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Lec 11-12-13 debt; a comprehensive discusssion

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Lec 11-12-13 debt; a comprehensive discusssion

  1. 1. Debt and its implications By Muhammad Shafiq forshaf@gmail.com http://www.slideshare.net/forshaf
  2. 2. WHAT IS Debt? • Debt is when goods, services, or money is received in exchange for a promise to pay a definite sum of money at a future date.
  3. 3. Debt… • A debt instrument is a paper or electronic obligation that enables the issuing party to raise funds by promising to repay a lender in accordance with terms of a contract. • Types of debt instruments include notes, bonds, certificates, mortgages, leases or other agreements between a lender and a borrower
  4. 4. Debt • ADVANTAGES • Convenient • Useful for emergencies • Often required to hold a reservation • Ability to purchase expensive items sooner • Eliminates the need to carry large amounts of cash • DISADVANTAGES • Paying interest • Additional fees are common • Temptation to overspend • Can cause large amounts of debt • Identity theft
  5. 5. Top 10 Questions to Ask Before Signing on the Dotted Line 1. Do I really need this item right now, or can I wait? 2. Can I qualify for credit? 3. What is the interest rate (APR) on this card? 4. Are there additional fees? 6.How much is the monthly payment, and when is it due? Can I afford to pay the monthly payments? 7.What will happen if I don’t make the payments on time? 8.What will be the extra cost of using credit? 9.What will I have to give up to pay for it? 10.All things considered, is using credit worth it for this purchase?
  6. 6. The Four “C’s” of Credit Collateral Capital Capacity Character
  7. 7. • Debt is the entire amount of money you owe to lenders. • APR (annual percentage rate) is the total cost to use credit in a year. • Term is how long you have to repay a loan, often expressed in months. • Fees are charged to use credit. Examples: annual credit card fee, loan origination fee, over-the-limit fee
  8. 8. DEBT TO INCOME RATIO •Debt to income ratios look at how much you owe in comparison to how much you earn. •It usually gives a good picture of your financial well being. •The lower your debt to income ratio, the more money you have to spend on things other than your monthly bills.
  9. 9. DEBT TO INCOME CALCULATION • Take the amount of money that goes to paying monthly obligations (loans, credit cards, rent, etc.) • Divide that amount by your gross monthly income (this is the amount before taxes are taken out) Monthly debt payment / gross monthly income = D/I
  10. 10. Short-Term Financing • Spontaneous Financing • Negotiated Financing • Factoring Accounts Receivable • Composition of Short-Term Financing
  11. 11. Spontaneous Financing • Accounts Payable (Trade Credit from Suppliers) • Accrued Expenses Types of spontaneous financing
  12. 12. Spontaneous Financing • Open Accounts: the seller ships goods to the buyer with an invoice specifying goods shipped, total amount due, and terms of the sale. • Notes Payable: the buyer signs a note that evidences a debt to the seller. Trade Credit -- credit granted from one business to another. Examples of trade credit are:
  13. 13. Spontaneous Financing Draft -- A signed, written order by which the first party (drawer) instructs a second party (drawee) to pay a specified amount of money to a third party (payee). The drawer and payee are often one and the same.  Trade Acceptances: the seller draws a draft on the buyer that orders the buyer to pay the draft at some future time period.
  14. 14. Terms of the Sale •Net Period - No Cash Discount -- when credit is extended, the seller specifies the period of time allowed for payment. “Net 30” implies full payment in 30 days from the invoice date.  COD and CBD - No Trade Credit: the buyer pays cash on delivery or cash before delivery. This reduces the seller’s risk under COD to the buyer refusing the shipment or eliminates it completely for CBD.
  15. 15. Terms of the Sale • Seasonal Dating -- credit terms that encourage the buyer of seasonal products to take delivery before the peak sales period and to defer payment until after the peak sales period.  Net Period - Cash Discount -- when credit is extended, the seller specifies the period of time allowed for payment and offers a cash discount if paid in the early part of the period. “2/10, net 30” implies full payment within 30 days from the invoice date less a 2% discount if paid within 10 days.
