Ch 5 Flashcards
Definition of Debt Finance
the loan of funds to a business without conferring ownership rights
if borrower does not make interest and principal payments on time, lender can apply to courts to have borrower liquidated (or “wound up”)
Tax Considerations of Debt Finance
debt = tax-efficient
interest paid out of pre-tax profits as business expense
thus, company’s cost of servicing the debt is actually cheaper than stated rate of interest
(e.g. 20% tax rate, published interest 5%, actual interest 5% * 80% = 4%)
Security on Debt Finance
FIXED CHARGE
debt secured against a specific asset, normally land or buildings
lender at front of queue of creditors in lquidation scenario, thus fixed charge often preferred
FLOATING CHARGE
debt secured against general assets of business
not as strong, although still “preferred creditor” status
Overview of Covenants on Debt Finance
put in place by lenders to protect themselves from brorowers defaulting on their obligations due to financial actions detrimental to themselves or the business
restrict the actions of the directors through specific requirements or limitations as a condition of taking on debt financing
objective is not to burden the borrower, sooner to solve the agency problem among mgmt of borrower, debt holder, and sh/h arising due to differing objectives of lender and borrower
Example Covenants on Debt Finance
DIVIDEND RESTRICTIONS
limitations on level of dividends company is permitted to pay
designed to prevents excessive dividends => weakened future CF => higher risk for lender
FINANCIAL RATIOS
specified levels which certain ratios may not breech
e.g. min interest cover, max gearing ratio, min EBITDA/fin cost
FINANCIAL REPORTS
provision of regular a/c and reports to lender for monitoring purposes
ISSUE OF FURTHER DEBT
amount/type of debt that can be issued may be restricted
subordinated debt (ranking below existing unsecured debt) can usually still be issued
Impact of Covenants on Lender and Borrower
LENDER
debt restrictions protect lender by requiring/preventing certain activities - thus from making decisions detrimental to the lender
BORROWER
can reduce cost of borrowings - through lower interest rates, higher credit ratings
Example Positive Debt Covenants
Meaning things that the borrower must do, e.g.
Maintain certain min fin ratios
Maintain GAAP a/c records
Timely provide audited F/S
Regularly maintain assets used as security
Maintain facilities in good working condition
Maintain life insurance policies on certain key employees
Timely pay taxes and other liabilities
Example Negative Debt Covenants
Meaning things the borrower cannot do, e.g.
take on additional l/t debt
pay cash dividends > threshold
sell certain assets (e.g. A/R)
enter into leases
combine with another firm in any way
compensate or increase salaries of certain employees
Most common financial ratios used in debt covenants
Net debt to cash flow
Net debt to EBITDA
Interest cover
Tangible net worth
Net worth
Gearing Ratio
Current Ratio
Cash Interest Cover
Debt to Equity
“Debt” aka total debt, funded debt, funded debt less cash
“Cash flow” aka cash from operations, EBIT, EBITDA
Potential impacts of breach of covenant
preferable for borrower to approach lender if they predict a breach; early negotiations can minimize possible penalties
a covenant breach is a breach of contract; lender response depends on severity and terms of agreement – if not sever, waiver or additional restrictions are most likely responses
Lender may waive the breach and continue the loan
Waive the breach and impose additional constraints
Require penalty payment
Increase interest rate
Demand immediate repayment of loan
Increase security needed
Terminate debt agreement
Two sources of Debt Finance
BANK FINANCE
typical first port of call - high street banks or, for larger orgs, merchant banks
T&S negotiable dependent on term of borrowing, amount borrowed, credit rating of borrower
CAPITAL MARKETS
alternatively, listed company may issue l/t bonds or s/t commercial paper in capital markets
Criteria for selecting debt instruments
bank borrowing viewed as more restrictive and expensive than selling bonds on cap mkt
entities should consider LIQUIDITY, TIMESCALE, and COST in weighing the two options
generally, bonds are for L/T and banks for S/T - but not always - attention shifting into bond market due to liquidity, flexibiltiy, and lower overall costs
access to the bond market implies costly and cumbersome hurdles vs bank borrowings
SMEs typically use banks - long term relationships mean flexibility in financing T&C, although charges and fees exist somewhat at the whim of the bank (e.g. early repayment)
entities in bond markets need REPUTATION - established through credit quality and standardized T&C, providing access to wider range of investors
standardized terms mean lower operating costs vs bank, although entry costs higher
Example Types of Long-Term Debt Finance
BANK FINANCE
Money Market Borrowings
Revolving Credit Facilities (RCFs)
CAPITAL MARKETS
Bonds
Commercial Paper
Money Market Borrowings
A form of bank finance
consists of fin institutions and dealers in money/credit wishing to borrow/lend
used by participants to borrow/lend in s/t (from days to <1 year) - in contrast to l/t funding from capital markets
core of money mkt is interbank lending, although large profit-making entities also lend/borrow in money market
Revolving Credit Facilities (RCFs)
A type of bank finance
borrower may use/withdraw funds up to pre-approved limit; amount of available credit dec/inc as funds are borrowed/repaid
borrower makes payments based only on amount actually used (plus interest), and may repay borrowing over time or in full at any time
very flexible, enabling org to minimize interest by never borrowing more than needed
offered by a single bank, or a syndicate if large amount of finance required
