Financial management and analysis phần 6 pot

Intermediate and Long-Term Debt 501 Deferred interest debt is usually used where cash flow problems are anticipated. For example, if a firm borrows heavily to restructure its oper- ations, deferred interest debt offers time to turn its operations around. Income Bonds An income bond pays interest only when there are sufficient earnings to pay it. If earnings are not sufficient, the firm need not pay the interest to its income bondholders. Unlike other types of debt, failure to pay interest on an income bond is not necessarily an act of default. Income bonds and notes are seldom issued, for two reasons. First, since they do not carry a fixed interest obligation, they are issued by companies that foresee financial difficulties—so this stigma is attached to income bonds. Second, since paying interest depends on accounting earnings, which can be manipulated, there is a potential problem—a possible conflict of interests between management, who represent share- holders, and the bondholders, who are the creditors. Moreover, the Internal Revenue Service (IRS) is not naive. It recog- nizes that a firm may attempt to disguise preferred stock by packaging it as an income bond. If the IRS believes that an income bond has all of the characteristics of preferred stock, it will seek to reclassify the interest rate payments that were deducted by the firm so that they are treated as divi- dend payments which are not tax deductible. Security A bond may be unsecured or secured with the pledge of specific prop- erty called collateral. A debt that is not secured by specific property is referred to as a debenture. If the obligations of the loan are not satis- fied, the creditor has the right to recoup the amount of principal, any accrued interest, and penalties from the proceeds from the sale of the pledged property in the case of secured debt. Unsecured bonds, as well as secured bonds, are backed by the general credit of the firm—the abil- ity of the firm to generate cash flows that are sufficient to meet its obli- gations. There are different types of secured bonds, classified by the type of property pledged. If the pledged property is real property—such as land or buildings—the debt is referred to as a mortgage. If the pledged prop- erty is any type of financial asset, such as stocks or bonds of other corpo- rations, the bond is referred to as collateral trust bond, since the stocks and bonds are held in a trust account until the bond is satisfied. If the pledged property is equipment, the secured debt is referred to as equip- ment obligation or equipment trust debt. Equipment trust debt, also referred to as equipment trust certificates, are often used by railroads to purchase rolling stock and airlines to finance the purchase of aircraft. 15-Intermed_Long-Term Debt Page 501 Wednesday, April 30, 2003 12:02 PM 502 FINANCING DECISIONS Seniority A firm can issue different kinds of bonds. But not all bonds are created equal. There is a pecking order of sorts with respect to each bond holder’s claim on the firm’s assets and income. This pecking order is referred to as seniority. One bond issue is senior to another if it has a prior claim on assets and income; one bond issue is junior to another if the other bond has a prior claim on assets and income. A subordinated bond is a bond that is junior to another. Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par value. The issuer can do so in one of following four ways: ■ Repay the entire par value in one payment at the maturity. This is the typical mechanism for bonds issued by corporations. ■ Repay the par value based on an amortization schedule. This mecha- nism is the same as for the repayment of the amount borrowed for the term loans described earlier. That is, each periodic payment made by the firm to bond holders includes interest and scheduled principal repayment. Many asset-backed securities, discussed in Chapter 26, are paid off in this way. ■ Retire a specified amount of the par value of the issue periodically. This provision is called a sinking fund provision. ■ Pay off the entire amount of the face value prior to the maturity date by one of two mechanisms: “calling” the issue if permitted or “defeas- ing” the issue. The first two mechanisms are straightforward. We describe the sinking fund, call, and defeasing mechanisms next, beginning with the call mechanism. In addition to the above mechanisms, a bond issue may give the bondholder the right to force the issuer to retire a bond issue prior to the maturity date. This right granted is referred to as a put prevision. We will also describe it below. Call Mechanism An important question in setting the terms of a new bond issue is whether the issuer shall have the right to redeem the entire amount of bonds outstanding on one or more dates before the maturity date. Issuers generally want this right because they recognize that at some time in the future the general level of interest rates may fall suffi- ciently