Chapter 5 - Financing: Debt finance Flashcards
What is debt finance?
Loan of funds to a business without conferring ownership rights
What are the key features of debt finance?
Interest paid out of pre-tax profits as an expense of the business
Paying interest reduces the taxable profits of the business and hence the tax payable
Debt finance carries a risk of default if interest and principal payments are not met
To reduce the risk to the lender, security and/or covenant are used
What is security?
In the event of default, the lender will be able to take assets in exchange for the amounts owing.
Fixed charge - The debt is secured against a specific asset, normally land or buildings
Floating charge - The debt is secured against the general assets of the business. This form of security is not as strong.
What is a covenant?
Specific requirements of limitations laid down as a condition of taking on debt finance.
Examples:
Dividend restrictions
Financial ratios
Financial Reports
Issue of further debt
What are some debt financing sources?
Bank finance
Traded debt/bonds
What do we assess when determing the choice of whether to use bonds or bank borrowings?
Liquidity - bond markets are extremely liquid, with many potential investors
Timescale - Generally speaking, bonds are used to finance long term investments, whereas bank borrowings are more suitable for short or long term needs
Costs - entering the bond market might be rather difficult and expensive, but once in, the costs reduce significantly
What are some less common types of bonds?
Convertible bonds
Deep discount bonds - bonds issued at a significant discount and have a low coupon rate
Zero coupon bonds - Coupon rate is zero so no annual interest is paid
What are eurobonds?
Bonds issued in foreign currency
What is the main reason for wanting to borrow in foreign currency?
Fund a foreign investment project or foreign subsidiary
Protects against changes in value due to currency movements
What are the three risks associated with debt finance?
Interest rate risk
Refinancing risk
Currency risk
What is interest rate risk?
Risk of gains or losses on assets and liabilities due to changes in interest rates
What is refinancing risks?
The risk that borrowings will not be refinanced or will be be refinanced at the same rates.
What are the three causes of refinancing risk?
Lenders are unwilling to lend or only prepared to lend at higher rates
Credit rating of the company has reduced making it a more unattractive lending option
The company may need to refinance quickly and therefore have difficulty in obtaining the best rates
What is currency risk?
Risk that arises from possible future movements in any exchange rate
Who does currency risk affect?
Any organisation with:
Assets and/or liabilities in a foreign currency
Regular income and/or expenditures in a foreign currency
