Sources of Long-Term Finance: Debt

Chapter 11
Sources of Long-Term
Finance: Debt
Copyright 2006 McGraw-Hill Australia Pty Ltd

PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder 111
Prepared by Dr Buly Cardak
Learning Objectives
Explain the general characteristics of

long-term debt.
Identify and explain the features of the main

types of long-term loans.
Identify and explain the features of the main

types of marketable long-term debt securities.

Learning Objectives (cont.)
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.

Introduction
Long-term debt is debt with a term to 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.

General Characteristics of Long-Term
Debt
Debt contract where borrower promises
to pay future cash flows to lender.
Debt contract specifies the size and timing of

interest payments and how they are calculated.
May specify if there are assets pledged as

security, if debt is transferable, any other
restrictions on and rights of the parties.

Debt (cont.)
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.

Debt (cont.)
Marketable
Securities such as notes, bonds or debentures that
are issued direct to investors and can then be traded
in a secondary market.
Non-marketable
Loans arranged privately between two parties.

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

Debt (cont.)
Effect of debt on control
Lenders have no voting rights.
However, lenders have a large degree of potential

control if the company breaches the loan agreement.
To protect their assets, creditors can take control of

loan security, appoint administrators, move for
receivership or liquidation.

Debt (cont.)
Security for debt
Legal ownership a bank or other financier can
purchase asset and lend it to a business.
This form of debt finance is called leasing.
Financier has legal ownership of asset, providing
some greater security.
Fixed charge lender has a charge over specific

asset or group of assets.
Restricts borrowers ability to deal in these assets.
Floating charge lender has a charge over a class

of assets such as inventory.
Borrower can deal in the asset.

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.
Typically used with larger loans to listed companies and
marketable security issues.
Negative pledge borrower undertakes not to pledge

existing or future assets of the company to anyone else
without the consent of the lender.
Guarantee promise from a third party to cover debt

obligation in event of default.
Typically, a parent company may guarantee a loan for
a subsidiary.

Long-Term Loans
Australian companies obtain long-term debt finance largely
by loans, rather than by issuing their own debt securities.
Important features of term loans:

Loan is for a fixed period
Other features that may be fixed include:

The amount borrowed
The interest rate
The repayments
In many respects, a term loan resembles a mortgage

loan used to purchase real estate.

Long-Term Loans (cont.)
Choices in taking long-term loans
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.

Choices in taking long-term loans (cont.)
Credit foncier loan type of loan that involves regular
repayments which include 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

in the case of infrequent payments, interest payments
may be arranged more frequently.

Variable-rate term loans
If a borrower chooses a 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.

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 1.
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 usually is an administration fee
and an early repayment adjustment.

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 together 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.

Eurocurrency loans
Loans that are normally denominated in a foreign
currency and sourced overseas.
Reasons for Eurocurrency loans include diversification

of funding sources and exposure to more than one
currency.
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.

Why do businesses use term loans? (cont.)
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).

Marketable Long-Term Debt
Most long-term debt securities are issued
by governments and financial institutions.
Long-term debt issues are important means for

Australian borrowers to raise funds from overseas.
Main domestic issuers of long-term debt securities

are financial institutions.
Domestic public issues of long-term debt securities

by non-financial corporations are a small, but
growing, proportion of long-term debt issues.

Marketable Long-Term Debt (cont.)
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.

In the Australian market (cont.):
Can be issued by finance companies or by
non-financial companies.
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.

Timbercorp is a non-financial company that
issued a debenture in 2003.
Key features:
Issue limited to a finite amount $40m.
Open for a limited time (7 weeks).
Debentures listed on ASX.
Standardised issue all debentures were identical in
terms of interest rate, frequency of payment and maturity.
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.

Unsecured notes
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 as cannot be
called debenture.

Corporate bonds
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 in amounts of at
least $500 000 per investor.
Australian market has grown rapidly since 1995, $20b

on issue, to 2004 when $128b are on issue.
Market for offshore bonds issued by Australian

borrowers has grown rapidly.

Corporate bonds (cont.)
This may be related to higher interest rates in
Australia relative to say, US, UK and Japan.
Foreign bonds bonds issued by an Australian

borrower in a foreign country and 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.

Main differences between corporate bonds and
debentures are that corporate bonds:
Minimum investment in corporate bonds is much larger.
Have less restrictive trust deeds.
Are placed privately with institutional investors.
Do not need a prospectus, if placed with institutional

investors.

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.

Interest Rate Swaps (cont.)
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 doesnt 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.

Example: Interest Rate Swaps
Example 11.2:
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?

Example: Interest Rate Swaps (cont.)
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
Counterparty B wants the fixed rate.
Counterparty A offers the fixed rate and takes

on the variable rate.

Payment on 1 July (for April quarter).

A pays B:
0.076 91 365 $10m $219 287.67
B pays A:
0.09 91 365 $10 m $224 383 .56
Net payment from B to A of $34 904.11

Payment on 1 October (for July quarter).

A pays B:
0.087 92 365 $10 m $189 479 .45
B pays A:
0.09 92 365 $10 m $226 849 .32
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%.

Project Finance
Technique that is commonly used to raise funds for
major mining and natural resource projects, infrastructure
projects such as power stations, pipelines and toll roads,
tourist resorts and other property developments.
Can also be used to fund acquisition of large

industrial assets.
Lenders rely on cash flows of a single project as

source of debt repayment.
Financial risk for originators of project who provide

equity finance is limited.

