5. Debt Finance

Question 1

What are the 5 considerations needed when choosing debt finance sources?

Answer 1

1. Timescale required
2. Cost (effective interest)
3. Liquidity (timing of repayments)
4. Currency
5. Interest type (fixed or variable)

Question 2

What are the 5 factors considered by lenders when determining whether to lend, and at what rate of interest?

Answer 2

1. Security offered
2. Timeframe (longer = higher interest)
3. Repayment profile (regularity)
4. Amount requested
5. Purpose (tangible vs R&D)

Question 3

What is a fixed charge/security?

Answer 3

A specific asset is assigned as security for a debt

Question 4

Why are fixed charges attractive to lenders?

Answer 4

Likely to receive in the event of a company becoming insolvent

Question 5

What are floating charges/securities?

Answer 5

Debt is secured over the assets of the business in general, with assets fixed to the charge only on insolvency

Question 6

What are the 5 main types of convenants?

Answer 6

1. Positive covenants (must do/achieve something)
2. Negative covenants (cannot do certain things)
3. Financial covenants (ratios that must be kept within range)
4. Dividend restrictions
5. Reporting and disclosure covenants

Question 7

What are 5 possible consequences of breaching a covenant?

Answer 7

1. Termination of debt/immediate repayment
2. Imposing a penalty payment
3. Increase in interest rate
4. Increase security required
5. Accept breach

Question 8

What is the market value of a bond?

Answer 8

The sum of the future interest payments and redemption proceeds of the bond, discounted at the cost of debt for similar bonds

Question 9

What is the cost of debt?

Answer 9

The required return for a lender is the effective interest rate they require in order to lend to a particular company

Question 10

What is the post-tax cost of debt for the borrower?

Answer 10

The effective interest rate that they pay, after tax savings, on the money borrowed

Question 11

What are the 4 reasons that debt requires lower return than equity?

Answer 11

1. Generally secured (less risky)
2. More certain returns (interest payments)
3. Often redeemable
4. Paid before shareholders in the case of insolvency

Question 12

What are the 2 reasons that debt is cheaper than equity?

Answer 12

1. Lower required return
2. Tax deductible

Question 13

What are the 2 main benefits of leasing over borrowing to buy?

Answer 13

1. Avoids the need to obtain finance
2. Can acquire assets if traditional funding is not available

Question 14

What will be the cash flows associated with leasing?

Answer 14

Annual lease payments

Question 15

What will be the cash flows associated with borrowing to buy?

Answer 15

Immediate cash outflow to purchase, and a possible tax inflow on scrapping

Question 16

What will be the tax impacts associated with leasing?

Answer 16

Positive cash flows from tax savings, often a year delayed

Question 17

What will be the tax impacts associated with borrowing to buy?

Answer 17

Positive cash flows from tax allowable depreciation

Question 18

What is the actuarial method for finding an interest charge on a lease, in a given year?

Answer 18

Step 1 - Calculate the total interest charge by total repayments minus fair value of asset

Step 2 - calculate the ‘sum of digits’ by the formula n(n+1)/2 (n is the number of interest payments)

Step 3 - calculate the interest payments in year X by the formula (n + X - 1) / total interest charge