Home » Debt Finance and Loans Explained, Long Term Debt Avenues

Mid-Long Term Debt Finance Uncovered

Firms should match the maturity structure of their assets (that are funded through debt) with the maturity structure of their liabilities (their debts)

Term loans – Banks

Fixed-term loan periods generally range from 3 to 15 years
Typically used ton finance capital expenditure (building equipment)
Interest may be fixed or variable, and depends upon
–      The credit rating of the borrower
–      Term of the loan repayment schedule

Term loans – Investment and Merchant banks

Loans generally do not exceed 5 years
Interest fixed, but usually divided into a series on interest rate review, or roll-over periods
Loan agreement also specifies indicator rate (bank bill swap most frequently rate)
May include a ‘bill option clause’ which allows the borrower to convert the loan to bill financing

Term loans

Debt covenants
–      Restrict the business and financial activities of the borrowing firm
–      Example
ð  Required to maintain a minimum level of interest cover
ð  Maximum debt-to-equity ratio
ð  Disclosure of financial statements
–      Breach of covenant results in default of loan contract

Mortgage finance

A mortgage is a form of security for a loan
The borrower (mortgagor) conveys an interest in the land to the lender (mortgagee)
The mortgage is registered on the land title
The mortgage is discharged when the loan is repaid
If the mortgagor defaults on the loan, the mortgagee is entitled to foreclose on the property
Mortgage loans can be either residential or commercial
Residential loans are typically granted for periods up to 20 years, while commercial loans are for periods up to 10 years
Variable interest rate loans dominate, but fixed rates are available for loans with terms up to 2 years

Securitisation

Process whereby illiquid financial assets (accounts receivable, credit card receivables) may be packaged together and sold
The cash flows associated with the existing financial assets are used to service funding raised through the issue of asset-back securities
Securitisation process
–      1. Financial assets (mortgage loans) accumulate on the balance sheet
–      2. Assets with comparable interest rates, liquidity and credit risk are pooled and sold into a special purpose vehicle (SPV)
–      3. The trustee issues new securities to investors
–      4. AAA credit enhancement may be sought to improve the marketability of the issue
–      5.  Service manager is appointed to manage the cash flows (on behalf of the trustee)
ð  repayments form borrowers (inflows)
ð  payment of interest and principal on securities issued by trustee (outflows)
–      6. Received cash flows from the original assets are used by the SPV to repay interest and principal due on securities issued ton investors

Debentures, Unsecured notes and Subordinated debt

Debentures and Unsecured notes
–      Issued on the corporate debt market
–      Specify that the lender will receive regular interest payments during the term of the loan and repay the face value to the holder at maturity
–      Interest can either be fixed or floating
–      The term unsecured note refers to a bond where there is no underlying security attached
–      Debentures are listed and traded on the stock exchange
–      Debentures have a higher claim over a company’s assets (on liquidation) than unsecured note holders
Issuing debentures and notes
There are three principle issuing methods
–      Public issue, to public at large by prospectus
–      Family issue, to existing shareholders and investors by prospectus
–      Private placement, to institutional investors, prospectus not required
Subordinated debt
–      Looks more like equity than debt
–      Claim of debt holders are subordinated behind all other company liabilities
–      Agreement may specify that the debt not be presented for redemption until after a certain period has elapsed

Calculations – Fixed interest securities

The price of a fixed interest security is the sum of the present value of the face value and the present value of the coupon stream
$100 face value
$10 coupon
20 years to maturity
10% market rate

Calculation of a debenture

Present value of face value
= 100 x 1/1.1020
= 100 x 1.4864
= $14.864
Annuity present, present value of coupons
= 10 x (1 – 1/1.1020)/0.1
= 10 x 8.5136
= $85.136

Total debenture value
= 14.864 = 85.136
= $100

Calculation of a discounted bond

$100 face value
$10 coupon
20 years to maturity
12% market rate

Present value of face value
= 100 x 1/1.1220
= 100 x .10366
= $10.366
Annuity present, present value of coupons
= 10 x (1 – 1/1.1220)/0.12
= 10 x 7.4694
= $74.694

Total debenture value
= 10.366 + 74.694
= $85.06

Calculation of a premium bond

$100 face value
$10 coupon
20 years to maturity
8% market rate

Present value of face value
= 100 x 1/1.0820
= 100 x .21455
= $21.455
Annuity present, present value of coupons
= 10 x (1 – 1/1.0820)/0.08
= 10 x 9.9181
= $98.181
Total debenture value
= 21.455 + 98.181
= $119.636

Leasing

A lease is a contract where the owner of an asset (lessor) grants another party (lessee) the right to use the assets for agreed period of time in return for periodic rental payments
Leasing is the borrowing of an asset instead of borrowing the funds to purchase the asset
Advantages of leasing
–      Conserves capital
–      Provides 100% financing
–      Matches cash flows (rental payments with  income generated by the asset)
–      Likely not to breach any existing loan covenants
–      Rental payments are tax deductible
Main types of lease contracts
–      1. Operating lease
–      2. Sale and Lease-back
–      3. Finance lease

Operating lease
–      Lessor may lease the asset to successive lessees (short-term use of equipment)
–      Maintenance and insurance of the asset is provided by lessor
–      Lessee makes rental payments for the period of use of the assets

Sale and lease-back
–      Existing assets owned by a company, or government are sold to raise cash
–      The assets are then leased back from the new owner

Finance Lease
–      Longer-term financing
–      Lessor finances the asset
–      Lessor earns return from a single lease contract
–      Lessee pays for insurance and maintenance
–      Residual amount due at end of lease period
–      Ownership of the asset passes to lessee on payment of the residual amount

Lease Structures

Three types of finance lease structures

Direct
–      Involves two parties (lessor and lessee)
–      Lessor purchases equipment with own funds and leases asset to lessee
–      Direct leases generally run from between 3 and 5 years
–      Leased asset generally less than $100,000

Leveraged leasing
–      Lessors contribute limited equity, and borrow the majority of funds required to purchase the asset
–      Asset then leased to lessee
–      Lessees gain tax advantages of depreciation and interest expense claims
–      Leased asset price usually large (>$2million)

Equity leasing
–      Leased asset cost usually between direct and leveraged range ($100,000-$2million)
–      Similar structure to leveraged lease, but lose the leverage advantage due to the smaller amount of debt financing required

Project finance and structured finance

Project finance – features
–      Lenders determine their participation primarily on the basis of the expected cash flows and assets of the project
–      The project company is established as a separate legal and financial entity
–      Commitments from related third parties are sought as credit support for the project
–      The debt of the project company is separate from the sponsor company’s other obligations
–      Lenders security usually limited to the assets of the project
–      Loans are generally longer-term that other direct finance forms
–      Most projects are jointly owned and controlled
Structured finance – features
–      Consists of finance for infrastructure projects (power, water, etc)
–      Is a specialist area of project finance
–      Structured fiance incorporates most equity and debt forms

Direct credit substitutes

Are OBS arrangements that allow a corporation or government to substitute or replace an actual borrowing of funds with and undertaking from a financial institution (investment banks)
Two categories of direct credit substitutes
–      1. Stand-by letter of credit
ð  Is an irrevocable obligation by a financial institution to make a payment of a client defaults
–      2. Guarantees
ð  Takes the form of an indemnity, guaranteeing the obligations of the institutions client.