Chapter 13 Long-Term Debt and Leasing
Chapter Overview
The Opening Focus looks at GE Capital’s 2009 issue of bonds. The bond issue was one of the first
by a financial company borrower without an explicit guarantee from FDIC. Despite its AAA
rating, GE Capital was forced to price the bonds at 400 basis points yield spread over the 30
Treasuries available at that time. This high yield illustrated that historical precedent does not
always give an accurate basis on bonds during a financial crisis.
Opening Focus Discussion Questions:
1. As students, what metrics might you use to evaluate the debt quality of a firm?
2. What metrics do rating organizations such as Standard and Poor’s and Moody’s use to come up
with their grades?
This chapter discusses:
1-1. Characteristics of Long-Term Debt Financing
Technology
1. Smart Ideas Video. Annette Poulsen of the University of Chicago discusses debt covenants as
performance promises made by the firm.
Lecture Guide
Long-term debt financing is the most popular form of external financing. Firms must make
13-1a The Choice between Public and Private Debt Issues
A firm must first choose between a private or a public debt offering. Private debt includes
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13-1b Loan Covenants
Debt covenants are designed to protect bondholders. The section discusses positive and
13-1c Cost of Long-Term Debt
Firms must consider the term of the debt – should the finance with short, intermediate or
long term financing. Since yield curves are normally upward sloping, most of the time longer term
13-2 Corporate Loans
13-2a Term Loans
• Characteristics of Term Loans
o This section lists more term loan terminology, including payment dates,
13-2b Syndicated Loans
Firms often turn to more creative financing to obtain the best terms. A loan may be too
13-3 Corporate Bonds
13-3a Popular Types of Bonds
13-3b Legal Aspects of Corporate Bonds
Legal aspects of corporate bonds include bond indentures, sinking fund, security interest
and bond trustee. The trustee, an individual, corporation or commercial bank trust department,
serves as the watchdog, set to protect bondholders interests. Trustees take their roles seriously. In
Chapter 13 Long-Term Debt and Leasing 357
Table 13-1 Characteristics and Priority of Lender’s Claims of Traditional Types of Bonds
Table 13-2 Characteristics of Some Newer Types of Debt Instruments
13-3c Methods of Issuing Corporate Bonds
Types of bonds include debentures, subordinated debentures, income bonds, mortgage
bonds, collateral trust bonds, equipment trust certificates, zero coupon bonds, junk bonds, floating
13-3d General Characteristics of a Bond Issue
It is possible that covenants could constrain the company’s operations. An extreme
example of this happened in the case of Burlington Northern Railroad. Burlington Northern issued
a 100 and a 150 year bond issue in the late 1890s. At the time of the issue railroads were king, and
13-3e High-Yield Bonds
Bonds rated below investment-grade are known as high-yield bonds, or junk bonds, and
they carry a much higher default risk than investment-grade bonds, but also offer higher yields.
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13-3f International Corporate Bond Financing
This section distinguishes between eurobonds and foreign bonds. A Eurobond is issued in
a foreign country in the company’s home currency. Bonds do not have to be issued in dollars in
Fig. 13-1 Par Value Amounts Outstanding and Default Rates for High-Yield Bonds
(Junk Bonds), 1971–2008Q3
13-3g Bond Refunding Options
Firms typically continue to reissue bonds over the life of the firm. Serial bonds are those
with staggered maturities. Firms may refinance bond issues by calling the bonds and then reissuing
• Bond Refunding Analysis
o This section looks at the steps a firm must take in order to decide if refinancing
Table 13.3 Finding the Initial Investment for the Davis Corporation’s Bond– Refunding
Decision
Table 13.4 Finding the Annual Cash Flow Savings for the Davis Corporation’s Bond–
Refunding Decision
Table 13.5 Finding the NPV of the Davis Corporation’s Bond-Refunding Decision
13-4 Leasing
13-4a Basic Types of Leases
The section distinguishes between capital and operating leases. While the lines can be a
Chapter 13 Long-Term Debt and Leasing 359
13-4b Lease Arrangements
13-4c The Lease Contract
A lease agreement specifies which party is responsible for maintenance. Often the lessor will
be responsible for maintenance, since this is an asset that belongs to the lessor, even though the
lessee is using the asset.