below the issue’s coupon rate so that redeeming the issue and replacing it with another issue with a lower coupon rate would be attractive. This right is a disadvantage to the bondholder because it 15-Intermed_Long-Term Debt Page 502 Wednesday, April 30, 2003 12:02 PM Intermediate and Long-Term Debt 503 forces the bondholder to reinvest the proceeds received at a lower inter- est rate. This is the reinvestment risk that we explained in Chapter 9. The right of the issuer to retire an issue prior to the maturity date is referred to as the right to call the issue. Effectively, it is the right of the issuer to take away the bonds from the bondholder at a specified price at specified times. Consequently, this right that the issuer has is referred to as a call option. While we described a call option in Chapter 4, those options were standalone options. That is, they were not part of any debt obligation. A call option that is part of a bond issue is referred to as an embedded option. As we discuss other features of a bond we will see other types of embedded options. Retiring an outstanding bond issue with proceeds from the sale of another bond issue is referred to as refunding a bond issue. The usual practice is a provision that denies the issuer the right to refund a bond issue during the first five to ten years following the date of issue with proceeds received from issuing lower-cost debt obligations ranking equal to or superior to the bond issue to be retired. For example, if a bond issue has a coupon rate of 10% and the issuer could issue a new bond issue with a coupon rate of 7%, then if there is a prohibition on refunding a bond issue, the issuer could not retire the 10% coupon issue with funds received from the sale of a 7% issue. While most long-term issues have these refunding restrictions, they may be immediately call- able, in whole or in part, if the source of funds comes from other than lower interest cost money. Cash flow from operations, proceeds from a common stock sale, or funds from the sale of property are examples of such sources of proceeds that a firm can use to refund a bond issue. Sometimes there is confusion between refunding protection and call protection. Call protection is much more absolute in that bonds cannot be redeemed for any reason. Refunding restrictions only provide protec- tion against the one type of redemption mentioned above. Typically, corporate bonds are callable at a premium above par. Generally, the amount of the premium declines as the bond approaches maturity and often reaches par after a number of years have passed since issuance. A framework for a firm to decide whether it will refund a bond issue will be discussed later in this chapter. Sinking Fund Bond indentures may require the issuer to retire a specified portion of an issue each year. This is referred to as a sinking fund requirement. This kind of provision for repayment of a bond issue may be designed to liquidate all of a bond issue by the maturity date, or it may be arranged to pay only a part of the total by the maturity date. 15-Intermed_Long-Term Debt Page 503 Wednesday, April 30, 2003 12:02 PM 504 FINANCING DECISIONS The purpose of the sinking fund provision is to reduce default risk. Generally, the issuer may satisfy the sinking-fund requirement by either (1) making a cash payment of the par amount of the bonds scheduled to be retired to the trustee who then calls the bonds for redemption using a lottery, or (2) delivering to the trustee bonds with a total par value equal to the amount that must be retired from bonds the issuer purchased in the open market. Usually, the sinking-fund call price is the par value of the bonds. Many corporate bond indentures include a provision that grants the issuer the right (i.e., option) to retire more than the required sinking fund payment. For example, suppose that the amount of the sinking fund requirement is $10 million for some year up to a specified amount. The issuer would have the right to retire more than $10 million. For some issues, the issuer may be permitted to retire twice the amount required. This is another embedded option granted to the issuer, called the acceler- ation option, because the issuer can take advantage of this provision if interest rates decline below the coupon rate. That is, suppose that an issue has a coupon rate of 10% and that current rates are well below 10%. Suppose further that there is a refunding restriction so that the issuer can- not refund the bond issue and that it does not have sufficient funds to retire the entire issue by another means that would be permitted. If there is a sinking fund requirement with an acceleration option, the issuer can use this option to get around the refunding restriction and thereby retire part of the outstanding bond issue. There is another advantage. When bonds are purchased to satisfy the sinking fund requirement, they are called by the trustee at par value. In contrast, when they are called if the issuer has the right