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
Bonds
A product on capital markets
debt security, in which issuer owes a debt to holders and (T&C dependent) is obliged to pay coupon (interest) and/or repay principal at later date
bond is like a loan - issuer is borrower, holder is investor/lender, coupon is interest, and outcome is providing borrower with external funding for l/t requirements
bondholders are creditors vs sh/h having equity stake
bonds usually have defined term/maturity (after which redeemed), whereas shares may be outstanding indefinitely
Commercial Paper
A product in the capital markets
large, well-established listed companies with good credit ratings may issue s/t unsecured money market securities aka “commercial paper”
typically matures between 1 week and 3 months, although 3-month paper often “rolled over” with new issues every 3 months - thus company can inc/dec the amt issued regularly
risky for l/t finance as investor interest at a three-month issue date may be insufficient - in which case back-up facilities would need to be on standby
can be traded at any time before maturity
Three Main Groups in the Bond Market
ISSUERS
sell bonds in cap mkts to fund operations - mostly govts, banks, corporations
govt the biggest (use bonds to fund country)
UNDERWRITERS
traditionally inv banks and other fin institutions helping issuer to sell bonds in the mkt
huge amounts of finance transacted in one offering => large amount of prep work req’d
underwriter needed most in corporate debt mkt due to higher risk
bonds can be placed of sold directly; or a medium term note (MTN) program whereby issuer can issue debt securities regularly and/or continuously
PURCHASERS
any type of investor
govts play one of the largest roles - they borrow/lend money to other govts and banks
govts often invest in bonds issued by other ocuntries if they have excess reserves of that country’s money as result of trade
Two stages of admission to UK Bond Market
LISTING
if issuer is not already a listed company, it must first become listed on London stock exch
debt issuer seeking London listing for its securities must apply for admission to Official List through UK Listing Authority (UKLA, a division of FCA), which controls admission
listing depends on the securities gaining admission to trading on Main Market through satisfying exch’s admission and disclosure standards
process can take only 3 days depending on tx complexity and doc completeness - getting someone experienced involved helps
ADMISSION TO TRADING
Order Book for Retail Bonds (ORB) is an electronic order-driven trading service for UK govt, corp, surpanational bonds
aims to offer retailed efficient, cost-effective, transparent access to fixed income securities
admission requires documentation 11 days in advance, including base prospectus, pricing supplement/final terms doc, copy of Board minutes approving issue, confirmation of MARKET MAKER supporting security, and indicative opening price
Market Making
all bonds admitted to ORB must have at least one registered market maker => to ensure all instruments are tradable on the platform and have prices throughout the day
issuer can do it themselves or use a 3P - but market maker must be member firm of London stock exch and authorized to deal
MM req’d to quote two-way prices (buy and sell) throughout trading period
prices within maximum spread req’ment determined by trading segment and trading sector of the security; there is also a min vol (similar to nominal value) which must be quoted one ither side
International Debt Finance
primary reason to borrow foreign currency = funding foreign investment project or foreign subsidiary
the borrowing creates a hedge of value of project/sub to protect against currency fluctuations
foreign currency borrowing can be serviced from cash flows arising from foreign currency investment
developed nation countries can choose which currency they prefer for borrowings and bonds; in most developing countries, finance will need to be raised in an “int’l currency” such as USD
Eurobond Markets
Eurobond Market is self-regulated offshore market for bonds issued on the int’l cap mkts
can be denominated in any int’l currency, not necessrily EUR
may be listed on domestic currency stock exch but not traded there
usually bearer instruments (no register of ownership, physically bearing the bond implies ownership) and pay interest annually, gross of tax
in contrast to domestic bonds - listed and traded on local stock exch and usually registered to named holder
Target Debt Profile considerations
Once entity has determined level of debt finance req’d, these qns need answers:
should they borrow at fixed or floating/variable rate?
should repayment date be s/t or l/t?
should domestic currency or foreign currency borrowings be used?
