SESSION 09 DEBT FINANCE

0901
OVERVIEW
Objective
To appreciate the options available to a company for long, medium and short-term debt
finance.



LONG-TERM
FINANCE
OTHER SOURCES
SHORT-TERM
FINANCE
Preference shares
Debentures
Deep discount bonds
Zero coupon bonds
Tax relief on interest
MEDIUM-TERM
FINANCE
Bank loans
Leasing
Sale and leaseback
Mortgage loans
Bank overdraft
Trade credit
Bills of exchange
Commercial paper
Grants
Loan guarantee
scheme
Business angels
CONVERTIBLES
AND WARRANTS
Convertibles
Effect on EPS of convertible debt
Warrants
DEBT
FINANCE



SESSION 09 DEBT FINANCE
0902
1 LONG-TERM FINANCE
1.1 Preference shares
Definition

Shares with a fixed rate of dividend having a prior claim on profits available
for distribution.


Whilst legally equity, they are often treated as debt as they are similar in nature to debt.
1.1.1 Features
Shares which have a fixed percentage dividend payable before ordinary dividend.
The dividend is only payable if there are sufficient distributable profits. However if the
shares are cumulative preference shares the right of dividend is carried forward. Any
arrears of dividend are then payable before ordinary dividends.
As with ordinary dividends, preference dividends are not deductible for corporate tax
purposes they are a distribution of profit rather than an expense.
On liquidation of the company, preference shareholders rank before ordinary
shareholders.
1.1.2 Advantages
No voting rights; therefore no dilution of control.
Compared to the issue of debt:
Dividends do not have to be paid if profits are poor;
Not secured on company assets;
Non-payment of dividend does not give holders the right to appoint a liquidator.
1.1.3 Disadvantages
Dividends are not tax deductible (unlike interest on debt).
To attract investors the company needs to pay a higher return to compensate for
additional risk compared to debt.
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1.2 Debentures
Definition

A written acknowledgement of a debt, usually given under the companys seal,
containing provisions for payment of interest and repayment of principal. The
debt may be secured on some or all of the companys assets



Type Secured debentures Unsecured debentures
Security and
voting rights
Can be secured on one or more
specific assets - a fixed charge e.g.
over property
Or a floating charge can be offered
over a class of assets e.g. over net
current assets (working capital)
On default the assets are sold and
debt repaid
No voting rights.
No security.
Holders have the same rights as
ordinary creditors.
No voting rights.
Income A fixed annual amount, usually
expressed as a % of nominal value.
A fixed annual amount, usually
expressed as a % of nominal value.
Amount of
capital
A fixed amount per unit of loan stock
or debenture.
A fixed amount per unit of loan
stock or debenture.

In the UK debentures are usually issued with a face value of 100. They can then be traded
on the bond market and reach a market price. Hence, if a debenture is said to be selling at a
premium of 15%, this means that a debenture with a face value of 100 is currently selling
for 115. This indicates that the rate of interest on this debenture is attractive when
compared with current market rates, creating demand for the debenture and a rise in price.
In the US the face value of each debenture is usually $1000.
Note the terms debenture, loan stock and bond all basically refer to the same thing
i.e. a written acknowledgement of a companys debt which can then be traded. Also face
value can also be referred to as par value of nominal value.
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0904
1.3 Deep discount bonds
Definition

Loan stock issued at a large discount to nominal value redeemable at par on
maturity


Investors receive large capital gain on redemption, but low rate of interest during term
of the loan.
Cash flow advantage to the borrower useful for financing projects which produce
weak cash flows in early years.
Illustration 1

A five year $1000 3% Bond issued at $800 would generate the following cash
inflows/(outflows) for the issuing company:
t0 t1 t2 t3 t4 t5
Issue price 800
Interest (30) (30) (30) (30) (30)

Redemption (1000)


1.4 Zero coupon bonds
Definition

Bonds issued at a discount to face value and which pay zero annual interest

No interest is paid.
Investors gain from the difference between issue and redemption price.
Advantages to borrowers:
No cash payout until maturity;
Cost of redemption known at time of issue.
1.5 Tax relief on debt interest
Interest expense is tax deductible and therefore reduces corporate tax payments.
Regarding the tax system the Issue of debt is preferable to the issue of shares as
dividends are not allowable for tax.

SESSION 09 DEBT FINANCE
0905

Illustration 2

CoA CoB
Profit before tax 100 100
Interest (10)
___ ___
100 90
Corporation tax 30% (30) (27)
___ ___
70 63



Effective cost of debt in CoB

Interest 10
Less Tax relief (3)

___
$7

___

$7 difference


After-tax cost of debt = Pre-tax cost of debt (1 Tax rate)
The fact that interest on debt is tax allowable is referred to as the tax shield
2 CONVERTIBLES AND WARRANTS
2.1 Convertibles
Definition

Bonds or preference shares that can be converted into ordinary shares.

Pay fixed interest or dividend until converted.
They may be:
converted into ordinary shares;
on a pre-determined date;
at a pre-determined rate;
at the option of the holder.
Conversion ratio may change during the period of convertibility to stimulate early
conversion.
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Advantages to investors a relatively low risk investment with the opportunity to make
high returns upon converting to ordinary shares.
Advantages to issuing company can offer a lower rate of interest than on straight
debentures.
2.2 Effect on EPS (Earnings Per Share) of convertible debt
Convertible debentures require a fully diluted EPS to be calculated to indicate what EPS
might be if debt is converted into equity.
Method
Increase earnings by the loan interest saved, net of tax.
Increase the number of shares due to conversion.
Recalculate EPS
2.3 Warrants
Definition

A right given to an investor to subscribe cash for new shares at a future date at
a fixed price the exercise price.


