Chapter 18 Planning for Debt

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Chapter 18 - Planning for Debt Financing
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PART FIVE PLANNING AND DECISION MAKING IN THE
INVESTING AND FINANCING CYCLES
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L.O.1 Explain the risks and rewards of
long-term debt financing. L.O.2 Describe the
characteristics of the three basic types of
long-term debt instruments. L.O.3 Identify
sources of debt financing. L.O.4 Understand
how firms plan their financial structure.
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HOW IS DEBT FINANCING USED?

• To provide cash resources for daily operations
  through short-term debt, or current liabilities,
  such as accounts payable, salaries payable, and
  trade note payables.
• To finance acquisition of long-term assets such
  as buildings, equipment, land, and patents to
  support operations, and that provide the
  infrastructure for the firms operating
  activities.

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HOW IS LONG-TERM DEBT FINANCING CREATED?
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RISKS OF DEBT FINANCING
The risk in debt financing is called financial
risk - the chance that a firm will default on
its debt.
Youre going to do what?
Loan agreement
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REWARDS OF DEBT FINANCING

• When companies generate a return on their
  borrowed funds that is greater than the cost to
  them of using the borrowed funds, the owners of
  the companies benefit.

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CASH FLOW ADVANTAGES OF DEBT FINANCING

• Interest is tax deductible while dividends are
  not. When comparing the cash outflows of an
  equal amount of interest and dividend payments,
  there is a cash flow advantage from paying
  interest because it saves taxes.

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AFTER-TAX COST OF BORROWING

• The tax savings on paying interest equates to a
  reduction in the cost of borrowing to a business.
  
• Assume a company borrows 2,000,000 at a cost of
  10. The tax savings on the annual interest of
  200,000, in effect, pays part of the cost of
  borrowing.

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WHAT ISFINANCIAL LEVERAGE?

• Financial leverage is a financing strategy to
  increase the rate of return on owners investment
  by generating a greater return on borrowed funds
  than the cost of using the funds.
• Two financial ratios are key indicators of
  financial leverage debtequity ratio and the
  return on owners equity.

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DEBT EQUITY RATIO

• The debtequity ratio measures financial leverage
  by comparing total debt to the total amount of
  the owners investment.
• As financial leverage increases, the ratio of
  debt to equity increases. Risk also increases.

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RATE OF RETURN ON OWNERS EQUITY

• The rate of return on owners equity measures
  firm performance relative to the amount of the
  owners investment. This is a key financial
  benchmark.
• As financial leverage increases and a business
  earns a greater return on borrowed funds then the
  cost of borrowing, the rate of return on owners
  investment increases.

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ILLUSTRATION OF FINANCIAL LEVERAGE

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PAUSE AND REFLECT
Without borrowed funds, the total resources
(assets) available to the business would be equal
to the amount of the owners investment, or
1,000,000. The return on the owners investment
was 90,000 during the year, or 9
(90,000/ 1,000,000).
In the illustration of financial leverage, what
would have been the rate of return on owners
equity if the business had no borrowed funds?
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TIMES INTEREST EARNED RATIO

• The times interest earned ratio measures a firms
  ability to meet its interest obligations on debt
  financing.
• The adequacy of net income in covering interest
  obligations provides information on financial
  risk.

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• Covenants
• Covenants are provisions in loan documents
  that place restrictions on the borrower.
• Proceeds
• Proceeds equal the amount of cash raised
  from the issuance of the debt by the borrower.
• Market rate
• Also called effective rate, the market rate
  is the actual interest rate charged for the use
  of the proceeds.

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LONG TERM DEBT INSTRUMENTS, CONT.

• Face value-the amount stated on the face of the
  debt instrument. This amount is used to
  calculate periodic interest payments, and is the
  amount that is paid when the debt instrument
  matures (maturity date). The face value is also
  the maturity value.
• Face or stated interest rate-used to determine
  interest payments.

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NONPUBLIC DEBT FINANCING
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PUBLIC DEBT FINANCING

• Bonds are long-term debt instruments.
• Usually issued by corporations.
• Allow corporations to raise larger sums than
  possible through bank.
• Available to the public as bond certificates.
• Bonds can be issued to public by a(n)
• Underwriter (investment banker).
• Private placement.
• Bonds are for sale in the market.

