WS8 - Debt Finance

Question 1

Debt Finance - a) Intro: Why may companies use this over equity fiannce?

Answer 1

• Many private companies may find it difficult to raise money through equity finance and they are unable to offer shares to the public.
• So, laternative option is to borrow money (debt fiannce) usually from banks or other lenders.

Question 2

Debt Finance - a) Intro: Will companies be restricted in their ability to borrow?

Answer 2

Most companies will have unrestricted power to borrow, however, important to check when company incorporated and the articles to ensure no restrictions

Question 3

Debt Finance - b) What is debt finance: What can the types of debt finance be classified as?

Answer 3

Either:
* Loan facilities or
* Debt securities

Question 4

Debt Finance - b) What is debt finance: What will a lender do in return for loan?

Answer 4

• Ensure they are protected as far as possible from possibility that borrowing company may be unable to repay loan
• Key methodd of protection is for lender to take security over assets of borrowing company

Question 5

Debt Finance - b) What is debt finance: What is it important not to confuse?

Answer 5

Important not to confuse the term debt security, which is a type of debt with the term security for debt which is something lender will take over assets of borrower.

Question 6

Debt Finance - c) Types of debt finance - Loan facilities: What is a loan facility?

Answer 6

An agreement between a borrow and a lender which gives the borrow right to borrow money on terms set out in agreement.

Question 7

Debt Finance - c) Types of debt finance - Loan facilities: What are the different types of loan facilities?

Answer 7

• Overdraft
• Term loan

Question 8

Debt Finance - c) Types of debt finance - Loan facilities - i) Overdraft: What does this allow for?

Answer 8

• On demand facilities
• This means that bank can call for all money owed to it at any point in time and demand it is repaid immediately as such, they are unsuitable as a long term borrowing facility.
• Interest paid by customer on amount overdrawn.

Question 9

Debt Finance - c) Types of debt finance - Loan facilities - ii) Term Loan: What does this allow for?

Answer 9

• Loan of money for fixed period of time and repayable on certain date.
• Lender cannot demand early repayment unless borrower breaches agreement.
• Lender will receive interest on loan throughout the period.
• Term loans which are repayable in a single lump sum at end are referred to as having bullet repayment or if payment in installments then referred to as “amortising”

Question 10

Debt Finance - c) Types of debt finance - Loan facilities - iii) Revolving credit facility: What does this allow for?

Answer 10

• Loan of money fo specified period of time.
• Unlike term loan, borrower can repeatedly borrow and repay loans up to agreed maximum when it chooses.
• Helps keep interest payments down by borrwoing only when it needs funds and repaying when cash available so combines features of overdraft and term loan.

Question 11

Debt Finance - d) Types of debt finance - Debt Security: What do debt securities allow for?

Answer 11

• They have similarties to equity securties as they are means company receives funds from external sources.
• In return for finance, the company issues a security acknowlsging the investors right.
• This security is a piece of pasper acknowldging the debt which can be kept or sold to another investor and at maturity date of the security, company pays value back to the holder.

Question 12

Debt Finance - e) Debt/Equity hybriads - i) Convertible bonds: What do convertible bonds allow to be converted?

Answer 12

• These are bonds which can be converted into shares in the issuer.
• On concersion, issuer issues shares to bondholder in agreement to give up its right to receive interest and repamyment of prinipal amount invested.

Question 13

Debt Finance - e) Debt/Equity hybriads - i) Convertible bonds: How does this have debt/equity hybrid?

Answer 13

It has charcteristics of both but not at the same time:
* Starts off as a debt security but later on if investor so elects, the bond is swapped for shares.

Question 14

Debt Finance - e) Debt/Equity hybriads - ii) Preference Shares: What is the position for preference shares?

Answer 14

• Wholly equity
• But often called hybrid because has elements that make it look simialr to debt.
• Holder of share usually has no voting rights and gets definite amount of dividend ahead of other SH’s which makes it look similar to interest.
• If it also have fixed maturity date on which company must redeem, then it look more like debt.
• However, if it does not have fixed matuerty date and divdend will only be paid when company declaes dividend (unlike interest which has to be paid) then this is more akin to equity.

