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1. The Role of Debt Financing for the Business Firm
1. Corporate debt is expanding. In the last three decades, the amount of corporate debt outstanding has risen dramatically and the ability of corporations to pay debt service or interest expense has fallen, as a result. See Slide 2 (33.0K) . As the economy expands, corporate debt expands along with it as firms try to finance their operations and expansion. Because corporate debt is high in the U.S. and the fact that corporate bonds are the most often-used form of long-term debt financing, the bond contract has become increasingly important. Take a look at this website for a good tutorial on corporate bonds. This video [Insert Finance Video fibo28k.rm here] .
2. Basic Bond Contract Terminology. The following are important terms in the basic bond contract. Bond contracts are also called _____(Key Term) which are complex agreements spelling out every detail of the bond. The _____(Key Term) is the stated or initial value of the bond. The terms "principal" and "face value" are sometimes used in place of this term. The coupon rate of a bond is _____(Key Term) Interest payments on corporate bonds are generally made (Key Term) Bonds have two interest rates that are important. One is the coupon rate. The other is the prevailing market interest rate of yield to maturity. As the current market interest rate goes up and down, the value of the bond also fluctuates around par. The _____(Key Term) is the final date on which the repayment of the principal is the bond is due to the investor. See Slide Bond Terminology (40.0K) . Go to this educational site to learn more about the characteristics of bonds.
3. Terminology regarding bond security. Secured debt is one in which specific assets are pledged to bondholders in the event of default. Generally, if a firm defaults, it is reorganized and bonds are issued to bondholders for the new firm. Unsecured bonds, without a specific claim to corporate assets, are called _____(Key Term). There are two types of unsecured debt. One is the senior-ranking debenture. The other is the subordinated debenture. Owners of subordinated debentures claims are satisfied, in case of default, after both claims for secured debt and debentures. See Slide More Bond Terminology (59.0K) . Owners of a firm's preferred and common stock are the last claimholders to be paid in the event of financial failure. See Slide Priority of Claims (37.0K)
4. Methods of Repayment of Bonds. Many bonds pay interest over their term and repay the principal in a lump sum at maturity. There are other methods of repayment. _____(Key Term) payment means that the bonds are paid off in installments over the life of the bond. The sinking fund provision of repayment is a method where the issuing corporation makes contributions into a fund administered by a trustee for the purchases of retirement of debt. The proceeds are then used by the trustee to purchase bonds from bondholders. Conversion is a method of repayment where bonds are converted into shares of common stock. A _____(Key Term) allows the corporation to retire the debt issue before maturity. Corporations often call bonds when interest rates on new bonds are much lower than those on outstanding bonds. See Slide Methods of Repayment (54.0K)
5. Bond Yields. What does a bond yield to the investor? Bond yields are quoted in three ways. Those ways are _____, _____ and _____(Critical Concept) The _____(Key Term) is the stated interest rate on the bond contract. The current yield is ________(Key Term). The most important bond yield for you to understand is the yield to maturity. It is essentially the internal rate of return of the bond or what the bond will yield to an investor if held to maturity. This website calculates and forecasts corporate bond yields. See Slide 3 Types of Bond Yields (47.0K)
6. Bond Ratings. Two major agencies rate bonds, Moody's Investor Service (1621) and Standard and Poor's Corporation (1622). Since the relationship between risk and return is positive, the higher the rating of a bond, the lower the interest payment to the investor. Ratings are based on the firm's ability to make interest payments, consistency of performance, size, debt/equity ratio, working capital position and other factors. Interest rates on bonds also change with economic conditions.
7. Other Forms of Bond Financing. Some firms sell zero-coupon bonds to its investors. Zero coupon bonds have two major characteristics. The first is that they _____ and the second is that they _____(Critical Concept). Zero-coupon bonds are advantageous to the firm because there is no cash outflow until the bonds mature but an immediate cash inflow when investors buy the bonds. The floating rate bond is another type of bond financing, which has long been popular in Europe. Instead of a fixed coupon rate and changing bond values based on interest rates as is the case with most corporate bonds, the interest rate on floating rate bonds changes with market conditions. See Slide Other Forms of Bond Financing (50.0K) . _____(Key Term) are bonds payable in the borrower's currency but sold outside the borrower's country.
8. Benefit of Debt Financing. There are four major advantages of debt financing. See Slide Advantages and Disadvantages of Debt (77.0K)
1. Interest payments are tax-deductible. This lowers the firm's taxable income.
2. The financial obligation is clearly specified and of a fixed nature.
3. During inflation, debt may be repaid with cheaper dollars.
4. Using debt financing, up to a point, lowers the cost of capital for the firm.
9. Drawbacks of Debt Financing. There are three major disadvantages of debt financing.
1. Interest and principal payments are contractual and must be met regardless of the firm's financial position.
2. The bond contract may place restrictions on the firm.
3. Beyond a given point, the use of debt may depress the stock price of the firm.
2. Leasing
1. Leasing can be a form of debt financing. Leasing used to be treated as an off-balance sheet type of debt financing and was often only noted in a footnote. Now, leases have to be included in the debt structure of the firm as indicated on the balance sheet.
2. Capital Leases. A capital lease is a lease that must be stated in present value terms and placed on the balance sheet. A lease is only required to be a capital lease when all the benefits and risks of ownership are transferred in the lease. Business firms use more capital leases than operating leases.
3. Operating Leases. Operating leases are basic rental agreements that do not have to be capitalized. More consumers than business firms use operating leases. See Slide 32 Advantages of Leasing (53.0K) for the advantages of leasing.