define a mortgage, explain the purpose and operation of a mortgage loan and
identify and describe the parties to a mortgage loan. )30 10./*
A mortgage is a form of security against which a loan is advanced.
3nder a mortgage agreement/ the borrower 8mortgagor9 conveys an interest in the land or
property to the lender 8mortgagee9.
!he mortgage is discharged when the loan is repaid.
;uring the life of the agreement/ if the mortgagor fails to meet the terms of the loan/ the
mortgagee is entitled to take control of the property/ and to dispose of it in order to recover its
debt due. !his is called the right of foreclosure.
A mortgage loan is simply a term loan with a specific form of security attached/ being the
mortgage.
@ortgage finance lenders include banks/ building societies/ life insurance offices/
superannuation funds/ trustee institutions/ finance companies/ private individuals/ and
government and semi%government instrumentalities.
!here are residential mortgages and commercial mortgages.
(esidential mortgages 8housing loans9 typically taken over 3$ years in Australia.
6ommercial mortgages are usually for a period of less than 1$ years.
1ixed interest and variable interest mortgage loans are available/ however a fixed rate loans will
typically be reset every two to three years.
@ortgage loans are usually amortised 8credit foncier9 with monthly loan instalments.
@ortgage loans for amounts above '$: of the loan%to%valuation%ratio will generally require
mortgage insurance.
<. As the proprietor o% a business( you plan to purchase ne$ business premises costing =<86
/60. 'n addition( establishment e,penses o% 0.:0 per cent o% the purchase price( plus legal
e,penses o% =8600 are payable. The total cost to purchase the property $ill be %inanced by =460
000 o% your o$n %unds plus a mortgage loan %rom your ban# at <.86 per cent per annum. The
loan $ill be amortised by monthly instalments o&er the ne,t 1$ years. +hat is the amount o%
each monthly instalment-
Total outlays:
cost of premises ?*& 2$
establishment expenses ? '1
legal expenses ?& $$ ?*'' #$1
Funding arrangements:
own savings ?3$ $$$
mortgage finance ?#3' #$1 ?*'' #$1
Formula: ( A A
1 % 81 B i9
%n
i
whereC A A ?#3' #$1
i A .$$'12 8*.&: p.a. D 12 months9
n A 12$ 81$ years E 12 months9
( A #3' #$1
1 % 81.$$'129
%12$
$.$$'12
( A ?' 31.$$ monthly instalment
10. A corporation listed on the ASX is expanding its business operations into China. In order
to expand, the company will need to raise additional funds through the issue of corporate
bonds direct to the capital markets. T$o securities that are issued into the corporate bond
mar#et are debentures and unsecured notes.
)a* 0utline the attributes o% each o% these securities. 'n your ans$er( include a discussion on
the nature o% a %i,ed and %loating charge.
;ebentures and unsecured notes are corporate bonds issued into what is often described as the
corporate bond market
;ebentures and unsecured notes are contracts between the borrower and the lender that specify
that the lender will receive regular interest payments during the term of the loan/ and receive the
face value of the instrument on maturity.
A debenture is the form of security attached to the corporate bond.
!he security takes the form of either a fixed andDor a floating charge over the issuing company"s
unpledged assets.
3nsecured note are corporate bonds issued on an unsecured basis.
!he ranking of bond holders is as followsC
o firstC fixed charge debenture holders are entitled to the proceeds of the sale of the assets over
which the charge has been placed. .f the proceeds from the sale prove to be inadequate to
repay the debenture holders in full the outstanding balance ranks equally with unsecured debt
holders.
o secondC floating charge debenture holders have no claim over the proceeds from the sale of
the pledged assets 8until fixed charge debenture holders" claims have been satisfied9.
>owever/ they rank ahead of unsecured creditors in their entitlement to the proceeds of the
sale of unpledged assets.
o thirdC unsecured note holders have no priority claim over the assets of the company and rank
