LONG-TERM FINANCING. Degree in Business Administration CORPORATE FINANCE. Szabolcs Sebestyén

Transcription

1 LONG-TERM FINANCING Szabolcs Sebestyén Degree in Business Administration CORPORATE FINANCE Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 1 / 62

2 Outline 1 Introduction to Long-Term Financing Ordinary Shares Corporate Long-Term Debt: The Basics Preference Shares Patterns of Financing Hierarchies in Long-Term Financing 2 Equity Financing The Private Equity Market 3 Debt Financing Protective Covenants Bond Refunding Bond Ratings Some Different Types of Bond Private Placement Compared with Public Issues 4 Leasing 5 All-In Cost Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 2 / 62

3 Introduction to Long-Term Financing Outline 1 Introduction to Long-Term Financing Ordinary Shares Corporate Long-Term Debt: The Basics Preference Shares Patterns of Financing Hierarchies in Long-Term Financing 2 Equity Financing The Private Equity Market 3 Debt Financing Protective Covenants Bond Refunding Bond Ratings Some Different Types of Bond Private Placement Compared with Public Issues 4 Leasing 5 All-In Cost Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 3 / 62

4 Introduction to Long-Term Financing Ordinary Shares Outline 1 Introduction to Long-Term Financing Ordinary Shares Corporate Long-Term Debt: The Basics Preference Shares Patterns of Financing Hierarchies in Long-Term Financing 2 Equity Financing The Private Equity Market 3 Debt Financing Protective Covenants Bond Refunding Bond Ratings Some Different Types of Bond Private Placement Compared with Public Issues 4 Leasing 5 All-In Cost Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 4 / 62

5 Introduction to Long-Term Financing Ordinary Shares Par and No-Par Shares The term ordinary shares is usually applied to equity that has no special preference either in dividends or in bankruptcy Owners of ordinary shares in a firm are referred to as shareholders or stockholders They receive share certificates for the shares they own There is usually a stated value on each share certificate called the par value Nowadays many shares have no par value The total par value is the number of shares issued multiplied by the par value of each share: dedicated capital of firm Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 5 / 62

6 Introduction to Long-Term Financing Ordinary Shares Retained Earnings The proportion of net income not paid out as dividends is called retained earnings The sum of equity components, or the total equity, is referred to as the firm s book value It represents the amount contributed directly or indirectly to the firm by equity investors Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 6 / 62

7 Introduction to Long-Term Financing Ordinary Shares Example: Equity Accounting Example Suppose Louest Rouge plc was formed in 1910 with 10,000 shares of equity issued with each share valued at 1 par value. Because the shares were sold for 1, the first balance sheet showed a zero amount for capital surplus. By 2009, the company had become very profitable and had retained profits of 100,000. The shareholders equity of Louest Rouge in 2009 is as follows: Louest Rouge plc Equity Accounts 1 January 2009 Ordinary shares; par 1; 10,000 shares outstanding 10,000 Additional paid-in capital 0 Retained earnings 100,000 Total shareholders equity 110,000 Book value per share = 110, , 000 = 11 Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 7 / 62

8 Introduction to Long-Term Financing Ordinary Shares Example: Equity Accounting Example Suppose the company has profitable investment opportunities and decides to sell 10,000 shares of new equity. The current market price is 20 per share. What is the effect of the sale of shares on the balance sheet? Louest Rouge plc Equity Accounts 31 December 2009 Ordinary shares; par 1; 20,000 shares outstanding 20,000 Additional paid-in capital ( 20 1) 10, 000 shares 190,000 Retained earnings 100,000 Total shareholders equity 310,000 Book value per share = 310, , 000 = 15.5 Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 8 / 62

9 Introduction to Long-Term Financing Ordinary Shares Market Value and Book Value The shares bought back are called treasury stock The book value per share is given by Book value per share = Total common shareholders equity Shares outstanding The market value can be below or above the book value Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 9 / 62