  16. 16. Trade Credit as a Means of Financing $1,000 x 30 days = $30,000 account balance What happens to accounts payable if a firm purchases $1,000/day at “net 30”? What happens to accounts payable if a firm purchases $1,500/day at “net 30”? $1,500 x 30 days = $45,000 account balance A $15,000 increase from operations!
  17. 17. Cost to Forgo a Discount Approximate annual interest cost = % discount 365 days (100% - % discount) (payment date - discount period) What is the approximate annual cost to forgo the cash discount of “2/10, net 30” after the first ten days? X
  18. 18. Cost to Forgo a Discount Approximate annual interest cost = 2% 365 days (100% - 2%) (30 days - 10 days) = (2/98) x (365/20) = 37.2% What is the approximate annual cost to forgo the cash discount of “2/10, net 30,” and pay at the end of the credit period? X
  19. 19. Payment Date*Annual rate of interest 11744.9% 2074.5 3037.2 6014.9 909.3 * days from invoice date Cost to Forgo a Discount The approximate interest cost over a variety of payment decisions for “2/10, net ____.”
  20. 20. S-t-r-e-t-c-h-i-n-g Account Payables • Cost of the cash discount (if any) forgone • Late payment penalties or interest • Deterioration in credit rating Postponing payment beyond the end of the net period is known as “stretching accounts payable” or “leaning on the trade.” Possible costs of “stretching accounts payable”
  21. 21. Advantages of Trade Credit • Convenience and availability of trade credit • Greater flexibility as a means of financing Compare costs of forgoing a possible cash discount against the advantages of trade credit.
  22. 22. Who Bears the Cost of Funds for Trade Credit? • Buyers -- when costs can be fully passed on through higher prices to the buyer by the seller. • Both -- when costs can partially be passed on to buyers by sellers.  Suppliers -- when trade costs cannot be passed on to buyers because of price competition and demand.
  23. 23. Accrued Expenses • Wages -- Benefits accrue via no direct cash costs, but costs can develop by reduced employee morale and efficiency. • Taxes -- Benefits accrue until the due date, but costs of penalties and interest beyond the due date reduce the benefits.  Accrued Expenses -- Amounts owed but not yet paid for wages, taxes, interest, and dividends. The accrued expenses account is a short-term liability.
  24. 24. Spontaneous Financing •Money Market Credit •Commercial Paper •Bankers’ Acceptances •Unsecured Loans •Line of Credit •Revolving Credit Agreement •Transaction Loan Types of negotiated financing:
  25. 25. “Stand-Alone” Commercial Paper • Commercial paper market is composed of the (1) dealer and (2) direct-placement markets. • Advantage: Cheaper than a short-term business loan from a commercial bank. • Dealers require a line of credit to ensure that the commercial paper is paid off. Commercial Paper -- Short-term, unsecured promissory notes, generally issued by large corporations (unsecured corporate IOUs).
  26. 26. “Bank-Supported” Commercial Paper • Letter of credit (L/C) -- A promise from a third party (usually a bank) for payment in the event that certain conditions are met. It is frequently used to guarantee payment of an obligation. • Best for lesser-known firms to access lower cost funds.  A bank provides a letter of credit, for a fee, guaranteeing the investor that the company’s obligation will be paid.
  27. 27. Bankers’ Acceptances • Used to facilitate foreign trade or the shipment of certain marketable goods. • Liquid market provides rates similar to commercial paper rates. Bankers’ Acceptances -- Short-term promissory trade notes for which a bank (by having “accepted” them) promises to pay the holder the face amount at maturity.
  28. 28. Short-Term Business Loans • Secured Loans -- A form of debt for money borrowed in which specific assets have been pledged to guarantee payment.  Unsecured Loans -- A form of debt for money borrowed that is not backed by the pledge of specific assets.
  29. 29. Unsecured Loans • One-year limit that is reviewed prior to renewal to determine if conditions necessitate a change. • Credit line is based on the bank’s assessment of the creditworthiness and credit needs of the firm. • “Cleanup” provision requires the firm to owe the bank nothing for a period of time.  Line of Credit (with a bank) -- An informal arrangement between a bank and its customer specifying the maximum amount of unsecured credit the bank will permit the firm to owe at any one time.
