Chapte

r
16 Long-Term Debt
and Lease Financing

Revised By:
P Chua

Prepared by:
Terry Fegarty

May 4, 2005

McGraw-Hill Ryerson ©2003 McGraw-Hill Ryerson

© 2003 McGraw-Hill Limited
Ryerson Limited
 PPT 16-2
Chapter 16 - Outline
Bonds

Bond Terminology
Priority of Claims on Bankruptcy

Methods of Retiring (Repaying) Bonds

Reading Bond Price Quotations

3 Types of Bond Yields

Bond Ratings

Other Forms of Bond Financing

Lease vs. Purchase

2 Types of Leases

Advantages/Disadvantages of Debt

Advantages/Disadvantages of Leasing

Summary and Conclusions

© 2003 McGraw-Hill Ryerson Limited

 PPT 16-4

Bonds
 Firms and governments “borrow” money from
investors by selling bonds
 A bond is a written promise that the borrower (firm)

will pay the lender (investor) at a stated future date,

the principal plus a stated rate of interest
 Bonds differ from one another in terms of maturity

(payment date), potential yield (interest rate), and

investment quality (risk)
 Several companies rate the quality of various bonds

© 2003 McGraw-Hill Ryerson Limited

 PPT 16-5
Bond Terminology

Par Value:
 principal or face value (usually $1,000)

Coupon Rate:
 stated interest rate

Maturity Date:
 date when repayment of principal is due

Indenture:
 legal document detailing the corporation’s obligations and Restrictive

Covenants
Secured Debt:
 where specific assets are pledged in the event of default

Debenture:
 a L/T unsecured corporate bond

© 2003 McGraw-Hill Ryerson Limited

 PPT 16-6
Figure 16-2
Priority of claims
Secured debt
Senior First claim on assets pledged
Junior Second claim on assets pledged

Remaining assets are distributed below.

Unsecured debt
(debentures)

Senior
Subordinated
Subordinated debenture holders will not receive
payment unless designated senior debenture
holders are paid in full.
Lower priority
of claims

Preferred stock
Common stock
© 2003 McGraw-Hill Ryerson Limited
 PPT 16-7

Methods of Retiring (Repaying)

Bonds
Principal at maturity:
 lump-sum payment when bond is due

Serial payments:
 bond is paid off in installments

Sinking fund:
 corporation contributes regularly to

a trust fund used to buy back bonds

Conversion:
 bond can be converted into shares of common stock at the option of

the bondholder
Call feature:
 corporation can redeem bonds early by paying a premium over par

value
© 2003 McGraw-Hill Ryerson Limited
 PPT 16-9

Reading Bond Price

Quotations Maturity Date
Coupon
Company Name (April 8, 2022)
(interest rate %)
Your Daily Paper
Issuer Coupon Maturity Price Yield Change

BC Tel 9.65 Apr 8-22 138.5 6.488 +1.118

Price Change
(Last transaction (Closing
Yield price up
price = $138.50/ $100) (Annual interest $1.11 from
Market price) previous day)
© 2003 McGraw-Hill Ryerson Limited
Table 16-2: PPT 16-10
Interest rates and bond prices
(the bond pays 12 percent
interest)

Years to Rate in the Market (percent)

Maturity

8% 10% 12% 14% 16%

1 $1,037.72 $1,018.59 $1,000 $981.92 $964.33
15 1,345.84 1,153.72 1,000 875.91 774.84
25 1,429.64 1,182.56 1,000 861.99 755.33

Note: This table is based on semiannual interest payments, with annualized interest
rates