10 Introduction to Long-Term Financing Ordinary Shares Dividends Dividends paid to shareholders represent a return on the capital directly or indirectly contributed to the firm by shareholders The payment of dividends occurs at the discretion of the board of directors Some important characteristics of dividends: Unless a dividend is declared by the board of directors, it is not a liability of the firm: a firm cannot default on an undeclared dividend = firms cannot become bankrupt because of non-payment of dividends The payment of dividends is not a business expense and are not deductible for corporate tax purposes = dividends are paid out of after-tax profits Dividends received by individual shareholders are for most part considered ordinary income by tax authorities, and are fully or partially taxable Corporations with shares in other firms are normally permitted to exclude some component of the amounts they receive as dividends Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 10 / 62

11 Introduction to Long-Term Financing Corporate Long-Term Debt: The Basics Outline 1 Introduction to Long-Term Financing Ordinary Shares Corporate Long-Term Debt: The Basics Preference Shares Patterns of Financing Hierarchies in Long-Term Financing 2 Equity Financing The Private Equity Market 3 Debt Financing Protective Covenants Bond Refunding Bond Ratings Some Different Types of Bond Private Placement Compared with Public Issues 4 Leasing 5 All-In Cost Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 11 / 62

12 Introduction to Long-Term Financing Corporate Long-Term Debt: The Basics Interest versus Dividends (1) Debt is the result of borrowing money so it must be repaid When firms borrow, they promise to make regularly scheduled interest payments and to repay the original amount borrowed (the principal) The person or firm making the loan is called a creditor or lender The firm borrowing the money is called a debtor or borrower The amount owed the creditor is a liability of the firm This liability is of limited value as the firm can legally default on its liability at any time Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 12 / 62

13 Introduction to Long-Term Financing Corporate Long-Term Debt: The Basics Interest versus Dividends (2) The main differences between debt and equity are: Debt is not an ownership in the firm; creditors do not usually have voting power; the device used by creditors to protect themselves is the loan contract (the indenture) The firm s interest payment on debt is considered a cost of doing business and is fully tax-deductible = interest expense is paid out before the corporate tax liability is computed = governments provide a direct tax subsidy on the use of debt when compared with equity Unpaid debt is a liability of the firm; if not paid, creditors can legally claim the assets of the firm = liquidation and bankruptcy; the cost of financial failure does not arise with equity Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 13 / 62

14 Introduction to Long-Term Financing Corporate Long-Term Debt: The Basics Is it Debt or Equity? Sometimes it is not clear whether a particular security is debt or equity Firms are very adept at creating hybrid or compound securities that look like equity but are called debt The aim is to obtain the tax benefits while eliminating bankuptcy costs According to International Accounding Standard 32 (IAS32), a debt instrument has a contractual obligation to deliver cash or another financial asset equity is a security that has a residual cash flow after all other liabilities have been paid When accounting for hybrid or compound securities, the instrument should be disaggregated into its equity and debt components and recorded accordingly Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 14 / 62

15 Introduction to Long-Term Financing Corporate Long-Term Debt: The Basics Basic Features of Long-Term Debt Long-term corporate debt is usually denominated in multiples of 100, called the principal or face vlue Long-term debt is a promise by the borrowing firm to repay the principal amount by a certain date, called the maturity date Debt price is often expressed as a percentage of the par or face value If it is greater than 100 the debt is selling at a premium, while if it is lower than 100 the debt is selling at a discount The borrower generally pays interest at a rate expressed as a fraction of par value These payments are referred to as coupons, and the interest is called the coupon rate Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 15 / 62

16 Introduction to Long-Term Financing Preference Shares Outline 1 Introduction to Long-Term Financing Ordinary Shares Corporate Long-Term Debt: The Basics Preference Shares Patterns of Financing Hierarchies in Long-Term Financing 2 Equity Financing The Private Equity Market 3 Debt Financing Protective Covenants Bond Refunding Bond Ratings Some Different Types of Bond Private Placement Compared with Public Issues 4 Leasing 5 All-In Cost Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 16 / 62