equally with other unsecured creditors. >owever/ note holders may be somewhat protected if
a deed limits the company in relation to total secured liabilities relative to total liabilities.
.ssues to the public require a prospectus. !his is time consuming and expensive. !herefore many
issuers tend to issue by direct placement with institutional investors/ where the prospectus
requirements are less stringent.
!he yield on a debenture will be lower than that on an unsecured note/ reflecting the lower risk
because of the underlying security and the higher liquidity of debentures listed on the stock
exchange.
)b* Explain which types of borrowers will have access to funds through the issue of debentures
and unsecured notes into the capital markets. )30 10.4*
An issuer of corporate bonds will need to obtain a credit rating on the issue= for example/ a
corporation may require an investment grade credit rating of +++ or above issued by a credit
rating company such as ,tandard and 7oor"s.
0nly issuers with a very good rating will be able to issue unsecured notes because of the higher
risk associated with this type of paper. .ssuers of debentures will generally also require an
investment grade credit rating/ but the security of the debenture may lower the cost of funds
8yield9.
.ssuers of debentures and unsecured notes include finance companies/ multi%national
corporations and commercial banks.
11. The corporate bond mar#et is a signi%icant source o% %unds %or corporations raising %inance
direct %rom the capital mar#ets.
)a* .escribe the structure and operation o% the corporate bond mar#et. 'n your ans$er e,plain
$hy corporations see# to raise debt %unds direct %rom the mar#ets( $hy in&estors pro&ide debt
%unds directly to the capital mar#ets and $ho are the main pro&iders o% direct %inance in the
capital mar#ets.
;irect finance occurs when a borrower issues a financial security into the debt markets in order
to raise funds
!he corporate bond market includes the issue of debentures/ unsecured notes and subordinated
debt
;ebenture<a corporate bond issued with a fixed or floating charge over the assets of the issuer
3nsecured note<a corporate bond issued without any form of underlying security attached
.ncludes both domestic and international capital markets.
-hy do corporations seek to raise debt funds direct from the marketsF
.f a corporation can borrow without the need to use a bank then it is able to save the cost of the
bank"s profit margin.
Another important reason that a corporation will borrow direct from the markets is to diversify
its funding sources.
.f a corporation obtains debt funds from a number of different sources then it is able to choose
the most cost effective sources.
-hy do investors provide debt funds directly to the marketF
+y lending direct an investor is accepting the credit risk associated with the ultimate borrower
and should receive a higher return for the higher risk.
.nvestors will endeavour to measure the credit risk of a particular debt issuer.
0ne international standard used as a measure of the credit worthiness of a borrower is a credit
rating.
A credit rating is the rating agency"s view of the credit worthiness of a debt issue.
-here do direct investment funds come fromF
;eregulation of the financial system with the removal of constraints that would otherwise limit
the flow of funds around the world/ coupled with technology to support the rapid and efficient
conduct of financial transactions/ has encouraged the development of direct investment markets.
.ncreased investor sophistication and the expectation of higher yields on investments have also
drawn a greater pool of investors into the markets/ in particular/ managed funds.
.n many countries there is an ever%increasing pool of accumulated retirement and superannuation
savings that are available for investment.
In recent years there has been a practice by many governments to limit and reduce their net debt
outstanding. This has resulted in an even greater pool of funds available for direct business
investment.
(b) Commercial banks also issue bonds into the capital markets. Some of these bonds may be
