Chapter 25

Principles
of
Corporate
Finance

Ninth Edition
The Many Different
Kinds of Debt
Slides by
Matthew Will
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin
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Topics Covered
Domestic Bonds, Foreign Bonds and Euro Bonds
The Bond Contract
Security and Seniority
Repayment Provisions
Debt Covenants
Convertible Bonds and Warrants
Private Placements and Project Finance
Innovation in the Bond Market
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Bond Terminology
Foreign bonds - bonds that are sold to local investors in
another country's bond market

Yankee bond- a bond sold publicly by a foreign company
in the United States

Samurai - a bond sold by a foreign firm in Japan

Eurobond market - when European and American
multinationals are forced to tap into international markets
for capital
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Bond Terminology
Indenture or trust deed - the bond agreement between the
borrower and a trust company

Registered bond - a bond in which the Company's records
show ownership and interest and principal are paid directly
to each owner

Bearer bonds - the bond holder must send in coupons to
claim interest and must send a certificate to claim the final
payment of principal

Accrued interest - the amount of accumulated interest since
the last coupon payment

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Bond Contract
Trustee Bank of America National Trust and Savings Association
Rights of default
The trustee or 25% of debenture holders may declare the principle due
and payable
Registered Fully registered
Denomination $1,000
Amount issued $250 million
Issue Date 26-Aug-1992
Offered
Issued at a price of 99.489% plus accrued interest (proceeds to
company 98.614%) through First Boston Corporation
Interest At a rate of 8.25% per annum, payable February 15 and August 15
Seniority Ranks pari passu with other unsecured unsubordinated debt
Security
Not secured. Company will not permit to have any lien on its property
or assets without equally and ratably securing the debt securities
Maturity 15-Aug-2022
Sinking fund
Annually from August 15, 2003, sufficient to redeem $12.5 million
principal amount, plus an optional sinking fund of up to $25 million
Callable
At whole or in part on or after August 15, 2002, at the option of the
company with at least 30 days, but not more than 60 days notice to each
August 14 as follows: schedule inserted here
Moody's rating B
Summary of terms of 8.25% sinking fund debenture 2022
issued by J.C. Penney
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Bond Terminology

Debentures - long-term unsecured issues on debt

Mortgage bonds - long-term secured debt often
containing a claim against a specific building or
property

Asset-backed securities - the sale of cash flows
derived directly from a specific set of bundled
assets

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Recovery Rates
77.5
62
42.6
30.3
29.2
19.1
0
10
20
30
40
50
60
70
80
Bank Debt Senior
secured notes
Senior
unsecured
notes
Senior
subordinated
notes
Subordinated
notes
Junior
subordinated
notes
Ultimate Percentage Recovery Rates on
Defaulting Debt (1987 2005)
R
e
c
o
v
e
r
y

P
e
r
c
e
n
t
a
g
e

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Bond Terminology
Sinking fund - a fund established to retired debt
before maturity

Callable bond - a bond that may be repurchased by
a the firm before maturity at a specified call price

Defeasance - a method of retiring corporate debt
involving the creation of a trust funded with
treasury bonds
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Bond Terminology
Restrictive covenants - Limitations set by
bondholders on the actions of the Corporation

Negative Pledge Clause - the processing of giving
unsecured debentures equal protection and when
assets are mortgaged

Poison Put - a clause that obliges the borrower to
repay the bond if a large quantity of stock is bought by
single investor, which causes the firms bonds to beat
down rated
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Bond Terminology
Pay in kind (PIK) - a bond that makes regular interest
payments, but in the early years of the bonds life the issuer
can choose to pay interest in the form of either cash or
more bonds with an equivalent face value

Puttable bond A provision that allows the bondholder to
demand immediate payment. This is the central feature in
loan guarantees issued by the government.
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Straight Bond vs. Callable Bond
Value of
straight bond
25 50 75 100 125 150
25
50
75
100
bond
Value of
Straight bond
bond callable
at 100
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Covenants
Debt ratios:
Senior debt limits senior borrowing
Junior debt limits senior & junior borrowing
Security:
Negative pledge
Dividends
Event risk
Positive covenants:
Working capital
Net worth

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Event Risk: An Example
October 1993 Marriott spun off its hotel management business worth 80% of its
value.

Before the spin-off, Marriotts long-term book debt ratio was 2891/3644 = 79%.
Almost all the debt remained with the parent (renamed Host Marriott), whose
debt ratio therefore rose to 93%.

Marriotts stock price rose 13.8% and its bond prices declined by up to 30%.

Bondholders sued and Marriott modified its spinoff plan.
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What is a Convertible Bond?
Ford
4.25% Convertible 2036
Convertible into 108.7 shares
Conversion ratio 108.7
Conversion price = 1000/108.7 = $9.20
Market price of shares = $12.00

Lower bound of value
Bond value
Conversion value = 108.7 x 12 = $1,304
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What is a Convertible Bond?
How bond value varies with firm value at maturity
0
1
2
3
0 1 2 3 4 5
Value of firm ($ million)
default
bond repaid in full
Bond value ($ thousands)
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What is a Convertible Bond?
How conversion value at maturity varies with firm value
0
1
2
3
0 0.5 1 1.5 2 2.5 3 3.5 4
Value of firm ($ million)
Conversion value ($ thousands)
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What is a Convertible Bond?
How value of convertible at maturity varies with firm value
0
1
2
3
0 1 2 3 4
Value of firm ($ million)
default
bond repaid in full
convert
Value of convertible ($ thousands)
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Bond Warrant Package
Bond and Option
Warrants are usually issued privately
Warrants can be detached
Warrants are exercised for cash
A package of bonds and warrants may be taxed
differently
Warrants may be issued on their own

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Project Finance
1. Project is set up as a separate company.

2. A major proportion of equity is held by project
manager or contractor, so provision of finance and
management are linked.

3. The company is highly levered.
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Parties In Project Finance
Contractor Supplier(s)
Equity investors
Government Project
company
Equity sponsor
Lenders
Purchaser(s)
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Risk Allocation
Risk Shifted to: Contract
Completion/
continuing
management
Sponsor Management contract/
completion gtees / working
capital maintenance
Construction cost Contractor Turnkey contract/ fixed price/
delay penalties
Raw materials Supplier(s) Long-term contract/ indexed
prices/ supply or pay
Revenues Purchaser(s) Long-term contract/ indexed
to costs/ take or pay/
throughput agreements/ tolling
contract
Concession/regulation Government Concession agreement/
provision of supporting
infrastructure
Currency
convertibility
Government Gtees or comfort letters/ hard
currency paid to offshore
escrow account




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Bond Innovations
Liquid yield option notes
(LYONS) Puttable, callable, convertible zero coupon debt
Floating-price (death
spiral) convertibles
Convertible debt where the bondholder can convert into a fixed value
of shares
Asset backed securities Many small loans are packaged together and resold as a bond
Catastrophe (CAT) bonds Payments are reduced in the event of a specific natural disaster
Reverse floaters (yield
curve notes)
Floating rate bonds that pay a higher rate of interest when other interest
rates fall and a lower rate when other rates rise
Equity linked bonds Payments are linked to the performance of a stock market index
Pay-in-kind bonds (PIKs)
Issuer can choose to make interest payments either in cash or in more
bonds with an equivalent face value
Rate sensitive bonds Coupon rate changes as company's credit rating changes
Ratchet bonds Floating rate bonds whose coupons can only be reset downwards
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Web Resources
www.ipfa.com

www.hbs.edu/projfinportal



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