  30. 30. Unsecured Loans • Firm receives revolving credit by paying a commitment fee on any unused portion of the maximum amount of credit. • Commitment fee -- A fee charged by the lender for agreeing to hold credit available. • Agreements frequently extend beyond 1 year. Revolving Credit Agreement -- A formal, legal commitment to extend credit up to some maximum amount over a stated period of time.
  31. 31. Unsecured Loans • Each request is handled as a separate transaction by the bank, and project loan determination is based on the cash-flow ability of the borrower. • The loan is paid off at the completion of the project by the firm from resulting cash flows.  Transaction Loan -- A loan agreement that meets the short-term funds needs of the firm for a single, specific purpose.
  32. 32. Detour:Cost of Borrowing Differential from prime depends on: • Cash balances • Other business with the bank • Cost of servicing the loan Interest Rates  Prime Rate -- Short-term interest rate charged by banks to large, creditworthy customers.
  33. 33. $10,000 in interest $100,000 in usable funds Detour:Cost of Borrowing Computing Interest Rates  Collect Basis -- interest is paid at maturity of the note. Example: $100,000 loan at 10% stated interest rate for 1 year. = 10.00%
  34. 34. $10,000 in interest $90,000 in usable funds Detour:Cost of Borrowing Computing Interest Rates Discount Basis -- interest is deducted from the initial loan. Example: $100,000 loan at 10% stated interest rate for 1 year. = 11.11%
  35. 35. $100,000 in interest $850,000 in usable funds Detour:Cost of Borrowing Compensating Balances  Non-interest-bearing demand deposits maintained by a firm to compensate a bank for services provided, credit lines, or loans. Example: $1,000,000 loan at 10% stated interest rate for 1 year with a required $150,000 compensating balance. = 11.76%
  36. 36. Detour:Cost of Borrowing Commitment Fees  The fee charged by the lender for agreeing to hold credit available is on the unused portions of credit. Example: $1 million revolving credit at 10% stated interest rate for 1 year; borrowing for the year was $600,000; a required 5% compensating balance on borrowed funds; and a .5% commitment fee on $400,000 of unused credit. What is the cost of borrowing?
  37. 37. $60,000 in interest + $2,000 in commitment fees $570,000 in usable funds Detour:Cost of Borrowing Interest: ($600,000) x (10%) = $ 60,000 Commitment Fee: ($400,000) x (0.5%) = $ 2,000 Compensating Balance: ($600,000) x (5%) = $ 30,000 Usable Funds: $600,000 - $30,000 = $570,000 = 10.88%
  38. 38. Secured (or Asset-Based) Loans • Marketability • Life • Riskiness  Security (collateral) -- Asset (s) pledged by a borrower to ensure repayment of a loan. If the borrower defaults, the lender may sell the security to pay off the loan. Collateral value depends on:
  39. 39. Uniform Commercial Code • Security interests of the lender • Security agreement (device) • Filing of the security agreement  Model state legislation related to many aspects of commercial transactions that went into effect in Pennsylvania in 1954. It has been adopted with limited changes by most state legislatures. Article 9 of the Code deals with:
  40. 40. Accounts-Receivable-Backed Loans • Quality: not all individual accounts have to be accepted (may reject on aging). • Size: small accounts may be rejected as being too costly (per dollar of loan) to handle by the institution.  One of the most liquid asset accounts.  Loans by commercial banks or finance companies (banks offer lower interest rates). Loan evaluations are made on:
  41. 41. Accounts-Receivable-Backed Loans • Notification -- firm customers are notified that their accounts have been pledged to the lender and remittances are made directly to the lending institution. Types of receivable loan arrangements:  Nonnotification -- firm customers are not notified that their accounts have been pledged to the lender. The firm forwards all payments from pledged accounts to the lender.
  42. 42. Inventory-Backed Loans • Marketability • Perishability • Price stability • Difficulty and expense of selling for loan satisfaction • Cash-flow ability  Relatively liquid asset accounts Loan evaluations are made on:
  43. 43. Types of Inventory-Backed Loans  Floating Lien -- A general, or blanket, lien against a group of assets, such as inventory or receivables, without the assets being specifically identified.  Chattel Mortgage -- A lien on specifically identified personal property (assets other than real estate) backing a loan.
