Fundamentals of Corporate Finance Fourth Edition Chapter 15

Fundamentals of Corporate Finance Fourth Edition Chapter 15 Debt Financing Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

15. 1 Corporate Debt (1 of 6) • Private Debt – Bank Loans § § Term Loan Syndicated Bank Loan Revolving Line of Credit Asset-Backed Line of Credit – Private Placements Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

15. 1 Corporate Debt (2 of 6) • Public Debt – The Prospectus § Indenture – A formal contract between a bond issuer and a trust company, which represents the bondholders’ interests § Original Issue Discount (OID) Bond – A coupon bond issued at a discount Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Figure 15. 1 Front Cover of the Offering Memorandum for the Hertz Junk Bond Issue Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

15. 1 Corporate Debt (3 of 6) • Public Debt – Unsecured Corporate Debt § Notes § Debentures – Secured Corporate Debt § Mortgage Bonds § Asset-Backed Bonds Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Types of Corporate Debt Table 15. 1 Types of Corporate Debt Secured Debt Unsecured Debt Mortgage bonds (secured with real property) Notes (original maturity of less than 10 years) Asset-backed bonds (secured with any asset) Debentures Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

15. 1 Corporate Debt (4 of 6) • Public Debt – Seniority § A bondholder’s priority, in the event of a default, in claiming assets not already securing other debt § Subordinated Debenture – A debenture issue that has a lower priority claim to the firm’s assets than other outstanding debt § Tranches – Different classes of securities that comprise a single bond issuance Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Hertz’s December 2005 Junk Bond Issues Table 15. 2 Hertz’s December 2005 Junk Bond Issues Blank Tranche 1: Senior Dollar-Denominated Note Tranche 2: Senior Euro-Denominated Note Tranche 3: Senior Subordinated Dollar-Denominated Note Face value $1. 8 billion : 225 million $600 million Maturity December 1, 2014 December 1, 2016 Coupon 8. 875% 7. 875% 10. 5% Issue price Par Par Yield 8. 875% 7. 875% 10. 5% Rating: Blank Standard and Poor’s B B B Moody’s B 1 B 3 Fitch BB− BB+ Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

15. 1 Corporate Debt (5 of 6) • Public Debt – International Bonds § Domestic Bonds – Issued by a local entity and traded in a local market, but purchased by foreigners – Denominated in the local currency § Foreign Bonds – Issued by a foreign company in a local market and are intended for local investors – Denominated in the local currency – Yankee bonds • Foreign bonds issued in the United States Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

15. 1 Corporate Debt (6 of 6) • Public Debt – International Bonds § Eurobonds – International bonds that are not denominated in the local currency of the country in which they are issued § Global Bonds – Combines the features of domestic, foreign, and Eurobonds, and are offered for sale in several different markets simultaneously – Can be offered for sale in the same currency as the country of issuance Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Summary of New Debt Issued as Part of the Hertz LBO Table 15. 3 Summary of New Debt Issued as Part of the Hertz LBO Type of Debt Amount ($ million) Public Debt Blank Senior dollar-denominated 1800. 0 Senior euro-denominated (€ 225 million) 268. 9 Subordinated dollar-denominated 600. 0 Private Debt Blank Term loan 1707. 0 Asset-backed revolving line of credit Asset-backed “fleet debt”* Total 400. 0 6348. 0 $11, 123. 9 * The collateral for this debt was Hertz’s fleet of rental cars. Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

15. 2 Other Types of Bonds (1 of 2) • Sovereign Debt – Debt issued by national governments – Long bonds § Bonds issued by the U. S. Treasury with the longest outstanding maturities (30 years) – TIPS § Treasury Inflation-Protected Securities – STRIPS § Separate Trading of Registered Interest and Principal Securities Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Existing U. S. Treasury Securities Table 15. 4 Existing U. S. Treasury Securities Treasury Security Type Original Maturity Bills Discount 4, 13, 26, and 52 weeks Notes Coupon 2, 3, 5, 7, and 10 years Bonds Coupon 30 years Inflation indexed Coupon 5, 10, and 30 years Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

15. 2 Other Types of Bonds (2 of 2) • Municipal Bonds – – Serial Revenue General Obligation Double-Barreled • Asset-Backed Securities (ABS) – – Asset Securitization Mortgage-Backed Securities (MBS) Prepayment Risk Collateralized Debt Obligations (CDO) Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

