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INTRODUCTION TO CORPORATE FINANCE SECOND EDITION Lawrence Booth & W. Sean Cleary Prepared by Ken Hartviksen & Jared Laneus Chapter 18 Debt Instruments 18.1 What Is Debt? 18.2 Short-Term Debt and the Money Market 18.3 Bank Financing 18.4 Long-Term Debt and the Money Market 18.5 Bond Ratings Booth/Cleary Introduction to Corporate Finance, Second Edition 2 Learning Objectives 18.1 Define “debt” and identify the basic features that distinguish debt from equity financing. 18.2 Identify and describe the different types of short-term debt issued in the money market. 18.3 Describe the types of debt financing provided by banks. 18.4 Identify the requirements that must typically be satisfied by public debt issuers. 18.5 Explain how debt ratings are determined, what they mean, and how useful they are in predicting default and recovery rates associated with public debt issues. Booth/Cleary Introduction to Corporate Finance, Second Edition 3 What Is Debt? • Debt creates fixed contractual commitments which include: • Repayment of the principal borrowed • Payment of interest for the use of the amount borrowed • Adherence to other agreed terms such as limiting the amount of additional debt taken on, maintaining financial ratios, regular financial reporting, etc. • Short-term debt has a maturity of one year or less • Interest rates are often lower than those on long-term borrowing • Interest rates are typically variable (floating) which exposes the borrower to interest rate risk • Long-term debt has a maturity that exceeds one year • Interest rates are typically greater than those on short-term debt • Often borrowing occurs at a fixed rate, which immunizes the borrower from interest rate risk by locking in a coupon rate in the case of bonds and debentures Booth/Cleary Introduction to Corporate Finance, Second Edition 4 Interest Expense Tax Deductibility • Interest on debt is a tax-deductible expense for a firm, so there is a tax shield benefit for firms that use this type of financing • The after-tax cost of debt is found using Equation 18-1: K K d (1 T ) The tax shield benefit depends on the corporate tax rate. • The higher the tax rate, the greater the benefit a firm has from financing profit-making activities with debt. • Small businesses in Canada pay about 20% in corporate tax, but are riskier than larger businesses and so borrow at higher rates • Example: If a small business borrows at 200 basis points above prime and prime is 5%, the cost of debt is 7%. The after-tax cost of debt, with a 20% tax rate, is: K K d (1 T ) 0.07(1 0.2) 5.6% Booth/Cleary Introduction to Corporate Finance, Second Edition 5 Interest Expense Tax Deductibility • Large corporations in Canada pay about 34% in corporate tax. • Example: If a corporation borrows at 25 basis points above prime and prime is 5%, the cost of debt is 5.25%. The after-tax cost of debt, with a 34% tax rate, is: K K d (1 T ) 0.0525(1 0.34) 3.465% CRA Tests to Determine if Interest is Tax-Deductible • Interest is compensation for the use or retention of money owed to another • Interest must be referable to a principal sum • Interest accrues from day to day Booth/Cleary Introduction to Corporate Finance, Second Edition 6 Short-Term Debt and the Money Market • Short-term debt is traded in the money market and is any debt instrument sold with a life that is 365 days or shorter • Examples: Treasury bills, commercial paper, bankers’ acceptances • Usually there is no stated rate of interest and instead money market instruments are sold at a discount from face value • The difference between the purchase price and the par value is treated as interest by Canada Revenue Agency (CRA) Booth/Cleary Introduction to Corporate Finance, Second Edition 7 Government of Canada Treasury Bills • Government of Canada treasury Bills (T-bills) are short-term unsecured promissory notes of the Government of Canada • T-Bills are sold at weekly auctions through the Canadian Government’s fiscal agent, the Bank of Canada, to primary dealers called Government Securities Dealers (GSDs) • There is a strong secondary market in outstanding T-bills • T-Bills are sold with maturities of 365 days or less. Generally, Tbills are sold with three different maturities: • 3 month T-bills (91 days) • 6 month T-bills (182 days) • 1 year T-bills Booth/Cleary Introduction to Corporate Finance, Second Edition 8 Government Treasury Bill Yields • Government of Canada treasury bills are sold at a discount to face value, so the difference between the price paid and face value is treated as interest. • Price are quoted on the basis of a $100 par value to four digits • Bills are normally purchased in denominations of at least $100,000 • Example: A 91-day Government of Canada treasury bill is sold for a price of $99.0909 with a par value of $100. What is the T-bill yield? P1 P0 365 T - Bill Yield P0 number of days to maturity $100 $99.0909 365 $99.0909 91 3.7% Booth/Cleary Introduction to Corporate Finance, Second Edition 9 Commercial Paper • Commercial paper are short-term debt instruments that are usually unsecured and issued by corporations • It is usually sold at a discount from face value with maturities of 30 to 60 days • Commercial paper involves more credit risk than government treasury bills because the financial condition of a corporation can deteriorate and thereby risk the repayment of the amount borrowed • Since there is additional credit risk, there is usually only a market for commercial paper issued by the most creditworthy corporate issuers Booth/Cleary Introduction to Corporate Finance, Second Edition 10 Commercial Paper Payoffs • Since there is a non-negligible probability of