16

Long-Term Debt
and Lease
Financing

Chapter

McGraw-Hill/Irwin
Copyright 2009 by The McGraw-Hill Companies, Inc. All

Chapter Outline
Analyzing long-term debt
Bond yield and prices
Refunding the obligation upon decline in
interest rates
Long-term lease obligations and its
characteristics
Bankruptcy

16-2

The Expanding Role of Debt

Growth in corporate debt is attributed to:
Rapid business expansion
Inflationary impact on the economy
Inadequate funds generated from the internal
operations of business firms

Expansion of the U.S. economy has placed

pressure on U.S. corporations to raise
capital
New set of rules have been developed for
evaluating corporate bond issues
16-3

Times Interest Earned

for Standard & Poors Industrials

16-4

The Debt Contract

Contract bond: the basic long-term debt
instrument for most large U.S. corporations
basic items include:
Par value: initial value of the bond
Principal or face value

Coupon rate: actual interest rate on the bond

Maturity date: final date on which repayment of
bond principal is due
Bond indenture, a supplement to the bond agreement
16-5

Security Provisions
Secured debts have specific assets pledged
to bondholders in the event of default
These assets are seldom actually sold and
distributed (proceeds)
Terms used to denote collateralized or secured
debts:
Mortgage agreement: real property is pledged
After-acquired property clause: requires any new
property to be placed under the original mortgage

Greater the protection offered, lower the interest

rate on the bond
16-6

Unsecured Debt
Debt that is not secured by a claim to a
specific asset
Debenture: unsecured, long-term corporate
bond
General claim against the corporation, is common for
defaults

Subordinated debenture
Payment to the holder will occur only after the
designated senior debenture holders are satisfied

16-7

Priority of Claims

16-8

Methods of Repayment
Does not always involve a lump-sum
disbursement at the maturity date
Repayment of bonds can be done by:
Simplest method - single-sum payment at maturity
Serial payments: paid off in installments over the life
of the issue
Sinking-fund provision: semiannual/annual
contributions made into a fund run by a trustee
Conversion: converting debt to common stock
Call feature: retire or force in debt issue before
maturity
16-9

Bond Prices, Yields, and Ratings

Financial managers must be sensitive to the
bond market with regard to:
Interest rate changes
Price movements

Market conditions will influence:

Timing of new issues
Coupon rate offered
Maturity date

Bonds do not maintain stable long-term

price patterns
16-10

Bond Price Table

16-11

Bond Yields
Three different ways; computed below:
Example: par value: $1,000; payment: $100/year;
period: 10 years; current price: $900
Coupon rate (nominal yield): interest rate / par value
$100 = 10%
$1,000
Current yield: in terms of the current price
$100 = 11.11%
$900
Yield to maturity: for bonds is held until maturity
Interest rate approximate: 11.70% = payment of $100
for 10 years and a final payment of $1,000
16-12

Bond Ratings
Two major bond rating agencies:
Moodys Investor Service
Standard & Poors Corporation

Ratings are based on a corporations:

Ability to make interest payments
Consistency of performance
Size
Debt-equity ratio
Working capital position, etc.
16-13

Examining Actual Bond Ratings

The true return on a bond is measured by
yield to maturity
If a bond is relatively low in quality:
A corporation pays a yield to maturity, although
they may be secured in nature

16-14

The Refunding Decision

Example: bonds issued at 11.75% witnesses
a drop in interest rates to 9.5%
Assuming that the interest rates will rise:
The expensive 11.75% bonds may be redeemed
A new debt at the prevailing 9.5% may be issued

This process labeled as a refunding operation

It is made possible by the option of call provision

16-15

A Capital Budgeting Problem

The refunding decision involves:
Outflows in the form of financing costs related to
redeeming and reissuing securities
Inflows represented by savings in annual
interest costs and tax savings

16-16

Restatement of Facts

16-17

Steps
A. Outflow considerations:
1. Payment of call premium
2. Underwriting cost on new issue

B. Inflow considerations:
3. Cost savings in lower interest rates
4. Underwriting cost on old issue

C. Net present value:

Present value of inflow present value of
outflow = net present value
16-18

Step C - Net Present Value

16-19

Other Forms of Bond Financing

Two innovative forms of bond financing that
are popular include:
Zero-coupon rate bond
Floating rate bond

16-20

Zero-coupon Rate Bond

A bond that does not pay interest
Advantages to the corporation:
Immediate cash inflow, no outflow until maturity
The difference in the value at maturity can be
amortized for tax purposes

Advantage to the investor:

Allows lock in of a multiplier of the initial investment

Disadvantages:
Annual increase in the value of the bonds is taxable
as ordinary income
Prices are volatile in nature
16-21

Zero-Coupon
and Floating Rate Bonds

16-22

Floating Rate Bond

The interest rate paid on the bond changes
with market conditions
Advantage to the investor:
A constant market value for the security, although
interest rates vary

Exception:
These bonds often have broad limits that interest
payments cannot exceed

16-23

Advantages of Debt
Interest payments are tax-deductible
The financial obligation is clearly specified
and of a fixed nature
Exception: floating rate bonds

In an inflationary economy, debt may be paid

with cheaper dollars
The use of debt, up to a prudent point, may
lower the cost of capital to the firm
16-24

Drawbacks of Debt
Interest and principal payment obligations
are set by contract and must be met
Indenture agreements may place undue
restrictions on the firm
Bondholders may take virtual control of the firm
if important indenture provisions are not met

Utilized beyond a given point, debt may

depress outstanding common stock values
16-25

Eurobond Market
A bond payable in the borrowers currency
but sold outside the borrowers country
Usually sold by an international syndicate of
investment bankers
Disclosure requirements in the Eurobond market
are less demanding

16-26

Examples of Eurobonds

16-27

Leasing as a Form of Debt

Leasing has the characteristics of a debt
A corporation contracts to lease and signs a
noncancelable, long-term agreement
Companies are expected to fully divulge all
information about leasing obligations

Leasing was made official as a result of

Statement of Financial Accounting
Standards (SFAS) No. 13:
issued by the FASB in November 1976
16-28

Capital Lease (Financing Lease)

Four conditions for identification include:
The arrangement transfers ownership of the
property to the lessee by the end of the lease
term
The lease contains a bargain purchase price at
the end of the lease
The lease term is equal to 75% or more of the
estimated life of the leased property
The present value of the minimum lease
payments equals 90% or more of the fair value
of the leased property at the inception of the
lease
16-29

Operating Lease
Does not meet the conditions of a capital
lease
Usually short-term, cancelable at the option
of the lessee
The lessor may provide for the maintenance
and upkeep of the asset
Does not require a capitalization, or
presentation, of a full obligation on the
balance sheet
16-30

Income Statement Effect

Capital lease
Requires treatment similar to a purchaseborrowing arrangement
Intangible asset is amortized, or written off, over the
life of the lease - annual expense deduction
Liability account is written off through regular
amortization - implied interest cost on the balance

Operating lease
Requires annual expense deduction equal to the
lease payment, with no specific amortization
16-31

Advantages of Leasing
Takes care of lack of sufficient funds or the
credit capability issues to purchase assets
Obligation may be substantially less
restrictive
May not require a down payment
Lessors expertise may reduce negative
effects of obsolescence
Lease on chattels have no limitations for
bankruptcy and reorganization proceedings
16-32

Other Advantages of Leasing

Tax advantage factors include:
Depreciation write-off or research-related tax
credits

Infusion of capital can occur if a firm

chooses to engage in a sale-leaseback
arrangement
Allows the lessee to continue the usage of the
asset

16-33