TYPES OF LONG-TERM DEBT AND THEIR USEFULNESS

All companies incur debt; the amount of debt will largely depend on the company`s available collateral. For long-term debt financing, sources include mortgages and bonds. Either instrument may be appropriate, depending on a company`s circumstances. To determine which instrument will serve your company`s needs best, you will need to know the characteristics, advantages, and disadvantages of these long-term debt sources.

Mortgages
Mortgages are notes payable that have real assets as collateral and request periodic payments. Mortgages can be issued to finance the purchase of assets, construction of plant, and modernization of facilities. The bank requires that the value of the property exceed its mortgage. Most mortgage loans are made for between 70% and 90% on the collateral. Mortgages may be obtained from a bank, a company, or another financial institution. It is easier to obtain loans for multiple-use real assets than for single-use real assets.

There are two types of mortgages: a senior mortgage, which has first claim on assets and earnings, and a junior mortgage, which has a subordinate lien.

A mortgage may have a closed-end provision that prevents you from issuing-additional debt of the same priority against the same property. If the mortgage is open-ended, you can issue additional first-mortgage bonds against the property.
Mortgages have a number of advantages, including favorable interest rates, fewer financing restrictions, extended maturity date for loan repayment, and relatively easy availability.

Bonds

Long-term debt principally takes the form of bonds payable and loans payable. A bond is a certificate indication that you have borrowed a given sum of money and agree to repay it. A written agreement, called an indenture, describes the features of the bond issue (e.g., payment dates, call and conversion privileges (if any), and restrictions). The indenture is a contract between your company, the bondholder, and the trustee.The trustee makes sure that you meet the terms of the bond contract. In many instances, the trustee is the trust department of a commercial bank. Although the trustee is an agent for the bondholder, it is selected by your company prior to the issuance of the bonds. The indenture provides for certain restrictions on you such as a limitation on dividends and minimum working capital requirements. If a provision of the indenture is violated, the bonds are in default. The indenture may also have a negative pledge clause, which precludes the issuance of new debt taking priority over existing debt in the event of liquidation. The clause can apply to assets currently held as well as to assets that may be purchased in the future.

Computing Interest
Bonds usually come in $1,000 denominations. Many bonds have maturities of 10 to 30 years. The interest payment to the bondholder is called nominal interest (coupon interest, stated interest), which is the interest on the face value (maturity value, par) of the bond. Although the interest rate is stated on an annual basis, interest on a bond is typically paid semiannually. Interest expense is tax-deductible.

Example 17-1.

You issue a 15%, 10-year bond. The tax rate is 34%. The annual after-tax cost of the debt is 9.9% (15%x 66%).

Example 17-2.

You issue a $100,000, 8%, 10-year bond. The semiannual interest payment is $4,000 ($ 100,000 x 8% x 6/12). With a 34% tax rate, the after-tax semiannual interest is $2,640 ($4,000 x 66%).

A bond sold at face value is said to be sold at 100%. If a bond is sold below its face value (less than 100%) it is issued at a discount. If a bond is sold above face value, (more than 100%) it is sold at a premium.

Why would your company`s bond be sold at a discount or a premium? A bond may be sold at a discount when the interest rate on the bond is below the prevailing market interest rate for that type of security. It may also be issued at a discount if your company is risky, or there is a very long maturity period. A bond is issued at a premium when the opposite market conditions exist.

Example 17-3.

You issue a $100,000, 14%, 20-year bond at 94%. The maturity value of the bond is $100,000. The annual cash interest payment is $14,000 (14% x $100,000). The proceeds received for the issuance of the bond equal $94,000 ($100,000 x 94%). The amount of the discount is $6,000 ($100,000 - $94,000). The annual discount amortization is $300 ($6,000/20).
The yield on a bond is the effective (real) interest rate you incur. The two methods of computing yield are the simple yield and the yield-to-maturity.

The price of a bond depends on several factors such as maturity date, interest rate, and collateral. Bond prices and market interest rates are inversely related. For example, as market interest rates increase, the price of the existing bond falls because investors can invest in new bonds paying higher interest rates.

Types of Bonds
The various types of bonds your company may issue are as follows:

1. Debentures. Because debentures are unsecured (no collateral) debt, they can be issued only by large, financially strong companies with excellent credit ratings.

