bbpw3203 financial management ii · pdf filetopic 2 intermediate term financing and long-term...

Topic 2

Intermediate Term Financing

and Long-term Financing

30 September 2017

BBPW3203 FINANCIAL MANAGEMENT II

Content

1.1 Intermediate-term financing

2.2 Sources of intermediate-term financing

2.3 Cost of interest

2.4 Equipment financing

2.5 Sources of equipment financing

2.6 Medium term notes (MTN)

2.7 Long-term debt financing

2.8 Mortgage loan

2.9 Leasing

2.10 Corporate bonds

By the end of this topic, you should be able to:

1. Describe how long-term capital investments are financed;

2. Differentiate between intermediate and long-term financing;

3. Recognise the sources of intermediate and long-term financing;

4. Differentiate between term loans and medium term notes;

5. Assess the four types of corporate bond; and

6. Compute the price of bond.

Learning Objectives

• Most companies use both short-term and intermediate-term financing as a principle means through which assets are funded.

• Importantly, intermediate term financing is self-liquidating and is thus similar to short-term financing.

• However, unlike short-term financing, intermediate-term financing can fulfil the requirements for permanent funding.

• Furthermore, it can serve as an interim substitute for long-term financing.

2.1 INTERMEDIATE-TERM FINANCING

• If a firm wishes to raise much needed funds by issuing long-term debt or common stock, the firm should meet the various conditions set by the security exchange commissions and other governing bodies.

• While at the time of issue, market conditions might not be favourable to the issuer. In such circumstances, a firm may resort to intermediate-term financing as an interim substitute until long-term debt or equity can be issued.

• Hence, intermediate-term financing might provide some sort of flexibility in the timing of long-term financing. The most important use of intermediate-term financing is to provide credit when the expected cash flow of the firms are such that debt can be retired steadily over a period of several years.

2.1 INTERMEDIATE-TERM FINANCING

There are a number of alternatives that can be used by firms to

finance their capital requirements. These are shown in Figure 2.1.

2.2 SOURCES OF INTERMEDIATE-TERM

FINANCING

2.2.1 Term Loans

2.2.1 Term Loans

• A bank or insurance company term loan is a business loan with a final maturity of more than one year, repayable according to a specified schedule.

• Banks tend to give out term loans in the 3-5 maturity period, whereas insurance companies are willing to make longer-term loans.

• Term loans are repayable in periodic terms: quarterly, semi-annually and even yearly.

• The payment schedule of a loan is normally designed to meet the borrower’s cash-flow ability to service the debt.

• Typically, this schedule calls for equal periodic instalments, but it may specify irregular amounts or repayment in lump sum at final maturity.

• Sometimes, the loan is amortised in equal period instalments except for the final payment in the form of a balloon payment.

• term loans can be arranged based on a fixed agreed rate or a floating rate over the life of the loan.

• Floating rates are frequently adjusted in keeping with the changes in the prime rate, better known in Malaysia as the Base Lending Rate (BLR).

2.2 SOURCES OF INTERMEDIATE-TERM FINANCING

2.2.2 Use of Term Loans

• Term loans are well suited for financing small additions to plant facilities and equipment, particularly when buying new machinery.

• This can be used to increase working capital when the cost of a public offering of bonds and stocks is high.

• Firms tend to take term loans only until earnings are sufficient to amortise the loan.


2.2.3 Advantages

Advantages of using term loans:

(a) Term loans provide the borrowers with a certain degree of security rather

than having to be concerned whether a short-term loan will be renewed or not.

(b) The borrower can take a term loan in such a way that the economic life of

the asset being financed generates enough cash flow surplus to service the loan without putting any additional financial burden on the borrower.

(c) It also offers potential cost advantages over longer-term sources of

financing. Term loans are privately negotiated between borrowers and

lenders, proving less costly compared with a public offering of bond and

stocks.


2.2.4 Methods of Repayment

• Money borrowed for intermediate-term financing is repaid in a series of annual, semi-annual, quarterly, or even monthly payments.

• There are a few repayment methods that can apply to term loans:

(a) Firms are required to pay off the loan in instalments rather than in a lump sum. Hence, amortisation of the loan might require making equal quarterly, semi-annual, and annual payments.

(b) The borrower might require making equal reductions in the principal outstanding each period. The interest is computed on the remaining unpaid balance for each period.

(c) The borrower might be required to make equal periodic payments over the life of the loan. The loan is partially amortised, leaving a lump sum payment that falls due on the termination day of the loan period. This is better known as a balloon loan.