  44. 44. Types of Inventory-Backed Loans  Trust Receipt -- A security device acknowledging that the borrower holds specifically identified inventory and proceeds from its sale in trust for the lender.  Terminal Warehouse Receipt -- A receipt for the deposit of goods in a public warehouse that a lender holds as collateral for a loan.
  45. 45. Types of Inventory-Backed Loans  Field Warehouse Receipt -- A receipt for goods segregated and stored on the borrower’s premises (but under the control of an independent warehousing company) that a lender holds as collateral for a loan.
  46. 46. Factoring Accounts Receivable • Factor is often a subsidiary of a bank holding company. • Factor maintains a credit department and performs credit checks on accounts. • Allows firm to eliminate their credit department and the associated costs. • Contracts are usually for 1 year, but are renewable. Factoring -- The selling of receivables to a financial institution, the factor, usually “without recourse.”
  47. 47. Factoring Accounts Receivable • Factor receives a commission on the face value of the receivables. • Cash payment is usually made on the actual or average due date of the receivables. • If the factor advances money to the firm, then the firm must pay interest on the advance. • Total cost of factoring is composed of a factoring fee plus an interest charge on any cash advance. • Although expensive, it provides the firm with substantial flexibility. Factoring Costs
  48. 48. Composition of Short-Term Financing • Cost of the financing method • Availability of funds • Timing • Flexibility • Degree to which the assets are encumbered The best mix of short-term financing depends on:
  49. 49. M&M (Debt Policy Doesn’t Matter) • Modigliani & Miller • When there are no taxes and capital markets function well, it makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure.
  50. 50. M&M (Debt Policy Doesn’t Matter) Assumptions • By issuing 1 security rather than 2, company diminishes investor choice. This does not reduce value if: • Investors do not need choice, OR • There are sufficient alternative securities • Capital structure does not affect cash flows e.g... • No taxes • No bankruptcy costs • No effect on management incentives
  51. 51. Example - Macbeth Spot Removers - All Equity Financed 201510%5(%)sharesonReturn 2.001.501.00$.50shareperEarnings 2,0001,5001,000$500IncomeOperating DCBA Outcomes 10,000$SharesofValueMarket $10shareperPrice 1,000sharesofNumber Data M&M (Debt Policy Doesn’t Matter) Expected outcome
  52. 52. Example cont. 50% debt M&M (Debt Policy Doesn’t Matter) 3025150%(%)sharesonReturn 321$0shareperEarnings 500,11,000500$0earningsEquity 500500500$500Interest 000,21,5001,000$500IncomeOperating CBA Outcomes 5,000$debtofueMarket val 5,000$SharesofValueMarket $10shareperPrice 500sharesofNumber Data D
  53. 53. Example - Macbeth’s - All Equity Financed - Debt replicated by investors 3020100%(%)investment$10onReturn 3.002.001.000$investmentonearningsNet 1.001.001.00$1.0010%@Interest:LESS 4.003.002.00$1.00sharestwoonEarnings DCBA Outcomes M&M (Debt Policy Doesn’t Matter)
  54. 54. MM'S PROPOSITION I If capital markets are doing their job, firms cannot increase value by tinkering with capital structure. V is independent of the debt ratio. AN EVERYDAY ANALOGY It should cost no more to assemble a chicken than to buy one whole. No Magic in Financial Leverage
  55. 55. Leverage and Financial Risk Leverage is encountered whenever fixed costs are incurred to support operations that generate revenue  Operating leverage – when a portion of a company’s operating costs are fixed  Financial leverage – when a firm finances part of its business with securities that entail fixed financing charges such as bond, debentures, or preferred shares A firm’s financial results that accrue to equity investors are magnified through the use of operating and financial leverage
  56. 56. Leverage and Financial Risk Operating and Financial Leverage
  57. 57. Leverage and Financial Risk A firms total leverage is a combination of operating and financial leverage and measures the % variation in EPS for a given % change in sales Increased leverage leads to increased risk  Business risk – results from general economic cycles, changing industry conditions, and operating cost structure of an individual firm  Degree of financial leverage – is the % change on common equity or EPS divided by the % change in EBIT that caused the change in equity returns
  58. 58. Leverage and Financial Risk If only common equity is used changes in ROE reflect only business risk  Financial leverage = 1 If senior securities are used in the capital structure the variations on ROE are magnified  Financial leverage > 1 Total value of the firms is expressed by: Value of firm = value of debt + value of equity
  59. 59. Indifference Analysis Indifference analysis is a common tool used in assessing the impact of leverage and is used to:  determine EPS as a function of EBIT for various capital structures  identify the level of EBIT beyond which reliance on leverage produces higher EPS
  60. 60. Indifference Analysis Limitations of indifference analysis include: 1. It ignores cash flow considerations such as sinking fund provisions for the periodic retirement of fixed income securities. 2. It does not consider how equity investors may react to the increased risk imposed by leverage in the light of uncertain future operating performance.
