Chapter 5: Long-Term Debt Financing: Prerequisite
Chapter 5: Long-Term Debt Financing: Prerequisite
Chapter 5: Long-Term Debt Financing: Prerequisite
Prerequisite:
One of the basic distinction of the modern theory and practice of corporate finance classify
securities issued by a corporation roughly as equity or debt.
Equity Debt
securities
At its crudest level, debt represents something that must be repaid, it is a result of borrowing
money.
When corporation borrow, they contract to make regularly scheduled interest payments and to
repay the original amount borrowed (that is the principal).
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tax liability has been determined. Dividend are considered a return to
shareholders on their contributed capital.
✓ Unpaid debt is a liability of the firm. If is not paid, the creditors can
legally claim the assets of the firm. This action may result in liquidation
and bankruptcy.
Introduction:
Chapter 1 introduced the mechanics of new long-term financing with an emphasis on equity. This
chapter takes a closer look at long term debt instruments.
Debt
Term Loan
Corporate notes and
Secured Debt unsecured Debt (bilateral/syndicated Private placement
bonds.
)
1. Corporate Debt:
Companies differ from governments and government- related entities in that their primary
goal is profit; they must be profitable to stay in existence.
We can focus on publicly issued debt, but loans from banks and other financial institutions are
a significant part of the debt raised by companies. For example, it is estimated that European
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companies meet 75% of their borrowing needs from banks and only 25% from financial
markets. In Japan, these percentages are 80% and 20%, respectively. However, in the US
debt capital is much more significant: 80% is from financial markets and just 20% from
bank lending. (2018)
➢ A bilateral loan:
A bilateral loan is a loan from a single lender to a single borrower.
Companies routinely use bilateral loans from their banks, and these bank loans are governed
by the bank loan documents.
Bank loans are the primary source of debt financing for small and medium- size companies as
well as for large companies in countries where bond markets are either under- developed or
where most bond issuances are from government, government- related entities, and financial
institutions.
Access to bank loans depends not only on the characteristics and financial health of the
company, but also on market conditions and bank capital availability
➢ A syndicated loan:
A syndicated loan is a loan from a group of lenders, called the “syndicate,” to a single
borrower.
A syndicated loan is a hybrid between relational lending and publicly traded debt.
Syndicated loans are primarily originated by banks, and the loans are extended to companies
but also to governments and government- related entities.
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The coordinator, or lead bank, originates the loan, forms the syndicate, and processes the
payments.
B) Private Placements:
A private placement is a bond issue that does not trade on a public market but rather is sold
to a small group of investors.
Because a private placement does not need to be registered, it is less costly to issue.
Instead of an indenture, often a simple promissory note is sufficient.
Privately placed debt also need not conform to the same standards as public debt; as a
consequence, it can be tailored to the particular situation.
Private placements sometimes represent a step in the company’s financing evolution
between syndicated loans and public offerings.
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not only publicly traded securities, such as commercial paper1, notes, and bonds, but also
non- publicly traded loans.
The Institute of International Finance reports that the size of the global debt market
surpassed USD 247 trillion in the first quarter of 2018.
Understanding how fixed- income markets are structured and how they operate is important
for debt issuers and investors. Debt issuers have financing needs that must be met. For
example, a government may need to finance an infrastructure project, a new hospital, or a
new school. A company may require funds to expand its business. Financial institutions also
have funding needs, and they are among the largest issuers of fixed- income securities.
Fixed income is an important asset class for both individual and institutional investors.
1.2.1. Bonds
The general procedures followed in a public issue of bonds are the same as those for stocks.
The issue must be registered with SEC (or other). The registration statement for a public issue
of bonds is different from common stock: for bonds, the registration statement must indicate
a trust deed which is the legal contract that describes the form of the bond, the obligations of
the issuer, and the rights of the bondholders. Market participants frequently call this legal
contract the bond indenture, particularly in the United States and Canada.
The trustee is typically a financial institution with trust powers, such as the trust
department of a bank or a trust company.
The indenture is a written agreement, can be a document hundred pages, between the
corporation (the borrower) and a trust company it generally includes:
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Commercial paper is a short- term, unsecured promissory note issued in the public market or via a private
placement that represents a debt obligation of the issuer. Commercial paper is a valuable source of flexible,
readily available, and relatively low cost short- term financing. It is a source of funding for working capital and
seasonal demands for cash. Traditionally, only the largest, most stable companies issued commercial paper
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Trust
Corporation
Indenture company
A
Details of
The basic description The Sinking
the Call
terms of of property seniority of fund
protective provision
bonds used as the bonds agreement
covenants
security
A trust company:
In the event of default, the discretionary powers of the trustee increase considerably. The
trustee is responsible for calling meetings of bondholders to discuss the actions to take.