17 Introduction to Long-Term Financing Preference Shares Preference Shares Preference shares represent equity of a firm, but they are different from ordinary shares because they are preferred in the payment of dividends and in the assets of the firm in the event of bankruptcy Preference means that the holder of the preference share must receive a dividend before holders of ordinary shares are entitled to anything Preference share are the most common form of compound security, and can be viewed as equity or as debt Preference shares have a stated liquidating value The dividend of preference shares is described in terms of euros per share Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 17 / 62

18 Introduction to Long-Term Financing Preference Shares Cumulative and Non-Cumulative Dividends A preference share dividend is not like interest on a bond The board of directors may decide not to pay the dividends on preference shares, regardless of the current net income of the firm Dividends on preference shares are either cumulative or non-cumulative Cumulative dividends, if not paid in a particular year, will be carried forward Usually both the cumulated (past) preference share dividends plus the current preference share dividends must be paid before the ordinary shareholders can receive anything Unpaid preference share dividends are not debts of the firm Directors elected by ordinary shareholders can defer preference share dividends indefinitely Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 18 / 62

19 Introduction to Long-Term Financing Preference Shares Equity vs Debt Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 19 / 62

20 Introduction to Long-Term Financing Patterns of Financing Outline 1 Introduction to Long-Term Financing Ordinary Shares Corporate Long-Term Debt: The Basics Preference Shares Patterns of Financing Hierarchies in Long-Term Financing 2 Equity Financing The Private Equity Market 3 Debt Financing Protective Covenants Bond Refunding Bond Ratings Some Different Types of Bond Private Placement Compared with Public Issues 4 Leasing 5 All-In Cost Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 20 / 62

21 Introduction to Long-Term Financing Patterns of Financing Patterns of Financing (1) Source: Jenny Corbett and Tim Jenkinson, How is investment financed? A study of Germany, Japan, the United Kingdom, and the United States, The Manchester School, volt. 65 (1997), pp Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 21 / 62

22 Introduction to Long-Term Financing Patterns of Financing Patterns of Financing (2) Corporations mostly rely on internal financing fo their investment expenditure However, there is a financial gap between the level of funds available from ongoing operations and the total investment expenditure (internal financing < 100%) Internal financing comes from internally generated cash flow and is defined as Internally generated cash flow = Net income + Depreciation Dividends External financing is net new debt and new shares of equity net of buybacks Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 22 / 62

23 Introduction to Long-Term Financing Hierarchies in Long-Term Financing Outline 1 Introduction to Long-Term Financing Ordinary Shares Corporate Long-Term Debt: The Basics Preference Shares Patterns of Financing Hierarchies in Long-Term Financing 2 Equity Financing The Private Equity Market 3 Debt Financing Protective Covenants Bond Refunding Bond Ratings Some Different Types of Bond Private Placement Compared with Public Issues 4 Leasing 5 All-In Cost Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 23 / 62

24 Introduction to Long-Term Financing Hierarchies in Long-Term Financing Hierarchies in Long-Term Financing (1) The hierarchy of a company s securities determines who gets a claim on the assets of bankrupt company first Senior secured debt: it is backed by a claim on the assets of the issuing firm It is known as collateral, and may comprise buildings, manufacturing facilities, and any other fixed assets Mortgage debt is secured by property and buildings Non-recourse debt is only partially (80-90%) secured by some assets in the firm Senior secured debt has the first and highest claim on the assets of a defaulting company Second lien loans: they are normally secured to some form of collateral, but are second in line behind senior secured debt Senior unsecured debt: it is not supported by any collateral Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 24 / 62

25 Introduction to Long-Term Financing Hierarchies in Long-Term Financing Hierarchies in Long-Term Financing (2) Subordinated or junior debt: it is fairly risky as in case of a default it is unlikely that the subordinated bondholders will receive any of their money back Shareholder loans: they are very long-term low-interest loans given to a company by dominant shareholders Since the loans are owned by shareholders, they are commonly regarded as equity Given their unique nature, they are the lowest ranking of all debt instruments Preference shares Ordinary equity: equity holders are also known as residual claimants Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 25 / 62

26 Equity Financing Outline 1 Introduction to Long-Term Financing Ordinary Shares Corporate Long-Term Debt: The Basics Preference Shares Patterns of Financing Hierarchies in Long-Term Financing 2 Equity Financing The Private Equity Market 3 Debt Financing Protective Covenants Bond Refunding Bond Ratings Some Different Types of Bond Private Placement Compared with Public Issues 4 Leasing 5 All-In Cost Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 26 / 62