Question 15

Debt Finance - f) Main debt finance documents - i) Term Sheet: What is this a statement of?

Answer 15

• Key tyerms of the transaction such as (loan amount, interest rate, fees to be paid, key represenations, undertakings and events of default) which have been agreed by the lender and borrower.
• It is equivalent to a heads of terms.

Question 16

Debt Finance - f) Main debt finance documents - i) Term Sheet: Are they legally binding?

Answer 16

Not intended to be legally binding, rather a statement of understanding on which parties agree to enter into transaction.

Question 17

Debt Finance - f) Main debt finance documents - ii) Loan Agreement: What will this set out?

Answer 17

• The main commercial terms of the loan agreed between parties such as amount of interest, dates it will be paid and date principal needs to be repaid.
• As aell as most of the information from term sheet but in much more details.
• This is most negotiated document in a debt finance transaction.

Question 18

Debt Finance - f) Main debt finance documents - iii) Security Document: What is purpose of this document?

Answer 18

If loan is secured, a seperate security document will be negotiated and entered.

Question 19

Debt Finance - g) Debentures: What are the two meanings of debenture?

Answer 19

• Under s738 this covers any form of debt security issued by a company, including debenture stock, bonds and any other securities of a company, whether or not consituting a charge on the assets.
• A debenture is a type of security document and one of most common used in secured loan transactions and it is in this content the term is usually used and it is seperate document from loan agreement.

Important to understand the terminology in debt finance

Question 20

Debt Finance - h) Important terms in loan agreements - i) Representations: What are representations in loan agreements?

Answer 20

• Usually referred to as representations and warranties
• They are statements of fact as legal and commercial matters made on signing of the lona agreement and repeated peridocially during life of loan.

Question 21

Debt Finance - h) Important terms in loan agreements - ii) Undertakings: What are undertakings?

Answer 21

• Undertakings are promises to do or not do something or to procure that something is done or not done.

Question 22

Debt Finance - h) Important terms in loan agreements - iii) Event of default: What do this provide for?

Answer 22

• Representations and undertakings are important.
• Breach of either gives bank contractual remedies where breach consistutes event of default.
• Event of default vital in terms of giving the bank the power to call in its money early if borrower shows signs of becoming enhanced credit risk.

Question 23

Security - a) Intro: What is this section concerned with?

Answer 23

The types of security that can be taken by a lender over borrowers assets.

Question 24

Security - b) Nature of security: What does security mean in this context?

Answer 24

Temporary ownership, possession of other proprietary interest in an asset to ensure that a debt owed to a lender is repaid.

Question 25

Security - b) Nature of security: What is the benefit of taking security?

Answer 25

• PRotects the creditor in event borrower enters formal insolvency procedure
• Possible to improve priority of a debt by taking seucrity for it

Question 26

Security - b) Nature of security: What are examples of forms of security?

Answer 26

• Pledge
• Lien
• Mortgage
• Charge

Question 27

Security - b) Nature of security - i) Plege: What is a pledge?

Answer 27

• Security provider (usually borrower or another company in borrowers group) gives possesion of asset to creditor until debt paid back.
• Pawning a watch or item of jewellery is a form of pledge.

Question 28

Security - b) Nature of security - ii) Lien: What does a lien allow?

Answer 28

• Creditor retains possesion of asset until the debt is paid back.
• Such as mechanics lien which is operation of law and allowas a mechanic to retain possesion of repaired vehicle until invoice paid.

Question 29

Security - b) Nature of security - iii) Mortgage: What doesm mortgage allow?

Answer 29

• Security provider retains possession of asset, but transfer ownership to creditor
• This transfer is subject to security providers right to require creditor to transfer asset back when debt paid and this right is known as equity of redemption.
• An example would be charge by way of legal mortgage for alnd, but unusually, ownership remains with security provider in this case.

Question 30

Security - b) Nature of security - iv) Charge: What do charges allow for?

