Long-Term Financing

1. Long-Term
Financing
Debt

2. Financial Decisions
Revisited
2

3. Section 1
Sources of Long-Term
Financing
3

4. The Sources of Long-
Term Financing
A range of long-term sources of
finance are available to
businesses including;
a.debt finance;
b.leasing;
c.venture capital;
d.and equity finance;
4

5. Advantages of Debt
Financing
 The lender is not entitled to interfere borrower’s business decisions.
The relationship between two parties is terminated once the debt is
settled;
 Lender can’t claim on business’s future earnings;
 Business may plan for repayments as they are typically fixed and
known;
 Interest payments are tax deductible which smooth the effect of
interest burden;
 Finally ,it’s more convenient from legal and regulative perspective;
5

6. Disadvantages of Debt
Financing
6
 Debt amount must be repaid in some future
time;
 Payments never take account company’s
business cycle or economy’s future conditions as
a result company may confront with insolvency
risk in rough financial periods;
 Interest charge is a cash expense and to
cover it some money must be withdrawn from
business which limits company’s growth
opportunities;
 The company is typically required pledge some
assets as collateral or sometimes lenders seek for owner’s personal
guarantee;

7. Reasons for Seeking Debt
Finance
 Sometimes businesses may need
long-term funds, but may not wish to issue
equity capital;
a. shareholders will be unwilling to
contribute additional capital;
b. company may not wish to involve
outside shareholder;
c. particularly if the company has little or
no existing debt finance it may be easily
available;
7

8. 8
SECTION 2
Long-Term Debt
Instruments

9. Bonds and Their Features
Basic Terminology
 A long-term debt instrument with a final maturity
generally being 10 years or more;
a. par value- amount to be paid the lender at the end of
maturity(it’s usually $1000);
b. coupon rate- a stated rate of interest on a
bond.Calculated by dividing coupon payment by par
value;
c. maturity-bond always have a stated maturity when the
company is obligated to pay bondholder the par value;.
d. current yield-the amount of return an investor will
realize on a bond.Calculated by dividing amount of
interest by market value;
e.
9

10. Trustee and IndentureTrustee and Indenture
 TrusteeTrustee – a person or institution
designated by a bond issuer as the
official representative of the
bondholders. Typically, a bank serves
as trustee;
 IndentureIndenture – the legal agreement,
also called the deed of trustdeed of trust, between
the corporation issuing bonds and the
bondholders, establishing the terms of
the bond issue and naming the
trustee.
10

11. The Risks of Bond
Interest Rate Risk
 Market price of bonds moves inversely to
prevailing interest rates in market;
 When market interest rates rise bond’s
value will decrease;
 When market interest rates decrease then
an increase in bond’s price will be inevitable;
 This situation is relevant only for
bondholders who are going to keep
instrument until maturity;
11

12. The Risks of Bond
Interest Rate Risk
 As a result of fluctuations in market rates value or
market price of bond may change;
 If there is an increase in market rates bond’s value tend
to decrease and will be sold at discount(less than par
value);
 On the contrary when market interest rates pursues
downward trend then increase in bond price will be
expected.This will cause the bond to be traded higher
than it’s par value;
12

13. Example
Interest Rates and Bond Price
You purchased a $10 000 bond at par with a coupon yield
of 4%.It means that your $400 per year is guaranteed if you
keep the bond until the maturity.
Now let’s suppose that you’re intending to sell the bond.
Two scenarios are possible;
a)market rate will rise to 5%;
b)market rate decrease to 3 %;
13

14. Example
Interest Rates and Bond Price
a)If market interest rate rises to 5% your bond offering 4%
will seem unattractive to investors(%5 compared to %4).To
compensate for this you have to decrease the price of bond
to an extent until it promises the same yield with the new
bonds .
Hence,
to offer %5 yield for bond with 4% coupon rate and par
value of $1000 you have to sell bond at a price of $8000.
Bond PriceX5%=$400
Bond Price= $8000
14

15. Example
Interest Rates and Bond Price
b)If market rates fall below coupon rate then on the
contrary your product will be a good option for investors(4%
compared to 3%) and you will be able to increase the price
of bond again up to an extent that 3% yield is preserved.
Hence,
to offer %3 yield for bond with 4% coupon rate and par
value of $1000 you have to sell bond at a price of $13 300
15
Bond PriceX3%= $400
Bond Price= $13 300

