peirson business finance10e powerpoint 10

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides prepared by Farida Akhtar and Barry Oliver, Australian National University

Chapter 10

Sources of Finance: Debt

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Learning Objectives• Identify the main forms of borrowing by Australian

companies.

• Explain the general characteristics of debt.

• Understand the main forms of bank lending and appreciate when each may be suitable to a borrower’s needs.

• Understand debtor finance, inventory loans and bridging finance, and be able to distinguish them.

• Explain the features of the main types of long-term loans and short-term debt securities.

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Learning Objectives (cont.) • Understand the process of using commercial

paper and bills of exchange to raise funds.

• Calculate prices and yields for promissory notes and bills of exchange.

• Explain the features of the main types of long-term debt securities.

• Identify and explain the main features of project finance.

• Understand the role of interest rate swaps in managing debt.

• Identify and explain the features of securities that have the characteristics of both debt and equity.

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Introduction• Long-term debt — maturity greater than 12 months.

Long-term debt typically comprises more than half of the total debt of listed Australian companies.

• Two broad types of long-term debt:– Loans from banks and other financial intermediaries.

– Funds raised by issuing marketable debt securities such as corporate bonds.

• Short-term debt — due for repayment within 12 months.

• Australian companies’ major short-term borrowing choices are:– Borrowing from banks and other financial institutions.

– Issuing marketable (short-term) debt securities — commercial paper and bills of exchange.

– Investment banks and credit unions.

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General Characteristics of Long-Term Debt (cont.)• Debt — contract where borrower promises to pay future

cash flows to lender. Contract specifies the size and timing of interest payments and how they are calculated. May specify whether there are assets pledged as security.

• Secured: Lender has claims against the borrower and against assets of the borrower.

• Unsecured: Lender has a claim against the borrower, but no claim to any particular property owned by the borrower.

• Marketable: Securities such as notes, bonds or debentures that are issued directly to investors and can then be traded in a secondary market.

• Non-marketable: Loans arranged privately between two parties.

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General Characteristics of Long-Term Debt (cont.)• Interest cost of debt

– Fixed versus variable — if variable, typically some benchmark rate (cash rate) plus a premium dependant on risk of borrower.

– Higher for subordinated debt — lowest ranking debt in event of company being wound up.

• Effect of debt on risk– Financial risk — risk attributable to the use of debt as

a source of finance.

– Financial risk effects: leverage effect.

financial distress effect.

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General Characteristics of Long-Term Debt (cont.)• Effect of debt on control:

– Lenders have no voting rights except when company’s operations. However, if the company breaches the loan agreement, lenders have potential control.

– To protect their assets, creditors can take control of loan security, move for receivership or liquidation.

• Security for debt:– Legal ownership — a bank or other financier can purchase

asset and lend it to a business. Example — leasing.

– Fixed charge — lender has a charge over specific asset or group of assets.

– Floating charge — lender has a charge over a class of assets such as inventory.

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General Characteristics of Long-Term Debt (cont.)• Security for debt (cont.):

– Restrictive covenants — rather than requiring security or a charge, place some financial or accounting restriction on the borrower to ensure ability to service debt.

– Negative pledge — borrower undertakes not to pledge existing or future assets of the company to anyone else without the consent of the lender.

– Limited recourse — Limited recourse debt is commonly used for project finance.

– Guarantee — promise from a third party to cover debt obligation in event of default.

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Short-Term (ST) Borrowing from Banks and Other Financial Institutions (cont.)• Bank overdraft:

– An overdraft permits a company to run its current (cheque) account into deficit up to an agreed limit.

– The cost of a bank overdraft includes the interest cost and fees.

– The interest rate charged is usually at a margin above an indicator rate, published regularly by the bank, and only on the amount by which the account is overdrawn.

• Debtor financing:– Debtor finance allows a company to raise funds by selling

its accounts receivable on a continuing basis to a financier (called a discounter), who is then responsible for managing the sales ledger and collecting the debts.

– The discounter earns a return by discounting the value of the receivable and charging a fee.

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Short-Term Borrowing from Banks and Other Financial Institutions (cont.)• Debtor finance with recourse vs without recourse

– An agreement where the discounter is reimbursed by the selling company if debtor defaults in the case of with recourse. However, it is not the same in the case of without recourse.

