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Chapter 10 Medium- to long-term debt Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-1 Learning objectives • Identify the main types of medium- to long-term debt instruments in the market – Term loans or fully drawn advances, mortgage finance, bond markets (debentures, unsecured notes and subordinated debt) and lease financing • Describe the main features of these facilities • Identify the financial institutions and parties involved in the provision of these facilities • Undertake calculations related to the pricing of these debt instruments • Discuss the availability and appropriateness of these debt instruments for business Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-2 Chapter organisation 10.1 Term loans or fully drawn advances 10.2 Mortgage finance 10.3 Debentures, unsecured notes and subordinated debt 10.4 Calculations: fixed-interest securities 10.5 Leasing 10.6 Summary Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-3 10.1 Term loans or fully drawn advances • Term loan – A loan advanced for a specific period (three to 15 years), usually for a known purpose; e.g. purchasing land, premises, plant and equipment – Secured by mortgage over asset purchased or other assets of the firm • Fully drawn advance – A term loan where the full amount is provided at the start of the loan • Provided by: – mainly commercial banks and finance companies – to a lesser degree, investment banks, merchant banks, insurance offices and credit unions Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips (cont.) 10-4 10.1 Term loans or fully drawn advances (cont.) • Term loan structures – Interest only during term of loan and principal repayment on maturity – Amortised or 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 (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-5 10.1 Term loans or fully drawn advances (cont.) • Term loan structures (cont.) – Interest may be fixed (for a specified period of time; e.g. two years) or variable – Interest rate charged on term loan is based on:  an indicator rate (e.g. BBSW or a bank’s own prime lending rate) and is also influenced by: • credit risk of borrower—risk that borrower may default on loan commitment, giving rise to a risk premium • term of the loan—usually longer term attracts a higher interest rate • repayment schedule—frequency of loan repayments (e.g. monthly or quarterly) and form of the repayment (e.g. amortised or interest-only loan) (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-6 10.1 Term loans or fully drawn advances (cont.) • Term loan structures (cont.) – Other fees include:      establishment fee service fee commitment fee line fee bill option clause fee (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-7 10.1 Term loans or fully drawn 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. maximum D/E ratio, minimum working-capital ratio, unaudited periodic financial statements – Breach of covenant results in default of the loan contract, entitling lender to act (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-8 10.1 Term loans or fully drawn advances (cont.) • Calculating the loan instalment—ordinary annuity A R 1 (1 i ) n [ ] i 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. (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-9 10.1 Term loans or fully drawn 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 high-speed CD burner. The bank offers a $150 000 loan, amortised over five years at 8% per annum, payable monthly. Calculate the monthly loan instalments. (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-10 10.1 Term loans or fully drawn advances (cont.) • Calculating the loan instalment—ordinary annuity (cont.) – Example 1 (cont.) A $150 000 0.08 i 0.006667 12 n 5 years 12 months 60 $150 000 R 1 (1 0.006667)  60 [ ] 0.006667 R $3041.49 per month Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips (cont.) 10-11 10.1 Term loans or fully drawn advances (cont.) • Calculating the loan instalment—annuity due R A 1 (1 i ) n [ ](1 i ) i (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-12 10.1 Term loans or fully drawn 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 annum. The loan will be repaid by equal monthly instalments at the beginning of each month. Calculate the amount of the loan instalments. (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-13 10.1 Term loans or fully drawn advances (cont.) – Example 2 (cont.) A $21 500 0.12 0.01 12 n 7 12 84 $21 500 R 1 (1 0.01)  84 [ ] (1  0.01) 0.01 $21 500  57.21494 $375.78 monthly instalment i Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-14 Chapter organisation 10.1 Term loans or fully drawn advances 10.2 Mortgage finance 10.3 Debentures, unsecured notes and subordinated debt 10.4 Calculations: fixed-interest securities 10.5 Leasing 10.6 Summary Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-15 10.2 Mortgage finance • A mortgage is a form of security for a loan – The borrower (mortgagor) conveys an interest in the land and property to the lender (mortgagee) • 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, i.e. take possession of assets and realise any amount owing on the loan (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-16 10.2 Mortgage finance (cont.) • Use of mortgage finance – Mainly retail home loans  Up to 30-year terms – To a lesser degree commercial property loans  Up to 10 years as businesses generate cash flows