Sources of Long-Term Finance: Debt Finance

Course Reading and References

Recommended Reading: Hillier, Chapter 6 (relevant sections).
Supplementary Reading: - Arnold, Chapter 7. - Pike and Neale, Chapter 16.

Learning Objectives

Explain how debt finance can be distinguished from equity finance.
Distinguish between secured and unsecured debentures, which are also known as corporate bonds.
Explain the primary features of convertible bonds and warrants and discuss their differences.
Understand the valuation methods for both irredeemable and redeemable bonds.
Understand and explain specific features of corporate bonds, including floating rate bonds, deep-discounted and zero-coupon bonds, and the processes for bond redemption.
Develop the ability to discuss the relative advantages and disadvantages of equity versus debt finance for a company upon completion of the lecture series.

Distinguishing Features of Debt Finance

Risk Perception: Investors perceive debt finance as less risky than equity finance because interest is paid out before dividends and debt holders have seniority in the event of company liquidation.
Cost of Finance: Because investors perceive debt as lower risk, they require a lower expected rate of return. From the perspective of the borrowing company, this makes debt finance a cheaper source of capital than equity finance.

Secured Debentures and Secured Loan Stock

Definition: A debenture is a bond given in exchange for money lent to a company. In this contract, the company agrees to: - (i) Pay the principal (also known as par, face, or nominal value) at a specific future redemption date. - (ii) Pay a stated annual rate of interest, referred to as a coupon payment, until the funds are repaid.
Structure: These are typically divided into security units with a nominal value of \text{#}100.
Example: A specific issue might be labeled as "7.25% Debenture Stock 2030/2035 (floating charge) \text{#}2.5\text{ million}."
Irredeemable (Perpetual) Debentures: These have no specified redemption date. The company can repay the principal at its discretion, but the holder cannot demand payment. Because this is generally unattractive to investors, it is a very rare form of finance.
Floating Charge (Blanket) Debentures: These are secured by a floating charge attached to all present and future assets of the company without specifying particular assets. The company may dispose of these assets without consulting debenture holders or trustees as long as contractual obligations are met. If the company defaults (e.g., missed interest payment or liquidation), the floating charge "crystallises" and becomes a fixed charge.
Fixed Charge (Mortgage) Debentures: These are secured by specific assets, usually land and buildings. In liquidation, these assets are sold, and the proceeds are prioritized to meet the claims of the debenture holders.

Payment Obligations and Seniority

Mandatory Payments: Unlike dividends, debenture interest must be paid regardless of whether the company generates a profit.
Default Power: If interest is not paid, debenture holders can force the company into liquidation and demand payment.
Claim Priority: Debenture holders rank ahead of all shareholders (including preference shareholders) in their claims on company assets during liquidation.
Interest Rate Determinants: The interest rate borne by debentures depends on: - (a) The long-run market interest rates prevailing at the time of the issue. - (b) The specific type of debenture (e.g., secured versus unsecured).

Unsecured Debentures and Loan Stock

Risk Profile: Unsecured debentures are inherently riskier than secured ones, resulting in a higher interest rate to compensate the investor.
Protective Covenants: Due to the higher risk, loan agreements often include protective covenants to restrict the company's actions, such as: - (a) Dividend restrictions. - (b) Mandatory maintenance of specific financial ratios. - (c) Regular delivery of financial reports. - (d) Restrictions on the issue of further debt.

Convertible Debentures and Warrants

Convertible Debentures: A debt instrument that the holder can, at their option, convert into equity shares. It starts as a debenture with a fixed annual interest rate. Because of the value of this conversion option, the interest rate is lower than that of "straight debt."
Warrants: A warrant holder originally purchases a debenture that provides annual interest and the option to purchase equity shares at a fixed future date at a predetermined price. Unlike convertibles, warrant holders do not have to relinquish their debenture to exercise the option; they can hold both the debt and the equity.