• Invoice discounting

– Where the debtors of the company seeking finance are unaware of the existence of the discounting agreement.

• Inventory loans (also known as floor-plan or wholesale finance).

– Loan made by a wholesaler to a retailer, which finances an inventory of durable goods, such as motor vehicles.

• Bridging finance

– A short-term loan, usually in the form of a mortgage, to cover a need normally arising from timing differences between two or more transactions.

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Long-Term Borrowing from Banks and Other Financial Institutions (cont.)

• Australian companies obtain long-term debt finance largely by loans, rather than by issuing their own debt securities. Important feature of term loans is that it is for a fixed period.

• Long-term loans choices available to borrowers:

– Typically, a minimum amount is specified by the lender, while the maximum depends on the borrowers’ debt capacity and ability to repay.

– Lender will specify minimum and maximum terms, while the borrower would choose the actual term.

– Interest rates can be fixed or variable — variable rates will be tied to the yield on government bonds.

– Interest rates will also vary, depending on security on the loan and type of asset used as security.

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• Long-term loans choices available to borrowers (cont.)

– Credit financier loan — type of loan that involves regular repayments, including principal and interest.

– Alternative payment arrangements, principal plus interest, interest only and interest only in advance.

– Frequency of repayment can vary from weekly to yearly.

• Variable-rate term loans:

– If borrowing at variable interest rate, there is considerable flexibility for the amount borrowed and repayment pattern.

– Variable-rate loan is flexible in that it can be repaid early without penalty and a redraw facility may be available.

– Possible to convert to fixed rate loan without penalty.

– Capped option: Rate can rise but not above some agreed cap.

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• Fixed-rate term loans:

– Borrower chooses to pay an agreed fixed interest rate for a period of at least 1 year. The maximum varies from 5–10 years.

– Fixed-rate loan loses some of the flexibility of variable-interest-rate loan.

– Progressive draw down is not allowed — you borrow and pay interest on the full amount from day one.

– Repayment patterns are flexible but once determined, cannot be varied during the fixed-rate period.

– May be able to make special repayments or repay in full before end of term, but there is usually an administration fee and an early repayment adjustment.

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• Other features of term loans:

– In addition to interest, there may be loan establishment and periodic loan service fees.

– Bank may not wish to lend the whole amount a single borrower seeks for risk-management reasons.

– This can be overcome through a syndicated loan.

– A number of banks join to provide what is in effect a term loan, with each lender having identical rights.

– A way to spread the credit risk without having several loans and worrying about subordination of debt.

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Long-Term Borrowing from Banks and Other Financial Institutions (cont.)• Why do businesses use term loans?

– Loans from financial intermediaries are preferred where borrowing is small, with direct finance being more competitive as the size of the loan increases.

– Low transaction costs of term loans — better for small amounts.

– Issue of marketable securities has strict disclosure requirements, while a term loan does not require such public disclosure.

– Term-loan repayments are much more flexible, with banks willing to renegotiate repayment patterns.

– Debt securities may need to be rated by a rating agency — not feasible for small borrowers (costs: financial and public disclosure).

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Debt Securities — Marketable Debt Short-Term • Debt security: general principles

– Companies can obtain short-term debt funding by issuing securities such as commercial paper and bills of exchange.

– The securities are a promise to pay a sum of money on a future date.

– These are generally discount securities exchanged in secondary market.

• Commercial paper (also known as promissory note)– A promise to pay a stated sum of money on a future date.– Face value: Promise to pay sum in the future on the debt.– Discounter: Purchaser of a short-term debt security such as a

promissory note or a bill of exchange.– A promissory note can be underwritten — banks and other

financial institutions are usually involved.– Facilitate trading — usual to have credit rating from a ratings

agency.

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Commercial Paper — Marketable Debt Short-Term (cont.) • To calculate the price P of a promissory note, use the

following formula:

• Example 10.3: 90-day promissory note, $500k face value, and a yield of 4.926% p.a. What is the price?

( )( )3651 dr

FP

+=

maturity todays ofnumber

basisinterest simple aon p.a. yield

payable) sum (future valueface

:where

===

drF

( )( )73.999493$

3659004926.01

000500$

=

+=

P

P

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Debt Securities — Marketable Debt Short-Term (cont.) • A marketable short-term debt security in which

one party (the drawer) directs another party (the acceptor) to pay a stated sum on a stated future date.

