Tài chính doanh nghiệp - Chapter 11: Sources of long - Term finance: debt

Chapter 11Sources of Long-Term Finance: DebtLearning ObjectivesExplain the general characteristics of long-term debt.Identify and explain the features of the main types of long-term loans.Identify and explain the features of the main types of marketable long-term debt securities.Learning Objectives (cont.)Identify and explain the main features of project finance.Understand the role of interest rate swaps in managing debt.Identify and explain the features of securities that have the characteristics of both debt and equity.Introduction‘Long-term debt’ is debt with a term to maturity greater than 12 months.Long-term debt typically comprises more than half of the total debt of listed Australian companies.Two broad types of long-term debt:Loans from banks and other financial intermediaries.Funds raised by issuing marketable debt securities such as corporate bonds.General Characteristics of Long-Term DebtDebt — contract where borrower promises to pay future cash flows to lender.Debt contract specifies the size and timing of interest payments and how they are calculated.May specify if there are assets pledged as security, if debt is transferable, any other restrictions on and rights of the parties.General Characteristics of Long-Term Debt (cont.)Secured Lender has claims against the borrower and against assets of the borrower.UnsecuredLender has a claim against the borrower, but no claim to any particular property owned by the borrower.General Characteristics of Long-Term Debt (cont.)Marketable Securities such as notes, bonds or debentures that are issued direct to investors and can then be traded in a secondary market. Non-marketableLoans arranged privately between two parties.Interest cost of debtFixed versus variable — if variable, typically some benchmark rate (cash rate) plus a premium dependant on risk of borrower.Higher for subordinated debt — lowest ranking debt in event of company being wound up.Effect of debt on riskFinancial risk — risk attributable to the use of debt as a source of finance.Financial risk effects:leverage effectfinancial distress effectGeneral Characteristics of Long-Term Debt (cont.)Effect of debt on controlLenders have no voting rights.However, lenders have a large degree of potential control if the company breaches the loan agreement.To protect their assets, creditors can take control of loan security, appoint administrators, move for receivership or liquidation.General Characteristics of Long-Term Debt (cont.)Security for debtLegal ownership — a bank or other financier can purchase asset and lend it to a business.This form of debt finance is called ‘leasing’.Financier has legal ownership of asset, providing some greater security.Fixed charge — lender has a charge over specific asset or group of assets.Restricts borrowers ability to deal in these assets.Floating charge — lender has a charge over a class of assets such as inventory.Borrower can deal in the asset.General Characteristics of Long-Term Debt (cont.)Security for debt (cont.)Restrictive covenants — rather than requiring security or a charge, place some financial or accounting restriction on the borrower to ensure ability to service debt.Typically used with larger loans to listed companies and marketable security issues.Negative pledge — borrower undertakes not to pledge existing or future assets of the company to anyone else without the consent of the lender.Guarantee — promise from a third party to cover debt obligation in event of default.Typically, a parent company may guarantee a loan for a subsidiary.General Characteristics of Long-Term Debt (cont.)Long-Term LoansAustralian companies obtain long-term debt finance largely by loans, rather than by issuing their own debt securities.Important features of term loans:Loan is for a fixed periodOther features that may be fixed include:The amount borrowedThe interest rateThe repaymentsIn many respects, a term loan resembles a mortgage loan used to purchase real estate.Long-Term Loans (cont.)Choices in taking long-term loansTypically, a minimum amount is specified by the lender, while the maximum depends on the borrowers debt capacity and ability to repay.Lender will specify minimum and maximum terms, while the borrower would choose the actual term.Interest rates can be fixed or variable — variable rates will be tied to the yield on government bonds.Interest rates will also vary, depending on security on the loan and type of asset used as security.Long-Term Loans (cont.)Choices in taking long-term loans (cont.)Credit foncier loan — type of loan that involves regular repayments which include ‘principal and interest’.Alternative payment arrangements, ‘principal plus interest’, ‘interest only’ and ‘interest only in advance’.Frequency of repayment can vary from weekly to yearly — in the case of infrequent payments, interest payments may be arranged more frequently.Long-Term Loans (cont.)Variable-rate term loansIf a borrower chooses a variable interest rate, there is considerable flexibility for the amount borrowed and repayment pattern.Variable-rate loan is flexible in that it can be repaid early without penalty and a redraw facility may be available.Possible to convert to fixed rate loan without penalty.Capped option — rate can rise but not above some agreed cap.Long-Term Loans (cont.)Fixed-rate term loansBorrower chooses to pay an agreed fixed interest rate for a period of at least 1 year. The maximum varies from 5 –10 years.Fixed-rate loan loses some of the flexibility of variable-interest-rate loan.Progressive draw down is not allowed — you borrow and pay interest on the full amount from day 1.Repayment patterns are flexible but, once determined, cannot be varied during the fixed-rate period.May be able to make special repayments or repay in full before end of term but there usually is an administration fee and an early repayment adjustment.Long-Term Loans (cont.)Other features of term loansIn addition to interest, there may be loan establishment and periodic loan service fees.Bank may not wish to lend the whole amount a single borrower seeks for risk-management reasons.This can be overcome through a syndicated loan.A number of banks join together to provide what is in effect a term loan, with each lender having identical rights.A way to spread the credit risk without having several loans and worrying about subordination of debt.Long-Term Loans (cont.)Eurocurrency loansLoans that are normally denominated in a foreign currency and sourced overseas.Reasons for Eurocurrency loans include diversification of funding sources and exposure to more than one currency.Why do businesses use term loans?Loans from financial intermediaries are preferred where borrowing is small, with direct finance being more competitive as the size of the loan increases.Long-Term Loans (cont.)Why do businesses use term loans? (cont.)Low transaction costs of term loans — better for small amounts.Issue of marketable securities has strict disclosure requirements, while a term loan does not require such public disclosure.Term-loan repayments are much more flexible, with banks willing to renegotiate repayment patterns.Debt securities may need to be rated by a rating agency — not feasible for small borrowers (costs: financial and public disclosure).Marketable Long-Term DebtMost long-term debt securities are issued by governments and financial institutions.Long-term debt issues are important means for Australian borrowers to raise funds from overseas.Main domestic issuers of long-term debt securities are financial institutions.Domestic public issues of long-term debt securities by non-financial corporations are a small, but growing, proportion of long-term debt issues.Marketable Long-Term Debt (cont.)DebenturesFixed charge / floating charge.Coupon rate is a function of general interest rates at time of issue and riskiness of issuer.Need for a trust deed.In the Australian market:Usually secured, long-term, fixed-interest securities that are issued for fixed periods but can be sold by the investor if required.Marketable Long-Term Debt (cont.)In the Australian market (cont.):Can be issued by finance companies or by non-financial companies.Finance company debentures issued continuously under a prospectus that is valid for up to 12 months.Interest rates can be varied (over the 12-month period) though, once issued, the rate is fixed until maturity.Intended to provide secure income stream and not typically listed on ASX.Marketable Long-Term Debt (cont.)Timbercorp is a non-financial company that issued a debenture in 2003.Key features:Issue limited to a finite amount $40m.Open for a limited time (7 weeks).Debentures listed on ASX.Standardised issue — all debentures were identical in terms of interest rate, frequency of payment and maturity.Company issuing debentures draws up a trust deed and appoints a trustee — specifies nature of security and where the debt ranks in terms of claims against company assets.Marketable Long-Term Debt (cont.)Unsecured notesSame as debentures — unsecured creditors that rank below secured creditors for repayment of debt.Riskier than debentures.Higher interest rate than debentures.Unsecured but may be secured by a charge over intangible assets — Corporations Act 2001 does not allow use of term ‘secured’ in such cases.May use term ‘bond’ to describe such securities if they are secured by intangibles as cannot be called ‘debenture’.Marketable Long-Term Debt (cont.)Corporate bondsMay use the term ‘bond’ as an alternative to ‘unsecured note’.Corporate bond — generally long-term, fixed-interest debt securities with coupon payments every 6 months, issued by non-government entities in amounts of at least $500 000 per investor.Australian market has grown rapidly since 1995, $20b on issue, to 2004 when $128b are on issue.Market for offshore bonds issued by Australian borrowers has grown