Bank Borrowing

Form: No tradable security is issued. The bank provides a term-loan, usually for a duration exceeding 10 years.
Interest Rates: These may be fixed or variable, typically ranging from 3\text{%} to 6\text{%} above the base rate, depending on the borrowing company's credit rating.
Security and Restraints: Banks generally require loans to be secured against the company's assets and may impose restrictive covenants.

Valuing Fixed-Interest Securities

Fixed Interest (Income) Securities: This category covers all securities where the promised payments are fixed amounts.
Key Terms: - Coupon Rate: The interest rate offered on the face value of the bond. - Face (Nominal/Par/Principal) Value: The price at which the bond is redeemed. - Issue Price: The initial price at which the bond is sold to the public. - Market Price: The current trading price of the bond in the secondary market.

Valuation of Irredeemable Debt

Investor Focus: The investor is concerned solely with coupon payments ( $I$ ) rather than the principal.
Formula: $P_{ID} = \frac{I}{K_D}$
Variables: - $P_{ID}$ is the price of the irredeemable debt. - $I$ is the annual interest payment. - $K_D$ is the cost of debt (the market rate of interest for securities in the same risk class).
Example 1: - Coupon rate: 5\text{%} - Nominal Value: \text{#}100 - Market rate ( $K_D$ ): 10\text{%} - Price: P_{ID} = \frac{100 \times 0.05}{0.1} = \text{#}50
Example 2 (Falling Market Rates): - Market rate ( $K_D$ ) falls to 2.5\text{%} - Price: P_{ID} = \frac{100 \times 0.05}{0.025} = \text{#}200
Conclusion: The market price of a debenture is a function of its coupon rate, market interest rates, and the risk class of the debt.

Valuation of Redeemable Debt

Investor Focus: Both the annual interest ( $I$ ) and the final principal payment ( $M$ ) are critical.
Formula: $P_{RD} = \sum_{t=1}^{n} \frac{I_t}{(1 + K_D)^t} + \frac{M_n}{(1 + K_D)^n}$
Numerical Example Solving for Redemption Yield: - Debenture details: \text{#}100 par, redeemable in 2 years. - Coupon: 10\text{%} annually. - Market price ( $P_{RD}$ ): \text{#}85 - Step 1: Set up the equation: $85 = \frac{10}{(1 + K_D)^1} + \frac{10}{(1 + K_D)^2} + \frac{100}{(1 + K_D)^2}$ - Step 2: Simplify: $85 = \frac{10}{(1 + K_D)^1} + \frac{110}{(1 + K_D)^2}$ - Step 3: Solve the quadratic equation for $K_D$ (the redemption yield/Yield to Maturity).
Complexities and Problems: - (1) If interest is paid semi-annually (every 6 months), the discounting frequency must change. - (2) If the debt matures in a longer timeframe (e.g., 10 or 20 years), the quadratic equation is no longer applicable, and calculations become significantly more difficult.

Additional Bond Features

Floating Rate Bonds: Introduced due to high interest rate volatility in the late 1970s. These prevented investors from being locked into low rates when market rates rose, and protected companies from high rates when market rates fell. The coupon rate is variable and usually tied to the six-month interbank rate.
Deep-Discounted and Zero-Coupon Bonds: These offer a coupon rate that is zero or significantly below the market rate. Investors are compensated by a discount on the purchase price. - Discount: The difference between the issue price and the amount payable on redemption (excluding interest). - Example: A bond issued at \text{#}50 with no interest, redeemable at \text{#}100, offering a \text{#}50 discount. - Value Proposition: These are attractive to investors seeking lump-sum payments rather than annual cash flows and to companies wanting to raise funds without immediate cash flow drain.

Redemption of Bonds

Companies use several methods to ensure funds are available for repayment upon the redemption date: - (i) Issuing new debt to replace the old. - (ii) Utilizing profits generated in the specific year of redemption. - (iii) Establishing a sinking fund reserve, where funds are placed periodically over the life of the debt.