Answer 30

• As with mortgage, security provider retains asset and rather than transferring ownership, charge simply involves creation of equitable proprietory interest on the asset in favour of creditor.
• In addition to this itnerest, charging doc also gives lender certain contractual rights over asset such as to appioint an adminstrator to take possesion and sell it if debt not paid back.

Question 31

Security - b) Nature of security - iv) Charge: What are the two types of charges?

Answer 31

Fixed Charges
Floating charges

Question 32

Security - c) Fixed Charges: What is a fixed charge and what does it allow?

Answer 32

• Normally taken over assets such as machinery and vehicles.
• Key element is creditor can control what security provider can do with asset.
• Usually by security provider untaking not to dispose of or create futher charges over charged asset without consent.
• Control in this sense that borrower can usually stil use in ordinary business but cannot dispose or charge further.

Question 33

Security - c) Fixed Charges: What if fixed charge becomes enforceable?

Answer 33

Creditor can appoint receiver of that asset or exercise power of sale.

Question 34

Security - d) Floating Charge: When may floating charge be appropiate?

Answer 34

• Not always practical for security provider to undertake not to dispose of assets
• This could be a trading company who needs to dipose of its stock, and in that case, a floating charge may be more suitable.

Question 35

Security - d) Floating Charge: What does a floating charge allow for?

Answer 35

• This charge “floats” over the whole of a class of curclating/fluctuating assets.
• Whatever assets in that class owned by the security provider at any given time are subject to the floating charge and they are free to dispose of them as he wishes until “crstylisation.”

Question 36

Security - d) Floating Charge: What is crystallisation in respect of floating charge?

Answer 36

• Floating charge stops floating and fixes to the assets in relvant class which are owned by the security provider at time of crystallisation and creditor acquires control of them and it is then like a fixed time.
• It can occur by operation of law or may be triggered by certain events as contrctually agteeed between parties.

Question 37

Security - d) Floating Charge - i) Disadvantages of floating charge for creditor: What freedom does security provider have and what does this mean?

Answer 37

• Security provider ha sfreedom to dispose in ordinary course of business, creditor will not be sure of the value of secured assets.

Question 38

Security - d) Floating Charge - i) Disadvantages of floating charge for creditor: What does the stutory order of priorty of payment mean?

Answer 38

• Statutory order ofpriority of payment of creditors on wound up and a floating charge generally ranks below a fixed chagre (and crystalissation does not change this) and below preferantial creditors.
• However - Note if floating charge doc contained term not to create a fixed charge later but company did, then floating charge holder would have priority if fixed charge had notice of this restriction.* Security provider ha sfreedom to dispose in ordinary course of business, creditor will not be sure of the value of secured assets.

Question 39

Security - d) Floating Charge - i) Disadvantages of floating charge for creditor: What if the floating charge created on or after september 15 2003?

Answer 39

Floating chharges created on or after 15 September 2003 are subject to a part of the proceeds of assets being set aside which is known as “prescribed part fund” for unsecured creditors.

Question 40

Security - d) Floating Charge - i) Disadvantages of floating charge for creditor: What is adminstrators free to do?

Answer 40

• Adminstrator free to deal with floating charge assets in their control without reference to charge holder or the court and pay their remuneration and expenses out of proceeds of those assets.

Question 41

Security - e) Guarantees: What is the strict position regarding guarantees?

Answer 41

• They are not security as do not give rights in assets.
• However, as their commercial effect is similar to security, they tend to be treated tgether.

Question 42

Security - e) Guarantees: What is a gurantee?

Answer 42

• A gurantee for a loan means an agreement that the gurantor will pay the borrowers debt if the borrower fails to do so.
• They can come from companies or individuals such as directors.

Question 43

Security - e) Guarantees: Example of a gurantee

Answer 43

Question 44

Security - f) Registration of Charges: What needs to be done on creation of security?

Answer 44

• Most secuirty created by company needs to be registered at CH.
• This includes charges created by Englsh company over assets in UK and abroad.

Question 45

Security - f) Registration of Charges: What is required for registrar of companies to register a security created at CH?

