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Slide 1: Business borrowing and Leasing
Slide 2: Outline              Domestic Bonds, Foreign Bonds and Euro Bonds The Bond Contract Security and Seniority Repayment Provisions Debt Covenants Convertible Bonds and Warrants Private Placements and Project Finance Innovation in the Bond Market What is a Lease? Why Lease? Operating Leases Valuing Financial Leases When Do Financial Leases Pay?
Slide 3: Bond Terminology  Foreign bonds - bonds that are sold to local investors in another country's bond market Yankee bond- a bond sold publicly by a foreign company in the United States Samurai - a bond sold by a foreign firm in Japan Eurobond market - when European and American multinationals are forced to tap into international markets for capital   
Slide 4: Bond Terminology  Indenture or trust deed - the bond agreement between the borrower and a trust company Registered bond - a bond in which the Company's records show ownership and interest and principal are paid directly to each owner Bearer bonds - the bond holder must send in coupons to claim interest and must send a certificate to claim the final payment of principal Accrued interest - the amount of accumulated interest since the last coupon payment   
Slide 5: Bond Contract Trustee Summary of terms of 8.25% sinking fund debenture 2022 issued by J.C. Penney Rights of default Registered Denomination Amount issued Issue Date Offered Interest Seniority Bank of America National Trust and Savings Association The trustee or 25% of debenture holders may declare the principle due and payable Fully registered $1,000 $250 million 26-Aug-1992 Issued at a price of 99.489% plus accrued interest (proceeds to company 98.614%) through First Boston Corporation At a rate of 8.25% per annum, payable February 15 and August 15 Ranks pari passu with other unsecured unsubordinated debt Not secured. Company will not permit to have any lien on its property or assets without equally and ratably securing the debt securities 15-Aug-2022 Annually from August 15, 2003, sufficient to redeem $12.5 million principal amount, plus an optional sinking fund of up to $25 million At whole or in part on or after August 15, 2002, at the option of the company with at least 30 days, but not more than 60 days notice to each August 14 as follows: schedule inserted here B Security Maturity Sinking fund Callable Moody's rating
Slide 6: Bond Terminology  Debentures - long-term unsecured issues on debt Mortgage bonds - long-term secured debt often containing a claim against a specific building or property Asset-backed securities - the sale of cash flows derived directly from a specific set of bundled assets  
Slide 7: Recovery Rates Ultimate Percentage Recovery Rates on Defaulting Debt (1988 – 2002) 90 Recovery Percentage 80 70 60 50 40 30 20 10 0 81.6 67 46 32.4 31.2 18.7 Bank Debt Senior secured notes Senior unsecured notes Senior Subordinated Junior subordinated notes subordinated notes notes
Slide 8: Bond Terminology  Sinking fund - a fund established to retired debt before maturity Callable bond - a bond that may be repurchased by a the firm before maturity at a specified call price Defeasance - a method of retiring corporate debt involving the creation of a trust funded with treasury bonds  
Slide 9: Bond Terminology  Restrictive covenants - Limitations set by bondholders on the actions of the Corporation Negative Pledge Clause - the processing of giving unsecured debentures equal protection and when assets are mortgaged Poison Put - a clause that obliges the borrower to repay the bond if a large quantity of stock is bought by single investor, which causes the firms bonds to beat down rated  
Slide 10: Bond Terminology  Pay in kind (PIK) - a bond that makes regular interest payments, but in the early years of the bonds life the issuer can choose to pay interest in the form of either cash or more bonds with an equivalent face value Puttable bond – A provision that allows the bondholder to demand immediate payment. This is the central feature in loan guarantees issued by the government. 
Slide 11: Covenants      Debt ratios:  Senior debt limits senior borrowing  Junior debt limits senior & junior borrowing Security:  Negative pledge Dividends Event risk Positive covenants:  Working capital  Net worth
Slide 12: Event Risk: An Example October 1993 Marriott spun off its hotel management business worth 80% of its value. Before the spin-off, Marriott’s long-term book debt ratio was 2891/3644 = 79%. Almost all the debt remained with the parent (renamed Host Marriott), whose debt ratio therefore rose to 93%. Marriott’s stock price rose 13.8% and its bond prices declined by up to 30%. Bondholders sued and Marriott modified its spin-off plan.
