978-1259277160 Chapter 16 Lecture Note

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Long-Term Debt and Lease Financing

Author’s Overview

This chapter covers a broad range of debt topics including secured versus unsecured debt,

sinking fund provisions, bond prices, yields, ratings, and conversion and call features. The

student gets a good indoctrination into the various influences on bond prices, which can be

strongly reinforced by problems at the back of the chapter. Table 16-3 summarizes various

points about bond pricing such as coupon rate versus market rate and the influence of bond

ratings.

The bond refunding decision is covered from the approach of a capital budgeting problem and

leasing is examined as a special form of debt, rather than as a separate type of financing.

Studies and pronouncements by the accounting profession have taken the authors in this

direction. However, the reasons for a lease arrangement are clearly enumerated. Additional

material on the lease versus purchase decision is also covered in Appendix 16B.

Financial alternatives for distressed times are covered in Appendix 16A, with a discussion of

out-of-court and in-court settlements. Disposal of assets under liquidation are also examined in

this appendix.

Chapter Concepts

LO1. Analyzing long-term debt requires consideration of the collateral pledged, method of

repayment, and other key factors.

LO2. Bond yields are important to bond analysis and are influenced by how bonds are rated

by major bond rating agencies.

LO3. An important corporate decision is whether to call in and reissue debt (refund the

obligation) when interest rates decline.

LO4. Long-term lease obligations have many characteristics similar to debt and are

recognized as a form of indirect debt by the accounting profession.

LO5. When a firm fails to meet its financial obligations, it may be subject to bankruptcy.

Annotated Outline and Strategy

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I. The Expanding Role of Debt

Perspective 16-1: The expanding role of debt is not just an issue for corporations but also

for federal and state governments and consumers.

A. Corporate debt has expanded dramatically in the last three decades.

B. The rapid expansion of corporate debt is the result of:

1. Rapid business expansion.

2. Inflation.

3. At times, inadequate funds generated from the internal operations of

business firms.

4. Repurchase of common stock with cheap debt.

C. Corporations suffered a decline in interest coverage until 2008 and then remained

relatively stable which is the same pattern exhibited by Walmart. Although the

financial crisis had a dramatic affect on financial institutions most corporations

suffered a temporary decline in earnings. As earnings rebounded and they

refinanced debt at low interest rates, their earnings coverage ratios rebounded to

record levels.

PPT Times Interest Earned for Walmart Stores, Inc.

(Figure 16-1)

II. The Debt Contract

A. Par value: the face value of a bond

B. Coupon rate: the actual interest rate on a bond; annual interest/par value

C. Maturity date: the final date on which repayment of the debt principal is due

D. Indenture: lengthy, legal agreement detailing the issuer’s obligations pertaining

to a bond issue. The indenture is administered by an independent trustee.

E. Security provisions

1. Secured claim: specific assets are pledged to bondholders in the event of

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default.

2. Mortgage agreement: real property is pledged as security for loan.

3. Senior claims require satisfaction in liquidation proceedings prior to

junior claims.

4. New property may become subject to a security provision by an “after

acquired property clause.”

F. Unsecured debt

1. Debenture: an unsecured, long-term corporate bond

2. Subordinated debenture: an unsecured bond in which payment will be

made to the bondholder only after the holders of designated senior debt

issues have been satisfied.

PPT Priority of Claims (Figure 16-2)

Perspective 16-2: The example of General Motors bankruptcy is a wonderful example of the

priority of claims and also of government intervention in the markets.

G. Methods of Repayment

1. Lump: sum payment at maturity

2. Serial payments: bonds are paid off in installments over the life of the

issue; each bond has a predetermined maturity date.

3. Sinking fund: the issuer is required to make regular contributions to fund

under the trustee’s control. The trustee purchases (retires) bonds in the

market with the contributions.

4. Conversion: retirement by converting bonds into common stock; this is

the option of the holder but it may be forced. (See Chapter 19.)

5. Call Feature: an option of the issuing corporation allowing it to retire the

debt issue prior to maturity. It requires payment of a call premium over

par value of 5 percent to 10 percent to the bondholder. The call is usually

exercised by the firm when interest rates have fallen.

H. An Example: Eli Lilly’s 6.77 Percent Bond. (See Table 16-1)

III. Bond Prices, Yields, and Ratings

A. Bond prices are largely determined by the relationship of their coupon rate to the

going market rate and the number of years until maturity.

1. If the market rate for the bond exceeds the coupon rate, the bond will sell

below par value. If the market rate is less than the coupon rate, the bond

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will sell above par value.

2. The more distant the maturity date of a bond, the farther below or above

par value the price will be given the coupon rate and market rate

relationship.

3. Table 16-2 features and Excel spreadsheet that demonstrates years to

maturity and changing bond prices as market rates change.

PPT Bond Price Table (Table 16-2)

PPT Long-Term Yields on Debt (Figure 16-3)

B. Bond yields are quoted on three different bases. Assume a $ 1,000 par value bond

pays $100 per year interest for 10 years. The bond is currently selling at $900 in

the market.