(d) The borrower might be required to make a single principal payment at maturity while making periodic interest payments only over the life of the loan. This is better known as a bullet loan.


• Interest rate charges on term loans depend on various factors namely, general economic conditions, size of the term loan, maturity of the loan and the credit rating of the borrower.

• Generally, interest rates on intermediate-term loans tend to be slightly higher than interest rates on short-term loans because the supplier is taking a higher risk extending the longer-term loan.

2.3 COST OF INTEREST

• Equipment represents another asset that may be used as collateral to secure a loan. If a firm either owns marketable equipment or is purchasing such equipment, it can usually obtain some sort of secured loan.

• Maturity of such a loan is usually more than one year. Hence, we classify these loans as intermediate-term financing.

• As for other types of assets, the lenders evaluate the marketability of the collateral and decide a market value, depending on the quality of the equipment.

• In most cases, the repayment schedule of the loan is set in keeping with the economic life of the equipment.

• In setting repayment schedules, the lenders try to ensure that the market value of the equipment exceeds the amount of the loan.

• If the market value of the equipment exceeds the outstanding balance of the loan, the excess market value serves as a safety margin for such loan.

2.4 EQUIPMENT FINANCING

• There are a number of sources of equipment financing. These are commercial banks, finance companies and the equipment vendors themselves.

• The vendor or seller of the equipment may finance the purchase either by holding secured notes or by selling notes to its captive finance subsidiary.

• The interest charge depends on the extent to which the sellers use financing as a sales tool.

(a) Chattel Mortgage

The chattel mortgage is a mortgage on specific assets other than land and buildings. A lien charge against the title is registered with the Province. The borrower signs a security agreement that gives the lenders a lien on equipment specified in the agreement. If the borrower fails to pay interest or principal, the lenders can sell the equipment.

(b) Pledge

The pledge is an agreement similar to the chattel mortgage, except that possession is transferred to the lender but title remains with the borrower.

Example: stocks and bonds held by the bank.

2.5 SOURCES OF EQUIPMENT FINANCING

• Unlike firms that arrange term loans with financial institutions, medium term notes are sold to investors through an investment bank. For some companies, MTN(s) are a major source of funding.

• One of the important features of MTN(s) is that the instrument may be offered continuously.

• These instruments are mostly unsecured; where issuers are usually large and reputable as evidenced by their credit worthiness.

• MTN(s) have a maturity ranging from nine months to 10 years. Medium Terms Notes are registered with the Security Exchange Commission (SEC) under security exchange rules.

• The major advantage of MTN(s) to corporate borrowers is flexibility. This type of financing is somehow similar to bonds.

2.6 MEDIUM TERM NOTES (MTN)

• Long-term debt financing is the most popular form of external financing.

• A firm must first choose between a private or a public debt offering.

• Private debt includes loans, private debt agreements between corporate borrowers and financial institutions and private placements, and unregistered security offerings sold to accredited investors. Debt covenants are designed to protect bondholders.

• Highly protected bonds should have a lower coupon interest rate since the covenants make them less risky to the investor. On the other hand, it is possible that covenants could limit the company’s operations. For example, a firm may not be allowed to undertake a risky project that may jeopardise the security of the debt holders.

2.7 LONG-TERM DEBT FINANCING

2.7.1 Long-term Loan

• Long-term loans are debt instruments which are arranged when the scheduled repayment of the loan and the estimated useful life of the assets purchased (e.g. building, land, machinery, computers, equipment, shelving, etc.) is expected to exceed one year.

• Long-term loans are normally secured, first, by the new asset (s) purchased and then by other unencumbered physical assets of the business.

• On the balance sheet, the equipment purchased shows up in the section on long-term assets, while the counterpart loan information is shown in the current and long term liabilities portion. The useful life of the assets is directly reflected in their depreciation schedules.

• Debt lenders (creditors) make loans to businesses that exhibit strong management ability and steady growth potential. A written business plan, including a cash flow demonstrating the business’s ability to repay the loan principal and interest over the term of the repayment schedule, is mandatory.


2.7.1 Long-term Loan

• The lender will expect the borrower to have the appropriate insurance to protect the assets.

• Generally, long-term loans carry higher interest rates than short-term loans because the lender assumes a higher risk due to the exposure to longer periods of uncertainty that may lead to a default of repayments.

• The providers of basic long-term loans include banks, trust companies, insurance companies, pension funds and various loan specialists.


