SIXTEEN

CHAPTER

Long-term Debt and

Lease Financing

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Figure 16-1
Foundations of Financial
Management

Interest coverage - Canadian non-financial corporations

PPT 16-1

Block
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Figure 16-2
Priority of claims
Foundations of Financial PPT 16-2
Management

Secured debt
Senior First claim on assets pledged
Junior Second claim on assets pledged

Remaining assets are distributed below.

Unsecured debt
(debentures)

Senior
Subordinated
Subordinated debenture holders will not receive
payment unless designated senior debenture
holders are paid in full.
Lower priority
of claims

Block Preferred stock

Hirt Common stock
Short
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Table 16-1
Corporate bond record (partial)
Foundations of Financial
Management
PPT 16-3

Air Canada

5.75% Subordinated Perpetual Bonds 1986

Issued: SwF200,000,000 Jan. 1, 1986 Euro
O/S: SwF200,000,000 Dec. 31, 1997
Interest: 5.75% (A) Feb. 7
Redemption: Redeem. on Feb. 7, 1999 at SwF101.50 and at SwF102.00 every fifth year
thereafter on the interest payment date
Underwriter: Swiss Bank Corporation

5.25% Subordinated Perpetual Bonds 1986

Issued: SwF300,000,000 Jan. 1, 1986 Euro
O/S: SwF300,000,000 Dec. 31, 1997
interest 6.25% (A) Jan.22
Redemption: Redeem. On Jan.22, 2001 and every fifth year thereafter at SwF 102.00
Block Underwriter: Swiss Bank Corporation
Hirt
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Figure 16-3
Long-term yields on corporate debt
Foundations of Financial
Management
PPT 16-4

20

18

16

14

12
Percent

10

Block 0
Hirt
1979 1982 1985 1988 1991 1994 1997
Source : Bank of Ca nada Re view, March 1999, F1 se rie s.
Short
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Table 16-4
Outstanding debt issues, April 30, 1999
Foundations of Financial PPT 16-5
Management

Issuer Coupon Maturity Date Price Yield to Maturity

Government of Canada 8.750 Dec 01/05 119.96 5.13
Government of Canada 9.500 Jun 01/10 135.45 5.24
Government of Canada 8.000 Jun 01/27 136.58 5.44
AA rating
Canadian Utilities 8.430 Jun 01/05 115.16 5.46
Canadian Utilities 11.400 Aug 15/10 146.06 5.78
Nav Canada 6.600 Dec 01/06 106.24 5.58
Nav Canada 7.400 Jun 01/27 119.78 5.94
A rating
Bombardier 6.400 Dec 22/06 103.91 5.76
Canadian Tire 5.650 Jan 16/06 99.85 5.68
Canadian Tire 12.100 May 10/10 150.09 5.86
BBB rating
Domtar 10.350 Sep 01/06 106.97 7.50
Domtar 10.850 Aug 15/17 125.77 8.12
Talisman 9.800 Dec 22/04 113.57 6.85
Cdn Occidental Petroleum 6.300 Jun 02/08 94.39 7.15
BB rating
Air Canada 6.750 Feb 02/04 100.50 6.62
Block B rating
Hirt Rogers Cable 8.750 July 17/07 104.00 8.07
Short Source: www.canpx.ca
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Summary of bond refunding decision
Step C—Net Present Value
Foundations of Financial PPT 16-6
Management

Outflows (Costs) Inflows (Benefits)

1. Net cost of call 4. Cost savings in lower
premium . . . $1,000,000 interest rates $1,720,488
2. Net cost of borrowing
expense on new issue 152,493
3. Duplicate interest
during overlap
period . . . 20,000

Present value of outflows $1,172,493 Present value of inflows $1,720,488

Net present value . . . . $ 547,995

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Table 16-5
Examples of Eurobonds
Foundations of Financial PPT 16-7
Management

Amount
Outstanding Currency
Rating Coupon Maturity ($ millions) Denomination*

Merrill Lynch & Co., Inc. † A1 0.00% 2000 100.0 DM

Nippon Telephone & Telegraph Aaa 10.25% 2001 200.0 U.S.$
Petro-Canada Baa1 9.25% 2021 300.0 U.S.$
Procter & Gamble Co. Aa2 10.88% 2001 200.0 C$
Sony Corporation Aa3 1.40% 2005 300.0 Yen
Telecom Corporation Aa1 7.50% 2003 100.0 N Z$

*DM is Deutsche mark, N Z $ is New Zealand dollar, and C$ is Canadian dollar.