to call an issue, for other than to satisfy the sinking fund requirement, the call price is typically above the par value. A sinking fund adds extra comfort to the bondholder—the presence of the sinking fund reduces the default risk associated with the bond. That is, if the issuer fails to make a scheduled payment to satisfy the sinking fund provision, the trustee may declare the bond issue in default; this has the same consequences as not paying interest or princi- pal. However, because the inclusion of the acceleration option allows the issuer to retire more of the scheduled amount prior to the maturity date, it effectively is a call option granted to the issuer and therefore increases the reinvestment risk to the bondholders. Defeasance Another way of effectively retiring a bond issue is to defease it by creating a trust to pay off the payments that must be made to the bondholders. To do this, the firm establishes an irrevocable trust (where the firm cannot get back any funds it puts in it), deposits risk-free secu- rities into the trust (such as U.S. government bonds) such that the cash 15-Intermed_Long-Term Debt Page 504 Wednesday, April 30, 2003 12:02 PM Intermediate and Long-Term Debt 505 flows from these bonds (interest and principal) are sufficient to pay the obligations of the debt. The interest and principal of the defeased debt is then paid by this trust. Defeasing debt requires that the issuer undertake the following three steps: An issuer would employ the defeasance mechanism for several rea- sons: ■ If the bonds cannot be bought back from the bondholders (the issue cannot be called or refunded), defeasance provides a way of retiring bonds. ■ If interest rates on the securities in the trust is high relative to the inter- est rate on the defeased bond, this difference ends up increasing the firm’s reported earnings. ■ If certain requirements are met, as set forth in the Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 76, the debt obligation is removed from the borrower’s financial state- ments, which should lead to a an improved credit evaluation. Owners of a bond issue that has been defeased are assured they will be paid interest and principal as promised, so their default risk is in effect eliminated. Put Provision A put provision grants the bondholder the right to sell the issue back to the issuer on designated dates. Bonds with such a provision are referred to as putable bonds. The advantage to the bondholder is that if interest rates rise after the bonds are issued, thereby reducing the value of the bond, the bondholder can put the bond to the issuer for par value. The put provision, just like the call provision, is an embedded option. Consequently, the put provision is referred as a put option. Unlike a call option which is an option granted to the issuer to retire the bond issue prior to the maturity date, a put option grants the bond- holder the right to have the bond issue retired prior to the maturity date. Step 1: Create a trust dedicated to making payments due on the bond issue. Step 2: Place in the trust U.S. government securities having cash inflows (interest and principal) that match the cash outflows on the firm’s bond (interest and principal). Step 3: Place the securities in the trust. The bond’s interest and prin- cipal payments are made by the trust. 15-Intermed_Long-Term Debt Page 505 Wednesday, April 30, 2003 12:02 PM 506 FINANCING DECISIONS Put provisions have been used for reasons other than to protect the bondholder against a rise in interest rates after the bond is issued. The right to sell the debt back is permitted under special circumstances. In the late 1980s, many firms took on a great deal of debt, increasing the risk of default on all their debt obligations. Many debtholders found themselves with debt whose default risk increased dramatically. Put pro- visions were included in bond indentures as a way of protecting bond- holders. If an event affecting the bond issue took place, such as a leveraged buyout or a downgrade in the credit rating of the issuer, bond- holders have the right to sell the bonds back to the issuer. In the late 1980s, some firms issued puts designed specifically to make takeovers more expensive. Called poison puts, they take affect only under some specified change in control of the firm, such as if some- one acquires more than 20% of the common stock. By designing putable bonds with this feature, the management is able to make any takeover more expensive. Bondholders will want to sell the bonds back to the firm for more than its par value, draining the company of cash. A “change in control” put provision may state: In the event of a change-in-control of Co., each holder will have the one-time optional right to require Co. to repur- chase such holder’s debentures at the principal amount thereof, plus accrued interest. If there is a change in control, as defined in more detail in the indenture, the bond holder can “put” the bond back to the issuer at par value. Convertibility