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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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16-1
16
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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16-2
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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Education.
16-3
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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16-4
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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16-9
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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