2. Subordinated debentures. The claims of the holders of these bonds are subordinated to those of senior creditors. Debt with a prior claim over the subordinated debentures is set forth in the bond indenture. Typically, in liquidation, subordinated debentures come after short-term debt.

3. Mortgage bonds. These are bonds secured by real assets. The first mortgage claim must be met before a distribution is made to a second mortgage claim. There may be several mortgages for the same property (e.g., building).

4. Collateral trust bonds. The collateral for these bonds is your company`s security investments in other companies (bonds or stocks), which are given to a trustee for safekeeping.

5. Convertible bonds. These may be converted to stock at a later date, based on a specified conversion ratio. The conversion ratio equals the par value of the convertible security divided by the conversion price. Convertible bonds are typically issued in the form of subordinated debentures. Convertible bonds are more marketable and are typically issued at a lower interest rate than regular bonds because they offer the conversion right to common stock. Of course, if bonds are converted to stock, debt repayment is not involved. A convertible bond is a quasi-equity security because its market value is tied to the value of the shares of stock into which the bond can be converted.

6. Income bonds. These bonds pay interest only if there is a profit. However, because it accumulates regardless of earnings, the interest, if bypassed, must be paid in a later year when adequate earnings exist.

7. Guaranteed bonds. These are debt issued by one party with payment guaranteed by another.

8. Serial bonds. A portion of these bonds comes due each year. At the time serial bonds are issued, a schedule shows the yields, interest rates, and prices for each maturity. The interest rate on the shorter maturities is lower than the interest rate on the longer maturities because less uncertainty exists regarding the future.

9. Deep discount bonds. These bonds have very low interest rates and thus are issued at substantial discounts. The return to the holder comes primarily from appreciation in price rather than from interest payments.

10. Zero coupon bonds. These bonds do not provide for interest. The return to the holder is in the form of appreciation in price.

11. Variable-rate bonds. The interest rates on the bonds are adjusted periodically to changes in money market conditions. These bonds are popular when there is uncertainty about future interest rates and inflation.

12. Junk bonds. These bonds are high risk and therefore high-yield securities that are normally issued when the debt ratio is very high. Thus, the bondholders have as much risk as the holders of equity securities. Such bonds are not highly rated by credit evaluation companies. Junk bonds have become accepted because of the tax deductibility of the interest paid.

13. Inflation-linked bonds. These bonds have coupons (and the principal amount as well) that are adjusted according to the rate of inflation. The U.S. Treasury Inflation Protection Securities (TIPS) is an example.

A summary of the characteristics and priority claims associated with bonds appears in Table 17-1.

Bond Ratings
Financial advisory services (e.g., Standard and Poor`s, Moody`s) rate publicly traded bonds according to risk in terms of the receipt of principal and interest. An inverse relationship exists between the quality of a bond issue and its yield. That is, low-quality bonds will have a higher yield than high quality bonds. Hence, a risk-return trade-off exists for the bondholder. Bond ratings are important because they influence marketability and the cost associated with the bond issue.

The Advantages and Disadvantages of Debt Financing
You will need to determine whether or not your company should issue long-term debt.
The advantages of issuing long-term debt include the following:

• Interest is tax-deductible, while dividends are not.
• Bondholders do not participate in superior earnings of your firm.
• The debt is repaid in cheaper dollars during inflation.
• There is no dilution of company control.
• Financing flexibility can be achieved by including a call provision in the bond indenture. A call provision allows your company to pay the debt before the expiration date of the bond.
• It may safeguard your company`s future financial stability (e.g., in times of tight money markets when short-term loans are not available.)

Table 17-1. Summary of Characteristics and Priority Claims of Bonds

The following disadvantages may apply to issuing long-term debt:
• Interest charges must be met regardless of your company`s earnings.
• Debt must be repaid at maturity.
• Higher debt implies greater financial risk, which may increase the cost of financing.
• Indenture provisions may place stringent restrictions on your company.
• Overcommitments may arise because of forecasting errors.

Should you buy a bond? To investors, bonds have the advantages of a fixed interest payment each year and of greater safety than equity securities because bondholders have a priority claim in the event of corporate bankruptcy. To investors, bonds have the disadvantages of not participating in incremental earnings and of no voting rights.