The trustee can also bring legal action against the issuer on behalf of the bondholders
a) Basic terms:
Bonds usually have a face value, called also the principal value and it is stated on the bond
certificate. In addition, the par value (initial accounting value) of a bond is the same as the
face value.Transactions between bond buyers and bond sellers determine the market value of
the bond.
b) Security:
Debt securities are classified according to the collateral protecting bondholders. Collateral is a
general term for the assets that are pledged as security for payment of debt.
c) Seniority:
In general terms, seniority indicates preference in position over other lenders and debts are
sometimes labeled “senior” or “junior” to indicate seniority. Some debts are subordinated. In
the event of default, holders of subordinated debt must give preference to others special
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creditors. Usually, this means that the subordinated lenders are paid off from cash flow and
asset sales only after the specified creditors have been compensated.
d) Protective covenants :
Bond covenants are legally enforceable rules that borrowers and lenders agree on at the
time of a new bond issue. An indenture will frequently include affirmative (or positive)
and negative covenants.
In other words, protective covenant is that part of the indenture or loan agreement that
limits certain actions of the borrowing company.
Covenants are clauses that specify the rights of the bondholders and any actions that the
issuer is obligated to perform or prohibited from performing. Protective covenants can be
classified in two types: negative covenants and positive covenants.
Limitations are placed on the amount of dividend a company The issuer may promise to comply with all laws and
may pay. regulations, maintain its current lines of business, insure and
maintain its assets, and pay taxes as they come due
The firm cannot pledge any of its assets to other lenders.
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The firm cannot merge with another firm.
The firm may not lease or sell its major assets without the
approval by the lender.
For example, a corporate bond issue may require a specified percentage of the bond’s
outstanding principal amount to be retired each year. The issuer may satisfy this requirement
in one of two ways. The most common approach is for the issuer to make a random call for
the specified percentage of bonds that must be retired and to pay the bondholders whose
bonds are called the sinking fund price. Alternatively, the issuer can deliver bonds to the
trustee with a total amount equal to the amount that must be retired. To do so, the issuer may
purchase the bonds in the open market. The sinking fund arrangement on a term maturity
structure accomplishes the same goal as the serial maturity structure—that is, both result in a
portion of the bond issue being paid off each year.
In other words; a sinking fund; is an account managed by the bond trustee for the purpose of
repaying the bonds. Typically, the company makes yearly payments to the trustee. The trustee
can purchase bonds in the market or can select bonds randomly using a lottery and purchase
them, generally at face value. ***
A call provision lets the company repurchase or call the entire bond issue at a
predetermined price over a specified period. Historically, the call price was set above the
bond’s face value of $1, 000. The difference between the call price and the face value is
the premium.
Call provisions are not usually operative during the first years of a bond’s life. For
example, a company may be prohibited from calling its bonds for the first 10 years. This
is refereed to as deferred call.
https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-
bulletins/investor-bulletins/what-are
2. Other debts :
Sovereign bonds denominated in local currency have different names in different countries.
For example, they are named US Treasuries in the United States, Japanese government bonds
(JGBs) in Japan, gilts in the United Kingdom, Bunds in Germany, and obligations
assimilables du Trésor (OATs) in France.
Names may also vary depending on the original maturity of the sovereign bond. For example,
US government bonds are named Treasury bills (T- bills) when the original maturity is one
year or shorter, Treasury notes (T- notes) when the original maturity is longer than one year
and up to 10 years, and Treasury bonds (T- bonds) when the original maturity is longer than
10 years.
Sovereign bonds are usually unsecured obligations of the sovereign issuer—that is, they are not
backed by collateral but by the taxing authority of the national government.
Highly rated sovereign bonds denominated in local currency are virtually free of credit risk. Credit
rating agencies assign ratings to sovereign bonds, and these ratings are called “sovereign ratings.”
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2.2. Non- Sovereign Bonds
Levels of government below the national level such as provinces, regions, states, and cities
issue bonds called non- sovereign government bonds or non- sovereign bonds. These bonds
are typically issued to finance public projects, such as schools, motorways, hospitals, bridges,
and airports. The sources for paying interest and repaying the principal include the taxing
authority of the local government, the cash flows of the project the bond issue is financing, or
special taxes and fees established specifically for making interest payments and principal
repayments. Non- sovereign bonds are typically not guaranteed by the national government
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