2.7.2 Evaluation of Creditors• Long-term loan evaluation tends to be more rigorous and sophisticated than a

mortgage loan evaluation.

• The lender evaluates the ability of the management team, the collateral available to support the loan and the commercial viability of the situation, as indicated in the projected financial submissions.

• This evaluation will normally require a detailed business which provides extensive information on the management of the company or project;

a detailed history of the business,

its products,

its production methods,

its operations,

its position in the marketplace;

the purpose for which the loan is intended, any

security available to be pledged; and

extensive financial information and projections.


• Mortgages can also be used to buy office buildings, apartment buildings, and others.

• A mortgage loan has collateral, an asset that backs the loan.

• If the borrower fails to make required payments on the mortgage, the lender can take ownership of the property.

• Mortgage loans have a maturity of 15 to 30 years, and are thus considered as long-term finance.

• In a mortgage loan, the collateral reduces mortgage risk.

• Therefore, this type of loan usually carries a lower interest rate compared with an equivalent risk loan with no collateral.

• The interest charged on mortgage loans is based on either a fixed rate or a floating rate depending on terms and conditions offered by the lender.

2.8 MORTGAGE LOAN

• Leases can be operating or capital leases.

• While they share several characteristics, in operating leases the leasing firm, lessor, and the lessee agree to make periodic payments to the lessor to obtain an asset’s services.

• Financial or capital leases are non-cancellable and obligate the lessee to make lease payments, even if the asset is no longer needed.

• Capital leases are basically a form of long-term debt financing. Most lenders look at the firm’s debt plus capital lease obligations in evaluating whether or not a firm can take on more debt.

• Note that the lease versus buy decision is simply another decision that can be made by using a discounted cash flow analysis. The least costly choice is the one that the firm should accept.

2.9 LEASING

• Bonds are long-term debt contracts in which the issuer promises to repay the lender the original principal (the face value or par value) plus interest at periodic intervals.

• It is a promissory agreement between the borrower (issuer) and the lender (buyer) to trade current cash flow with expected future cash flow.

• The borrower promises to pay future cash flow in the form of coupon interest payments and principal payments for current cash flow (bond price).

• The value of the bond at the current period is the present value of expected future cash flow (coupon interest payment and principal payment).

2.10 CORPORATE BONDS

2.10.1 Bond Characteristics

(a) Intrinsic Features

• The coupon, maturity, principal value and type of ownership are important intrinsic features of a bond. These are fundamental to the bond valuation.

(i) The coupon of a bond indicates the income that the bond investor will receive over the life (holding period) of the issue. This is also known as the interest income.

(ii) Term to maturity: specifies the date or the number of years before a bond matures or expires.

(iii) Principal or par value of an issue represents the original value of the obligation.


2.10.1 Bond Characteristics

(b) Types of Issuer

There are three issuers of bonds:

(i) The Federal Government and its agencies;

(ii) Municipal governments; and

(iii) Corporations.


2.10.2 Types of Bonds

• Though there are various types of bonds available in the market, bonds can be categorised into coupon bearing debentures, zero coupon bonds, junk bonds, callable bonds and putable bonds.

• Note that many new securities are introduced to fulfil a particular need - to complete the capital markets.

• For example, zero coupon bonds were introduced to fulfil the needs of investors who were willing to pay a smaller amount now (the discounted value of the bond) in order to receive a larger sum in the future.

• This kind of payoff pattern is ideal for those saving for a child’s college education or for retirement.



(a) Coupon Bearing Bonds provide a regular coupon interest payment semiannually, annually and on a quarterly basis.

The amount of coupon payments is negotiated between issuers and buyers of the contract. Terms and conditions are specifically highlighted in the bond contract.

(b) Zero Coupon Bonds provide the issuer no legal obligation to pay periodic coupon interest payments before the bond matures.

Rather, the bonds are sold at discount prices (price lower than their par value).



(c) Junk Bonds are considered most risky and are issued by corporations.

Since the required rate of return for such bonds is higher, bonds are sold at a very discounted price.

(d) Callable and Putable Bonds The call provision gives the issuing corporation the right to call off the bond earlier than maturity.

The call provision generally states that the company must pay bondholders an amount greater than par value if they are called.

The additional sum is called the premium.

The put provision also allows the holders of the bond to sell off the bond to the issuer earlier than maturity at a specified price stated in the debt contract.


bbpw3203 financial management ii · pdf filetopic 2 intermediate term financing and long-term...

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