Block †These are zero-coupon rate bonds.
Hirt Source: Moody’s Bond Record, July 1998..
Short
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Table 16-8
Net present value of borrow-purchase
Foundations of Financial
Management
PPT 16-8

(1) (2) (3) (4) (5)

Year PV of Interest Aftertax
CCA Tax Cost of Present
Shield Payment Shield (2)-(3) Value at 6%

1 . .. . . . . . . . . . ($1,319) $500 x .4 $(1,119) $(1,056)

2 . .. . . . . . . . . . ($1,319) $418 x .4 (1,152) (1,025)

3 . .. . . . . . . . . . ($1,319) $328 x .4 (1,188) (997)

4 . .. . . . . . . . . . ($1,319) $229 x .4 (1,227) (972)

5 . .. . . . . . . . . . ($1,319) $120 x .4 (1,271) (950)

(5,000)

Block Or Cost of asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,000)

Hirt PV of CCA shield . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,495
PV of borrowing alternative . . . . . . . . . . . . . . . . . . . ($3,505)
Short
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Table 16-9
Net present value of operating lease outflows
Foundations of Financial
Management
PPT 16-9

Year Payment Tax Aftertax Cost Present

Shield of Leasing Value at 6%
0 . . . . . . . . $1,250 $ 0 $1,250 $1,250
1........ 1,250 500 750 708
2........ 1,800 500 1,300 1,157
3........ 1,800 720 1,080 907
4........ 1,800 720 1,080 855
5........ 0 720 (720) (538)
$4,339

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Chapter 16 - Outline
Foundations of Financial
Management

LT 16-1

• Bond Terminology
• More Bond Terminology
• Priority of Claims
• Methods of Repayment
• 3 Types of Bond Yields
• Other Forms of Bond Financing
• Advantages and Disadvantages of Debt
• 2 Types of Leases
• Advantages of Leasing
• Lease vs. Borrow to Purchase (See PPT 16-8 and 16-9)
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Bond Terminology
Foundations of Financial
Management

LT 16-2
Par Value:
principal or face value (usually $1,000)
Coupon Rate:
actual or stated interest rate
Maturity Date:
date when repayment of principal is due
Indenture:
legal document detailing the corporation’s obligations
Secured Debt:
where specific assets are pledged in the event of default
Debenture:
Block
Hirt a L/T unsecured corporate bond
Short
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Priority of Claims
Foundations of Financial
Management

LT 16-3

Secured Debt (first priority)

↓
Unsecured Debt (or Debenture)
↓
Preferred Shareholders
↓
Common Shareholders (last to receive any money)

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Methods of Repayment
Foundations of Financial
Management

LT 16-4
Principal at maturity:
– lump-sum payment when bond is due
Serial payments:
– bond is paid off in instalments
Sinking fund:
– corporation contributes regularly to a trust fund used
to buy back bonds
Conversion:
– bond can be converted into shares of common stock at
the option of the bondholder
Call feature:
Block
Hirt
– corporation can redeem bonds early by paying a
Short premium over par value
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3 Types of Bond Yields

Foundations of Financial
Management

LT 16-5

Nominal Yield (or Coupon Rate):

– stated yield
Current Yield:
– yield in terms of the current price of the bond
Yield-to-Maturity (YTM):
– interest rate that equates the future (expected) interest
payments and payment at maturity to the current
market price of the bond
– affected by current market interest rates
• If rates ↑,
↑ YTM ↑, bond price ↓
Block – and bond rating
Hirt
Short • If rating high (low risk), YTM ↓
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Other Forms of Bond Financing

Foundations of Financial
Management

LT 16-6

Zero-Coupon Bond / Strip Bond:

– do not pay interest
– are issued at a deep discount from face value
Floating Rate Bond:
– interest rate paid on the bond changes with market
conditions
Real Return Bond
– principal adjusted for inflation
Revenue Bond
– security based upon cash flow
Block
Hirt
Eurobond:
Short – bond issued in another country
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Foundations of Financial

Advantages and Disadvantages of Debt

Management

LT 16-7

Advantages of Debt:
– interest payments are tax deductible to a firm
– financial obligation is fixed
– wise use of debt may lower a firm’s weighted average
cost of capital (WACC)

Disadvantages of Debt:
– interest and principal must always be met when due,
regardless of a firm’s financial position
– agreements may restrict financial management in firm
Block – poor use of debt may lower a firm’s stock price
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2 Types of Leases
Foundations of Financial
Management

LT 16-8

Capital Lease (or Financing Lease):

– equivalent to a purchase
– must be shown on a firm’s balance sheet
– ex., oil drilling equipment and airplanes

Operating Lease:
– a conventional rental agreement
– firm doesn’t expect to own property
– is not shown on a firm’s balance sheet
– ex., automobiles and office equipment
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Advantages of Leasing
Foundations of Financial
Management

LT 16-9

• Loan may be more expensive / refused

• May be no down payment on lease, usually down payment
with loan
• May have fewer restrictions than loan
• Fixed payment on lease, but loan interest may vary with
prime
• Lease from manufacturer may have attractive terms (ex:
lower interest cost) or provide specialist expertise
• May restrict creditor claims in bankruptcy
• Equipment may have rapid obsolescence (ex: computers)
Block • May be tax advantages
Hirt
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