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SOURCES OF LONG-TERM DEBT FINANCING

• Nonpublic sources of debt financing
• Individuals
• Financial institutions such as banks, insurance
  companies and other financing companies
• Public sources of debt financing
• The bond market

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LONG-TERM DEBT INSTRUMENTS - ILLUSTRATION

• Borrower Sprint lender Citibank
• Proceeds 500,000
• Rate of interest 8
• Covenants - no dividend payments

• Long-term debt instrument between
• Sprint and Citibank
• Citibank agrees to lend Sprint 500,000 at 8.0
  on July 1, 1999, and Sprint agrees to repay the
  loan in equal quarterly installments over the
  next two years in the amount of 68,254.73.
  During the period of the loan, Sprint may not pay
  dividends to its stockholders.

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• Periodic Payment Notes - a debt instrument that
  contains a promise to make a series of equal
  payments consisting of both interest and
  principal at equal time intervals over a
  specified period of time. Examples mortgages,
  car loans.

• Lump-Sum Payment Notes - a debt instrument that
  contains a promise to pay a specific amount of
  money at the end of a specific period of time.
  These are noninteresting-bearing notes because
  the note only specifies a face value due at a
  certain time. Example Frequently negotiated
  commercial loan.

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NONPUBLIC DEBT FINANCING
Private lenders can protect claims by

• Issuing covenants - restrictions imposed by the
  lender on the borrower.
• Requiring collateral - specific assets or groups
  of assets that secure a loan and protect the
  lender if default occurs. A mortgage is a
  long-term debt involving real estate that acts as
  the collateral for the debt.

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PERIODIC PAYMENT NOTES
Exhibit 18.3

• The Sprint/Citibank loan used in the illustration
  of a long-term debt instrument is a periodic
  payment note.
• By using the present value of an annuity concepts
  from Chapter 14, we can determine the required
  quarterly payments.

• Long-term debt instrument between
• Sprint and Citibank
• Citibank agrees to lend Sprint 500,000 at 8.0
  on July 1, 1999, and Sprint agrees to repaid the
  loan in quarterly installments over the next two
  years in the amount of 68,254.73. During the
  period of the loan, Sprint may not pay dividends
  to its stockholders.

Annuity x P (8,2) Present value Annuity x
7.3255 Present value Annuity
68,254.73
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PERIODIC PAYMENT NOTES FLOWCHART
Exhibit 18.3
Periodic payments of principal interest
Face amount received
No payments remain at end of loan period
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PAUSE AND REFLECT
Sprint will make 8 payments of 68,254.73 for
a total of 546,037.84. Each payment consists
of a portion of the principal borrowed and an
interest charge on the remaining balance. Since
the company borrowed 500,000, the interest is
46,037.84.
If Sprint borrows this money and repays the note
in accordance with the terms, how much interest
will Sprint have paid?
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LUMP SUM PAYMENT NOTES
Exhibit 18.4

• If the Sprint/Citibank loan was a lump sum
  payment note, it might appear as illustrated
  below.
• By using the present value of an amount of 1
  concepts from Chapter 14, we can determine the
  loan proceeds of a lump sum note, and by using
  the future value of a 1 concepts, we can
  determine the face value of the note.

• Long-term debt instrument between
• Sprint and Citibank
• Citibank agrees to lend Sprint 500,000 at on
  July 1, 1999, and Sprint agrees to repay the loan
  on July 1, 2001 at a rate of 8 interest,
  compounded semi-annually.

Future value P(4,4) Present value Future
value 0.8548 500,000 Future value
584,932.15
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LUMP SUM PAYMENT NOTES FLOWCHART
Exhibit 18.4
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PAUSE AND REFLECT
In a periodic payment note, the loan proceeds
are equal to the amount of the loan - interest
is paid above the amount received as a loan,
and regular payments are made over the period of
the loan. In a lump-sum note, the loan proceeds
are not equal to the amount of the loan - they
are less because the face value of the loan is
discounted for the interest that is not stated,
and no payments are made until the loan is due.
Regardless of the type of long-term note,
interest is paid. How are these two debt
instruments different?
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COMBINATION NOTES

• A periodic payment and lump-sum note is a debt
  instrument that combines periodic cash payments
  and a final lump-sum cash payment.

• The periodic payments are determined by
  multiplying the face rate of interest times the
  face value of the note 500,000 x .08 x 1/2
  20,000.

• Long-term debt instrument between
• Sprint and Citibank
• Citibank agrees to lend Sprint 500,000 at 8.0
  semi-annually on July 1, 1999, and Sprint agrees
  to repay the loan in four equal semiannual
  installments over the next two years in the
  amount of 20,000, and a final lump sum payment
  of 500,000 at the end of two years.

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BONDS

• A bond is a long-term debt instrument. Bonds are
  a means of public debt financing. They are
  offered to individual investors through the bond
  market. Bonds are a type of combination note,
  requiring periodic payments of interest, and a
  final lump-sum payment equal to face value at
  maturity date.