  61. 61. Evaluation of Capital Structures A capital structure that maximizes share prices generally will minimize the firm’s WACC If a firm can lower its WACC, shareholders will receive greater returns reflected in increased share prices  capital structure  market price per share,  WACC  market price per share,  WACC
  62. 62. Evaluation of Capital Structures Different capital structures results in different levels of financial risk created through leverage. Three trade-off possibilities include: 1. Cost equity increases with leverage at a moderate rate so that when combined with debt  WACC decreases with increased leverage 2. Cost of equity increases at a rate that offsets the benefits gained through cheaper financing  WACC remains constant 3. Cost of equity increases rapidly with leverage and increase more than offsets any gains from debt  WACC increases with leverage
  63. 63. Evaluation of Capital Structures Consequences of Different Shareholder Attitudes Toward Risk
  64. 64. Evaluation of Capital Structures Leverage is measured as the proportion of debt in relation to equity in the capital structure (B/E)  With V = B + E WACC is: V E k V B bk eb 
  65. 65. Traditional Position Under the traditional position firms can:  issue reasonable amounts of debt with little effect on its cost of equity and a low risk of default Corporations use debt to take advantage of the positive aspects of leverage It is important for companies to find the optimal level where the WACC is minimized
  66. 66. Traditional Position The Traditional Position on Capital Structure and the Cost of Capital
  67. 67. Theory of Capital Structure Capital structure without taxes and bankruptcy costs  denoting ke u and ke L as the cost of equity for unlevered and levered firms we have:  rearranged we get: tconsk V B b V E k U eb L e tan E B kkkk b U e U e L e )( 
  68. 68. Theory of Capital Structure Relationship Between the WACC, Cost of Equity, and Leverage
  69. 69. Theory of Capital Structure Corporate taxes  exert an important influence on financing decisions because the amount of taxes depends on the capital structure  levered firm’s taxes are reduced by the tax shield on interest (IT) VL > Vu  Ignoring bankruptcy, investors would prefer owning debt and equity of L over equity U
  70. 70. Theory of Capital Structure Assuming debt outstanding (B) is perpetual and the tax shield generated by interest payments becomes a perpetual annuity of IT then: Present value of tax savings = then BT r IT b  BTVV UL 
  71. 71. Theory of Capital Structure The cost of equity ke L increases at a slower rate, which can be seen through the formulas:  b U e L U e L e kkT E B kk  )1(         L U eb L e L EB BT kk V B k V E k 1
  72. 72. Theory of Capital Structure Individual taxes can influence the value of a company, therefore they must be considered for decisions on capital structure A company wants a capital structure that minimizes total taxes or maximizes after-tax distribution Total after-tax distribution )1)(1()( pdcpi TTETII 
  73. 73. Theory of Capital Structure Cash Flow with Corporate and Personal Taxes
  74. 74. Theory of Capital Structure Bankruptcy Costs  As firms increase financial leverage they increase the probability of bankruptcy  Regardless of ownership any enterprise that generates a positive NPV should continue operating Bankruptcies often reduce a firm’s economic value because: 1. the direct costs such as fees for trustees, lawyers, and court proceedings 2. the loss of profits caused by the loss of trust in the company
  75. 75. Theory of Capital Structure Benefit of Tax Savings, Expected Bankruptcy Costs, and Optimal Capital Structure
  76. 76. Market Imperfections and Practical Considerations Agency Problems  when managers fail to act in the best interests of shareholders Market Inefficiencies  Imperfections in the markets cause share prices to fall whenever companies issue equity no matter if the stock is undervalued, overvalued, or valued correctly.  Based on the imperfections, companies should issue bonds when internal equity is not available and only issue equity as a last resort, which gives rise to the “pecking order” of corporate finance