described as covered bonds. What are covered bonds issued by commercial banks- )30 10.4*
6overed bonds is the term used to describe a bond issued into the capital markets by commercial
banks.
6overed bonds are regarded as being less risky as they are supported by an underlying security/
being a claim against mortgage securities held by the issuer bank.
.f the commercial bank issuer defaulted on bond repayment the holder of the bonds are able to
seek repayment of the bonds from the sale of mortgage assets held by the bank.
1/. >?! 3imited is a subsidiary o% a multinational organisation rated AA@. The company
plans to issue debentures to raise additional %unds to %inance %urther gro$th $ithin the
company. The in&estment ban# ad&ising the company on the debenture issue has in%ormed the
company that it could issue the debentures through a public issue( a %amily issue or a pri&ate
placement. E,plain each o% the three issue methods. 'nclude in your ans$er a brie% discussion
on prospectus and in%ormation memorandum requirements. )30 10.4*
A debenture is a corporate bond issued with a fixed or floating charge over the assets of the
issuer.
A public issue occurs when the debenture offer is made to the public at large.
A family issue occurs when the debentures are offered to parties associated with the issuer such
as parties who are already holders of the companys securities, including share-holders, bond-
holders and holders of convertible notes.
A private placement occurs when the offer is made only to institutional investors such as funds
managers and insurance offices.
Corporations law will require that an offer of debentures to the public must be accompanied by a
prospectus that has first been registered with the regulator.
A prospectus is a formal written offer to sell securities to the public and will provide detailed
information on the business/ includingC
o financial statements
o directors and executive managers
o specialist accounting/ taxation and legal reports
o any material information that may affect the company
o strategic business plans and the intended use of the funds gained from the issue.
!he prospectus should enable an investor to make an informed decision regarding the
investment opportunity.
A prospectus is time%consuming to prepare and register/ which can be especially costly during
periods of volatile interest rates. !he time delay could prevent a borrower being able to come to the
market with an issue at the most advantageous time.
A private placement does not require the preparation of a prospectus= rather the issuer only
needs to provide institutional investors with an information memorandum.
.nstitutional investors are more informed than the general public and therefore it is not
necessary to provide the full extent of the detail that is incorporated in a prospectus.
!he information memorandum must include up%to%date financial statements/ material changes
that may affect the business/ and the purpose of the debt issue.
14. "2A "illiton 3imited has issued =10 million o% debentures( $ith a %i,ed-interest coupon
equal to current interest rates o% ;./6 per cent per annum( coupons paid hal%-yearly and a
maturity o% se&en years.
)a* +hat amount $ill "2A "illiton ha&e raised on the initial issue o% the debentures-
!he amount raised by +>7 +illiton on the initial issue of the debentures into the market will be
equal to the face value of the debentures= that is/ ?1$ million.
!his is because current yields on this type of security/ at the issue date/ are equal to the fixed
interest rate paid on the debenture.
)b* A%ter t$o years( yields on identical types o% securities ha&e %allen to 8.86 per cent per
annum. The e,isting debenture no$ has e,actly %i&e years to maturity. +hat is the &alue( or
price( o% the e,isting debenture in the secondary mar#et-
.n order to calculate the value/ or price/ of the existing debentures in the market/ it
is necessary to determine the present value of the face value/ plus the present
value of the coupon stream 8noteC the price is being calculated at a coupon date
exactly one year after initial issue9.
( )
( )