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BONDS, CONT.

• At issue date, the stated (face) rate of interest
  on a bond generally equals the market rate.
  However, bonds are traded on the secondary
  market. Thus the market rate can change from the
  original market rate at time of issue. This
  fluctuation in interest rates will affect the
  selling price (proceeds) of the bond.

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RELATIONSHIP BETWEENRATES AND YIELDS
Yield TO MARKET
Incr.
Decr.
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RELATIONSHIP BETWEENRATES AND YIELDS
Lets assume a 10,000 note, such as a bond that
is traded in the marketplace, is originally
issued at 10 when market rates are 10. What
happens to the market value of this bond when
interest rates rise and fall from 10?
Bond now sells at 8,333, a discount. Face rate
Bond issued at 10,000. Face rate market rate
Bond now sells at 12,500, a premium. Face rate
market rate.
10
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BONDS MARKET RATE FACE RATE
Exhibit 18.5

• The amount of the loan proceeds that Sprint
  receives for the bond depends on the market rate
  of interest at the time the note is issued. Lets
  assume the market rate is 10 when the face rate
  is 8 on the bond.
• The first step is to compute the cash flows
  promised by the bond

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MARKET RATE FACE RATE
Exhibit 18.5

• The second step is to compute the present value
  of the promised future cash flows at the market
  rate of interest

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MARKET RATE FACE RATE
Exhibit 18.5

• The third step is to compute the present value of
  the combined cash flows - this is equal to the
  proceeds that Sprint will receive to earn the
  market rate of 10.
• Since the market rate of interest is greater than
  the face amount of interest on the Sprint bond,
  the bond is issued at a discount, meaning the
  loan proceeds are less than the face of the loan
  obligation

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AMORTIZATION OF THE LOAN DISCOUNT
Exhibit 18.6

• The discount allows the investor to earn the
  market rate of interest of 10 rather than the
  face rate of interest of 8.
• Sprint is required to amortize the discount over
  the life of the loan and treat this discount as
  additional interest expense on the loan.
• Thus, there is a difference between the cash
  amount of interest paid (based on the face rate)
  and the interest expense reported on the income
  statement (which is based on the market rate).

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MARKET RATE Exhibit 18.7

• The amount of the loan proceeds that Sprint
  receives for the bond depends on the market rate
  of interest at the time the note is issued. Lets
  assume the market rate is 6 when the face rate
  is 8 on the bond.
• The first step is to compute the cash flows
  promised by the bond (same as previous example)

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COMBINATION NOTES - MARKET RATE Exhibit 18.7

• The second step is to compute the present value
  of the promised future cash flows at the market
  rate of interest

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MARKET RATE Exhibit 18.7

• The third step is to compute the present value of
  the combined cash flows - this is equal to the
  proceeds that Sprint will receive, and that the
  investor will pay, to earn the market rate of 6.
  This is the bond selling price.
• Since the market rate of interest is greater than
  the face amount of interest on the Sprint note,
  the bond is issued at a premium, meaning the loan
  proceeds are greater than the face of the loan
  obligation

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AMORTIZATION OF THE BOND PREMIUM
Exhibit 18.8

• The premium requires the investor to adjust the
  face rate of interest at 8 to the market rate of
  interest of 6.
• Sprint is required to amortize the premium over
  the life of the loan and treat this premium as a
  reduction in the interest expense on the loan.
• Thus, there is a difference between the cash
  amount of interest paid (based on the face rate)
  and the interest expense reported on the income
  statement (which is based on the market rate).

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BOND PROVISIONS

• Ownership provisions
• Registered bonds
• Bearer bonds

• Repayment provisions
• Callable bonds
• Convertible bonds
• Serial bonds

• Security provisions
• Secured bonds
• Unsecured bonds
• Subordinated bonds

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PAUSE AND REFLECT
When an investor purchased a zero coupon bond,
the company is promising to pay the face value
of the bond at maturity. Thus no cash flows are
needed during the life of the bond. Companies
sometime use zeros when the bonds are funding
investments that have uncertain cash flows.
Many companies issue zero coupon (noninterest
bearing) bonds. What are the cash flows promised
by this bond issue?
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PLANNING FOR EQUITY AND DEBT FINANCING
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PLANNING FOR EQUITY AND DEBT FINANCING
Commence planning process to finance investments
Debt financing? Which instruments optimizes cash
flows while minimizing negative impact on
pro-forma financials?
Debt or equity financing?
Update financing budget