L6 Corporate finance refined: Debt financing and leasing

The bond market and Yields:

Inverse relationship between price and yield e.g. when YTM goes up the bond price goes down. Using a yield curve you can analyze this.

-        Normal Curve: Upward sloping, short-term yields are low because they involve less risk and inflation uncertainty, while long-term yields are higher to compensate for duration.

-        Flat Curve: Occurs during times of future economic uncertainty when yields across all maturities are similar.

-        Inverted Curve: A negative slope where short-term yields are higher than long-term yields, signaling expectations of lower interest rates in the future.

Sovereign debt (government bonds):

Are issued by national treasuries and pay the coupons and the face value. They have lower risk in comparison to corporate bonds that carry credit risk making it uncertain for investors if a corporation will return their money. Since they are riskier they must offer higher yields to compensate investors. Bank borrow from each other to ensure liquidity which is the interbank lending rate (LIBOR).

Issued by national governments to finance spending, such as that issued by the US Department of the Treasury or Riksgälden in Sweden.

Yield to maturity for different bonds

-        Treasure bills: risk free bond, upward sloping and normal yield curve

-        Corporate: Low risk, yield to maturity is higher than government bonds because there is some risk involved.

NPV:

Present value of all cashflows from an investment minus the cost of the investment today. Value is created if NPV is higher than 0 meaning if it’s positive then accept. For bonds it focuses on the coupon rate and YTM and are priced by discounting promised payoffs. Bonds values it’s worth through cash flows, timing and risks then deduct all costs.

Equity financing:

When firms sell ownership claims (shares) to investors allowing them to claim future dividends. Useful for firms that cannot guarantee fixed payments.

Either to:

-        Private firms like founders, angels for startups to get liquidity, venture capital.

-        Public firms: Through equity offerings or through IPO (sell publicly for the first time).

Equity financing advantage

o   No fixed payments

o   Risk is shared with investors

o   Useful when firms cannot promise e.g. bond payment, which could be risky for startups. Therefore, selling equity is useful then own the claims of my future cashflows.

Costs of equity:

o   Dilution of ownership and control

o   Information problems (issuance may signal overvaluation)

o   High issuance costs (underpricing, fees)

o   Stock prices often fall after new equity issues

-        Firms therefore rely heavily on — instead of equity financing:

o   Debt contracts

o   Leasing and alternatives.

Debt financing (corporate public debt)

Firms often rely on debt contracts as an alternative to equity. Corporate (public) debt involves selling bonds or taking loans to raise immediate cash in exchange for promising fixed payments in the future. Instead of borrowing from a single bank, a firm often splits a loan into many pieces, known as bonds, which can be bought and sold in financial markets (publicly traded debt) by institutional investors like pension funds, mutual funds and insurance companies.

E.g. private and public corporate debt, sovereign debt. Allows firms to raise money without ownership control.

Characteristics of corporate debt financing

o   They are often large and long-term investments where corporations promise fixed coupons, a fixed maturity (<30) paid semiannually. Other characteristics are face value (often denominated in $1000 increments), and a specific Yield to Maturity (YTM),

o   Key features: Face value, maturity, YTM, default risk.

Legality of corporate debt

These must have a prospectus that include details (e.g. regulations and rules) of the offerings and includes an indenture (skuldebrev) which is a formal contract between issuer and a trust company that represents the bondholders´ interest.

Risk and pricing of corporate bonds: Risk is determined by what happens if a firm defaults: The potential of default depends on:

-        Security: If bonds are secured (like mortgage or asset-backed bonds), they are protected by collateral that gives the investor a direct claim to assets if the company defaults. Unsecured bonds (debentures) offer no collateral, resulting in a higher YTM due to increased risk.

-        Seniority: determines the priority of an investor’s claim to assets; those with higher seniority are paid first during bankruptcy which reduces the risk for the higher priorities, not pledged as collateral. Subordinated debentures have lower priority.

-        Credit quality: Bonds are categorized as either investment-grade or high-yield (junk).

Corporate bond design: Bonds vary by:

-        Maturity (short 1-5 years, medium 5-10, or long-term 10-30+)

-        Convertibility: Callable, puttable and convertible bonds.

• Purpose (general corporate purpose, project/infrastructure, green bonds, sustainability bonds, blue bonds).

• Coupon type (fixed-rate, floating-rate, or zero-coupon).

• Price: Issued at par, discount or premium.

Callable bonds

o   These allow the issuer to repurchase or "call back" the bond before maturity, usually to refinance if interest rates drop. They are less attractive to investors, who evaluate them using Yield to Call (YTC) in addition to YTM.

Puttable bonds

These allow the investor to decide to put the bond back to the issuer, making them attractive to the lender rather than the issuer.

Convertible bonds

These give the investor the right to convert their bonds into a fixed number of equity shares. This is beneficial if the company's stock price rises above a certain level.

International bonds

-        Domestic Bond = Issued by a local entity and traded in a local market in the local currency, but purchased by foreigners.

-        Foreign Bond = Issued by a foreign company in a local market in the local currency for local investors

o   Ex: Yankee Bonds (foreign bonds in the US), Samurai Bonds (foreign bonds in Japan), and Bulldogs (foreign bonds in the UK)

-        Eurobonds = International bonds that are not in denominated in local currency of country in which they are issued (ex. US denominated bond in UK)

-        Global Bond = offered for sale in several different markets simultaneously. Combination of all types.

Corporate (private) debt

Other than public corporate debt, firms fund through private debt by taking term loans from the bank. These are easy to set up and no promises to pay dividends or bonds but it’s more expensive and illiquid (not easy to convert to cash) and no one can buy this loan. Private placements: A bond issue that is sold to a small group of investors rather than the general public.