+ +

+
=

n
n
i A
i
i
C P 1
1 % 1

A A ?1$ $$$ $$$
6 A ?412 $$
n A x 2 A 1$
i A .$&& D 2 A $.$3'&
Present value of the face value:
A A81 B i9
%n
A ?1$ $$$ $$$ 81 B .$3'&9
%1$
A ?# '3& 3&'.##
plusB
Aresent &alue o% coupon streamB
A 6 G1 % 81 B i9
%

n
H
i
A ?412 $$ G1 % 81 B .$3'&9
%1$
H
.$3'&
A ?3 3## ##1.43
Arice o% the debentureC A ?# '3& 3&'.## B ?3 3## ##1.43
A ?1$ 2$4 $4$.$*
)c* E,plain $hy the &alue o% the debenture has changed; that is, discuss using the above
example the bond price/yield relationship. )30 10.C*
!he price of the existing fixed interest security 8debenture9 has risen because yields in the market
have fallen= that is/ there is an inverse relationship between interest rate movements and price.
!he coupon payments on the existing bond are fixed= therefore the higher coupon being paid on
the existing bond is worth more to an investor.
1C. 0n 1 Danuary /011 a company issued %i&e-year %i,ed-interest bonds $ith a %ace &alue o% =4
million( paying hal%-yearly coupons at <.4: per cent per annum. Coupons are payable on 40
Dune and 41 .ecember each year until maturity. 0n 16 August /01/ the holder o% the bonds
sells at a current yield o% <.;C per cent per annum. Calculate the price at $hich the in&estor
sold the bond. )30 10.C*
( )
( ) ( )
k n
n
i i A
i
i
C P 1 1
1 % 1
+

+ +

+
=

where k is the fraction of elapsed interest period since the last coupon payment.
!hereforeC
i A $.$*'4D2 A $.$4*2$
n A & Gone coupon due 31.12.12/ then 2$13 829/ 2$14 829 and 2$1 829H
C A ?3 $$$ $$$ x $.$*3#D2 A ?14$ 4$$
k A 4# days elapsed in 1'4 day period A 4#D1'4 A $.2
)a* Aresent &alue o% %ace &alueB
A ?3 $$$ $$$ 81 B .$4*2$9
I&
A ?2 143 44*.#3
plus
)b* Aresent &alue o% coupon streamB
43 . '14&#& ?
$4*2$ .
9 $4*2$ . 1 8 1
14$4$$ ?
&
=