Slide 13: What is a Convertible Bond?  Amazon      4.75% Convertible 2009 Convertible into 6.41 shares Conversion ratio 6.41 Conversion price = 1000/6.41 = $156.05 Market price of shares = $120  Lower bound of value   Bond value Conversion value = 6.41 x 120 = $768.00
Slide 14: What is a Convertible Bond?  How bond value varies with firm value at maturity Bond value ($ thousands) 3 2 bond repaid in full 1 default 0 0 1 2 3 4 5 Value of firm ($ million)
Slide 15: What is a Convertible Bond?  How conversion value at maturity varies with firm value Conversion value ($ thousands) 3 2 1 0 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 Value of firm ($ million)
Slide 16: What is a Convertible Bond?  3 How value of a convertible at maturity varies with firm value Value of convertible ($ thousands) 2 convert bond repaid in full 1 default 0 0 1 2 3 4 5 Value of firm ($ million)
Slide 17: Bond Warrant Package  Bond and Option      Warrants are usually issued privately Warrants can be detached Warrants are exercised for cash A package of bonds and warrants may be taxed differently Warrants may be issued on their own
Slide 18: Project Finance 1. Project is set up as a separate company. 2. A major proportion of equity is held by project manager or contractor, so provision of finance and management are linked. 3. The company is highly levered.
Slide 19: Parties In Project Finance Contractor Supplier(s) Equity investors Government Project company Equity sponsor Lenders Purchaser(s)
Slide 20: Risk Allocation Risk Completion/ continuing management Construction cost Raw materials Revenues Shifted to: Sponsor Contract Management contract/ completion gtees / working capital maintenance Turnkey contract/ fixed price/ delay penalties Long-term contract/ indexed prices/ supply or pay Long-term contract/ indexed to costs/ take or pay/ throughput agreements/ tolling contract Concession agreement/ provision of supporting infrastructure Gtees or comfort letters/ hard currency paid to offshore escrow account Contractor Supplier(s) Purchaser(s) Concession/regulation Government Currency convertibility Government
Slide 21: Bond Innovations Liquid yield option notes (LYONS) Puttable, callable, convertible zero coupon debt Floating-price (death spiral) convertibles Asset backed securities Convertible debt where the bondholder can convert into a fixed value of shares Many small loans are packaged together and resold as a bond Catastrophe (CAT) bonds Payments are reduced in the event of a specific natural disaster Reverse floaters (yield curve notes) Equity linked bonds Floating rate bonds that pay a higher rate of interest when other interest rates fall and a lower rate when other rates rise Payments are linked to the performance of a stock market index Issuer can choose to make interest payments either in cash or in more Pay-in-kind bonds (PIKs) bonds with an equivalent face value Rate sensitive bonds Ratchet bonds Coupon rate changes as company's credit rating changes Floating rate bonds whose coupons can only be reset downwards
Slide 22: Straight Bond vs. Callable Bond Value of bond 100 75 bond callable at 100 Straight bond 50 25 Value of straight bond 25 50 75 100 125 150
Slide 23: Lease Terms Lease = A rental agreement that extends for a year or more and involves a series of fixed payments   Operating Leases Financial Leases     Rental Lease Net lease Direct lease Leveraged lease
Slide 24: Why Lease?  Sensible Reasons for Leasing       Short-term leases are convenient Cancellation options are valuable Maintenance is provided Standardization leads to low costs Tax shields can be used Avoiding the alternative minimum tax
Slide 25: Why Lease?  Dubious Reasons for Leasing     Leasing avoids capital expenditure controls Leasing preserves capital Leases may be off balance sheet financing Leasing effects book income
Slide 26: AMT Income Tax Rate Tax Regular Tax 10 0.35 3.5 Alternative Minimum Tax 10 + 9 = 19 0.2 3.8
Slide 27: Operating Lease Example Acme Limo has a client who will sign a lease for for 7 years, with lease payments due at the start of each year. The following table shows the NPV of the limo if Acme purchases the new limo for $75,000 and leases it our for 7 years.
Slide 28: Operating Lease Example - cont Acme Limo has a client who will sign a lease for for 7 years, with lease payments due at the start of each year. The following table shows the NPV of the limo if Acme purchases the new limo for $75,000 and leases it our for 7 years. 0 Initial cost Maintenance, insurance, selling, and administrative costs Tax shield on costs Depreciation tax shield Total NPV @ 7% = - $98.15 Break even rent(level) Tax Break even rent after-tax NPV @ 7% = - $98.15 -75 -12 4.2 0 -82.8 1 -12 4.2 5.25 -2.55 2 -12 4.2 8.4 0.6 Year 3 -12 4.2 5.04 -2.76 4 -12 4.2 3.02 -4.78 5 -12 4.2 3.02 -4.78 6 -12 4.2 1.51 -6.29 26.18 -9.16 17.02 26.18 -9.16 17.02 26.18 -9.16 17.02 26.18 -9.16 17.02 26.18 -9.16 17.02 26.18 -9.16 17.02 26.18 -9.16 17.02
Slide 29: Financial Leases Example Greymare Bus Lines is considering a lease. Your operating manager wants to buy a new bus for $100,000. The bus has an 8 year life. The Bus Saleswoman says she will lease Greymare the bus for 8 years at $16,900 per year, but Greymare assumes all operating and maintenance costs. Should Greymare Buy or Lease the bus?