  77. 77. Market Imperfections and Practical Considerations  “Pecking order” of finance holds that 1. Retained earnings or depreciation should be used first 2. After internal resources are depleted, debt should be used 3. New common equity should be issued only when more debt is likely to increase the chance of bankruptcy Debt capacity  Debt capacity – the ability of an enterprise to tolerate higher leverage
  78. 78. Market Imperfections and Practical Considerations Considerations determining the debt capacity of a firm include:  debt capacity can be viewed as a function of both collateral and stable cash flow  the variability and level of cash flow during difficult times influences debt capacity  firms with product lines that involve long-term commitments to customers have a lower debt capacity
  79. 79. Long-Term Debt, Preferred Stock, and Common Stock •Bonds and Their Features •Types of Long-Term Debt Instruments •Retirement of Bonds •Preferred Stock and Its Features •Rights of Common Shareholders •Dual-Class Common Stock
  80. 80. Bonds and Their Features Basic Terms Par ValueCoupon Rate MaturityBond Ratings Bond -- A long-term debt instrument with a final maturity generally being 10 years or more.
  81. 81. Trustee and Indenture Trustee -- A person or institution designated by a bond issuer as the official representative of the bondholders. Typically, a bank serves as trustee. Indenture -- The legal agreement, also called the deed of trust, between the corporation issuing bonds and the bondholders, establishing the terms of the bond issue and naming the trustee.
  82. 82. Types of Long-Term Debt Instruments • 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 clause. • A negative-pledge clause precludes the corporation from pledging any of its assets (not already pledged) to other creditors. Debenture -- A long-term, unsecured debt instrument.
  83. 83. Types of Long-Term Debt Instruments • 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 Debenture -- A long-term, unsecured debt instrument with a lower claim on assets and income than other classes of debt; known as junior debt.
  84. 84. Types of Long-Term Debt Instruments • Frequently, there is a cumulative feature, which provides that any unpaid interest in a particular year accumulates. The cumulative obligation is usually limited to no more than three years. • The bonds are unpopular with investors (usually limited to reorganizations), but are still senior to preferred and common shareholders in the event of liquidation. Income Bond -- A bond where the payment of interest is contingent upon sufficient earnings of the firm.
  85. 85. Types of Long-Term Debt Instruments • These are bonds with a rating of Ba (Moody's) or lower. • Principal investors are pension funds, high-yield bond mutual funds, and some individual investors. • Liquidity varies depending on investor sentiments. • Junk bonds were used frequently in the 1980s as a means of financing leveraged buyouts (LBOs). Junk Bond -- A high-risk, high-yield (often unsecured) bond rated below investment grade.
  86. 86. Types of Long-Term Debt Instruments • The issue is secured by a lien on specific assets of the corporation. • The market value of the collateral should exceed the amount of the bond issue by a reasonable margin of safety to help protect bondholders. Mortgage Bond -- A bond issue secured by a mortgage on the issuer’s property.
  87. 87. Types of Long-Term Debt Instruments • If the corporation defaults, the trustee can foreclose on behalf of the bondholders. The bondholders become general creditors for any residual amount after the sale of the collateral. • The corporation may have a first mortgage and a second mortgage on the same assets. The first mortgage has a senior claim on the assets. Mortgage Bond (Continued)
  88. 88. Types of Long-Term Debt Instruments • A railroad arranges with a trustee to purchase equipment from a manufacturer. • The railroad signs a contract with the manufacturer for the construction of specific equipment. • When the equipment is delivered, equipment trust certificates are sold to investors. Equipment Trust Certificate -- An intermediate- to long- term security, usually issued by a transportation company such as a railroad or airline, that is used to finance new equipment. Let us look at an example using a railroad.
