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© 2003 McGraw-Hill Ryerson Limited
1616Chapt
er
Chapt
er Long-Term Debt
and Lease FinancingLong-Term Debt
and Lease Financing
McGraw-Hill Ryerson ©2003 McGraw-Hill Ryerson Limited
Revised By:P Chua
Prepared by:Terry Fegarty
May 4, 2005
© 2003 McGraw-Hill Ryerson Limited
Chapter 16 - Outline
BondsBond TerminologyPriority of Claims on BankruptcyMethods of Retiring (Repaying) BondsReading Bond Price Quotations3 Types of Bond YieldsBond Ratings
Other Forms of Bond FinancingLease vs. Purchase
2 Types of LeasesAdvantages/Disadvantages of DebtAdvantages/Disadvantages of Leasing
Summary and Conclusions
PPT 16-2
© 2003 McGraw-Hill Ryerson Limited
Firms and governments “borrow” money from investors by selling bonds
A bond is a written promise that the borrower (firm) will pay the lender (investor) at a stated future date, the principal plus a stated rate of interest
Bonds differ from one another in terms of maturity (payment date), potential yield (interest rate), and investment quality (risk)
Several companies rate the quality of various bonds
Bonds
PPT 16-4
© 2003 McGraw-Hill Ryerson Limited
Bond Terminology
Par Value: principal or face value (usually $1,000)
Coupon Rate: stated interest rate
Maturity Date: date when repayment of principal is due
Indenture: legal document detailing the corporation’s obligations and
Restrictive Covenants
Secured Debt: where specific assets are pledged in the event of default
Debenture: a L/T unsecured corporate bond
PPT 16-5
© 2003 McGraw-Hill Ryerson Limited
Figure 16-2Priority of claims
PPT 16-6
SeniorJunior
Preferred stockCommon stock
Unsecured debt(debentures)
Senior
First claim on assets pledgedSecond claim on assets pledged
Remaining assets are distributed below.
Lower priorityof claims
Subordinated debenture holders will not receive payment unless designated senior debentureholders are paid in full.
Secured debt
Subordinated
© 2003 McGraw-Hill Ryerson Limited
Methods of Retiring (Repaying) Bonds
Principal at maturity: lump-sum payment when bond is due
Serial payments: bond is paid off in installments
Sinking fund: corporation contributes regularly to
a trust fund used to buy back bonds
Conversion: bond can be converted into shares of common stock at the option
of the bondholder
Call feature: corporation can redeem bonds early by paying a premium over
par value
PPT 16-7
© 2003 McGraw-Hill Ryerson Limited
Your Daily Paper Issuer Coupon Maturity Price Yield Change
BC Tel 9.65 Apr 8-22 138.5 6.488 +1.118
Company NameCompany NameCouponCoupon(interest rate %)(interest rate %)
Maturity DateMaturity Date(April 8, 2022)(April 8, 2022)
PricePrice(Last transaction(Last transactionprice = $138.50/ $100)price = $138.50/ $100)
YieldYield((Annual interestAnnual interestMarket price)Market price)
ChangeChange(Closing (Closing price upprice up$1.11 from$1.11 fromprevious day)previous day)
