WEEK 2a: RAISING FINANCE - DEBT

Debt

Lang (2002:113) keeps it nice and simple:

 “You hire the money. You borrow the money and promise to pay it back at some time in the future, together with the interest. The amount you pay back is the same whether you succeed or fail. Even if your company is widely successful, [the lenders] get no more than the original loan and interest”.

Debt is not necessarily a bad thing!

Gearing:

The following extract from the accounts of AstraZeneca Group (2009) illustrates how even a hugely successful and well-established company is likely to use loans as a source of finance:

                              $m

Interest bearing loans and borrowings:            9137

Total assets (less current liabilities)        54,920

We can now calculate the ‘gearing ratio’     ß

 Borrowings / current assets - current liabilities X 100

(9137/ 54920) X 100 = 16.6%

Thus it can be seen that 16.6% (OR £1 OUT OF EVERY £6)

invested in the group has been borrowed.

And yet the same accounts showed that the group had ‘Cash and cash equivalents’ of $9,918m.

In other words they have enough liquid funds to pay-off the debt completely and immediately. So………….why don’t they do so?

The answer is because debt can be good.

Will we develop this idea further below.

Before we leave AstraZeneca, overleaf is a more detailed breakdown of their

different so-called debt ‘instruments’ (borrowings): 

Notes:   

1.  The percentage denotes the annual rate of interest or 'yield'

1. ‘Callable’ bonds are also known as redeemable bonds.

1.  This means AstraZeneca have the option (but not the obligation) to repay the bondholder earlier than the maturity date. (maturity date - the date on which the final payment is due on a loan)

2. . The date in the middle column is the repayment date.

3. ‘Bonds’ and ‘debentures’ are a means of dividing the debt into smaller denominations

Short-term, medium-term and long-term borrowing

• Short term: repayable within one year e.g.:

• overdrafts (repayable on demand)

• bridging finance (plugging a gap between longer loan periods)

• Medium-term: repayable within 1-7 years

• Long term: repayable over 7 years

AstraZeneca appears to mix all three of these.

Who buys the bonds and debentures?

• Pension funds

• Mutual funds

• Insurance companies

• Banks.

• Wealthy individuals

Bonds                            

• The co. borrows money in return for a formal 'IOU' plus interest.

• Bonds are generally fixed interest securities.

• Are generally long-term contracts (7-30 years)

• Most bonds are unsecured. Secured bonds are known as debentures.

• Higher risk bonds are likely to be bought by venture capitalists and venture capitalist trusts

Low risk investment is likely to bring a low return.

Shares have to offer a higher return than bonds in the long-term.

Debentures

These are a more secure type of bond because the company’s assets (e.g. machines or buildings) will be put up as ‘collateral’. If the company does not pay interest or repayments to the bondholders then those assets may be sold and the funds returned to the bondholders. Since the debenture holders enjoy such extra security (lower risk) the ‘return’ (interest rate) of these bonds also tends to be lower.

Convertible bonds

The money is originally invested as bonds, but for the investor there is the option to convert them into equity at a later date.

For investors, these offer the attraction of a mix of risk and return – i.e., the possible capital gain associated with a share is added to the steady income that is obtained from a bond. For the issuer, the benefits are that the finance is likely to be cheaper as the interest rate will be lower due to the extra attraction it has for the prospective investor. The future conversion rate is specified at the issue date. Hence the opportunity for capital gains.

Deep-Discount bonds (‘Zero-coupon’ bonds)

Normally bonds pay an annual fixed interest return (sometimes called the ‘coupon’). For example a “£1, 8% bond” would pay 8p per annum in interest.

But some bonds earn no interim interest payments, because they are issued at a considerable discount – i.e., below their par value. They are redeemable at their par value, thus providing a guaranteed gain.  For example, a £100 zero coupon bond could be issued at a discount of 20%.

This means that the investor would pay £80 now and would receive £100 when the bond matures. The profit of £20 would be compensation for not receiving any annual dividend or ‘coupon’. 

Debt versus equity; which is ‘best’?

If a company wishes to raise £1m, should it do so by issuing shares, or borrowing, or a mixture of both?

As was stated before, debt is not necessarily a bad thing. Reasons:

1. Debt is cheaper (for the company) than equity …… (why?)…

Two reasons:

1. Equity must offer a higher return

to compensate for the increased risk

this return may be through:

a healthy dividend; or

capital gains; or

a mixture of these

1. Debt attracts tax relief

Imagine a company raises £1m:

In scenario 1: by issuing shares

In scenario 2; by issuing “8% bonds”

Imagine also that this company makes a profit (before the deduction of loan

interest and tax) of £200k this year, and that the rate of corporation tax is 30%.

