Business borrowing and Leasing

Outline

Domestic Bonds, Foreign Bonds and Euro Bonds

The Bond Contract Security and Seniority Repayment Provisions Debt Covenants Convertible Bonds and Warrants Innovation in the Bond Market

Outline (cont.)

Leases and Lease Types Accounting and Leasing Taxes, the IRS and Leases The Cash Flows from Leasing Lease or Buy? A Leasing Paradox Reasons for Leasing

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

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

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

Recovery Rates

81.6

67

46

32.4 31.2

18.7

0

10

20

30

40

50

60

70

80

90

Bank Debt Seniorsecured notes

Seniorunsecured

notes

Seniorsubordinated

notes

Subordinatednotes

Juniorsubordinated

notes

Ultimate Percentage Recovery Rates on Defaulting Debt (1988 – 2002)

Rec

over

y P

erce

ntag

e

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

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

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.

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

Event Risk: An ExampleOctober 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.

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

What is a Convertible Bond? How bond value varies with firm value at maturity

0

1

2

3

0 1 2 3 4 5

Value of firm ($ million)

default

bond repaid in full

Bond value ($ thousands)

What is a Convertible Bond? How conversion value at maturity varies with firm value

0

1

2

3

0 0.5 1 1.5 2 2.5 3 3.5 4 4.5

Value of firm ($ million)

Conversion value ($ thousands)

What is a Convertible Bond? How value of a convertible at maturity varies with firm value

0

1

2

3

0 1 2 3 4 5

Value of firm ($ million)

default

bond repaid in full

convert

Value of convertible ($ thousands)

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

Bond Innovations

Liquid yield option notes (LYONS) Puttable, callable, convertible zero coupon debt

Floating-price (death spiral) convertibles

Convertible debt where the bondholder can convert into a fixed value of shares

Asset backed securities 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)

Floating rate bonds that pay a higher rate of interest when other interest rates fall and a lower rate when other rates rise

Equity linked bonds Payments are linked to the performance of a stock market index

Pay-in-kind bonds (PIKs)Issuer can choose to make interest payments either in cash or in more bonds with an equivalent face value

Rate sensitive bonds Coupon rate changes as company's credit rating changes

Ratchet bonds Floating rate bonds whose coupons can only be reset downwards

Straight Bond vs. Callable Bond

Value ofstraight bond

25 50 75 100 125 150

25

50

75

100

bondValue of

Straight bond

bond callableat 100

Lease Terminology

Lease – contractual agreement for use of an asset in return for a series of payments

Lessee – user of an asset; makes payments Lessor – owner of the asset; receives

payments Direct lease – lessor is the manufacturer Captive finance company – subsidiaries that

lease products for the manufacturer

Types of Leases Operating lease

Shorter-term lease Lessor is responsible for insurance, taxes and maintenance Often cancelable

Financial lease (capital lease) Longer-term lease Lessee is responsible for insurance, taxes and maintenance Generally not cancelable Specific capital leases

Tax-oriented Leveraged Sale and leaseback

Lease Accounting

Leases are governed primarily by FASB 13 Financial leases are essentially treated as

debt financing Present value of lease payments must be

included on the balance sheet as a liability Same amount shown on the asset as the

“capitalized value of leased assets” Operating leases are still “off-balance-sheet”

and do not have any impact on the balance sheet itself

Criteria for a Capital Lease

If one of the following criteria is met, then the lease is considered a capital lease and must be shown on the balance sheet Lease transfers ownership by the end of the lease

term Lessee can purchase asset at below market price Lease term is for 75 percent or more of the life of

the asset Present value of lease payments is at least 90

percent of the fair market value at the start of the lease

Taxes

Lessee can deduct lease payments for income tax purposes Must be used for business purposes and not to avoid taxes Term of lease is less than 80 percent of the economic life

of the asset Should not include an option to acquire the asset at the

end of the lease at a below market price Lease payments should not start high and then drop

dramatically Must survive a profits test – lessor should earn a fair return Renewal options must be reasonable and consider fair

market value at the time of the renewal

Incremental Cash Flows

Cash Flows from the Lessee’s point of view After-tax lease payment (outflow)

Lease payment*(1 – T)

Lost depreciation tax shield (outflow) Depreciation * tax rate for each year

Initial cost of machine (inflow) Inflow because we save the cost of purchasing the asset

now

May have incremental maintenance, taxes or insurance

Example: Lease Cash Flows

ABC, Inc. needs some new equipment. The equipment would cost $100,000 if purchased and would be depreciated straight-line over 5 years. No salvage is expected. Alternatively, the company can lease the equipment for $25,000 per year. The marginal tax rate is 40%. What are the incremental cash flows?

After-tax lease payment = 25,000(1 - .4) = 15,000 (outflow years 1 - 5)

Lost depreciation tax shield = (100,000/5)*.4 = 8,000 (outflow years 1 – 5)

Cost of machine = 100,000 (inflow year 0)

Lease or Buy?

The company needs to determine whether it is better off borrowing the money and buying the asset or leasing

Compute the NPV of the incremental cash flows

Appropriate discount rate is the after-tax cost of debt since a lease is essentially the same risk as a company’s debt

Net Advantage to Leasing

The net advantage to leasing (NAL) is the same thing as the NPV of the incremental cash flows If NAL > 0, the firm should lease If NAL < 0, the firm should buy

Consider the previous example. Assume the firm’s cost of debt is 10%. After-tax cost of debt = 10(1 - .4) = 6% NAL = 3,116

Should the firm buy or lease?

Example

Do the calculations for a $30,000 car, 5-year loan at 7% with monthly payments and a $3000 down payment. The available lease is for 3 years and requires a $550 per month payment with a $1000 security deposit and $1000 other upfront costs.

Good Reasons for Leasing

Taxes may be reduced May reduce some uncertainty May have lower transaction costs May require fewer restrictive covenants May encumber fewer assets than secured

borrowing

Dubious Reasons for Leasing

Balance sheet, especially leverage ratios, may look better if the lease does not have to be accounted for on the balance sheet

100% financing – except that leases normally do require either a down-payment or security deposit

Low cost – some may try to compare the “implied” rate of interest to other market rates, but this is not directly comparable

Quick Quiz

What is the difference between a lessee and a lessor?

What is the difference between an operating lease and a capital lease?

What are the requirements for a lease to be tax deductible?

What are typical incremental cash flows and how do you determine the net advantage to leasing?

What are some good reasons for leasing? What are some dubious reasons for leasing?