  89. 89. Types of Long-Term Debt Instruments • Proceeds plus the railroad downpayment are used to pay the manufacturer. • Title of the equipment is held by the trustee, and the trustee leases the equipment to the railroad. • Lease payments are used to pay a fixed dividend to the certificate holders and to retire a specified portion of the certificates at regular intervals. • After the final lease payment (all certificates are retired), title to the equipment passes to the railroad. Equipment Trust Certificates (Continued)
  90. 90. Asset Securitization • Purpose: To reduce financing costs • Firm picks assets to “package” and use cash flows • Assets removed from the balance sheet and sold to bankruptcy-remote entity (special-purpose vehicle -- SPV) • SPV raises money by selling asset-backed securities Asset Securitization – The process of packaging a pool of assets and then selling interests in the pool in the form of asset-backed securities. Asset-backed Security – Debt securities whose interest and principal payments are provided by the cash flows coming from a discrete pool of assets.
  91. 91. Retirement of Bonds •The corporation makes a cash payment to the trustee, which calls the bonds. •The corporation purchases bonds in the open market and delivers them to the trustee. Sinking 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-fund retirement of a bond:
  92. 92. Sinking Fund and the Retirement of Bonds • When bonds are called for redemption, the bondholders will receive the sinking-fund call price. • The bonds are called on a lottery basis (by their serial numbers) and published in periodicals like The Wall Street Journal. • Bonds should be purchased in the open market if the market price is less than the sinking-fund call price.
  93. 93. Sinking Fund and the Retirement 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.
  94. 94. Sinking Fund and the Retirement 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 Payment -- A payment on debt that is much larger than other payments.
  95. 95. Serial Bonds • For example, a $10 million issue of serial bonds might have $500,000 of predetermined bonds maturing each year for 20 years. • Investors are able to choose the maturity that best fits their needs (wider investor appeal). Serial Bonds -- An issue of bonds with different maturities, as distinguished from an issue where all bonds have identical maturities (term bonds).
  96. 96. Call Provision • Not all bonds are callable. In periods of low interest (hence, low coupon) rates, firms are more likely to issue noncallable bonds. • When a bond is callable, the call price is usually above the par value of the bond and often decreases over time. Call Provision -- A feature in an indenture that permits the issuer to repurchase securities at a fixed price (or series of fixed prices) before maturity; also called call feature.
  97. 97. Call Price • For example, the call price for the first year might equal the bond par value plus one-year’s interest. • According to when they can be exercised, call provisions can be either immediate or deferred. • The call provision provides financing flexibility for the firm as conditions change. Call Price -- The price at which a security with a call provision can be purchased by the issuer prior to the security’s maturity.
  98. 98. Value of the Call Privilege • The call privilege is valuable to the firm to the detriment of bondholders. As such, bondholders require a premium for this additional risk in the form of a higher yield. • The greater the volatility of interest rates, the greater the probability that the firm will call the bonds. Thus, the call- option is more valuable all else equal. Callable-bond value Noncallable- bond value Call-option value= -
  99. 99. Summary 1. A firm that incurs fixed costs while generating variable revenues is subject to leverage. Leverage is used to increase the expected profitability of a firm. Financial risk is the added variability in returns to shareholders introduced by financing through fixed-cost senior securities. 2. Indifference analysis is used to evaluate the effect of leverage on profitability.
  100. 100. Summary 3. A firm’s capital structure is optimal if it maximizes shareholder wealth. The desirability of financial leverage depends on equity investors’ attitudes toward the implied trade-offs between risk and expected returns. The traditional position suggests, optional moderate leverage. 4. Given corporate taxes, interest on debt allows the firm to reduce its tax bill and to increase the amount available for distribution to security holders.
  101. 101. Summary 5. Firms restrict debt financing in order to limit the probability of financial distress. Liquidation decisions entail capital budgeting analysis that is based on net present values. Total expected bankruptcy costs increase with financial leverage and reduce the value of the firm. The trade-off facing management is between the tax benefits that accrue through debt financing and the expected costs of financial distress that increase with leverage.
  102. 102. Summary 6. Since debt payments represent contractual obligations, high leverage reduces a firm’s free cash flow. It thus limits management flexibility and discretion. A firm’s debt capacity is mainly a function of the stability of its cash flow and its collateral’s value and liquidity. 7. Financial leverage affects a firm’s systematic risk. Beta, as specified by the Capital Asset Pricing Model, varies as a function of the debt proportion that the firm employs.

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