rapidly.Marketable Long-Term Debt (cont.)Corporate bonds (cont.)This may be related to higher interest rates in Australia relative to say, US, UK and Japan.Foreign bonds — bonds issued by an Australian borrower in a foreign country and denominated in the currency of that country.Eurobonds — medium- to long-term securities sold in countries other than the country of the currency in which the bond is denominated.Corporate bonds will typically require some sort of credit rating to enhance their marketability and liquidity.Marketable Long-Term Debt (cont.)Main differences between corporate bonds and debentures are that corporate bonds:Minimum investment in corporate bonds is much larger.Have less restrictive trust deeds.Are placed privately with institutional investors.Do not need a prospectus, if placed with institutional investors.Interest Rate SwapsAgreement between two or more parties to exchange a set of interest payments over a specified period of time.No exchange of principal is involved — only interest payments are exchanged (that relate to a notional principal amount).The counterparty is offering a swap of variable interest payments for fixed interest payments.Interest Rate Swaps (cont.)The swapping counterparty is taking on risk and hoping that the variable rate will fall.That way, the payments they receive will exceed the payments they have to make.The company doesn’t want to be exposed to the risk of variable rate rises.Attractive feature:Allows many companies to borrow, at a fixed interest rate, funds which otherwise would not be available and/or would only be available at a higher interest rate.Example: Interest Rate SwapsExample 11.2:Counterparties A and B enter into a swap agreement.Notional principal of $10m with cash flows quarterly in arrears.Counterparty A agrees to pay counterparty B floating rate payments based on the bank bill rate.Counterparty B agrees to pay counterparty A fixed rate payments at 9% p.a.What are the cash flows made in the swap?Example: Interest Rate Swaps (cont.)Agreement entered on 1 April 2006 when the bank bill rate was 7.6%.Subsequently, it was: 8.70% — 1 July 2006 9.35% — 1 October 2006 9.25% — 1 January 2007Counterparty B wants the fixed rate.Counterparty A offers the fixed rate and takes on the variable rate. Example: Interest Rate Swaps (cont.)Payment on 1 July (for April quarter).A pays B:B pays A:Net payment from B to A of $34 904.11Example: Interest Rate Swaps (cont.)Payment on 1 October (for July quarter).A pays B:B pays A:Net payment from B to A of $7561.65Example: Interest Rate Swaps (cont.)Payment on 1 January (for October quarter).Bank bill rate was 9.35% for this quarter.Net payment from A to B of $8821.92.Payment on 1 April (for December quarter).Bank bill rate was 9.25% for this quarter.Net payment from A to B of $6164.38.Counterparty B gained in the third and fourth quarters because the variable rate moved above 9%.Project FinanceTechnique that is commonly used to raise funds for major mining and natural resource projects, infrastructure projects such as power stations, pipelines and toll roads, tourist resorts and other property developments.Can also be used to fund acquisition of large industrial assets.Lenders rely on cash flows of a single project as source of debt repayment.Financial risk for originators of project who provide equity finance is limited.Project Finance (cont.)Main Features of Project FinanceNo such thing as standard project finance, though some common features are:Project established as a special-purpose legal entity whose sole business activity is the project.Usually organised for a new project rather than established business.High proportion of debt finance, 70–90%, with remainder coming from project sponsors who own project.Lender’s decision based on expected cash flows of assets.Project Finance (cont.)Common features of project finance (cont.):Limited recourse debt — debt holders have limited claim against equity holders (project sponsors) — usually until project completed.Main security is intangible — project company contracts, a concession (toll roads) or rights to natural resources.Project finance loans are for longer terms than normal corporate loans — loans repaid by end of project’s life.Project Finance (cont.)When is project finance attractive?Lenders need to evaluate the terms of any project contracts that may affect construction and operating costs.Also interested in potential to shift risks onto third parties — off-take agreements, pricing power, guaranteed price rises etc.Project assessment is slow, complex and costly so lenders charge a larger margin than on other corporate debt.Project finance is viable where operating cash flows are predictable so low risk of project allows high gearing to be employed.Hybrid Debt–Equity Finance:Preference SharesA form of equity financing with characteristics of debt securities.Normally, holders have no voting rights.Normally entitled to receive a specified fixed