Perspective 16-3: It is important for students to understand the difference between the

various bond yields. The most important yield is the yield to maturity, which is a function of

price change as well as annual cash flow.

1. Coupon rate (nominal yield): Stated interest payment divided by par

value $100/$1,000 = 10%

2. Current yield: Stated interest payment divided by the current price of the

bond, $100/$900 = 11.11%

Perspective 16-4: You may want to refer to the material on page 306 in Chapter 10 that

demonstrates the calculation of yield to maturity using an Excel spreadsheet or calculator

keystrokes. The approximate yield to maturity calculation demonstrates the impact on YTM

when the bond sells at a premium or discount.

3. Yield to Maturity: the interest rate that will equate future interest

payments and payment at maturity to current market price (the internal

rate of return). The yield to maturity may be computed approximately by

the following formula found in footnote 2 on page 511.

Perspective 16-5: Of course with spreadsheets and calculators, approximation formulas are

not necessary but the calculation is instructive in terms of examining the impact on yield to

maturity with the bond sells at a discount or premium. While the excel examples give the right

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answer they are not always as instructive. The denominator is 60-40 rather than 50-50 to make

up for the curvilinear nature of the bond price over time as seen in Figure 10-2 on page 304.

C. Bond ratings

1. There are two major bond-rating agencies: Moody’s Investor Service and

Standard and Poor’s Corporation.

2. The higher the rating, the lower the interest rate that must be paid.

3. The ratings are based on the:

a. firm’s ability to make interest payments.

b. consistency of performance.

c. firm size.

d. debt/equity ratio.

e. firm’s working capital position.

f. and other factors.

D. Examining actual bond ratings: See Table 16-3 and discussion.

Finance in Action: “Open Sesame” –The Story of Alibaba and the Six Bond Tranches

In Chapter 15 we saw that Alibaba was the largest IPO of 2014 and in this box we highlight

their $8 billion bond offering two months after the IPO. There were six separate bonds with

different sizes, due dates and terms with the final one a $300 million floating rate note

denominated in Singapore dollars. This is a great international example of a Chinese company

selling bonds in the U.S. and with one tranche in a foreign currency.

IV. The Refunding Decision

A. The process of calling outstanding bonds and replacing them with new ones is

termed refunding. This action is most likely to be pursued by businesses during

periods of declining interest rates.

B. Interest savings from refunding can be substantial over the life of a bond but the

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payment) (Principal .4 + bond) theof (Price .6

maturity toyears ofNumber

bond theof Price -payment Principal

+payment interest Annual

Maturity

toYield

eApproximat

costs of refunding can also be very large.

Perspective 16-6: Compare the refunding decision with paying off a high-cost mortgage

early and refinancing it at a lower rate with all the resultant costs of financing, points, closing

fees, lawyers, etc. Notice that all present value examples have calculator keystroke solution in

the margin.

C. A refunding decision is nothing more than a capital budgeting problem. The

refunding costs constitute the investment. The net reduction in annual cash

expenditures are the inflows.

1. Outflow Considerations:

a. The after tax cost of the call premium

b. The Underwriting Cost on the new issue less the PV of the future

tax savings (on the new underwriting cost)

2. Inflow Considerations:

a. The present value of the after tax savings on the difference in the

interest rates

b. Tax benefit from the immediate write off of the remaining

unamortized underwriting cost of old issue. (The difference

between immediate write off of remaining value and the PV of

annual write off times the tax rate.)

3. Net Present Value: Inflows minus outflows equals Net Present Value.

PPT Net Present Value

D. A major difference in evaluating a capital expenditure for refunding is that the

discount rate applied is the aftertax cost of debt rather than the cost of capital

because the annual savings are known with greater certainty.

V. Other Forms of Bond Financing

A. Zero-Coupon Rate Bonds

1. Do not pay interest; sold at deep discounts from face value.

2. These bonds provide immediate cash inflow to the corporation (sell

bonds) without any outflow (interest payments) until the bonds mature.

3. Since the difference between the selling price and the maturity value is

amortized for tax purposes over the life of the bond, a tax reduction

benefit occurs without a current cash outflow.

4. Allows investor to “lock-in” a multiplier of the initial investment.

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5. Most investors in these bonds are tax exempt because the annual increase

in bond value is taxed as ordinary income even though no payment is

received.

6. Brokerage houses are marketing future interests in government securities

which are a variation of the zero-coupon rate bond.

PPT Zero-Coupon Bonds (Table 16-4)

B. Floating Rate Bonds

1. The interest rate varies with market conditions.

2. Unless market rates move beyond floating rate limits, the price of the

floating rate bond should not change, therefore, the investor is assured

(within limits) of the market value of his investment.

VI. Advantages and Disadvantages of Debt

A. Benefits of Debt

1. Tax deductibility of interest.

2. The financial obligation is specific and fixed (with the exception of

floating rate bonds).