+
=

There%oreB 8a9 B 8b9 A ?2 143 44*.#3 B ?'14 &#&.43

A ?2 *' 21&.$#
Arice )adEusted %or elapsed day*B
A ?2 *' 21&.$# 81.$4*2$9
$.2
A =/ <<4 <60.C6
Jote I elapsed days Kuly 31
August 1
4# days elapsed
Jote I days in the full coupon period A 1'4
!hereforeC k A 4# D 1'4
A $.2$$
16. At FE Finance you are the manager o% lease %inance. ?ou ha&e begun to tal# to local
companies to try and sell the concept o% lease %inance %or their businesses.
)a* E,plain to the companies the nature o% lease %inance( and distinguish bet$een operating
leases( %inance leases, sale and lease-back leases, and cross%border leases.
A lease is a contract whereby the owner of an asset/ the lessor/ grants to another party/ the lessee/
the exclusive right to use the asset/ usually for an agreed period of time/ in return for the
payment of rent.
!he lessor is the owner of an asset that is sub)ect to a lease agreement= receives lease rental
payments.
!he lessee is the user of an asset sub)ect to a lease agreement= makes lease rental payments.
5easing is the borrowing 8renting9 of an asset instead of the borrowing of funds to purchase the
asset.
0perating leaseB
A short%term arrangement where the lessor may lease the same asset to successive lessees over
time in order to earn a return on the asset.
!he lease arrangements normally contain only minor penalties for cancellation of the lease. !his
feature leaves the risk of obsolescence of the asset with the lessor.
An operating lease is usually a full service lease= that is/ the maintenance and insurance of the
leased asset is the responsibility of the lessor.
Finance leaseB
Lenerally a longer%term arrangement between the lessor and the lessee.
!he lessor earns a return on the asset from the one lease contract.
!he lessorMs role is essentially one of financing.
!he lessee contracts to make regular lease rental payments/ usually monthly/ over the period of
the lease/ which may be for more than two years.
A distinguishing characteristic of the finance lease is that the lessee contracts to make a lump
sum payment/ representing the residual value of the asset/ at the end of the lease period.
-hen the residual payment is made/ the ownership of the asset normally passes to the lessee and
appears on its balance sheet.
A finance lease is usually a net lease= the costs of ownership and operation of the asset are borne
by the lessee. !hese costs include maintenance and repairs/ insurance/ taxes and stamp duties
associated with the lease.
1ale and lease-bac# leaseB
involves the sale of an asset by its original owner, but the original owner immediately enters into
an agreement with the new owner to lease back the asset for an agreed period
has no need to continue funding the asset from the balance sheet
payments are derived from the income earned from leasing the asset.
Cross-border leaseB
means a lessor in one country leases an asset to a lessee in another country
means there is a need to consider additional factors, including:
o how to recover an asset if the lessee should default on the agreement.
o foreign exchange risk; that is, cash flows will need to be converted into another currency at
the current exchange rate.
o the legal jurisdiction that will apply if legal action needs to be taken under the terms of the
lease.
)b* Aro&ide e,amples o% ho$ a business might use each o% these %orms o% lease arrangement.
0perating lease exampleC a plumber may lease a mechanical digger for a short%term to install gas
pipes in a new residential development. Alternatively/ a special events organiser may lease an
outdoor sound system for a weekend festival.
1inance lease exampleC a corporation leases a number of desk top computer systems for 8say9
two years= or a government department leases a motor vehicle fleet for 8say9 three years.
,ale and lease%back leaseC A government may sell its railway rolling stock to an investment
company and then immediately lease the railway stock back to continue operating the railway
service.
6ross%border leaseC an airline company such as Nantas may lease aircraft from an international
finance group/ or perhaps lease surplus aircraft from +ritish Airways over the summer tourist
season.
)c* 3ist and e,plain the ad&antages o% lease %inance to a business.
5easing does not involve the use of the companyMs capital and other unused lines of credit. !his
allows the company to use its capital to take advantage of other investment opportunities that
may arise.
5easing provides 1$$: financing in that the lessor provides the asset required for use by the
company. 0ther forms of debt funding may require the borrower to contribute a portion of its
own funds.
(ental payments under the lease agreement may be structured to reflect the cash flows generated
by the asset/ that is/ repayment scheduling may be more flexible under lease agreements than
under other forms of debt repayment schedules.
5ease rental payments are generally tax%deductible/ and so it is important to structure the
repayments to match taxable income streams.
2xisting borrowing covenants in loan and note agreements may allow lease financing while
restricting further debt funding.
-here the asset that is the sub)ect of the lease is required for only a relatively short term/ it may
be preferable to lease/ rather than to buy and then have to seek to dispose of the asset at the end
of the period.
(d) From the perspective of a lessor, explain the structure of a direct finance lease versus a
leveraged finance lease contract. )30 10.6*
A direct lease involves two parties, the lessor and the lessee. The lessor retains ownership of the
asset and may also seek additional guarantees to support the lease contract.
A leveraged lease is an arrangement whereby the lessor borrows to fund the purchase of an asset
that is to be leased. Often a lessor partnership is formed for very large ticket items such as ships
and aircraft. Because of the complexity of leveraged leasing arrangements, a lease manager will
