Chapter 3 - Long Term Debt Finance

Question 1

Why is it risky to extensively rely on short-term finance?

Answer 1

• Because it may not be possible to re-new or roll over finance (aggressive financing policy)

Question 2

Sources of short- to medium-term finance

Answer 2

• Trade Credit
• Debt factor
• Overdraft
• Loan
• Commercial paper
• Revolving credit facility

Question 3

Trade credit involves:

Answer 3

• No immediate cost

* Risks loss of supplier goodwill + discounts

Question 4

Debt factors are:

Answer 4

• Flexible form of finance that grows with the business
• Cheaper than overdraft as lender has security (with recourse factoring)
• Can cause damage to customer goodwill

Question 5

Overdrafts as a source of short-term finance

Answer 5

• Flexible source of finance
• Risky due to instant recall
• Only pay interest if overdraft facility is being used

Question 6

`Loans as a source of finance:

Answer 6

• More secure than overdraft, but less flexible

Question 7

Commercial paper as a source of finance:

Answer 7

• Non-interest bearing
• Unsecured IOU
• Only issued by listed firms with highest credit ratings
• Issued via a placing with investors – raised quickly

Question 8

Revolving credit facility

Answer 8

• Payment of an arrangement fee for an arrangement that the bank will agree to lend up to a set amount over a specific period of time at a specific interest rate

Question 9

Procedures for issuing debt finance

Answer 9

• Long-term debt finance is raised by issuing debt securities to investors through capital markets or by private placement

Question 10

Capital Markets:

Answer 10

• Source of both debt and equity finance
• To trade, companies need to obtain a stock market listing which can be a long and costly process which also requires advisors such as investment banks and stockbrokers
• Debt & equity securities may be underwritten by financial institutions – financial institutions agree to buy any unsold securities and bears the risk of securities not being sold

Question 11

Private placement of debt:

Answer 11

• Process whereby company sells debt securities to specific institutional investors rather than to the public through capital markets
• Does not have high cost of issuing debt to public investors
• Finance can be raised more quickly & without onerous requirements of obtaining a stock market listing

Question 12

Institutional investors

Answer 12

Institutional investors (big investors) = institutions which have large amounts of funds to invest in bonds and shares which offers satisfactory returns and security

• Pension funds
• Insurance companies
• Investment trusts
• Unit trusts

Question 13

Sources of long-term finance

Answer 13

• Bank loans
• Conventional bonds
• Convertible bonds
• Deep discount bonds
• Zero coupon bonds
• Eurobonds

Question 14

Bank Loans:

Answer 14

• Interest payments attract tax relief (pre-tax cost of the loan x [1- tax rate])

Question 15

To obtain a bank loan, a firm may need to:

Answer 15

1. Present convincing business plan (including info on cash flow forecasts, management team and investment proposals)
2. Provide commercial collateral through fixed/ floating charges on assets
3. Provide personal collateral such as directors’ homes

Question 16

Conventional bonds:

Answer 16

• Fixed rate IOU’s – effectively a loan from an investor for a period of time at a fixed interest rate with a fixed redemption value
• Issued at par = coupon rate is fixed and set according to prevailing market conditions given the credit rating of the issuing company
• Marketable = ability to sell debt means investors are willing to accept lower return compared to a bank
• Redeemable = normally redeemable but may be irredeemable or undated (perpetual bonds) and issued by the bank
• Secured = normally secured. If unsecured the bonds are likely to carry debt covenants & investors are likely to expect a higher yield to compensate for higher risk

Question 17

Convertible Bonds:

Answer 17

• Liability that gives holder the right to (but not obligation) to convert bond at a specific future date into new equity shares
• Conversion rate is also specified when bonds are issued
• Lower coupon rate – price investor has to pay for conversion rights
• If bondholders choose not to convert their bonds, the bond is normally redeemable on maturity at par value

Question 18

Conversion of convertible bonds:

Answer 18

• Convertible bonds are popular due to the tight cash flows around the time of issue and easier situations when the bond is due to be converted
• Company expects the bond to be converted and view the bond as delayed equity
• IRR approach is used to identify cost of bond & redemption value of bond is replaced with value of shares if conversion is likely to happen
• If bond holders do decide to convert, convertible bonds can become very expensive sources of finance

Question 19

Conversion value calculation:

Answer 19

• Conversion value = conversion ratio x market price per share
• Conversion value = total market value of shares into which bond may be converted
• Conversion value will be below value of bond at date of issue but will be expected to increase as the date of redemption approaches
• This is based on the assumption that a company’s shares will increase in market value over time

Question 20

Conversion premium calculation:

Answer 20

• Conversion premium = current market value of bond – current conversion value

Question 21

Convertible bonds are used because of 2 reasons:

Answer 21

• The ordinary share price is considered to be particularly depressed at the time of issue
• The issue of equity shares would result in an immediate and significant drop in EPS

Question 22

Deep discount bonds:

