Sources of Long-Term Finance: Debt Finance Study Guide

Reading and Reference Materials

• 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 (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 the specific features of corporate bonds, including:

  • Floating rate bonds.

  • Deep-discounted bonds.

  • Zero-coupon bonds.

  • The redemption of bonds.

• Discuss the relative advantages and disadvantages of equity versus debt finance for a company (to be completed after lectures on both topics).

Distinguishing Features of Debt Finance

• Seniority and Risk: Debt finance is perceived by investors as less risky than equity finance for two primary reasons:

  • Interest payments are disbursed to debt holders before dividends are paid to shareholders.

  • Debt is more senior in the event of company liquidation.

• Cost of Finance: Because investors perceive debt as lower risk, they require a lower expected rate of return compared to equity. Consequently, from the perspective of the borrowing company, debt finance is cheaper than equity finance.

Secured Debentures and Secured Loan Stock

• Definition of a Debenture: A debenture is a bond provided in exchange for money lent to a company. In this arrangement, the company agrees to:

  • (i) Repay the principal (also known as the par, face, or nominal value) at a specified future date, known as the redemption date.

  • (ii) Pay a stated rate of interest, referred to as the coupon payment, each year until the debt is repaid.

• Denomination: Debentures are typically divided into securities with a nominal value of $£100$.

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

• Irredeemable Debentures (Perpetual Debenture):

  • These have no specified date for redemption.

  • The company may repay the principal at its own discretion, but the holder cannot demand payment.

  • These are very rare because they are generally not attractive to investors.

Types of Secured Debentures

• Floating Charge (Blanket) Debentures:

  • The debt is secured by a floating charge attached to all current and future assets of the company.

  • No particular assets are specified in the charge.

  • The company is free to dispose of these assets without consulting debenture holders or their trustees, provided it meets its contractual obligations.

  • Crystallization: If the company defaults (e.g., misses an interest payment or is wound up), the floating charge "crystallizes" and becomes a fixed charge.

• Fixed Charge (Mortgage) Debentures:

  • The debenture is secured against specific assets, typically land and buildings.

  • In the event of liquidation, these specific assets are sold, and the proceeds are used primarily to satisfy the claims of the debenture holders.

Legal and Payment Obligations of Debt

• Mandatory Interest: Unlike dividends, debenture interest must be paid regardless of whether the company generates a profit.

• Default Rights: If interest is not paid, debenture holders have the legal right to force the company into liquidation to demand payment.

• Asset Claims: Debt holders rank ahead of all types of shareholders (including preference shareholders) in their claims on company assets during liquidation.

• Determinants of Interest Rates: The interest rate a debenture carries depends on:

  • (a) Long-run market interest rates prevailing at the time of the issue.

  • (b) The specific type of debenture (e.g., secured vs. unsecured).

Unsecured Debentures and Loan Stock

• Risk Profile: Unsecured debentures are riskier than secured ones because they are not backed by specific assets.

• Interest Rates: Due to the higher risk, interest rates for unsecured debt are higher than for secured debt.

• Protective Covenants: To mitigate risk, loan agreements often include protective covenants that restrict company actions. Examples include:

  • (a) Dividend restrictions: Limits on how much can be paid out to shareholders.

  • (b) Financial ratios: Requirements to maintain specific liquidity or leverage ratios.

  • (c) Financial reports: Requirements for regular financial transparency.

  • (d) Issue of further debt: Restrictions on the company's ability to take on additional borrowing.

Convertible Debentures and Warrants

• Convertible Debentures:

  • A debt instrument that gives the holder the option to convert the debt into equity (shares).

  • It starts as a debenture, providing a fixed annual interest rate.

  • Interest Rate Benefit: Because of the valuable conversion option, the interest rate paid on convertibles is lower than on "straight" debt.

• Warrants:

  • The holder purchases a debenture that includes the 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 give up (relinquish) their debenture to get the shares. They can keep the debt and purchase the equity, effectively holding both.

Bank Borrowing

• Nature: Unlike debentures, no tradable security is issued. This is a direct agreement between a bank and a company.