be responsible for the management of the contract.
E,tended learning questions
1:. )a* .e%ine the purpose o% securitisation.
,ecuritisation is a form of financing in which the cash flows associated with existing financial
assets are used to service funding raised through the issue of asset%backed securities= for
example/ the securitisation of mortgages involves the pooling of like assets such as registered
first mortgages/ and then issuing securities that give investors a proportional entitlement to the
assets and the income stream that the underlying assets generate.
)b* .ra$ a diagram o% a basic securitisation structure.
)c* Gse your diagram to e,plain in detail the securitisation process.
!he diagrammatic representation of the securitisation process may be summarised as followsC
1inancial assets/ for example housing loans/ accumulate and are funded on a balance sheet by the
loan originator.
Financial
intermediary
Special purpose
vehicle (trustee)
Investors
Service
manager
Credit enhancer
Sell loan assets
Receive funds Issue securities
Receive funds
Cash flows from loan asset
repayments
Cash flows to investors in
asset-backed securities
Assets with comparable maturity and risk structures/ including interest rate/ liquidity and credit
risks/ are pooled together and sold into a special%purpose vehicle 8,749 controlled by a trustee.
!he assets have now moved from the balance sheet of the originator to the balance sheet of the
,74.
!he trustee issues new negotiable securities to investors to raise funds to finance the purchase of
the assets into the ,74. !he new securities are attractive to investors because they are supported
by the mortgage assets held by the trustee/ and by the associated future cash flows/ being the
periodic interest and principal repayments due from the original housing loan borrowers.
!o improve the marketability of the new issue/ a AAB credit enhancement may be created by
guarantees given by a financial institution and supported by the credit rating issued by a credit
rating agency.
A service or administration manager will generally be appointed by the trustee to manage the
associated cash flows. !hese are the receipts from repayments due from the original borrowers/
and payment of interest and principal due on the asset%backed securities issued by the trustee to
investors. !he service manager may also provide custodial services for the underlying securities.
!he trustee may outsource these roles back to the originator.
As cash flows are received from the original assets/ they are used by the trustee to repay interest
and principal due on the asset%backed securities issued to investors.
18. Gp until mid-/008( the gro$th in the securitisation o% assets in the international capital
mar#ets had been enormous.
)a* 'denti%y and discuss at least si, reasons $hy this %orm o% %unding had become so attracti&e.
.ncreased return on equityC business growth is increased without the need to dilute shareholdersM
funds
A source of finance when other traditional sources of intermediated and debt finance may not be
available
.mproved return on assets/ particularly where/ through the securitisation process/ assets with
lower credit ratings are upgraded with credit enhancement
;iversify funding sourcesC asset%backed securities are often attractive to a new range of investors
(educed credit exposureC the sale of assets may transfer the credit risk associated with the pooled
assets to the ,74 and ultimate investors
(egulatory advantageC banks in particular are required to maintain minimum capital
requirements based/ in part/ on their balance%sheet assets
,ecuritisation/ where there is no recourse back to the bank/ removes assets from the balance
sheet and removes the capital cost imposition
.ncreased balance%sheet liquidityC assets which previously were non%liquid and remained on the
balance sheet are converted to cash
(educed asset concentrationC for example/ banks tend to provide a large proportion of their asset
portfolio in mortgage finance<securitisation allows the bank to divest itself of some of these
assets and to give new mortgage finance without increasing its overall mortgage asset
concentration
Accelerated incomeC by divesting assets through securitisation/ an institution effectively brings
forward returns that would otherwise have progressively occurred over time
.mproved financial ratiosC return on investment and return on equity may be improved through
the process of securitisation.
)b* +hat occurred a%ter mid-/008 to slo$ do$n gro$th signi%icantly in the securitisation
mar#et- )30 10.:*
!he initial event that occurred that had a negative impact on the securitisation market was the
sub%prime crisis in the 3,A.
5arge amounts of mortgage loans in the 3,A had been securitised into the international financial
markets.
,ignificant increases in loan default rates caused the failure of some financial institutions and
diminished confidence in the market.
!he mortgage loan problems extended to other countries/ in particular/ the 3O/ further impacting
the securitisation market.
!he sub%prime crisis evolved into a credit crisis within the financial system and ultimately led to
a ma)or global economic downturn.
.n an economic downturn it is expected that default rates on loans will increase which also
reduced any remaining confidence in the securitisation market.
!he global financial crisis was further compounded by a massive increase in sovereign debt/
particularly in the 3,A/ the 2uro%Pone and the 3O. As the sovereign debt crisis worsened/
investors withdrew further from the bond markets/ including securitised assets.
)c* .o you thin# the mar#et $ill reco&er- +hy-
0nce global economic growth and international financial market credit conditions return to
normal it is expected that confidence will slowly return to the securitisation market. >owever/ it
is also expected that the risk structure of future securitised issues will change= that is/ investors
will seek greater protection from default losses.