Long-Term Debt And Leasing
Course Name / Number
Long-Term Debt Financing
• Must be registered with the SEC in U.S.
• Almost always issued with the help of
Public issue investment bankers
• Vast majority are fixed rate offerings.
• Loans: private debt agreements with a
• Term loans or syndicated loans
• Most are floating-rate issues, with the rate
Private issue set as a fixed spread from some base
• Private placements: unregistered
issues sold directly to accredited investors
• Rule 144A: most popular private
Contractual clauses within debt agreements that
constrain borrowers’ actions
• Things that the borrower “must do,” such as:
• Maintain satisfactory accounting records in
Positive accordance with GAAP;
• Maintain a minimum level of net working capital;
• Maintain life insurance on “key employees,” and
• Spend borrowed funds on a proven financial need.
• Things that the borrower “must not do,” such as:
• Sell accounts receivable to generate cash;
Negative • Issue additional debt, unless firm requires that
additional debt be subordinated, and
• Avoid certain types of leases or other fixed-
Cost of Long-Term Debt
Function of at least four factors
• Yield curves typically slope upward.
• Longer maturities mean longer terms, and
so greater exposure to default risk.
• Trade-off between administrative cost per
Loan size dollar and risk exposure that increases
with the loan size
Borrower risk • The greater the risk of default, the higher
the rate that the lender will charge.
Basic cost of • The greater the prevailing rate on lowest-
money risk money (such as Treasury securities),
the greater the rate on other loans.
Private loans that financial institutions make to businesses.
Have initial maturities of more than one year. Generally
have maturities of 5-12 years
• Commercial banks
• Insurance companies
• Pension funds
Term • Regional development companies
lenders • Small business administration
• Finance companies
• Equipment manufacturer finance subsidiaries
Characteristics of Term Loans
• Usually monthly, quarterly, semiannual or
Payment • Usually these payments fully pay the interest
dates and principal over the life of the loan.
• May involve periodic payments followed by a
balloon payment of the remaining principal
• Secured loans involve the pledging of
Collateral specific assets as collateral.
requirements • Reduces risk for lender
• Gives the lender the right to purchase a
Stock fixed number of shares of common stock
purchase at specified price over a fixed time period
warrants • Can be used as “sweeteners” for both
6 term loans and corporate bond issues
Large-denomination credit arranged by a group
(syndicate) of commercial banks for a single borrower
Over $2 trillion worth of syndicated loans are arranged
annually (two thirds of which are corporate).
Eurocurrency lending: the Eurocurrency loan market is
largely a syndicated loan market.
Project finance : loans arranged for infrastructure
projects such as toll roads, bridges, etc.
Debt security carrying a promise to pay cash flows to
Most maturities range from 10 to 30 years with a
par (face) value of $1000
• Main types
• Subordinated debentures
• Income bonds
• Mortgage bonds
• Collateral trust bonds
8 • Equipment trust certificates
Legal Aspects of Bonds
• The bond contract, which specifies:
• Payments and payment dates;
Bond • Positive and negative covenants;
indenture • Security (any collateral), and
• Any sinking fund requirements.
• Third party who ensures that the issuer does
not default on contractual responsibilities
Trustee • Can be an individual or a corporation; most
often a commercial bank trust department
• Services paid for by the issuer.
Methods of Issuing Corporate
Bonds and Common Features
• Shelf registration
• Often used when issuing bonds
• Allows firms to register large amounts of debt, then sell the
securities over time as market conditions warrant
• Rule 144A
• Allows institutional investors to trade non-registered
securities among themselves
• Created a new market for privately-placed issues, including
• Three special features are often included in the bond indenture
• Call feature
• Conversion feature
• Stock purchase warrant attachments
Common Features of Corporate
Call feature allows the issuer to repurchase bonds prior to
maturity at a certain call price.
Call feature gives the issuer the ability to retire an issue
early when interest rates fall, so this benefits issuers.