answers will determine level of int rate, refinancing, and currency risk faced
Interest Rate Risk
risk of gains/losses on assets/liabilities due to int rate changes
arises for any org which has ssets/liabs on which interest is payable/receivable
exposure to risk depends on amt of interest-bearing assets/liabs than an entity holds, and whether these are fixed or floating
Refinancing Risk
risk that borrowings will not be refinanced or not at same rates - thus related to int rate risk
reasons could be: lenders unwilling to lend / only willing to do so at higher rates
borrower credit rating has reduced
borrower may need to refinance quickly, thus difficult to get best rate
use of l/t debt finance reduces this risk; whereas s/t debt finance needs regular repayment and renegotiation if addnl finance is needed - thus refinancing risk is higher
Currency Risk
risk that arises from possible future exch rate movements - two-way risk as mvmts are adverse or favorable
affects any org with:
assets/liabs in a foreign currency
regular income and/or exp in foreign currency
even an org with no dealings in foreign currency faces a risk if competitors are faring better due to favorable exch rates on their transactions
Other Sources of Finance
RETAINED EARNINGS / EXISTING CASH BALANCES
important to remember that R/E is not cash; internal sources of finance can only be used if enough cash is on hand
SALE AND LEASEBACK
funds released without loss of use of assets; potential capital gain is foregone; popular for retail orgs with substantial high street property (e.g. Tesco, M&S)
GRANTS
often re tech, job creation, regional policy; particularly important to SMEs, do not need repaying
DEBT WITH WARRANTS ATTACHED
warrant is option to buy shares in future for set price - offered as a sweetener to encourage bond uptake; warrant gives potential cap gain where share price increases to > exercise price
CONVERTIBLE DEBT
similar but “warrant” element cannot be detached and sold separately unlike above; the holder will convert the debt on exercise date if share price > ex price, otherwise holds debt to maturity
VENTURE CAPITAL
usually equity finance, can be equity/debt mix, to young orgs to help expansion; venture capitalists expect most returns as capital gains one exit, typically via IPO/flotation
BUSINESS ANGELS
wealthy investors providing equity to small businesses - but rarely very small as monitoring progress is uneconomic
GOVERNMENT ASSISTANCE
for SMEs, entities wishing to expand into particular regions, to promote tech and innovation, to create new jobs or protect existing jobs
Definition of Lease
commercial agreement where lessor conveys right to use equipment in return for payment by lessee of a specified rental over a pre-agreed period of time
Reasons for leasing
readily available form of finance, especially for plant/equipment or vehicles - thus convenient
removes need for major capital outlay at start of project life
may be cheaper than conventional debt financing, b/c asset-backed finance thus less risky for lender
Lease versus Buy Decision
not a pure financing decision as also involves interactions with investment decision
financing decision which will only be made once decision to invest in asset has been taken
investment decision would be made by discounting operational costs/benefts from using asset at entity’s normal COC (usually weighted ave COC) - investment justified if NPV +ve
financing decision then concerned with identifying least-cost financing option - usually assuming that org would have to borrow funds in order to purchase the asset
How to evaluate Lease vs Buy
Traditional approach is to use NPV method - PV of cost of leasing vs PV of borrowing funds to buy outright
Discount Rate used in NPV calc should be the same as, from org’s perspective, risk is the same
POST-TAX COST OF DEBT FINANCE is the appropriate discount rate - it is obviously the right rate of borrow-to-buy; it is also effectively the opportunity cost of leasing
Example use of ACTUARIAL and SUM OF DIGITS methods to calculate interest payments on a lease
option to buy at 100k vs lease for 4 years at 29.5k
interest is clearly 29.5*4 = 118 - 100k = 18k total over the 4 years
ACTUARIAL METHOD
implied interest rate found using IRR approach
divide 100k by 29.5k to give 4-year annuity factor of 3.39 - using tables is close to 7% interest rate
e.g. Year 1 c/f 100,000
+ 7% int = 107,000
less repayment = 107,000 - 29,500
b/f 77,500
and so on until end of year 4 where b/f would be zero
SUM OF DIGITS
simpler approximation using formula n(n+1)/2 where n is number of periods (here, 4 years)
4(4+1)/2 = 10, thus interest allocation is
Year 1 = 4/10 * 18,000 = 7,200
Year 2 = 3/10 * 18,000 = 5,400
Year 3 = 2/10 * 18,000 = 3,600
Year 4 = 1/10 * 18,000 = 1,800
in both cases, calculation of interest payments means tax relief can also be easily calculated