default, the forecast annualized return on commercial paper is known as the promised yield • Payoff expectations must always take into account the possibility of default as demonstrated in Figure 18-1 Booth/Cleary Introduction to Corporate Finance, Second Edition 11 Commercial Paper Promised Yield • Since commercial paper is riskier than treasury bills, the promised yield on commercial paper is higher than the treasury-bill yield • The value of the 30-day commercial paper issue can be found from Equation 18-2: PAR(1 R) RECOVER (1 P) V 1 K where the par value PAR is $1,000 • R is the promised yield • P is the probability of not defaulting • (1 – P) is the probability of defaulting • RECOVER is the recovery rate if the company defaults • K is the investor’s required return Booth/Cleary Introduction to Corporate Finance, Second Edition 12 Commercial Paper Promised Yield • If we assume the recovery rate is zero and the investor’s required return is equal to the T-bill yield, then Equation 18-2 becomes Equation 18-3: 1 K TB R 1 P • In the absence of default risk (where P = 1), the promised yield on commercial paper is the same as the treasury bill yield Booth/Cleary Introduction to Corporate Finance, Second Edition 13 Commercial Paper Yield Spreads • The difference between commercial paper yields and equivalent maturity Treasury bill yields is called the yield spread, and it depends on the default risk of the commercial paper issuer and on market conditions. • Yield spreads increase when the market becomes pessimistic about the future of the economy (i.e., expects a recession) • Yields spreads decrease when the market becomes optimistic about the future of the economy (i.e., expects improvement) Booth/Cleary Introduction to Corporate Finance, Second Edition 14 Commercial Paper Ratings and Liquidity Support Ratings • The Dominion Bond Rating Service (DBRS), Moody’s and Standard & Poor’s (S&P) rate Canadian commercial paper issues. • DBRS has three ratings: R1 (prime quality), R2 (adequate quality) and R3 (speculative) • Commercial paper ratings help to reduce uncertainty in the market and can make different issuers of paper interchangeable if they have the same rating. Liquidity Support • In addition to ratings, commercial paper issuers try to reduce investor uncertainty by arranging liquidity support, often in the form of a dedicated line of credit from a bank that ensures that the company will have access to money to pay off the commercial paper at maturity if the firm finds it cannot refinance the issue Booth/Cleary Introduction to Corporate Finance, Second Edition 15 Bankers’ Acceptances • Bankers’ acceptances (BAs) are short-term paper sold by an issuer to a bank which guarantees (or “accepts”) it, obligating the bank to pay the debt instrument at maturity if the issuer defaults • Therefore, bankers’ acceptances are a type of bank-guaranteed commercial paper • The yield on bankers’ acceptances reflect the credit risk of the guaranteeing bank rather than that of the corporate issuer • Corporate issuers pay a stamping fee to the bank for its guarantee, usually between 0.5% and 0.75% of the amount guaranteed • Commercial paper tends to be a lower cost alternative to bankers’ acceptances for the most creditworthy corporations that do not require 100% backup from a line of credit Booth/Cleary Introduction to Corporate Finance, Second Edition 16 The Canadian Money Market • Creditworthy governments and corporations gain access to large sums of low-cost short-term financing in the Canadian money market • Investors, banks, corporations and governments also use the money market to invest in very high quality short-term investments Booth/Cleary Introduction to Corporate Finance, Second Edition 17 Bank Financing • Chartered Banks are an important source of two major types of shortterm financing for Canadian companies: lines of credit and term loans • Lines of credit in support of working capital needs • Two types: operating (demand) and term (revolving) • Useful for working capital financing, e.g., receivables • A “cleanup” period in which a firm maintains a zero-balance on its line of credit to ensure that the bank is not providing permanent financing maybe required • Term loans in support of longer term investment requirements, such as equipment purchases • Have fixed maturity and require repayment to be made on a fixed schedule • Floating interest rates based on the prime rate, which places interest rate risk on the borrower • Various payment structures, including: blended, bullet and balloon payments Booth/Cleary Introduction to Corporate Finance, Second Edition 18 More on Operating Lines of Credit • Made for operating purposes, and not to back up a commercial paper program • Technically, operating lines of credit can be cancelled at any time • Establishes a maximum dollar amount the firm can drawn down electronically • Usually the balance must be returned to zero for a period of time in the operating year, usually following the seasonal buildup of inventory and receivables around the major sales season • The cost is usually set at the prime lending rate although it is not uncommon for the most creditworthy corporate customers to borrow at rates lower than prime • Less creditworthy customers pay prime plus a risk premium (e.g., 0.5%, 1.0%, etc.) Booth/Cleary Introduction to Corporate Finance, Second Edition 19 More on Revolving Lines of Credit • Term is between 364 days and five years, renewable every six months • “Revolving” means that the line of credit may be drawn upon, partially retired, and then drawn upon again without the full retirement of the balance during the operating year • Revolving lines of credit are for liquidity purposes