Reading Bond Price Quotations
PPT 16-9
© 2003 McGraw-Hill Ryerson Limited
Table 16-2:Interest rates and bond prices (the bond pays 12 percent interest)
PPT 16-10
Years toMaturity
Rate in the Market (percent)
11525
8%$1,037.72
1,345.841,429.64
10%$1,018.59
1,153.721,182.56
12%$1,0001,0001,000
14%$981.92
875.91861.99
16%$964.33
774.84755.33
Note: This table is based on semiannual interest payments, with annualized interestrates
© 2003 McGraw-Hill Ryerson Limited
3 Types of Bond Yields
Coupon Rate (or Nominal Yield ): interest payment divided by par value
Current Yield: interest payment divided by current price of the bond
Yield-to-Maturity (YTM): interest rate that equates the future (expected) interest
payments and payment at maturity to the current market price of the bond
affected by current market interest rates If rates , YTM , bond price
and bond rating
If rating high (low risk), YTM
PPT 16-11
© 2003 McGraw-Hill Ryerson Limited
Figure 16-3Long-term yields on corporate debt
PPT 16-12
© 2003 McGraw-Hill Ryerson Limited
Bond Ratings
Rating ServiceHigh
Grade
Medium Grade (Investment
Grade) SpeculativePoor
Grade
Moody's Aaa Aa A Baa Ba B Caa to CStandard & Poor's AAA AA A BBB BB B CCC to DDominion AAA BBB CB
Risk Factor Low High
Bond Ratings
PPT 16-13
© 2003 McGraw-Hill Ryerson Limited
Table 16-3Outstanding debt issues, March 1, 2002
Rating/Issuer Coupon Maturity Date Price Yield to Maturity
AAACARDS Trust Receivables 5.630 Dec. 21/05 102.94 4.77Government of Canada 5.750 Sept. 01/06 104.10 4.72Government of Canada 8.000 June 01/27 127.72 5.88AABMO 8.150 May 9/06 111.29 5.11BMO 6.685 Dec. 31/11 101.69 6.45Nav Canada 6.600 Dec 01/06 106.13 5.12Nav Canada 7.400 June 01/27 109.78 6.60A Bell Canada 6.700 June 28/07 105.74 5.44Bell Canada 7.850 April 02/31 106.11 7.34Loblaw 6.000 June 02/08 101.92 5.63Loblaw 6.650 Nov. O8/27 96.67 6.93BBB Domtar 10.000 Apr. 15/11 108.21 8.68Talisman 5.800 Jan. 30/07 97.69 6.35BBRogers Cable 10.500 June 01/06 103.00 9.61BAir Canada 6.750 Feb 02/04 72.00 26.29Saskatchewan Wheat Pool 6.600 July 18/07 71.00 14.56
PPT 16-14
© 2003 McGraw-Hill Ryerson Limited
Other Forms of Bond Financing
Zero-Coupon Bond / Strip Bond: does not pay interest is issued at a deep discount from face value
Floating Rate Bond: interest rate paid on the bond changes with market
conditionsReal Return Bond
principal adjusted for inflationRevenue Bond
security based upon cash flowEurobond:
bond issued in another country
PPT 16-17
© 2003 McGraw-Hill Ryerson Limited
Table 16-4Examples of Eurobonds
Amount Outstanding Currency
Rating Coupon Maturity ($ millions) Denomination*
Petro-Canada Baa1 9.25% 2021 300.0 U.S.$
Procter & Gamble Co. Aa2 10.88% 2003 200.0 C$
Sony Corporation Aa3 1.40% 2005 300.0 Yen
Telecom Corporation Aa1 7.50% 2003 100.0 N Z$
*C$ is Canadian dollar, and N Z $ is New Zealand dollar.Source: Mergent Bond Report,July 2000
PPT 16-18
Source: Moody’s Bond Record, July 1998..
