Finance WK 3

What is debt and features of debtholders

• when investors contribute capital temporarily for a pre-specified time eg. 5 year loan

  • Generally No voting rights

  • Fixed and prior contractual right to a return on capital (interest payments)

  • Fixed and prior contractual right to a return of capital(principal) upon liquidation. 

Are interest payments tax deductible

Yes

Types of debt

Bank Loans

• Short term bank loans

  • bank overdraft

  • inventory loans

  • bridge loans

• Long term

  • term loans

Debt securities

• Short term

  • bills of exchange

• Medium term

  • debentures

• Long term

  • bonds

  • unsecured notes

  • corporate bonds

What are debt covenants

Mechanisms that allow debtholders to protect their investments

• You can have two types of debt coveneants

  • Negative components(where debtholders impose restrictions on certain actions by borrowers)

    • Companies can limit the access the other company has to future debt

    • Companies can have the potential to limit your holdings of certain investments

    • Companies can say they can limit the amount of dividends the other company is able to pay

    • Positive covenants: that require borrowers to take specific actions

      • companies can say that the other company should maintain assets and collateral

      • can specifiy that companies should provide audited statements to companies

Equity vs debt

• Equity

  • Equity is more valuable if cash flows are more volatile (cuz if there's a lot cash, shareholders benefit)

  • Shareholders More risk loving

• Debt

  • Main concern is of defaulting

  • Debtholders(lender) dislike risky projects

  • Through covenants, debtholders try to reduce firms’ downside risk. 

What is a lease and the difference between a lessor and lessee

• a contract where the lessor receives fixed payments from lessee in return for use of asset

• lessor: is the legal owner of the asset

• lessee: the user of the asset

Types of leases

• Operating leases

  • Like a rental agreement

  • Generally short term (car, telephones, coffee machines-bought by companies)

  • Able to be cancelled by lessee at short notice generally without substantial penalty

  • Risks of ownership are handled by lessor eg. if they lessee cancels and they lose income from it

• Finance Lease

  • Long term lease

  • Generally over the entire life of the asset eg. for airplanes. 

  • Can be cancelled with substantial penalty

  • Risk of ownership is handled by lessee

  • Is an alternative to borrowing funds to buy an asset

What is k (the discount rate) in the NPV calculations

after tax cost of borrowing: interest rate on loan x (1- corporate tax rate)

Valuation considerations by Lessee

Valuation by Lessee

CONSIDERATIONS OF LESSEE when leasing or borrowing to buy

1. Cost of asset 👍

2. Lease payment 👎

3. Tax shield from lease payment👍

4. Depreciation tax shield 👎

5. Residual payment/value (what happens to the asset at the end of contract)👎

6. Tax on gain/loss of sale👍👎(if its a gain, its good cuz you don’t have to pay)

Investment decision

• The question between leasing and buying from debt is a financing decision

• Whether to invest is an investment decision

  • Overall + npv so generally should take project, but should remain skeptical because the financing decision is rescuing the investment project and every other company can find financing conditions to help lead to a +NPV

Advantages of Leasing

• Because of market frictions enable NPVlessee>0 and NPVlessor>0

• Frictions

  • Company Taxes

    • If lessors tax rate>lessee’s tax rate (eg. shields on dep and gain on sale) and the lessor shares this tax benefit through lower lease payments, then leasing exists

  • Different costs of capital

    • If costs of capital is sufficiently lower for lessor and lessor gives benefit to lessee, then npv for both can be positive. and lessor can sometimes borrow at cheaper rates.

    • ie. bc lessor can borrow more cheaply hence get asset more cheaply and pass on through cheaper lease payments

  • Transactions costs

    • Is lessee defaults then lessor might be subject to simpler and less costly bankruptcy process since they own asset. ie easier than recovering a loan from a firm that’s gone bankrupt.

    • Standardization might lead to low transaction costs eg. ne lessor can buy multiple planes in bulk and lease them out to multiple firms

  • Off balance sheet financing (doesn't really apply)

    • Not an advantage anymore cuz of accounting standards

    • where leasing used to be able to be undisclosed to understate debt levels, but this doesn’t apply anymore

Hybrid securities

• Securities that display qualities of both debt or equity based on where they are in their life cycle 

  • Convertible notes (short term), convertible bonds (long term)

    • Give option to holder to be able to convert the note or bond into an ordinary share at a specific date

    • Debt to equity

    • Do it cuz it overcomes negative signal associated with issuing equity (markets think its overpriced)

    • Interest rate on convertibles is less than debt

  • Preference shares

    • Usually give holder preference over ordinary shareholders

      • Cumulative: must be paid any accumulated dividends before maying div to ordinary shareholders

      • Irredemable: no maturity date

      • Non participating (don’t give excess money)

      • Non-voting

      • Have a specified dividend rate