F3 – Financial Strategy CH5 Financing – debt finance

Chapter 5
Financing – debt finance

Chapter learning objectives:

Lead Component Indicative syllabus content

B.2 Analyse long-term Analyse: • Types of debt instruments and criteria for
debt finance. (a) Selecting debt selecting them
instruments • Managing interest, currency and refinancing
(b) Target debt profile risks with target debt profile
(c) Issuing debt • Private placements and capital market
securities issuance of debt
(d) Debt covenants
(e) Tax considerations • Features of debt covenants

Page 1
 F3 – Financial Strategy CH5 Financing – debt finance

1. Debt finance – introduction

Bank borrowings
The simplest and most convenient form of long-term debt finance is to arrange a loan
through a bank. Considerations on bank borrowings as debt finance include:
• Fixed interest vs variable interest
• Secured vs unsecured
• Period of maturity
• Currency

Security charges
Fixed charge:
• The debt is secured against a specific asset, i.e. land or building.
• This is a preferred form of security.
• In the event of liquidation, the lender is first in the queue of creditors.
Floating charge:
• The debt is secured against the general assets of the business.
• Not such a strong form of security.
• Confers a measure of security on liquidation as a “preferred creditor”, meaning that the
lender is higher in the list of creditors than otherwise.

Covenants
• A covenant is a further means of limiting the risk to the lender by restricting the actions of
directors.
• These are specific requirements or limitations laid down as a condition of taking on debt
financing.

Page 2
 F3 – Financial Strategy CH5 Financing – debt finance

Dividends
restriction

Financial
ratios
Covenants
Financial
reports

Issue of
further debt

Positive and negative debt covenants

Positive covenants: Negative covenants:

States what a borrower must do and may States what a borrower must NOT do and
include the following: may include the following:
• Maintain certain minimum financial • Incur additional long-term debt
ratios
• Pay cash dividends exceeding a certain
• Maintain accounting records in threshold
accordance with GAAP
• Sell certain assets
• Provide audited financial statements
• Enter into certain types of lease
• Perform regular maintenance of assets
• Combine in any way with another firm
used as security
• Compensate or increase the salaries of
• Maintain life insurance policies on
certain employees
certain key employees
• Pay taxes and other liabilities when due

Breach of a covenant – possible responses:

• Waive the breach and continue the loan.
• Waive the breach and impose additional constraints.
• Require a penalty payment.
• Increase the interest rate.
• Demand immediate payment of the loan.
• Increase the security needed.
• Terminate the debt agreement.

Page 3
 F3 – Financial Strategy CH5 Financing – debt finance

Types of debt finance

Debt can be raised from two general sources:
Bank finance: Capital markets:

• Appropriate for both listed and non-listed • An alternative to borrowing funds

companies from the banks if the company is
listed on a stock exchange
• Could be high-street banks or merchant
banks • A listed entity on a stock exchange
may issue long-term bonds to
• Negotiable terms and conditions depending
investors in the capital market
on the terms of borrowing and the credit
rating of the company wishing to make the
borrowing

Criteria for selecting debt instruments:

Entities deciding whether to issue a bond or borrow from a bank to finance a particular
investment should consider:
• Flexibility – banks are more willing and able to support a company through financial
difficulties than bondholders are. Debt covenants should be examined to see if they place
unacceptable restrictions on an entity’s future activities.
• Availability – public bond issues are only likely to be available to large companies with
good credit ratings.
• Cost – The cost of finance will always be a consideration, as well as issue costs.
• Time period – does the maturity of the loan match the maturity of the investment and the
entity’s desired maturity mix?
• Speed – bank loans are quick to arrange compared to many other forms of finance, such
as bonds and debt factoring.
• Tax – for example, Eurobonds might not be subject to withholding tax in some countries.
Zero-coupon and deep-discount bonds involve zero or low-interest payments, which
mean that the company will not benefit from tax relief on interest.

Page 4
 F3 – Financial Strategy CH5 Financing – debt finance

Examples of long-term debt finance

Long-term
debt finance

Bank finance Capital

markets

Revolving Commercial
Money market
credit facilities Bonds paper
Borrowing
(RCFs)

Bank finance:
Money market borrowing:
• Consists of financial institutions and dealers in money or credit that either wish to borrow
or lend.
• Used by participants as a means of borrowing or lending in the short term, from several
days to just under a year.
• Contrasts with the capital market for longer-term funding, for example, bonds and equity.
Revolving credit facilities:
• The borrower may use or withdraw funds up to a pre-approved credit limit.
• The amount of the available credit decreases and increases as funds are borrowed and
then repaid.
• The borrower makes payments based on only the amount they have actually withdrawn
or used, plus interest, and the borrower may repay the borrowing over time or in full at
any time.
• Very flexible debt financing options.
• Enable a company to minimise interest payments, because the amount of funds borrowed
fluctuates over time and is never more than the company needs.

Capital markets:
Bonds:
• A bond is a debt security in which the issuer owes the holder a debt.
• Depending on the terms of the bond, the issuer is obliged to pay interest.
• And/or to repay the principal at a later date.
Page 5
 F3 – Financial Strategy CH5 Financing – debt finance

• A bond is like a loan.

• The issuer is the borrower (debtor).
• The holder is the lender (creditor).
• The holder is more commonly referred to as the investor, and the coupon is the interest.
• Bonds provide the borrower with external funds to satisfy long-term funding requirements.
• Bonds have defined terms and a maturity after which the bond is redeemed.
Commercial papers:
• Large profit-making entities may issue unsecured short-term loan notes in the capital
market, referred to as commercial papers.
• These loan notes will generally mature within 9 months, typically between a week and
three months.
• These notes can be traded at any time before their maturity date.

