© 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)

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© 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