15. 3 Bond Covenants • Covenants – Restrictive clauses in a bond contract that limit the issuer from taking actions that may undercut its ability to repay the bonds • Advantages of Covenants – With more covenants, a firms can reduce its costs of borrowing. § The reduction in the firm’s borrowing cost can more than outweigh the cost of the loss of flexibility associated with covenants Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Typical Bond Covenants Table 15. 5 Typical Bond Covenants Restrictions on: Typical Restrictions Issuing new debt New debt must be subordinate to existing debt No new debt unless firm maintains specific leverage or interest coverage ratios Dividends and share repurchases Payouts can be made only from earnings generated after the bond issue Payouts can be made only if earnings exceed some threshold Mergers and acquisitions Mergers are allowed only if the combined firm has a minimum ratio of net tangible assets to debt Asset disposition Maximum amount of assets that can be sold, and/or minimum amount of assets that must be maintained Restrictions on making loans or any other provision of credit Requiring Maintenance of: Accounting measures Minimum retained earnings, working capital, and/or net assets Maximum leverage ratios Source: Adapted from the American Bar Association’s Commentaries on Debentures. Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

15. 4 Repayment Provisions (1 of 8) • Call Provisions – Callable Bond § Call Date § Call Price § Call Premium Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Call Features of Hertz’s Bonds Table 15. 6 Call Features of Hertz’s Bonds Blank Call Features Tranche 1: Senior Dollar-Denominated Note Tranche 2: Senior Euro-Denominated Note Tranche 3: Senior Subordinated Dollar-Denominated Note Up to 35% of the outstanding principal callable at 108. 875% in the first three years. After four years, fully callable at: • 104. 438% in 2010. • 102. 219% in 2011. • Par thereafter. Up to 35% of the outstanding principal callable at 107. 875% in the first three years. After four years, fully callable at: • 103. 938% in 2010. • 101. 969% in 2011. • Par thereafter. Up to 35% of the outstanding principal callable at 110. 5% in the first three years. After five years, fully callable at: • 105. 25% in 2011. • 103. 50% in 2012. • 101. 75% in 2013. Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

15. 4 Repayment Provisions (2 of 8) • Call Provisions – Call Provisions and Bond Prices § Investors will pay less for a callable bond than for an otherwise identical noncallable bond § A firm raising capital by issuing callable bonds instead of non-callable bonds will either have to pay a higher coupon rate or accept lower proceeds Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

15. 4 Repayment Provisions (3 of 8) • Call Provisions – Yield to Call § The yield of a callable bond calculated under the assumption that the bond will be called on the earliest call date – Yield to Worst § Quoted by bond traders as the lower of the yield to call or yield to maturity Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

15. 4 Repayment Provisions (4 of 8) • Sinking Fund – A company makes regular payments into a fund administered by a trustee over the life of the bond – These payments are then used to repurchase bonds, usually at par • Balloon Payment – A large payment that must be made on the maturity date of a bond when the sinking fund payments are not sufficient to retire the entire bond issue Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

15. 4 Repayment Provisions (5 of 8) • Convertible Provisions – Convertible Bonds – Conversion Ratio Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

15. 4 Repayment Provisions (6 of 8) • Convertible Provisions – Convertible Bond Pricing § Consider a convertible bond with a $1000 face value and a conversion ratio of 20 § If you converted the bond into stock on its maturity date, you would receive 20 shares – If you did not convert, you would receive $1000 § Conversion Price – By converting the bond you essentially “paid” $1000 for 20 shares, implying a conversion price per share of $1, 000/20 = $50 Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

15. 4 Repayment Provisions (7 of 8) • Convertible Provisions – Convertible Bond Pricing § Straight (Plain-Vanilla) Bond – A non-callable, non-convertible bond – Convertible Bonds and Stock Prices § When a firm’s stock price is low, conversion is unlikely, and the value of the convertible bond is close to that of a straight bond § When a firm’s stock price is much higher than the conversion price, conversion is very likely and the convertible bond’s price is close to the price of the converted shares Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Figure 15. 2 Convertible Bond Value Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

15. 4 Repayment Provisions (8 of 8) • Convertible Provisions – Combining Features § Companies have flexibility in setting the features of the bonds they issue – Leveraged Buyout (LBO) § When a group of private investors purchases all the equity of a public corporation and finances the purchase primarily with debt Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Real. Networks’ 2003 Convertible Debt Issue Table 15. 8 Real. Networks’ 2003 Convertible Debt Issue Convertible Subordinated Notes Blank Issued under Rule 144 A Blank Aggregate principal amount: $100 million Proceeds net of offering costs: $97. 0 million Coupon: 0% Conversion ratio: 107. 5650 shares per $1000 principal amount Call date: July 1, 2008 Call price: 100% Maturity: July 1, 2010 Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Fundamentals of Corporate Finance Fourth Edition Chapter 15 Appendix Using a Financial Calculator to Calculate Yield to Call Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.

Using a Financial Calculator to Calculate Yield to Call (1 of 3) • Calculate the Yield to Call of the bond in Example 15. 1: – HP 10 -B II: Press [Orange Shift] and then the [C] button to clear all previous entries – Enter the number of periods, PV, PMT, and FV as with yield to maturity, but for N enter the number of periods until the bond is eligible to be called for FV enter the price you would receive if it’s called (in this case the same as par) Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.