Answer 22

• Bonds offered at a large discount to the face value so that significant proportion of return to investor comes by way of capital gain on redemption rather than through interest payments
• Companies with specific cash flow requirements might find deep discount bonds attractive due to the low servicing costs during the period of the bond and the high cost of redemption on maturity
• Offer much lower rate of interest
• Tax advantage is that the gain gets taxed in one lump on maturity or sale not as amounts of interest each year

Question 23

Zero-coupon bonds:

Answer 23

• Issued at discount to redemption value with no interest paid on them
• Investor gains from difference between issue price and redemption value
• There is an implied interest rate in the amount of discount at which bonds are issued
• Used to raise cash immediately with no repayment until redemption date
• Tax advantage is that the gain gets taxed in one lump on maturity or sale not as amounts of interest each year

Question 24

Eurobonds:

Answer 24

• Bond sold outside jurisdiction of the country in whose currency the bond is denominated
• Organised by merchant banks
• Long-term loan issued by international companies/ institutions and sold to investors in several countries at the same time – much bigger market

Question 25

Advantages of Eurobonds

Answer 25

• Cheap debt finance = investor will accept a lower yield in return for greater equity, no regulatory burden and no prospectus with investors
• Flexible = unsecured, less stringent covenants, fewer rules over timing issues & only issued by companies with excellent credit rating
• Long-term debt in a foreign currency = (5 -15 years) help hedge translation risk by creating a liability in a foreign currency to match foreign currency asset
• Amounts = ability to raise greater amounts of finance by moving out of domestic markets

Question 26

Factors influencing choice of finance

Answer 26

1. Availability
   * Only listed companies are able to make a public issue of bonds on stock exchange
   * Smaller companies are only able to obtain significant amounts of debt finance from a bank
2. Credit rating
   * Large companies prefer to issue bonds if they have a strong credit rating as the credit rating affects the interest yield required by investors
3. Amount
   * Bond issues are for large amounts – if small amount is required, a bank loan would be more appropriate
4. Duration
   * Length pf the loan should match the length of time that the asset will be generating revenues
   * Returns being generated by the investment would most likely be used to repay the debt so if return are being gradually generated by the project for 10 years then it may be difficult to repay a debt that matures in 4 years
   * And a loan whose maturity date is longer than the investment would require the company to pay interest over an unnecessary long period of time
5. Interest rates
   * Expectations of interest rate movements will determine whether the company borrows at a fixed or floating rate
   * Fixed rate finance may be more expensive, but business runs the risk of adverse upward rate movements if using floating rates
   * Banks may refuse to lend at a fixed rate above a certain period of time
6. Security and covenants
   * Choice of finance will be determined by the assets available to be used as security and also the restrictions through covenants imposed by the lenders
7. Taxation
   * Zero coupon and deep discount bonds involve low or zero interest rate payments which means the entity will not benefit from tax relief as much as with other forms of debt
   * Domestic bonds may be subject to withholding tax but Eurobonds are not which enhances their popularity
8. Debt warrants
   * If a company changes its mind about the type of debt to use, it will have to renegotiate and compensation will have to be paid via debt warrants (debt sweetener)
   * Debt warrants = option to buy shares at a fixed price which can be sold on stock market or exercised
   * Sometimes issued with bonds to make the bond more attractive and to justify a lower interest rate being paid on the bond

Question 27

Debt covenants

Answer 27

Conditions which the borrower must comply with and if they do not the loan may be considered in default and the bank can demand repayment

Question 28

Positive covenants

Answer 28

• Maintain certain levels of particular financial ratios = debt/equity ratio, debt to cash flow ratio, debt to EBITDA ratio
• May also include the company providing the bank with regular financial statements/forecasts, to maintain assets used as security and to insure key assets and staff

Question 29

Negative covenants

Answer 29

Limit borrower’s behaviour:

• Prevent borrowing from another lender
• Disposal of key asset paying dividends above a certain level
• Acquiring another company

Question 30

Leasing

Answer 30

• Source of finance for small- medium sized companies
• Very useful where capital is rationed
• Involves obtaining the asset by using the lease as a source of debt finance

Question 31

Attractions of leasing:

Answer 31

• Lessee does not have enough cash to pay for the asset, and would have difficulty obtaining a bank loan to buy it
• Leases are cheaper than bank loans – lessor is prepared to lend at lower cost as they have greater security (ownership of the asset)
• Leases are legally binding and cannot be withdrawn with immediate effect such as overdraft might
• Lessee may find tax relief available advantageous

Question 32

Lease or buy decision:

Answer 32

• Discounted cash flow techniques are used to evaluate the decision so that the least-cost financing option can be chosen
• The cost of capital used in the evaluation is the cost of borrowing
• The cost of borrowing is compared to the cost of leasing by applying the cost of borrowing to the financing cash flows
• Cost of borrowing does not include interest repayments on the loan as this debt is dealt with via the cost of capital