International debt finance

• Large companies can borrow money in foreign currencies as well as in their domestic
currency from banks at home or abroad.
• The main reason for wanting to borrow in a foreign currency is to fund a foreign investment
project or foreign investment.
• The foreign currency borrowing provides a hedge of the value of the project or subsidiary
to protect against changes in the value due to currency movements.
• The foreign currency borrowings can be serviced from cash flows arising from the foreign
currency investments.

The choice of currency for debt finance:

• In the developed countries of the world, companies can choose which currency they
prefer for both bank borrowings or bonds.
• In most developed countries, companies will need to raise finance in an international
currency such as US dollars.

Eurobonds:
• These are bonds issued on the international capital markets.
• They can be denominated in any major international currency.
• May be listed on the domestic currency stock exchange but cannot be traded through that
exchange.
• They are usually bearer instruments and pay interest annually, gross of tax.
• The Eurobond market is a self-regulated off-shore market.

Page 6
 F3 – Financial Strategy CH5 Financing – debt finance

• Self-regulation is promoted by the international capital market association (ICMA), which

sets rules for members in areas such as processing transactions and the payment of
commission.

Preference shares
• It is worth mentioning these here, as shares may not only be equity finance.
• These are shares with a fixed rate of dividend that have a prior claim on profits available
for distribution (unlike ordinary shares, where the dividend can fluctuate). On the
liquidation of a company, preference shares rank higher than ordinary shares.
• Although legally equity, these are often treated as debt because they carry a fixed
dividend, thus creating an obligation to pay cash, making them similar to debt.
• Dividends are only payable if there are sufficient distributable profits. The dividends are
not tax-deductible to the company.
• If not sufficient, then the right to a dividend is carried forward if they are cumulative
preference shares. Otherwise, the right to the dividend for that year is lost.

2. Target debt profile

Interest rate risk

Interest rate risk is the risk of gains or losses on assets and liabilities due to changes in
interest rates. It will occur for any organisation that has assets or liabilities on which interest
is payable or receivable.

Types of interest rate risk exposure:

• Floating-rate borrowings: if a company has floating-rate borrowings, changes in interest
rates alter the amount of interest payable or receivable. This directly affects the cash
flows and profits, and the risk, therefore, is quite obvious.
• Fixed-rate borrowings: if the company has fixed-rate borrowings, interest rate risk still
exists. Even though interest charges themselves will not change, a fixed rate can make
a company uncompetitive if its costs are higher than those of companies with a floating
rate and the interest rate falls.

Refinancing risk
Refinancing risk is associated with interest rate risk because it looks at the risk that borrowing
will not be refinanced at the same rates.

Page 7
 F3 – Financial Strategy CH5 Financing – debt finance

Reasons for refinancing risk:

• Lenders are unwilling to lend or are only prepared to lend at higher rates.
• The credit rating of the company has reduced, making it a more unattractive lending
option.
• The company may need to refinance quickly and therefore have difficulty in obtaining the
best rates.

Currency risk
Currency risk is the risk that arises from possible future movements in an exchange rate. It is
a two-way risk since exchange rates can move either adversely or favourably.
Currency risk affects any organisation with:
• Assets or liabilities in a foreign currency
• Regular income and/or expenditures in a foreign currency
• No assets, liabilities or transactions that are denominated in a foreign currency. Even if a
company does not deal in any currency, it will still face a risk, since its competitors may
be faring better due to favourable exchange rates on their transactions

3. Other sources of finance

• Retained earnings/existing cash balances - retained earnings are profits accumulated
over the company’s life. That does not mean that the company can use them to fund its
project. They are not the same as cash – cash (internal sources) can be used to fund new
projects.
• Sale and leaseback
• Grants – provided by local/national governments and other larger bodies.
• Debt with warrants attached – a warrant is an option to buy shares at a specified point
in the future for a specified price. They are usually used together with bonds as a
sweetener to encourage investors to purchase the bond.
• Convertible debt – similar to a warrant except that it can be detached and traded
separately (a warrant cannot). It is where debt can be converted into shares.
• Venture capital – finance provided to young unquoted startups to help them grow. It is
usually equity finance. Venture capitalists expect low dividends but higher capital gains
on exit (e.g. via IPO or flotation).
• Business angels – similar to venture capitalists. VCs are interested in bigger companies,
while business angels are wealthy investors who provide finance to small businesses.
• Government assistance

Page 8
 F3 – Financial Strategy CH5 Financing – debt finance

4. Lease vs buy decisions

If a new project requires the use of an asset such as a machine, a business often has a choice
of whether to buy the asset or lease it.
Lease:
A lease is a commercial agreement where an equipment owner (lessor) coveys the rights to
use equipment in return for payment by the equipment user (lessee) of a specified rental
over a pre-agreed period of time.

Lease or buy decisions

To evaluate whether an asset should be leased, or whether money should be borrowed to
buy the asset, compare the NPVs of:
1. The cash flows related to leasing (e.g. lease payments and associated tax relief on the
interest).
2. The cash flows related to the purchase (e.g. capital cost, residual value, tax
depreciation allowances tax relief, maintenance costs).
Discount BOTH options at the POST TAX cost of debt – to reflect the fact that both options
are considered to have similar risk (the risk associated with borrowing).
The cheaper alternative (lower negative NPV) should be chosen.

5. Chapter summary

Page 9