Session 6: Bond and Other Long Term Finance

Transport Financial Analysis

Page 38 of 43 pages. Chapter: 12: Sources of Funding for Transport Sector

Session 6: Bond and Other Long Term Finance

Learning Objective

Explain to the learner the various sources of finance available to the enterprise.

Important terms

Bond
Term structure of interest
Real rate
Money rate

Introduction

Debentures and long term debts are alternative to equity in financing an entity’s long term finance requirements. The distinguishing feature of debt finance is that it is less risky than equity finance to the investor as is always assured of interest and capital repayment ahead of shareholders. From the view of the company it is less expensive as equity finance because the risks are less; the investor is satisfied with the lower expected rate of return. Further because interest is an allowable expense for tax purpose. The following factors should be considered when raising long term finance.

The minimum and maximum loan limits.
Expenses of raising the loan.
Dilution of ownership.
Interference in decision making.
Security required.
Market liquidity – are the funds available?
Signalling effects – how will the market react?

The cost of any finance is the rate of interest which is charged. Interest is defined as an amount earned by investors over time.

Real rate - the rate of return required by the investor
in absence of inflation
Money rate - the rate which includes return to compensate
for inflation

Term Structure of Interest

Term Structure of Interest refers to the way in which the yield on security varies according to the term of the borrowing, which is the length of time the debt will be repaid.

Yield curve – A graph showing the relationship between the length of time to maturity of a bond and the rate of interest. Higher rate in the long term to

Compensate for the time value of money.
Greater risk in lending long term.

Reverse Yield Curve

Normally debts are regarded as having lower risk therefore lower returns and equity higher risk and return. In practice stockholders are willing to accept lower return on the investments anticipating capital gain.

Factors affecting interest rates:

- Inflation
- Need for real rate of return
- Rates in other country
- Monetary policy
- Balance of payment
- Liquidity preference
- Uncertainty

Normal yield curve showing that with long term loans the rate of interest is always high.

Bond and Their Valuation

A bond is defined as long term contract in which the bondholder lends money to the firm or government. Debt finance is less expensive than equity finance, not only because the costs of raising the funds are lower, but because the annual return required to attend investors is less than for equity. This is because investors recognise that investing in a firm via debt finance is less risky than investing via stocks.

Classification of Bonds

Redeemable or irredeemable bonds
Fixed or floating rate debentures
Zero coupon bonds
Convertible loan stock

Types of Bonds

Treasury bonds – issued by the federal government
Corporate bonds – issued by the corporations
Municipal bonds – issued by state and local government
Foreign bonds - issued by foreign corporations or government

Trust Deeds and Covenants

Bond investors are willing to lower the interest they demand if they can be assured that their money will not be exposed to a high risk. A trust deed sets out the terms of the contract between bondholders and the firm. The trust deed may include provisions like, repayment schedule, interest charges, and the information that the borrower will be expected to provide to the lender over the period of the loan but also the covenants attached to the loan. These covenants may be positive or negative as outlined below.

Affirmative covenants
• Regular supply of financial statements.
• Provide management accounts.
• Provide certificates that the company is keeping to the loan agreement.
• Dates for interest and capital repayments
• Additional fees due to delays in repayments

Negative covenants
• Limits on further debt issuance.
• Ceiling on divided level.
• Limit on disposal of assets.
• Financial ratio levels.
• The maintenance of certain levels of working capital.
• Limitation of redemption of shares.

Bond Valuation

(a) Cost of irredeemable debt
These are debts where the company will go on paying interest every year in perpetuity, without ever having to redeem the loan.

Where Kd is the return required by the loan stocks investor.

(b) Cost of redeemable debt
The market value of the redeemable debt is the discounted present value of future interest receivable, up to the year of redemption, plus the discounted present value of the redemption payment. Likewise the cost of debt is given by the internal rate of return of the cash flows.

YEAR	ITEM	CASHFLOW
O	Market value of loan	P
1 to n	Annual interest until redemption in year n	I (1-t) per annum
n	Redemption value of loan	RV

Example - To calculate the rate of return demanded by investors from a K100 Bond redeemable in 3 years with market price of $ at and rate at 6%.

Value of the debenture as outlined above can be calculated as the present value of future cash flows of the annual interest payable plus the capital repayment.

Example - A Company has issued some 9% debenture, which are now redeemable at par in three years time. Investors now require an interest yield of 10%. What will be the current market value of K100 of the debentures?

Answer:

Year		Cash flow	Discount factor	Present value
		K	10%
K
1	Interest	9	0.909	8.18
2	Interest	9	0.826	7.43
3	Interest	9	0.751	6.76
3	Redemption Value	100	0.751	75.10
				97.47

Debenture of K100 will have a market value of K97.47.

Interest Yield

(a) Yield to maturity - rate of return earned if bond is held up to specified maturity period.

(b) Flat yield – the gross interest amount divided by the current bond price expressed as a percentage.

(c) Redemption Yield - the coupon plus the capital gain or less on maturity.

(d) Semi – annual interest - rate used when the coupon payments will be paid half yearly

(e) Yield to call - Additional yield because the issues (firm) has the option to repay the bond before maturity period.

Riskiness of a Bond

(a) Interest rate risk - The risk of a decline in a bond’s price due to an increase in interest rate.

(b) Reinvestment rate risk - The risk that a decline in income from a bond portfolio.

(c) Default risk - the risk that the issue of the bond will fall to owner the obligations (interest and repayments).

Bond Rating

issues of the bond contracts the agency to evaluate and rate the bond as well as to update the rating through out the bond’s life.
Firms with high total debt burden, poor cash flow position worsening market environment will have a high default risk therefore a low grade
The highest rating is triple A and lowest D
Bonds with lowest rating has higher costs

Advantages of Debt Capital

Lower cost that equity
No dilution of voting powers
Interest payment is tax deductible
May contain options for early settlement
Flexibility in arrangement than equity

Drawback of Debt Capital

Interest and principal payment obligations are set by contract and must be met, regardless of the economic position of the firm.
Both the indenture agreements may place burdensome restrictions on the firm, such as maintenance of working capital at a given level, limits on future debt offerings, and guidelines for dividend policy. Although bondholders generally do not have the right to vote, they may take virtual control of the firm if important indenture provisions are not met.
Utilised beyond a given point, debt may serve as a depressant on outstanding ordinary share value.