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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.
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.
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.
LO3. An important corporate decision is whether to call in and reissue debt (refund the obligation)
when interest rates decline.
LO5. When a firm fails to meet its financial obligations, it may be subject to bankruptcy.
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Annotated Outline and Strategy
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.
4. Repurchase of common stock with cheap debt.
C. Corporations suffered a decline in interest coverage until 2008 and then remained
relatively stable. Macy’s took advantage of the low interest rates to increase leverage
PPT Earnings Before Interest and Taxes and Times Interest Earned for
Macy’s Inc. 1999–2017
(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
E. Security provisions
1. Secured debt: 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.
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 provision: the issuer is required to make regular contributions
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.
PPT Eli Lilly’s Bond Offering (Table 16.1)
Finance in Action: Soccer Bonds Bounce Back
The Football Club Internazionale Milano S.p.A (also known as “Inter Milan”) became one of the
most recent sports franchises to issue bonds. The bonds carry an interesting twist in that they
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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
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.
PPT Interest Rates and Bond Prices (Table 16-2)
PPT Long-Term Yields on Debt (Figure 16-3)
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.
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.
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 307 in Chapter 10 that
demonstrates the calculation of yield to maturity using an Excel spreadsheet or calculator keystrokes.
3. Yield to Maturity: the interest rate that will equate future interest payments
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formula found in Footnote 2 on page 513.
Perspective 16-5: Of course with spreadsheets and calculators, approximation formulas are not
C. Bond ratings
1. There are two major bond -rating agencies: Moody’s Investor Service and
Standard & Poor’s Corporation.
3. The ratings are based on the:
a. firm’s ability to make interest payments.
b. consistency of performance.
c. firm size.
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
IV. The Refunding Decision
A. The process of calling outstanding bonds and replacing them with new ones is
Approximate
Yield to
Maturity(Y‘)
=
Annual interest payment + Principal payment – Price of the bond
Number of years to maturity
0.6 (Price of the bond) + 0.4 (Principal payment)
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termed refunding. This action is most likely to be pursued by businesses during
periods of declining interest rates.
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 solutions 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:
2. Inflow considerations:
a. The present value of the after tax savings on the difference in the
3. Net present value: Inflows minus outflows equals Net Present Value.
D. A major difference in evaluating a capital expenditure for refunding is that the
V. Other Forms of Bond Financing
A. Zero-coupon rate bonds
1. Do not pay interest; sold at deep discounts from face value.
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3. Since the difference between the selling price and the maturity value is
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.
PPT Zero-Coupon Bonds (Table 16-4)
B. Floating Rate Bonds
1. The interest rate varies with market conditions.
VI. Advantages and Disadvantages of Debt
A. Benefits of debt
1. Tax-deductibility of interest.
3. In an inflationary economy, debt may be repaid with “cheaper dollars.”
B. Drawbacks of debt
1. Interest and principal payments must be met when due regardless of the
firm’s financial position.
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.
4. See examples in Table 16-5.
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PPT Examples of Eurobonds (Table 16-5)
VII. Leasing as a Form of Debt
A. A long-term, noncancelable lease has similar characteristics to a debt obligation.
B. The release of Accounting Standards Update 2016-02 requires that all leases, with
C. Leases that substantially transfer all the benefits and risks of ownership from the
owner to the lessee must be capitalized. A finance lease is required whenever any
one of the following conditions exists.
2. The lease contains a purchase price (sure to be purchased) at the end of the
lease.
4. The present value of all payments exceeds the asset’s fair value.
5. The asset is of a specialized nature and so has no alternative use to lessor at
end of term.
D. A lease that does not meet any of the five criteria is an operating lease.
1. Usually short-term.
2. Often cancelable at the option of the lessee.
4. Capitalization and presentation on the balance sheet are not required.
E. Impact of finance lease on the income statement
2. The obligation under finance lease (liability) is written off through
1. Lessee may not have sufficient funds to purchase or borrowing capability.
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4. Expert advice of leasing (lessor) company.
6. Certain retail malls or retail complexes only available for lease.
7. Tax considerations
8. Infusion of capital through a sale-leaseback.
VIII. Appendix 16A: Financial Alternatives for Distressed Firms
A. Financial distress
2. Bankruptcy—a firm’s liabilities exceed the value of its assets—negative
net worth.
B. Out-of-court settlement
1. Extension—creditors allow the firm more time to meet its financial
obligations.
3. Creditor committee—a creditor committee is established to run the
business in place of the existing management.
C. In-court settlements—formal bankruptcy
2. The decisions of a court-appointed referee who arbitrates the bankruptcy
proceedings are final, subject only to court review.
3. Reorganization—a fair and feasible plan to reorganize the bankrupt firm.
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the firm’s capital structure is also required.
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
Other Chapter Supplements
Cases for Use with Foundations of Financial Management
Case 25, Warner Motor Oil Co. (Bond refunding)