Session 2: Debt Finance

This is the source of funds which can be obtained from external funding agencies. These may include the issue of bonds, preference shares or term loans from financial institutions.

Important Learning Terms

• Debt finance
• Bond
• Nominal/Par/Face value
• Call provision
• Floatation Costs
• Conversion
• Bank borrowing
• Collateral

Introduction
This session introduces the financing sources of business organizations by the use of debt. Specifically it outlines the use of corporate bonds. These include a description of various forms of restrictive covenants, call provisions, convertible and putable bonds, and the types of security that can be used to collateralize bonds. Because many of the characteristics surrounding preferred stock are similar to those of debt, this method of financing is discussed in this session. Debt is something, which at some time, will have to be repaid.

Rationale for Debt Finance
Debt finance is more attractive than equity finance, not only because the costs of raising the funds (for example arrangement fees with a bank or issue costs of a bond) are lower, but because the annual return required to attract investors is less than for equity.

This is because investors recognize that investing in a firm via debt finance is less risky than investing via shares. It is less risky because interest is paid out before dividends are paid so there is greater certainty of receiving a return than there would be for equity holders. Also, if the firm goes into liquidation, the holders of a debt type of financial security are paid before shareholders receive anything. Offsetting these plus-points for debt are the facts that lenders do not, generally, share in the value created by an extraordinarily successful business and there is an absence of voting power – although debt holders are able to protect their position to some extent through rigorous lending agreements.

When a company pays interest the tax authorities regard this as a cost of doing business and therefore it can be used to reduce the taxable profit. This lowers the effective cost to the firm of servicing the debt compared with servicing equity capital through dividends which are not tax deductible. Thus to the attractions of the low required return on debt we must add the benefit of tax deductibility.

Dangers in the Use of Debt Finance
There are dangers associated with raising funds through debt instruments. Creditors are often able to claim some or all of the assets of the firm in the event of non-compliance with the terms of the loan. This may result in liquidation. Institutions which provide debt finance often try to minimize the risk of not receiving interest and their original capital. They do this by first of all looking to the earning ability of the firm, that is, the pre-interest profits in the years over the period of the loan.

The Corporation Bond
A corporate bond represents a promise of the borrower (e.g., a corporation) to make interest and principal payments to the lender (the creditor or bondholder) according to a specified timetable.

A bond is a long-term contract in which the bondholders lend money to a company. In return the company (usually) promises to pay the bond owners a series of interest, known as the coupon payments, until the bond matures. At maturity the bondholder receives a specified principal sum called the par, face or nominal value of the bond. The time to maturity is generally between 7 and 30 years

The bond indenture spells out the specifics of the bond contract:

1. Face value, maturity date, coupon rate of interest, and payment dates
   Note: The bond's Yield to maturity (YTM) is not set in the indenture--it is determined by the going market rate of interest
2. Any security to be used as collateral in case of default
3. Early payment procedures:

Bonds with staggered maturities are sold in packages with part of the total issue being paid off as it matures.

A bond issue with a sinking fund is paid off in portions as contributions to the fund are made each year.

A call provision gives the option to the corporation to retire the bonds before maturity (to "call" the bonds) at a pre-stated call price. A decrease in interest rates provides the incentive for firms to exercise the call option (known as a refunding operation)

The decision whether to refund or not is a capital budgeting decision. There are cash outflows involved in the form of the call premium that are usually required when bonds are called, flotation costs incurred when new bonds are sold, and tax deductions lost when lower-interest-rate bonds replace higher-interest-rate bonds. The inflows come mainly from the interest savings (lower payouts of interest represent cash inflows) that come when high-interest-rate debt is retired and replaced with lower-interest-rate debt.

Types of restrictive covenants:
Note: Restrictive covenants set limits on the kinds of business decisions the firm can make if those decisions might jeopardize the ability of the firm to honour its bond contract

Restrictive covenants, by lowering risk, tend to lower the return required by purchasers of the firm's bonds. Examples are:

• Limitations on future borrowings
• Restrictions of dividend payments
• Maintaining minimum levels of working capital

Bond Variations
Bonds which are sold at well below the par value are called deep discounted bonds, the most extreme form of which is the zero coupon bond. It is easy to calculate the rate of return offered to an investor on this type of bond.

These bonds are particularly useful for firms with low cash flows in the near term, for example firms engaged in a major property development which will not mature for many years.

Another variation in bond markets is the floating rate loan (FRN). These instruments pay an interest that is linked to a benchmark rate – such as the LIBOR (London Inter-Bank Offered Rate – the rate that banks charge each other for borrowed funds). The issuer will pay, say 70 basis points (0.7 of a percentage point) over LIBOR. The coupon is set for, say, the first six months at the time of issue, after which it is adjusted every six months; so if LIBOR was 10%, the FRN would pay 10.7% for that particular six months. Junk bonds and convertible bonds are amongst the other variations on the basic vanilla bond.

Types of secured and unsecured bonds:
Mortgage bonds are secured by real physical assets. Bonds backed only by the good name of the firm are unsecured bonds known as debentures
Senior debentures stand ahead of subordinated debentures in the case of liquidation of the firm's assets
Convertible bonds contain an embedded option giving the owner the right to convert the bond to a pre-specified number of shares of the firm's stock.