Drawer has bill accepted by Acceptor

Then the drawer has

the bill discounted by Discounter

The discounter lends the drawer an amount of money in exchange for the bill

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Bills of Exchange — Short-Term Marketable Debt (cont.) • A company will struggle to issue/sell a promissory note if it does

not have a credit rating from a ratings agency. This is one of the reasons that bills of exchange have been developed.

• In addition to the issuer of the bill, there is an acceptor who promises to redeem the bill in the event that the issuer defaults.

• The face value is paid to whoever holds the bill on the maturity date.

• The discounter has the choice of either holding the bill until maturity, when payment will be received from the acceptor, or selling (rediscounting) the bill.

• However, if the bill is sold, the seller normally endorses the bill at the time of sale, creating a chain of protection for the bill holder.

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Bills of Exchange — Short-Term Marketable Debt (cont.) • Endorsement:

– Acceptance by the seller of a bill in the secondary market, of responsibility to pay the face value if there is default by the acceptor, drawer and earlier endorsers.

• Normal process of repayment:

Current approaches the approaches the

Holder acceptor for repayment Acceptor drawer for Drawerrecompense

Initia lly the acceptor pays The drawer reimburses the

the holder the face value acceptor for this paymentof the bill to the holder

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Bills of Exchange — Short-Term Marketable Debt (cont.) • Bank accepted bill: Bills of exchange that have been

accepted or endorsed by a bank. The bill of exchange will not be either accepted or endorsed if it’s a non-bank bill.

• Bill discount facility: Agreement in which one entity (normally a bank) undertakes to discount (buy) bills of exchange drawn by another entity (the borrower).

• Bill acceptance facility: Agreement in which one entity (normally a bank) undertakes to accept bills of exchange drawn by another entity (the borrower).

• Fully drawn bill facility: Bill facility in which the borrower must issue bills so that the full agreed amount is borrowed for the period of the facility.

• Revolving credit bill facility: Bill facility in which the borrower can issue bills as required, up to the agreed limit.

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Debentures — Long-Term Marketable Debt • Debentures:

– Fixed charge/floating charge.

– Coupon rate is a function of general interest rates at time of issue and riskiness of issuer.

– Need for a trust deed.

• In the Australian market:

– Usually secured, long-term, fixed-interest securities that are issued for fixed periods but can be sold by the investor if required.

– Can be issued by finance companies or by non-financial companies.

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Debentures — Long-Term Marketable Debt (cont.) • Finance company debentures issued continuously

under a prospectus that is valid for up to 12 months.

– Interest rates can be varied (over the 12-month period); though once issued, the rate is fixed until maturity.

– Intended to provide secure income stream and not typically listed on ASX.

• Company issuing debentures draws up a trust deed and appoints a trustee — specifies nature of security and where the debt ranks in terms of claims against company assets.

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Unsecured Notes — Long-Term Marketable Debt (cont.)

– Same as debentures — unsecured creditors that rank below secured creditors for repayment of debt.

– Riskier than debentures.

– Higher interest rate than debentures.

– Unsecured but may be secured by a charge over intangible assets — Corporations Act 2001 does not allow use of term secured in such cases.

– May use term bond to describe such securities if they are secured by intangibles and cannot be called debenture.

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Corporate Bond — Long-Term Marketable Debt (cont.) • May use the term ‘bond’ as an alternative to ‘unsecured note’.

• Corporate bond — generally long-term, fixed-interest debt securities with coupon payments every 6 months, issued by non-government entities.

• Australian market has grown rapidly since 1995, $20b on issue, the market reached $131b in 2004 and $242 in 2007. Offshore bonds market grown rapidly — due to high interest rate in Australia relative to US, UK or Japan.

• Foreign bonds — Australian borrower issues bond in a foreign country denominated in the currency of that country.

• Eurobonds — medium- to long-term securities sold in countries other than the country of the currency in which the bond is denominated.

• Corporate bonds will typically require some sort of credit rating to enhance their marketability and liquidity.

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Corporate Bond — Long-Term Marketable Debt (cont.)• Main differences between corporate bonds and

debentures are that corporate bonds:– Have much larger amounts minimum investment.

– Have less restrictive trust deeds.

– Are placed privately with institutional investors.

– Do not need a prospectus if placed with institutional investors.

