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Chapter 10 Medium- to Longer-term Debt Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 1 Learning Objectives • Identify the types of medium- to long-term debt instruments in the market • Understand the securitisation process • Pricing of longer-term debt instruments Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 2 Chapter Organisation 10.1 Introduction 10.2 Term Loans or Fully-drawn Advances 10.3 Mortgage Finance 10.4 Debentures, Unsecured Notes and Subordinated Debt Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 3 Chapter Organisation (cont.) 10.5 Calculations: Fixed Interest Securities 10.6 Leasing 10.7 Direct Credit Substitutes 10.8 Summary Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 4 10.1 Introduction • Matching principle – Firms should match the maturity structure of their assets with the maturity structure of their sources of funds (liabilities and shareholder funds) – Therefore, longer-term assets should be funded with longer-term liabilities and equity The repayment schedule of debt financing for long-term projects should align with the project’s expected future cash flows Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 5 10.1 Introduction (cont.) • Repayment may be – Interest only during term of loan and principal repayment on maturity – Amortised loan (credit foncier loan) – periodic loan instalments consisting of interest due and reduction of principal Deferred repayment loan loan instalments commence after a specified period related to project cash flows, and the debt is amortised over the remaining term of the loan Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 6 Chapter Organisation 10.1 Introduction 10.2 Term Loans or Fully-drawn Advances 10.3 Mortgage Finance 10.4 Debentures, Unsecured Notes and Subordinated Debt Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 7 10.2 Term Loans or Fullydrawn Advances • Fixed-term loan periods generally range from 3 to 15 years • Typically used to finance capital expenditure e.g. building, equipment • Repayment can be amortised or deferred Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 8 10.2 Term Loans or Fullydrawn Advances (cont.) • Interest may be fixed or variable, is linked to an indicator rate e.g. BBSW or bank’s prime rate, and is influenced by Credit risk of borrower (risk premium) – Term of the loan – Repayment schedule – Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 9 10.2 Term Loans or Fullydrawn Advances (cont.) • Other fees include – Establishment fee – Service fee – Commitment fee – Line fee – Bill option clause fee Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 10 10.2 Term Loans or Fullydrawn Advances (cont.) • Loan covenants – Restrict the business and financial activities of the borrowing firm Positive covenant requires borrower to take prescribed actions e.g. maintain a minimum level of working capital Negative covenant restricts the activities and financial structure of borrower e.g. amount of dividend, maximum debt to equity ratio Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 11 10.2 Term Loans or Fullydrawn Advances (cont.) • Loan covenants (cont.) – Breach of covenant results in default of the loan contract entitling lender to act Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 12 10.2 Term Loans or Fullydrawn Advances (cont.) • Calculating the loan instalment— ordinary annuity A R 1 (1 i )n [ ] i (10.1) where : R the instalment amount A the loan amount (present value) i the current nominal interest rate per period expressed as a decimal n the number of compoundin g periods. Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 13 10.2 Term Loans or Fullydrawn Advances (cont.) • Calculating the loan instalment— ordinary annuity (cont.) – Example 1: Floppy Software Limited has approached Mega Bank to obtain a term loan to finance the purchase of a new highspeed CD burner. The bank offers a $150,000 loan, amortised over five years at 8 per cent per annum, payable monthly. Calculate the monthly loan instalments. Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 14 10.2 Term Loans or Fullydrawn Advances (cont.) • Calculating the loan instalment— ordinary annuity (cont.) – Example 1 (cont.) A $150 000 0.08 0.006667 12 n 5 years 12 months 60 i R $150 000 1 (1 0.006667)60 [ ] 0.006667 R $3041.49 per month Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 15 10.2 Term Loans or Fullydrawn Advances (cont.) • Calculating the loan instalment—annuity due A R 1 (1 i )n [ ](1 i ) i (10.2) Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 16 10.2 Term Loans or Fullydrawn Advances (cont.) • Calculating the loan instalment—annuity due (cont.) – Example 2: A business proprietor is purchasing a computer system for the business at a cost of $21,500. a finance company has offered a term loan over seven years at a rate of 12 per cent per annum. The loan will be repaid by equal monthly instalments at the beginning of each month. Calculate the amount of the loan instalments. Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 17 10.2 Term Loans or Fullydrawn Advances (cont.) – Example 2 (cont.) A $21 500 0.12 0.01 12 n 7 12 84 i $21 500 1 (1 0.01)84 [ ] (1 0.01) 0.01 $21 500 57.21494 $375.78 monthly instalment R Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 18 Chapter Organisation 10.1 Introduction 10.2 Term Loans or Fully-drawn Advances 10.3 Mortgage Finance 10.4 Debentures, Unsecured Notes and Subordinated Debt Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 19 10.3 Mortgage Finance • A mortgage is a form of security for a loan • The borrower (mortgagor) conveys an interest in the land to the lender (mortgagee) • The mortgage is registered on the land title Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 20 10.3 Mortgage Finance (cont.) • The mortgage is discharged when the loan is repaid • If the mortgagor defaults on the loan, the mortgagee is entitled to foreclose on the property • Mortgage loans can be either residential or commercial Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 21 10.3 Mortgage Finance (cont.) • Residential loans are typically granted for periods of up to 20 years, while commercial loans are for periods of 5 to 10 years, typically • Variable interest rate loans dominate, but fixed rates are available for loans with terms of up to 2 years Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 22 10.3 Mortgage Finance (cont.) • Mortgagee (lender) may reduce their risk exposure to borrower default by – – – Requiring mortgagor to take out mortgage insurance Mortgagee buying a put option on the mortgage or property Securitisation i.e. the sale of mortgage loans The conversion of non-liquid assets into new asset-backed securities that are serviced with cash flows from the original assets Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 23 10.3 Mortgage Finance (cont.) • Calculating the instalment on a mortgage loan A R n 1 (1 i ) [ ] i (10.3) Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 24 10.3 Mortgage Finance (cont.) • Calculating the instalment on a mortgage loan (cont.) – Example 3: A company is seeking a fully-amortised commercial mortgage loan of $650,000 from its bank. The conditions attached to the loan include an interest rate of 8 per cent per annum, payable over five years by equal end-of-quarter instalments. The company treasurer needs to ascertain the quarterly instalment amount. Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 25 10.3 Mortgage Finance (cont.) • Calculating the instalment on a mortgage loan (cont.) – Example 3 (cont.): A $650 000 0.08 0.02 4 n 5 4 20 i R [ $650 000 1 (1 0.02)20 ] 0.02 $39 751.87 monthly instalment Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 26 Chapter Organisation 10.1 Introduction 10.2 Term Loans or Fully-drawn Advances 10.3 Mortgage Finance 10.4 Debentures, Unsecured Notes and Subordinated Debt Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 27 10.4 Debentures, Unsecured Notes and Subordinated Debt • These securities are issued in the corporate bond market – – Markets for the direct issue of longer-term debt securities Lenders face higher Risk compared to lending indirectly through intermediaries Yield due to sharing in the profit margin usually taken by intermediaries Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 28 10.4 Debentures, Unsecured Notes and Subordinated Debt (cont.) • Debentures and unsecured notes – Are both described as a corporate bond – Specify that the lender will receive regular interest payments (coupon) during the term of the bond and receive repayment of the face value at maturity – Debentures are secured by either a fixed or floating charge over the issuer’s unpledged assets Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 29 10.4 Debentures, Unsecured Notes and Subordinated Debt (cont.) • Debentures and unsecured notes (cont.) – Unsecured notes are bonds with no underlying security attached – Debentures are listed and traded on the stock exchange – Debentures have a higher claim over a company’s assets (e.g. on liquidation) than unsecured note holders Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 30 10.4 Debentures, Unsecured Notes and Subordinated Debt (cont.) • Issuing debentures and notes – There are three principal issue methods – Public issue—issued to the public at large, by prospectus Family issue—issued to existing shareholders and investors by prospectus Private placement—issued to institutional investors, prospectus not required Usually issued at face value, but may be issued at a discount, or with deferred or zero interest Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 31 10.4 Debentures, Unsecured Notes and Subordinated Debt (cont.) • Subordinated debt – More like equity than debt i.e. quasi-equity – Claims of debt holders are ‘subordinated’ behind all other company liabilities – Agreement may specify that the debt is not presented for redemption until after a certain period has elapsed – May be regarded as equity in the balance sheet and treated as Tier 2 capital Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 32 Chapter Organisation (cont.) 10.5 Calculations: Fixed Interest Securities 10.6 Leasing 10.7 Direct Credit Substitutes 10.8 Summary Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 33 10.5 Calculations: Fixed Interest Securities • Price of a fixed interest bond at coupon date – The price of a fixed interest security is the sum of the present value of the face value and the present value of the coupon stream 1 (1 i )n n P C[ ] A(1 i ) i Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger (10.4) 34 10.5 Calculations: Fixed Interest Securities (cont.) • Price of a fixed interest bond at coupon date (cont.) – Example 4: Current corporate bond yields in the market are 8 per cent per annum. An existing corporate bond with a face value of $100,000, paying 10 per cent per annum half-yearly coupons, and exactly six years to maturity, would be sold at a price of: Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 35 10.5 Calculations: Fixed Interest Securities (cont.) – a Example 4 (cont.): PV $100 000(1 0.04)12 face value $62 459.70 plus b 1 (1 0.04) 12 PVcoupons $5000[ ] 0.04 $46 925.37 Price $62 459.70 $46 925.37 $10 9385.07 Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 36 10.5 Calculations: Fixed Interest Securities (cont.) • Price of a fixed interest bond between coupon dates 1 (1 i )n n k P C A ( 1 i ) ( 1 i ) i (10.7) Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 37 10.5 Calculations: Fixed Interest Securities (cont.) • Price of a fixed interest bond between coupon dates (cont.) – Example 5: Current corporate bond yields in the market are 8 per cent per annum. An existing corporate bond with a face value of $100,000, paying 10 per cent per annum half-yearly coupons, maturing 31 December 2009, would be sold on 20 May 2004 at a price of: Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 38 10.5 Calculations: Fixed Interest Securities (cont.) – a Example 5 (cont.): PV $100 000(1 0.04)12 face value $62 459.70 plus b 1 (1 0.04) 12 PVcoupons $5000[ ] 0.04 $46 925.37 PV $62 459.70 $46 925.37 $10 9385.07 Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 39 10.5 Calculations: Fixed Interest Securities (cont.) – c Example 5 (cont.): 140 P $109 385.07(1.04)181 $112 754.27 Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 40 Chapter Organisation (cont.) 10.5 Calculations: Fixed Interest Securities 10.6 Leasing 10.7 Direct Credit Substitutes 10.8 Summary Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 41 10.6 Leasing • A lease is a contract where the owner of an asset (lessor) grants another party (lessee) the right to use the asset for an agreed period of time in return for periodic rental payments • Leasing is the borrowing (renting) of an asset, instead of borrowing the funds to purchase the asset Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 42 10.6 Leasing (cont.) • Advantages of leasing – Conserves capital – Provides 100% financing – Matches cash flows (i.e. rental payments with income generated by the asset) – Less likely to breach any existing loan covenants – Rental payments are tax deductible Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 43 10.6 Leasing (cont.) • Types of leases – Operating lease Lessor may lease the asset to successive lessees (e.g. short-term use of equipment) Maintenance and insurance of the asset is provided by the lessor Lessee makes rental payments for the period of use of the assets Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 44 10.6 Leasing (cont.) • Types of leases (cont.) – Finance lease Longer-term financing Lessor finances the asset Lessor earns return from a single lease contract Lessee pays for insurance and maintenance Residual amount due at end of lease period Ownership of the asset passes to lessee on payment of the residual amount Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 45 10.6 Leasing (cont.) • Types of leases (cont.) – Sale and lease-back – Existing assets owned by a company or government are sold to raise cash The assets are then leased back from the new owner Cross-border lease A lessor in one country leases an asset to a lessee in another country Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 46 10.6 Leasing (cont.) • Lease structures – Direct Involves two parties (lessor and lessee) Lessor purchases equipment with own funds and leases asset to lessee Direct leases generally run from between 3 and 5 years Leased asset price is, generally, less than $100,000 Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 47 10.6 Leasing (cont.) • Lease structures (cont.) – Leveraged leasing Lessors contribute limited equity, and borrow the majority of funds required to purchase the asset Asset then leased to lessee Lessors gain tax advantages of depreciation and interest expense claims Leased asset price is, usually, large (upwards of $2 million) Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 48 10.6 Leasing (cont.) • Lease structures (cont.) – Equity leasing Leased asset cost usually between direct and leveraged range ($100,000 to $2 million) Similar structure to leveraged lease, but lose the leverage advantage due to the smaller amount of debt financing required Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 49 Chapter Organisation (cont.) 10.5 Calculations: Fixed Interest Securities 10.6 Leasing 10.7 Direct Credit Substitutes 10.8 Summary Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 50 10.7 Direct Credit Substitutes • These are OBS arrangements that allow a corporation or government to substitute or replace an actual borrowing of funds with an undertaking from a financial institution such as a bank Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 51 10.7 Direct Credit Substitutes (cont.) • Three categories of direct credit substitutes – Letter of credit—an irrevocable undertaking to meet a financial commitment in the event of default by a named party – Letter of comfort—advice given by a parent company provided reassurance that its subsidiary can meet its obligations Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 52 10.7 Direct Credit Substitutes (cont.) • Three categories of direct credit substitutes (cont.) – Guarantee—a guarantor agrees to assume the liabilities of a third party in the event of default Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 53 Chapter Organisation (cont.) 10.5 Calculations: Fixed Interest Securities 10.6 Leasing 10.7 Direct Credit Substitutes 10.8 Summary Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 54 10.8 Summary • When choosing the most appropriate source of medium- to longer-term debt, a borrower should consider the following factors – – – – – Matching the maturity and repayment schedule of debt with cash flows generated by assets financed by debt Fixed or variable interest rate Term of the financing arrangement Repayment schedule Loan covenants Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 55 10.8 Summary (cont.) • When choosing the most appropriate source of medium- to longer-term debt, a borrower should consider the following factors (cont.) – – – – Whether secured by fixed or floating charge, or unsecured Impact on capital adequacy requirements of borrowing corporation Impact of direct credit substitutes on the availability and cost of funds Leasing an asset as opposed to buying an asset Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 56