3. In an inflationary economy, debt may be repaid with “cheaper dollars.”

4. Prudent use of debt may lower the cost of capital.

B. Drawbacks of Debt

1. Interest and principal payments must be met when due regardless of the

firm’s financial position.

2. Burdensome bond indenture restrictions.

3. Imprudent use of debt may depress stock prices.

C. Eurobond Market

1. Usually denominated is dollars but not always.

2. Disclosure less stringent then U.S. Securities and Exchange Commission.

3. Not able to rely on rating agencies.

4. See examples in Table 16-5.

PPT Examples of Eurobonds (Table 16-5)

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VII. Leasing as a Form of Debt

A. A long-term, noncancellable lease has all the characteristics of a debt obligation.

B. The position of the accounting profession that companies should fully divulge all

information about leasing obligations was made official for financial reporting

purposes in November, 1976. The Financial Accounting Standards Board

(FASB) issued Statement No. 13.

1. Prior to FASB Statement No. 13, lease obligations could be disclosed in

footnotes to financial statements.

2. FASB No. 13 requires that certain types of leases be shown as long-term

obligations on a firm’s financial statements.

C. Leases that substantially transfer all the benefits and risks of ownership from the

owner to the lessee must be capitalized. A capital lease is required whenever

any one of the following conditions exists.

1. Ownership of the property is transferred to the lessee by the end of the

lease term.

2. The lease contains a bargain purchase price (sure to be purchased) at the

end of the lease.

3. The lease term is equal to 75 percent or more of the estimated life of the

leased property.

4. The present value of the minimum lease payments equals or exceeds 90

percent of the fair value of the leased property at the beginning of the

lease.

D. A lease that does not meet any of the four criteria is an operating lease.

1. Usually short-term.

2. Often cancelable at the option of the lessee.

3. The lessor frequently provides maintenance.

4. Capitalization and presentation on the balance sheet is not required.

E. Impact of capital lease on the income statement

1. The intangible leased property under capital lease (asset) amount is

amortized and written off over the life of the lease.

2. The obligation under capital lease (liability) is written off through

amortization with an “implied” interest expense on the remaining balance.

F. Advantages of leasing

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1. Lessee may not have sufficient funds to purchase or borrowing capability.

2. Provisions of lease may be less restrictive.

3. May be no down payment.

4. Expert advice of leasing (lessor) company.

5. Creditor claims on certain types of leases are restricted in bankruptcy and

reorganization procedures.

6. Tax considerations

a. Obtain maximum benefit of tax advantages.

b. Tax deductibility of lease payments for land.

7. Infusion of capital through a sale-leaseback.

VIII. Appendix 16A: Financial Alternatives for Distressed Firms

A. Financial Distress

1. Technical Insolvency-firm has positive net worth but is unable to pay its

bills as they come due.

2. Bankruptcy-a firm’s liabilities exceed the value of its assets-negative net

worth.

B. Out-of-Court Settlements

1. Extension-creditors allow the firm more time to meet its financial

obligations.

2. Composition-creditors agree to accept a fractional settlement on their

original claim.

3. Creditor committee-a creditor committee is established to run the

business in place of the existing management.

4. Assignment-a liquidation of the firm’s assets without going through

formal court action.

C. In-Court Settlements-Formal Bankruptcy

1. Bankruptcy proceedings may be initiated voluntarily by the firm or

forced by the creditors-involuntary bankruptcy.

2. The decisions of a court appointed referee who arbitrates the bankruptcy

proceedings are final subject to court review.

3. Reorganization-a fair and feasible plan to reorganize the bankrupt firm.

a. Internal reorganization necessitates an evaluation of existing

management and policies. An assessment and possible redesign of

the firm’s capital structure is also required.

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b. External reorganization-a financially strong and managerially

competent merger partner is found for the bankrupt firm.

4. Liquidation-if reorganization of the firm is determined to be infeasible;

the assets of the firm will be sold to satisfy creditors. The priority of

claims is:

a. Bankruptcy administrative costs (legal fees)

b. Wages of workers earned within 3 months of bankruptcy

declaration

c. Federal, state and local taxes

d. Secured creditors-designated assets

e. General creditors-there is a priority within this category also

f. Preferred stockholders

g. Common stockholders

IX. Appendix 16B: Lease versus Purchase Decision

A. Leasing as a means of financing is often compared to borrow-purchase

arrangements when assets are to be acquired. This procedure is particularly

appropriate for comparing an operating lease to purchasing.

B. The present value of all after-tax cash outflows associated with each form of

financing is computed. The procedure requires consideration of all tax shields

for each method. Since all outflows are fixed by contract, the discount rate

employed in computing the present value of the outflows is the after-tax cost of

debt.

C. Although qualitative factors must be considered, the usual decision criterion is to

accept the financing method (lease, or purchase) which has the lowest present

value of cash outflows. The cash inflows should be the same whether the asset

is leased or purchased.

Other Chapter Supplements

Cases for Use with Foundations of Financial Management

Case 24, Leland Industries (Debt Financing)

Case 25, Warner Motor Oil Co. (Bond refunding)

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