Lecture 11 - Raising Capital: Debt and Lease

What is debt financing?

Borrowed capital with fixed repayment obligations

What two payments must debt financing include?

• Interest payments at fixed intervals

• Repayment of principal at maturity

What is short-term debt

Debt with maturity one year or less

What is long-term debt?

Debt with maturity more than one year

Does debt financing dilute ownership?

No ownership dilution

Who has priority in liquidation?

Debtholders

Why is debt financing often cheaper than equity?

• Lower cost of raising funds

• Lower required return

• Interest provides tax shield

What income do equity investors receive?

Dividends

What income do debt investors receive?

Interest

Are dividends tax deductible?

No

Is interest tax-deductible?

Yes — interest is a business expense

What control do equity holders have?

Voting rights

What control do debtholders have?

Loan agreement restrictions

What happens if dividends are not paid?

Firm cannot be forced into bankruptcy

What happens if debt payments are not made?

Firm can enter bankruptcy

What is the bottom-line comparison between equity and debt?

Tax status favours debt but default risk favours equity

What are key advantages of debt financing?

• Tax shield

• Cheaper capital

• No ownership dilution

• Discipline for managers

What are key disadvantages of debt financing?

• Default risk

• Restrictive debt covenants

• Higher earnings volatility

Why can debt increase earnings volatility?

Fixed interest payments

When are firms more likely to use debt?

• Stable cash flows

• Tangible assets

• Profitable firms

• Low distress costs

What are the two main categories of debt financing?

• Public debt

• Private debt

What is public debt?

Debt issued to many investors in public markets

What is private debt?

Debt provided by banks or small groups of investors

What are examples of private debt sources?

• Bank loans

• Private placements

• Peer-to-peer lending platforms

What are floating-rate bonds?

Bonds with coupon rates linked to an interest rate index

What are floating-rate bonds?

Bonds with coupon rates linked to an interest rate index

What interest rate indexes are often used for floating bonds?

• Treasury bill rate

• LIBOR

What does LIBOR stand for?

London Interbank Offer Rate

What risk do floating-rate bonds reduce

Inflation risk

What is a zero-coupon bond?

Bond that pays no coupons and is sold at a discount

Example of zero-coupon bond

Why do investors buy zero-coupon bonds?

They receive the face value at maturity

What are income bonds?

Bonds that pay coupons only if firm income is sufficient

What is a bond?

Public issue of long-term borrowing contract

Who must approve a bond issue?

Board of directors

What must be prepared before issuing bonds?

Registration statement

Who reviews the registration statement?

Regulatory authority

What document defines the bond contract?

Bond indenture

What is a bond indenture?

Formal agreement between company and trust company

What basic terms are included in a bond indenture?

• Face value

• Coupon rate

• Term to maturity

• Bearer or non-bearer

• Clean price or dirty price

What does bond security describe?

• Colleteral pledged

• Debenture

What is a debenture?

Bond without collateral

What are protective covenants?

Rules restricting actions of borrowing company

What are negative covenants?

Restrictions on dividends or new borrowing

What are positive covenants?

Requirements to maintain certain financial ratios

What is a sinking fund?

System to repay bond principal gradually

When might a sinking fund start?

Several years after issuance

What types of sinking fund payments exist?

• Equal payments

• Balloon paymemt

What are equal sinking fund payments?

Regular payments of the same amount made each period into a sinking fund to repay debt over time

What is a balloon sinking fund payment?

Small payments during the loan period followed by one large final lump-sum payment at the end

What is a call provision?

Right of issuer to repurchase bonds early

When do firms prefer to call bonds?

When interest rates fall

Why might firms include call provisions?

To refinance debt at lower interest rates

Why do callable bonds usually have higher coupons?

Investors require compensation for call risk

What is a line of credit?

Bank allows borrowing up to a maximum amount

What is a loan commitment?

Bank promises to lend specified amount at set interest rate

What is a syndicated loan?

Loan provided by a group of banks

Who negotiates syndicated loan terms?

Lead bank

What is a private placement?

Debt issued to a small group of institutional investors

What investors commonly provide private placements?

• Pension funds

• Insurance companies

What are advantages of private placements?

Lower issuance costs and flexible renegotiation

Why are private placements more flexible?

Easier renegotiation with small group of investors

What is a disadvantage of private placements?

Higher interest rates

What measure is used to estimate cost of debt?

Yield to maturity

What determines YTM in markets?

• Creditworthiness

• Loan terms

• Market conditions

What is a credit rating?

Assessment of borrower’s ability to repay debt

What two major agencies rate debt?

• Standard & Poor’s

• Moody’s

What factors do rating agencies analyse?

• Financial statements

• Cash flow stability

• Leverage

• Liquidity

• Covenants

What are the two rating categories?

• Investment grade

• Speculative grade

How do credit ratings affect borrowing costs?

Lower ratings lead to higher yields

What is a lease?

Rental agreement to use an asset for periodic payments

Who are the two parties in a lease?

• Lessee - user of the asset

• Lessor - owner of the asset

Why is leasing similar to debt?

It is similar to borrowing to buy an asset

What assets are commonly leased?

• Property

• Vehicles

• Aircraft

• IT equipment

• Medical devices

What are the two main types of leases?

• Operating lease

• Financial lease

What is an operating lease?

Short-term lease similar to renting

(Lessor handles the maintenance)

What is a financial lease?

Long-term lease similar to borrowing to buy

(Lessee handles the maintenance)

Why might firms lease instead of buy?

• No large upfront payment

• Flexibility to upgrade assets

• Transfer residual value risk

• Lower transaction costs

• Predictable payments

When is buying better than leasing?

• Need full control

• Long asset life

• Cheap borrowing

• Asset sensitive to usage

• Firm wants depreciation tax shield

Why is leasing not “100% financing”?

Lease is still a financial liability

Why are accounting tricks less relevant today?

IFRS 16 treats leases similar to purchases

Which firms use leasing as substitute for debt?

Small or young firms

How do large firms use leases?

Complement debt financing

Why might low-tax firms lease?

They cannot use depreciation tax shields