Advantages of convertible bonds to the company
Convertible bonds have the following advantages to the company

1. Lower interest than on a similar debenture – the firm can ask investors to accept a lower interest on these debt instruments because the investor values the conversion right.
2. The interest is tax deductible – because convertible bonds are a form of debt the coupon payment can be regarded as a cost of the business and can therefore be used to reduce taxable profit.
3. Self liquidating – when the share price reaches a level at which conversion is worthwhile the bonds will (normally) be exchanged for shares so the company does not have to find cash to pay off the loan principal – it simply issues more shares. This has obvious cash flow benefits. However the disadvantage is that the other equity holders may experience a reduction in earnings per share.
4. Fewer restrictive covenants – the company has greater operating and financial flexibility than they would with a secured debenture. Investors accept that a convertible is a hybrid between debt and equity finance and do not tend to ask for high-level security, impose strong operating restrictions on managerial action or insist on strict financial ratio boundaries.
5. Underpriced shares – a company which wishes to raise equity finance over the medium term but judges that the stock market is temporarily underpricing its shares may turn to convertible bonds. If the firm does perform as the managers expect and the share price rises, the convertible will be exchanged for equity.

Advantages of convertible bonds to the investor
The advantages of the convertible bonds to the investor are as follows:

1. They are able to wait and see how the share price moves before investing in equity.
2. In the near term there is greater security for their principal compared with equity investment, and the annual coupon is usually higher than the dividend yield.

Valuing Bonds
Bonds, particularly those which are traded in secondary markets, are priced according to supply and demand. The main influences on the price of a bond will be the general level of interest rates for securities of that risk level and maturity. If the coupon is less than the current interest rate the bond will trade at less than the par value (say, of $100).

Example 1
Take the case of an irredeemable bond with an annual coupon of 8%. This financial asset offers to any potential purchaser a regular $8 per year forever. When the bond was first issued general interest rates for this risk class may well have been 8% and so the bond may have been sold at $100. However interest rates change over time. Suppose that the rate demanded by investors is now 10%.

Investors will no longer be willing to pay $100 for an instrument which yields $8 per year. The current market value of the bond will fall to $80 ($ 8/0.10) because this is the maximum amount needed to pay for similar bonds given the current interest rate of 10%. If the coupon is more than the current market interest rate the market price of the bond will be greater than the nominal (par) value. Thus, if market rates are 6% the irredeemable bond will be priced at $133.33 ($8/0.06).

Variable rate bonds are coupon-paying bonds where the coupon interest rate (and dollar coupon) is tied to a common market rate such as the current interest rate on Treasury bonds.

Relative to fixed coupon rate bonds, variable rate bonds protect the lender from rising interest rates.

A putable bond gives the owner the right to sell the bond back to the issuer before maturity at a pre-specified price.

Typically investors will exercise their put option when interest rates have risen.

A junk bond (a high yield bond) is a bond that is rated below investment grade.

Junk bonds reflect the return/risk tradeoff in that a higher return is required by the investor to compensate for increased default risk.

An international bond is one sold in a country different from the issuing company.
An international bond can be denominated in the domestic currency of the issuing country (a Eurobond) or the local currency of the foreign country.

Bank Borrowing
An alternative to going to the capital markets to raise money via a public bond issue or a private bond placement is to borrow directly from a bank.

In this case a tradable security is not issued. The bank makes the loan from its own resources and over time the borrowing company repays the bank with interest. Borrowing from banks is attractive to companies for the following reasons:

1. Administrative and legal costs are low
2. Quick – the key provisions of a bank loan can be worked out speedily and the funding facility can be in place within a short time.
3. Flexibility – if the economic circumstances facing the firm should change during the life of the loan banks are generally better equipped (and are more willing) to alter the terms of the lending agreement than bondholders.
4. Available to small firms – theoretically, bank loans are available to firms of almost any size whereas the bond market is for the big players only.

Factors for a Firm to Consider when Contemplating Bank Borrowing
There are a number of issues a firm needs to address when considering bank borrowing.

1. Costs
   The borrower may be required to pay an arrangement fee, say 1% of the loan, at the time of the initial lending, but this is subject to negotiation. The interest rate can be either fixed or floating.

   Floating-rate borrowings have advantages for the firm over fixed-rate borrowings:
   • If interests fall the cost of the loan falls.
   • At the time of arrangement fixed rates are usually above floating rates (to allow for lenders’ risk of mis-forecasting future interest rates).
   • Returns on the firm’s assets may be positively related to times when higher interest rates reign and therefore the risk of higher rates is offset.
   However, floating rates have some disadvantages:
   • The firm may be caught out by a rise in interest rates.
   • There will be uncertainty about the precise cash outflow effects of the interest.

2. Security Bonds
   When banks are considering the provision of debt finance for a firm they will be concerned about the borrower’s competence and honesty. They need to evaluate the proposed project and assess the degree of managerial commitment to its success.
   The firm will have to explain why the funds are needed and provide detailed cash forecasts covering the period of the loan. Between the bank and the firm stands the classic gulf called “asymmetric information” in which one party in the negotiation is ignorant of, or cannot observe, some of the information which is essential to the contracting and decision-making process.
   Another way for a bank to reduce its risk is to ensure that the firm offers sufficient collateral for the loan. Collateral provides a means of recovering all or the majority of the bank’s investment should the firm fail. If the firm is unable to meet its loan obligations then holders of fixed-charge collateral can seize the specific asset used to back the loan. Also, on liquidation, the proceeds of selling assets will go first to the secured loan holders, including floating-charge bank lenders.
   Collateral can include stocks, debtors and equipment as well as land, buildings and marketable investments such as shares in other companies.
   
3. Repayment
   A firm must carefully consider the period of the loan and the repayment schedules in the light of its future cash flows.

   For some situations repayment holidays or grace periods may be granted, with the majority of the repayment being made once cash flows are sufficiently positive.

   A term loan is a business loan with an original maturity of more than one year and a specified schedule of principal and interest payments. It may or may not be secured and has the advantage over the overdraft of not being repayable at the demand of the bank at short notice. The terms of the loan are usually tailored to the specific needs of the individual borrower and these are capable of wide variation.