Answer 45

The company or any person interested in charge (lender) delivered to CH either elctronically or by paper filing within 21 days begining with day after the day on which charge crated:

A section 859D statement of particulars set out on Form MR01 detailing:
* Company creating the charge
* Date of creation of the charge
* The persons entitled to the charge and
* A short description of any land, ships aircraft, IP registered or required to be in the UK which is subject to fixed charge
* Certigfied copy of charge and
* relevant fee

Question 46

Security - f) Registration of Charges - i) Who: Who registeres the charge?

Answer 46

S859A provides that the statement above may be delivered either by company creating charge or the person interested and in practice usually lenders solicitors who will complete as they have most to lose.

Question 47

Security - f) Registration of Charges - ii) Effect of failure to register: What is the effect of failure to register?

Answer 47

Under s859H, if charge not registered at all or within 21 day period:
* Charge is void against a liqudiator, adminstrator or any creditor of the company; and
* Debt becomes immediately payable

So, if charge not valid against liquidtor, or adminstrator, security will efectively be worthless if not registered.

Question 48

Security - f) Registration of Charges - iii) Records to be kept by company: What must company keep available for inspection?

Answer 48

• Under S859P, comapny must keep available for inspection a copy of every charge and a copy of every instrument that amends or varies any charge and they can be certified copies rather than originals.

Question 49

Security - f) Registration of Charges - iii) Records to be kept by company: Where must documents be kept?

Answer 49

Either at companies registered office or such other location as permitted under Companies (company records) regulations 2008.

Question 50

Security - f) Registration of Charges - iii) Records to be kept by company: What must company inform companies house regarding documents and available to who?

Answer 50

Where they are available for inspection and of any charges to that place and they msut be avialable for any creditor or emmber of the com,pany free of charge and by any other person for a prescribed fee.

Question 51

Security - f) Registration of Charges - iii) Records to be kept by company: What if company refuses inspection?

Answer 51

Court may order the company allows an immediate inspection.

Question 52

Security - f) Registration of Charges - iii) Records to be kept by company: What if company fails to comply with requirements above?

Answer 52

An offence and the company and every office in default will be liable to fine.

Question 53

Security - g) Order of Prioroty between creditors: What is the order creditors will be paid on winding up?

Answer 53

• Creditors with fixed charges - Entitled to first call on proceeds from sale of those assets charged to them under fixed charge
• Preferential credcitors - Primarily wages (up to £800 per employee) occupation pensions and certain sums owed to HMRC
• Creditors with floating charges - (Which will have crystalised if not before,upon commencement of winding up): For floating charges created on or after 15 September 2003, a proporation of proceeds of floating charge assets set aside for payment of unsecured creditors before floating charge holders paid referred to as prescribed part fund.
• Unsecured creidotrs - to the extent they are not paid off from prescribed part funds.
• Sharegolders (according to rights attaching to shares)

Question 54

Security - g) Order of Prioroty between creditors - i) Priority among secured creditors: What is the general positon?

Answer 54

• Complex area but in general, if more than one creditor has fixed charge over same asset, the one first created has priority (provided properly registered as per above)
• Simialrly, if more than one creditor has floating charge over same assets, the first ceated has prioty.

Question 55

Security - g) Order of Prioroty between creditors - i) Priority among secured creditors: How can the general order above be varied?

Answer 55

• Through agreement between creditors through document known as deed of prioity, an intervreditor agreement or a subordination agreement.
• Such arrangement has benefit that creditors can make specific provision for order they will rank and do not need to rely on compelx/uncertain rules above.

Question 56

Security - g) Order of Prioroty between creditors - ii) Priority among other categories of creditors and SH’s: How do these creditors/SH’s rank?

Answer 56

• SH’s, unsecured and preferential rank equally among themselves (subject to any preferential rights attached to certain classes of share) within their category.
• For exmaple, this means for category of unsecured, it does not matter when debt was incurred, as no unsecred creditor will take prioty upon distrubition and it will not change the order as it did above.

Question 57

Effect of Equity and Debt Finance on the balance sheet: What will company need to do if issuing shares or raising finance by loan?

Answer 57

It will need to record these changes in its accounts.