A conversion feature gives the investor the right to exchange the bond issue for some other security of the issuer, typically shares of common stock, at a predetermined rate of exchange. A bond issue that has such a feature is called a convertible bond. The conversion feature must specify the conversion ratio, the num- ber of shares of stock that the bond may be exchanged for of the other security to be acquired. For example, suppose a $1,000 par value bond of ABC Company is convertible into the common stock of ABC Com- pany and the conversion ratio is 20. This means that the bondholder can exchange one bond for 20 shares of common stock. At the time of issuance of a convertible bond, the issuer effectively grants the bondholder the right to purchase the common stock at a price equal to the bond’s par value divided by the conversion ratio. This price is called the stated conversion price. For the ABC Company convertible 15-Intermed_Long-Term Debt Page 506 Wednesday, April 30, 2003 12:02 PM Intermediate and Long-Term Debt 507 bond, the stated conversion price is $50, found by dividing the par value of $1,000 by the conversion ratio. At the time the convertible bonds are issued, the stated conversion price is often 15 to 20% above the current market price of the common share. The bondholder must hold the bond until it becomes attractive to convert it into shares of stock. It won’t be worth converting unless the price of the shares of stock increases. After the convertible bond has been issued, the price of the convert- ible bond will change due to changes in interest rates (just as bonds without a conversion feature would change) and due to changes in the price of the security that the bond issue can be converted into. Subse- quent buyers of the convertible bond are effectively buying the common stock when they buy the convertible bond at a price that reflects the bond’s prevailing market price. This price is called the effective conver- sion price or simply conversion price and is found by dividing the cur- rent market price of the bond by the conversion ratio. So, for example, if the current market price of ABC Company’s convertible bond is $900, the conversion price is $45 found by dividing $900 by 20. Another measure used by buyers of convertible bonds is the bond’s conversion value. This is the value of the convertible bonds that would be obtained by converting it. The conversion value is obtained by multi- plying the current market price of the common stock by the conversion ratio. For example, suppose that the price of ABC Company’s common stock is $60. Since the conversion ratio is 20, the conversion value is $1,200 ($60 × 20). The decision to convert will be affected by the current market price of the common stock. But it is not the only factor that influences a bondholder’s decision to convert the bond. By not converting, the bond- holder continues to get the interest payments. If the bondholder exchanges the bond for common stock, the bondholder does not get this interest but, instead, would be entitled to receive dividends. So the bondholder must to weigh the benefits of holding the bond with the benefits of converting into common stock. Almost all convertible issues are callable by the issuer. This is a valuable feature for issuers who deem the current market price of their stock undervalued enough so that selling stock directly would dilute the equity of current stockholders. The firm would prefer to raise common stock over incurring debt, so it issues a convertible, setting the conver- sion ratio on the basis of a stock price it regards as acceptable. Once the market price reaches the conversion point, the firm will want to see the conversion happen in view of the risk that the stock price may drop in the future. This gives the firm a motive to force conversion, even though 15-Intermed_Long-Term Debt Page 507 Wednesday, April 30, 2003 12:02 PM 508 FINANCING DECISIONS this is not in the interest of the owners of the bond, whose price is likely to be adversely affected by the call. Why does a firm needing funds issue a convertible bond? Conversion is attractive to investors because they can switch their convertible bond to common stock if the shares do well. So, investors are willing to accept a lower yield on convertible bond. This means a lower cost of financing for the issuer. Another reason a firm may issue convertible bond is weak demand for its common stock. But by issuing a convertible bond, the firm is, in effect, issuing a stock at a later time if the stock price increases. Credit (Debt) Ratings We say that an issuer who fails to live up to the terms of the bond agree- ment is “in default.” Since there is always some chance the issuer will not pay interest or principal when promised, or abide by some other part of the debt agreement, there is always some chance of default. For some firms, this chance is extremely small, for others default is likely. Organizations that analyze the likelihood of default and