and not credit enhancement. The bank reserves the right to withdraw the line of credit if there is a material adverse change in the customer’s business. • Borrowers have to meet a variety of restrictions and conditions (covenants), such as: • • • • Minimum current ratio of 1.4 or net working capital of $100 million Net worth in excess of $250 million Minimum interest coverage ratio Asset coverage ratio in excess of 2 and a debt ratio less than 0.75 • In addition to interest costs, banks normally change a commitment fee of about 0.5% for setting up the line of credit Booth/Cleary Introduction to Corporate Finance, Second Edition 20 Long-Term Debt and the Money Market • Long-term financing is any debt issue with a term longer than one year, and is also known as funded debt • Examples: mortgage bonds, secured and unsecured debentures, subordinated debt • Private Placements are debt financing commonly available through insurance companies and other specialized financial institutions through an offering memorandum • Public Debt Offerings require a prospectus approved by the provincial securities regulator Booth/Cleary Introduction to Corporate Finance, Second Edition 21 Long-Term Debt and the Money Market Types of Public Debt Offerings • Mortgage bonds where the lender has a registered claim on the underlying real property • First mortgage bonds where the lender has first claim on the assets • Second mortgage bonds where the lender ranks behind the first mortgage bonds • Unsubordinated debt which is unsecured and ranks first among unsecured debt Booth/Cleary Introduction to Corporate Finance, Second Edition 22 Long-Term Debt and the Money Market Public Debt Offerings: The Bond Indenture • The bond indenture is the legal document that specifies the rights and responsibilities of the parties to the contract • Bond indentures include: • Actions that could trigger default • Covenants (promises), including limits on additional borrowing, prohibitions on subsequent issues of more senior debt, requirements to maintain certain financial ratios, etc. • Bond investors realize they have a fixed financial claim on the firm over a long period of time, so when financial contracting occurs they negotiate covenants that will protect their long-term financial exposure to the issuing firm Booth/Cleary Introduction to Corporate Finance, Second Edition 23 Bond Ratings Interpreting Debt Ratings • Bond ratings vary from AAA (highest quality) to CCC (lowest quality) • Bond ratings are changed by the bond-rating service over time in response to changes in the financial condition of the issuer • Ratings reflect the downside risk faced if economic conditions deteriorate • The most common rating is A, which is describe as: Long-term debt rated “A” is of satisfactory credit quality. Protection of interest and principal is still substantial, but the degree of strength is less than that of AA rated entities. While “A” is a respectable rating, entities in this category are considered to be more susceptible to adverse economic conditions and have greater cyclical tendencies than higher-rated securities. Booth/Cleary Introduction to Corporate Finance, Second Edition 24 Bond Ratings Investment Grade Bonds Junk or High-Yield Bonds Booth/Cleary Introduction to Corporate Finance, Second Edition DBRS Rating Descriptor AAA Highest credit quality AA Superior credit quality A Satisfactory credit quality BBB Adequate credit quality BB Speculative B Highly speculative CCC / CC / C Very highly speculative 25 Bond Ratings Determining Bond Ratings • Companies pay to have their bonds rated because this reduces market uncertainty regarding their credit risk • Rating agencies conduct extensive analysis of a company, including onsite visits and historical reviews of its financial performance • Ratings are on the bonds, not on the issuer, so different bond issues from the same issuer could have different ratings • Six factors are considered in the rating process 1. Core profitability 2. Asset quality 3. Strategy and management strength 4. Balance sheet strength 5. Business strength 6. Miscellaneous issues Booth/Cleary Introduction to Corporate Finance, Second Edition 26 Bond Ratings Empirical Evidence on Debt Ratings as Predictors of Default • The quality of DBRS ratings can be assessed by examining their correlation with future default rates to examine their predictive power • DBRS ratings are good indicators of credit risk • Default rates are very low for investment grade bonds • Default risk increases exponentially as credit quality deteriorates • DBRS modifies ratings over time as the financial condition of the issuer changes, although this is not reflected in Table 18-2 Booth/Cleary Introduction to Corporate Finance, Second Edition 27 Bond Ratings Empirical Evidence Regarding Bond Yield Spreads • The priority of the debt claim on the firm in the case of insolvency has a direct relationship to the degree of discount from face value • High risk bonds have both a higher probability of default as well as a lower recovery rate Booth/Cleary Introduction to Corporate Finance, Second Edition 28 Bond Ratings Empirical Evidence Regarding Bond Yield Spreads • Yield spreads are greater with lower-rated debt, as well as more variable • During economic slowdowns there is a flight to quality as investors abandon lower quality bonds and increasing yield spreads • Economic slowdowns can limit or even eliminate access to long-term market-traded debt capital by low quality bond issuers Booth/Cleary Introduction to Corporate Finance, Second Edition 29 Copyright Copyright © 2010 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein. Booth/Cleary Introduction to Corporate Finance, Second Edition 30