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13.0
Chapter
15
Debt Financing
13.1
Chapter Outline
15.1 Corporate Debt
15.2 Bond Covenants
15.3 Repayment Provisions
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Learning Objectives
 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
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15.1 Corporate Debt
 Companies
can raise debt using different
sources:
Public debt, which trades in a public market
 Private debt, which is negotiated directly with a
bank or a small group of investors.

 The
securities that companies issue when
raising debt are called corporate bonds.
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Example 15.1a: Calculating the Net
Amount of Funds
Problem:
 You are finalizing a bank loan for $200,000 for
your small business and the closing fees payable
to the bank are 2% of the loan. After paying the
fees, what will be the net amount of funds from
the loan available to your business?
$200,000 x 2% = $4,000
$200,000 - $4,000 = $196,000
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Example 15.1a: Calculating the Net
Amount of Funds
Solution:
Plan:
 The net amount of funds available is the
amount of loan proceeds left after the fees are
paid. Therefore, the plan is to subtract the fees,
which are 2% of the $200,000 loan principal,
from the loan amount.
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Example 15.1a: Net Funds on
Borrowings
Execute:
$200,000 x 2% = $4,000
$200,000 - $4,000 = $196,000
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Example 15.1a: Net Funds on
Borrowing
Evaluate:
 The actual amount you get to use is $196,000.
It is important to consider not only the
principal amount and the interest rate, but also
the fees and their effect on the funds available
to you.
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Example 15.1b: Corporate Debt
Problem:
 Your firm is issuing $100 million in straight
bonds at par with a coupon rate of 7% and
paying total fees of 5%. What is the net amount
of funds that the debt issue will provide for
your firm?
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Example 15.1b: Corporate Debt
Solution:
Plan:

The net amount of funds your firm will net from the debt
issue is the issue amount less the fees. The coupon rate
will be paid semi-annually out of going revenues and is
not considered in the initial cash intake. Therefore, the
plan is to subtract the fees, which are 5% of the issue
amount, from the issue amount to determine how much
your firm will net from the debt issue.
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Example 15.1b: Corporate Debt
Execute:
 $100 million x 5% = $5,000,000
 $100 million - $5 million = $95,000,000
 Amount
firm has available for its use from
issuing $100 million in debt is only $95 million
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Example 15.1b: Corporate Debt
Evaluate:
 There are costs for issuing bonds to the public.
Your firm must consider these in assessing its
debt issue. The amount your firm will have
available from issuing $100 million in debt is
only $95 million.
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Private Debt
Private Debt: debt that is not publicly traded. The
private debt market is larger than the public debt
market.
 Private debt has the advantage that it avoids the cost
and delay of registration with the U.S. Securities and
Exchange Commission (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.

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Private Debt
Bank Loans:
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
Term Loan: Loan that lasts for specific time frame (term).

Syndicate Bank Loan: A single loan is funded by a group
banks rather than just a single bank.

Revolving line of credit: A credit commitment for specific
time period up to some limit which a company can use as
needed

Asset Backed line of credit: A company may be able to get a
larger line of credit or a lower interest rate if it secures the line
of credit by pledging an asset as collateral.
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Private Placement
 Private
placement: a bond issue that does not
trade on a public market but rather is sold to a
small group of investors.
 Advantages
It is less costly to issue
 Privately placed debt also need not conform to the
same standards as public debt; as a consequence, it
can be tailored to the particular situation.

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Public Debt
 The
Prospectus: A public bond issue is similar
to a stock issue.
 The prospectus must include an indenture, a
formal contract that specifies the firm’s
obligations to the bondholders
 If a coupon bond is issued at a discount, it is
called an original issue discount (OID) bond.
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Secured and Unsecured Corporate
Debt
 Four
types of bonds issued
Notes: are unsecured debt with maturities typically
of less than 10 years
 Debentures: are unsecured debt with maturities of
10 years or longer
 Mortgage Bonds: are secured by real property
 Asset backed Bonds: bonds can be secured by any
kind of asset

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Table 15.1 Types of Corporate Debt
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International Bond Markets
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
Domestic bonds: issued by a local entity and traded in a local market, but
purchased by foreigners. They are denominated in the local currency.

