EC2607: Sources of Long-Term Debt Finance Study Notes

Course Information and Learning Objectives

• Course Code: EC2607

• Topic: Sources of Long-Term Finance: Debt Finance

• Reading Recommendations:     * Recommended: Hillier Chapter 6 (relevant sections)     * Supplementary: Arnold Chapter 7     * Supplementary: Pike and Neale Chapter 16

• Learning Objectives:     * Explain how debt finance can be distinguished from equity finance.     * Distinguish between secured and unsecured debentures (corporate bonds).     * Explain the main features of convertible bonds and warrants and discuss their differences.     * Understand how both irredeemable and redeemable bonds are valued.     * Understand and explain specific corporate bond features including floating rate bonds, deep-discounted and zero-coupon bonds, and the redemption of bonds.     * Discuss the relative advantages and disadvantages of equity and debt finance to a company (to be completed after both topics are covered).

Distinguishing Features of Debt Finance

• Risk Perception: Investors perceive debt finance as less risky than equity finance for two primary reasons:     1. Interest is paid out to debt holders before dividends are paid to shareholders.     2. Debt is more senior in the ranking of claims 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 borrowing company’s perspective, this makes debt finance a cheaper source of capital than equity finance.

Secured Debentures and Secured Loan Stock

• Definition of a Debenture: A bond given in exchange for money lent to a company. The company enters a contract that stipulates:     * (i) It agrees to pay the principal (also known as par, face, or nominal value) at a specific future date called the redemption date.     * (ii) It pays a stated rate of interest, known as the coupon payment, every year until the debt is repaid.

• Nominal Units: Debentures are typically divided into securities with a nominal value of $\text{£100}$.

• Example: "7.25% Debenture Stock 2030/2035 (floating charge) £2.5 million."

• Irredeemable (Perpetual) Debentures:     * These have no specified date for redemption.     * The company may repay the principal at its own discretion, but the holder cannot demand payment.     * This form of finance is very rare as it is not very attractive to investors.

• Main Types of Secured Debentures:     * Floating Charge (Blanket) Debentures: Secured by a charge attached to all present and future assets of the company without specifying particular assets. The company can dispose of these assets freely in the normal course of business as long as it meets contractual obligations.     * Crystallization: If the company defaults (e.g., misses an interest payment or is wound up), the floating charge "crystallises" and becomes a fixed charge.     * Fixed Charge (Mortgage) Debentures: Secured on specific assets, typically land and buildings. In liquidation, these specific assets are sold, and the proceeds are used first to satisfy the claims of the debenture holders.

• Payment Obligations: Interest on debentures must be paid regardless of whether the company makes a profit. If interest is not paid, debenture holders have the power to force the company into liquidation to demand payment. They rank ahead of all categories of shareholders, including preference shareholders.

• Interest Rate Determinants: The interest rate a debenture carries depends on:     * (a) Long-run market interest rates prevailing at the time of issue.     * (b) The specific type of debenture (secured vs. unsecured).

Unsecured Debentures and Loan Stock

• Risk and Return: Unsecured debt is riskier for the investor; consequently, the interest rate is higher than that of secured debentures.

• Protective Covenants: Because of the increased risk, loan agreements for unsecured debt often include protective covenants to safeguard the lender's interests:     * (a) Dividend restrictions.     * (b) Requirements to maintain certain financial ratios.     * (c) Mandatory provision of financial reports.     * (d) Restrictions on the issuance of further debt.

Convertible Debentures and Warrants

• Convertible Debentures:     * A debt instrument that provides the holder an option to convert the debt into equity (shares).     * Initially sold as a debenture entitling the holder to annual interest.     * The interest rate is typically lower than that of "straight" (standard) debt because of the value of the conversion option.

• Warrants:     * A warrant holder purchases a debenture that provides annual interest payments and an option to purchase equity shares at a fixed future date and a predetermined price.     * Difference from Convertibles: Unlike convertibles, warrant holders do not have to relinquish or "convert" their debenture to get the shares. They have the option to keep the debt and buy the equity, allowing them to hold both.

Bank Borrowing

• Nature: No tradable security is issued in bank borrowing.

• Terms: A bank provides a term-loan (usually lasting more than 10 years).

• Interest: Can be at a variable or fixed rate. It is typically set at roughly $3-6\%$ above the base rate, depending on the borrowing company's credit rating.