Warrants are sometimes attached to loan stock, to make the loan stock more attractive.
Warrants are basically share options
The holder of the warrants may sell them rather than keep them.
Advantages to issuing company
The warrants themselves do not involve the payment of any interest or dividends.
When they are initially attached to loan stock, the interest rate on the loan stock will be
lower than for comparable straight debt. This due to the additional benefit for the
investor of potential equity shares at an attractive price.
May make an issue of unsecured loan stock possible where no adequate security exists.
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0907
3 MEDIUM-TERM FINANCE
3.1 Bank loans
3.1.1 Advantages
The loan will be for a fixed term: no risk of early recall;
Interest rate may be fixed.
3.1.2 Disadvantages
Inflexible;
May require security,
May require covenants restrictions on the company e.g. limits on dividend
payments, limits on further borrowing.
3.2 Leasing
3.2.1 Advantages
Many willing providers;
Remains off-balance sheet if an operating lease;
Matches finance to the asset ;
Very flexible packages available, some of which include maintenance.

3.2.2 Disadvantage
Can be costly.
3.3 Sale and leaseback
Property is sold to an institution, such as a pension fund, and then leased back to the
company.
3.3.1 Advantages
Releases significant funds;
May improve ratios such as ROCE (Return on Capital Employed).
3.3.2 Disadvantages
No longer own property and hence cannot participate in any future increase in value;
Risk of lease payments increasing.
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3.4 Mortgage loan a loan secured on property.
3.4.1 Advantages
Given the security, the loan will attract a lower interest rate than other debt;
Institutions will be willing to lend over a longer term;
Still participate in the growth in value of the property.

3.4.2 Disadvantage
Default may result in a key asset being liquidated
4 SHORT-TERM FINANCE
4.1 Bank overdraft
4.1.1 Advantages
Flexible;
Provides instant finance.

4.1.2 Disadvantages
Repayable on call, unless the bank offers a revolving line of credit
High and variable interest rate.
4.2 Trade credit
4.2.1 Advantages
Generally cheap;
Flexible.

4.2.2 Disadvantages
May lose settlement (quick payment) discounts;
May lose suppliers goodwill.

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4.3 Bills of exchange

Definition

An acknowledgement of a debt to be paid at some time in the future e.g. by a
customer. Such a bill may then be discounted i.e. sold to a third party for a %
of face value


4.3.1 Advantages
Improves cash flow.
Flexible.
4.3.2 Disadvantages
Fees.

Illustration 3

X sells $2m worth of goods to Y. X writes out (draws) a bill of exchange for
$2m payable in 2 months (say) which it sends to Y. Y signs the bill to
acknowledge the debt and returns it to X.
X can hold on to the bill for 2 months until Y pays the debtor sell it at a
discount e.g. at 98%of face value. The buyer of the bill then receives the $2m
and makes a gain.

4.4 Commercial Paper
Definition

Commercial paper is short-term (usually less than 270 days) unsecured debt
issued by high quality companies. The paper can then be traded by investors
on the bond markets.


4.4.1 Advantages
Large sums can be raised and relatively cheaply
No security required

4.4.2 Disadvantages
Only available to large companies with very good credit ratings
SESSION 09 DEBT FINANCE
0910
5 OTHER SOURCES
Commentary

The following are particularly suitable for small and medium sized enterprises (SMEs)
which are of particular interest to the examiner as they often have difficulty finding
debt finance. Such difficulties may be caused byasymmetry of information where
banks fear making loans to companies which are not well known and without published
credit ratings.

5.1 Grants
Depending upon the location and nature of the business local, regional, national or
European grant assistance may be available.
5.2 Loan guarantee scheme
Just as small/medium sized companies find it hard to raise equity, they can also find it hard
to raise debt, due to their high perceived risk. The Loan Guarantee Scheme is a UK
government-backed scheme where, for a fee, a substantial proportion of the loan may be
guaranteed. Hence potential providers of that loan are willing to lend, as most of their risk
has been eliminated.
5.3 Business angels
Business angels are rich individuals who are prepared to invest money in small companies if
they see high potential for growth
Such angels are often retired businesspeople who became wealthy as entrepreneurs in the
high-tech sector.
They may also give useful advice as well as finance and may even be able to use their
contacts to obtain new business for the companies they invest in.

SESSION 09 DEBT FINANCE
0911

Key points

Preference shares are in substance debt as they pay a fixed committed
dividend in priority to any ordinary dividend. They also rank ahead of
ordinary shareholders upon liquidation (although after real debt such as
bank loans and debentures)
Preference shareholders therefore face lower risk than ordinary
shareholders and require lower returns
However banks and bondholders take even lower risks, as they rank
ahead of preference shareholders upon bankruptcy, and their debts may
be secured by fixed or floating charge over assets. Providers of loans
therefore require lower returns than other providers of finance.
Hence loans are the least expensive source of finance for a company,
particularly if the effect of the tax system is introduced (loan interest is a
tax allowable expense, unlike dividends.)
Unfortunately debt also has a dark side too much debt may increase the
risks faced by shareholders to unacceptable levels.



FOCUS
You should now be able to:

explain the features of preference shares and the reasons for their issue;
explain the features of different types of long-term straight debt and the reasons for
their issue;
explain the features of convertible debt and warrants and the reasons for their issue;
assess the effect on EPS of conversion and option rights;
suggest appropriate sources of debt finance for SMEs e.g. leasing, loan guarantee
scheme, and business angels.
SESSION 09 DEBT FINANCE
0912