© 2003 McGraw-Hill Ryerson Limited

 PPT 16-11
3 Types of Bond Yields

Coupon Rate (or Nominal Yield ):

 interest payment divided by par value

Current Yield:
 interest payment divided by current price of the bond

Yield-to-Maturity (YTM):
 interest rate that equates the future (expected) interest

payments and payment at maturity to the current market

price of the bond
 affected by current market interest rates

If rates ↑, YTM ↑, bond price ↓

 and bond rating

If rating high (low risk), YTM ↓

© 2003 McGraw-Hill Ryerson Limited
Figure 16-3 PPT 16-12

Long-term yields on corporate

debt

© 2003 McGraw-Hill Ryerson Limited

 PPT 16-13

Bond Ratings

Bond Ratings
Medium Grade
High (Investment Poor
Rating Service Grade Grade) Speculative Grade

Moody's Aaa Aa A Baa Ba B Caa to C

Standard & Poor's AAA AA A BBB BB B CCC to D
Dominion AAA BBB B C

Risk Factor Low High

© 2003 McGraw-Hill Ryerson Limited

 PPT 16-14
Table 16-3
Outstanding debt issues, March
1, 2002
Rating/Issuer Coupon Maturity Date Price Yield to Maturity

AAA
CARDS Trust Receivables 5.630 Dec. 21/05 102.94 4.77
Government of Canada 5.750 Sept. 01/06 104.10 4.72
Government of Canada 8.000 June 01/27 127.72 5.88
AA
BMO 8.150 May 9/06 111.29 5.11
BMO 6.685 Dec. 31/11 101.69 6.45
Nav Canada 6.600 Dec 01/06 106.13 5.12
Nav Canada 7.400 June 01/27 109.78 6.60
A
Bell Canada 6.700 June 28/07 105.74 5.44
Bell Canada 7.850 April 02/31 106.11 7.34
Loblaw 6.000 June 02/08 101.92 5.63
Loblaw 6.650 Nov. O8/27 96.67 6.93
BBB
Domtar 10.000 Apr. 15/11 108.21 8.68
Talisman 5.800 Jan. 30/07 97.69 6.35
BB
Rogers Cable 10.500June 01/06 103.00 9.61
B
Air Canada 6.750 Feb 02/04 72.00 26.29
Saskatchewan Wheat Pool 6.600 July 18/07 71.00 14.56

© 2003 McGraw-Hill Ryerson Limited

 PPT 16-17
Other Forms of Bond Financing

Zero-Coupon Bond / Strip Bond:

 does not pay interest

 is issued at a deep discount from face value

Floating Rate Bond:

 interest rate paid on the bond changes with market conditions

Real Return Bond

 principal adjusted for inflation

Revenue Bond
 security based upon cash flow

Eurobond:
 bond issued in another country

© 2003 McGraw-Hill Ryerson Limited

 PPT 16-18
Table 16-4
Examples of Eurobonds
Amount
Outstanding Currency
Rating Coupon Maturity ($ millions) Denomination*

Petro-Canada Baa1 9.25% 2021 300.0 U.S.$

Procter & Gamble Co. Aa2 10.88% 2003 200.0 C$
Sony Corporation Aa3 1.40% 2005 300.0 Yen
Telecom Corporation Aa1 7.50% 2003 100.0 N Z$

*C$ is Canadian dollar, and N Z $ is New Zealand dollar.

Source: Mergent Bond Report,July 2000

Source: Moody’s Bond Record, July

1998..
© 2003 McGraw-Hill Ryerson Limited
 PPT 16-19
Advantages and Disadvantages
of Debt
Advantages of Debt:
 interest payments are tax deductible to a firm

 wise use of debt may lower a firm’s weighted

average cost of capital (WACC)

 financial obligation is fixed

 no reduction in control or equity of present

shareholders
 company may get a better return on equity from

leverage

© 2003 McGraw-Hill Ryerson Limited

 PPT 16-20
Advantages and Disadvantages
of Debt

Disadvantages of Debt:

 interestand principal must always be met when

due, regardless of a firm’s financial position
 agreements may restrict financial management in

firm
 poor use of debt may lower a firm’s stock price

 expensive financing when interest rates are high

© 2003 McGraw-Hill Ryerson Limited

 PPT 16-21

2 Types of Leases

Capital Lease (or Financing Lease):