• There is indication of issuing bonds offshore rather than domestically due to two reasons:– There is greater capacity to absorb securities of lower

credit quality.

– Difference in term to maturity, amounts borrowed, and currency denomination.

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Project Finance• Technique used to raise funds for major mining and natural

resource projects, infrastructure projects, tourist resorts, and other property developments.

• Can also be used to fund acquisition of large industrial assets.

• Lenders rely on CFs of a single project as source of debt repayment.

• Financial risk is limited for originators of project who provide equity finance.

• Main (common) features of project finance:

– Project established as a special-purpose legal entity whose sole business activity is the project.

– Usually organised for a new project rather than established business.

– High proportion of debt finance — 70–90%, with remainder coming from project sponsors who own project.

– Lender’s decision based on expected cash flows of assets.

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Project Finance (cont.)– Limited recourse debt.

– Main security is intangible.

– Project finance loans are for longer terms than normal loans.

• When is project finance attractive?– Lenders need to evaluate the terms of any project contracts

that may affect construction and operating costs.

– Also interested in potential to shift risks onto third parties — off-take agreements, pricing power, guaranteed price rises, etc.

– Project assessment is slow, complex and costly so lenders charge a larger margin than on other corporate debt.

– Project finance is viable where operating cash flows are predictable, so low risk of project allows high gearing to be employed.

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Interest Rate Swaps• Agreement between two or more parties to exchange a set of

interest payments over a specified period of time.

• No exchange of principal is involved — only interest payments are exchanged (that relate to a notional principal amount).

• The counterparty is offering a swap of variable interest payments for fixed interest payments.

• The swapping counterparty is taking on risk and hoping that the variable rate will fall. That way, the payments they receive will exceed the payments they have to make.

• The company doesn’t want to be exposed to the risk of variable rate rises.

• Attractive feature: Allows many companies to borrow, at a fixed interest rate, funds which otherwise would not be available and/or would only be available at a higher interest rate.

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Example: Interest Rate Swaps• Example 10.4:

Counterparties A and B enter into a swap agreement. Notional principal of $10m with cash flows quarterly in arrears.

Counterparty A agrees to pay counterparty B floating rate payments based on the bank bill rate. Counterparty B agrees to pay counterparty A fixed rate payments at 9% p.a. What are the cash flows made in the swap?

• Solution: Agreement entered on 1 April 2006 when the bank bill rate was 7.6%. Subsequently, it was:

– 8.70% — 1 July 2006

– 9.35% — 1 October 2006

– 9.25% — 1 January 2007

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Example: Interest Rate Swaps (cont.)• Counterparty B wants the fixed rate. However,

Counterparty A offers the fixed rate and takes on the variable rate.

Payment on 1 July (for April quarter):

• A pays B:

• B pays A:

• Net payment from B to A of $34 904.11.

( ) ( ) 67.287219$ m10$ 36591 076.0 =××

( ) ( ) 56.383 224$ m10$ 36591 09.0 =××

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Example: Interest Rate Swaps (cont.)Payment on 1 October (for July quarter).• A pays B:

• B pays A:

• Net payment from B to A of $7561.65.

Payment on 1 January (for October quarter).• Bank bill rate was 9.35% for this quarter.

• Net payment from A to B of $8821.92.

Payment on 1 April (for December quarter).• Bank bill rate was 9.25% for this quarter.

• Net payment from A to B of $6164.38.

• Counterparty B gained in the third and fourth quarters because the variable rate moved above 9%.

( ) ( ) 45.479 189$ m10$ 36592 087.0 =××

( ) ( ) 32.849 226$m10$ 36592 09.0 =××

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Hybrid Debt and Equity Finance• Convertible securities

– Provide holder with the right to convert into ordinary shares at some future date or dates.

– Typically convertible unsecured notes (debt) but convertible preference shares have been issued.

– Converting securities automatically change from one form of security to another at a particular date — converting preference share is most common.

• Convertible notes– A convertible note is a debt instrument issued for a fixed

term at a stated interest rate, which gives the holder the right to convert the note into ordinary shares at specified future dates.

– Notes are usually issued at an interest rate that is lower than that offered on straight debt instruments.

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Hybrid Debt and Equity Finance (cont.)• In addition to the explicit conversion option, there may

be an implicit option as note holders can normally participate in pro rata issues of new equity.