27 Equity Financing The Private Equity Market Outline 1 Introduction to Long-Term Financing Ordinary Shares Corporate Long-Term Debt: The Basics Preference Shares Patterns of Financing Hierarchies in Long-Term Financing 2 Equity Financing The Private Equity Market 3 Debt Financing Protective Covenants Bond Refunding Bond Ratings Some Different Types of Bond Private Placement Compared with Public Issues 4 Leasing 5 All-In Cost Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 27 / 62

28 Equity Financing The Private Equity Market The Private Equity Firm A large amount of private equity investment is undertaken by professional private equity managers representing large institutional investors (e.g., mutual funds, pension funds) The limited partnership is the dominant form of intermediation in this market Typically, the institutional investors act as the limited partners and the professional managers act as general partners The general partners are firms that specialise in funding and managing equity investments in closely held private firms The private equity market has been important for both traditional start-up companies (venture equity) and established public firms (non-venture equity) A large part of the non-venture market is made up of firms in financial distress Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 28 / 62

29 Equity Financing The Private Equity Market Suppliers of Venture Capital There are at least four types of supplier of venture capital: A few old-line, wealthy families have traditionally provided start-up capital to promising businesses (e.g. Rockefellers) Private partnerships and corporations: the partnership might raise capital from institutional investors or a group of individuals might provide the funds Large industrial and financial corporations have established venture capital subsidiaries Participants in an informal venture capital markets (angels): it is perhaps the largest of all sources of venture capital Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 29 / 62

30 Equity Financing The Private Equity Market Stages of Financing 1 Seed money stage: a small amount of financing needed to prove a concept or develop a product; no marketing 2 Start-up: financing for firms that started within the past year; funds are likely to pay for marketing and product development expenditures 3 First-round financing: additional money to begin sales and manufacturing after a firm has spent its start-up funds 4 Second-round financing: funds earmarked for working capital for a firm that is currently selling its product but still losing money 5 Third-round financing: financing for a company that is at least breaking even and is contemplating an expansion (mezzanine financing) 6 Fourth-round financing: money provided for firms that are likely to go public within half a year (bridge financing) Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 30 / 62

31 Debt Financing Outline 1 Introduction to Long-Term Financing Ordinary Shares Corporate Long-Term Debt: The Basics Preference Shares Patterns of Financing Hierarchies in Long-Term Financing 2 Equity Financing The Private Equity Market 3 Debt Financing Protective Covenants Bond Refunding Bond Ratings Some Different Types of Bond Private Placement Compared with Public Issues 4 Leasing 5 All-In Cost Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 31 / 62

32 Debt Financing Protective Covenants Outline 1 Introduction to Long-Term Financing Ordinary Shares Corporate Long-Term Debt: The Basics Preference Shares Patterns of Financing Hierarchies in Long-Term Financing 2 Equity Financing The Private Equity Market 3 Debt Financing Protective Covenants Bond Refunding Bond Ratings Some Different Types of Bond Private Placement Compared with Public Issues 4 Leasing 5 All-In Cost Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 32 / 62

33 Debt Financing Protective Covenants Protective Covenants A protective covenant limits certain actions of the borrowing company A negative covenant limits or prohibits actions that a company may take Examples: Limitations on the amount of dividends a company may pay The firm cannot pledge any of its assets to other lenders The firm cannot merge with another firm The firm cannot issue additional long-term debt A positive covenant specifies an action that the company agrees to take or a condition the company must abide by Examples: The firm agrees to maintain its working capital at a minimum level The firm must furnish periodic financial statements to the lender Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 33 / 62

34 Debt Financing Bond Refunding Outline 1 Introduction to Long-Term Financing Ordinary Shares Corporate Long-Term Debt: The Basics Preference Shares Patterns of Financing Hierarchies in Long-Term Financing 2 Equity Financing The Private Equity Market 3 Debt Financing Protective Covenants Bond Refunding Bond Ratings Some Different Types of Bond Private Placement Compared with Public Issues 4 Leasing 5 All-In Cost Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 34 / 62