make the information about their opinions to the public in terms of a rating sys- tem are referred to as rating agencies. These organizations are private firms. Organizations that are recognized by the U.S. government as hav- ing ratings that can be used for investment purposes are referred to as “nationally recognized statistical rating organizations” (NRSROs). At the time of this writing, there are three NRSROs—Moody’s Investors Service, Standard & Poor’s Corporation, and Fitch. The rating systems use similar symbols, as shown in Exhibit 15.4. The ratings are referred to as debt ratings or credit ratings. Credit ratings are important for the cost of and marketability of debt. Many banks, pension funds, and governmental bodies are restricted from investing in securities that do not have a minimum credit rating. Because investors want to be compensated for risk, the greater the default risk associated with debt, as represented by the credit ratings, the greater the yield on debt demanded by investors. The greater the yield required means the greater the cost of raising funds via debt. Rating Systems In all systems the term high grade means low default risk, or conversely, high probability of future payments. The highest-grade bonds are desig- nated by Moody’s by the symbol Aaa, and by the other two rating agen- cies by the symbol AAA. The next highest grade is denoted by the symbol Aa (Moody’s) or AA (the other two rating agencies); for the third grade all rating agencies use A. The next three grades are Baa or BBB, Ba or BB, and B, respectively. There are also C grades. 15-Intermed_Long-Term Debt Page 508 Wednesday, April 30, 2003 12:02 PM Intermediate and Long-Term Debt 509 EXHIBIT 15.4 Summary of Corporate Bond Rating Systems and Symbols Fitch Moody’s S&P Summary Description Investment Grade—High Creditworthiness AAA Aaa AAA Gilt edge, prime, maximum safety AA+ Aa1 AA+ AA Aa2 AA High-grade, high-credit quality AA− Aa3 AA− A+ A1 A+ A A2 A Upper-medium grade A− A3 A− BBB+ Baa1 BBB+ BBB Baa2 BBB Lower-medium grade BBB− Baa3 BBB− Speculative—Lower Creditworthiness BB+ Ba1 BB+ BB Ba2 BB Low grade, speculative BB− Ba3 BB− B+ B1 B B2 B Highly speculative B− B3 Predominantly Speculative, Substantial Risk, or in Default CCC+ CCC+ CCC Caa CCC Substantial risk, in poor standing CC Ca CC May be in default, very speculative C C C Extremely speculative CI Income bonds—no interest being paid DDD DD Default DD 15-Intermed_Long-Term Debt Page 509 Wednesday, April 30, 2003 12:02 PM 510 FINANCING DECISIONS Bonds rated triple A (AAA or Aaa) are said to be prime; double A (AA or Aa) are of high quality; single A issues are called upper-medium grade; and triple B are medium grade. Lower-rated bonds (i.e., bonds rated below triple B) are said to have speculative elements or be dis- tinctly speculative. All rating agencies use rating modifiers to provide a narrower credit quality breakdown within each rating category. S&P and Fitch use a rat- ing modifier of plus and minus. Moody’s uses 1, 2, and 3 as its rating modifiers. Bond issues that are assigned a rating in the top four categories are referred to as investment-grade bonds. Issues that carry a rating below the top four categories are referred to as noninvestment-grade bonds or speculative bonds, or more popularly as high-yield bonds or junk bonds. Thus, the corporate bond market can be divided into two sec- tors: the investment-grade and noninvestment-grade markets. Ratings of bonds change over time. Issuers are upgraded when their likelihood of default (as assessed by the rating agency) decreases, and downgraded when their likelihood of default (as assessed by the rating agency) increases. It is important to remember that debt ratings reflect credit quality only—no evaluation is done of other risks (e.g., interest rate risk) associ- ated with the debt. The rating process involves the analysis of a multi- tude of quantitative and qualitative factors over the past, present, and future. The ratings apply to the particular issue, not the issuer. A rating is only an opinion or judgment of an issuer’s ability to meet all of its obligations when due, whether during prosperity or during times of stress. The purpose of ratings is to rank issues in terms of the probabil- ity of default, taking into account the special features of the issue, the relationship to other obligations of the issuer, and current and prospec- tive financial condition and operating performance. Factors Considered in Assigning a Rating In conducting its examination, the rating agencies consider the four Cs of credit—character, capacity, collateral, and covenants. The first of the Cs stands for character of management, the foundation of sound credit. This includes the ethical reputation as well as the business qualifications and operating record of the board of directors, management, and execu- tives responsible for the use of the borrowed funds and repayment of those funds. Character analysis involves the analysis of the quality of management. Although difficult to quantify, management quality is one of the most important factors supporting an issuer’s credit strength. When the unexpected occurs, it is management’s ability to react appro- 15-Intermed_Long-Term Debt Page 510 Wednesday, April 30, 2003 12:02 PM [...]