Chp 3: Long-term Debt Finance

Question 1

What are six sources of short-medium term debt finance (inlcue pros and cons)?

Answer 1

1. Trade Credit (ie. paying suppliers later) - No immediate costs but risks loss of goodwill with suppliers
2. Debt Factor - Flexible form of finance that grows as the business expands but can damage customer goodwill
3. Overdraft - Only pay interest if used, could be instantly recalled.
4. Loan - More secure than an overdraft but less flexible
5. Commerical Paper - no-interest bearing IOU (eg. £100 paper bought for £95 and redeemed in future)
6. Revolving Credit Facility - a bank lending to a company up to a specified amount for a specified interest rate

Question 2

What are six sources of Long-term finance?

Answer 2

1. Bank Loans - companies may need to present a convincing business plan, commerical collateral and/or personal collateral
2. Conventional Bonds - Fixed rate IOUs
3. Convertible Bonds - these give the owner the right to convert their bonds into equity shares at a point in time. If not used, they will be redeemed at maturity.
4. Deep Discount Bonds - offered at a large discount to their nominal value and a low interest rate so that most of the capital gain comes at the redemption point, not with the interest payments.
5. Zero Coupon Bonds - issued at a discount to their redemption but wiht no interest payments. Tax advantage for the investor is that it is only taxed in one lump sum at redemption (Deep discount also beneifts from this)
6. Eurobonds - international bonds sold outside of the currencies jurisdiction. Advantages include: cheap, flexible, long-term, larger amounts on this market

Question 3

What is the calculation for tax releif on interest payments?

Answer 3

Pre-tax cost of the loan * (1 - tax rate)

Question 4

What are the four features of conventional bonds?

Answer 4

1. Issued at par - rate is fixed at time of issue
2. Marketable - can sell the debt on which reduces the cost
3. Redeemable - bonds are normally redeemable at a point in time
4. Secured - normally secured, unsecured bonds would require a higher yield to compensate for the additional risk

Question 5

How do you calculate the conversion value and the conversion premium of convertible debt?

Formula

Answer 5

CV = Conversion Ratio * Market Price per share
CP = Current Market Value (of debt per nominal value) - Current Conversion Value

Conversion ratio is the number of shares converted at the conversion date per nominal value
CP as a percentage of CV means that the share price will need to raise by that amount before conversion becomes an attractive offer
Companies want the highest possible CP but firms will accept based on that companies growth potential

Question 6

What factors influence the choice of debt finance?

Answer 6

1. Availability - some markets are limited by their membership
2. Credit rating - will affect the interst that will need to be given
3. Amount - bonds are typically for large amounts
4. Duration - length of loan should match the investment length
5. Interest rates - can choose fixed or floating rates depending on interest rate expectations
6. Security & Covenants

Question 7

How does Taxation affect the choice of debt finance?

Answer 7

Zero Coupon and Deep Discount bonds won’t allow the entity to benefit from the tax relief on interest payments to the same extent as with other forms of debt

Some domestic bonds are subject to withholding tax but Eurobonds are not, which can enhance their popularity.

Question 8

Debt Covenants are restricitions that the borrower agrees ti that are set by the lending institution. What is the difference between positive and negative covenants?

Answer 8

Negative covenants restrict the borrowers behaviour (eg. prevent further borrowing, prevent excessive dividends etc.)

Positive covenants won’t restrict behaviour direclty but would include maintaining financial ratios at a certain level, providing the lender with regular financial statements.

Question 9

Leasing

Answer 9

IFRS 16 Leases - contract which conveys the right to use an asset, for a period of time, in exchange for consideration.

Pros - cheaper, can’t be cancelled suddenly as they are contractual, tax relief may be advantageous.

Buy or Lease? - Decision only made once it has been decided to invest in an asset. At this point, discounted cash flows can be used to make the decision

Don’t include interest payments on the loan in discounted cash flows as this is already included in the cost of capital