35 Debt Financing Bond Refunding Bond Refunding Replacing all or part of an issue of outstanding bonds is called bond refunding A call provision lets the company repurchase or call the entire bond issue at a predetermined price over a specific period Generally the call price is above the face value; the difference is the call premium Usually the first step in a bond refunding is to call the entire issue of bonds at the call price Bond refunding raises two questions: 1 Should firms issue callable bonds? 2 Given that callable bonds have been issued, when should the bonds be called? Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 35 / 62

36 Debt Financing Bond Refunding Should Firms Issue Callable Bonds? Call provisions have value Many publicly issued bonds have call provisions A call works to the advantage of the issuer: with lower interest rates and higher bond prices the option to buy back the bonds at the call price is valuable In bond refunding, firms typically replace the called bonds with a new bond issue The new bonds will have a lower coupon rate than the called bonds However, bondholders will take the call provision into account when buying the bond They will demand higher interest rates on callable bonds then on non-callable bonds In efficient capital markets call provisions are zero-sum Any expected gains to the issuer from being allowed to refund the bond at lower rates will be offset by higher initial interest rates Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 36 / 62

37 Debt Financing Bond Refunding Why Are Callable Bonds Issued? Superior interest rate predictions: company insiders may know more about interest rate changes on the company s bonds than the investors Bondholders would infer that a company expected an improvement in its credit rating whenever it issued callable bonds = they would require an increase in the coupon rate as protection Taxes: call provisions may have tax advantages if the bondholder is taxed at a lower rate than the company Some of the tax savings can be passed on to the bondholders in the form of a high coupon Future investment opportunities: protective covenants can be very restrictive, and by buying back the bonds the firm may take advantage of a superior investment opportunity Less interest rate risk: the call provision reduces the sensitivity of a bond s value to interest rate changes = it reduces the risk of both shareholders and bondholders Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 37 / 62

38 Debt Financing Bond Ratings Outline 1 Introduction to Long-Term Financing Ordinary Shares Corporate Long-Term Debt: The Basics Preference Shares Patterns of Financing Hierarchies in Long-Term Financing 2 Equity Financing The Private Equity Market 3 Debt Financing Protective Covenants Bond Refunding Bond Ratings Some Different Types of Bond Private Placement Compared with Public Issues 4 Leasing 5 All-In Cost Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 38 / 62

39 Debt Financing Bond Ratings Bond Ratings The debt rating depend on the likelihood that the firm will default the protection afforded by the loan contract in the event of default Bonds with lower rating tend to have higher interest costs However, no conclusive evidence that bond ratings affect risk, and share prices and bond prices do not show any unusual behaviour on the days around a rating change Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 39 / 62

40 Debt Financing Bond Ratings Junk Bonds Junk bonds (or high-yield, speculative, or low-grade): bonds with a S&P s rating of BB and below or a Moody s rating of Ba and below The market for junk bonds became very important when they were used to finance mergers and other corporate restructurings While a firm can issue only a small amount of high-grade debt, it can issue much more debt if low-grade financing is allowed Since mid-2008 the junk bond market has closed down Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 40 / 62

41 Debt Financing Bond Ratings Historical Default Rates of Junk Bonds Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 41 / 62

42 Debt Financing Bond Ratings Mortality Rates of Bonds ( ) Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 42 / 62

43 Debt Financing Some Different Types of Bond Outline 1 Introduction to Long-Term Financing Ordinary Shares Corporate Long-Term Debt: The Basics Preference Shares Patterns of Financing Hierarchies in Long-Term Financing 2 Equity Financing The Private Equity Market 3 Debt Financing Protective Covenants Bond Refunding Bond Ratings Some Different Types of Bond Private Placement Compared with Public Issues 4 Leasing 5 All-In Cost Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 43 / 62