• For companies the attractions are:– More favourable terms than straight debt, i.e. longer maturity.

– Interest is normally tax deductible.

– Unsecured.

• Why issue convertible notes?– They may seem like a cheap debt alternative.

– However, there is an option to acquire shares, this is a cost to the company as well — may dilute returns to existing shareholders.

– See empirical study of Jen, Choi and Lee (1997), p. 307–8.

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Hybrid Debt and Equity Finance (cont.)• Preference share

– A form of equity financing with characteristics of debt securities. Holders have no voting rights and are entitled to receive a specified fixed return out of a firm’s net profit.

– Rank ahead of ordinary shares with respect to dividend payments — and with respect to claims on assets in liquidation events.

– There are different types of preference shares (p. 308–09).

• Cumulative or non-cumulative– A company that issues cumulative preference shares is

required to pay any accumulated preference dividends before a distribution may be made to ordinary shareholders.

– Non-cumulative preference shares do not oblige the company to pay any past accumulation of unpaid preference dividends.

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Hybrid Debt and Equity Finance (cont.)• Participating or non-participating

– May issue participating shares that allow the holders to share in any profit earned in excess of a certain amount.

– These participating preference shareholders can obtain a dividend in excess of the preference dividend rate.

– Non-participating preference shareholders are not entitled to a dividend in excess of the stated dividend rate.

• Voting or non-voting– Restricted voting rights.

• Classification as debt or equity– Usually regard preference shares as hybrids of debt or

equity. However, for tax and accounting purposes it is necessary to classify each financial instrument as either debt or equity.

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Hybrid Debt and Equity Finance (cont.)

• Why issue preference shares?

• Three advantages over ordinary shares and debt:

– Non-voting — can raise capital without affecting control of ordinary shareholders.

– Preference shareholders cannot force a company into liquidation — preferred over debt for this reason.

– Easy to value as they pay a fixed dividend and interest rates on debt easily observable.

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Development in the Design of Hybrid Shares• Converting preference shares:

– Offer a guaranteed dividend prior to a specified conversion date.

– Conversion ratio — number of ordinary shares received by the holder of each converting preference share.

– This discount means the holder is protected against a fall in the ordinary share price prior to conversion date.

• Reset preference shares: Where the dividend rate can be varied at specified intervals. (p. 311)

• Step-up preference shares: Where the dividend rate is reset at a higher rate on a specified date unless the securities have been re-marketed, redeemed or converted. (pp. 311–2)

• Hybrid security and credit rating: Issuers are more interested to know how the security will be treated by credit ratings agencies. Hybrids are grouped into three categories depending on whether the security’s equity content is assessed as minimal, intermediate or high. (p. 312–3)

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Summary• Various sources of short-term finance are

available to companies.

• The simplest is trade credit; however, cash discounts are forgone.

• Banks and other financial institutions offer a range of short-term finance:

– Banks offer overdrafts, which are a common and flexible form of short-term finance.

– More specialised forms of finance include debtor finance, inventory loans and bridging finance.

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Summary (cont.)• A company can issue short-term marketable

debt such as promissory notes and bills of exchange.

– Promise to pay face value at a future date and sold at a discount to face value.

• Promissory note — promise/guarantee made only by issuer of note.

• Bill of exchange — there is an acceptor who guarantees the loan.

• Secondary market for these debt instruments exists.

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Summary (cont.)• Long-term debt finance can be either:

– Non-marketable — bank loans, mortgage loans from life insurance offices and superannuation funds.

– Marketable — debentures, unsecured notes and corporate bonds.

• Debt with term to maturity of more than 12 months is considered long term.

• Loans from banks and other financial intermediaries are the most important source of long-term debt finance for Australian companies.

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Summary (cont.)

• Companies can borrow by directly issuing marketable debt securities, including debentures, unsecured notes and corporate bonds.

• Project finance is important in Australia — allowing large natural resource and infrastructure projects to be financed with a high proportion of debt.

• Hybrid securities — convertible notes, convertible and converting preference shares.

– All pay fixed dividend (like debt) and convert into ordinary shares at some future date.

peirson business finance10e powerpoint 10

Documents

peirson slides prepared

hill australia pty

australian national university

business finance 10e

interest rate swaps

term loans choices

participating preference shareholders

higher interest rate