Debt

Question 1

What are the properties of Debt Capital?

Answer 1

1. More frequent/important than equity financing
2. Companies borrow money and are obligated to make regular interest payments and repay principal at maturity
3. Interest payments are tax deductible
4. Firms may default on their obligations, in which case the lenders take over the firms assets

Question 2

What is a Debt Covenant?

Answer 2

Specific provisions in the debt contract which are designed to protect lenders

Question 3

What are the two types of Debt Covenants?

Answer 3

1. Negative covenants - limit access to further debt, restrict dividends paid and holdings of certain investments
2. Positive covenants - maintain assets (working capital or collateral), provide audited financial statements to the lenders

Question 4

How do you calculate a firm’s value (market value of assets)?

Answer 4

V = D + E

Question 5

What are the risk profiles of debtholders vs shareholders?

Answer 5

1. Equity is more valuable if cash flows are more volatile (more upside potential), therefore shareholders have more incentive to take risky projects
2. Debtholders main concern is defaulting, therefore they dislike risky projects creating conflicting interests between them and shareholders (covenants reduce firm’s downside risk)

Question 6

What is a Lessor?

Answer 6

The legal owner or financier of an asset which they are leasing

Question 7

What is a Lessee?

Answer 7

The asset user

Question 8

What is a Lease?

Answer 8

A contract where lessor receives fixed payments from the lessee in return for the use of the asset

Question 9

What are the properties of an Operating Lease?

Answer 9

1. Generally short term
2. Cancellable by lessee at short notice, typically without substantial penalty
3. Risks of ownership borne by lessor
4. Lessor is often a supplier of the asset
5. Leasing vs buying decision

Question 10

What are the properties of a Finance Lease?

Answer 10

1. Long term agreement (life of asset)
2. Non-cancellable without substantial penalty
3. Risks of ownership transferred to lessee
4. Effectively the lessor is a source of finance for lessee (borrowing alternative)
5. Leasing vs borrowing to buy decision

Question 11

How can a lessee calculate the incremental cash flows of a lease?

Answer 11

1. Add the cost of the asset (lease avoids paying this)
2. Subtract the lease payments (must pay these)
3. Add the tax shield from lease payments (reduces tax payable)
4. Subtract the depreciation tax shield which is missed out on by lessee
5. Subtract the proceeds from the gain on the sale of the asset which lessee misses out on; or
   Add the loss from the sale of the asset which the the lessee doesn’t bear
6. Add tax on the gain on the sale of the asset which lessee does not pay; or
   Subtract the tax shield missed out on from the loss on the sale of the asset

Question 12

How do you calculate the lease payment and depreciation tax shields when evaluating a lease?

Answer 12

1. Lease payments tax shield = Tc•lease payment
2. Depreciation tax shield = Tc•depreciation p.a.

Question 13

How do you calculate the gain/loss on the sale of an asset?

Answer 13

Gain/loss on sale = (residual value - book value)•Tc
where the book value = cost of asset - accumulated depreciation

Question 14

How can a lessee calculate the NPV of a Finance Lease?

Answer 14

1. Calculate the incremental cash flows from leasing the asset
2. Calculate the after-tax cost of borrowing - ATC = Discount rate•(1-Tc)
3. Calculate the NPV of the incremental cash flows using the AT discount rate
4. If NPV < 0, reject the lease and borrow money to buy the asset

Question 15

How can a lessee calculate the maximum lease payment they would be willing to pay?

Answer 15

1. Calculate the incremental cash flows from leasing using L to represent the value of the lease payment
2. The maximum lease payment the lessee is willing to pay occurs when the NPV = 0
3. Solve for L given that NPV = 0

Question 16

Can a negative NPV project still create wealth?

Answer 16

The NPV of a financing lease is only a financing decision (i.e. whether to lease or to borrow to buy the asset), not an investing decision. If the NPV of the lease is great enough to make the negative NPV project positive, it can still create wealth.

Question 17

How can a lessee calculate the NPV of an Operating Lease?

Answer 17

NPV(operating lease) = NPV(finance lease) + PV(option to cancel)

Question 18

Why does leasing exist if NPV(lessor) = -NPV(lessee)?

Answer 18

Market frictions can make leasing advantageous:
1. Company taxation is lower and can share the benefits to the lessee
2. Company has lower cost of capital (borrowing at cheaper rates)
3. Company has lower transaction costs (bulk discounts or lower penalties)
4. Off-balance sheet financing (no longer viable as companies must capitalise leases now)

Question 19

What are the two types of Hybrid Securities?

Answer 19

1. Convertible notes & convertible bonds
2. Preference shares

Question 20

What is a Convertible?

Answer 20

Issue of debt through a note or bond with the additional feature that the holder has the option to convert it into ordinary shares a specified date. Issued to avoid negative signals of IPOs and have lower interest rate than debt.

Question 21

What are the different types of Preference Shares?

Answer 21

1. Converting - convert to ordinary shares approx. 5-10 years after issue
2. Reset - have a dividend rate that resets after a specified period
3. Step-up - have a dividend rate that is variable and at a specified date the issuer may remarket, redeem at face value, or convert the securities.

Question 22

What are the properties of Preference Shares?

Answer 22

1. Give holder priority on dividends and capital over ordinary shareholders
2. Cumulative - must be paid any accumulated dividends & capital
3. Irredeemable - have no maturity date
4. Non-participating - only entitled to receive the stated dividend rate
5. Non-voting - not entitled to vote