Conversion feature allows bondholders to change each bond
into a stated number of shares of common stock.
Stock purchase warrants give the bondholder the right to
purchase a certain number of shares at a specified price
over a certain period of time.
International Corporate Bond
• Issued by an international borrower and sold
to investors in countries whose native
Eurobonds currency is different than the bond’s
• For example, bonds sold in Europe by a U.S.
firm, denominated in U.S. dollars
• Bonds issued by an international borrower in
Foreign a foreign country, denominated in the foreign
bonds country’s currency
Most international bonds are bearer securities
Bond Refunding Options
A firm has two options if it tries to avoid a single repayment
in the future or wants to refund a bond prior to maturity:
Serial bonds are issues with staggered maturities, often with
different interest rates paid to various maturities.
If interest rates drop, issuers with call provisions may
consider a refunding (refinancing) operation.
Existing bonds are retired; new, lower-interest bonds issued.
Bonds are called when the marginal benefit of doing so
(stream of reduced paid interest) exceeds marginal cost.
Bond Refunding Analysis
Refunding decision is based on capital budgeting
The capital budgeting procedure:
• Step 1: Find the initial investment required to call the old issue and
issue new bonds:
• Include the call premium, flotation costs of the new bond,
overlapping interest, unamortized discount and flotation costs of
the old bond.
• Step 2: Find the cash flow savings:
• Largest impact will be from the differential interest costs.
• Step 3: Find the NPV of the refunding operation:
• If NPV > 0, the refunding operation is recommended.
Bond Refunding Analysis: Example
• Contemplated bond refunding operation:
• Existing bond issue ($50 million)
• 30-year bonds issued 5 years ago with a coupon interest rate
of 9%, callable at a price of $1,090
• Initially issue netted $48.5 million due to a discount of $30 per
• Initial flotation cost was $400,000
• Proposed bond issue ($50 million of 25-year bonds)
• Expected to sell at par value with a coupon interest rate of 7%
• Flotation costs estimated at $450,000
• Other Data
• Firm’s tax rate is 30%; after-tax cost of debt is 4.9% = (1-
0.30) x 7%
• Two months of overlapping interest is expected
Step 1: Find the Initial Investment
After-tax cost of the call premium:
• Call premium: $90 per bond, (tax deductible)
• Before taxes ($90 x 50,000 bonds) $4,500,000
• Less: tax savings (0.30 x $4,500,000) 1,350,000
• After-tax cost of premium $3,150,000
Flotation cost of new bond was given as $450,000.
• Before taxes ($0.09 x (2/12) x 50,000 bonds) $750,000
• Less: tax savings (0.30 x $750,000) 225,000
• After-tax cost of overlapping interest $525,000
Step 1: Find the Initial Investment
Unamortized discount on old bond
• Discount ($1,500,000 = $50,000,000 - $48,500,000) was
amortized over thirty years
• Only five years of amortization have been used
• Firm can deduct the remaining twenty-five years as a lump sum
• Reduced taxes (25/30 x $1,500,000 x 0.30) ($375,000)
Unamortized floatation cost of old bond:
• Initial floatation cost ($400,000) was amortized over thirty years
• Reduced taxes (25/30 x $400,000 x 0.30) ($100,000)
Initial investment is $3,650,000
Step 2: Find the Cash Flow Savings
• Interest cost of old bond
• Annually: ($50,000,000 x 0.09 x (1-0.30)) $3,150,000
• Amortization of discount on old bond
• Annually: (($1,500,000/25) x 0.30) ($15,000)
• Amortization of floatation cost on old bond
• Annually: (($400,000/25) x 0.30) ($4,000)
• Interest cost of new bond
• Annually: ($50,000,000 x 0.07 x (1-0.30)) ($2,450,000)
• Amortization of flotation cost on new bond
• Annually: (($450,000/25) x 0.30) $5,400
• Total annual cash flow savings $686,400
Step 3: Finding the NPV of the Refunding
• Present value of cash flow savings $9,771,792
($686,400 per year for 25 years, discounted at 4.9%)
• Less: total initial investment $3,650,000
• Equals NPV $6,121,792
• Present value of cash flow savings computed as annual cash flow
savings x Present value interest factor of a r %, n-year annuity (PVAr,n)
1 1 1 1
(1 r) n $686,400 0.049 1 (1.049)25 $9,771,792
PVA nr $686,400 1
Since the NPV is positive, recommend the bond
Similar to long-term debt, leases involve periodic,
Payments may be fixed or variable.
