Lecture 13

Term & LT Financing

From the desk of Adeel Durvesh

Key Sources of
Value Creation
Industry Attractiveness

Growth Barriers to Other --

phase of competitive e.g., patents,
product entry temporary
cycle monopoly
power,
oligopoly
pricing

Marketing Superior
and Perceived
Cost quality organizational
price capability

Competitive Advantage
 What sources of long-term
capital do firms use?

Long-Term Capital

Long-Term Debt Preferred Stock Common Stock

Retained Earnings New Common Stock

 Term Loans & Leases
Term Loan -- Debt originally scheduled
for repayment in more than 1 year, but
generally in less than 10 years.
 Credit is extended under a formal loan arrangement.
 Usuallypayments that cover both interest and
principal are made quarterly, semiannually, or
annually.
 The repayment schedule is geared to the borrower’s
cash-flow ability and may be amortized or have a
balloon payment.
 Costs of a Term Loan
 The interest rate is higher than on a short-
term loan to the same borrower (25 to 50
basis points on a low risk borrower).
 Interest rates are either (1) fixed or (2)
variable depending on changing market
conditions -- possibly with a floor or ceiling.
 Borrower is also required to pay legal
expenses (loan agreement) and a
commitment fee (25 to 75 basis points) may
be imposed on the unused portion.
 Benefits of a Term Loan
 The borrower can tailor a loan to their
specific needs through direct negotiation
with the lender.
 Flexibility in terms of changing needs allows
the borrower to revise the loan more quickly
and more easily.
 Term loan financing is more readily available
over time making it a more dependable
source of financing than, say, the capital
markets.
Revolving Credit Agreements
Revolving Credit Agreement -- A formal, legal
commitment to extend credit up to some
maximum amount over a stated period of time.

Provisions of Loan Agreements

Loan Agreement -- A legal agreement specifying
the terms of a loan and the obligations of the
borrower.
 Covenant -- A restriction on a borrower imposed by
a lender; for example, the borrower must maintain
a minimum amount of working capital.
 Formulation of Provisions
The important protective covenants fall into
three different categories.
 General provisions are used in most loan
agreements, which are usually variable to fit the
situation.
 Routine provisions used in most loan
agreements, which are usually not variable.
 Specific provisions that are used according to the
situation.
 Frequent
General Provisions
 Working capital requirement
 Cash dividend and repurchase of
common stock restriction
 Capital expenditures limitation
 Limitation on other indebtedness
 Frequent
Routine Provisions
 Furnish financial statements and maintain
adequate insurance to the lender
 Must not sell a significant portion of its
assets and pay all liabilities as required
 Cannot sell or discount accounts receivable
 Prohibited from entering into any leasing
arrangement of property
 Restrictions on other contingent liabilities
 Equipment Financing
 Loans are usually extended for more than 1 year.
 The lender evaluates the marketability and quality of
equipment to determine the loanable percentage.
 Repayment schedules are designed by the lender so
that the market value is expected to exceed the loan
balance by a given safety margin.
 Trucking equipment is highly marketable, and the
lender may advance as much as 80% of market
value
 Sources and Types of
Equipment Financing
Sources of financing are commercial banks,
finance companies, and sellers of equipment.
Types of financing
1. Chattel Mortgage -- A lien on specifically
identified property (assets other than real
estate) backing a loan.
 Sources and Types of
Equipment Financing
2. Conditional Sales Contract -- A means of financing
provided by the seller of equipment, who holds title
to it until the financing is paid off.
 The buyer signs a conditional sales contract
security agreement to make installment payments
(usually monthly or quarterly) over time.
 The seller has the authority to repossess the
equipment if the buyer does not meet all of the terms
of the contract.
 The seller can sell the contract without the buyer’s
consent -- usually to a finance company or bank.
 Lease Financing
Lease -- A contract under which one party, the
lessor (owner) of an asset, agrees to grant the
use of that asset to another, the lessee, in
exchange for periodic rental payments.
 Issues in Lease Financing
 Advantage: Use of an asset without
purchasing the asset
 Obligation: Make periodic lease payments
 Contract specifies who maintains the asset
 Full-service lease -- lessor pays maintenance
 Net lease -- lessee pays maintenance costs
 Cancelable or noncancelable lease?
 Operating lease (short-term, cancelable) vs.
financial lease (longer-term, noncancelable)
 Options at expiration to lessee
CONDITIONS OF FINANCE LEASE
 Transfer of title at the end of the
period
 Lease period should be atleast 75%
of the asset life
 PVof lease rentals should atleast be
90% of the asset value
 Leasemoney/security deposit=
Residual value. It is also known as
Bargain Purchase Price
 Types of Leasing
Sale and Leaseback -- The sale of an asset with
the agreement to immediately lease it back for
an extended period of time.
Direct Leasing -- Under direct leasing a firm
acquires the use of an asset it did not
previously own.
 The firm often leases an asset directly
from a manufacturer (e.g., IBM leases
computers and Xerox leases copiers).
 Types of Leasing
Leverage Leasing -- A lease arrangement in which the
lessor provides an equity portion (usually 20 to 40
percent) of the leased asset’s cost and third-party
lenders provide the balance of the financing.