44 Debt Financing Some Different Types of Bond Floating-Rate Bonds Floating-rate bonds: the coupon payments are adjustable The adjustments are tied to an interest rate index such as the Treasury bill rate, the LIBOR or the EURIBOR The majority of the floaters have put provisions, and floor and ceiling provisions: With a put provision the holder has the right to redeem her note at par on the coupon payment date With floor and ceiling provisions the coupon rate is subject to a minimum and maximum Inflation risk is borne by both issuers and bondholders, and floaters reduce this risk since the coupon rate is tied to the current interest rate An alternative is to roll over short-term notes, but with a higher transaction cost Since floaters always sell at or near par, they do not generally have call features Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 44 / 62

45 Debt Financing Some Different Types of Bond Zero-Coupon Bonds Zero-coupon bond (or deep-discount bond or pure discount bond): pays no coupon and is offered at a price that is much lower than its face value Due to the lack of coupon payments, these bonds are attractive to certain investors and unattractive to others Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 45 / 62

46 Debt Financing Some Different Types of Bond Income Bonds Income bonds: coupon payments depend on company income Coupons are paid only if the firm s income is sufficient For a firm they are a cheaper form of debt than conventional bonds It provides the same tax advantage, but the firm is less likely to experience financial distress An omitted coupon payment does not imply default Why don t firms issue more income bonds? The smell of death explanation: firms that issue income bonds signal the capital markets of their increased prospects of financial distress The deadweight costs explanation: shareholders and bondholders may not agree how to calculate the income = agency costs associated with the firm s accounting methods Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 46 / 62

47 Debt Financing Private Placement Compared with Public Issues Outline 1 Introduction to Long-Term Financing Ordinary Shares Corporate Long-Term Debt: The Basics Preference Shares Patterns of Financing Hierarchies in Long-Term Financing 2 Equity Financing The Private Equity Market 3 Debt Financing Protective Covenants Bond Refunding Bond Ratings Some Different Types of Bond Private Placement Compared with Public Issues 4 Leasing 5 All-In Cost Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 47 / 62

48 Debt Financing Private Placement Compared with Public Issues Term Loans v Private Placement More than 50% of all debt is privately placed Two basic forms of direct private long-term financing: term loans and private placement Term loans are direct business loans with maturities of 1 15 years The typical term loan is amortised over the life of the loan Interest rates can be fixed or floating Positive and negative covenants are typically applied The lenders are banks and insurance companies A private placement involves the sale of a bond or loan directly to a limited number of investors It is similar to a term loan, but its maturity is longer Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 48 / 62

49 Debt Financing Private Placement Compared with Public Issues Direct v Public Long-Term Financing A direct long-term loan avoids the cost of registration with stock exchange authorities Direct placement is likely to have more restrictive covenants It is easier to renegotiate a term loan and a private placement in the event of a default Life insurance companies and pension funds dominate the private placement segment of the bond market, while banks are significant participants in the term loan market The costs of distributing bonds are lower in the private market The interest rates on term loans and private placements are usually higher than those on an equivalent public issue Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 49 / 62

50 Leasing Outline 1 Introduction to Long-Term Financing Ordinary Shares Corporate Long-Term Debt: The Basics Preference Shares Patterns of Financing Hierarchies in Long-Term Financing 2 Equity Financing The Private Equity Market 3 Debt Financing Protective Covenants Bond Refunding Bond Ratings Some Different Types of Bond Private Placement Compared with Public Issues 4 Leasing 5 All-In Cost Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 50 / 62

51 Leasing Leasing Basics A lease is a contractual agreement between a lessee and lessor The lessee has the right to use an asset and in return must make periodic payments to the lessor, the owner of the asset For the lessee, it is the use of the asset that is most important, not who owns the asset Leasing and buying involve alternative financing arrangements for the use of an asset Direct lease: the lessor is not the asset s manufacturer, but an independent leasing company Sales-type leasing: the asset s manufacturer is itself the lessor Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 51 / 62

52 Leasing Buying versus Leasing Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 52 / 62

53 Leasing Operating Leases Operating lease: the lessee receives an operator along with the equipment Its characteristics: Operating leases are usually not fully amortised It usually requires the lessor to maintain and insure the leased assets Cancellation option: it gives the lessee the right to cancel the lease contract before the expiration date; if the option is exercised, the lessee must return the equipment to the lessor Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 53 / 62