The effect of issuing bonds has been to attract tax relief equal to:

• 60 – 36 = 24 (note that this is also equal to 30% of £80k, i.e. the tax rate multiplied by the interest charge)

2. Issuing debt brings no dilution of equity

Suppose five partners formed a company two years ago, each partner buying 20,000 £1 shares. Suppose also that a further £60,000 is to be raised in one of two ways:

i) via the issue of a further 60,000 £1 shares to a VC.

ii) via the issue of £60k worth of bonds to a VC

The effect of ‘gearing’

We saw earlier that debt is cheaper than equity. This is true, but only up to a point. Beyond a certain level of debt a company runs the risk of financial distress.

WHY? 

More debt leads to higher interests and repayments

These responsibilities are unavoidable (unless the debt can be re-scheduled)

Equity carries No such responsibilities – ‘no dividends’ acceptable, even expected in early stage companies

Default carries high costs – e.g.: penalty clauses

For the above reasons, the traditional view is that there is an ‘optimum’ level of debt, as indicated by the following graph:

A graph to show the theoretical ‘optimal’ level of debt in a company

        Debt as a % of total finance (‘gearing’)

Cost %

The implications of this graph are:

• the WACC = the weighted average cost of capital

• at 0% debt: the WACC equals the cost of equity i.e. the shareholders desired minimum return: (30% here) 

• as the company takes on debt: the WACC falls because debt is cheaper than equity

• as the company takes on really high levels of debt: the WACC rises again because the risk of default/ financial, distress increases

• so there is an optimal level of gearing

The optimum level of gearing differs with individual firms and industries. Some

analysts dispute the existence of an optimum level of gearing at all.

Other drawbacks of loans:

1.  Loan Covenants

These are clauses put into loan contracts to enforce the borrowers to comply with certain obligations. For example, a few years ago with Liverpool F.C.

"When I took the role [as Chairman] they [Hicks and Gillette] gave a couple of written undertakings to Royal Bank of Scotland - that I was the only person entitled to change the board and that they would take no action to frustrate any reasonable sale," stated Broughton.

From the BBC website, 7^th October 2010

[background: Martin Broughton was installed as Chairman (on the insistence of RBS) when the (then) club owners, Messrs.  Hicks and Gillette, were arranging their re-financing deal].

2. Future borrowing

The more highly-geared a firm, the higher-risk it becomes to the potential investor. Therefore arranging further loans becomes more difficult and / or expensive.

Other effects of gearing

Imagine our company has to raise £1m again

In scenario 1: by issuing £1 ordinary shares

In scenario 2; by issuing “8% bonds”

But this time there is already £0.5 m of 8% bonds and £0.5m of £1 ordinary shares issued. In order to keep things simple we will ignore corporation tax this time.

If profits are low / moderate (say £150K): ß

Conclusions: ß

• Better (for ordinary shareholders) for Co. to be low-geared when profits are low.

• Interest charges don’t eat away all the profits.

If profits are higher (say £300k):

Conclusions: ß

• Better (for ordinary shareholders) for Co. to be higher-geared when profits are higher

• Interest charges are higher

• But the profit left-over gets shared between fewer shares

Calculating the ‘interest cover’ ratio

This is simply the net profit before interest (NPBI in the above)

divided by the interest charge for the year.

So using the higher profit figure of £300k:

In scenario 1 (above) the interest cover is 300/40 = 7.5 times

In scenario 2 (above) the interest cover is 300/120 = 2.5 times

Calculating the level of gearing

There was a simple calculation on the first page of this handout, but we will now re-visit:

There are several different ways to calculate the gearing ratio. The method we will use on this Unit is as follows:

Long-term debt x 100

All finance*

(*long-term debt plus shareholders funds**)

**Ordinary share capital plus reserves of any kind)

Thus if a company had loans of £350k, Ordinary share capital of £100k and a share premium of £50k and a P & L balance of £150k the gearing ratio would be:                       

£350k / (£350k + £100k + £50k + £150k)  X 100 = 53.8%

Meaning that, out of every £100 invested^[2] in the company £53.80p had been borrowed – the remaining £46.20p is shareholders investment. A company with a gearing ratio of over 50% is normally considered ‘high-geared’. Broadly speaking, less than 25% would be regarded as low – geared.

^[1] (No amounts appear for short term debt in the above table, because it is classed as a current liability, and the table only shows non-current liabilities, but you can see the names of the three instruments).

^[2] Please note we are taking a loose definition of investment here – in other words, profits not taken out of the company also constitute ‘investment’