 Popular for big-ticket assets such as aircraft, oil

rigs, and railway equipment.
 The role of the lessor changes as the lessor is
borrowing funds itself to finance the lease for the
lessee (hence, leveraged lease).
 Bonds and Their Features
Bond -- A long-term debt instrument
with a final maturity generally being
10 years or more.
Basic Terms
Par Value Coupon Rate
Maturity Bond Ratings
 Trustee and Indenture
Trustee -- A person or institution designated
by a bond issuer as the official
representative of the bondholders. Typically,
a bank serves as trustee.

Indenture -- The legal agreement, also called

the deed of trust, between the corporation
issuing bonds and the bondholders,
establishing the terms of the bond issue and
naming the trustee.
 Types of Long-Term
Debt Instruments
Debenture -- A long-term, unsecured debt
instrument.
Subordinated Debenture -- A long-term,
unsecured debt instrument with a lower claim
on assets and income than other classes of
debt; known as junior debt.

Income Bond -- A bond where the payment of

interest is contingent upon sufficient
earnings of the firm.
 Types of Long-Term
Debt Instruments
Junk Bond -- A high-risk, high-yield (often
unsecured) bond rated below investment
grade.

Mortgage Bond -- A bond issue secured by a

mortgage on the issuer’s property. The
issue is secured by a lien on specific assets
of the corporation.
 Retirement of Bonds
Sinking Fund -- Fund established to periodically
retire a portion of a security issue before
maturity. The corporation is required to make
periodic sinking-fund payments to a trustee.
Two forms for the sinking-fund
retirement of a bond:
 The corporation makes a cash payment to the
trustee, which calls the bonds.
 The corporation purchases bonds in the open
market and delivers them to the trustee.
 Serial Bonds
Serial Bonds -- An issue of bonds with
different maturities, as distinguished from
an issue where all bonds have identical
maturities (term bonds).
 For example, a $10 million issue of serial
bonds might have $500,000 of predetermined
bonds maturing each year for 20 years.
 Investors are able to choose the maturity that
best fits their needs (wider investor appeal).
 Call Provision
Call Provision -- A feature in an indenture that
permits the issuer to repurchase securities at
a fixed price (or series of fixed prices) before
maturity; also called call feature.
 Preferred Stock
and Its Features
Preferred Stock -- A type of stock that
promises a (usually) fixed dividend, but at
the discretion of the board of directors.
Basic Terms
Par Value
Dividend Rate
Maturity
 Retirement of
Preferred Stock
 Call Provision -- almost all issues carry a call provision
because of the infinite maturity. It is often a cheaper
method of retirement than open market purchases,
inviting tenders, or an exchange of securities.
 Sinking Fund -- like bonds, many preferred issues
provide for this method of retirement.
 Conversion -- certain issues are convertible into
common stock at the option of the preferred
stockholder. Used most frequently in the acquisition of
other companies (the transaction is not taxable to the
shareholders of the acquired firm).
 Common Stock
and Its Features
Common Stock -- Securities that
represent the ultimate ownership (and
risk) position in a corporation.
Basic Terms
Authorized Shares
Issued Shares
Outstanding Shares
 Dual-Class
Common Stock
Dual-class Common Stock – Two or more classes of
common stock, usually designated Class A and Class
B.