Project Finance (cont.)
Main Features of Project Finance
No such thing as standard project finance,
though some common features are:
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, 7090%, with remainder

coming from project sponsors who own project.
Lenders decision based on expected cash flows

of assets.

Common features of project finance (cont.):
Limited recourse debt debt holders have limited claim
against equity holders (project sponsors) usually until
project completed.
Main security is intangible project company contracts,

a concession (toll roads) or rights to natural resources.
Project finance loans are for longer terms than normal

corporate loans loans repaid by end of projects life.

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.

Hybrid DebtEquity Finance:
Preference Shares
A form of equity financing with characteristics
of debt securities.
Normally, holders have no voting rights.
Normally entitled to receive a specified fixed

return out of a firms net profit.
Rank ahead of ordinary shares with respect to

dividend payments, and usually with respect
to claims on assets in the event of a liquidation.

Preference Shares (cont.)
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.

Redeemable, irredeemable, converting
or convertible:
Redeemable preference shares are similar to debentures,
but dividends are not deductible for income tax purposes.
Irredeemable preference shares are similar to ordinary

shares.
Converting preference shares automatically convert

to ordinary shares at some specified time in the future.
Convertible preference shares can be converted

to ordinary shares at the option of the holder.

Participating or non-participating
A company may issue participating preference 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.

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 are readily observable.

Hybrid DebtEquity Finance: Convertible
and Converting Securities
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.

and Converting Securities (cont.)
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.

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.
Maturity longer than for straight debt.
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.
Jen, Choi and Lee (1997) find that convertible

issues have less of a negative impact on the shares
of high-growth companies.
For these types of companies, conventional debt and

equity are expensive and unattractive thus issue
convertible securities.

Converting preference shares
Offer a guaranteed dividend prior to a specified
conversion date, at which time the preference shares
automatically convert to ordinary shares in the company.
Conversion ratio number of ordinary shares received

by the holder of each converting preference share.
Expressed in terms of discount to market price of shares.
This discount means the holder is protected against a fall

in the ordinary share price prior to conversion date.

Summary
Long-term debt finance can be either:
Non-marketable bank loans, mortgage loans from
life insurance offices and super 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.

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.


Sources of Long-Term Finance: Debt

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Sources of Long-Term Finance: Debt

Uploaded by

Copyright:

Available Formats

Chapter 11

Copyright 2006 McGraw-Hill Australia Pty Ltd

Explain the general characteristics of

Identify and explain the features of the main

Identify and explain the features of the main

Copyright 2006 McGraw-Hill Australia Pty Ltd

Identify and explain the main features of

Understand the role of interest rate swaps

Identify and explain the features of securities that

Copyright 2006 McGraw-Hill Australia Pty Ltd

Long-term debt is debt with a term to maturity

Long-term debt typically comprises more than half

Two broad types of long-term debt:

Funds raised by issuing marketable debt securities

Copyright 2006 McGraw-Hill Australia Pty Ltd

Debt contract specifies the size and timing of

May specify if there are assets pledged as

Copyright 2006 McGraw-Hill Australia Pty Ltd

Copyright 2006 McGraw-Hill Australia Pty Ltd

Copyright 2006 McGraw-Hill Australia Pty Ltd

Higher for subordinated debt lowest ranking debt in event

Effect of debt on risk

Copyright 2006 McGraw-Hill Australia Pty Ltd

However, lenders have a large degree of potential

To protect their assets, creditors can take control of

Copyright 2006 McGraw-Hill Australia Pty Ltd

Fixed charge lender has a charge over specific

Floating charge lender has a charge over a class

Copyright 2006 McGraw-Hill Australia Pty Ltd

Negative pledge borrower undertakes not to pledge

Guarantee promise from a third party to cover debt

Copyright 2006 McGraw-Hill Australia Pty Ltd

Important features of term loans:

Other features that may be fixed include:

In many respects, a term loan resembles a mortgage

Copyright 2006 McGraw-Hill Australia Pty Ltd

Lender will specify minimum and maximum terms, while

Interest rates can be fixed or variable variable rates

Interest rates will also vary, depending on security on

Copyright 2006 McGraw-Hill Australia Pty Ltd

Alternative payment arrangements, principal plus

Frequency of repayment can vary from weekly to yearly

Copyright 2006 McGraw-Hill Australia Pty Ltd

Variable-rate loan is flexible in that it can be repaid early

Possible to convert to fixed rate loan without penalty.

Capped option rate can rise but not above some

Copyright 2006 McGraw-Hill Australia Pty Ltd

Fixed-rate loan loses some of the flexibility of

Progressive draw down is not allowed you borrow and

Repayment patterns are flexible but, once determined,

May be able to make special repayments or repay in full

Copyright 2006 McGraw-Hill Australia Pty Ltd

Bank may not wish to lend the whole amount a single

This can be overcome through a syndicated loan.

A number of banks join together to provide what

A way to spread the credit risk without having several

Copyright 2006 McGraw-Hill Australia Pty Ltd

Reasons for Eurocurrency loans include diversification

Why do businesses use term loans?

Copyright 2006 McGraw-Hill Australia Pty Ltd

Issue of marketable securities has strict disclosure

Term-loan repayments are much more flexible, with

Debt securities may need to be rated by a rating