return out of a firm’s net profit.Rank ahead of ordinary shares with respect to dividend payments, and usually with respect to claims on assets in the event of a liquidation.Hybrid Debt–Equity Finance: Preference Shares (cont.)Cumulative or non-cumulativeA company that issues cumulative preference shares is required to pay any accumulated preference dividends before a distribution may be made to ordinary shareholders.Non-cumulative preference shares do not oblige the company to pay any past accumulation of unpaid preference dividends.Hybrid Debt–Equity Finance: Preference Shares (cont.)Redeemable, irredeemable, converting or convertible:Redeemable preference shares are similar to debentures, but dividends are not deductible for income tax purposes.Irredeemable preference shares are similar to ordinary shares.Converting preference shares automatically convert to ordinary shares at some specified time in the future.Convertible preference shares can be converted to ordinary shares at the option of the holder.Hybrid Debt–Equity Finance: Preference Shares (cont.)Participating or non-participatingA company may issue participating preference shares that allow the holders to share in any profit earned in excess of a certain amount.These participating preference shareholders can obtain a dividend in excess of the preference dividend rate.Non-participating preference shareholders are not entitled to a dividend in excess of the stated dividend rate.Hybrid Debt–Equity Finance: Preference Shares (cont.)Why issue preference shares?Three advantages over ordinary shares and debt.Non-voting — can raise capital without affecting control of ordinary shareholders.Preference shareholders cannot force a company into liquidation — preferred over debt for this reason.Easy to value as they pay a fixed dividend and interest rates on debt are readily observable.Hybrid Debt–Equity Finance: Convertible and Converting SecuritiesConvertible securities provide holder with the right to convert into ordinary shares at some future date or dates.Typically convertible unsecured notes (debt) but convertible preference shares have been issued.Converting securities automatically change from one form of security to another at a particular date — converting preference share is most common.Hybrid Debt–Equity Finance: Convertible and Converting Securities (cont.)Convertible notesA convertible note is a debt instrument issued for a fixed term at a stated interest rate, which gives the holder the right to convert the note into ordinary shares at specified future dates.Notes are usually issued at an interest rate that is lower than that offered on straight debt instruments.Hybrid Debt–Equity Finance: Convertible and Converting Securities (cont.)In addition to the explicit conversion option, there may be an implicit option as note holders can normally participate in pro rata issues of new equity. For companies the attractions are:More favourable terms than straight debt.Maturity longer than for straight debt.Interest is normally tax deductible. Unsecured.Hybrid Debt–Equity Finance: Convertible and Converting Securities (cont.)Why issue convertible notes?They may seem like a cheap debt alternative.However, there is an option to acquire shares, this is a cost to the company as well — may dilute returns to existing shareholders.Jen, Choi and Lee (1997) find that convertible issues have less of a negative impact on the shares of high-growth companies.For these types of companies, conventional debt and equity are expensive and unattractive — thus issue convertible securities.Hybrid Debt–Equity Finance: Convertible and Converting Securities (cont.)Converting preference sharesOffer a guaranteed dividend prior to a specified conversion date, at which time the preference shares automatically convert to ordinary shares in the company.Conversion ratio — number of ordinary shares received by the holder of each converting preference share. Expressed in terms of discount to market price of shares.This discount means the holder is protected against a fall in the ordinary share price prior to conversion date.SummaryLong-term debt finance can be either:Non-marketable — bank loans, mortgage loans from life insurance offices and super funds.Marketable — debentures, unsecured notes and corporate bonds.Debt with term to maturity of more than 12 months is considered long term.Loans from banks and other financial intermediaries are the most important source of long-term debt finance for Australian companies.Summary (cont.)Companies can borrow by directly issuing marketable debt securities including debentures, unsecured notes and corporate bonds.Project finance is important in Australia allowing large natural resource and infrastructure projects to be financed with a high proportion of debt.Hybrid securities — convertible notes, convertible and converting preference shares.All pay fixed dividend (like debt) and convert into ordinary shares at some future date.