• Term-Loans: These are usually long-term (greater than $10$ years).

• Interest Rates: Can be fixed or variable. They are typically set at a spread of $3\%$ to $6\%$ above the base rate, depending on the company's credit rating.

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

Valuing Fixed-Interest Securities

• Terminology:

  • Coupon Rate: The interest rate offered on the face value of the bond.

  • Face Value (Nominal/Par/Principal): The price at which the bond is redeemed at maturity.

  • Issue Price: The price at which the bond is first sold to investors.

  • Market Price: The current trading price of the bond in the secondary market.

Valuing Irredeemable Debt

• In this case, the investor only cares about the annual coupon payments ($I$) since the principal is not expected back at a specific date.

• Formula:     $\mathbf{P_{ID} = \frac{I}{K_D}}$

• Definitions:

  • $P_{ID}$: Market price of irredeemable debt.

  • $I$: Annual interest (coupon) payment.

  • $K_D$: Cost of debt, representing the market rate of interest for securities in the same risk class.

• Example 1:

  • Coupon rate: $5\%$.

  • Face value: $£100$.

  • Current market interest rate ($K_D$): $10\%$.

  • Annual Interest ($I$): $0.05 \times £100 = £5$.

  • Market Price ($P_{ID}$): $\frac{£5}{0.1} = £50$.

• Example 2 (Rate Fall):

  • If market interest rates fall to $2.5\%$.

  • Market Price ($P_{ID}$): $\frac{£5}{0.025} = £200$.

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

Valuing Redeemable Debt

• The investor receives annual interest payments plus the principal (maturity value) at the end of the term.

• Formula:     $\mathbf{P_{RD} = \sum_{t=1}^{n} \frac{I_t}{(1 + K_D)^t} + \frac{M_n}{(1 + K_D)^n}}$

• Definitions:

  • $P_{RD}$: Current market price of redeemable debt.

  • $I_t$: Periodic interest payment.

  • $M_n$: Maturity value (principal) paid at year $n$.

  • $K_D$: Cost of debt or redemption yield (also known as Yield to Maturity).

• Calculation Example:

  • Face Value: $£100$.

  • Redemption: $2$ years at par.

  • Coupon Rate: $10\%$ (payable annually).

  • Market Price ($P_{RD}$): $£85$.

  • Equation setup: $85 = \frac{10}{(1 + K_D)^1} + \frac{10}{(1 + K_D)^2} + \frac{100}{(1 + K_D)^2}$.

  • Simplified: $85 = \frac{10}{(1 + K_D)} + \frac{110}{(1 + K_D)^2}$.

  • This is a quadratic equation used to solve for the redemption yield ($K_D$).

• Mathematical Complications:

  • Semi-annual interest payments change the discounting frequency.

  • Longer maturities (e.g., $10$ or $20$ years) make manual quadratic solutions impossible.

Advanced Bond Features

• Floating Rate Bonds:

  • Introduced due to high interest rate volatility in the late 1970s.

  • Volatility caused large capital gains or losses for both parties.

  • Floating rate debentures have a variable coupon rate, typically pegged to the six-month interbank rate.

• Deep-Discounted and Zero-Coupon Bonds:

  • Zero-Coupon: Coupon rate is $0\%$.

  • Deep-Discounted: Coupon rate is significantly lower than the current market rate.

  • Compensation: Investors are compensated by a large discount on the issue price.

  • Example: A bond with no interest issued at $£50$ and redeemable at $£100$. The $£50$ difference is the discount.

  • Investor Profile: Suitable for those who prefer lump-sum final payments over annual cash flows.

  • Company Benefit: Allows the company to raise funds immediately without draining short-term cash flows through interest payments.

Redemption of Bonds

• Companies must plan how to ensure sufficient funds are available to repay debt holders at the redemption date. Methods include:

  • (i) Issuing more debt to pay off old debt.

  • (ii) Utilizing profits earned in the year of redemption.

  • (iii) Creating a sinking fund reserve, where funds are set aside periodically over the life of the debt.