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Chapter 25 Principles of

Corporate

Finance

Ninth Edition

The Many Different

Kinds of Debt

Slides by

Matthew Will

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

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McGraw Hill/Irwin

Topics Covered

Domestic Bonds, Foreign Bonds and Euro Bonds

The Bond Contract

Security and Seniority

Repayment Provisions

Debt Covenants

Convertible Bonds and Warrants

Private Placements and Project Finance

Innovation in the Bond Market


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Bond Terminology

Foreign bonds - bonds that are sold to local investors in another country's bond market

Yankee bond- a bond sold publicly by a foreign company in the United States

Samurai - a bond sold by a foreign firm in Japan

Eurobond market - when European and American multinationals are forced to tap into international markets

for capital


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Bond Terminology

Indenture or trust deed - the bond agreement between the borrower and a trust company

Registered bond - a bond in which the Company's records show ownership and interest and principal are paid directly to each owner

Bearer bonds - the bond holder must send in coupons to claim interest and must send a certificate to claim the final payment of principal

Accrued interest - the amount of accumulated interest since the last coupon payment


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Bond Contract

Trustee Bank of America National Trust and Savings Association

Rights of default

The trustee or 25% of debenture holders may declare the principle due

and payable

Registered Fully registered

Denomination $1,000

Amount issued $250 million

Issue Date 26-Aug-1992

Offered

Issued at a price of 99.489% plus accrued interest (proceeds to

company 98.614%) through First Boston Corporation

Interest At a rate of 8.25% per annum, payable February 15 and August 15

Seniority Ranks pari passu with other unsecured unsubordinated debt

Security

Not secured. Company will not permit to have any lien on its property

or assets without equally and ratably securing the debt securities

Maturity 15-Aug-2022

Sinking fund

Annually from August 15, 2003, sufficient to redeem $12.5 million

principal amount, plus an optional sinking fund of up to $25 million

Callable

At whole or in part on or after August 15, 2002, at the option of the

company with at least 30 days, but not more than 60 days notice to each

August 14 as follows: schedule inserted here

Moody's rating B

Summary of terms of 8.25% sinking fund debenture 2022

issued by J.C. Penney


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Bond Terminology

Debentures - long-term unsecured issues on debt

Mortgage bonds - long-term secured debt often containing a claim against a specific building or

property

Asset-backed securities - the sale of cash flows derived directly from a specific set of bundled

assets


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Recovery Rates

77.5

62

42.6

30.3 29.2

19.1

0

10

20

30

40

50

60

70

80

Bank Debt Senior

secured notes

Senior

unsecured

notes

Senior

subordinated

notes

Subordinated

notes

Junior

subordinated

notes

Ultimate Percentage Recovery Rates on

Defaulting Debt (1987 2005) R

eco

ver

y P

erce

nta

ge


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Bond Terminology

Sinking fund - a fund established to retired debt before maturity

Callable bond - a bond that may be repurchased by a the firm before maturity at a specified call price

Defeasance - a method of retiring corporate debt involving the creation of a trust funded with

treasury bonds


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Bond Terminology

Restrictive covenants - Limitations set by bondholders on the actions of the Corporation

Negative Pledge Clause - the processing of giving unsecured debentures equal protection and when

assets are mortgaged

Poison Put - a clause that obliges the borrower to repay the bond if a large quantity of stock is bought by

single investor, which causes the firms bonds to beat

down rated


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Bond Terminology

Pay in kind (PIK) - a bond that makes regular interest payments, but in the early years of the bonds life the issuer

can choose to pay interest in the form of either cash or

more bonds with an equivalent face value

Puttable bond A provision that allows the bondholder to demand immediate payment. This is the central feature in

loan guarantees issued by the government.


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Straight Bond vs. Callable Bond

Value of

straight bond

25 50 75 100 125 150

25

50

75

100

bond

Value of Straight bond

bond callable

at 100


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Covenants

Debt ratios:

Senior debt limits senior borrowing

Junior debt limits senior & junior borrowing Security:

Negative pledge Dividends Event risk Positive covenants:

Working capital

Net worth


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Event Risk: An Example

October 1993 Marriott spun off its hotel management business worth 80% of its

value.

Before the spin-off, Marriotts long-term book debt ratio was 2891/3644 = 79%.

Almost all the debt remained with the parent (renamed Host Marriott), whose

debt ratio therefore rose to 93%.

Marriotts stock price rose 13.8% and its bond prices declined by up to 30%.

Bondholders sued and Marriott modified its spinoff plan.


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What is a Convertible Bond?

Ford 4.25% Convertible 2036

Convertible into 108.7 shares

Conversion ratio 108.7

Conversion price = 1000/108.7 = $9.20

Market price of shares = $12.00

Lower bound of value Bond value

Conversion value = 108.7 x 12 = $1,304


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How bond value varies with firm value at maturity

0

1

2

3

0 1 2 3 4 5

Value of firm ($ million)

default

bond repaid in full

Bond value ($ thousands)


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How conversion value at maturity varies with firm value

0

1

2

3

0 0.5 1 1.5 2 2.5 3 3.5 4


Conversion value ($ thousands)


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How value of convertible at maturity varies with firm value

0

1

2

3

0 1 2 3 4


default

bond repaid in full

convert

Value of convertible ($ thousands)


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Bond Warrant Package

Bond and Option

Warrants are usually issued privately

Warrants can be detached

Warrants are exercised for cash

A package of bonds and warrants may be taxed

differently

Warrants may be issued on their own


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Project Finance

1. Project is set up as a separate company.

2. A major proportion of equity is held by project

manager or contractor, so provision of finance and

management are linked.

3. The company is highly levered.


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Parties In Project Finance

Contractor Supplier(s)

Equity investors

Government Project

company

Equity sponsor

Lenders

Purchaser(s)


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Risk Allocation

Risk Shifted to: Contract

Completion/

continuing

management

Sponsor Management contract/

completion gtees / working

capital maintenance

Construction cost Contractor Turnkey contract/ fixed price/

delay penalties

Raw materials Supplier(s) Long-term contract/ indexed

prices/ supply or pay

Revenues Purchaser(s) Long-term contract/ indexed

to costs/ take or pay/

throughput agreements/ tolling

contract

Concession/regulation Government Concession agreement/

provision of supporting

infrastructure

Currency

convertibility

Government Gtees or comfort letters/ hard

currency paid to offshore

escrow account


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Bond Innovations

Liquid yield option notes

(LYONS) Puttable, callable, convertible zero coupon debt

Floating-price (death

spiral) convertibles

Convertible debt where the bondholder can convert into a fixed value

of shares

Asset backed securities Many small loans are packaged together and resold as a bond

Catastrophe (CAT) bonds Payments are reduced in the event of a specific natural disaster

Reverse floaters (yield

curve notes)

Floating rate bonds that pay a higher rate of interest when other interest

rates fall and a lower rate when other rates rise

Equity linked bonds Payments are linked to the performance of a stock market index

Pay-in-kind bonds (PIKs)

Issuer can choose to make interest payments either in cash or in more

bonds with an equivalent face value

Rate sensitive bonds Coupon rate changes as company's credit rating changes

Ratchet bonds Floating rate bonds whose coupons can only be reset downwards


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Web Resources

www.ipfa.com

www.hbs.edu/projfinportal

Click to access web sites

Internet connection required

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