1.
Debt and its implications
By Muhammad Shafiq
forshaf@gmail.com
http://www.slideshare.net/forshaf

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.
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.
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.
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.
The Four “C’s” of Credit
Collateral
Capital
Capacity
Character

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.
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.
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.
Short-Term Financing
• Spontaneous Financing
• Negotiated Financing
• Factoring Accounts Receivable
• Composition of Short-Term
Financing

11.
Spontaneous Financing
• Accounts Payable (Trade Credit from Suppliers)
• Accrued Expenses
Types of spontaneous
financing

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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
Spontaneous Financing
•Money Market Credit
•Commercial Paper
•Bankers’ Acceptances
•Unsecured Loans
•Line of Credit
•Revolving Credit Agreement
•Transaction Loan
Types of negotiated financing:

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.
“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.
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.
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.
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.
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.
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.
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.
$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.
$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.
$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.
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.
$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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
Leverage and Financial Risk
Operating and Financial Leverage

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.
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.
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.
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.
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.
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.
Evaluation of
Capital Structures
Consequences of Different Shareholder Attitudes
Toward Risk

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.
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.
Traditional Position
The Traditional Position on Capital Structure and the
Cost of Capital

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.
Theory of Capital Structure
Relationship Between the WACC, Cost of Equity, and
Leverage

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.
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.
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.
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.
Theory of Capital Structure
Cash Flow with Corporate and Personal Taxes

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.
Theory of Capital Structure
Benefit of Tax Savings,
Expected Bankruptcy
Costs, and Optimal Capital
Structure

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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.