 Lease payments are usually sufficient to fully cover
the lessor’s cost of purchasing the assets and provide
the lessor a return on investment
 The lessee is usually responsible for the upkeep of the

asset
 Generally, lease cannot be cancelled

 must be shown on a firm’s balance sheet

 ex., oil drilling equipment and airplanes

© 2003 McGraw-Hill Ryerson Limited

 PPT 16-21

2 Types of Leases

Operating Lease:
 Usually a shorter term lease
 a conventional rental agreement

 Often cancellable on short notice

 Lessor is responsible for upkeep of

asset
 firm doesn’t expect to own the asset

 is not shown on a firm’s balance

sheet
 ex., automobiles and office
equipment

© 2003 McGraw-Hill Ryerson Limited

Capital Lease Criteria
 A lease is considered a Capital Lease if it meets one of
the following criteria:
 The lease transfers ownership of the asset to the

lessee at the end the lease term

 Lessee has the option to purchase the asset at a price

below the fair market value when the lease expires.

 The lease term is 75% or more of the estimated

economic life of the asset

 The PV of the lease payments is at least 90% of the

fair market value of the asset at the start of the lease

© 2003 McGraw-Hill Ryerson Limited

 PPT 16-22
Advantages of Leasing

 A loan may be more expensive / refused

 There may be no down payment on a lease, but usually a

down payment with a loan

 A lease may have fewer restrictions than a loan

 There is a fixed payment on a lease, but loan interest may

vary with prime

 Lease from a manufacturer may have attractive terms (ex:

lower interest cost) or provide specialist expertise

 Using a lease may restrict creditor claims in bankruptcy

 Lease may be preferable for equipment with rapid

obsolescence (ex: computers)

 May have more tax advantages using a lease

© 2003 McGraw-Hill Ryerson Limited

Lease vs Borrow-Purchase
Problem
 A Firm is considering the purchase of an asset as opposed to
leasing it.
 The asset costs $5,000. To purchase it, the firm must get a

loan from its bank. The loan amortization will be $1,319 for
5 years at 10%. Interest payments from yrs. 1 to 5 are: $500,
$418, $328, $229, and $120. CCA rate is 20 %.
 To lease the asset, the firm must pay $1,250 during the 1st and

2nd years, and $1,800 during the 3rd to 5th years. Note that lease
payments are made at the beginning of each year.
 Tax rate is 40%

 Which option is less costly?

© 2003 McGraw-Hill Ryerson Limited

Table 16-7 PPT 16-23

Net present value of borrow-

purchase
(1) (2) (3) (4) (5)
Year PV of Interest Aftertax
CCA Tax Cost of Present
Shield Payment Shield (2)-(3) Value at 6%

1............ ($1,319) $500 x .4 $(1,119) $(1,056)

2............ ($1,319) $418 x .4 (1,152) (1,025)

3............ ($1,319) $328 x .4 (1,188) (997)

4............ ($1,319) $229 x .4 (1,227) (972)

5............ ($1,319) $120 x .4 (1,271) (950)

(5,000)

Or Cost of asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,000)

PV of CCA shield . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,495
PV of borrowing alternative . . . . . . . . . . . . . . . . . . . ($3,505)
© 2003 McGraw-Hill Ryerson Limited
Table 16-8 PPT 16-24

Net present value of operating

lease outflows

Year Payment

0 . . . . . . . . ($1,250
© 2003 McGraw-Hill Ryerson Limited
 PPT 16-25

Summary and Conclusions

Debt financing by major corporations often involves
the sale of secured bonds or unsecured bonds
(debentures).
Corporate bonds may have sinking-fund, call, or

conversion features causing retirement before

maturity.
Bond prices and yields are inversely related and are

based upon the level of interest rates and bond ratings

Long-term capital leases are an alternative form of

long-term financing

© 2003 McGraw-Hill Ryerson Limited