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Debt Financing
 15.1
Corporate Debt
 15.2 Bond Covenants
 15.3 Repayment Provisions
 Identify
different types of debt financing
available to a firm
 Understand limits within bond contracts
that protect the interests of bondholders
 Describe the various options available to
firms for the early repayment of debt
 Corporate
dent can be private debt, which is
negotiated directly with a bank or a small
group of investors, or public debt, which
trades in a public market.
 The private bank is larger than public debt
market.
 Private debt has advantage that it avoids the
cost and delay of registration with the U.S.
SEC. the disadvantage is that because it is
not publicly traded, it is illiquid, meaning
that it is hard for a holder of the firm’s
private debt to sell it in a timely manner.
 Private Debt
• Bank Loans
 Term Loan: A bank loan that lasts for a specific term.
 Syndicated Bank Loan: A single loan that is funded by a
group of banks rather than just a single bank.
 Revolving Line of Credit: A credit commitment for a specific
time period, typically two to three years, which a company
can use as needed.
 Asset-Backed Line of Credit: A type of credit commitment,
where the borrower secures a line of credit by pledging an
asset as collateral.
• Private Placements: A bond issue that does not trade
on a public market but rather is sold to a small group
of investors.
 Public
Debt
• The Prospectus
 Indenture
 Included in a prospectus, it is a formal contract between a
bond issuer and a trust company, which represents the
bondholders’ interests
 Original Issue Discount (OID) Bond
 A coupon bond issued at a discount

Public Debt
• Unsecured Corporate Debt: A type of corporate debt that, in the
event of a bankruptcy, gives bondholders a claim to only the
assets of the firm that are not already pledged as collateral on
other debt.
 Notes: A type of unsecured corporate debt with maturities shorter
than ten years.
 Debentures : A type of unsecured corporate debt with maturities of
ten years or longer.
• Secured Corporate Debt: A type of corporate loan or debt
security in which specific assets are pledged as a firm’s
collateral that bondholders have a direct claim to in the event of
a bankruptcy.
 Mortgage Bonds: A type of secured corporate debt in which real
property is pledged as collateral.
 Asset-Backed Bonds: A type of secured corporate debt in which
specific assets are pledged as collateral.
 Public
Debt
• Seniority: A bondholder’s priority, in the event of
a default, in claiming assets not already securing
other debt
 Subordinated Debenture: A debenture issue that has a
lower priority claim to the firm’s assets than other
outstanding debt
 Tranches: Different classes of securities that comprise
a single bond issuance
 Public
Debt
• International Bonds
 Domestic Bonds
 Issued by a local entity and traded in a local market, but
purchased by foreigners
 Denominated in the local currency
 Foreign Bonds
 Issued by a foreign company in a local market and are
intended for local investors
 Denominated in the local currency
 Public
Debt
• International Bonds
 Foreign Bonds
 Yankee bonds
 Foreign bonds issued in the United States
 Eurobonds
 International bonds that are not denominated in the local
currency of the country in which they are issued
 Public
Debt
• International Bonds
 Global Bonds
 Combines the features of domestic, foreign, and Eurobonds,
and are offered for sale in several different markets
simultaneously
 Can be offered for sale in the same currency as the country
of issuance
 Covenants
• Restrictive clauses in a bond contract that limit
the issuer from taking actions that may undercut
its ability to repay the bonds
 Advantages
of Covenants
• With more covenants, a firm firms can reduce its
costs of borrowing.
 The reduction in the firm’s borrowing cost can more
than outweigh the cost of the loss of flexibility
associated with covenants
 Call
Provisions
• Callable Bond: Bonds containing a call provision
that allows the issuer to repurchases the bonds at
a predetermined price.
 Call Date: The date in the call provision on or atfer
which the bond issuer has the right to retire the bond.
 Call Price: A price specified at the issuance of a bond
for which the issuer can redeem the bond.
 Call Premium: the difference between the call price
and the par value.
 Call
Provisions
 Call Provisions and Bond Prices
 Investors will pay less for a callable bond than for an
otherwise identical noncallable bond
 A firm raising capital by issuing callable bonds instead of
non-callable bonds will either have to pay a higher coupon
rate or accept lower proceeds
 Call
Provisions
 Yield to Call
 The yield of a callable bond calculated under the
assumption that the bond will be called on the earliest call
date
 Yield to Worst
 Quoted by bond traders as the lower of the yield to call or
yield to maturity
Problem:

IBM has just issued a callable (at par) five-year, 8% coupon bond
with annual coupon payments. The bond can be called at par in
one year or anytime thereafter on a coupon payment date. It has a
price of $103 per $100 face value, implying a yield to maturity of
7.26%. What is the bond’s yield to call?
Solution:
Plan:

The timeline of the promised payments for this bond (if it is not
called) is:
Solution:
Plan: (cont’d)

If IBM calls the bond at the first available opportunity, it will call the
bond at year 1. At that time, it will have to pay the coupon payment
for year 1 ($8 per $100 of face value) and the face value ($100). The
timeline of the payments if the bond is called at the first available
opportunity (at year 1) is:
Solution:
Plan: (cont’d)

To solve the YTC, we use these cash flows, set the price equal to the
bond’s current price and solve for the discount rate.
Execute:

For the YTC, setting the present value of these payments equal to
the current price gives:
108
Solving for the yield to call gives:
(1  YTC)
108
YTC =
 1  4.85%
103
103 
Given:
Solve for:
1
-103
8
4.85
Excel Formula: =RATE(NPER, PMT, PV,FV) = RATE(1,8,-103,100)
100
Evaluate:

The YTM is higher than the YTC because it assumes that you will
continue receiving your coupon payments for 5 years, even though
interest rates have dropped below 8%. While under the YTC
assumptions, you are repaid the face value sooner, you are
deprived of the extra 4 years of coupon payments, so your total
return is lower.
 Sinking Fund
• A company makes regular payments into a fund
administered by a trustee over the life of the
bond.
• These payments are then used to repurchase
bonds, usually at par.
 Balloon Payment
• A large payment that must be made on the
maturity date of a bond when the sinking fund
payments are not sufficient to retire the entire
bond issue.
 Convertible
Provisions
• Convertible Bonds: Corporate bonds with a
provision that gives the bondholder a option to
convert each bond owned into a fixed number of
shares of common stock.
• Conversion Ratio
 Convertible
Provisions
• Convertible Bond Pricing
 Consider a convertible bond with a $1000 face value
and a conversion ratio of 20
 If you converted the bond into stock on its maturity
date, you would receive 20 shares
 If you did not convert, you would receive $1000
 Conversion Price
 By converting the bond you essentially “paid” $1000 for 20
shares, implying a conversion price per share of $1,000/20 =
$50.
 Convertible Provisions
• Convertible Bond Pricing
 Straight (Plain-Vanilla) Bond
 A non-callable, non-convertible bond
• Convertible Bonds and Stock Prices
 When a firm’s stock price is much higher than the
conversion price, conversion is very likely and the
convertible bond’s price is close to the price of the
converted shares
 Convertible
Provisions
• Combining Features
 Companies have flexibility in setting the features of the
bonds they issue
• Leveraged Buyout (LBO)
 When a group of private investors purchases all the
equity of a public corporation and finances the
purchase primarily with debt.