• Student Involvement: Ask students what are the incentives the lessee has to pay
maintenance costs. Why are there differences between maintenance agreements with
capital vs. financial leases?
13-4d Lease versus Purchase Decision
Most lenders look at the firm’s debt plus capital lease obligations in evaluating whether or not a
Table 13-6 Lease vs. Purchase Analysis for ClumZee Movers: After-Tax Cash Flows ($)
13-4e Effects of Leasing on Future Financing
Most lenders consider leases to be a form of debt financing and will look at the firm’s lease
13-4f Advantages and Disadvantages of Leasing
This section details all of the commonly cited advantages and disadvantages of leasing versus
buying.
Long-Term Debt and Leasing, Summary
Ch. 13 Resource Articles
“Lower Rates Revive Junk Bonds as Investors Regain their Interest,” Wall Street Journal, January
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Answers to Concept Review Questions
1. When deciding on the amount and type of long-term debt to be used to finance a business, a
manager must consider if the debt financing should be private – loan or private placement – or
a registered public offering. The manager needs to look at the transactions costs associated
with each option, matched with the use of the funds – how much money is needed
immediately? Will more money be needed in the near future? Several years down the road?
2. When negotiating the covenants in a long-term debt agreement, a manager does not want to
have covenants that are too restrictive or that will constrain operations. Yet, managers want
3. When estimating the firms’ cost of long-term debt prior to meeting with a lender, a manager
should first look at the equivalent risk-free rate – 10 year Treasury bond if the firm is
4. When a specialty retail firm takes out a term loan from a bank, the lender would probably
5. Collateral is all or part of a firm’s assets. If the firm is financially distressed and potentially
unable to pay its debts, it is because the cash flows generated by the assets are not sufficient for
6. The dispersion of risk is attractive to syndicated lenders. A single lender does not bear all of
7. Syndicated loans are valuable to companies involved in corporate takeovers because they allow
8. Project finance loans differ from other types of syndicated loans in that they are extended to
stand-alone (vehicle) companies created for the sole purpose of constructing and operating a
Chapter 13 Long-Term Debt and Leasing 361
9. When choosing between a term loan and a bond issue for funding long-term debt, a manager
should consider that bank loans are generally short to intermediate term. A firm looking for
10. A portion of a serial bond issue matures each year, with differing interest rates attached to the
bonds maturing at different times. They cannot be retired at the option of the issuer, but they to
allow systematic retirement of the debt. In a bond with a sinking fund, the sinking fund may be
11. Factors, other than the current interest rate at which new debt could be sold, a manager should
consider when deciding to refund a bond issue include the call premium – what amount above
the face value of the bonds will be paid to bondholders because the bonds are called before
maturity. What are the transactions costs associated with calling the old bond issue and issuing
new bonds? Do the savings from a lower interest rate compensate for the up-front costs of
12. The classification of a lease as financial or operating affects where that lease appears on the
13. When deciding between leasing an asset and borrowing funds to purchase the asset, the firm
needs to look at the tax implications of the lease vs. buy decision. In an operating lease, the
Answers to Self-Test Problems
ST13-1. The initial proceeds per bond, the size of the issue, the initial maturity of the bond, and
the years remaining to maturity are shown in the following table for a number of bonds.
Each bond has a $1,000 par value, and the issuing firm is in the 35% tax bracket.
Bond
Proceeds per
Bond
Size of
Issue
Initial
Maturity of
Bond
Years
Remaining to
Maturity
a. Indicate whether each bond was sold at a discount, at a premium, or at its par value.
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b. Determine the total discount or premium for each issue.
A: Premium/Discount per bond = Proceeds per bond – Par value per bond
Total Premium/Discount = Premium/Discount per bond Size of issue (# of bonds)
Annual premium/Discount amortized per bond = Premium/Discount per bond Initial
maturity (in years)
Bond
Premium (+)
or Discount (–)
per Bond
Total Premium
or Discount
per Bond
Unamortized
Premium or
Discount
per Bond
After-Tax Cash
Flows from
Retiring Issue
ST13-2. The principal, coupon interest rate, and interest overlap period are shown in the
following table for several different bonds.