Foreign bonds: issued by a foreign company in a local market and are
intended for local investors. They are also denominated in the local
currency.

Eurobonds: are international bonds that are not denominated in the local
currency of the country in which they are issued. Consequently, there is no
connection between the physical location of the market on which they trade
and the location of the issuing entity.

Global bonds: combine the features of domestic, foreign, and Eurobonds,
and are offered for sale in several different markets simultaneously.
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15.2 Bond Covenants
Covenants: restrictive clauses in bond contract
limiting the issuer from taking actions that may
undercut its ability to repay the bonds.
 Advantages



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By including more covenants, firms can reduce their 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.
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Table 15.4 Typical Bond Covenants
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15.3 Repayment Provisions
 Call
Provisions: Firms can repay bonds by
exercising a call provision.
 Callable Bonds: Allow the firm to repurchase
the bonds at a predetermined price.
 YTC: Yield to Call on a callable bond
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Table 15.6 Bond Calls and Yields
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Example 15.1
Calculating the Yield to Call
Problem:
 IBM has just issued a callable (at par) fiveyear, 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?
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Example 15.1
Calculating the Yield to Call
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Solution:
Plan:

The timeline of the promised payments for this bond (if it is not called) is:
0


1
2…
5
$8
$8
$108
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).
To solve the YTC, we use these cash flows set the price equal to the
discounted cash flows and solving for the discount rate.
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Example 15.1
Calculating the Yield to Call
Execute:
 For the YTC, setting the present value of these
payments equal to the current price gives
103 = 108
( 1+ YTC)
Given:
Solve for:
1
YTC= 108 -1= 4.85%
103
-103
8
100
4.85
Excel Formula: =RATE(NPER, PMT, PV,FV) = RATE(1,8,-103,100)
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Example 15.1
Calculating the Yield to Call
Evaluate:

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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.
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Repayment Provisions
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
Sinking Funds: a provision that allows the company
to make regular payments into a fund administered by
a trustee over the life of the bond instead of repaying
the entire principal balance on the maturity date

Balloon Payment: Large payments on a maturity date

Convertible Provisions: Corporate bonds with a
provision that gives the bondholder an option to
convert each bond owned into a fixed number of
shares of common stock at a ratio called the
conversion ratio.
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Convertible Bonds and Stock Prices





The likelihood of eventually converting a convertible bond
depends upon the current stock price.
When the stock price is low, conversion is unlikely, and the value
of the convertible bond is close to that of a straight bond
When the stock price is much higher than the conversion price,
conversion is verylikely and the convertible bond’s price is close
to the price of the converted shares.
When the stock price is the middle range, near the conversion
price, there is the greatest uncertainty about the whether it will be
optimal to convert or not
Convertible debt carries a lower interest rate than other
comparable non-convertible debt.
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Figure 15.2 Convertible Bond Value
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Combining Features
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
Combining Features: Companies have flexibility in
setting the features of the bonds they issue.

Subordinated bonds typically have a higher yield
because of their riskier position relative to senior bond

Leveraged Buyouts: a public company becoming
private, in this case through a leveraged buyout. In a
leveraged buyout (LBO), a group of private
investors purchases all the equity of a public
corporation
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Chapter Quiz
1.
2.
3.
4.
5.
6.
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What are the different types of corporate debt?
Explain some of the differences between a public debt offering
and a private debt offering.
Explain the difference between a secured corporate and an
unsecured corporate bond.
Why would a call feature be valuable to a company issuing
bonds?
What is the effect of including a call feature on the price a
company can receive for its bonds?
Why is the yield on a convertible bond lower than the yield on
an otherwise identical bond without a conversion feature?
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