54 Leasing Financial Leases Financial leases are the exact opposite of operating leases: They do not provide for maintenance or service by the lessor They are fully amortised The lessee usually has a right to renew the lease on expiration Generally, they cannot be cancelled: the lessee must make all payments or face the risk of bankruptcy Two special types of financial lease: Sale and leaseback arrangement Leveraged lease Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 54 / 62

55 Leasing Sale and Leaseback Sale and leaseback: a company sells an asset it owns to another firm and immediately leases it back The lessee receives cash from the sale of the asset The lessee makes periodic lease payments, thereby retaining use of the asset Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 55 / 62

56 Leasing Leveraged Leases Leveraged lease: a three-sided agreement between the lessee, the lessor, and the lenders: The lessee uses the assets and makes periodic lease payments The lessor purchases the assets, delivers them to the lessee, and collects the lease payments; however, the lessor puts up no more than 40 to 50 percent of the purchase price The lenders supply the remaining financing and receive interest payments from the lessor The lenders in a leveraged lease typically use a non-recourse loan: the lessor is not obligated to the lender in case of a default However, the lender is protected in two ways: The lender has a first lien on the asset In te event of loan default, the lease payments are made directly to the lender Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 56 / 62

57 All-In Cost Outline 1 Introduction to Long-Term Financing Ordinary Shares Corporate Long-Term Debt: The Basics Preference Shares Patterns of Financing Hierarchies in Long-Term Financing 2 Equity Financing The Private Equity Market 3 Debt Financing Protective Covenants Bond Refunding Bond Ratings Some Different Types of Bond Private Placement Compared with Public Issues 4 Leasing 5 All-In Cost Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 57 / 62

58 All-In Cost Definition All-in cost is the total cost of a transaction after commissions, interest rates, and other expenses This is the effective cost a company faces when entering a transaction To compare financing opportunities, one should compare the all-in costs of all opportunities to make a decision Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 58 / 62

59 All-In Cost All-In Cost of a Bank Loan A bullet loan is a loan where the payment of the principal of the loan is due at the end of the loan term Define the following variables: L: value of the loan r: interest on the loan T: maturity of the loan t cr : tax on opening the credit line t r : tax on interest payments Then the all-in cost, i.e., the yield to maturity, y, of the loan can be calculated from L (1 t cr ) = T L r (1 + t r ) t=1 (1 + y) t + L (1 + y) T Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 59 / 62

60 All-In Cost All-In Cost of Bond Issuance Define the following variables: F: face value of the bond r: coupon rate T: maturity of the loan IP: issuance premium = the difference between the issuance value and the face value IC: issuance costs (commission, registering costs, etc.) RP: redemption premium = the difference between the redemption value and the face value Then the all-in cost, i.e., the yield to maturity, y, of the bond issuance can be calculated from F + IP IC = T t=1 F r (1 + y) t + F + RP (1 + y) T Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 60 / 62

61 All-In Cost All-In Cost of Leasing Define the following variables: VL: value of the lease T: maturity of the loan L t : lease payment at time t RV: residual value of the lease Then the all-in cost, i.e., the yield to maturity, y, of the lease can be calculated from VL = T 1 t=1 L t (1 + y) t + RV (1 + y) T Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 61 / 62

62 All-In Cost Borrowing (in the form of a loan, bond issuance or leasing) can occur in a foreign currency Interest rate on the borrowing is determined in the issuer country of the foreign currency, and can be fixed or floating The payments to the lender depend on the evolution of the exchange rate between the home and foreign currency = exchange-rate risk If the foreign currency appreciates (depreciates), the payments in home currency increase (decrease) = higher (lower) financing costs A lower interest rate in the home country does not necessarily imply a lower financing cost The all-in cost for any way of financing can be calculated as before, but the payments must be converted into the home currency and it should take into account the uncertain movement of the exchange rate during the term of the loan Sebestyén (ISCTE-IUL) LONG-TERM FINANCING Corporate Finance 62 / 62 Financing with Foreign Currency