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Chapter SixLecture Notes

Long-Term Financing

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Long-Term Financing

Used to pay for capital assets when capital costs exceed the cash available from operations or it would not be prudent to useoperating cash flow for capital purposes.

Equity - additions to the permanent capital of an organization. Capital Campaigns - fundraising drives aimed at raising

money to pay for long-lived assets.

Long-Term Debt - borrowed money with a maturity of more than one year. Short-term debt refers to borrowed money that must be repaid within one year.

Leases - contracts to make fixed payments in return for the right to use a capital asset.

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Types of Long-Term Debt

Long-Term Notes - unsecured loans. Can be secured or unsecured (i.e. “collateralized”)

Mortgages - loans that are backed by a security interest in land and/or buildings that are owned by the borrower.

Bonds - standardized loan agreements between borrowers and lenders. Big amounts.

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Calculating MortgagePayments

Mortgages call for equal periodic payments which repay the amount borrowed and pay interest to the lender.

At the beginning payments are mostly interest and near the end they are mostly principal. Mortgage payments are annuities.

Assume a 30-year, $500,000, 12% per year mortgage with monthly payments:

0 1 359 360 1% ...

$500,000 PMT PMT PMT

N = 360, i = 1%, PV = $500,000, PMT = ?Mortgage PMT = $5,143.06 per month

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Bond Characteristics

Bond agreements specify:- the amount to be repaid, called the par, principal, stated, face,

or maturity value of the bond;

- the maturity date when the money must be repaid;

- the rate of interest, called a coupon rate or stated rate, to - be paid on the face value of the bond; and,

- the time intervals at which the interest must be paid, usuallyevery six months (semi-annual).

These factors are fixed for the life of the bond.

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Typical Bond Cash Flows

Bonds are an example of mixed cash flows. Here is the time line for a ten-year, $1,000,000 face value bond that bears an interest rate of 10%

per annum and pays interest every six months.

0 1 19 20

5%

0 $50,000 $50,000 $50,000 $1,000,000

Principal

Annuity Single Payment

...

...

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Valuing a Bond

Normally, bonds can be sold by their owners. But, interestrates fluctuate on a daily basis.

Since the cash flows from bonds are fixed, bond prices vary with changes in interest rates.

Bonds are worth the PV of the stream of cash flows paid by borrower discounted at the prevailing market rate of interest.

Example: Suppose that we own a $1,000,000, 10%, 10-year semi-annual bond and want to sell it in a market where interest rates have risen to 12%. What will the bond be worth?

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The Cash Flows Are Fixed!

0 1 ... 19 20

6%

0 $50,000 ... $50,000 $50,000 $1,000,000

Principal

The cash flows are unchanged! To value the bond we only change the interest rate used in the PV calculations to reflect the prevailing market rate!

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The Calculations

First, calculate the PV of the $50,000 annuity using the 12% market interest rate.

N = 20, i = 6%, PMT = $50,000, PV = ?PV = $573,496

Second, calculate the PV of the $1,000,000 repayment of principal.N = 20, i = 6%, FV = $1,000,000, PV = ?PV = $311,805

Then, add the two PVs to get the value of the bond.Value of Bond = $573,496 + $311,805 = $885,301

Note: Excel and some calculators can do this as one calculation. Enter N, i, FV, and PMT. Solve for PV.=PV(rate, nper, pmt, fv, type) =PV(6%,20,-50000,-1000000)

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Term Versus Serial Bonds

Term bonds are all paid at one maturity date. However, amounts can be paid into a Sinking Fund at various times to accumulate money to repay principal at maturity.

Serial Bonds have a number of different maturity dates. This allows some of the principal to be paid back each year over a range of years, rather than all at once.

Call provisions allow bonds to be “called in” or repaid before the maturity date.

Call provisions generally increase the interest rate on the bond when first issued, since it creates an advantage for the borrower.

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Calculating Interest Ratesfor Serial Bonds – NIC Method

$10,000 serial bond, principal payments of $1,000 at the end of Years 1 and 2, $2,000 at the end of year 3, and $3,000 at the end of years 4 and 5. Interest rates are 3, 4, 5, 6 and 7% on the respective maturities, and the bond issue is initially sold at a $100 discount.

Par or Principal Coupon Rate Years Interest $1,000 x 3% x 1 = $ 30 1,000 x 4% x 2 = 80 2,000 x 5% x 3 = 300 3,000 x 6% x 4 = 720 3,000 x 7% x 5 = 1,050

Interest Payments $2,180Plus Discount 100Total Interest $2,280

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Calculating the NIC Interest Ratefor Serial Bonds, continued

Calculate Bond Dollar Years$10,000 x 1 = $10,000 9,000 x 1 = 9,000 8,000 x 1 = 8,000 6,000 x 1 = 6,000 3,000 x 1 = 3,000Bond Year Dollars $36,000

Then the NIC is calculated as:

Total Interest (-premium+discount) $2,280 NIC = ---------------------------------------------- = ---------- =

6.333% Bond Dollar Years $36,000

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Calculating the TIC Interest Ratefor Serial Bonds

Par or Coupon ________Interest Paid at the End of___ _____ Principal Rate Year 1 Year 2 Year 3 Year 4 Year 5 Total $1,000 x 3% = $ 30 $ 30 1,000 x 4% = 40 40 80 2,000 x 5% = 100 100 100 300 3,000 x 6% = 180 180 180 180 720 3,000 x 7% = 210 210 210 210 210 1,050Interest Payment $560 $530 $490 $390 $210 $2,180Principal Payment 1,000 1,000 2,000 3,000 3,000 10,000Total Payment $1,560 $1,530 $2,490 $3,390 $3,210 $12,180

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Calculating the TIC Interest Ratefor Serial Bonds, continued

Therefore, the TIC is the interest rate that makes:

$9,900 = (PV of $1,560, N=1) + (PV of $1,530, N=2) + (PV of $2,490, N=3) + (PV of $3,390, N=4)

+ (PV of $3,210, N=5)

Using a spreadsheet program such as Excel®, this can be solved using the IRR function. In Excel®, the solution formula would be:

= IRR(values, guess)= 6.347%

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Leases

Types of leasesOperating Leases: All short-term or cancelable leasesCapital Leases: Some long-term and non-cancelable leases

Possible advantages of Leasing flexibility and protection against obsolescenceBypass legal governmental debt requirements

equipment cost, and tax-related savings

Possible disadvantages of leasing tendency toward higher costs

Capital lease obligations are valued at the PV of the remaining future lease payments