Bond
Principal
Coupon
Interest Rate
Interest
Overlap Period
A: Interest payable during overlap = Coupon rate Principal [Months overlap 12]
After-tax cost of overlapping interest = Interest during overlap period (1 – Tax rate)
Chapter 13 Long-Term Debt and Leasing 363
Bond
Calculation of Interest Payable
During Overlap Period
Interest Payable During
Overlap Period
After-Tax Cost of
Overlapping Interest
A
$15,000,000 0.065 [2 12]
$ 162,500
$ 97,500
ST13-3. Well-Sprung Corporation is considering offering a new $100 million bond issue to
replace an outstanding $100 million bond issue. The firm wishes to take advantage of the
decline in interest rates that has occurred since the original issue. The two bond issues
are described in what follows. The firm is in the 30% tax bracket.
Old bonds. The outstanding bonds have a $1,000 par value and an 8.5% coupon interest
rate. They were issued five years ago with a 20-year maturity. They were initially sold at
a $30 per bond discount, and a $750,000 floatation cost was incurred. They are callable
at $1,085.
New bonds. The new bonds would have a 15-year maturity, a par value of $1,000, and a
7.0% coupon interest rate. It is expected that these bonds can be sold at par for a
floatation cost of $600,000. The firm expects a 3-month period of overlapping interest
while it retires the old bonds.
a. Calculate the initial investment that is required to call the old bonds and issue the
new bonds.
b. Calculate the annual cash flow savings, if any, expected from the proposed bond-
refunding decision.
c. If the firm uses its 4.9% after-tax cost of debt to evaluate low-risk decisions, find the
net present value (NPV) of the bond-refunding decision. Would you recommend the
proposed refunding? Explain your answer.
A: Steps in bond refunding decision: (1) Calculate the initial investment required to call the
(1) Finding the Initial Investment for the Bond Refunding Decision
(a) Call premium
Before tax [($1,085 – $1,000) 100,000 bonds] $8,500,000
Initial investment $7,243,750
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(2) Finding the Annual Cash Flow Savings for Bond Refunding Decision
Old bond
(a) Interest cost
New bond
(d) Interest cost
(3) Finding the Net Present Value of the Bond Refunding Decision
(a) Present value of annual cash flow [from part (2)]
ST13-4. Strident Corporation is attempting to determine whether to lease or purchase a new
telephone system. The firm is in the 40% tax bracket, and its after-tax cost of debt is
currently 4.5%. The terms of the lease and the purchase are as follows:
Lease. Annual beginning-of-year lease payments of $22,000 are required over the 5-year
Chapter 13 Long-Term Debt and Leasing 365
a. Calculate the after–tax cash outflows associated with each alternative.
b. Calculate the present value of each cash outflow stream using the after-tax cost of
debt.
c. Which alternative—lease or purchase—would you recommend? Why?
A: Leasing the research equipment
Beginning of period lease payment: $22,000
Purchasing the equipment
$100,000 equipment cost
Depreciation, based on MACRS table:
Year 1: 20% 100,000 = $20,000
Loan interest and principal:
Year
Principal Balance
Payment
Interest
Principal
Ending Principal
1
$100,000
$24,716
$7,500
$17,216
$82,784
3
$24,716
19,896
4
$24,716
21,388
Loan cash flows:
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After-tax cash outflows associated with purchasing the telephone system:
End of
Year
Loan
Payments
(1)
Maint.
Costs
(2)
Deprec
(3)
Interest
(4)
Total Deductions
2+3+4=(5)
Tax
Shields
0.405=(6)
After-Tax
Cash
Outflows
1+2-6=(7)
1
$24,716
$3,500
20,000
$7,500
$31,000
$12,400
$15,816
2
$24,716
$3,500
32,000
11,532
3
$24,716
$3,500
19,200
17,208
4
$24,716
$3,500
11,520
20,876
5
$24,716
$3,500
11,520
21,518
Since the present value of the after-tax cash outflows for the purchase alternative, –
$75,547, is less than for the lease alternative, -85,712, it is less costly to purchase than to
lease the equipment. This ignores the depreciation deduction for the purchase option for
year 6, as well as year-6 maintenance payments made under the lease option after the
asset is purchased in year 5.
Answers to End-of-Chapter Questions
Q13-1. Comment on the following proposition: The use of floating-rate debt eliminates interest
A13-1. Floating rate debt eliminates interest rate risk for the lender – who will always be receiving
the market interest rate on the debt. This makes the loan less risky for the lender and so
Q13-2. What purpose do loan covenants serve in a debt agreement? What factors should a
manager consider when negotiating covenants?