How does issuing debt stack up against equity securities to your company? The advantages of issuing debt rather than equity securities are as follows: interest is tax deductible, whereas dividends are not; during inflation, the payback will be in cheaper dollars; no dilution of voting control occurs; and flexibility in financing can be achieved by including a call provision in the bond indenture. The disadvantages of debt incurrence relative to issuing equity securities are that fixed interest charges and principal repayment must be met irrespective of your firm`s cash flow position, and stringent indenture restrictions often exist.
The proper mixture of long-term debt to equity depends on company organization, credit availability, and the after-tax cost of financing. Where a high degree of debt already exists, you should take steps to minimize other corporate risks.

When should long-term debt be issued? Debt financing is more appropriate at these times:

1. The interest rate on debt is less than the rate of return earned on the money borrowed. By using other people`s money (OPM), the after-tax profit of the company will increase. Stockholders have made an extra profit with no extra investment!

2. Stability in revenue and earnings exists so that the company will be able to meet interest and principal payments in both good and bad years. However, cyclical factors should not scare a company away from having any debt. The important thing is to accumulate no more interest and principal repayment obligations than can reasonably be satisfied in bad times as well as good.

3. There is a satisfactory profit margin so that earnings exist to meet debt obligations.

4. There is a good liquidity and cash flowposition.

5. The debt/equity ratio is low so that the company can handle additional obligations.

6. Stock prices are currently depressed so that it does not pay to issue common stock at the present time.

7. Control considerations are a primary factor so that if common stock was issued, greater control might fall in the wrong hands.

8. Inflation is expected so that debt can be paid back in cheaper dollars.

9. Bond indenture restrictions are not burdensome.

Tip: If your company is experiencing financial difficulties, it may wish to refinance short-term debt on a long-term basis (e.g., by extending the maturity dates of existing loans). This may alleviate current liquidity and cash flow problems.

As the default risk of your company becomes higher, so will the interest rate to compensate for the greater risk.

Recommendation: When a high degree of debt (financial leverage) exists, try to reduce other risks (e.g., product risk) so that total corporate risk is controlled.

Bond Refunding
Bonds may be refunded before maturity through either the issuance of a serial bond or the exercise of a call privilege on a straight bond. The issuance of serial bonds allows you to refund the debt over the life of the issue. A call feature in a bond enables you to retire it before the expiration date, The call feature is included in many corporate bond issues.

When future interest rates are expected to drop, a call provision is recommended. Such a provision enables your firm to buy back the higher interest bond and issue a lower-interest one. The timing for the refunding depends on expected future interest rates. A call price is typically set in excess of the face value of the bond. The resulting call premium equals the difference between the call price and the maturity value. Your company pays the premium to the bondholder in order to acquire the outstanding bonds prior to the maturity date. The call premium is usually equal to one year`s interest if the bond is called in the first year, and it declines at a constant rate each year thereafter. Also involved in selling a new issue are flotation costs (e.g., brokerage commissions, printing costs).

A bond with a call provision typically will be issued at an interest rate higher than one without the call provision. The investor prefers not to face a situation where your company can buy back the bond at its option prior to maturity. The investor would obviously desire to hold onto a high-interest bond when prevailing interest rates are low.

Example 17-4.

A $100,000, 8% 10-year bond is issued at 94%. The call price is 103%. Three years after the issue, the bond is called, The call premium is equal to
Call price $103,000
Less: Face value of bond (100,000)
Call premium $ 3,000

The desirability of refunding a bond requires present value analysis, which was discussed in Chapter 12.

Example 17-5.

Your company has a $20 million, 10% bond issue outstanding that has 10 years to maturity. The call premium is 7% of face value. New 10-year bonds in the amount of $20 million can be issued at an 8% interest rate. Flotation costs of the new issue are $600,000.

Refunding of the original bond issue should occur as shown below.

Old interest payments ($20,000,000 x 0. 10) $2,000,000
Less: New interest payments ($20,000,000 x 0.08) (1,600,000)
Annual savings $ 400,000
Call premium ($20,000,000 x 0.07) $1,400,000
Flotation cost 600,000
Total cost $2,000,000

Year Calculation
Present Value
0 -$2,000,000 x 1 -$2,000,000
1-10 $ 400,000 x 6.71a 2,684,000
Net present value $ 684,000
a 6.71 = T4 (8%, 10 years) from Table 11-4

Sinking fund requirements may exist in a bond issue. With a sinking fund, you put aside money to buy and retire part of a bond issue each year. Usually, there is a mandatory fixed amount that must be retired, but occasionally the retirement may relate to your company`s sales or profit for the current year. If a sinking fund payment is not made, the bond issue may be in default.

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