• Owner of the asset
Lessor • Retains the tax benefit associated with
ownership of the asset
• User of the asset
Lessee • Makes payments to the lessor under the
terms of the lease
• For relatively short-lived assets, such as
computers or automobiles
• Can be cancelled after some time period
• May be re-leased by lessor after initial leasing
• Lessor’s original cost generally exceeds total
value of original lessee’s payments
• For longer-lived assets such as land, buildings,
Financial and large pieces of equipment:
(capital) • Cannot be cancelled, obligate the lessee to
make payments over a defined period of time
• Total payments are greater than the lessor’s
• Lessor acquires the asset(s) to be leased to the
Direct lease given lessee (did not previously own the asset).
• One firms sells an asset to another for cash,
Sale- then leases the asset from the new owner.
leaseback • Attractive for firms that need cash and are
arrangemen willing to exchange a promise to make periodic
lease payments for immediate cash.
• A third party lender is involved.
• Lessor provides only a portion, about 20% of
Leveraged the asset value; lender provides the balance.
leases • Popular way of structuring very expensive
• Leasing agreements usually specify who is
responsible for maintenance of leased assets.
Maintenance • Operating leases usually require the lessor to
clauses pay for maintenance, insurance, and taxes.
• Financial leases usually require lessee pay these
• Lessee usually has the option to renew a lease
• Operating leases commonly can be renewed, as
Renewal the useful life of the asset normally extends
options beyond the original lease.
• Instead of renewing the lease, lessee may also
have a purchase option at the end of the
23 original leasing agreement.
The Lease versus Purchase Decision
• Lease the asset
• Borrow funds and purchase the asset
• Purchase the asset with available liquid
Employ a capital budgeting framework:
• Step 1: Find the after-tax cash outflows under the lease alternative.
• Step 2: Find the after-tax cash outflows under the purchase
• Step 3: Calculate the present value of the expected future cash
flows under each of the alternatives, discounting at the
firm’s after-tax cost of debt.
• Step 4: Select the alternative with the lower present value of
expected cash outflows.
Effects of Leasing on Future
Similar to long-term debt, leases involve periodic, tax-
FASB (13) requires explicit disclosure of financial lease
obligations on the firm’s balance sheet.
Must be shown as both an asset and as a liability on firm’s
Under FASB (13), calculated financial ratios assessing debt
load will include leases along with other obligations.
Advantages and Disadvantages
• Allows for the effective depreciation of land, which is
not allowed when land is purchased
• Sale-leaseback can enhance firm liquidity.
• Leasing can provide 100% financing.
Advantages • Lower claims against the firm in bankruptcy
• Avoid restrictive covenants that would likely be
present in a long term loan agreement
• May enhance a firm’s financing flexibility
• Leases do not have stated interest cost. Effective
cost may be considerably higher than if the firm
• At the end of the lease, lessee does not receive any
Disadvantage “salvage value” associated with the asset.
s • Lessee may not be allowed to modify or improve
leased assets without lessor’s approval.
26 • Even if assets become obsolete or unusable, the
remaining lease payments must be made.
Long-Term Debt And Leasing
Long term debt and leases are important sources of capital
The conditions of a term loan are specified in the loan
The conditions of a bond issue are specified in the bond
Leasing serves as an alternative to borrowing funds to
purchase an asset.