enabling earlier repayment • Providers (lenders) of mortgage finance – Commercial banks, building societies, life insurance offices, superannuation funds, trustee institutions, finance companies and mortgage originators (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-17 10.2 Mortgage finance (cont.) • Interest rates – Both variable and fixed interest rate loans are available to borrowers  With fixed interest loans, interest rates reset every five years or less – With interest-only mortgage loans, interest-only period is normally a maximum of five years • Mortgagee (lender) may reduce their risk exposure to borrower default by: – requiring the mortgagor to take out mortgage insurance up to 100% of the mortgage value (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-18 10.2 Mortgage finance (cont.) • Calculating the instalment on a mortgage loan R A  n 1 (1 i ) [ ] i (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-19 10.2 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 annum, payable over five years by equal end-of-quarter instalments. The company treasurer needs to ascertain the quarterly instalment amount. (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-20 10.2 Mortgage finance (cont.) • Calculating the instalment on a mortgage loan (cont.) – Example 3 (cont.): A $650 000 0.08 i 0.02 4 n 5 4 20 $650 000 R 1 (1 0.02) 20 [ ] 0.02 $39 751.87 monthly instalment (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-21 10.2 Mortgage finance (cont.) • Securitisation and mortgage finance – Mortgage originators, commercial banks and other institutions use securitisation to manage their mortgage loan portfolios – Involves conversion of non-liquid assets into new assetbacked securities that are serviced with cash flows from the original assets – Original lender sells bundled mortgage loans to a specialpurpose vehicle  That is, a trust set up to hold securitised assets and issue asset-backed securities like bonds, providing investors with security and payments of interest and principal (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-22 10.2 Mortgage finance (cont.) • The securitisation of mortgage finance suffered a large contraction during the GFC. – Securitised mortgage assets in 2007: $215 billion – Securitised mortgage assets in 2010: $112 billion • These falls were recorded in Australia despite the much lower default rates experienced on mortgages compared to other parts of the world. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-23 Chapter organisation 10.1 Term loans or fully drawn advances 10.2 Mortgage finance 10.3 Debentures, unsecured notes and subordinated debt 10.4 Calculations: fixed-interest securities 10.5 Leasing 10.6 Summary Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-24 10.3 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 attract higher:  risk compared with lending indirectly through intermediaries  yield owing to sharing in the profit margin usually taken by intermediaries (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-25 10.3 Debentures, unsecured notes and subordinated debt (cont.) • Debentures and unsecured notes – Are corporate bonds – 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 – Unsecured notes are bonds with no underlying security attached – Debentures:  are secured by either a fixed or floating charge over the issuer’s unpledged assets  are listed and traded on the stock exchange  have a higher claim over a company’s assets (e.g. on liquidation) than unsecured note holders (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-26 10.3 Debentures, unsecured notes and subordinated debt (cont.) • Issuing debentures and notes – There are three principal issue methods  1. Public issue—issued to the public at large, by prospectus  2. Family issue—issued to existing shareholders and investors, by prospectus  3. Private placement—issued to institutional investors, by information memorandum – Usually issued at face value, but may be issued at a discount or with deferred or zero interest – A prospectus contains detailed information about the business Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips (cont.) 10-27 10.3 Debentures, unsecured notes and subordinated debt (cont.) • Subordinated debt – More like equity than debt, i.e. quasi-equity – Claims of debt holders are ‘subordinated’ to all other company liabilities – Agreement may specify that the debt not be presented for redemption until after a certain period has elapsed – May be regarded as equity in the balance sheet, improving the credit rating of the issuer Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-28 Chapter organisation 10.1 Term loans or fully drawn advances 10.2 Mortgage finance 10.3 Debentures, unsecured notes and subordinated debt 10.4 Calculations: fixed-interest securities 10.5 Leasing 10.6 Summary Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-29 10.4 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 P C[ ]  A(1 i ) n i (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-30 10.4 Calculations: fixed-interest securities (cont.) • Price of a fixed-interest bond at coupon date (cont.) – Example 4: Current AA+ corporate bond yields in the market are 8% per annum. What is the price of an existing AA+ corporate bond with a face value of $100 000, paying 10% per annum half-yearly coupons, and exactly six years to maturity? A = $100 000 C = $100 000 x 0.10/2 = $5000 i = 0.08/2 = 0.04 n = 6 x 2 = 12 Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips (cont.) 10-31 10.4 Calculations: fixed-interest securities (cont.) – Example 4 (cont.): (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-32 10.4 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     (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-33 10.4 Calculations: fixed-interest securities (cont.) • Price of a fixed-interest bond between coupon dates (cont.) – Example 5: Current AA+ corporate bond yields in the market are 8% per annum. An existing AA+ corporate bond with a face value of $100 000, paying 10% per annum half-yearly coupons, maturing 31 December 2016, would be sold on 20 May 2011 at what price? (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-34 10.4 Calculations: fixed-interest securities (cont.) – Example 5 (cont.): (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-35 10.4 Calculations: fixed-interest securities (cont.) – Example 5 (cont.): Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-36 Chapter organisation 10.1 Term loans or fully drawn advances 10.2 Mortgage finance 10.3 Debentures, unsecured notes and subordinated debt 10.4 Calculations: fixed-interest securities 10.5 Leasing 10.6 Summary Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-37 10.5 Leasing • Leasing defined – 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 (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-38 10.5 Leasing (cont.) • Advantages of leasing for lessee over ‘borrow and purchase’ alternative – 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 (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-39 10.5 Leasing (cont.) • Advantages of leasing for lessor over a straight loan provided to a lessee – Leasing has relatively low level of overall risk as asset can be repossessed if lessee defaults – Leasing can be administratively cheaper than providing a loan – Leasing is an attractive alternative source of finance to both business and government (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-40 10.5 Leasing (cont.) • Types of leases – Operating lease  Short-term lease • Lessor may lease the asset to successive lessees (e.g. short-term use of equipment) • Lessee can lease asset for a short-term project  Full-service lease—maintenance and insurance of the asset is provided by the lessor  Minor penalties for lease cancellation  Obsolescence risk remains with lessor (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-41 10.5 Leasing (cont.) • Types of leases (cont.) – Finance lease Longer term financing Lessor finances the asset Lessor earns a return from a single lease contract Net lease—lessee pays for maintenance and repairs, insurance, taxes and stamp duties associated with lease  Residual amount due at end of lease period  Ownership of the asset passes to lessee on payment of the residual amount     (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-42 10.5 Leasing (cont.) • Types of leases (cont.) – Sale and lease back  Existing assets owned by a company or government are sold to raise cash; e.g. government car fleet  The assets are then leased back from the new owner  This removes expensive assets from the lessee’s balance sheet – Cross-border lease  A lessor in one country leases an asset to a lessee in another country (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-43 10.5 Leasing (cont.) • Lease structures – Direct finance lease  Involves two parties (lessor and lessee)  Lessor purchases equipment with own funds and leases asset to lessee  Lessor retains legal ownership of asset and takes control or possession of asset if lessee defaults  Security of the lessor provided by: • lease agreement • leasing guarantee—an agreement by a third party to meet commitments of the lessee in the event of default (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-44 10.5 Leasing (cont.) • Lease structures (cont.) – Leveraged finance lease  Lessor contributes limited equity and borrows the majority of funds required to purchase the asset  Lease manager • Structures and negotiates the lease and manages it for its life • Brings together the lessor (or equity participants), debt parties and lessee  Asset then leased to lessee  Lessor gains tax advantages from the depreciation of equipment and the interest paid to the debt parties (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-45 10.5 Leasing (cont.) • Lease structures (cont.) – Equity leasing  Similar to a leveraged lease, except funds needed to buy asset are provided by the lessor  Therefore, it is usually smaller than a leveraged lease  Has many characteristics of a leveraged lease, including the formation of a partnership to purchase the asset, but not the advantage of leverage Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-46 Chapter organisation 10.1 Term loans or fully drawn advances 10.2 Mortgage finance 10.3 Debentures, unsecured notes and subordinated debt 10.4 Calculations: fixed-interest securities 10.5 Leasing 10.6 Summary Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-47 10.6 Summary • When choosing the most appropriate source of mediumto long-term debt, a borrower should consider the following factors: – – – – – – Fixed or variable interest rate Term of the financing arrangement Repayment schedule Loan covenants Whether secured by fixed or floating charge, or unsecured The merits of leasing an asset as opposed to buying an asset Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 10-48