A13-2. Covenants protect bondholders, reduce bondholder-stockholder conflicts and lower the
Q13-3. List and briefly discuss the key features that distinguish long-term debt issues from each
other.
A13-3. Debt issues differ according to maturity (when the debt must be repaid), loan size (how
A13-4. A term loan is a loan made by a financial institution to a company. It lasts at least a year
and generally lasts 5-12 years. Typically term loans are made to finance permanent
Chapter 13 Long-Term Debt and Leasing 367
Q13-5. What is a syndicated loan? Why have these loans proven so popular with corporate
borrowers?
A13-5. A syndicated loan is a large-denomination credit arranged by a group or syndicate of
Q13-6. What is a project finance (PF) loan? What role does a stand-alone company play in the
typical project finance deal?
A13-6. A project finance loan is a limited or non-recourse loan, often arranged to finance large
Q13-7. What is a debenture? Why do you think that this is the most common form of corporate
bond in the United States, but is much less commonly used elsewhere?
A13-7. A debenture is an unsecured bond backed only by the creditworthiness of the firm. They
may be used widely in the U.S. because the U.S. has a bankruptcy cost that tends to favor
Q13-8. How do sinking funds reduce default risk?
A13-8. Sinking fund requirements reduce the default risk of bonds because they require the firm to
either buy back a portion of the bonds each year, reducing the total amount of the debt, or
Q13-9. What is a trustee? Why do bondholders insist that a trustee be included in all public bond
offerings? Why are these less necessary in private debt placements?
A13-9. A trustee is an individual, corporation or a commercial bank trust department designated to
look out for the interests of bondholders. This is required for public bond issues. When
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Q13-10.What impact has adoption of Rule 144A had on debt-issuance patterns in the United
States?
A13-10.Rule 144A allowed institutional investors to trade nonregistered securities among
Q13-11.Why are most corporate bonds callable? Who benefits from this feature, and what is the
cost of adopting a call provision in a public bond issue?
A13-11.A call feature allows a corporation to recall its bonds before their maturity and reissue
them if desired. This feature is advantageous to the issuer. For example, when interest
Q13-12. Why do corporations have their debt rated? Compare the role played by rating agencies
A13-12. Companies have their bonds rated by bond rating agencies so that the investing public
has the assessment from an independent source concerning the quality of the company.
Q13-13. What does investment grade mean in the context of corporate bond issues? How do these
bonds differ from junk bonds, and why have the latter proven so popular with investors?
A13-13. Investment grade bonds are the four top grades – all A grades and the highest B (BBB or
Baa) rating. Many institutions are only allowed to purchase investment grade bonds, the
highest quality bonds. Junk bonds have ratings of BB (Ba) or below. Some companies
Q13-14. What is a Eurobond? Why did these bonds come into existence? Why do Eurobond
investors like the fact that these are typically “bearer bonds”? What risk does an investor
run from holding bearer bonds rather than registered bonds?
A13-14. A Eurobond is a bond issued by an international borrower and sold to investors in
countries with currencies other than the currency in which the bond is denominated.
This market developed to satisfy European investors who wanted to hold dollar-
Q13-15. Explain how uncertainty concerning future interest rates would affect the decision to
refund a bond issue.
A13-15. If interest rates fall, it may lower the firm’s costs by calling and then refunding the bond
issue with bonds carrying a lower interest rate. Before making this decision, the firm
Q13-16. Define the following: direct lease, sale-leaseback arrangement, leveraged lease, and
financial (capital) lease. What elements must be included in a lease in order for it to be
considered a financial (capital) lease?
A13-16. A direct lease results when a lessor acquires the assets that are leased to a given lessee.
In other words, the lessee did not previously own the assets it is leasing. In a sale-
leaseback arrangement, one firm sells an asset to another for cash, then leases the asset
from its new owner. In a leveraged lease, one or more third-party lenders are involved.
Q13-17. How would the availability of floating-rate debt affect the lease-versus-purchase
decision?
A13-17. A lease does not have a stated interest cost. A firm might be better off borrowing and
then purchasing the asset. A choice of fixed versus floating rate debt could impact the
Q13-18. For acquiring an asset, what are the key advantages of leasing as compared to
borrowing? What are the key disadvantages of leasing?
A13-18. The main advantages of leasing are