16. The Risks of Bond
 Reinvestment Risk- danger that bond investors face is
reinvestment risk, which is the risk of having to reinvest
proceeds at a lower rate than the funds were previously
earning;
 Call option*****
 Default Risk-possibility of default must be considered;
 Inflation Risk-purchasing power will decrease so the real
return rate:
 Liquidity Risk-repayments are never fully guaranteed;
16

17. Embedded Bond Options
 Call option-when interest
rates fall until the last day
that bond issued then the
company will be better of if
it calls the existing
one back and reissue bond
with new prices;
 Put option-holder entitled to force
the issuer to buyback the security.
Typically the reason is improved
interest rates;
17

18. Types of Bonds
 Zero-coupon bond is bond that makes no periodic interest
payments and are sold at a deep discount from face value;
 Floating-rate notes have a variable coupon,equal to a money
market reference rate, like LIBOR or federal funds rate, plus a
quoted spread.;
• Junk bond-Companies that issue junk bonds typically have less-
than-stellar credit ratings, and investors demand these higher yields
as compensation for the risk of investing in them;
18

19. Types of Bonds(cont.)
 Convertible bonds include provision
of obtaining debt issuing company’s
stock in future. Typically lower interest
rates are inherent to convertible bonds;
• Eurobond-is a bond issued in a
currency other than the currency of the
country or market in which it is issued;
19

20. DebenturesDebentures
 Investors look to the earning power of the firm as their
primary security;
 Investors receive some protection by the restrictions
imposed in the bond indenture, particularly any
negative-pledge clausenegative-pledge clause;
 A negative-pledge clausenegative-pledge clause precludes the corporation
from pledging any of its assets (not already pledged) to
other creditors;
DebentureDebenture – A long-term, unsecured
debt instrument.
20

21. DebenturesDebentures
 In this case, subordinated debenture holders rank
behind debenture holders but ahead of preferred and
common stockholders in the event of liquidation;
 Frequently, the security is convertible into common
stock to lower the yield required by subordinated
debenture holders (often less than regular
debentures);
Subordinated DebentureSubordinated Debenture – A long-term,
unsecured debt instrument with a lower claim on
assets and income than other classes of debt;
known as junior debt.
21

22. Retirement of BondsRetirement of Bonds
• The corporation makes a cash payment to the trustee,
which calls the bond;
• The corporation purchases bonds in the open market
and delivers them to the trustee;
Sinking FundSinking Fund – Fund established to periodically
retire a portion of a security issue before maturity.
The corporation is required to make periodic
sinking-fund payments to a trustee.
Two forms for the sinking-fundTwo forms for the sinking-fund
retirement of a bondretirement of a bond::
22

23. Sinking Fund and theSinking Fund and the
Retirement of BondsRetirement of Bonds
 When bonds are called for redemption, the
bondholders will receive the sinking-fund call pricesinking-fund call price;
 The bonds are called on a lottery basis (by their
serial numbers) and published in periodicals like
The Wall Street JournalWall Street Journal;
 Bonds should be purchased in the open market if
the market price is less than the sinking-fund callsinking-fund call
priceprice;
23

24. Sinking Fund and theSinking Fund and the
Retirement of BondsRetirement of Bonds
 Volatility in interest rates or a decline in the
credit quality of the firm could lower the market
price of the bond and enhance the value to the
firm of having this option;
 Bondholders may benefit from the orderly
retirement of debt (amortization effect), which
reduces the default risk of the firm and adds
liquidity to bonds outstanding;
24

25. Sinking Fund and theSinking Fund and the
Retirement of BondsRetirement of Bonds
 Many bond issues are designed to have a larger final
payment to pay off the debt.
 For example, a corporation may undertake a $10
million, 15-year bond issue. The firm is obligated to
make $500,000 sinking-fund payments in the 5th
through 14th
years. The final balloon payment in the
15th
year would be for the remaining $5 million of
bonds.
Balloon PaymentBalloon Payment – A payment on debt that is
much larger than other payments.
25

26. Thank You