© 2003 McGraw-Hill Ryerson Limited
Advantages and Disadvantages of Debt
Advantages of Debt: interest payments are tax deductible to a firm wise use of debt may lower a firm’s weighted
average cost of capital (WACC) financial obligation is fixed no reduction in control or equity of present
shareholders company may get a better return on equity from
leverage
PPT 16-19
© 2003 McGraw-Hill Ryerson Limited
Advantages and Disadvantages of Debt
Disadvantages of Debt:
interest and principal must always be met when due, regardless of a firm’s financial position
agreements may restrict financial management in firm
poor use of debt may lower a firm’s stock price expensive financing when interest rates are high
PPT 16-20
© 2003 McGraw-Hill Ryerson Limited
2 Types of Leases
Capital Lease (or Financing Lease): Lease payments are usually sufficient to fully cover
the lessor’s cost of purchasing the assets and provide the lessor a return on investment
The lessee is usually responsible for the upkeep of the asset
Generally, lease cannot be cancelled must be shown on a firm’s balance sheet ex., oil drilling equipment and airplanes
PPT 16-21
© 2003 McGraw-Hill Ryerson Limited
2 Types of Leases
Operating Lease: Usually a shorter term lease a conventional rental agreement Often cancellable on short notice Lessor is responsible for upkeep of
asset firm doesn’t expect to own the asset is not shown on a firm’s balance
sheet ex., automobiles and office
equipment
PPT 16-21
© 2003 McGraw-Hill Ryerson Limited
Capital Lease Criteria
A lease is considered a Capital Lease if it meets one of the following criteria: The lease transfers ownership of the asset to the
lessee at the end the lease term Lessee has the option to purchase the asset at a price
below the fair market value when the lease expires. The lease term is 75% or more of the estimated
economic life of the asset The PV of the lease payments is at least 90% of the
fair market value of the asset at the start of the lease
© 2003 McGraw-Hill Ryerson Limited
Advantages of Leasing A loan may be more expensive / refused There may be no down payment on a lease, but usually a
down payment with a loan A lease may have fewer restrictions than a loan There is a fixed payment on a lease, but loan interest may
vary with prime Lease from a manufacturer may have attractive terms (ex:
lower interest cost) or provide specialist expertise Using a lease may restrict creditor claims in bankruptcy Lease may be preferable for equipment with rapid
obsolescence (ex: computers) May have more tax advantages using a lease
PPT 16-22
© 2003 McGraw-Hill Ryerson Limited
Lease vs Borrow-Purchase Problem A Firm is considering the purchase of an asset as opposed to
leasing it. The asset costs $5,000. To purchase it, the firm must get a
loan from its bank. The loan amortization will be $1,319 for 5 years at 10%. Interest payments from yrs. 1 to 5 are: $500, $418, $328, $229, and $120. CCA rate is 20 %.
To lease the asset, the firm must pay $1,250 during the 1st and 2nd years, and $1,800 during the 3rd to 5th years. Note that lease payments are made at the beginning of each year.
Tax rate is 40% Which option is less costly?
© 2003 McGraw-Hill Ryerson Limited
Table 16-7Net present value of borrow-purchase
(1)
(2)
(3)
(4)
(5)
Year PV of CCA
Shield
Payment
Interest Tax
Shield
Aftertax Cost of
(2)-(3)
Present Value at 6%
1 . . . . . . . . . . . . ($1,319) $500 x .4 $(1,119) $(1,056)
2 . . . . . . . . . . . . ($1,319) $418 x .4 (1,152) (1,025)
3 . . . . . . . . . . . . ($1,319) $328 x .4 (1,188) (997)
4 . . . . . . . . . . . . ($1,319) $229 x .4 (1,227) (972)
5 . . . . . . . . . . . . ($1,319) $120 x .4 (1,271) (950)
(5,000)
Or Cost of asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,000) PV of CCA shield . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,495 PV of borrowing alternative . . . . . . . . . . . . . . . . . . . ($3,505)
PPT 16-23
© 2003 McGraw-Hill Ryerson Limited
Table 16-8Net present value of operating lease outflows
Year Payment Tax Shield
Aftertax Cost of Leasing
Present Value at 6%
0 . . . . . . . . ($1,250) $ 0 ($1,250) ($1,250)
1 . . . . . . . . (1,250) 500 (750) (708)
2 . . . . . . . . (1,800) 500 (1,300) (1,157)
3 . . . . . . . . (1,800) 720 (1,080) ( 907)
4 . . . . . . . . (1,800) 720 (1,080) ( 855)
5 . . . . . . . . 0 720 720 538
($4,339)
PPT 16-24
© 2003 McGraw-Hill Ryerson Limited
Summary and Conclusions
Debt financing by major corporations often involves the sale of secured bonds or unsecured bonds (debentures).Corporate bonds may have sinking-fund, call, or conversion features causing retirement before maturity.Bond prices and yields are inversely related and are based upon the level of interest rates and bond ratingsLong-term capital leases are an alternative form of long-term financing
PPT 16-25
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