Government Bond Types:

-        Treasury Bills (T-bills) are pure discount bonds (<26 weeks)

-        Treasury Notes are semiannual coupon bonds (2-10 years)

-        Treasury Bonds have maturities longer than 10 years.

-        Long bonds: Bonds with longest maturities (30 years).

-        TIPS (Treasury Inflation Protected Securities) adjust the outstanding principal for inflation, making them attractive during times of high inflation or uncertainty.

Municipal Bonds:

"Munis" are issued by state and local governments to finance public projects like schools and roads. They are generally considered riskier than federal debt and are often issued as serial bonds with multiple maturity dates. In Sweden, municipalities typically borrow through Kommuninvest which is a jointly owned funding agency that raises funds in capital markets and lends to its members.

ASSET BACKED SECURITIES (ABS)

• They are securities made from other financial assets (like loans).

• The cash you receive comes from the payments on those underlying assets.

How They Contributed to the 2008 Crisis

• Many CDOs were built from mortgage‑backed securities.

• Risky junior tranches were repackaged to look safer than they were.

• When housing prices fell and people defaulted:

  • Junior tranches were wiped out.

  • Even senior tranches—supposed to be safe—took big losses.

• Losses spread through the entire financial system.

Types of ABS

1. Mortgage‑Backed Securities (MBS)

• Biggest type of ABS.

• Backed by home mortgages.

• Often issued by U.S. agencies like Freddie Mac and Sallie Mae.

2. Collateralized Debt Obligations (CDOs)

• A re‑bundling of other ABS (often MBS).

• Cash flows are split into tranches:

  • Senior (safest)

  • Mezzanine (medium risk)

  • Junior (riskiest)

Bond covenants:

Legally binding, written promises within a bond indenture that require the issuer (borrower) to adhere to specific rules or refrain from certain actions to protect bondholders' investments. E.g. to prevent the CEO from making "crazy decisions" that could jeopardize repayment.

Repayment provisions:

A bond issuer typically repays its bond by making coupon and principal payments as specified in the contract. However, the issuer can:

o   Repurchase a fraction of the outstanding bonds in the market

o   Exercise a call provision → callable bonds

Callable Bonds and why issuers call them

It has a call provision, meaning the issuer is allowed to buy back the bond early at a preset call price, starting on the call date.

Why issuers call bonds

• They call the bond when market interest rates fall below the bond’s coupon rate.

• This lets them refinance more cheaply, just like a homeowner refinancing a mortgage.

Because of this extra risk to investors, callable bonds usually:

• Trade at lower prices

• Offer higher yields than similar non‑callable bonds

o   If not called: YTM is the same as non-callable bond interest. Usually don’t call when market rate is higher than the coupon rate (would be expensive to refinance).

-        Investors need to consider both the yield to call (YTC) and the (standard) yield to maturity (YTM)

1. Yield to Maturity (YTM)

• Applies if the bond is NOT called.

• Usually happens when market rates are higher than the coupon rate (too expensive for the issuer to refinance).

2. Yield to Call (YTC)

• Applies if the bond IS called at the earliest call date.

• Issuers call when market rates fall below the coupon rate (cheaper to refinance).

Investors calculate YTC because the bond might be taken away early.

Convertible Bonds 2

A way to retire a bond is to convert it into equity. These give the bondholder an option to convert the bond into a fixed number of shares based on a specific conversion ratio and conversion price. At maturity, an investor will convert if the stock price is higher than the conversion price; otherwise, they take the cash. A convertible bond is always worth at least as much as a straight bond and thus trades at a lower yield. The bond contains a warrant (option for new stock).

Coversion ratio and price

-        Conversion ratio: The number of shares you get from converting the bond into stocks.

-        Conversion price: Base value/number of shares received

Leasing:

Leasing is a form of financing where a firm pays periodic payments to use an asset instead of borrowing to buy it. Firms lease to preserve liquidity, access financing, manage risk, or for tax and accounting reasons.

Participants of leasing

The lessee is the party renting the asset and commits to make periodic payments, while the lessor is the owner who leases it out and decides the ownership of the asset after contract ends.

Benefits of leasing

It allows firms to avoid high upfront costs, preserve liquidity and manage business risk, which is particularly useful for small companies with limited access to traditional financing.

Types of lease transactions:

-        Sales-type leases (e.g., cars) where the lessor is the primary dealer.

-        Direct leases (via an independent company like a car dealer) where lessor is not the manufacturer but independent that purchase and lease.

-        Sale-and-lease-back arrangements: Firm owns an asset it would prefer to lease through payments. The firm receives cash from the sale of the asset and then makes lease payments to retain the use of the asset. Customer (sells the car) => Hedin Bil => leases car back.

Valuation:

The cost of a lease depends largely on the asset's residual value (its worth after depreciation). The price of the lease should ideally equal the present value of the lease payments plus the residual value

The residual value:

The market value of the asset at the end of the lease.

In a perfect market:

The Present Value (PV) of lease payments = the purchase price - the PV of the residual value. Leasing cost is theoretically equivalent to the cost of purchasing and then reselling the asset.

Alternative to leasing:

A loan finances the entire cost of an asset, while a lease finances only the economic depreciation during the lease term. Because of this, loan payments are higher than lease payments. In a perfect market, an individual should be indifferent between leasing and taking a loan to finance an asset.

• Market Imperfections:

In reality, leasing decisions may be influenced by taxes, differences between borrowing and leasing rates, or information asymmetries where users know more about the asset's use than the lessor.