Slide 30: Financial Leases Example - cont Greymare Bus Lines is considering a lease. Your operating manager wants to buy a new bus for $100,000. The bus has an 8 year life. The Bus Saleswoman says she will lease Greymare the bus for 8 years at $16,900 per year, but Greymare assumes all operating and maintenance costs. Should Greymare Buy or Lease the bus? Cash flow consequences of the lease contract to Greymare 0 Cost of new bus Lost Depr tax shield Lease payment Tax shield of lease Cash flow of lease 100.00 (16.90) 5.92 89.02 (7.00) (16.90) 5.92 (17.98) (11.20) (16.90) 5.92 (22.18) (6.72) (16.90) 5.92 (17.70) (4.03) (16.90) 5.92 (15.01) (4.03) (16.90) 5.92 (15.01) (2.02) (16.90) 5.92 (13.00) (16.90) 5.92 (10.98) 1 2 Year 3 4 5 6 7
Slide 31: Financial Leases Example - cont Greymare Bus Lines is considering a lease. Your operating manager wants to buy a new bus for $100,000. The bus has an 8 year life. The Bus Saleswoman says she will lease Greymare the bus for 8 years at $16,900 per year, but Greymare assumes all operating and maintenance costs. Should Greymare Buy or Lease the bus? Cash flow consequences of the lease contract to Greymare : •Greymare saves the $100,000 cost of the bus •Loss of depreciation benefit of owning the bus •$16,900 lease payment is due at the start of each year •Lease payments are tax deductible
Slide 32: Financial Leases Example - cont Greymare Bus Lines Balance Sheet without lease Greymare Bus Lines (figures in $1,000s) Bus 10 100 Loan secured by bus All other assets 1000 450 Other loans 550 Equity Toital Assets 1100 1100 Total liabilities Equivalent lease balance sheet Greymare Bus Lines (figures in $1,000s) Bus 10 100 Financial lease All other assets 1000 450 Other loans 550 Equity Toital Assets 1100 1100 Total liabilities
Slide 33: Financial Leases Example - cont Greymare Bus Lines can borrow at 10%, thus the value of the lease should be discounted at 6.5% or .10 x (1-.35). The result will tell us if Greymare should lease or buy the bus.
Slide 34: Financial Leases Example - cont Greymare Bus Lines can borrow at 10%, thus the value of the lease should be discounted at 6.5% or .10 x (1-.35). The result will tell us if Greymare should lease or buy the bus. 17.99 22.19 17.71 15.02 NPV lease = 89.02 2 3 1.065 (1.065) (1.065) (1.065) 4 15.02 13.00 10.98 5 6 7 (1.065) (1.065) (1.065) = −.70 or - $700
Slide 35: Financial Leases Example - cont Greymare Bus Lines lease cash flows can also be thought of as loan equivalent cash flows.
Slide 36: Financial Leases Example - cont Greymare Bus Lines lease cash flows can also be thought of as loan equivalent cash flows. 0 Amount borrowed at year end Interest paid @ 10% Tax shield @ 35% Interest paid after tax Principal repaid Net cash flow of equivalent loan 89.72 1 77.56 -8.97 3.14 -5.83 -12.15 -17.99 2 60.42 -7.76 2.71 -5.04 -17.14 -22.19 Year 3 46.64 -6.04 2.11 -3.93 -13.78 -17.71 4 34.66 -4.66 1.63 -3.03 -11.99 -15.02 5 21.89 -3.47 1.21 -2.25 -12.76 -15.02 6 10.31 -2.19 0.77 -1.42 -11.58 -13.00 7 0.00 -1.03 0.36 -0.67 -10.31 -10.98 89.72
Slide 37: Financial Leases Example - cont The Greymare Bus Lines lease cash flows can also be treated as a favorable financing alternative and valued using APV. APV = NPV of project NPV of lease APV = -5,000 + 8,000 = $3,000
Slide 38: Financial Lease Benefits Value of lease to lessor = 17.99 22.19 17.71 15.02 13 10.98 + + + + + 1.065 (1.065) 2 (1.065) 3 (1.065) 4 (1.065) 5 (1.065) 6 = +.70 or $700 = -89.02 + Value of lease = 16.9 = +100 − ∑ t t =0 (1.10) = +100 − 99.18 = +.82 or $820 7