Question 58

Effect of Equity and Debt Finance on the balance sheet: What are the general rules when considering different types of raising finance?

Answer 58

• Equity: Both the net asset value of the company will change and the total equity (so both halves of the balance sheet will be effected)
• Debt: Net asset value of company will not change as a result of the loan and the equity will not change (so only top half of balance sheet will be effected)

Question 59

Effect of Equity and Debt Finance on the balance sheet - a) Equity effect on balanace: What changes must be recorded on balance sheet when company issues shares at nominal value?

Answer 59

Two changes must be recorded:
* Increase share capital (bottom half of balance sheeT) to show the nominal value of the shares issued to SH’s and
* Increase the cash (current assets - top half of the balance sheet) to show the cash received by the company for the shares from SH’s.

So - Top half shows you what company owns and btottom half shows where it come from and they willbalance as both top half and bottom will increase by amount of sahare issue.

Question 60

Effect of Equity and Debt Finance on the balance sheet - b) Private for shares: How may shares be sold?

Answer 60

As seenin shares chapter, they often will be sold at price more than nominal value and this is called the premium.

Question 61

Effect of Equity and Debt Finance on the balance sheet - b) Price for shares: How are price of shares calaculated?

Answer 61

In simple terms, it is by working out value of company as a whole and dividing by number of shares in issue which gives value per share.

Question 62

Effect of Equity and Debt Finance on the balance sheet - d) Effect of issing share for more than nominal value on balance sheet: What will be recorded in top half of balance sheet if issued at more than nominal value?

Answer 62

• The cash received from SH’s is shown by an increase in the assets on top half of the balance sheet.

Question 63

Effect of Equity and Debt Finance on the balance sheet - d) Effect of issing share for more than nominal value on balance sheet: What will be recorded in bottom half of balance sheet if issued at more than nominal value

Answer 63

• Nominal value of new shares is shown by an icnrease in share capital
• Premium per share is shown in newly created share premium accoount. The share premoum must be shown in seperate share premium account pursuant to S610.

Question 64

Effect of Equity and Debt Finance on the balance sheet - e) Earning per share: What is this ratio and what does it show?

Answer 64

• Commonly used ratio that can be used to measure financial performance of a company.
• It shows return due to the ordinary SH’s and is calacual;ted by dividing profit after tax by the average number of ordinaryshares in issue while the profit was generated.
• An increase in number of shares in issue will result in dilution of earning per share figure.

Question 65

Effect of Equity and Debt Finance on the balance sheet - f) Effect of Debt Finance on balance sheet: What changes must be recorded when company takes out loan?

Answer 65

• Company’s liabilities are increase by amount of the loan; and
• Company’s current assets (cash) are also icnreased by the loan funds

Net assets therfore remain unchanged and also because company has taken out loan (debt) and not issued new shares (equity) the total equity is also unchanged./

Question 66

Effect of Equity and Debt Finance on the balance sheet - g) Gearing: What is gearing?

Answer 66

• Gearing is the ratio of liabilities to SH funds (total equity in balance) or in simple terms, the ratio of debt to equity and it is important indictator of financial health of company.
• The higher the ratio, the more likely the company is geared.

Question 67

Effect of Equity and Debt Finance on the balance sheet - g) Gearing: What formula is sued to calaculate gearing?

Answer 67

Long term debt (non-current liabilities) x 100%/Total equity

See P216 for example of apply forumla

Question 68

Effect of Equity and Debt Finance on the balance sheet - g) Gearing - i) In practice: How are highly geared comapnies seen in practice?

Answer 68

• More of a credit risk by banks and other lends so they might find it more difficult to raise further loans in the future.
• This is because they have less equity to absorb any losses.
• Highly geared comapny has less equity to protect creditors and so poses higher risk.
• In addition, highly geared company will need to make more profits before interest and tax in order to meet demands for interest payments. (Which can be dagerous when econimic conditions bad or high interests rates as all profit could have to be used on interest payments)

Question 69

Effect of Equity and Debt Finance on the balance sheet - g) Gearing - ii) Advantages: Why would company want to be highly geared if above?