• Security: Banks generally require loans to be secured on company assets and may impose restrictive covenants.

Valuing Fixed-Interest Securities

• Key Features for Valuation:     * Coupon rate: The interest rate offered on the face value of the bond.     * Face (Nominal/Par/Principal) value: The price the bond will be redeemed at.     * Issue price: The price at which the bond is sold initially.     * Market price: The current trading price in the market.

Valuing Irredeemable Debt

• For irredeemable debt, the investor is focused on the coupon payments ($I$) rather than the principal.

• The Valuation Formula:     $P_D = \frac{I}{K_D}$     * Where $P_D$ is the market price of the debt.     * Where $I$ is the annual interest payment.     * Where $K_D$ is the cost of debt (the market rate of interest for securities in the same risk class).

• Example 1: A company issues irredeemable debentures with a $5\%$ coupon. Market rate for similar risk is $10\%$.     $P_D = \frac{100 \times 0.05}{0.10} = \text{£50}$

• Example 2: The market rate of interest falls to $2.5\%$.     $P_D = \frac{100 \times 0.05}{0.025} = \text{£200}$

• Conclusion: The market price of a debenture is a function of its coupon rate, general market interest rates, and the risk class of the debt.

Valuing Redeemable Debt

• The principal payment (maturity value) is a critical component of value for the investor.

• Redeemable debt involves annual interest payments until the redemption date, at which time the maturity payment ($M_n$) is received.

• The General Formula:     $P_{RD} = \sum_{t=1}^{n} \frac{I_t}{(1 + K_D)^t} + \frac{M_n}{(1 + K_D)^n}$     * Where $t = 1, 2, 3, \dots, n$.     * $M$ is the maturity value (principal).     * $K_D$ is the cost of debt, redemption yield, or Yield to Maturity (YTM).

Valuation Problems and Discussion

• Example Calculation for Redemption Yield:     * Investment: $\text{£100}$ debenture redeemable at par in 2 years.     * Coupon: $10\%$ ($\text{£10}$ annually).     * Current Market Price: $\text{£85}$.     * Step 1 (Setup): $P_{RD} = \frac{I}{(1 + K_D)^1} + \frac{I}{(1 + K_D)^2} + \frac{M}{(1 + K_D)^2}$     * Step 2 (Data entry): $85 = \frac{10}{(1 + K_D)^1} + \frac{10}{(1 + K_D)^2} + \frac{100}{(1 + K_D)^2}$     * Step 3 (Simplification): $85 = \frac{10}{(1 + K_D)^1} + \frac{110}{(1 + K_D)^2}$

• Analytical Challenges:     * Quadratic Solution: The 2-period equation is a quadratic that can be solved for $K_D$.     * Question 1: How do calculations change if interest is paid semi-annually (every 6 months)?     * Question 2: What if the debt matures in 10 or 20 years instead of 2? Calculations become extremely difficult because quadratic equations are no longer sufficient to solve for the interest rate directly.

Advanced Bond Features

• Floating Rate Bonds:     * Originated in the late 1970s due to high interest rate volatility.     * Volatile rates meant investors and companies faced significant capital gains or losses.     * Investors feared being locked into low rates when market rates rose; borrowers feared being locked into high rates when market rates fell.     * Mechanism: The coupon rate is variable rather than fixed, typically tied to the six-month interbank rate.

• Deep-Discounted and Zero-Coupon Bonds:     * Zero-Coupon: The coupon rate is $0\%$.     * Deep-Discounted: The coupon rate is set significantly below the current market rate.     * Compensation: The investor is compensated by the "discount" – the difference between the low issue price and the higher amount payable at redemption (excluding interest).     * Example: A bond issued at $\text{£50}$ with no annual interest, redeemable at $\text{£100}$, provides a $\text{£50}$ discount.     * Investor Profile: Only valuable to investors who do not require annual cash flows but prefer a final lump-sum payment.     * Company Advantage: Allows a company to raise funds immediately without draining short-term cash flows for interest payments.

• The Redemption of Bonds:     * Companies must ensure they have sufficient funds to repay debt holders at the redemption date. Methods include:         * (i) Issuing more debt to pay off old debt.         * (ii) Utilizing profits generated in the specific year of redemption.         * (iii) Establishing a sinking fund reserve, where funds are set aside periodically over the life of the debt.