... or $117, 060 ,000 for the entire issue The premium on these bonds $170 .60 (= $1,170 .60 – $1,000.00) per bond or $17, 060 ,000 in total and the flotation expenses—the $300,000 to pay the underwriters who sell the new bonds—are deductible for tax purposes If the firm faces a 40% tax rate, this means that the premium to buy back the old bonds only costs the firm 60 % of $17, 060 ,000, or $10,2 36, 000, and the flotation... the flotation expenses only cost 60 % of $300,000, or $180,000 The government pays for the difference by allowing the firm to lower its taxable income by $17, 360 ,000 (= $300,000 + $17, 060 ,000): Item Cost Firm’s Share Government’s Share Premium on old bonds Flotation costs on new bonds $17, 060 ,000 300,000 $10,2 36, 000 180,000 $6, 824,000 120,000 Total $17, 360 ,000 $10,4 16, 000 $6, 944,000 Therefore, considering... coupon rate of 16% , at par value so that its yield is 16% , then to realize that 16% each coupon payment must be reinvested to earn at least 16% If the coupon payments are reinvested at a rate of less than 16% , then the investor would earn less than 16% In fact, the investor could earn less than 16% if interest rates dropped In fact, interest rates did drop substantially since the early 1980s and investors... Toys for Kids would then be as follows: Interest paid On floating-rate bonds issued = 6- month LIBOR + 80 bp On interest rate swap = 10.85% Total = 11 .65 % + 6- month LIBOR Interest received On interest rate swap = 6- month LIBOR Net cost Interest paid Interest received Total = 11 .65 % + 6- month LIBOR = 6- month LIBOR = 11 .65 % As can be seen, by using the interest rate swap Toys for Kids is able to obtain... expense and thereby reduces current earnings.3 SUMMARY ■ Intermediate and long-term debt securities include term loans and bonds (notes) that have characteristics that can be packaged in different ways 3 The difference between the debt’s book value and the amount paid to retire the issue is treated as an extraordinary gain or loss [Statement of Financial Accounting Standards No 4, Reporting Gains and Losses... callable at 1 06 at any time Their outstanding bonds are priced to yield 6% on a bond-equivalent basis (i.e., a six-month yield of 3%) and the treasurer believes that if the bonds could retire the existing bonds, they could issue new bonds at par with a 6% coupon rate Pact Company’s marginal tax rate is 40% a What is the total market value of the outstanding bonds? b Should Pact Company buy the outstanding... yield 6% (that is, 3% per six-month period) The value of an old bond per $1,000 of par value is: 10 Value of old bond = $50 $1,000 ∑ -t + 10 t = 1 (1 + 0.03 ) ( 1 + 0.03 ) = $4 26. 51 + $744.09 = $1,170 .60 525 Intermediate and Long-Term Debt If the old bonds are not callable and the treasurer were to buy these bonds in the financial markets, the issuer would have to pay $1,170 .60 ...Intermediate and Long-Term Debt 511 priately that will sustain the company’s performance In assessing management quality, the analysts at Moody’s, for example, try to understand the business strategies and policies formulated by management The next C is capacity or the ability of an issuer to repay its obligations In assessing the ability of an issuer to pay, an analysis of the financial... 517 Intermediate and Long-Term Debt For Quick Funding Finance: Pay floating rate of 6- month LIBOR Receive fixed rate of 10 .6% For Toys for Kids: Pay fixed rate = 10.85% Receive floating rate = 6- month LIBOR The cost of the bond issue for Quick Funding Finance would then be as follows: Interest paid On fixed-rate bonds issued = 10.5% On interest rate swap = 6- month LIBOR Total = 10.5% + 6- month LIBOR Interest... $17, 360 ,000 $10,4 16, 000 $6, 944,000 Therefore, considering the flotation costs, the treasurer has to issue new 6% bonds with a par value of $110,3 56, 000 (= $117, 060 ,000 – $6, 824,000 + $120,000) to replace the 10% bonds If the treasurer does this, the firm will have interest payments of 3% of $110,3 56, 000 or $3,310 ,68 0 every six months instead of 5% of $100,000,000 or $5,000,000 on the old bonds With the old bonds, . of directors, management, and execu- tives responsible for the use of the borrowed funds and repayment of those funds. Character analysis involves the analysis of the quality of management. Although. rate swap = 6- month LIBOR Total = 10.5% + 6- month LIBOR Interest received On interest rate swap = 10 .6% Net cost Interest paid = 10.5% + 6- month LIBOR Interest received = 10 .6% Total = 6- month. issued = 6- month LIBOR + 80 bp On interest rate swap = 10.85% Total = 11 .65 % + 6- month LIBOR Interest received On interest rate swap = 6- month LIBOR Net cost Interest paid = 11 .65 % + 6- month